THE HONG KONG INSTITUTE OF CHARTERED SECRETARIES THE INSTITUTE OF CHARTERED SECRETARIES AND ADMINISTRATORS

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1 THE HONG KONG INSTITUTE OF CHARTERED SECRETARIES THE INSTITUTE OF CHARTERED SECRETARIES AND ADMINISTRATORS International Qualifying Scheme Examination CORPORATE FINANCIAL MANAGEMENT DECEMBER 2012 Time allowed 3 hours Section A Compulsory case study Section B 5 long questions (attempt any 3) DO NOT OPEN THIS PAPER UNTIL INSTRUCTED TO DO SO BY THE INVIGILATOR Important Note: Candidates are allowed 15 minutes reading time to read through the question paper before the commencement of the examination between 9:15a.m.- 9:30a.m. During the reading time, all candidates must be silent and must not write or mark anything on their question papers or answer books. Candidates must close all their reference books, notes or other unauthorised materials and put these under their chairs. If any candidates write or make any marks during the reading time, or if they speak or in any other way communicate with anyone either in or outside the examination hall during this period or read any unauthorised materials, they will be disqualified from continuing this examination paper. Once candidates have opened the question paper, they are not allowed to leave the examination hall until 10:00a.m. Page 1 of 16

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3 SUBJECT NO. 16J CORPORATE FINANCIAL MANAGEMENT DECEMBER 2012 The examination paper is divided into TWO sections. Section A is a case study with compulsory questions and carries 40 marks. Candidates should attempt THREE questions from Section B, all of which carry 20 marks each. You should allow yourself approximately 70 minutes in total to answer the question in Section A, and 35 minutes for each of the questions attempted in Section B. Unless otherwise stated, $ denotes Hong Kong dollars. All interest rates are annual rates. Round your numerical answers to two decimal places. Friday morning 7 December 2012 SECTION A Time allowed: 3 hours (Compulsory answer ALL questions in this section) 1. Precision Technic Limited (PTL) is a listed manufacturing company. Its main products are electronic items and computer accessories. To increase productivity and reduce operating costs, PTL plans to acquire a new Electro-Discharge Machining (EDM) wire-cut machine, model Supreme Ex886 (Ex886). A decision has to be made whether to buy or lease the new machine. Ex886 could be purchased from a local supplier at a cost of $500,000, which would be paid on 31 March The annual maintenance costs and insurance would be $40,000 and $5,000 respectively payable from the first full financial year after the purchase. After three years, on 31 March 2015, the machine could be sold for approximately $40,000. If PTL were to purchase Ex886, it would be entitled to claim capital allowances at 30% per annum calculated on the reducing balance method. Alternatively, the same machine could be leased on a three-year contract in the rental market. The annual leasing fee of $150,000 would be payable in advance on 31 March 2012, 31 March 2013 and 31 March The maintenance costs and insurance would all be included in the annual leasing fee, as stated in the leasing contract. Page 3 of 16

4 Mr. Au, the Financial Controller of PTL, estimates that no profit tax will be payable by PTL for the year ended 31 March However, the company expects to have to pay profits tax in respect of the year commencing 1 April 2012 and years thereafter. The tax is paid in a year after the accounting year end. The capital allowances can be deducted for tax purposes in the year of acquisition of the assets concerned but not in the year of disposal. Any balancing adjustments arising from the sale of assets can be taken into account in the year of disposal. The profit tax rate for corporations is 20%. It can be assumed that any related tax benefits for capital allowances, balancing adjustments and lease payments in a loss making year can be carried forward to be set off against tax payable in future years. Ex866 is expected to generate $200,000 cash inflows per annum for three years. If it were to buy the machine, PTL would apply for an additional bank loan from Worldwide Kowloon Bank (WKB). The prevailing bank interest rate is 12.5% per annum. On assessing the risk associated with cash flows for Ex886, the company s external consultant thinks that a 15% after-tax return on this investment is required. Except for the lease payments, it is assumed that all cash flows made will occur at the year end. Recently, management has been worried about the changing business environment. In order to improve its position in the industry, PTL has made a takeover for Quality Limited (QL) which is a small competitor in the same industry. Both companies are listed in the Hong Kong stock market. The market information is as follows: Share price Number of shares PTL $ million QL $ million PTL s management has proposed two options to QL. The first proposal is a share offer of three shares of PTL for one share of QL. The second proposal is a cash offer of $16 per share of QL. PTL s management expects that synergies effect would be achieved after the takeover bid as excess operating assets and extra man-power would be reduced by re-engineering the organisational structure. The takeover bid could generate additional savings of $500 million in present value terms. REQUIRED: Provide the following information in responses to the following questions raised by the directors: (a) (b) (c) Assume it is now 31 March Critically evaluate which financing method for the EDM wire-cut machine is best. (15 marks) Based on the estimated cash flow generated by Ex886, discuss whether it should be acquired or leased. (5 marks) Suggest the non-financial factors that may influence the decision to lease or buy Ex886. (8 marks) Page 4 of 16

5 (d) Critically discuss whether a share offer or cash offer will be accepted by QL s shareholders. (12 marks) (Total: 40 marks) Page 5 of 16

6 SECTION B (Answer THREE questions from this section) 2. Giant Tiger Limited (GTL) is a private company with capital size of nearly $10 billion. It has planned to issue a 5-year redeemable Debenture X and 10-year redeemable Debenture Y. The annual coupon rate on Debenture X and Debenture Y are 10% and 6% respectively. The coupon on Debenture X is to be paid in arrears of the relevant year while that of Debenture Y to be paid in advance. The face value for both debentures is $1,000 and they will both be redeemable at par value on maturity. REQUIRED: (a) (b) (c) (d) Assuming the market interest rate is 8%, evaluate the issue prices of Debenture X and Debenture Y. (5 marks) Explain with the reasons why investors are willing to pay a higher price than the face value of an investment. (5 marks) Evaluate which debenture is more attractive if the market interest rate is expected to fall substantially. (5 marks) GTL is considering issuing convertible debentures as a financing alternative. What are the benefits to GTL of issuing convertible debentures to raise funds? (5 marks) (Total: 20 marks) Page 6 of 16

7 3. In the latest Budget speech, the government has just announced it will lower the profits tax rate by six percentage points from 21% to 15%. During a management meeting, the directors of Big Mac Limited (BML) wish to know what the implications will be for BML s share price and cost of capital. BML s current capital structure is: Equity Ordinary share capital ($0.9 at par) Share premium Other reserves Liabilities 12% non-redeemable debentures ($100 at par) $ million BML is a public company with its shares and debentures listed on the stock market. The market price for the shares and debentures are $5 ex-dividend and $180 ex-interest respectively. The market return is 15% per annum. The tax reduction will result in an increase in the company s operating cash flow of $66.48 million in net present value terms. The equity beta of BML was 1.3 before the announcement. REQUIRED: Assume that the cost of debt and the market price of debt remain unchanged after the tax reduction; and that BML s debt is risk free. Ignore the provisional profits tax. (a) Evaluate BML s current cost of capital. (6 marks) (b) (c) Using Modigliani and Miller s theory of capital structure (with tax) estimate BML s expected share price and expected cost of capital after the tax reduction. (9 marks) Discuss the financial risk implications between the current cost of capital in part (a) and the expected cost of capital after the tax reduction in part (b), and recommend the finance strategy for BML. (5 marks) (Total: 20 marks) Page 7 of 16

8 4. Hewlette Industries Limited (HIL) is a principal subsidiary of a large listed company. It is the group s policy that the financial position of its subsidiary is evaluated using the net current assets ratio. The parent company sets HIL targets for working capital items like inventories, trade receivables, trade payables and cash levels. Due to the nature of business, most of the products made by HIL are fashion items with a short product life cycle. As such, it is hard for HIL to budget future sales. It is preset that inventories should be kept within the range of 5% to 8% of sales of previous year; trade receivables should be less than 2 months credit sales while trade payables should be more than 1.5 months purchases. When the cash level is more than 15% of the cash target, HIL is required to make a short-term deposit. When cash level drops to less than 5% of the cash target, a withdrawal is made from interest-bearing loans to meet the target cash level. This cash target is derived from the net current assets ratio after the targets set for inventories, trade receivables and trade payables mentioned above have been applied. In other words, the net current assets ratio is calculated based on the adjusted inventories, trade receivables and trade payables in accordance with the preset targets. REQUIRED: (a) (b) Analyse and discuss the disadvantages in the adoption of the above four areas of working capital controls in Hewlette Industries Limited. (15 marks) Assume that inventory turnover is six times, trade receivable days are 90 days and trade payable days are 50 days, and one year is equivalent to 360 days. Calculate the cash operating cycle. (5 marks) (Total: 20 marks) Page 8 of 16

9 5. You are the investment consultant of a well-diversified company, Capital Victory Limited (CVL). Two investment projects have been proposed during the management meeting. The costs and cash flows are predicted as follows: Project Industry (Costs) / Revenues $ 000 Year: Textile Food (26,000) (33,000) 10,000 8,000 10,000 10,000 10,000 20,000 10,000 15,000 CVL is financed by equity only. Its cost of capital is 12%. The market rate of return is 2% less than the cost of capital. The risk-free rate of return is 4% and the beta factors of different industries, which are undiversified and unleveraged, are as follows: Electrical Food Electronic Textile Transport Paper REQUIRED: (a) Explain which of the two projects should be chosen on the basis of: (i) net present value; and (ii) internal rate of return. (10 marks) (b) If the beta factors have been taken into account in evaluating project 1 and project 2, discuss which of the projects should be chosen on the basis of net present value. (10 marks) (Total: 20 marks) Page 9 of 16

10 6. Integrated International Limited (IIL) is a multi-national company. Its headquarters are in Hong Kong. IIL s policy requires its subsidiaries to minimise internally the effects of transactions in foreign currencies. IIL has subsidiaries in Singapore, Australia and Italy. For inter-company balances, it is forecast that at the end of the current month, Singaporean subsidiary will be owed SGD2,880,000 by the Australian subsidiary and the Singaporean subsidiary will owe the Italian subsidiary EUR2,050,800. The Australian subsidiary will be owed AUD6,626,000 by the Italian subsidiary and the Australian subsidiary will owe the Italian subsidiary EUR1,526,000. The finance unit at headquarters is required to net off inter-company balances in HK$ and to instruct the subsidiaries to settle the net balances. For this purpose the relevant exchange rates from ABC Bank are as follows: Currency Buy rate (HK$) Sell rate (HK$) Singapore (SGD) Australia (AUD) Italy (EUR) REQUIRED: (a) (b) Evaluate the net payments among IIL s subsidiaries. Discuss the pros and cons of this multilateral netting. (14 marks) (6 marks) (Total: 20 marks) End of Examination Paper Page 10 of 16

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