The following learning and growth perspective measures could enhance the implementation and management of Wellgas strategy:

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Griselda Dickerson
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1 SECTION A CASE QUESTIONS (Total: 50 marks) Answer 1(a) Wellgas strategy is to transform a fill-the-petrol tank routine into a delightful shopping experience for service-oriented customers who are ready to pay above the average price fuel. It aims to differentiate itself from other competitors in the marketplace. The focus of the balanced scorecard is on the measures of process improvement, quality of service, market share target and financial success through service differentiation. The scorecard mainly monitors the service differentiation strategy implementation. The scorecard seems to show Wellgas is doing a good job with this strategy. Apart from market share target missing, it has achieved most of the other targets from different perspectives. From Financial perspective, in order to increase shareholder value, Wellgas operating profit changes from price recovery and profit changes from growth have over achieved its target performance. From Internal business process perspective, in order to improve service delivery, Wellgas has over achieved its target quality index. Wellgas achieved 95% of refinery processes with advanced controls which means Wellgas has increased refinery process capability and over achieved its target 89% which demonstrates Wellgas has done a good job from learning and growth perspective. Since Wellgas is focusing on a specific target market within the whole market, the slight miss on the overall market share may not be that important. Answer 1(b) The following learning and growth perspective measures could enhance the implementation and management of Wellgas strategy: (i) Increase motivation, empowerment, and alignment such as the number of suggestions per employee, number of suggestions implemented per employee, employee turnover and employee satisfaction. (ii) Increase employee capability measures like hours of in-house training per employee and percentage of job requirements fulfilled. (iii) Increasing information systems capabilities means providing more accurate and timely information to employees to allow them to improve processes and to effectively execute new processes such as the measurement of the percentage of customer facing employees with on-line access to customer and service information. (iv) Increase research and development, provide more advance technology to employees to assist them to improve the processes. Module B (December 2016 Session) Page 1 of 12

2 Answer 1(c) Wellgas strategy is to focus on the service-oriented target market, not on the broad market. Hence, it should measure its market share of the service-oriented target market only, in order to reflect how well it has done. Although Wellgas has failed the customer objectives in its balanced scorecard, Wellgas has managed to achieve all its financial objectives. The reasons for Wellgas to fail their customer objectives may be due to the limitation of the current balanced scorecard mentioned above. Other reasons may be due to Wellgas has not put sufficient focus on their customer services, the quality of their products is unable to meet customers expectation or its failure in marketing strategy etc. However, Wellgas might have adopted a more responsible and discipline financial management strategy such as cost control, good pricing to secure their gross margin, as a result Wellgas has increased their shareholder value accordingly. A customer satisfaction survey may also help with the results received. The number of customer complaints, percentage of customers retained from last month, amount of new customer data would all help in the balanced scorecard to understand the customer s perspective. Answer 1(d) Wellgas should put more measures on the scorecard to determine the linkage between the internal business process and customer perspectives. The existing refinery operations may not provide good evidence of the linkage. Instead, some other measures of the petrol station such as the cleaniness of the facility, turnaround time at the petrol pumps, service provided by the staff could be added to the scorecard. Random audits of the facilities could also enhance the retail outlets performance more accurately. Module B (December 2016 Session) Page 2 of 12

3 Answer 2(a) Common shares: 80 million x HK$64 Preferred shares: 20 million x HK $54 Debt: $1 billion x 102% Value = HK$5.12 billion = HK$1.08 billion = HK$1.02 billion = HK$7.22 billion Re = 15% Rp = HK$6 / HK$54 = % Rd = 6.33% WACC = 5.12 / 7.22 x 15% / 7.22 x % / 7.22 x 6.33% x (1-15%) = % Answer 2(b) CF0 CF1= CF2 CF3 CF4 = - HK$593 million = + HK$126 million = + HK$158 million = + HK$158 million + HK$299 million = + HK$457 million Discount rate = % + 3% = % NPV = - HK$37.9 million Wellgas should not proceed with the project as NPV is negative. Alternative answer with tax consideration: CF0 CF1= CF2 CF3 = - HK$593 million = + HK$126 million x (1 15%) = + HK$107.1 million = + HK$158 million x (1 15%) = + HK$134.3 million CF4 = + HK$158 million x (1 15%) + HK$299 million x (1 15%) = + HK$388.5 million Discount rate = % + 3% = % NPV = - HK$121.2 million Wellgas should not proceed with the project as NPV is negative. Module B (December 2016 Session) Page 3 of 12

4 Answer 2(c) For environmental responsibilities Set stringent environmental targets and measure and report the performance against them as the environmental regulations and the cost for non-compliance have increased significantly. The Shenzhen unit needs to report on its environmental performance as part of its social responsibility disclosures since the successful treatment of environmental concerns is a significant competitive advantage. Make environment performance a line item on every employee s appraisal report card as the management needs fundamental inputs and causes to make sure environmental costs are under control. For ethical responsibilities Codes of business conduct should be circulated to signal appropriate and inappropriate individual behaviour. This will create strong customer and employee loyalty and thus help the company to enjoy better than average financial performance. The top management should communicate the absolute need for all staff to behave ethically at all times, even at the expense of business opportunities, if the firm has a long time vision in business performance. Emphasise ethical behaviour through the routine evaluation and education of employees against a business code of ethics with regard to what is right or wrong in the work environment and to help them to choose what is right. Answer 3(a) Kowloon Gas 2014 Turnover = HK$2,800 / $2,160 Margin = HK$880 / $2,800 ROI = = 1.296x = Alternative answer using total assets to calculate Turnover: 2014 Turnover = HK$2,800 / $2,460 Margin = HK$880 / $2,800 ROI = = 1.138x = Turnover = HK$2,120 / $2,140 Margin = HK$315 / $2,120 ROI = = 0.991x = Alternative answer using total assets to calculate Turnover: 2015 Turnover = HK$2,120 / $2,453 Margin = HK$315 / $2,120 ROI = = 0.864x = Module B (December 2016 Session) Page 4 of 12

5 Island Gas 2014 Turnover = HK$1,400 / $760 Margin = HK$304 / $1,400 ROI = = 1.84x = Alternative answer using total assets to calculate Turnover: 2014 Turnover = HK$1,400 / $993 Margin = HK$304 / $1,400 ROI = = 1.410x = Turnover = HK$2,350 / $1,130 Margin = HK$503 / $2,350 ROI = = 2.08x = Alternative answer using total assets to calculate Turnover: 2015 Turnover = HK$2,350 / $1,393 Margin = HK$503 / $2,350 ROI = = 1.687x = Kowloon Gas s ROI dropped substantially in 2015 as a result of a big decline in its operating margin. ROI for Island Gas increased slightly in 2015 due to an improving asset turnover compared with Answer 3(b) Issac is a better candidate than Kester for the CEO position of Wellgas. Both firms are in the same industry. The ROI of Island Gas is improving while that of Kowloon Gas is dropping in Market research has given Island Gas the top ranking versus the declining ranking of Kowloon Gas. The customer feedback survey for Kowloon Gas is poor. Answer 3(c) The controllable principle is that Kester should only be held accountable for costs over which he has some influence. From a motivation point of view, this is important because it can be very demoralising for Kester who may feel that his performance is being judged on the basis of elements where he has no control, such as the marketing cost decided by head office. The investment decisions of firms tend to have a long term impact, yet in the short term they could affect the ROI due to the higher depreciation expense, everything being equal. The continuous replacement of long term productive assets is important to keep a business sustainable. As a result, Kester has made a good point and the CEO selection committee of Wellgas should take that into account in its decision making. * * * END OF SECTION A * * * Module B (December 2016 Session) Page 5 of 12

6 SECTION B ESSAY / SHORT QUESTIONS (Total: 50 marks) Answer 4 (a) To: Mr Chow, CEO From: Mr Leo Li, Financial Controller Date: XXX Subject: Foreign currency risks You asked me to provide recommendations about the company s foreign currency risks. The following are my recommendations: The mechanisms of a currency option, future and natural hedge Currency options: right of an option holder to buy (call) or sell (put) foreign currency in exchange for another at a specific exchange rate on or before a specified future expiry date. The purchase price for an option is called the option premium. Currency futures: standardised exchanged traded contracts to buy or sell a specific quantity of foreign currency, for settlement at a future date. The prices at which futures are bought and sold are determined by the market (supply and demand) and interest rate differentials. Natural hedge: involves matching receipts and payments or assets and liabilities of a foreign currency. (b) Yen hedging strategies (i) If the investment does not proceed and for each quarter Options: as the direction of the Yen is unclear and the company has a net inflow of Yen, it is worthwhile to consider buying a 12 month Yen put option or buy USD call option on the net amount of revenue and expenses, say 120. If the Yen depreciates to below 120, exercise the option. Otherwise, let it lapse and take advantage of the strengthening of yen. An option premium is needed. The frequency of hedging depends on the volatility of the Yen and management s discretion. A natural hedge does not apply in this case because there is only a net inflow of Yen. Module B (December 2016 Session) Page 6 of 12

7 (ii) If the investment proceeds For the first quarter 2017: Options: the company can buy a 3 month Yen call option or buy USD put option at the exercise price at say, 110 since the overall amount of USD40 million is larger than the annual net inflow of USD( ) million = USD20.0 million, the company would like to be protected when the Yen appreciates. The company will also have to pay an option premium so it has to be taken into consideration. When the Yen appreciates above the exercise price, exercise the option, otherwise let it lapse to enjoy the savings from the Yen s depreciation. For the second quarter and afterwards, use a strategy similar to the scenario if the investment does not proceed. Natural hedge Alternatively, the company can borrow Yen equivalent to USD40 million, repayable in two years time, using the net operating inflow to pay off the loan. No exchange gain or loss will result. (c) In this case, the company may want to negotiate with its suppliers in the PRC and customers in Yen to use USD as the settlement currency. This may affect the company s competitiveness if its competitors do not follow this strategy. If you have any questions, please let me know. Answer 5(a) Total number of shares before rights issue 1,000,000 Subscription price HK$50 Current share price HK$100 A s ownership (%) 60% Independent third parties ownership (%) 40% A s share before issue 600,000 Independent third parties share before issue 400,000 Amount of financing needed HK$12,000,000 No. of new shares to be issued 240,000 Total number of shares after rights issue with full subscription 1,240,000 A s entitlement under rights issue 144,000 Independent third parties entitlement under rights issue 96,000 Module B (December 2016 Session) Page 7 of 12

8 Total amount of money A needs to fully subscribe = no. of shares A is entitled to subscribe x subscription price = 144,000 x HK$50 = HK$7,200,000 Answer 5(b) Subscription ratio = rights to subscribe to one new share = 1,000,000 / 240,000 Theoretical ex-right price = HK$ ( x ) / ( ) Value of one rights = HK$ Shareholders wealth: - before rights issue = (no. of shares x share price) = x after rights issue and sell the rights (no subscription) - after rights issue and full subscription = (no. of shares w/o subscription x ex-right price) + proceeds from selling rights x x = (no. of shares including subscription x ex-right price) - exercise price ( ) x As the existing shareholders wealth is not affected by subscription, therefore the discount on the exercise price is irrelevant. In other words, the shareholders wealth does not benefit from the deep discount of the subscription price. Answer 5(c)(i) If Mr. A does not subscribe at all: A s ownership percentage after rights issue = 48.39% original no. of shares / total number of shares after rights issue 600,000 / 1,240,000 If Mr. A would like to retain control, he has to have at least 51%. If he does not subscribe at all, he will lose control of his company. Module B (December 2016 Session) Page 8 of 12

9 Answer 5(c)(ii) No. of new shares needed by him = 632, x total number of shares after rights issue = 0.51 x 1,240,000 Additional shares needed : = 32, , ,000 Additional money needed: = HK$1,620,000 additional shares x subscription price 32,400 x HK$50 Answer 5(c)(iii) Strategy Mr. A can exercise some rights to obtain the necessary number of shares, financed partially by selling the remaining rights. Total rights entitlement (1 share 1 rights) = 600,000 Total rights needed = 135,000 no. of shares needed to subscribe x subscription ratio = x No. of rights that can be sold = 465, , ,000 Proceeds from selling the rights = HK$4,500, ,000 x Net cash inflow to him HK$2,880,000 proceeds from selling unneeded rights - subscription money = 4,500,000-1,620,000 To ensure 51% ownership Ownership using this strategy: New shares subscribed = 32,400 Original number of shares = 600,000 Total shareholding after rights issue = 632,400 Ownership % = 51% Advice to Mr. A He has to subscribe 32,400 shares using 135,000 rights in order to maintain a 51% ownership and hence control and sell the 465,000 rights from the 600,000 rights received and cashing about HK$2.88 million net inflow. Module B (December 2016 Session) Page 9 of 12

10 Answer 6(a)(i) CS Limited QM Limited No. of shares 100, ,000 Price per share HK$2.5 HK$1 Profit after tax HK$10,000 HK$10,000 EPS HK$0.1 HK$0.1 PE ratio Market value HK$250,000 HK$100,000 Cash paid per share HK$0.5 Exchange ratio 5 CS share price / share component of consideration New CS shares issued (N) 20,000 = 2.5 / 0.5 share component x no. of QM shares / CS share price After acquisition: = 0.5 x 100,000 / 2.5 Total no. of CS shares 120,000 = 100, ,000 Total value of the combined group transferred to QM s shareholders: = N x market value of the combined group / (O + N) = 20,000 x (250, ,000) / 120,000 = 58,333 N: new CS shares issued to QM shareholders O: existing CS shares N = 20,000 O = 100,000 Answer 6(a)(ii) Total consideration = cash price per share x no. of QM shares + total value of the combined group transferred to QM s shareholders = 0.5 x 100, ,333 = 108, Module B (December 2016 Session) Page 10 of 12

11 Premium = total consideration paid - value of QM before acquisition = HK$108,333 - HK$100,000 = HK$8, Answer 6(b)(i) EPS after acquisition = total profit of the combined group / total no. of CS shares after acquisition = (10, ,000) / 120,000 = HK$0.167 Answer 6(b)(ii) The EPS of the CS combined group after acquisition is $0.167, higher than that before the acquisition of 10,000 / 100,000 = HK$0.1. This looks great at first sight as the EPS is 67% higher. In fact, if this were an all cash deal, the EPS would have been even higher i.e. 20,000 / 100,000 = HK$0.2. In terms of shareholder value, the PE of CS before the acquisition is 2.5 / 0.1 = 25. If the market still gives a PE of 25 to the combined group, the share price should be 25 x = HK$4.18, up from HK$2.5 pre-acquisition. However, the market should not be fooled by this dubious EPS growth from acquisition. This is because there is no synergy and the increase in EPS is purely a numerical illusion. The deal does not generate any value for the CS shareholders and its share price should remain at (250,000-50, ,000) / 120,000 = HK$2.5. This implies the PE ratio of the combined group is reduced to 2.5 / 0.167= Answer 6(c) Revenue synergy: arises from increased market power, marketing synergies and strategic synergies. Revenue synergy is more difficult to estimate and materialise. Cost synergy: arises from economies of scale and elimination of overlapping capacity or operation resources. Cost synergy is easier to estimate and materialise. Financial synergy diversification: acquisition by a private or closely held firm can help owners diversify their holdings, therefore creating value. This is because owners of such private or closely held firms cannot easily diversify the investments themselves since such firms cannot be easily bought or sold. Module B (December 2016 Session) Page 11 of 12

12 Financial synergy cash slack: cash rich firms can acquire firms with good projects but with insufficient capital to invest, therefore creating value for the combined firm. The reverse is also true. Financial synergy tax benefits: combined firms can take advantage of tax benefits that otherwise individual firms cannot enjoy. One such example is tax loss. Financial synergy debt capacity: diversification can help reduce the business risk of the combined firms, hence providing more stable earnings. This may result in lower interest costs or even higher borrowing capacity. * * * END OF EXAMINATION PAPER * * * Module B (December 2016 Session) Page 12 of 12

SECTION A CASE QUESTIONS (Total: 50 marks)

SECTION A CASE QUESTIONS (Total: 50 marks) Answer ALL of the following questions. Marks will be awarded for logical argumentation and appropriate presentation of the answers. CASE Wellgas Oil & Gas Limited