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

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THE HONG KONG INSTITUTE OF CHARTERED SECRETARIES THE INSTITUTE OF CHARTERED SECRETARIES AND ADMINISTRATORS International Qualifying Scheme Examination CORPORATE FINANCIAL MANAGEMENT PILOT PAPER Time

minutes reading time to read through the question paper before the commencement of the examination between 2:15pm-2:30pm.

1 THE HONG KONG INSTITUTE OF CHARTERED SECRETARIES THE INSTITUTE OF CHARTERED SECRETARIES AND ADMINISTRATORS International Qualifying Scheme Examination CORPORATE FINANCIAL MANAGEMENT PILOT PAPER Time allowed 3 hours Section A Compulsory questions 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 2:15pm-2:30pm. 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 3:00pm. Page 1 of 14

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6 SUBJECT NO 16J CORPORATE FINANCIAL MANAGEMENT PILOT PAPER The examination paper is divided into TWO Sections. Section A is compulsory 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 questions 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 answer to two decimal places. Saturday afternoon 13 December 2008 Time allowed: 3 hours SECTION A (Compulsory answer ALL parts of this question) Question 1 Reliable Electric Ltd is a manufacturer of electric motors and it is 100% equity financed. Its equity beta is estimated to be Reliable Electric plans to diversify into another business, producing wireless communication devices. According to its CFO, Eric Chan, the new investment would be riskier than the company s existing operation. Reliable Electric can start the new project with an initial investment in equipment of $50 million. The equipment will be depreciated on a straight-line basis over four years to a salvage value of zero. If the new project goes well, Reliable Electric can further expand its investment in the production of wireless communication devices. Page 6 of 14

7 The production line will be installed in a building already owned by the firm. The building is currently vacant and has a market value of $10 million and its price is expected to increase by 3% per year (after-tax). Mr. Chan has drawn up the following sales forecast: Year Sales (millions) Costs of goods sold (COGS) will be 50% of sales. The new production line will reduce the after-tax cash flows of company's existing electric motors by $1 million each year. The company's interest expense will be $1 million each year. Reliable Electric has a 20% tax rate. There are three components to the company s net working capital: accounts receivable, inventory and accounts payable. The firm believes that net working capital at each date will be maintained at a constant percentage of next year s forecast sales. Mr. Chan has calculated asset turnover ratios based on last year s financial statements. The accounts receivable turnover ratio is 10 times; the inventory turnover ratio (defined as COGS/inventory) is 5 times; and the accounts payable turnover ratio is 20 times. The net working capital will be recovered after the project is completed. CK Communications Inc is a major competitor in the communications device business; this is also its only business. CK s stock is publicly traded and its beta is estimated to be Currently CK uses 40% debt and 60% equity in its capital structure. For simplicity, its debt can be considered to be risk-free (i.e. having a zero beta). Mr. Chan estimates that the market risk premium is 10% and the risk-free rate is 5%. Required: (a) Advise whether Reliable Electric s firm-wide cost of capital can be used to evaluate the new project and determine the cost of capital for the new project. (10 marks) (b) If Mr. Chan believes that asset utilisation for net working capital will remain unchanged for the new project, determine the cash flow related to the net working capital. If he believes the inventory utilization efficiency will be improved, evaluate the impact on the cash flow related to net working capital. (8 marks) Page 7 of 14

8 (c) Determine the relevant cash flows from the project. Advise whether Reliable Electric should accept the proposed project. (12 marks) (d) Hypothetically, if the proposed project has a negative NPV, is it still possible for Reliable Electric s management to accept it? In addition, if Reliable Electric has a different capital structure (with debt), will the presence of debt financing make it possible to accept the negative NPV project? Provide detailed explanations. (10 marks) (Total: 40 marks) Page 8 of 14

9 SECTION B (Answer THREE questions from this section) Question 1 Better Air Cleaner Inc has come out with an improved product. As a result, the firm projects a growth rate of 20% per year in earnings and dividends for next four years. By then, other firms will have developed copycat technology, competition will drive down profit margins, and the sustainable growth rate will fall to 5% per year. The most recent annual dividend was DIV 0 =$1.00 per share. The cost of equity is 10%. Better Air Cleaner s bond has a face value of $1,000 and a 6% coupon with semi-annual compounding. The bond will mature in five years. The yield to maturity on a similar bond is currently 8%. BAC has 10,000 bonds outstanding and 500,000 shares outstanding. Required: (a) Determine Better Air Cleaner s stock price and bond price. (12 marks) (b) Discuss the agency costs of debt and the risk-shifting problem. If Better Air Cleaner undertakes a zero- NPV project that increases the overall risk of its assets, assess the potential impact on the company s shareholders and bondholders. (8 marks) (Total: 20 marks) Page 9 of 14

10 Question 2 A US firm is evaluating a proposed expansion of its subsidiary located in France. The cash flows from the project would be 10 million per year for the next five years. The cost of expansion is 35 million. The dollar required rate is 12% per year, and the current exchange rate is $1.25/. The market interest rate on dollars is 8% per year and the market interest rate on euros is 6% per year. Required: (a) Project the exchange rates for euros over the next four years. Convert the projected euro cash flows into dollars and calculate the NPV in dollars (home currency approach). (10 marks) (b) Determine the required rate of return in euros. Calculate the NPV in euros and convert it to dollars (foreign currency approach). (5 marks) (c) Discuss how the firm can minimise the risk arising from exchange rate fluctuations. (5 marks) (Total: 20 marks) Page 10 of 14

11 Question 3 Greater China Shipping Company is a 100% equity-financed firm. It has perpetual earnings before interests and taxes (EBIT) of $40 million per year and pays out all its earnings as dividends. The after-tax cost of capital is 15%. The company s tax rate is 20%. Greater China Shipping currently has 20 million shares outstanding. The company s management is considering a recapitalisation that requires issuing $100 million of debt and using the proceeds to repurchase stock. The before-tax cost of debt is 8%. Assume the MM world with corporate taxes for both parts of this question. Required: (a) Assess the impact of the recapitalisation on firm value and its cost of equity after the recapitalisation. How many shares will be outstanding after the recapitalisation? (12 marks) (b) Explain why shipping companies tend to have a higher financial leverage than pharmaceutical companies. Discuss how debt financing can mitigate the free cash flow problem. (8 marks) (Total: 20 marks) Page 11 of 14

12 Question 4 Good Time Inc is a leading producer of chemicals and plastic goods. You are an assistant to the Vice-President of Finance. Your boss has asked you to estimate the weighted average cost of capital for the company. The balance sheet and some information about Good Time follows. Assets Current assets $ 40,000,000 Net plant, property, and equipment $120,000,000 Total Assets $160,000,000 Liabilities and Equity Accounts payable $ 10,000,000 Accruals $ 10,000,000 Long term debt (60,000 bonds, $1,000 face value) $ 60,000,000 Common Stock (10,000,000 shares) $ 30,000,000 Retained Earnings $ 50,000,000 Total liabilities and shareholders equity $160,000,000 Good Time stock is currently selling for $10 per share and it has a beta of The company s bonds have an 8% annual coupon rate, with semi-annual payments. The yield to maturity on the bonds is 10%. The bonds mature in ten years. The yield on a 6-month Treasury bill is 5%. The expected return on the stock market is 12%. Good Time s corporate tax rate is 40%. Required: (a) Determine the cost of equity, cost of debt and WACC for Good Time. (10 marks) (b) Evaluate whether firm-wide WACC can be used to evaluate a project that is less risky than the firm s business. Assess the consequence of using the firm-wide WACC for such a project. Describe how the pure play approach can be implemented to determine the cost of capital for the project. (10 marks) (Total: 20 marks) Page 12 of 14

13 Question 5 As treasurer of Plastic Products Inc, you are investigating the possible acquisition of Sunny Toys Inc. You estimate that the market currently expects a steady growth of about 6%in Sunny Toys earnings and dividends. After the merger, the growth rate would be increased to 8% per year, without any additional capital investment required. You have the following basic data: Plastic Products Sunny Toys Earnings per share $10.00 $3.00 Dividend per share $6.00 $1.60 Number of shares 1,000, ,000 Stock price $90 $20 Required: (a) Advise whether Plastic Products should go ahead with the merger under the following scenarios: (1) Plastic Products pays $25 in cash for each share of Sunny Toys. (2) One share of Plastic Products is offered for every three shares of Sunny Toys. (12 marks) (b) You observe that Plastic Products share price falls when the share offer is made to acquire Sunny Toys. Explain this negative market reaction. If the expected growth rate of Sunny Toys is uncertain after the acquisition, recommend a medium of payment (cash offer versus share offer). (8 marks) (Total: 20 marks) END OF EXAMINATION PAPER Page 13 of 14

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

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