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 JUNE 2014 Suggested Answer The suggested answers are published for the purpose of assisting students in their understanding of the possible principles, analysis or arguments that may be identified in each question 1

2 SECTION A 1. Pan Star Chemical Product Limited (PSCPL) is a medium-sized private limited company in Hong Kong. PSCPL is planning to expand its production line by acquiring another production plant in order to fulfill future foreseeable demand. At the last management meeting, the board instructed the financial controller, David Tam, to submit two acquisition proposals for consideration at the next management meeting. After working in detail with the production manager, Rex Li, David made two proposals: Project Alpha and Project Beta. The initial investments required for Alpha and Beta are $17 million and $12 million respectively. Both projects will last for five years. The initial outlays will be made at the beginning of the year 1; and the residual amount of the plant, estimated as 5% of their original cost, will be received at the end of year 6. The revenue generated and the operating costs from year 1 to year 5 will be incurred at the end of each of those years. After further thorough assessment, David estimates that the overall risk level of Alpha and Beta are similar to the company s existing investment projects. The details of the proposals are shown as below: Project Alpha ($ m) Year Initial investment 17 Revenue Operating costs Project Beta ($ m) Year Initial investment 12 Revenue Operating costs Under local tax law, profits tax will be paid in arrears if there is a profit in an assessment year (i.e. the profits tax payment for year 1 will be deducted in year 2). Any losses will be carried forward and set off against the profits of next 2

3 year: in other words, the profits of the following year will be reduced. The existing weighted average cost of capital (WACC) is 18%. The profits tax rate is 20%. Under the tax law, a depreciation allowance of 30% calculated using the reducing balance method can be applied in the tax computation. It is assumed that the WACC, the rate of depreciation allowance and the profits tax rate will not change in the coming 10 years. Recently, the board of PSCPL has been considering taking over one of its competitors, Jackson Chemical Workshop Limited (JCWL), in order to increase its market share by horizontal integration. Extracts from the financial information of both companies are as follows: PSCPL JCWL Current year earnings after tax $88 million $9 million Outstanding shares 40 million 2 million Existing price-earnings ratio David expects the earnings after tax of PSCPL will grow at a rate of 6% constantly. After discussion with the board chairman, the board expects the company s dividends will grow at the same rate as that of the earnings after tax. If the acquisition of JCWL is successful, the board projects the growth rate of both earnings after tax and dividends will increase to 9%. It also expects that PSCPL shareholders will benefit from the extra gain derived from the acquisition. Meanwhile, the board is reviewing whether the acquisition should be made via a cash offer or stock offer. The existing dividend per share is $1.80. REQUIRED: 1. (a) Evaluate Project Alpha and Project Beta and comment on how PSCPL should select between them. (23 marks) 3

4 Ans (a) Project Alpha ($ m) Year Investment 17 cost Revenue Operating costs Investment WDV b/d 30% deprecation allowance WDV c/d Tax saving (WDV) Project Alpha ($ m) Year Investment (17.00) cost Revenue Operating (5.00) (11.00) (12.00) (13.00) (12.00) costs (3.00) Loss b/d (3.00) Profit/(Loss) c/d (3.00) Tax payments - (0.60) (3.60) (3.80) (2.40) Tax saving (WDV) Residual value 0.85 Net cash flow (17.00) (1.98) (1.55) Discount factor % PV of net cash (17.00) (1.68) (0.57) flow Total 8.29 Project Beta ($ m) Year Investment cost 12 Revenue Operating costs Investment WDV b/d % deprecation allowance WDV c/d 4

5 Tax saving (WDV) Project Beta ($ m) Year Investment cost (12.00) Revenue Operating costs (4.00) (10.00) (11.00) (11.00) (1.00) Loss b/d (1.00) Profit/(Loss) c/d (1.00) (9.00) Tax payments (0.40) (1.60) - (3.60) Tax saving (WDV) Residual value (1.80) 0.60 (12.00) Net cash flow (2.25) (1.20) Discount factor % PV of Net cash (12.00) flow (1.37) (0.44) Total 6.67 The above workings show that both projects have positive net present value cash flows. However, the net present value of Project Alpha s cash flow is greater than that of Project Beta. Thus, Project Alpha should be adopted. 1. (b) Evaluate the cost of capital of PSCPL. (5 marks) Ans (b) PSCPL Dividend per share of current year = $1.8 Original dividend growth rate = 6% 5

6 PSCPL s dividend per share for next year = $1.8 (1 + 6%) = $1.91 Earnings after tax = $88 million Outstanding shares = 40 million PSCPL s earnings per share = $88 million 40 million = $2.2 Current price earnings ratio = 15 Share price = $15 $2.2 = $33 Dividend growth model: Cost of capital = Dividend per share next year Share price current year + Dividend growth rate = $1.91 $33 + 6% = 11.79% 1. (c) How much extra gain will the shareholders of PSCPL gain from the acquisition of JCWL? (Assume the cost of capital is constant.) (5 marks) Ans (c) After acquisition; new dividend growth rate = 9% Dividend growth model: New share price 6

7 = Div current year (1 + Div. growth rate new) (Cost of capital Div. growth rate new) New share price after the acquisition = $1.8 (1 + 9%) (11.79% - 9%) = $ = $70.32 Extra gain per share from the acquisition = $ $33 = $37.32 per share Extra gain to PSCPL s shareholders = $ million = $1,492.8 million 1. (d) The board of PSCPL is considering whether to offer $600 in cash for each JCWL outstanding share or 20 million of PSCPL s shares in exchange for all JCWL s outstanding shares. Evaluate which option the board of PSCPL should choose. Discuss what other factors PSCPL should take into account in making its decision. (7 marks) (Total: 40 marks) Ans (d) Cash offer = $600 2 million = $1,200 million Net extra gain to PSCPL s shareholders = $1,492.8 million - $1,200 million 7

8 = $292.8 million Share offer = 20 million $70.32 = $1,406.4 million Net extra gain to PSCPL s shareholders = $1,492.8 million - $1,406.4 million = $86.4 million The net extra gain derived from the cash offer is higher than that from the share offer. Therefore, the board of PSCPL should use a cash offer instead of a share offer for the acquisition of JCWL. However, PSCPL should also consider other factors: (1) An acquisition made via a cash offer could create a negative effect on operations due to the significant reduction in cash levels. (2) A fresh issue may be needed to support a cash offer. (3) Additional borrowing may be needed to support PSCPL s cash flow. (4) Any two relevant answers. 8

9 SECTION B 2. Amanda Trading Limited (ATL) is a local wholesaler which trades medical and health products. The business is continuing to grow steadily. The capital structure of ATL is 70% equity and 30% debt. The management of ATL adopts a financial strategy to give a required rate of return on assets (ROA) of 15%. The existing borrowing costs of ATL are 5%. These borrowing costs apply to different capital structures. Recently, management has decided to change the capital structure into 40% equity and 60% debt. REQUIRED: 2. (a) Evaluate the cost of equity and weighted average cost of capital (WACC) of ATL. (Assume there is NO tax.) (5 marks) Ans (a) ROA = 15% Existing capital structure = 70% equity and 30% debt Cost of debt = 5% M&M Proposition II: Cost of equity = ROA + (ROA cost of debt) (debt equity) = 15% + (15% - 5%) (30% 70%) = 15% + 10% (30% 70%) = 19.29% WACC = Cost of equity equity (debt + equity) + cost of debt debt (debt + equity) = 19.29% 70% (30% + 70%) + 5% 30% (30% + 70%) = 19.29% 70% + 5% 30% 9

10 = 15% OR When tax is ignored, WACC is equal to return on assets (ROA) under M&M Proposition II. Therefore, the WACC is 15%. 2. (b) Evaluate the cost of equity and WACC of ATL if the capital structure changes to 40% equity and 60% debt. Comment on the effect after the change. (Assume there is NO tax.) (7 marks) Ans (b) Cost of equity = 15% + (15% - 5%) (60% 40%) = 15% + 10% (60% 40%) = 30% WACC = Cost of equity equity (debt + equity) + cost of debt debt (debt + equity) = 30% 40% (60% + 40%) + 5% 60% (60% + 40%) = 30% 40% + 5% 60% = 15% OR When tax is ignored, WACC is also equal to return on assets (ROA) under M&M Proposition II, even though the capital structure changes to 40% equity and 60% debt. Therefore, the WACC is 15%. The WACC is equal to the sum of required returns of both shareholders and debt holders in the proportion of the debt-equity ratio. No matter what the proportion of equity and debt being held is, the WACC is the same. It seems that a change in capital structure does not affect the value of the WACC even though the cost of equity from parts (a) and (b) are not the same. Furthermore, the cost of equity can be broken down into two components. The first component is ROA and it is associated with business risk. Under M&M Proposition II with no tax, WACC is equal to ROA and is independent of the 10

11 capital structure of the firm. The second component, (ROA cost of debt) (debt equity), is, however, determined by the firm s capital structure and is called financial risk. 2. (c) Now assume that the tax rate is 20% and ATL needs to pay tax. Evaluate the cost of equity and WACC of ATL based on the capital structure in part (a) and part (b) and comment on the effect after taking into account tax and the change of capital structure. (Hint: Using CAPM, risk-free rate = 3%, market return = 15%, beta under current capital structure = 1.1 and beta under the new capital structure = 1.8) (8 marks) (Total: 20 marks) Ans (c) For part (a) Capital structure = 70% of equity and 30% of debt Cost of debt = 5% CAPM: Cost of equity = Risk-free rate + beta (market return risk-free rate) = 3% (15% - 3%) = 16.2% WACC = Cost of equity equity (debt + equity) + cost of debt debt (debt + equity) (1 tax%) = 16.2% 70% (30% + 70%) + 5% 30% (30% + 70%) (1 20%) 11

12 = 12.54% For part (b) Capital structure = 40% of equity and 60% of debt Cost of debt = 5% Beta under new capital structure = 1.8 CAPM: Cost of equity = Risk-free rate + beta (market return risk-free rate) = 3% (15% - 3%) = 24.6% WACC = Cost of equity equity (debt + equity) + cost of debt debt (debt + equity) (1 tax%) = 24.6% 40% (100%) + 5% 60% (100%) (1 20%) = 12.24% The WACCs for part (a) and part (b) are 12.54% and 12.24% respectively. Even though ROA is not related to the combination of equity and debt, the WACC is reduced because the interest expenses are tax deductible. When the debt-equity ratio rises from 0.43 (D/E = 30% 70%) to 1.5 (D/E = 60% 40%), the required rate of return rate for shareholders also increases due to the higher debt level. In brief, taking into account the tax saving, the WACC falls when there is a higher debt level. This implies that with taxes, as the firm increases 12

13 debt, the cost of equity increases, but the deductibility of interest more than offsets this increase, which reduces the WACC. 13

14 3. Sammy Kwan is the investment consultant of Poway Jewellery Company Limited (PJCL), a leading manufacturer in the jewellery industry. In the company s recent board meeting, the chief executive officer (CEO) of PJCL asked Sammy to prepare two investment projects to utilise the company s idle cash. The amount of idle cash is estimated at $100 million. Sammy knows that PJCL s required rate of return for investment projects is 13%. Sammy has settled on two projects, Project One and Project Two, which have the following expected net cash flows: REQUIRED: Expected Net Cash Flows Year Project One Project Two $ m $ m 0 ($50.0) ($50.0) 1 $32.5 $ $16.0 $ $15.0 $ $6.0 $ (a) Compute the payback period, net present value, internal rate of return and discounted payback period of Project One and Project Two. Ans (a) Payback (14 marks) Project One Project Two Year Cumulative Cumulative Cash Flow Cash Flow Cash Flow Cash Flow $m $m $m $m 0 (50.0) (50.0) (50.0) (50.0) (17.5) 18.0 (32.0) (1.5) 18.0 (14.0) Payback = Payback =

15 Net present value Project One Project Two Discount Cash Discoun Year Cash Flow Rate PV Flow t Rate PV $m $m $m $m $m $m 0 (50.0) (50.0) (50.0) (50.0) Discount factor: 13% Internal rate of return To solve for IRRs, calculate discount rates that make the NPV equal zero. For Project One NPV Project One = -50 (1+IRR) (1+IRR) (1+IRR) (1+IRR) (1+IRR) 4 0 = -50 (1+IRR) (1+IRR) (1+IRR) (1+IRR) (1+IRR) 4 By trial and error IRR Project One = 20% For Project Two NPV Project Two = -50 (1+IRR) (1+IRR) (1+IRR) (1+IRR) (1+IRR) 4 0 = -50 (1+IRR) (1+IRR) (1+IRR) (1+IRR) (1+IRR) 4 By trial and error IRR Project Two = 16% ** Other relevant methods are also acceptable. ** 15

16 Discounted payback Project One Project Two Year Present Value Cumulative Present Value Cumulative Discounted Cash Flow Discounted Cash Flow Discounted Cash Flow Discounted Cash Flow Million Million Million Million 0 ($50.0) ($50.0) ($50.0) ($50.0) 1 $28.8 ($21.2) $15.9 ($34.1) 2 $12.5 ($8.7) $14.1 ($20.0) 3 $10.4 $1.7 $12.5 ($7.5) 4 $3.7 $5.4 $11.0 $3.5 D. Payback = D. Payback = (b) The board decided in its last meeting that $20 million of idle cash should be kept for emergencies. Advise whether the company should choose Project One and/or Project Two and how the idle cash should be utilised if the two projects are (i) mutually exclusive, (ii) independent or (iii) divisible in nature. (6 marks) (Total: 20 marks) Ans (b) Project One is the better of the two projects. Project One has a shorter payback period, higher NPV, higher IRR and shorter discounted payback period. (i) Mutually exclusive If the two projects are mutually exclusive, Project One should be selected because it has a shorter payback period, higher NPV, higher IRR and shorter discounted payback period. (ii) Independent If the two projects are independent, both Project One and Project Two should be selected, subject to the availability of funds, as both projects derive a positive NPV. However, the management board decided in its last meeting that only 80% 16

17 of idle cash ($80 million) should be utilitised. Thus, only Project One should be selected. (iii) Divisible in nature If the two projects are divisible in nature, Project Two may be partially selected. If they are mutually exclusive, only Project One should be selected. If they are independent, 100% of Project One and 60% of Project Two should be selected. 17

18 4. Creative Limited (CL) runs a number of chocolate shops selling Supreme chocolate in the region. All CL s shops accept cash sales only. Recently, the company has been appointed as a sole agent for Supreme chocolate in the region. The management of CL is planning to be a wholesale supplier of Supreme chocolate. However, many retailers ask for credit sales with a one-month credit term. The sales manager has prepared the following information under two proposed credit policies for the management s consideration: No credit policy New credit policy Unit price $37.00 $40.00 Unit cost $24.00 $27.00 Sales per month (unit) 6,525 6,900 Probability of payment The higher unit cost reflects the greater amount of expenses associated with orders on credit. The higher unit price allows for a discount on cash sales. REQUIRED: 4. (a) Briefly discuss whether CL should grant credit to retailers or not. (5 marks) Ans (a) Cash discount = ($40 - $37) $40 = = 7.5% Probability of non-payment under new credit policy =

19 = 0.1 = 10% Credit sales are offered to increase sales volume but they also increase the risk of non-payment. However, cash discounts are offered to avoid non-payment. Since the probability of non-payment under the new credit policy (10%) is higher than the cash loss due to discount offered (7.5%), CL should not adopt the new credit policy. ** Other relevant methods are also acceptable. ** 4. (b) Explain how the receivables operate if CL adopts the new credit policy. (Assume all receivables are collectable and the monthly information is the same and continues forever.) (7 marks) Ans (b) Receivables result from the credit sales; any credit sales will increase accounts receivable by the same amount. In brief, receivables are informal credit arrangements supported by invoices and are due in the month after the sale. Theoretically, receivables operate as a perpetual cycle because with the same cash flow every year forever, CL will bear the cost of financing for the one-month period before it receives cash from its customers. Receivables will grow over the first one-month period and will then remain stable as the settlement of receivables and new sales off-set one another. However, other factors may also affect CL s decision. Due to credit risk, CL may take into account uncollectable receivables. These will reduce the overall benefit eventually. 4. (c) It is estimated that only 90% of retailers under credit sales will settle their payments. For the 10% of uncollectable receivables, CL is considering using a debt collection service from Sure Win Credit Agency Limited (SWCAL). The one-off basic charge is $1,200. An additional fee of $5 will be charged for each $100 of sales value. SWCAL claims that its debt collection service is good and 19

20 guarantees at least 95% of the debt can be received. Advise whether CL should use the debt collection service or not. (8 marks) (Total: 20 marks) Ans (c) CL should use SWCAL as its credit agency if the cost of the debt collection service is lower than 95% of expected uncollectible receivables. Cost of debt collection services = $1,200 + $5 ($40 6,900) $100 = $15,000 Expected uncollectible receivables = $40 6,900 (100% - 90%) = $27,600 95% of expected uncollectible receivables = $27,600 95% = $26,220 Net gain from adopting credit agency = $26,220 - $15,000 = $11,220 20

21 Since the cost of the debt collection service is lower than 95% of expected uncollectible receivables, CL should use SWCAL s debt collection service. 21

22 5. Sporty International Limited (SIL) is a rapidly growing company which produces and sells sport products. SIL issues a convertible debenture which carries a 10% coupon at par. The debenture is redeemable in seven years and each unit of $1,000 is convertible into 200 ordinary shares at any time before the redemption date. At the issue date, the yield of similar debentures without conversion is 13% and the market price of SIL s ordinary shares is $3.80. REQUIRED: 5. (a) Calculate the conversion premium on the convertible debentures at the issue date and discuss the relationship between the coupon rate and the conversion premium on convertible debentures. (Assume the debenture is issued at par.) (8 marks) Ans (a) Conversion value = $ = $760 Issue price of debenture = $1,000 Conversion premium = ($1,000 - $760) $760 = 31.6% Generally, the lower the coupon rate of the convertible debenture, the higher the expectation of the share value after the conversion, i.e. the conversion premium. In fact, the conversion premium mainly depends on the expected growth in SIL s 22

23 share value. The conversion premium is about 31.6% of the current share price. This indicates that the market is expecting a substantial growth in SIL s share price in the coming seven years. By comparing the coupon of non-convertible debentures in the market, it seems that the market is willing to accept a coupon rate of 3% less than the market for the convertible option in return. This is because the debenture holders give up the 3% coupon rate in exchange for purchase options which can convert the debentures into a fixed number of shares retained by the holders at a predetermined future period. 5. (b) If the growth rate in the share price is 12% annually: i. Compute the conversion value of the debenture after four years, and explain why the market value of the debenture exceeds the conversion value of the debenture; and ii. Discuss the relationship between the market value of the debenture and SIL s dividend policy. (12 marks) (Total: 20 marks) Ans (b) (i) Growth rate of share price = 12% Share price after four years = $3.8 (1 + 12%) 4 = $5.98 Conversion value after four years = $

24 = $1,196 (ii) The market value of the debenture is greater than the conversion value of the debenture unless the company is in default or holders are forced to convert. If not, an arbitrage opportunity exists for investors to buy the debenture, convert into shares and sell the shares. The holders of the convertible debenture do not have to convert immediately, giving them the option to convert before the expiry date. Even though SIL s profits may drop below market expectations or the holders do not exercise their conversion rights, the value of the debenture is also kept as its face value of $1,000 at maturity. The minimum, or floor value, of a convertible debenture is either its straight bond value or its conversion value, depending on which is greater. Some investors may want to buy these debentures because they expect the shares will grow substantially in the three years before the expiry date. Thus, they are willing to pay more than $1,196 to buy these debentures. The dividend policy has a direct impact on the market value of the convertible debenture. Basically, if the earnings are reinvested, this will generate profits and increase the earnings continually. The share price will grow with the increasing in earnings. If the management board of SIL distributes all earnings as dividends every year, the share price is likely to keep static assuming the profit level is the same every year. Shareholders can benefit from both SIL s dividends and/or SIL s capital growth under different dividend policies, but convertible debenture holders can only benefit from the coupons. 24

25 6. Good Taste Italian Food and Beverage Limited (GTIFBL) is a famous food and beverage importer in Hong Kong. GTIFBL will sell food products for 3.5 million to an Italian buyer on 1 January The credit term is three months, i.e. the due date will be 31 March Tammy Chan, the financial controller of GTIFBL, is worried that this transaction carries foreign exchange risk as she expects the euro will become weaker. The current spot rate of Hong Kong dollars to euros is HK$10.58/. To minimise the company s exposure to foreign exchange risk, Tammy is considering hedging the risk. The cost of capital of GTIFBL is 12%. Three hedging approaches are available: money market hedge, forward contract hedge and currency option hedge. Each hedging method is detailed below: Money market hedge The euro and Hong Kong dollar borrowing rates are 8% and 6% per annum respectively. The euro and Hong Kong dollar saving rates are 2% and 1.5% per annum respectively. Forward contracts hedge The 90-day forward exchange rate is $10.35/. Expected spot rate in 90 days is HK$10.40/. Currency option hedge The exercise exchange rate and option premium for a March 2014 put option for 3.5 million are HK$10.62/ and 2.1% respectively. Assume the Italian buyer will settle the above transaction by 3.5 million cash exactly on 31 March REQUIRED: 6. (a) If GTIFBL uses the money market hedging approach, 25

26 i. Describe the procedures and suggested transactions; and ii. Determine the amount receivable by GTIFBL in Hong Kong dollars under this hedging approach. (9 marks) Ans (a) (i) Money market hedging Euro borrowing rate = 8% Euro borrowing for three months = 8% 4 = 2% Hong Kong dollar saving rate = 1.5% Hong Kong dollar saving rate for three months = 1.5% 4 = 0.375% Euros should be borrowed at the invoice date = 3.5 million (1 + 2%) = million (1) At the invoice date, GTIFBL should borrow million from the euro money market. 26

27 million converts to Hong Kong dollars at invoice date = million HK$10.58/ = HK$ million (2) GTIFBL should convert the million into Hong Kong dollars at the current HK$- spot rate. The amount is HK$ million. (ii) HK$ million after three months = HK$ million ( %) = HK$ million (3) GTIFBL should invest the HK$ million in the Hong Kong money market for three months. After three months, it will become HK$ million. (4) The euro loan will be repaid by GTIFBL after three months, i.e. at the settlement date. The amount of the repayment plus interest over three months is exactly 3.5 million from the Italian buyer. 6. (b) Evaluate the Hong Kong dollar cash flow for GTIFBL if: i. Tammy uses forward contract hedging; and ii. Tammy does not use any hedging. Ans (b) Hedged (5 marks) 27

28 HK$ cash flow = 3.5 million $10.35/ = HK$ million in 90 days time Unhedged HK$ cash flow = 3.5 million $10.40/ = HK$ million If Tammy makes use of hedging, the Hong Kong dollar cash flow is HK$ million. However, if she does not make use of hedging, the Hong Kong dollar cash flow is HK$36.4 million. The difference of HK$0.175 million is the risk premium. 6. (c) Evaluate the Hong Kong dollar cash flows guaranteed by the currency option hedging. Which option should Tammy choose? (6 marks) Ans (c) GTIFBL may buy a put option in order to sell euro at HK$10.62/. (Total: 20 marks) Cost of option in Hong Kong dollars at invoice date = Contract size option premium spot rate [Assume the option contract is entered into at the invoice date] = 3.5 million 2.1% HK$10.58/ = HK$ million 28

29 Hong Kong dollar cash flows guaranteed by currency option hedging = 3.5 million HK$10.62/ - HK$ million = HK$ million Tammy should adopt money market hedging because the Hong Kong dollar cash flow is the greatest of the three options. END 29