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 JUNE 2007 Time

allowed 15 minutes reading time to read through the question paper before the commencement of the examination between 9:15am and 9:30am.

1 THE HONG KONG INSTITUTE OF CHARTERED SECRETARIES THE INSTITUTE OF CHARTERED SECRETARIES AND ADMINISTRATORS International Qualifying Scheme Examination CORPORATE FINANCIAL MANAGEMENT JUNE 2007 Time allowed 3 hours Section A 10 short questions (compulsory) 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 9:15am and 9:30am. All candidates must be silent and must not write or mark anything on their question papers or answer books. 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, 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 10:00am. Page 1 of 16

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3 SUBJECT NO 16J COPORATE FINANCIAL MANAGEMENT JUNE 2007 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. Friday morning 8 June 2007 Time allowed: 3 hours SECTION A (Compulsory answer ALL questions in this section) 1. (a) (i) Explain the liability faced by partners in a limited partnership (LP). (ii) What is (are) the difference(s) between a limited partnership (LP) and a limited partnership by guarantee (LPG)? (iii) What is (are) the difference(s) between a limited partnership (LP) and a limited liability partnership (LLP)? (b) (i) List the responsibilities of a financial controller in a corporation. (ii) List the responsibilities of a treasurer in a corporation. (c) Sincere Inc. is attempting to raise $5,000,000 in new equity with a rights offering. The subscription price will be $40 per share. The stock currently sells for $50 per share and there are 250,000 shares outstanding. (i) How many rights will be required to buy one share? Page 3 of 16

4 (ii) At what price will the stock sell when it goes ex-rights if the total value of all stocks increases by the amount of the new funds raised? (iii) Compute the theoretical value of one right. (d) Give two possible reasons for the stock price to drop upon the announcement of a seasoned new equity issue. (4 marks) (e) (i) What is (are) the difference(s) between authorised capital and issued capital? (ii) The common equity account of Company XYZ is given by: $ Common stock, $2 par 150,000 Additional paid-in capital 200,000 Retained earnings 2,500,000 Total 2,850,000 At what average price were the shares sold? What is the book value per share? (3 marks) (f) From the point of view of an issuing firm: (i) name one advantage of preferred stock relative to debt; and (ii) name one disadvantage of preferred stock RELATIVE TO debt. (g) ABC Corporation has an inventory conversion period of 65 days, a receivable collection period of 40 days, and a payable deferral period of 45 days. Assume a 365 day year. (i) What is the length of the firm s cash conversion cycle? (ii) If the annual sales are $3,650,000 and all sales are on credit, what is the firm s investment in account receivables? (iii) How many times per year does the firm turn over its inventory? Page 4 of 16

5 (h) From the point of view of the company that issues convertible bonds to raise funds: (i) name two advantages convertible bonds have RELATIVE TO issuing regular bonds; and (ii) name two advantages convertible bonds have RELATIVE TO issuing equities. (i) (i) Company X s common stock will pay a dividend of $2 per share next year and its price has been growing and will continue to grow at an annual rate of 16%. If this stock has a current price of $40, find the one-year expected return. (ii) If Company X has a beta of 2.5 and the risk free interest rate and expected return of the Hang Seng Index are 5% and 9% respectively, should you buy or short sell the stock according to CAPM? Does the stock lie above or below the security market line? (3 marks) (j) (i) What is the main duty of an auditor? Name the four company statements which an auditor examines. (ii) Explain why the independence of auditors has been undermined or called into question in recent years. (Total: 40 marks) Page 5 of 16

6 SECTION B (Answer THREE questions from this section) 2. A firm has four positive NPV projects to consider for this year. Unfortunately, it faces a credit rationing constraint of $30 million this year. The initial outlays and NPVs of the four projects are given below: Project Initial outlay ($m) NPV ($m) A B C D The four projects are independent. REQUIRED: (a) How should the firm allocate its limited capital among the projects assuming that they are divisible? Find the combined NPV of all the recommended projects. (Note: Divisibility here means that a project s cash flows vary in proportion to the fraction of the project implemented). (8 marks) (b) Redo part (a) above assuming that the projects are indivisible. (c) Define credit rationing problem. What is the difference between soft and hard credit rationing? (d) Why would a firm want to impose capital rationing on itself? Name four possible reasons and explain them. (8 marks) (Total: 20 marks) Page 6 of 16

7 3. Venture Corporation is considering a leasing arrangement to finance some equipment that it needs for production during the next three years. A planned change in the firm's production technology will make the tools obsolete after three years, i.e. they will have a residual value of zero. The firm uses the straight-line method to depreciate the cost of its equipment. The firm can borrow $4,500,000, the purchase price, at 10% on a simple interest loan to buy the tools, or it can make three equal end-of-year lease payments of $2,100,000 per year. The firm's tax rate is 16%. Annual maintenance costs associated with ownership are estimated at $240,000. REQUIRED: (a) Find the cost of leasing the equipment. (b) Find the cost of owning the equipment. (5 marks) (7 marks) (c) Suppose instead that the equipment in this question does have a residual value. Explain how this value would enter into the calculation of the lease or buy decision and affect the choice between leasing and buying. (8 marks) (Total: 20 marks) Page 7 of 16

8 4. Interlink Inc. produces mobile phones that sell for $20 per unit. It has a fixed cost of $300 million and a variable cost of $15 per unit. Its interest expense and dividend for preferred stock shareholders are fixed at $30 million and $5 million per year respectively. It faces a 16% profit tax rate and has 25 million shares of common stock outstanding. Its current sales are 100 million units per year. REQUIRED: (a) (i) Derive a formula for the operating breakeven output level Q QBE for Interlink in terms of the following notations: P = price AVC = per unit variable cost F = total fixed cost. (ii) Use the formula derived from the above part to compute the operating breakeven output level for Interlink. (b) (i) Derive a formula for the financial breakeven earnings before interest and tax (EBIT FBE ) for Interlink in terms of the following notations: I = interest expense D PS = dividend for preferred shares t = corporate tax rate (ii) Use the formula derived from the above part to compute the financial breakeven EBIT and output level for Interlink. (3 marks) (c) Compute Interlink s sales earnings before interest and tax (EBIT) earnings per share (EPS) at the current sales level of 100 million units and at a sales level of 110 million units. (7 marks) (d) Based on your answer in part (c), find the degree of operating leverage (DOL), degree of financial leverage (DFL), and the degree of total leverage (DTL). (5 marks) (Total: 20 marks) Page 8 of 16

9 5. Suppose there are two investments, A and B. They have the same initial cash outlay of $1,000,000, the same useful life of five years and the same cost of capital of 10%. Their cash flows from year 1 to year 5 and internal rate of returns are given by: End of year Investment A Investment B $ $ 1 320, , , , , , , , ,000 1,500,000 IRR 18.03% 15.84% (a) Which project(s) should be chosen if they are (i) independent projects and (ii) mutually exclusive projects? (4 marks) (b) Do your answers in part (a) change if the cost of capital increases to 15% for both projects? Explain. (4 marks) (c) What are the disadvantages of using IRR as a criterion for selecting an investment project? (6 marks) (d) Relative to IRR, what are the disadvantages of using payback period as a criterion for selecting an investment project? (6 marks) (Total: 20 marks) Page 9 of 16

10 6. (a) Assume the following information: Annual U.S. interest rate = 4% Annual Malaysian interest rate = 3% One-year forward exchange rate for Malaysian ringgit = US$ 0.4 per ringgit Spot exchange rate for Malaysian ringgit = US$ per ringgit A U.S. firm needs to settle a 300,000 ringgit bill one year from now and wishes to hedge this payable position. Would the firm be better off using a forward hedge or a money hedge? Support your answer with estimated costs for each type of hedge. (5 marks) (b) Assume that Citadel Co. purchases some goods in Chile that are denominated in Chilean pesos. The company also sells goods denominated in U.S. dollars to some firms in Chile. At the end of each month, it has a large net payables position in Chilean pesos. How can Citadel use an invoicing strategy to reduce this transaction exposure? List any limitations on the effectiveness of this strategy. (5 marks) (c) What are the similarity and difference between transaction exposure and economic exposure? (4 marks) (d) Tri-star is a Korean mobile phone manufacturer that purchases all of its supplies locally and sells all its mobile phones locally. Suppose the mobile phone manufacturing industry in Korean is open to foreign mobile manufacturers. Does Tri-star face any transaction exposure and/or economic exposure? If so, explain these exposures and suggest ways of managing them. (6 marks) End of Examination Paper (Total: 20 marks) Page 10 of 16

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

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