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 MAMANGMENT JUNE 2011

1 THE HONG KONG INSTITUTE OF CHARTERED SECRETARIES THE INSTITUTE OF CHARTERED SECRETARIES AND ADMINISTRATORS International Qualifying Scheme Examination CORPORATE FINANCIAL MAMANGMENT JUNE 2011 Suggested Answers 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 Q1. The board of directors of Everglade Company Limited, a publicly listed company in Hong Kong, is considering making an offer to acquire Target Co., a private limited company in the same industry locally. If Target is acquired, it is proposed to continue operating the company as a going concern in the same line of business. Details from the most recent set of financial statements for Everglade and Target are summarised below: ($ million) Statement of Financial Position as at 31 Dec.2010 Everglade Target Freehold property Plant & equipment Current assets inventory Debtors Cash Less: Current liabilities (310) 250 (5.18) , Everglade Target Financed by: Ordinary shares Reserves Shareholders funds Medium-term bank loans , Everglade has 50 cent ordinary shares, Target Co. 25 cent ordinary shares. ($ million) Everglade Target Year Profit after Dividend Profit after Dividend tax tax T T T T T

3 T 5 is five years ago and T1 is the most recent year. Target s shares are owned by a small number of private individuals. The company s managing director, Mr. So, dominates the company and receives an annual salary of $1.2 million. This is $400,000 more than the average salary received by managing directors of similar companies. The managing director would be replaced if Everglade were to acquire Target. The freehold property of Target has not been revalued for several years and is believed to have a market value of $8 million. The balance sheet value of Target s plant and equipment is thought to reflect its replacement cost fairly, but its value if sold is not likely to exceed $8 million. Approximately $550,000 of inventory is obsolete and could only be sold as scrap for $50,000. The ordinary shares of Everglade are currently trading at $43 ex-dividend. A suitable cost of equity for Target has been estimated at 15%. Both companies are subject to corporation tax at 16.5% REQUIRED: Estimate the value of Target using different valuation methods and advise Everglade s board as to how much it should offer for Target s shares. Ans The approaches that can be used for valuation are: (A) Net asset valuation (B) Dividend valuation model (DVM) (C) P/E ratio valuation (A) Net asset valuation Target is being acquired as a going concern, so realizable values are irrelevant. 3

4 $ million Net asset per accounts $ ( ) m Adjustment to freehold property $(8 4.6) m 3.40 Adjustment to inventory (0.50) Valuation $14.14 million (B) DVM The average rate of growth in Target s dividends over the last four years is 7.4% on a compound basis.. 85 (1 + g)^4 = hence g = 7.4% (Note the position of the power 4 ) The estimated value of Target using the DVM is therefore: Valuation $1,130,000 x = $15,982, (This is fine although candidates may use $1,131,000 instead) Say $16 million (C) P/E ratio valuation A suitable P/E ratio for Target will be based on the P/E ratio of Everglade as both companies are in the same industry. P/E of Everglade 70m x $ m = The adjustment: - Downwards by 20% (multiple by 0.80) since 1) Target is a private company and its shares may be less liquid. 2) Target is a private company and it may have a less detailed compliance environment and therefore may be more risky. A suitable P/E ratio is therefore x 0.80 = (multiplying by 0.80 results in the 20% reduction). Target s PAT + adjustment for the savings in the managing director s remuneration after tax: 4

5 $ 1.83m + ($0.4 million x 83.5%) = $2.164 million The estimated value is therefore $2,164,000 x = $ 26,011,280 Say $26 million Advice to Everglade s board On the basis of its tangible assets the value of Target is $14 million, which excludes any value for intangibles. The dividend valuation gives a value of around $16 million. The earnings based valuation indicates a value of around $26 million, which is based on the assumption, that not only will the current earnings be maintained, but that they will be increased by the savings in the managing director s remuneration. On the basis of these valuations an offer of around $20 million would appear to be most appropriate. However, a review of all potential financial gains from the merger is recommended. The Everglade directors should, nevertheless, be prepared to raise the offer to a maximum price of $26 million. 5

6 SECTION B (Answer THREE questions from this section) Q2. (a) In order to evaluate investments using discounted cash flows, a company must first establish its cost of capital, or an acceptable rate of return. REQUIRED: Explain what the cost of capital is. In making strategic and capital investment decisions, quantitative and qualitative factors are both important. Describe the qualitative factors in capital investment decisions. Ans (a) The cost of capital is the average cost of a firm s debt and its equity. In brief, it is the rate of return that a company must earn in order to satisfy the expectation of its owners and creditors. Qualitative factors in capital investment decisions include: An investment s effect on the quality of products and services offered. An investment s effect on the time during which products and services can be produced and delivered to customers. Other qualitative factors include consumer safety, government regulations, pollution control and environmental protection, worker safety, company image and prestige, preferences of owners as well as management and community welfare. Q2 (b) Durable Power Tools wants to purchase a lathe for $10,000. The machine will save $2,000 per year for the next 10 years. It can then be sold at the end of 10 years for $1,000. If the required rate of return is 10%, what is the net present value of investing in the new equipment? Ans (b) Cash flows Amount PV factor Value Purchase price $(10,000) $(10,000) 6

7 Cost savings 2, ,290 Salvage value 1, Net present value 2,676 Q2 (c) If the expected cash savings are uncertain in (b) above, what are the minimum annual cost savings needed in order to meet the required 10% required rate of return? Ans (c) Cash flows Amount PV factor Value Purchase price (10,000) (10,000) Cost savings 1, ,615 Salvage value 1, The minimum cost savings (net cash flow) to meet the required rate of return is therefore $1,565. (Note: Strictly speaking the minimum cost saving should be any amount over and above $1,565, that is, at least $1,566 on a dollar base, in order to give a positive NPV. A zero NPV normally does not merit that the project should go ahead.) Q2 (d) If the annual cash savings are certain but the expected useful life in (b) above is uncertain, how long does the lathe need to last in order for the investment to be still acceptable? Ans (d) Cash flows Amount PV factor Value Purchase price (10,000) (10,000) Cost savings 2, ,615 Salvage value 1, The present value of $1 annuity is At 10% cost of capital, the lathe needs to last up to nearly seven years when the present value of $1 annuity =

8 Q3. Williams Inc is considering acquiring Kidde Corporation. Williams earnings after tax are currently $4 million. The company has 4 million shares outstanding and its price/earnings (P/E) ratio is 20. Kidde s earnings are $3 million; the company has 1 million shares outstanding and its P/E ratio is 15. Williams earnings and dividends are expected to grow at a constant rate of 5% per annum. With the acquisition of Kidde the growth rate is expected to increase to 8%. REQUIRED: Q3 (a) (i) If Williams current dividend per share is $3, calculate the company s cost of capital. (ii) Determine the value of Kidde. (iii) If Williams offers $20 in cash for each outstanding share in Kidde, calculate the net present value of the acquisition. (iv) As an alternative, Williams is considering offering 800,000 of its shares in exchange for all the outstanding shares of Kidde. Evaluate whether this option is superior to a cash offer. Ans (a) Williams share price, P, is the present value of an annuity equal to the dividend expected from next year growing at a constant rate g (5%) forever. P Williams = DIV next year/ k g, where k is Williams cost of capital. From this relationship we obtain: K = DIV next year/ P + g The following table shows the calculation of Williams cost of capital using this equation: (1) Current dividend per share $ 3 8

9 (2) Expected dividend growth rate, g 5% (3) Dividend next year [(1)x(1+(2))] 3.15 (4) Earnings after tax $4 million (5) Number of shares outstanding 4 million (6 ) Earnings per share [(4)/(5)] $1 (7) P/E ratio 20 (8) P of Williams (7) x (6) $20 (9) Cost of capital [(3)/(8) + (2)] 20.75% If Williams acquires Kidde, the dividend would grow by 8% instead of 5%. Applying the price formula from above, we obtain: P* Williams = $3 x (1 +.08)/ = $25.41 This represents an increase of $( ) = $5.41 per share. Since Williams has 4 million shares outstanding, the value of Kidde to Williams shareholders is $(5.41 x 4 million) = $21.64 million. If Williams offers $20 in cash for each outstanding share of Kidde, it will acquire Kidde for $($20 x 1 million shares) =$20 million. The net present value of the acquisition would be $(21.64 million - $20 million) = $ 1.64 million. If Williams offers 800,000 of its shares in exchange for the outstanding stock of Kidde, Williams would give Kidde s shareholders 800,000 x $25.41 = $ million worth of the merged firm s stock. The net present value of the acquisition would be $( ) million = $1.312 million, which is not significantly different from the cash offer. Q3 (b) Describe THREE factors that Williams should consider in deciding whether to make a cash or share exchange offer. Ans (b) Whether Williams should make a cash or a stock offer depends upon the following considerations: 1) If Williams management believes that Williams shares are currently overvalued, the stock offer makes more sense than a cash offer. 9

10 2) If cash is offered to Kidde s shareholders, they would receive a fixed price. If the merger is very successful, they would not benefit from the additional wealth created by the merger. However, if the merger is a failure, the losses would not be shared by Kidde s shareholders, and shareholders in Williams would be worse off than in the case of a stock offer. 3) In a cash offer, Kidde s shareholders may have to pay capital gains tax, while in a stock exchange the transaction is tax free. 10

11 Q4 (a) Positive Company is an all-equity financed company with a cost of capital of 18.5%. The risk-free rate is 8% and the expected return on an average market portfolio is 15%. The company is considering the following capital investment projects: Project Outlay now ($) Expected receipt in one year ($) Beta factor A 1,000 1, B 1,000 1, C 1,500 1, D 2,000 2, E 2,000 2, REQUIRED: Calculate the CAPM required return and the expected rate of return of each project. Ans (a) Project CAPM required return Expected return A 8% + (7% x 0.3)= 10.1% 95/1,000 = 9.5% Reject B 8% + (7% x 0.5)= 11.5% 130/1,000 = 13% Accept C 8% + (7% x 1.0) = 15% 280/2,000 = 18.7% Accept D 8% + (7% x 1.5) = 18.5% 385/2,000 = 19.3% Accept E 8% + (7% x 2) = 22% 400/2,000 = 20% Reject (It is not a requirement in the question that candidates need to state whether a project is to be accepted or rejected) Q4 (b) A firm has evaluated three capital investment projects with the following 11

12 results: Initial investment ($ million) Net present value ($ million) Project A Project B Project C The total funds available for investment are $90 million. The firm has just started to consider Project D, the cash flows of which are as follows: Cash flows ($ million) Year 0 (30) Year 1 10 Year 2 20 Year 3 24 Year 4 16 REQUIRED: Calculate the net present value of Project D using the discount rate that was used to evaluate the other projects (15% per annum), and suggest how the firm should use its available investment funds. (The projects are indivisible, no project can be delayed and all projects are independent one of another.) Ans (b) Project D Year Cash flow PV Present value $m $m 0 (30) 1 (30) NPV Summary: Project A Project B Project C Project D 12

13 Initial investment ($ million) Net present value ($ million) Total investment required for all four projects: $117.6 million. Reduction in investment required to stay within financing limit of $90 million: $117.6 million - $90 million = $27.6 million Omitting any one of projects B, C, D (but not A) will reduce the total investment required below $90 million. Omit the project with the smallest NPV out of B, C, and D: Project B Hence, the firm should invest in Projects A, C and D. 13

14 Q5. Cosmo Company Limited currently pays an annual dividend of $2 per share. The current market price of its ordinary shares is $25 per share. REQUIRED: Q5 (a) If Cosmo Company Limited is expected to pay a constant dividend of $2- in perpetuity, what is its cost of equity? Alternatively, if its annual dividends were expected to grow at 5% per annum, what would be Cosmo s cost of equity? Ans (a) P Cosmo (P) = $25 Do = $2.00 Cost of capital (ordinary shares) = 2/25 = 0.08 or 8% If g = 5% Di = Do (1 + g) = $2.00 ( ) = $2.10 Cost of capital (ordinary shares) = (Di/P) + g = = or 13.4% Q5 (b) Cosmo is evaluating its cost of capital under alternative financing arrangements. The company expects to be able to issue new debt at par with a coupon rate of 7.5% and to issue new preference share with a constant $3 dividend per share at $24 per share. The current market price is $25 per ordinary share, the current dividend $2- per ordinary share and the company foresees growth in ordinary share dividends of 5% per annum. What is Cosmo s weighted average cost of capital if it raises capital using 20% debt, 30% preference shares, and 50% ordinary shares? (Cosmo s marginal tax rate is 20%.) Ans (b) Weighted average cost of capital = [(0.20) (0.06)] + [(0.30) (0.125)] + [(0.50) (0.134)] = 11.65% Cost of debt = 75%(1 20%) = 6% Cost of preference shares = $3/$24 =12.5% Cost of ordinary shares = ($2.10/$25.00) =13.4% 14

15 Q5 (c) Explain why, for a firm such as Cosmo, the required rate of return on capital is greater than the required rate of return on debt. Ans (c) Since equity is junior in its claims to assets and income relative to debt in case of insolvency while debt obligations mean a fixed, legal commitment to pay lenders. Q5 (d) Describe, giving reasons, any additional information which will be required in order to increase confidence in the estimate of the above cost of capital. Ans (d) 1. The prevailing market rates, to ensure reasonableness. The cost of capital should be equal to the risk free rate of interest plus a risk premium relevant to the company. 2. The movement of the market value of the shares over a period of time is important as the cost of capital calculation is dependent on current market price, which is assumed to be reflective of historical changes in market price and return. 3. Estimation of dividend growth and its sustainability. 4. Details of company plans which might affect shareholder expectations. 5. Any other reasonable answers, particularly those in line with the capital asset pricing model. 15

16 Q6. Alvin Company Limited is a small but fast growing firm, and many of its customers are also growing rapidly. Alvin is planning to increase its business by granting its customers extended credit terms of 90 days credit. Its current terms of trade are net 30 days, but its debtor days are at present 40 days. Alvin believes that it can enforce the new payment terms, and estimates that the new policy will increase its annual turnover by 20% from its present level of $2 million. Alvin is aware of the risks of the risks of overtrading, and plans to finance the increased debtors by raising new long-term capital at a cost of 16%. Alvin s material costs are 39% of sales, and the firm keeps 20 days stock of raw materials. Its stock of work-in-progress and finished goods are negligible. Other variable costs, related to purchases of services, are 55% of sales. Alvin receives on average 35 days credit from its suppliers. REQUIRED: Q6 (a) Calculate the resulting changes in working capital and margin, and evaluate whether the proposed change is worthwhile. Ans (a) Alvin s working capital and margin: Old New Sales $2 million $2.4 million Trade debtors: 40/365x$2.0 m $219,178 90/365x2.4m $591,781 Material stocks: 20/365x30%x2.0m $32,877 20/365x30%x2.4m $39,452 Trade creditors: 35/365x855x2.0m $163,014 35/365x85%x2.4m $ Working capital $89,041 $435,617 Change in working capital $ 346,576 Cost of increase in long term capital 16% of $346,576 $ 55,452 16

17 Increased margin: 15% of $0.4 million $ 60,000 Increase in profit: $ 4,548 Comment: If the new terms of trade are enforced and lead to the projected increase in turnover, and if the cost structure remains unchanged, the new policy will generate an increase in margin of $60,000 with an increased cost of capital for the increased working capital (mainly due to increased credit) of $55,452, increasing profit overall by $4,548. The change is worthwhile, but the increase in profit is small compared with the cost of the extra working capital. It would take only small proportional changes in the figures used to make the change not worthwhile. Q6 (b) (i) Bach Corporation is anticipating having to pay 10 million to a French supplier in three months time. It has decided to hedge the foreign exchange risk by using currency options. It has purchased a 10 million call option at an exchange rate of 1.45: 1 at a premium of 53,020. If the spot exchange rate of sterling against the euro in three months time is to 1, calculate the value of the option and the profit or loss that the firm makes by buying and using the option instead of buying Euros at the spot rate. (ii) Options are usually a more expensive way of hedging foreign currency risk than forward contracts or futures. Explain why this is so. Ans (b) (i) Cost of buying 10 million at spot rate in three months: 10 million/ : 1 = 6,960,880 Cost of buying 10 million by exercising option: 10 million/ 1.45 : 1 = 6,896,552 Saving = value of option 64,328 17

18 Cost of option 53,020 Profit by buying and exercising option UK Pound 11,308 (ii) A currency future or a forward contract commits the firm to buying or selling the foreign currency at the expiration of the contract (unless, as is often the case with a future, the future has been sold in the meantime). An option involves a right, but not the obligation, to buy or sell the foreign currency. A future or forward contract sets the exchange rate at the outset. It removes risk, but leaves no scope for gain if exchange rates move favourably. An option allows the possibility of profit. The combination of removal of downside risk with potential for profit makes an option more valuable. It is therefore more expensive. An option may also be more expensive than a forward contract, which may be for a larger amount and cannot be traded, because an option is for a standardised amount and can be traded. The administrative costs are therefore higher, though they may not be higher than for a future. END 18

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Institute of Certified Management Accountants of Sri Lanka. Strategic Level May 2012 Examination. Financial Strategy and Policy (FSP / SL 3-403)

Institute of Certified Management Accountants of Sri Lanka. Strategic Level May 2012 Examination. Financial Strategy and Policy (FSP / SL 3-403) Copyright Reserved Serial No Strategic Level May 2012 Examination Examination Date : 12 th May 2012 Number of Pages : 08 Examination Time: 9.30 a:m. 12.30 p:m. Number of Questions: 05 Instructions to Candidates