To: Sunny Chan, CFO From: Charles Lee Date: xx Subject: Kowloon Warehouse Limited s profitability, costing and pricing policies

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1 SECTION A CASE QUESTIONS (Total: 50 marks) Answer 1(a) To: Sunny Chan, CFO From: Charles Lee Date: xx Subject: Kowloon Warehouse Limited s profitability, costing and pricing policies Based on the activity cost and volume data, the monthly cost assigned to the three new customers of KWL: Send/receive goods: $18,000 / 500,000 = 3.6 cents per kilogram Store goods: $12,000 / 80,000 = 15 cents per cubic metre Move goods: $15,000 / 5,000 = $3 per square metre Identify goods: $6,000 / 500 = $12 per package KAC Ltd. = (3.6 cents x 40,000) + (15 cents x 3,000)+ ($3 x 300) + ($12 x 5) = $2,850 Issac Ltd. = (3.6 cents x 40,000) + (15 cents x 2,000) + ($3 x 200) + ($12 x 20) = $2,580 Bobson Ltd.= (3.6 cents x 40,000) + (15 cents x 1,000) + ($3 x 1000) + ($12 x 80) = $5,550 Answer 1(b) Net profit margin: net income / sales: 2011: $437,657 / $3,800,000 = 11.5% 2012: $347,957 / $4,180,000 = 8.32% 2013: $338,457 / $4,850,000 = 6.98% Total asset turnover: sales / average total assets: 2011: $3,800,000 / $1,706,400 = 2.23x 2012: $4,180,000 / $2,168,775 = 1.93x 2013: $4,850,000 / $2,760,007 = 1.76x The profitability trend is going down, coupled with a downward efficiency in turning assets into sales over the three years from 2011 to Answer 1(c) KAC Ltd. = (6 cents x 40,000) = $2,400 Issac Ltd. = (6 cents x 40,000) = $2,400 Bobson Ltd.= (6 cents x 40,000) = $2,400 Module B (June 2014 Session) Page 1 of 9

2 Answer 1(d) KAC Ltd.= $2,850 x (1 + 30%) = $3,705 Issac Ltd. = $2,580 x (1 + 30%) = $3,354 Bobson Ltd.= $5,550 x (1 + 30%) = $7,215 Gross profit margin = Gross profit / sales 2011: $1,340,000 / $3,800,000 = 35.3% 2012: $1,205,000 / $4,180,000 = 28.8% 2013: $1,650,000 / $4,850,000 = 34.0% If the three customers represent the average targeted customer base of KWL, the new policy on profit margin per se is lower compared with the existing policy. Answer 1(e) The existing pricing policy captures only one dimension of cost causality, send/receive goods. It fails to address the comprehensive cost structure of warehousing services. As a result, the prices charged for warehousing services are almost independent of the causes of the costs. Activity based costing is a cost accounting approach that does not address profitability, therefore, it does not address the CEO s concern. Answer 1(f) With the business sales increase, the accounts receivables increased by 65.1% from 2012 to That will definitely impose pressure for KWL to finance these receivables. By pledging its receivables, KWL s customers are not notified. It will avoid the perception of financial weakness that can accompany asset based financing transactions. The high financing cost of factoring transactions and customers awareness of the factoring arrangement will make this alternative unfavourable to KWL. If you have any questions regarding the above, please let me know. Module B (June 2014 Session) Page 2 of 9

3 Answer 2(a) Activity based accounting is a good financial management tool which analyses activities and identifies their cost drivers. It helps assure that customers perceive an equitable relationship between service selling price and value. Nonetheless, it lacks the non-financial and qualitative information on the operation. To the extent that factors such as customer goodwill and market reputation are involved in decisions driven by activity based costing prescriptions, those factors will not be accounted. Yet these qualitative factors could be equally important, if not more, compared with a costing reason in this policy shift decision. Answer 2(b) Pros: From the management perspective, KWL has all the right to remove unprofitable customers in order to be competitive. As a result, it can maintain its highest quality of service to profitable customers. More resources and attention of the firm could be allocated to serve the larger customers better. Too many small customers may adversely affect KWL assuming larger customers would enable larger economies of scale of operations. Cons: Fewer customers may increase concentration risks. It might also affect the reputation of the firm among customers. Answer 2(c) There are definitely issues in social responsibility by ending business relationships with existing small customers. It will be more pronounced for those customers which rely heavily and solely on the warehousing facilities of KWL. They might not easily locate an easy substitute firm to render the same service. Nevertheless, KWL at a minimum, should do the following: (i) (ii) (iii) explain why the service is discontinued and give sufficient time to those let go customers to find alternatives; provide alternative suggestions or sources of service supply availability; and respond to all negative feedback from those let go customers when the service is terminated. Module B (June 2014 Session) Page 3 of 9

4 Answer 3(a) EVA of FRUIT Division = $33,000 - $305,000 x 9.5% = $4,025 EVA of MEAT Division = $93,000 - $550,000 x 5.5% = $62,750 EVA only measures the profit produced above the cost of capital of the Division. Despite the popularity of the EVA measurement, it can discourage investment in long term healthy projects like the new FRUIT Division because such investments might have caused an immediate increase in the amount of invested capital. EVA is absolute dollar amount, not relative to investment size. The fact is the FRUIT Division fails to generate substantial after tax profit extensively in the short run. For better measurement, EVA should be supplemented with longer term financial and non-financial performance measures. Answer 3(b) More likely to help KWL because a balanced scorecard can be used to measure performance of relative new FRUIT Division by providing a set of measurements that reflect KWL s mission and strategy from: (i) (ii) (iii) financial perspective and customer perspective; internal process perspective; and learning and growth perspective. At times, KWL could consider including a sustainability perspective in their balanced scorecards. Answer 3(c) EVA is designed to be a uni-directional measurement which may not be fair to the FRUIT Division employees because of: (i) (ii) (iii) the division being new in marketing experience; instability in market share from existing and new competitors actions; and cost of financing is different in the two divisions perceived by external capital providers. * * * END OF SECTION A * * * Module B (June 2014 Session) Page 4 of 9

5 SECTION B ESSAY / SHORT QUESTIONS (Total: 50 marks) Answer 4(a) To: Ms. Lee, CFO From: xxx Date: xx Subject: Evaluation of interest rate hedge instruments You asked me to evaluate 3 instruments that can be employed to hedge the interest rate risk of our Company. Below is my analysis. Establishing forward rate agreement: A forward rate agreement is a contract between two parties that allows the borrower to fix the interest rate for a future loan at the time of the contract. It is a binding agreement and both parties i.e. the lender and borrower, must fulfil the obligation. The benefit of this type of arrangement is flexibility because it can be tailor-made to suit the risk profile of the borrower and return required by the lender. However, the party that uses this tool for hedging forgoes the upside in case interest rates move in its favour. It is also possible that a lender may not be available. However FRA usually is for a short term loan, i.e. twelve months or less. Since E would like to borrow for three years, FRA may be difficult to obtain or the interest rate may not be attractive at all. Set up interest rate swap with another borrower: An interest rate swap allows two borrowers to swap fixed and variable interest rates to suit their borrowing preferences. For example, a borrower that prefers a fixed rate loan but can obtain a variable rate loan at very low cost in the home market. Through an interest rate swap, this company can exchange interest payments with another borrower who prefers a variable rate loan but which can only borrow at an attractive fixed rate. The benefit is both borrowers can fully utilise their credit rating to obtain attractive loans and also can achieve their respective preferred interest rate exposures. However, the problem is a perfect match of the two borrowers may not be feasible. Also, this is usually arranged through a financial intermediary and will increase borrowing costs due to service fee incurred. Since E worries about rising interest rates and its loan offer is a variable rate, E should swap with another borrower who can obtain a similar loan for a fixed rate. The amount and duration of swaps are negotiable between the two parties. Module B (June 2014 Session) Page 5 of 9

6 Buy interest rate futures: Interest rate futures are standard sized forward rate contracts representing interest receivable or payable on notional lending or borrowing short term. The benefit is similar to those of a forward rate agreement. However, the party who uses this instrument for hedging forgoes the upside in case interest rates move in its favour. Another disadvantage is that since futures are standard size contracts, its terms such as maturity or rates offered may not fit the requirements of the party, hence may not be able to offer a perfect hedge. One thing to note is that a borrower worrying about a rise in interest rates should sell futures at the contract date and buy (close position) at a later date. Buying futures in this case is the wrong approach as E is the borrower. In conclusion, an interest rate swap and selling interest rate futures are worth further study. If you have further questions, please let me know. Answer 4(b) Based on the following table, E will pay a fixed rate of 3.05%, while F will pay a variable rate of Hibor + 1%. E will be able to eliminate the interest rate risk. % E F Borrowing cost before swap Hibor Swap receipt Hibor 2 Net borrowing costs Swap payments 2 Hibor Final borrowing costs 3.05 Hibor+1 Module B (June 2014 Session) Page 6 of 9

7 Answer 5(a) Group ABC EPS (before acquisition) 120,000,000 / 100,000, Share price 8 PE ratio No of new shares issued ABC / DEF share ratio no. of new ABC shares to be issued 50,000,000 x ,250,000 Total no. of shares 100,000, ,250, ,250,000 New EPS (after merger) - cost synergy only - 1 year after acquisition (120,000, ,000, ,000,000) / 131,250, cost and profit synergy - 2 years after acquisition (120,000, ,000, ,000,000) x 1.1 / 131,250, The EPS of the Group one year after the merger is 1.18, lower than the pre-acquisition value of 1.2. However, after two years, when the profit synergy materialises, the EPS returns to 1.299, which is higher than the pre-acquisition value. So the Board s statement is reasonable. However, this EPS is based on the profit synergy to materialise which is beyond the control of the group so there is a risk that EPS may not reach this level two years later. Module B (June 2014 Session) Page 7 of 9

8 Answer 5(b) Group ABC Market value of equity (pre-acquisition) 100,000,000 x $8 800,000,000 D/E ratio (pre- acquisition) 45% Market value of debt 0.45 x 800,000, ,000,000 PE of Group (assume same as ABC re-acquisition) Market value of equity (after acquisition) (120,000, ,000, ,000,000) x ,033,333,333 D/E ratio (after acquisition) 360,000,000 / 1,033, % Yes, as shown in the calculation, the Group s debt/equity (D/E) ratio will be 34.84% after the acquisition. Answer 5(c) Based on the static capital structure theory, each company has an optimal capital structure at which WACC is lowest and company value is highest. Since WACC is highest for an all equity company and the cost of debt is lower than the cost of equity, when a company starts adding debt, overall WACC will gradually reduce to a minimum where the capital structure is considered to be optimal. More debt added beyond this point will raise WACC as the cost of equity increases at a higher rate than the cost of debt. Since WACC is lowest at the optimal capital structure, the discount rate for capital investment analysis is also lowest and hence positive NPV added to a company will be maximum. The acquisition of DEF by ABC reduces the debt/equity ratio from 45% to about 35% which is the optimal capital structure and hence WACC is lowest. As such, value added to the Group from future investment is also highest. Answer 6(a) Mr. A has committed insider dealing which is one type of market misconduct as defined in the Securities and Futures Ordinance. He has committed a criminal offence. Module B (June 2014 Session) Page 8 of 9

9 Answer 6(b) (i) (ii) Violating a Code Provision is not a violation of the listing rules as long as the company provides a satisfactory explanation of departure from the Code in the Corporate Governance Report. This practice is called comply or explain. Not following the Recommended Best Practice is not a violation of the listing rules, an explanation in the Corporate Governance Report is not required, although recommended. Answer 6(c) Enforcement: SFO is a law, breaching which can be enforced through the court. Listing rules are developed by market practice and therefore are not legislation hence they cannot be enforced via the Hong Kong legal system but instead by the relevant regulatory bodies such as HKEX. Flexibility: Creating and amending laws are a lengthy process and therefore may not be able to accommodate rapidly changing market practices and conditions. Listing rules can be developed and revised in a relatively short period of time and consultation with market practitioners is usually required for major amendments and developments. * * * END OF EXAMINATION PAPER * * * Module B (June 2014 Session) Page 9 of 9