THE HONG KONG INSTITUTE OF CHARTERED SECRETARIES THE INSTITUTE OF CHARTERED SECRETARIES AND ADMINISTRATORS International Qualifying Scheme Examination CORPORATE FINANCIAL MANAGEMENT DECEMBER 2010 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
Section A 1. (a) Distinguish between forward currency contracts and currency futures. (a) Differences between currency futures contract / currency forward contract include:- almost never settled by actual delivery/usually settled by actual delivery for smaller amount/larger amounts (typically Euro 10,000 or $100,000/Euro 1 million or $ 1 million) standardized contract/individually tailored contract limited range of quarterly maturity dates/maturity dates arranged individually- any day traded in foreign exchange markets/not traded in markets market participants include market traders/parties to forward contracts are large companies and banks apart from small cumulative variations, losses must be made up from day to day/no margin adjustment 1. (b) Explain the relationship between net present value (NPV) and internal rate of return (IRR) and demonstrate how they may offer complementary methods for the evaluation of investments. (b) The Net Present Value (NPV) of a capital investment project is the sum of the present values of all the cash flows associated with the project. Present values are calculated by discounting the future cash flows to today s values using the cost of capital this may be the weighted average figure for the company or may be determined specifically for the project in question to reflect how it is financed or the degree of risk. A positive NPV for the project means that the project offers a surplus to the providers of capital over the return that they require (the required return being what they need to compensate them for the cost of capital and the project s risk). The internal rate of return (IRR) is the discount rate (cost of capital) that makes the NPV of a project equal to zero. The IRR represents the highest return that the project offers on the capital invested. NPV and IRR are both based on discounting project cash flows, but are complementary because:
- NPV gives the project surplus in today s money, while IRR gives the percentage annual return on capital invested. - NPV reflects the size, as well as the profitability, dollar for dollar, of a project. IRR reflects the return from each dollar invested for each year. Thus NPV gives a measure of the total return, which provides a basis for choosing one project over another, by showing which gives the larger surplus over the cost of capital, whereas IRR gives a way of ranking projects in order of priority, since it shows where each dollar can be invested most profitably. - The NPVs of two different projects can be added together to give the NPV from a combined investment in the two. The IRR of a combined project is somewhere between the IRRs of the separate projects, but has to be calculated from scratch using the combined cash flows of the two projects. - In order to calculate a NPV, the cost of capital needs to be known, whereas IRR is determined solely by the project cash flows. 1. (c ) Identify the key practical considerations that are likely to influence the dividend payout decisions of companies. (c) Factors that influence dividend decisions of companies may include:- - Firm s liquidity position. - Availability of distributable profits. - Sustainability of the rate of dividend in the future since dividend cuts convey negative signals to the market, firms avoid volatility by restricting dividend payments even when cash and distributable profits are sufficient to pay more. - Covenants imposed by lenders may restrict dividend payments. - Growth prospects companies that are growing rapidly may find it necessary and desirable to plough back profits to sustain growth, rather than pay them out as dividends, while companies without such opportunities for investment may prefer to pay high dividends. - Shareholder preference tax and income considerations may lead shareholders to seek capital gains rather than dividends (or vice versa). - Dividend policies of business competitors, or of other companies in which the shareholders may invest.
1. (d) What are the main causes of financial distress for companies? (d) Main causes of financial distress for companies could include:- - Loss of key management and staff; - Significantly higher stock levels, without he apparent source of finance to pay for them; - Regular work stoppages and labour disputes; - Dependence on a ingle product or project; - Dependence on a single supplier, or a large customer; - Outstanding legal proceedings; - Technical obsolescence; - Political risks; - Loss of a major franchise or patent; - History of poor performance within the industry. 1. (e) Distinguish between convertible bonds and bonds with equity warrants. (e) A convertible bond gives the holder the right (but not the obligation) to exchange the bond for a particular number of shares in the company at a specified price at a future date. An equity warrant is an instrument issued by a company along with bonds, which gives the bond-holder the right (but not the obligation) to buy a particular number of shares in the company at a specified price at a future date. Thus both these instruments are forms of call option issued by the company to investors. The key differences are:- - In the case of bonds with warrants attached, the option is a separate tradable instrument; in the case of convertible bonds, it is embedded in the bond. - Exercise of warrants results in increasing equity without any change in the level of debt; conversion of convertible bonds results in an increase in equity accompanied by a simultaneous decrease in debt, resulting in a greater reduction in the gearing level.
1. (f) Explain what is meant by hard and soft capital rationing. (f) Hard capital rationing occurs when the availability of capital for investment is limited by the lack of resources outside the company. This should not happen in a perfect market, since markets will make capital available at a price that reflects the risk associated with the project. When markets are imperfect, most importantly when small young companies are not fully understood by the market, market imperfections may mean that hard rationing can occur. Soft rationing occurs when the availability of investment funds is limited by management decisions. This can happen when divisional managers are given discretion to make capital investment decisions subject to limits on the total funds available for investment. This may be done as a way of enforcing corporate limits on borrowing and gearing, and on the amount of time spent in evaluating investment decisions. 1. (g) Distinguish between operating leases, finance leases and hire purchase. (g) An operating lease is a short-term agreement for renting an asset; the agreement can be cancelled during the contract period, and the asset is returned to the lessor well before the end of its life. A finance lease is a long-term non-cancellable agreement for renting an asset for virtually its full economic life. The asset is usually selected by the lessee, and is bought by the lessor for the specific purpose of leasing it out to the lessee only; the lessee is usually responsible for maintaining and insuring the asset. It is, in fact, a way of financing the acquisition of an asset without becoming its legal owner. A hire purchase contract is another method of financing assets, which envisages that ownership will ultimately pass to the user, who therefore receives the capital allowances. In leasing, the lessor receives the capital allowances (which can be reflected in the level of lease charges).
1. (h) State why directors might want to privatise a company and identify any possible disadvantages in so doing. (h) Taking a company private avoids disadvantages of a stock listing, including high issue costs and reporting costs, disclosure requirements and possibility of losing voting control. There is also scope for value creation due to closer management involvement, and reduction in information asymmetry between managers and shareholders. Indeed the managers are likely to be the controlling shareholders. A large amount of debt is usually raised in order to buy out the other shareholders, resulting in the tax benefits of higher gearing. This gives managers a very strong incentive to maximize profits. Finally, and often most importantly, directors have greater freedom of action, being no longer accountable to market investors. Drawbacks include the risks associated with high gearing, often accentuated by high interest rates on debt (since some of the debt capital is often in the form of mezzanine finance or junk bonds). A further disadvantage, though managers may not see it as such, is a reduced level of scrutiny of the executive, apart from that exercised by holders of debt instruments. An example of privatizing a public company is the repurchase of Virgin shares by Richard Branson. 1. (i) On 1 April 2010, Hutch Corporation purchased Company A s bonds for its investment accounts with face amount $100,000, coupon rate of interest at 6% per year payable semi-annually (30 September and 31 March) maturing 31 March 2015.The market rate of interest for debts of similar credit ratings was 4% per year. Calculate the market value of Company A bonds purchased as at 1 April 2010. (i) Market value of Company A bonds: Maturity payment
Present value of $100,000- at 2% (Market rate) after 10 periods $100,000 x 0.8203 = $82,030 Interest payments Annuity of 10 payments of $3,000 at 2% for 10 periods $3,000 x 8.983 = $26,949 Therefore, Market value of Company A bonds = $ 108,979 1. (j) What are the motives for a company to undertake foreign direct investments? (j) Possible motives for foreign direct investment:- - To establish new markets and attract new demand. - To avoid tariffs and trade restrictions. - To gain access to low-cost materials, labour or fixed assets. - To benefit from grants and subsidies offered by foreign governments. - To achieve economies of scale. - To take advantage of what is perceived to be an undervalued or overvalued foreign currency. - To exploit monopolistic or competitive advantage through internationalization of possession and control of information, technology, marketing or other commercial expertise. - To create value gains through international diversification, if the multinational can obtain access to market sectors which are not available to its shareholders (or are only available to them at significant extra costs).
Section B 2. Guardall Limited produces a wide range of collectible toys. It has developed a new type of toy and the directors of the company are now considering whether this product should be put into production. The following information has been produced to assist in the assessment of the commercial viability of the new product. 1). The cost of developing the new product was $125,000. In addition, market research was carried out by a firm of marketing consultants at a fee of $80,000. The developing cost and market research cost have been paid. 2). The company expects to sell 10,000 units per year for each of the next five years. The selling price of the toy is $65. 3). The company will purchase a new machine at a cost of $790,000 for the production of the new toy and residual value of the machine at the end of year 5 is $70,000. 4). Addition working capital of $150,000 will be required immediately in order to support production of the new product. This can be released at the end of the year 5. 5). Labour costs are estimated at $12 per unit. If the new product is not produced, these employees will be made redundant immediately at a cost of $50,000 to the company. If, however, the new product is produced, these employees will be used to produce the new product and will be made redundant at the end of the production period at a cost of $80,000 to the company. 6). Total fixed costs apportioned to the new product will be $200,000 per annum, of which $60,000 per year is estimated to arise as a direct result of the decision to produce the new product. 7). To produce the new product, two types of material will be required. Type A material is used throughout the product range of the business and the price is $15 per kilo. Type B material cost is $2.5 per kilo. Each unit requires one kilo of Type A material and three kilos of Type B material.
8). The company has a cost of capital of 12%. REQUIRED (a) Advise the management whether the company should produce this product. Present your answer in the net present value statement format. (b) Discuss another technique that could have been employed in the above appraisal to improve the quality of the information given. 2. (a) $ 000 Year 0 1 2 3 4 5 Sales 650 650 650 650 650 MaterialA (150) (150) (150) (150) (150) B ( 75) ( 75) ( 75) ( 75) ( 75) Labour cost 50 (120) (120) (120) (120) (120) Fixed cost ( 60) ( 60) ( 60) ( 60) ( 60) Machinery (790) Residual value of machinery 70 Working capital(150) 150 (890) 245 245 245 245 465 Discount factor 1 0.893 0.797 0.712 0.636 0.567 @ 12% (890) 219 195 174 156 264 Net Present Value = $ 1008 890 =$ 118 (Not including sunk cost of $50,000 and $80,000 since these are redundant costs) Since the appraisal gives a +ve NPV, the project should be accepted
(b) Sensitivity analysis is another technique that could be employed in the above appraisal to improve the quality of the information provided. - Sensitivity analysis is useful in pinpointing the areas where forecasting risks is especially severe. - The basic idea is to freeze all other variables except one and then see how sensitive our estimate of NPV is to changes in that one variable. - If our NPV estimate turns out to be very sensitive to relatively small changes in that variable, then the forecasting risk associated with that variable is very high.
3. (a) How can a financial manager use the capital market line (CML)? (b) Illustrate the rates of return and risk for an individual portfolio, the market portfolio and a risk free investment, using a capital market line graph. You should explain the relationship between the returns on the different investments. (c ) Calculate the expected returns on the following investments: Standard deviation of return (D) 5% 10% 6% Alfa Gamma Omega (The market return is 8.5%, made up of a dividend yield of 2.5% and a component based on growth expectations of 6%. The standard deviation of the return on the market portfolio (D m ) is 8%. The return on risk-free Treasury stock is 4.5%. Use D/D m as the beta factor for an investment.) 3.(a) The Capital Market Line allows a financial manager to estimate the required return given an estimate of the risk on an investment or portfolio. The risk can be represented by the beta value. Estimates of beta values are available from the London Business School and other organizations. This allows managers to develop investment policies that take account of the attitudes of investors to risk, and where they strike a balance between risk and return. If a financial manager estimates the required return for an investment taking account of risk in the way described above, the required return can be compared with the expected return. This will show whether the investment offers better or worse value than an investment on the CML, whose return exactly reflects its degree of risk.
(b) Capital Market Line: Rf represents the return on a risk-free investment, such as US Treasury Bill, and is therefore the minimum rate of return that an investor would be willing to accept. Rm represents the return on a portfolio representing all securities traded in the market. It is approximated in tracker funds by a portfolio equivalent to an investment in a representative share price index such as the Hong Kong Hang Seng Index. Since this involves market risk, the Rm is greater than the risk-free return. Rp represents the return on a portfolio. Since any portfolio involves risk, Rp, like the market return, it is greater than the risk-free return. Rp may either be greater or less than the market return. For instance, a portfolio invested in the shares of large companies in a range of mature industries, possibly with different cycles of turnover and profitability, could have a lower return than the market as a whole. (c) Rp = Rf + B (Rm Rf) Where: Rp =the return required/expected on a portfolio by an investor B = the beta factor Rm = the return required for holding the market portfolio =8.5% Rf =risk-free rate =4.5% Rp =4.5% + B (8.5% - 4.5%) Standard deviation Beta Expected of return return Alfa 5% 0.625 7% Gamma 10% 1.25 9.5% Omega 6% 0.75 7.5%
4. (a) Explain the Clientele theory of dividend payment. (b) A company would like to maintain a debt to equity ratio of 2:3. The company is considering either taking on a new project X, which will cost $750,000, or project Y, which will cost $1,250,000. The latest earnings for the company are $500,000. Calculate for both projects: (i) (ii) (iii) The dividend payout, if any. The new debts required, if any. The new equity required, if any. (c) A company has a net earnings of $400,000 and has declared a $250,000 dividend payout. The expected rate of return of the investment is 20%. The company has 1,000,000 shares issued. (i) (ii) Estimate the growth rate of dividend. Evaluate the value of a share for the company. 4. (a) Clientele Theory embraces:- - Basically there are two kinds of shareholder or share investor in a company. - The first group is those who prefer low dividend payout. - The dividend is expected to be retained by the company for reinvestment. - The assets and hence the value of the company would increase. - This will eventually leads to the increase in the share price. - Hence, when the share holders sell the shares later, there would be a substantial capital gain. - This group is wealthy people. - The second group of shareholders are those who prefer regular and consistent dividend pay. - The dividend provides a regular mean of income for the shareholders. - They are not too concerned with capital gain. - These are usually corporate client and retired people. - Thus, no matter what dividend policy a company pursue, it will only please one of the two above group.
(b) For Project X: Dividend payout = profit equity required for new project = $ 500,000 (3/5) x 750,000 = $ 500,000 450,000 = $ 50,000 New project financed in debt/equity = 2/3 Let the new amount of debt required = x X/($750,000 - X ) = 2/3 3X = $ 1,500,000 2X X = $ 300,000 New amount of debt = $300,000 New amount of equity = 0 Project Y: Dividend payout = $ 500,000 (3/5) x $ 1,250,000 = $ - 250,000 Therefore there will be no dividend payout. Let the new amount of debt = x Debt/ Equity = 2/3 X/ ($1,250,000 X) = 2/3 3X = $ 2,500,000 2X 5X = $ 2,500,000 X = $ 500,000 New amount of debt = $500,000 New amount of equity = $250,000 (c) (i) Growth rate of dividend = 0.20 x (0.4-0.25)M/0.4M = 0.075 = 7.5% (ii) Value of a share for the company Po = Do (1 + g)/(r g) = 0.25 (1 + 0.075)/0.20 0.075 = $ 2.15
5. Neptune Limited has annual sales of $40 million. All sales are on credit, and the terms of trade are payment net 30 days. However customers take on average 60 days to pay and Neptune is concerned about the cost of its working capital, which is funded by an agreed overdraft at an interest rate of 15%. Neptune is presently considering two possible options to reduce the cost of the working capital required to fund its debtors: Option (A) To provide a discount of 1% for payment within 30 days. Neptune is convinced that 70% of customers would accept and comply with these terms. The remaining 30% of sales would be to customers who are most likely to pay late. These customers are taking 90 days on average to pay at present, and would be expected to continue to do so. Option (B) To use an invoice discounter. The invoice discounter would advance 80% of the amounts invoiced at an interest rate of 13%. Neptune would remain responsible for collecting all its debts, and for bad debts, and would not expect the average debtor days to change from the present figure. The invoice discounter would charge an administration fee of $10,000 per month. REQUIRED (a) Advise Neptune s management of the best course of action, showing your workings. (b) Identify the respective advantages of the direct and indirect methods of credit checking.
5. (1) Option ((A) Discount for prompt payment Annual cost/saving Annual cost of discount: 1% of 70% of $40 million $280,000 Old debtor value:60/365 x $40 million $6,575,342 New debtor value: 30/365 x 70% of $40 million $2,301,370 90/365 x 30% of $40 million $2,958,904 $5,260,274 Reduction in credit to customers $1,315,068 Interest reduction at 15% 197,260 Additional annual cost $82,740 The discount for prompt payment does not reduce annual costs. Option (B): Invoice discounting Borrowing from invoice discounter: 80% x 60/365 x $40 million = $5,260,274 Reduction of interest charges: (15% - 13%) of $5,260,274 $105,205 Administration fee per year: 12 x $10,000 $120,000 Additional annual cost $ 14,795 Invoice discounting does not reduce annual costs. Overall advice to Neptune s management: It appears that neither offering a discount for prompt payment nor invoice discounting reduces costs on the terms specified. It might be worth investigating, however: - Whether better terms can be obtained. - Whether factoring, which may have different benefits in terms of reduced administration costs and transfer of bad debt risks to the factor, but which may adversely affect relations with customers, is worthwhile. - Whether efforts should be concentrated on getting customers to pay
in accordance with the terms of trade. (b) The direct method of credit checking involves investigations carried out by company personnel and may involve:- - enquires into a potential customer s creditworthiness through the sales force and its contacts. Local enquires by the credit controller and others. - Information collected from previous dealing with a customer where the level of business may be increased. These methods are flexible, taking into account the company s particular information needs and, provided a credit control function is in existence, the marginal cost of enquires is low. The indirect method relies on reports prepared by third parties to meet the company s requirements and may overlaps somewhat with sources such as bankers reports. It may include:- - Specialist reports provided for a fee by specialist credit rating agencies such as Dun and Bradstreet, Moody s and Standard and Poors. Reports from trade associations of which the company is a member - Client s bankers report - Existing suppliers references. Press and other report. Official records in relation to risk factors like directors bankruptcies Specialist reports are comprehensive, and can provide indications of the level of credit that would be appropriate. Their disadvantage is cost. Information from trade associations can be informative, provided it is available. Both of these sources may be more explicit than bankers reports, although these are useful if an experienced credit manager can read between the lines. Bank and supplier references are likely to be free, apart from the time required to obtain them. References from existing suppliers may not be representative, especially if the prospective customer nominates them, and the relationship between them may not be fully disclosed.
6. GB Processed Foods Plc, a manufacturer in the United Kingdom, is expanding its operations through foreign investment. The company has ordered the construction of a new factory in New Zealand, and a final payment of NZ$25,000,000 for the factory is due to the overseas building contractors in three months time. GB presently has no spare cash flow other than that to meet normal working capital needs, but anticipates it will receive 7.5million from the sale of a property in about three months time. Current rates in the foreign exchange and money markets are: Foreign exchange market NZ$/ Spot 3.4056-3.4093 1 month forward 12-15 basis points discount 3 months forward 50-56 basis points discount Money market Borrowing Deposit 6 % 4 % NZ$ 9 % 7 % REQUIRED (a) Use appropriate calculations to show the best alternative for GB Plc in managing this capital investment project in New Zealand. (b) Discuss the advantages and disadvantages of the alternatives that are available to GB Plc for managing the transaction risk of the final payment due to the overseas contractor.
6. (a) G B needs to purchase NZ$ 25,000,000 in 3 months time. Using a forward contract, NZ$25,000,000/ 3.4106 = Sterling Pounds 7,330,089 Using money market cover, the present value of NZ$ 25,000,000 has to be bought now and deposited for 3 months at 7 % p.a. A rate of 7 % per year is equivalent to 1.75 % per quarter. Hence, the amount to be bought now is NZ$ 25,000,000 divided by 1.0175 = NZ$ 24,570,025. NZ$ 24,570,025 can be bought now @ 3.4056, which will cost Sterling Pounds 7,214,595. Since G B has no surplus cash, this will have to be borrowed for 3 months at 6 % p.a. A rate of 6 % per year is equivalent to 1.5% per quarter. So: Sterling Pounds 7,214,595 x 1.015 = Pounds 7,322,814 Using lead payment, NZ$25,000,000 can be paid immediately @ 3.4056 =Sterling Pounds 7,340,850 This will have to be borrowed for 3 months at 6 % p.a. so total cost = Sterling Pounds 7,340,850 x 1.015 = Pounds 7,450,963 (b). Money market cover is the cheapest alternative as shown in calculations above. Another alternative would be to do nothing, and to buy NZ$ 25,000,000 in three months time at the exchange rate then prevailing. -This would result in a gain if NZ$ depreciated against sterling, but a loss if it appreciated, and would not limit the exchange risk. - Since G B s activity is food processing and not speculation, it would be more advisable to use a hedging strategy.