SECTION A CASE QUESTIONS (Total: 50 marks) Answer 1(a) Heli HK$ Robo HK$ Selling price 8,000 24,000 Variable costs (3,240) (9,400) Contribution per unit 4,760 14,600 Answer 1(b) Time required for target production level = 280 x 80 minutes + 100 x 140 minutes = 36,400 minutes Answer 1(c) Heli Robo Contribution per unit HK$4,760 HK$14,600 Time consumed in assembly dept 80 min 140 min Contribution margin per minute HK$59.50 HK$104.29 Since Robo contributes more on a per minute basis, the firm should use additional time in the Assembly Department to produce Robo. Firstly, produce 280 Heli and 100 Robo. Then it should produce an additional 31 Robo with the extra time (680 hours - 36,400 minutes) / 140 minutes per Robo. Total monthly contribution margin = 280 x HK$4,760 + (100 + 31) x HK$14,600 = HK$3,245,400 Module B (December 2015 Session) Page 1 of 12
Answer 2(a) (i) HKburger Chinaburger HK$ HK$ Current ROI Revenue 11,005,000 17,680,000 Expenses (9,240,000) (14,966,800) Net profit 1,765,000 2,713,200 Assets 8,900,000 17,400,000 ROI 19.83% 15.59% (ii) ROI of expansion project Increased profit 306,000 346,000 Expansion cost 1,800,000 1,800,000 ROI of project 17% 19.22% (iii) ROI after the project Total profit 2,071,000 3,059,200 Total assets 10,700,000 19,200,000 ROI 19.36% 15.93% Module B (December 2015 Session) Page 2 of 12
Answer 2(b) (i) Current residual income HKburger HK$ Chinaburger HK$ Net Profit 1,765,000 2,713,200 Less: Assets x 9% (801,000) (1,566,000) Residual income 964,000 1,147,200 (ii) Residual income of project Increased profit from project 306,000 346,000 Less: 9% x expansion cost (162,000) (162,000) Residual income 144,000 184,000 (iii) Residual income after project Net profit 2,071,000 3,059,200 Less: 9% x assets (963,000) (1,728,000) Residual income 1,108,000 1,331,200 Module B (December 2015 Session) Page 3 of 12
Answer 2(c) ROI allows for the comparison of performances across managers of different amounts of assets. It is in the form of an easily understood percentage. The problems of ROI include measurement errors resulting from the use of historical costs, manipulation, incentives to under-invest, and not including the discounting of cash flows. Also, Chinaburger actually made 50% profit more than HKburger. In terms of profits alone, the former is indeed more successful. Residual income has the advantage of explicitly recognising the cost of capital. Residual income is explicitly stated in absolute amount. The problems of residual income are that it does not facilitate the comparison of HKburger and Chinaburger nor does it relate the size of divisional income to the size of investment, which is significantly different between the two. Answer 2(d) The current ROI of HKburger and Chinaburger is different. HKburger has a ROI of over 20%, while Chinaburger has a ROI of over 15% only. Since the ROI of the project is 17%, adding the project to HKburger will lower its average ROI, while adding the project to Chinaburger will raise its average ROI. Therefore, the manager of HKburger will not want to expand. However, the manager of Chinaburger would want to add the project since the restaurant s ROI would subsequently rise. The franchised unit restaurant owners, they would definitely like to expand. Given the ROI of the expansion project is higher than the cost of capital at 9%, there will be positive residual income recorded. The drop in the ROI will be secondary, as long as the residual income of the restaurant increases. Answer 3(a) GoHK Limited has two business segments. Gogo Limited makes up 66% of revenue whereas Goburger Limited constitutes the other 34%. These two segments carry distinct risks from each other to warrant different costs of capital. The former is an electronics related business and the latter is a food and beverage business. As a consequence, the cost of capital of GoHK Limited is likely to be a weighted average of the combination of the two business segments cost of capital. Module B (December 2015 Session) Page 4 of 12
Answer 3(b) The capital asset pricing model will be appropriate. It highlights the risk nature of the different segments in this case. As for the dividend discount model, it may not be that appropriate due to the fact that GoHK Limited has no dividend payment history to its shareholders so far. Answer 3(c) Net assets valuation: Provides a lower limit for the value; difficult to establish asset value. Earnings based valuation: High growth may result in a high multiple such as P/E ratio; can be problematic when P/E ratios of listed firms are used to value the unlisted firm GoHK Limited. Free cash flow valuation: Values the total firm rather than just the equity stake; estimation of future cash flow requires a lot of assumptions and the discount rate on cash flow could vary significantly. * * * END OF SECTION A * * * Module B (December 2015 Session) Page 5 of 12
SECTION B ESSAY / SHORT QUESTIONS (Total: 50 marks) Answer 4(a) All values are in HK$m, except otherwise stated (i) a cash dividend (HK$ per share) 0.25 No. of existing shares (million) 400 Cash returned 100 Market price (HK$ per share) 10 Total shareholders wealth before dividend (400 x 10) 4,000 Share price after dividend (HK$) ((4,000-100) / 400) 9.75 Equity market value (9.75 x 400) 3,900 Total shareholders wealth after dividend (3,900 + 100) 4,000 (cash dividend + market value of equity after dividend) (ii) Scrip dividend 2.5% No. of scrip shares issued (million) 10 Total number of shares (million) 410 Total shareholders wealth before dividend 4,000 Share price after scrip dividend (HK$) (4,000 / 410) 9.756 Total shareholders wealth after dividend (9.756 x 410) 4,000 (total no. of shares x share price after dividend) (iii) Repurchase of shares No. of shares to be repurchased (million) (100 / 10) 10 Remaining shares after repurchase (million) (400-10) 390 Cash returned 100 Market value of remaining equity 3,900 Total shareholders wealth before repurchase 4,000 Total shareholders wealth after repurchase 4,000 (cash returned + market value of remaining equity = 3,900 + 100) Answer 4(b) From the answer in (a), it is noted that the total shareholders wealth remains the same regardless of dividend policy. This is known as the dividend irrelevance theory. This theory advocates that the form and timing of dividends do not affect shareholders wealth. In the context of this question, it has been shown that total shareholders wealth is unchanged no matter what form of dividend the company chooses. In terms of timing of payment, as long as the company delays dividends to shareholders and reinvests the amount retained at the required rate of return, the total value of a shareholder s investment in a company share is the same regardless of the timing of dividend payment. Module B (December 2015 Session) Page 6 of 12
The main assumption is that there is no personal tax. If there is personal tax, the net return to shareholders will vary depending on the tax jurisdiction of the shareholders. Another major assumption is that the shareholders and company can reinvest at the same required rate of return. Answer 4(c) Proposal i: Pay cash dividend since the increase in dividend will return the extra cash of $60 million as well as sending a positive signal of increased future EPSs. Since the company will not need further financing for future capital investment, it is prudent and to the shareholders benefit to return the extra cash. The company should be careful in deciding the dividend increase in order to pass an appropriate message about future prospects. So it will be better to split the dividend into two parts: regular and special. The regular dividend can be increased to, say, HK$0.15 and special dividend of HK$0.10. This will pass the appropriate message that earnings are expected to increase. Proposal ii: Pay a 2.5% (equivalent to HK$0.25, an increase from the historical level of HK$0.1) scrip dividend in order to save money. This scrip dividend should give the investors an impression that the company is returning extra value (HK$60 million) to them while conserving cash for investment in the next year. This hopefully will provide support to the depressed share price but the effect is uncertain due to the dilution effect. The company may consider giving a scrip dividend lower than 2.5% (or equivalent to HK$0.25 per share). This in effect is reducing from the historical HK$0.10 per share plus the extra HK$0.15 per share in order to convey the signal of pessimistic future earnings but the company must be careful about this approach as the share price may decline further. Proposal iii: Share repurchase will reduce the number of outstanding shares. With earnings stable, this will boost the ROE. Further, investors will see this action as a signal that existing shares are of good value and will start taking a position, hence providing support to the share price, at least temporarily. Answer 4(d) In proposing and recommending dividend policies, Mr Chan, CFO, should have the following ethical considerations: - Integrity: Present the historical financial information and future projections in a straight-forward and honest manner without misleading either the Board or other stakeholders; Module B (December 2015 Session) Page 7 of 12
- Objectivity: The information and proposal tabled should be unbiased, and with due consideration of the signalling effect of the different policies, the purpose being to pass the correct signal to the shareholders; - Professional competence and due care: Any dividend policies proposed should be in the best interests of shareholders and other relevant stakeholders such as creditors. In other words, striking a balance in returning extra cash to shareholders while maintaining adequate liquidity in the company to service future development and protection of creditors. Such recommendations should be based on sound financial management principles rather than personal preference or political pressure; and - Confidentiality: In formulating dividend policies, Mr Chan may have access to confidential information which has a bearing on the future earnings prospects of the company. Mr Chan should ensure the confidentiality of such information and avoid the premature leaking of the final dividend policy before its official announcement as a dividend is considered price sensitive information since it affects the share price. Answer 5(a) To: From: Date: Mrs Alice Fong, Chairperson Ken Wong, CFO xxx Subject: The Efficient Market Hypothesis theory - EMH Per your request, the following explains three aspects of the EMH with application to the Hong Kong stock market. Form of efficiency of the Hong Kong stock market The Hong Kong stock market has a semi-strong form of efficiency. By definition, a semi-strong form of efficient market is one in which share prices reflect all past and publicly available information about a company. It is observed that shares traded in the Hong Kong stock market continuously react to information, both past and present, released to the public and the Hong Kong stock market therefore has a semi-strong form of efficiency. Share prices can quickly reflect on past and present public information due to the following reasons: (1) efficient trading system; (2) low trading cost; (3) analysts and investors conduct research on companies; and (4) high level of transparency - free flow and easy access of company information. Module B (December 2015 Session) Page 8 of 12
Answer 5(b) Share price reaction on the day of profit announcement In a semi-strong form of market, share prices reflect all past and present publicly known information. In practice, before the actual results announcement, investors or analysts tend to predict the performance and price-in the expected profit in the share price. As such, the share price will rise before the announcement if profit is expected to increase over the previous year by a material amount. However, if the actual profit increase is lower than expected, this piece of surprise information will be reflected immediately in the share price on announcement day, causing it to decline. The implication to investors is that the market continuously updates its expectation about the upcoming profit announcement and adjusts the share price whenever new information is available which reflects the level of profit to be announced. Therefore, investors should not wait to make investment decisions until the actual announcement but instead should monitor all the news, operating statistics etc. which may have an impact on future profits and make investment decisions as soon as the information is available. Answer 5(c) Existence of the strong form of efficient market Despite its theoretical soundness, the strong form of efficient market does not exist in practice. Under the strong form of efficiency, the share price reflects all information about a company, both public and private. In practice, private information, such as unannounced mergers and acquisitions, may not be reflected in the share price until the announcement due to illegal insider dealing. Selected investors, including fund managers and other institutional investors may have private information from the management, but they cannot trade based on such knowledge to profit without violating the SFO insider dealing rules. Therefore, it may not be possible that private information can be priced into the share price before it becomes public. The implication to the issuer is that despite the fact that this form of market efficiency may not be fully observed in practice, the implication of a strong form of efficiency is not to be understated. A company should make sure its value is properly and timely reflected in the share price. One way to achieve this is transparency timely and unbiased disclosure. Investors can then make investment decisions based on such information and therefore reflect the true valuation of the share price as soon as practically possible. Further, the issuer should also take all necessary measures to maintain confidentialy of price sensitive private information to avoid the possibility of insider trading, which is not just illegal, but unfair to shareholders as well. If you have any further questions, please let me know. Module B (December 2015 Session) Page 9 of 12
Answer 6(a) 20x4 20x3 Ratios: Inventory days 115.96 70.80 Receivables days 65.34 44.72 Payables days 44.91 35.28 Cash operating cycle 136.39 80.24 Industry average (20x4) Inventory days 90.00 Receivables days 60.00 Payables days 45.00 Cash operating cycle 105.00 Comments: 20x4 vs. 20x3 The cash operating cycle increased by 56 days or 70%, indicating declining performance in working capital management. Sales increased about 41%, whereas inventory, receivables and payables days increased, respectively, by 63.7%, 46% and 27%. The increase in inventory days is a particular concern. As mentioned in the case, it may be due to: - poor sales planning; - excessive purchase of inventory; and - out-dated inventory management practices. The increase of receivables days was in line with the increase in sales but it is still worth analysing what caused the increase as it caused more than a 20 day increase in the cash operating cycle. Efficiency in the collection and potential risk of bad debt have to be considered. An increase in payables days actually helps the efficient use of capital. However, the company should strike a balance between lengthening the payment time to suppliers and maintaining a good relationship. 20x4 vs. industry average The cash operating cycle increased by 31 days or 29.5% compared to the industry average. Inventory days were again the core problem and were due to the same reasons mentioned above. It can be argued that 20x4 receivables and payables were in line with the industry but management should ask the question - was it really the original intention to stay close to the industry average in 20x4 or just less efficient working capital management compared with 20x3, given the deteriorating performance compared with 20x3 discussed above? Module B (December 2015 Session) Page 10 of 12
Answer 6(b) The company should focus its attention on reducing inventory days as this has worsened substantially versus 20x3 and is much longer than the industry average of 90 days. The other two elements, i.e. receivables days and payables days are already close to the industry average and so not much needs to be done. Ways the company can improve the inventory days include : - Reduce high value items to the operating needs as it ordered excessive high value items during 20x4 to take advantage of bulk discount. An analysis can be performed to compare the savings from bulk purchase and additional inventory costs. Also, the risks of obsolescence, breakage and theft need to be considered. - Better sales planning which drives the production and eventually inventory level. The actual sales were 30% below forecast and as such all inventory levels became higher as a result. - Explore Just-In-Time ( JIT ) inventory management practices. Most of company s competitors have adopted JIT which is supposed to reduce the inventory level and associated costs. Module B (December 2015 Session) Page 11 of 12
Answer 6(c) Credit terms extension for 20x5. All dollars are in HK$m. 20x4 Revenues 20,592 20x5 Revenue increase (5 % increase, $m) 5% (0.05 x 20,592) 1,029.6 Gross profit margin 20x5 (% of 20x4) 90% (8,316 / 20,592 x 0.9) 36.35% Payable days 45 Proposed credit terms (days) 75 Current credit terms (days) 60 Expected trade receivables based on proposed credit terms of 75 days 4,442.79 (75 / 365 x (20,592+1,029.6) Trade receivables based on existing credit terms of 60 days 3,384.99 (60 / 365 x 20,592) Increase in trade receivables 1,057.80 Increase in inventory 5% (3,900 x 0.05) 195.00 Less increase in trade payables 5% (0.05 x 1,435) (71.75) Net increase in working capital 1,181.05 Increase in gross profit (1,029.6 x 0.3635) 374.26 Return on extra investment (374.26 / 1,181.05) 31.69% Conclusion: The company should adopt the new credit terms as the return on the extra working capital investment (31.69%) exceeds 20%, the required return. * * * END OF EXAMINATION PAPER * * * Module B (December 2015 Session) Page 12 of 12