SECTION A CASE QUESTIONS Answer 1(a) To: Board of Directors From: Angel Chan Date: xx xxx xxxx Subject: Finacial performance of Winning Tools Limited and loan covenants We would need to resolve the dividend payout of Winning Tools Limited. The company has to decide on a share repurchase programme which is appropriate given the big drop in the stock price recently. The company is facing a financing constraint in dividend payout and share buyback, coupled with signalling the future outlook on the decisions and positioning of the stock s price in the capital market. There may be a cyclical downturn in the machine tool industry because the global economy is heading into recession. Also, the business restructuring of the company may not yield the expected positive financial results as new products incur a higher level of risk to win market share. The credibility of forecasts depends largely on the assessment of the management s ability to harvest potential profits. To support the new investment and resume dividend payout will increase the chance of taking on new debt. In an increasing interest rate environment, the risk of bankruptcy and financial distress cost are mounting. Answer 1(b) Return on investment (2013) = $12,992 / $674,582 = 1.93% Return on investment (2014) = -$250,785 / $536,874 = -46.71% Debt ratio (2013) = $273,411 / $674,582 = 40.5% Debt ratio (2014) = $359,684 / $536,874 = 67.0% (Alternative method of calculating debt ratio is acceptable.) Current ratio (2013) = $489,242 / $200,318 = 2.44x Current ratio (2014) = $447,083 / $267,367 = 1.67x Asset turnover ratio (2013) = $815,979 / $674,582 = 1.21x Asset turnover ratio (2014) = $656,638 / $536,874 = 1.22x Overall the financial performance is worsening in 2014 compared with 2013, with a negative return on investment, high debt ratio and tightening liquidity. Module B (June 2015 Session) Page 1 of 10
Answer 1(c) Dividend payout may affect the cash flow of the operation of the company where liquidity is weakening in 2014. It may further affect the repayment ability of the company to service the debt interest and principal to the existing lenders or bankers, as the debt ratio is increasing in 2014. Given the deterioration of the financial performance of the company in 2014, existing lenders or bankers may have more reservations and may even restrict the aggressive dividend payout ratio of the company by means of negative covenant clauses in the lending agreement. Loan covenants may also limit the company to sell assets to raise cash in order to make dividend payments. The creditors may even limit the capital expenditure of the company, which may affect the long term growth of Winning Tools Limited. Answer 2(a) The company s investment spending in research and development is likely to push up the financing requirement. The traditional presses and molds segment might continue to struggle in delivering profits while it will take time for the electrical industrial equipment sections to contribute to the bottom line. In the short run, the profit picture is not rosy. There is a good chance that a combined dividend payout in 2015 may still be higher than projected earnings. There will be pressure on the company to raise money through increasing debt levels to support the growth strategy and satisfy the dividend payment promise at the same time. As a result, the capital structure is likely to be more leveraged. Given the negative sentiment of the stock market, it may not be a good time to sell equities in order to raise long term funding. Answer 2(b) The decision on whether or not to repurchase shares relies on the assessment of the intrinsic value of the company versus the current market price. However, share repurchase in this case may not solve the company s dividend and financing problem. In fact, it will compete with the dividend decision for limited cash internally if implemented. Also, the message of share repurchase execution may not be consistent with the latest strategy: generate growth from another business line with heavy long term investment in research and development. Module B (June 2015 Session) Page 2 of 10
Answer 2(c) In general, a higher dividend payout usually signals anticipated good financial performance ahead. As a result, the capital market may react positively to the stock price when a higher than expected dividend payout announcement is made by the company. Moreover, the profile of the company s shareholders may influence the choice of dividend policy as well. Since the management of the company are largely family members of the founders, who own the largest and major share of the company, and they have decided to generate new growth by investing heavily. On top of that, there is a substantial increase in institutional investors who would like the company to create value. These might support the company not rushing to pay decent cash dividends before real and new growth starts to materialise. Answer 3(a) Post repurchase stock price = pre- repurchase stock price + present value of interest tax savings present value of financial distressed costs + signaling value of private information The debt increase will enhance tax savings which will have a positive effect on the stock price. The management may be perceived to convey positive private information to the market by share repurchase especially if the company used to maintain a high degree of information asymmetry with its shareholders. Yet, higher level of debt will increase the direct and indirect cost of bankruptcy and financial distress which are negative for the stock price. Overall, the stock price after share repurchase will be the result of these different forces. Stock buyback reduces the supply of stock but the share price may not increase if demand for stocks drops at the same time when investors are worried about the impact on future earnings. Answer 3(b) The weighted average cost of capital is likely to drop: there will be a higher portion of debt (additional financial leverage) being used relative to equity (reduction by stock repurchase). The cost of debt is lower than the cost of equity. Module B (June 2015 Session) Page 3 of 10
As a result, the weighted average cost of capital overall will go down, assuming that the increased debt level will not push the cost of financial distress to a very high level, and that outweighs the benefit of tax savings in taking on more debts. We also assume that the increase in the stock price as a result of share repurchase will not push up the market value of equity substantially. The beginning of the interest rate increase cycle will raise the cost of debt, or potential interest tax savings will benefit if the company is making a profit, not a loss. Answer 3(c) Andy s purchase of the company s stock based on his capacity as financial manager in the repurchase decision means he could be charged with insider dealing under the Securities and Futures Ordinance. The company should inform and educate its staff regarding the ethical standards in using information appropriately from time to time. Also, staff involved in stock price-sensitive information may need to sign a confidentiality agreement and make sure they are aware of the limitations of the use of information for trading purposes themselves or passing such information to someone else for trading purposes. Answer 4(a) Manufacturing cycle efficiency = manufacture time / (manufacture time+ transport time + store time + inspect time) = 7.2 / (7.2 + 3.2 + 4.8 + 1.2) = 43.9% MCE (Winning Tools) << MCE of industry average, coupled with the unsatisfactory latest financial performance might suggest too much time is spent on non-value added activities such as transport and storage. Relatively insufficient time is spent on the quality control of the manufacturing process. Answer 4(b) Winning Tools Limited may fail to link the measure to the company s goal or strategy. It may not validate the link thoroughly. It may not set the appropriate performance target. It may measure incorrectly. * * * END OF SECTION A * * * Module B (June 2015 Session) Page 4 of 10
SECTION B ESSAY / SHORT QUESTIONS Answer 5(a) Actual profit margin: Sales $1,000 Direct labour $190 Direct materials $320 Variable overhead $60 Allocated overhead $380 Gross profit margin $50 (or 5%) Gross profit margin is 5% (1,000-950) / 1,000. Therefore current cost structure is not acceptable. The unit cost must be reduced from $950 to $930 in order to reach the 7% target gross margin. The company can achieve the $20 per unit reduction by considering one of the following three alternatives, (i) labour cost, (ii) materials cost and (iii) overheads. As given in the case, the labour cost in mainland China is rising due to economic growth and the increase is expected to be about 10% for TTC s plan, so it is unlikely that this cost can be reduced by $20 per unit or 10.5% (20/190). The reduction in materials cost is also difficult to achieve given that the commodity prices are determined by the market and TTC essentially has no control over it. Also, as TTC is already an established manufacturer of mobile phones and it has a reputation for being a low cost producer, a further increase in production efficiency is unlikely to deliver a cost reduction equivalent to a 33.33% reduction (20/60) in variable overheads. However, as TTC has an extra fixed manufacturing overhead, it is worth exploring (1) reduction of fixed manufacturing overhead, if possible, or (2) increase in the volume of production to reduce the allocated fixed overhead. As an illustration for (2), assuming total fixed overhead remains constant, in order to reduce the unit allocated fixed overhead from $380 to $360, the volume of production should be increased by 5.56% (380 / 360-1) or to 527,800 units. It is therefore worthwhile for TTC s management to explore with its customer the possibility of a higher purchase volume in order to reach the 7% target gross profit margin. Module B (June 2015 Session) Page 5 of 10
Answer 5(b) Total Gross Profit = $10,000,000 - $3,000,000 = $7,000,000 Traditional Gross Profit approach: ($ 000) Sales 10,000 COGS Direct labour 900 Direct materials 1,800 Manufacturing overhead 300 Gross profit margin 7,000 Yes, Model X should be developed. Life Cycle Costing approach Traditional Gross Profit approach: ($ 000) Sales 10,000 COGS: Direct labour 900 Direct materials 1,800 Manufacturing overhead 300 Gross profit margin 7,000 Brand building 4,000 R&D 2,900 Customer service (set up and running cost) 200 Termination cost (disposal of related assets, inventory write-off) 200 Abnormal wastage of materials due to learning curve 50 Life cycle profit / (loss) (350) Excluded costs: HR and admin support and legal support 300 Loss of disposal of idle equipment 500 Module B (June 2015 Session) Page 6 of 10
Model X is expected to suffer a loss of $350,000 during its life cycle when all relevant costs in developing, marketing, manufacturing and servicing the product are included. Unless Model X has significant strategic value to TTC, e.g. to develop an own brand to expand to a new market, it should not be launched unless total life cycle costs can be reduced and controlled to at least a breakeven level. R&D, branding, customer service, termination cost and abnormal wastage are all part of the life cycle costs incremental to Model X s development, i.e. the company will not incur these costs if Model X is not developed. HR, administration and legal support are excluded since they are allocated and these functions are shared by existing staff. Loss of disposal of idle equipment is a sunk cost and is therefore irrelevant to the decision. Answer 5(c) Advantages: - Give a better picture of the total performance of a product, particularly a new product. - Help identify design costing problems at an early phase and therefore reduce future maintenance and warranty costs. - Help shape product strategy to establish early presence and create early mover advantage. - Provide an indication of financial return over the life of a product. - Can be used to determine a target selling price at different stages of a product s life cycle. Disadvantages: - Additional cost may be needed to enhance accounting system to capture cost over life cycle. - Ignores time value of money. - Substantial uncertainty in estimation of sales, cost, R&D etc. on a product with a long cycle and / or when business is operating under a dynamic environment. - Inclusion of some costs may be subjective such as the accounting system development, product enhancement. This problem can be solved by applying incremental cost analysis by asking the question: is this cost incurred or saved if the product is launched? Module B (June 2015 Session) Page 7 of 10
Answer 6(a) All figures are in 000. Yr 0 Yr 1 Yr 2 Yr 3 Yr 4 Future Sales 12,100 13,552 15,178 17,076 18,270 EBIT 2,178 2,440 3,036 3,416 3,472 Tax (30%) (653.40) (732) (910.80) (1,024.80) (1041.60) Add depreciation 262 292 364 410 416 Capital Expenditure (1,816) (1,490) (1,518) (1,708) (1,828) Changes in working capital (384) (306) (250) (76) (56) Free cash flow (413.40) 204 721.20 1,017.20 962.40 Terminal value 12,030 Total cash flow (413.40) 204 721.20 13,047.20 PV factor 0.869565 0.756144 0.657516 0.571753 Total PV (359.50) 154.30 474.20 7,459.80 NPV 7,728.8 Less debt (950.0) Equity value 6,778.8 Working: Working capital 2,400 2,784 3,090 3,340 3,416 3,472 Changes (384) (306) (250) (76) (56) Terminal value = [962.4 / (0.15-0.07)] = 12,030 (Constant Growth Model) WACC 15% Growth rate beyond 5th year 7% Module B (June 2015 Session) Page 8 of 10
Answer 6(b) Forward exchange rates: 1 month: 12.8488 + 0.0230 = 12.8718 3 months: 12.8488 + 0.0625 = 12.9113 Therefore, total HK dollar payment = [ 7,000,000 x (0.3 x 12.8718 + 0.7 x 12.9113) ] = HK$90,296,150 If WYZ does not hedge, how much would it pay if GBP appreciates by 2% on the prescribed payment dates compared to the spot rate? 7,000,000 x 1.02 x 12.8488 = HK$91,740,432. WYZ has to pay = 91,740,432-90,296,150 = HK$1,444,282 more if it does not hedge. Answer 6(c) Premium = 7,000,000-0.75 x 6,778,800 = 1,915,900. Possible justification for premium: WYZ will derive cost savings due to increased economies of scale as it can act as the supplier to T s fashion business. Acquisition provides fast penetration into the UK market compared to organic growth. Since this is the first cross-border acquisition, WYZ will learn from this transaction for future overseas expansion activities. The use of A s brand will help enhance business. As a partner of a major UK company, WYZ may have the possibility of business opportunities in the EU market in the future. Answer 7(a) Apply equity carve-out to SA Equity carve out is a process in which a parent company sells the whole or part of a subsidiary or business to a new or group of new shareholders for cash. The key features of this transaction are actual cash inflow to the Group and a new shareholder. Existing shareholders of HEE will not be able to participate. Module B (June 2015 Session) Page 9 of 10
Reasons: As this action brings cash, it will immediately reduce cash flow pressure and provide stronger liquidity for the Group s future operating use. Selling partially to an independent new shareholder will help to establish a market value for this business. The Group s shareholding in SA, which is a cash cow, will be lower after the carve out, therefore the attractiveness of the Group to a corporate raider will be reduced. Apply spin-off to SB Spin off is a restructure technique in which a parent company distributes its shareholding of a subsidiary or business to its existing shareholders on a pro rata basis. After the distribution, the effective holding of shareholders remains the same and there will be no new shareholders. For example, the shareholders of HEE effectively hold 75% of SB through HEE before distribution, if 35% is distributed, then HEE s shareholders will hold 35% of SB directly and 40% through HEE. Reasons: The Group s size is smaller after distribution, reducing the attractiveness and threat of the takeover. Distribution will increase shares in trading. Higher trading volume is expected to help reflect the internal value. Answer 7(b) The Board should further consider the following matters before implementation: Extent of restructuring considering whether the Group still wants control over either one. This decision has to be taken in conjunction with the overall long term corporate strategy. Listing rules compliance: the extent of downsizing should not jeopardise the listing status of the Group and compliance requirements. Tax effect: will this action adversely affect the overall tax position of the Group? Also, can the transactions be structured tax free? Morale of employees. Effect on overall viability of the Group after restructuring. How to communicate with the shareholders and stakeholders to ensure their support. Cost: both transactions may involve substantial professional fees. * * * END OF EXAMINATION PAPER * * * Module B (June 2015 Session) Page 10 of 10