SECTION A CASE QUESTIONS (Total: 50 marks)

SECTION A CASE QUESTIONS (Total: 50 marks) Answer 1(a) The one year forward exchange rate of HKD / JPY is not equal to the current spot exchange rate because there exists a difference between the interest rates of HKD and JPY. As a matter of fact, the interest rate difference is driven by the expected inflation rate differential between Hong Kong and Japan. Answer 1(b) The HKD revenue = 1,000 x JPY40 million /(JPY15.523/HKD) = HKD2.5768 billion Answer 1(c) (i) The forward hedge requires selling JPY40 billion forward (1,000 x JPY40 million per apartment) Therefore, the loss on the one-year forward contract = JPY40 billion / (JPY16.111 / HKD) JPY40 billion / (JPY15.311 / HKD) = HKD2.4828 billion HKD2.6125 billion = -HKD129.7 million (ii) The net proceeds to Sanae Greater China Limited = JPY40 billion / (JPY15.311 / HKD) HKD129.7 million = HKD2.4828 billion Answer 1(d) The management of the exchange rate is worth doing if it has a material and significant impact on the value of the firm s cash flow. It could then mitigate the risk of financial distress and bankruptcy in the short run. At the same time, it could enhance the long run business sustainability and maintain a relative stable cash flow. It also helps to mitigate exchange rate risk to the firm, amid uncertain exchange rate movement. Besides, the cost involved in hedging FX movement is not very substantial as compared to its benefit. Module B (June 2016 Session) Page 1 of 10

Answer 2(a)(i) The one-year forward loss will not change since it would not affect the price of the forward contract the firm entered and closed. Answer 2(a)(ii) Net HKD proceeds to the firm = 1,000 x JPY40 million x (1-5%) / (JPY15.311 / HKD) HKD129.7 million = HKD2.4819 billion HKD129.7 million = HKD2.3522 billion Answer 2(b) Yes, I agree with the Head of the Marketing Department. Sanae faces risk if it does not drop the price because it might encounter difficulty to sell 1,000 apartments amid competition from other builders. Apartment buyers are price sensitive. Price cutting strategy would definitely attract more customers, help to speed up the selling process, gain market share and strengthen the firm s brand name. Answer 2(c) No, the firm should not have entered into the currency forward contract with the bank. The intention of the forward hedge for Sanae is to cover JPY revenue and match them against the running cost in HKD. Nevertheless, we have uncertainty as to what price in JPY and the quantity of apartments that could be sold in a year, and hence the amount of JPY required to hedge. This could result in being over-hedged if the amount of JPY required to hedge is smaller than expected. By definition, currency options could be abandoned by the holder and the holder is not obligated to exercise the terms of the contract. On the contrary, currency forward requires the contract holder to honor the terms of the contract on maturity. The firm would therefore be better off using currency options at the inception of the hedging period. Options are only rights accrued to the buyer, but not obligations, to exercise the contract. Yet, forward contracts do not provide this flexibility. Module B (June 2016 Session) Page 2 of 10

Unless the firm has a strong view that JPY will continue to depreciate substantially against HKD, it is not recommended to terminate the forward contract once entered into. It is a legally binding contract between the firm and the bank. The termination of a forward hedge can be costly and might lead to a substantial loss if the bank (only counterparty of the contract) offers a huge spread to close the position for Sanae. A big loss on the forward contract may reveal governance concern among investors and may tarnish the reputation and image of the management team. Answer 2(d) Yes, managing exchange rate risk is necessary. The management of exchange rate risk creates value if it reduces the probability of bankruptcy. Given the high volatility of the HKD / JPY exchange rate in the past years, it makes sense for the management of Sanae to hedge the exchange rate risk. Besides, firms that manage exchange rate risk could be more cost effective than shareholders separately. As a result, the cost of capital may also decrease due to a lower risk. The group s risk tolerance as well as the perceived future volatility of the exchange rate of HKD / JPY would affect the management s decision with regard to exchange rate risk management. Currency futures are not better than currency forwards in this case because of the additional risk of a margin call requirement if the HKD / JPY exchange rate movement is volatile. Currency forward could be tailor made to suit the firms need while futures are standardized contract without flexibility on contract size. Answer 3(a) (i) Breakeven number of units for Osaka apartment product line = JPY3,000 million / [(JPY40,000 million JPY31,000 million) / 1000] = 333 units (ii) Breakeven number of units for Tokyo apartment product line = JPY4,000 million / [(JPY64,000 million JPY48,000 million) / 800] = 200 units Module B (June 2016 Session) Page 3 of 10

Answer 3(b) Package contribution margin consists of 5 Osaka units and 4 Tokyo units = (JPY9 billion / 1,000) x 5 + (JPY16 billion / 800) x 4 = JPY125 million Number of breakeven packages = JPY9.25 billion / JPY125 million = 74 Hence, breakeven sales volume for Osaka apartments = 74 x 5 = 370 units And breakeven sales volume for Tokyo apartments = 74 x 4 = 296 units Answer 3(c) Revenue function is linear. Price, total fixed costs and unit variable costs can be reasonably identified. Sales mix and product mix are assumed to be known and relatively stable over time. * * * END OF SECTION A * * * Module B (June 2016 Session) Page 4 of 10

SECTION B ESSAY / SHORT QUESTIONS (Total: 50 marks) Answer 4(a) By CAPM : = 5.0 + 0.8 (10.5-5.0) = 9.4% = 9.4 + (9.4-5.5) 0.5 (1-0.165) / 1.5 = 10.486% = 9.4(1-0.165 x 0.25) = 9.012% L= 0.5 / (0.5 + 1.5) = 0.25 Answer 4(b)(i) = 0.95 x 4 [ 1 / (4 + 1 x (1-0.165))] = 0.95 x 0.827 = 0.786 βe: average industry equity beta Answer 4(b)(ii) By CAPM: = 5.0 + 0.786 x (10.5-5.0) = 9.323% Module B (June 2016 Session) Page 5 of 10

= 9.323 x (1-0.165 x 0.25) = 8.938% L = 0.5 / (0.5 + 1.5) = 0.25 KLM should use 8.938% as the cost of capital for investment evaluation since this cost considers the business risk of the service industry in which KLM plans to invest, and also the capital structure of KLM. Using KLM s original WACC calculated in part 4(a) is not correct as the original business risk is different. Answer 4(c) A company will not gear up as highly as possible for the following reasons: Limitation due to repayment ability. Various covenants imposed by lenders. Debt is not risk free at high gearing and therefore cost will increase. There is not enough profit to take advantage of the tax shield. Company may prefer keeping more money instead of paying interest and principal to cater for a good investment opportunity that may arise. Answer 5(a) Target cash balance by the Miller- Orr Model L = 1,200,000 F = 500 (fixed transaction cost for buying and selling securities) V = 100,000,000 (variance of daily cash flows) C = 2.5% (opportunity cost of holding cash) R = 0.0068% per day (1 + C) ^ (1/365) - 1 T = 1,282,144.94 (target cash balance = L+ [3/4 x F x (V/R) ^ (1/3)]) Module B (June 2016 Session) Page 6 of 10

Answer 5(b) (i) (ii) (iii) Private company shares the issue here is that private company shares are not liquid i.e. inability to convert to cash when the company needs the funds. Also, transaction costs (documentation for example) are high. Also, valuation risk is high due to the lack of market value. Shares of a UK major listed company of high beta as a major listed company, liquidity and credit risk should be of less concern. However, the risk here is foreign exchange as well as valuation due to fluctuations in the exchange rate between HK dollars and British pounds which may bring substantial profit or loss upon disposal. Further, high beta indicates the share price is volatile, which may cause substantial loss (or gain) when the shares are disposed of. A 10 year bond issued by the US Federal Government, YTM is 2%. the credit risk is very minimal as treasury bonds by the US Federal Government are considered risk free. Liquidity is also of no concern since the market for US Treasury bonds is mature and substantial. However, given its long term nature, the valuation is very sensitive to changes in the interest rate and market sentiment and therefore selling the bond before maturity may cause capital gain or loss. Answer 5(c) As the excess cash is only temporary in nature and the company will need it to fund working capital later in the high season, it should consider an investment that has high liquidity as well as offering a stable return. None of these investments fulfil these requirements. As such, the company should look for other more suitable opportunities. Module B (June 2016 Session) Page 7 of 10

Answer 6(a) TTC solution (Currency in BRL) Year 0 1 2 3 4 5 Real discount rate (WACC) 9% General inflation 4.3% Country risk premium 5.0% Initial investment ($50,000,000) Units / Year 2,500,000 4,500,000 5,500,000 2,500,000 Inflation for price 5% 5% 5% 5% Inflation for variable cost 4% 4% 4% 4% Inflation for fixed cost N/A 6% 6% 6% Selling price / unit 15.0 15.75 16.54 17.37 18.24 Variable cost / unit 6.0 6.24 6.49 6.75 7.02 Contribution / unit 9.51 10.05 10.62 11.22 Year 0 1 2 3 4 5 Initial investment (50,000) $ 000 $ 000 $ 000 $ 000 $ 000 $ 000 Total sales / revenue 39,375 74,430 95,535 45,600 Total variable cost (15,600) (29,205) (37,125) (17,550) Total contribution 23,775 45,225 58,410 28,050 Fixed cost (W1) (2,500) (2,650) (2,809) (2,978) Relevant cash flow 21,275 42,575 55,601 25,072 Tax 30% 0 (6,383) (12,773) (16,680) (7,522) Tax savings from capital allowance (W2) 0 3,750 2,813 2,109 6,328 After tax cash flows 21,275 39,942 45,641 10,501 (1,194) Nominal discount rate (W3) 18.69% 18.69% 18.69% 18.69% 18.69% Discount factor 0.842531 0.709858 0.598078 0.503899 0.424550 Present values 17,925 28,353 27,297 5,291 (507) NPV analysis: Present values of future cash flows 78,359 Initial investment (50,000) NPV 28,359 The company should take the project since the NPV is positive. Module B (June 2016 Session) Page 8 of 10

Working 1 (W1) Fixed costs Fixed cost should exclude $2,000,000 non-cash amortisation Year 0 1 2 3 4 $000 Original fixed cost (4,500) (4,650) (4,809) (4,978) Non-cash amortisation 2,000 2,000 2,000 2,000 Inflation for fixed cost N/A 6% 6% 6% Adjusted fixed cost (2,500) (2,650) (2,809) (2,978) Working 2 (W2) Tax benefit from allowable depreciation Year 0 1 2 3 4 $000 allowable depreciation % 25% 25% 25% 25% allowable depreciation 12,500 9,375 7,031 21,094 tax written down value 50,000 37,500 28,125 21,094 0 tax savings 30% 3,750 2,813 2,109 6,328 Working 3 (W3) Nominal discount rate Nominal discount rate = (1 + real WACC) (1 + general inflation) - 1 + Country risk = (1 + 0.09) (1 + 0.043) 1 + 0.05 = 18.69% Answer 6(b) The rate should include the country risk premium of 5% to reflect the overseas nature of the investment. As all cash flows are adjusted for inflation, i.e. they are nominal cash flows. Therefore, a nominal WACC is needed by adjusting the real WACC for inflation. Module B (June 2016 Session) Page 9 of 10

Answer 6(c) There are two methods to incorporate foreign exchange risks into the analysis: 1) Convert all Brazilian Real cash flows into Hong Kong dollars first by estimating and applying exchange rates for each year when relevant cash flows exist before calculating the Hong Kong dollar NPV. For this approach, the discount rate should be one that is applicable to the return based on the Hong Kong dollar. OR 2) Perform the analysis based on Brazilian Real and convert the NPV to Hong Kong dollars using the spot rate at the day of the analysis. For this approach, the discount rate should be one that is applicable to the return based on the Brazilian Real. * * * END OF EXAMINATION PAPER * * * Module B (June 2016 Session) Page 10 of 10