HKICPA Qualification Programme Module B Corporate Financing KPMG Mock Exam Answers http://www.kaplanfinancial.com.hk
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Answer To: Mr. Chan, Chairman of the Board, B-Group From: XXX Wong, Finance Manager, B-Group Date: dd/mm/yyyy In respect of the proposed projects (Anning, Baoshan and Chuxiong) in relation to the integrated material logistics platform, my responses to your queries are as follows: Project appraisal methods For long-term projects, the main methods of project appraisal include the payback period, accounting rate of return (ARR), net present value (NPV) and internal rate of return (IRR). The general principles of the main project appraisal methods, may need to be explained before I calculate the payback period, accounting rate of return and net present value of each of the three projects, Payback period The payback period of a project is calculated by counting the number of years that it takes for cumulative forecasted net cash flows to equal the initial investment. When the cash flows are not uniform, the total payback period can be calculated by:. Subtracting the period cash inflows from the amount of the initial investment until the next period cash inflow will cover all the remaining investment, and adding the number of periods; and. Dividing the remaining investment amount by that last period cash flow to determine the fraction of the period when the total investment is recovered. Thus the payback period for: Project Anning Project Baoshan Project Chuxiong = years + ( 55) / =.75 years = years + ( 7) / =.7 years = years + ( 75) / =. years Accounting rate of return The accounting rate of return (ARR) method focuses on the incremental accounting profit that result from the project. A significant difference between the ARR, the payback and discounted cash flow methods is that the ARR includes accruals in the calculation of project return numbers and the others do not. ARR = Average incremental profit / Average investment Where average incremental profit = (sum of cash flows investment cost) / project s life; and average investment = (initial investment + salvage value) / = RMB million / = RMB million Thus the accounting rate of return for: Project Anning = ( / 7 years) / =.8 x =.8% Project Baoshan = (7 / 5 years) / =.4 x = 4% Project Chuxiong = (5 / 4 years) / =.875 x = 8.75% QP B Mock Exam Answers (Dec) Copyright Kaplan Financial
Net present value and Internal rate of return (IRR) A project s net present value is calculated by discounting all net cash flows generated by the project to their present values. IRR is the discount rate which gives NPV value of zero. Generally speaking, the higher a project's internal rate of return, the more desirable it is to undertake the project. (in million RMB) Anning Baoshan Chuxiong Year Discount factor Cash PV Cash PV Cash PV 4 5 7 8..99.84.75.8.9.545.5.45 () 5 5 55 5 7 8 () 45 4 4 4 4 4 4 () 5 9 () 8 4 75 75 5 () 75 () 9 9 4 NPV IRR 89.5% Thus the net present value of each project: Project Anning = RMB 89 million Project Baoshan = RMB 5 million Project Chuxiong = RMB 57 million 7 5 9.7% 5 57 4.% Project preferred by the ordinary shareholders The following rankings are based on the different evaluation procedures: Project IRR Payback ARR NPV Anning Baoshan Chuxiong Each of the project appraisal methods would have its limitations. Simple non-discounting methods such as payback and ARR are often used in practice because they are easier to understand than discounted cash flow methods like NPV and IRR. However, payback ignores cash flows outside the payback period, and it also ignores the timing of cash flows within the payback period. For example, the large cash flows for project Anning are ignored after the payback period. This method may be appropriate for companies experiencing liquidity problems who wish to recover their initial investment quickly. However, this is not the case for B-Group. While the accounting rate of return ignores the timing of cash flows, but it is considered an important measure by those who believe reported profits have a significant impact on share prices. In project appraisal, it is important to allow for the time value of money since one dollar received or paid in the future is not worth as much as one dollar received or paid today, for the dollar received or paid today can be invested to earn interest. This means that for projects that generate cash flows far in the future, we cannot just add future cash flows into our analysis at their nominal value. We should discount them first so that all the numbers have the present value. Discounting methods are necessary to allow for the time value of money when appraising long term projects. The theoretically correct evaluation procedure is generally believed to be the net present value. QP B Mock Exam Answers (Dec) Copyright Kaplan Financial
If NPV is positive, this means that the project is acceptable on quantifiable grounds because it will add value to the entity undertaking the project. For ranking competing projects, the NPV method is generally preferred over the IRR method since the latter can give incorrect rankings, particularly when the projects are of different sizes, because it measures the rate of return rather than the absolute gain that each project offers the shareholders. A high rate of return on a small project can be worth less than a lower rate of return on a large project. A positive net present value from an investment is supposed to indicate an increase in the market value of the shareholders funds, though this claim depends upon the belief that the share price is the discounted present value of the future dividend stream. Therefore, it is recommended that the net present value method is used and that project Anning should be selected. It should be noted that the cash flows have been discounted at the company s cost of capital. It is only suitable to use the company s cost of capital as the discount rate if the three projects are equivalent to the average risk of all the company s existing projects. If they are not of average risk then project risk-adjusted discount rates should be used. Since the projects have unequal lives, it is assumed that the warehouses will not be replaced. If the warehouses are to be replaced, it will be necessary to consider the projects over a common time horizon. Max (c) Mr. Leung prefers project Chuxiong because it produces the highest accounting profits in year. Since Mr. Leung regards his appointment at B-Group as temporary, enabling him to gain experience before moving on to a larger organisation, he hopes to achieve a good profit within the next three years so that he can leave B-Group in three years time, with its share price standing high. As a consequence, he is particularly concerned that the reported profits of B- Group should be as high as possible in his third and final year with B-Group. Mr. Leung is assuming that share prices are influenced by short-run reported profits. This action to fulfill his personal goal at the expense of the company as a whole is considered unethical. Besides, the assumption that share prices are influenced by short-term reported profits is in contrast to financial theory, which typically assumes that the share price is the discounted present value of the future cash flow. Mr. Leung is also assuming that the market only has access to reported historical profits and is not aware of the future benefits arising from the projects. The stock market also obtains company information on future prospects from sources other than reported profits: for example, press releases, chairman s report and signals of future prosperity via increased dividend payments Max 4 Total QP B Mock Exam Answers (Dec) Copyright Kaplan Financial
Answer The Mega-Mall Unit has adopted a low-price strategy. The Mega-Mall Unit seeks to achieve a lower price than competitors, which is evidenced by the lowest gross profit margin (: 7.95%) and total profit margin (:.5%) amongst the three strategic units. The Mega-Mall Unit also seeks to maintain similar perceived services to those offered by competitors, for example by offering a broad range of products to meet the customers one-stop shopping needs to offset the inconvenience of the locations. The Supermarkets Unit has adopted a hybrid strategy. The Supermarkets Unit seeks to achieve differentiation by locating the supermarkets in densely populated residential areas to cater for customers daily necessities. The Supermarkets Unit also seeks to achieve lower prices by setting highly competitive pricing for promotional products. The Stores Unit has adopted a focused differentiation strategy. The Stores Unit seeks to provide highly perceived services to customers, that is, fast, convenient and 4-hour shopping services. Such highly perceived services justify a higher price premium, which is evidenced by the highest gross profit margin (:.5%) and total profit margin (: 5.%) amongst the three strategic units. Although GCS s three strategic business units are catering to quite different markets and customer needs, their businesses are principally the retailing of daily consumables. GCS has therefore adopted related diversification through horizontal integration using franchising. Research on the relationship between diversification and corporate performance suggests that related diversified companies perform better on average than either undiversified companies or highly diversified companies. The reasons may be that related diversification benefits from both the economies of scale and the economies of scope to some extent. Franchising allows rapid expansion using minimum capital, as the franchisee is the party who invests the capital. In this sense, GCS may be right in its adoption of related diversification using franchising at the corporate level. 5 Total QP B Mock Exam Answers (Dec) 4 Copyright Kaplan Financial
Answer Since the manager of the Shanghai Hub is responsible for investment decisions on opening new outlets and closing down existing ones, the manager has control over the assets employed by the hub. The Shanghai Hub should therefore be classified as an investment centre for the purpose of performance evaluation. The most commonly used financial performance measure for an investment centre is the return on investment, which is the ratio of the income report in the income statement and the amount of assets employed in the balance sheet. Another conceptually sound but less widely used financial performance measure is the residual income (or economic value added), which is arrived at by subtracting a capital charge from the operating profit. Based on the information given, the most appropriate financial performance measure for the Shanghai Hub would be the return on investment of non-current assets employed of 9.% [RMB8,/RMB4,] in. Return on investment of total assets employed of.4% [RMB8,/RMB,,] in may also be an appropriate financial performance measure. Since the manager of the supermarket SH-SM is responsible decisions regarding daily operations, including the product mix and extent of promotional discount, the manager has control over the revenue as well as the operating costs. Since control over the asset employed is limited, e.g. to the level of inventory, the supermarket SH-SM should therefore be classified as a profit centre for the purpose of performance evaluation. A common financial performance measure for a profit centre is the contribution margin, which reflects the spread between revenue and variable expenses. A close approximate of the contribution margin based on the information given is the gross profit margin of 4.% [RMB5,/RMB,7,]. Another financial performance measure for a profit centre is the controllable profit, which reflects the spread between revenue and expenses controllable by the supermarket manager, excluding non-controllable items. A close approximate of the controllable profit based on the information given is the gross profit plus other income of RMB,8, [ RMB5,+ RMB87,]. The supermarket manager s control over the distribution and selling costs and administrative costs, which are likely to be mainly of premises rental, employee costs, and other fixed expenses, is likely to be limited. Another possible financial performance measure for a profit centre would be the direct profit, which includes all revenue and expenses directly attributable to the profit centre, whether or not they are controllable by the manager of the profit centre. A close approximate of the direct profit based on the information given is the operating profit of RMB9,. The financial measure most appropriate to SH-SM should be the controllable profit, which is approximated by the gross profit plus other income in this case, since it includes only those items that are under the manager s control. The contribution margin of SH-SM (approximated by the gross profit) ignores the other income on display and promotion which is significant in the supermarket s revenue and profit. The direct profit is a good performance measure for the profit centre, but not for the performance of the profit centre s manager. 7 Total QP B Mock Exam Answers (Dec) 5 Copyright Kaplan Financial
Answer 4 Rights issue price =.5 x.8 = $. per share Theoretical ex rights price = ((.5 x 4) + ( x.))/5=$.4 per share (Alternatively, number of rights shares issued = $5m/$. =.5m shares Existing number of shares = 4 x.5m = m shares Theoretical ex rights price per share = ((m x.5) + (.5m x.))/.5m = $.4) Current price/earnings ratio = 5/.4 = 7.7 times Average growth rate of earnings per share = x ((.4/7.7)^.5 ) = 4.% Earnings per share following expansion =.4 x.4 =.7 cents per share Share price predicted by price/earnings ratio method =.7 x 7.7 = $. Since the price/earnings ratio of Dai Hing Co has remained constant in recent years and the expansion is of existing business, it seems reasonable to apply the existing price/earnings ratio to the revised earnings per share value. (c) The proposed business expansion will be an acceptable use of the rights issue funds if it increases the wealth of the shareholders. The share price predicted by the price/earnings ratio method is $.. This is greater than the current share price of $.5, but this is not a valid comparison, since it ignores the effect of the rights issue on the share price. The rights issue has a neutral effect on shareholder wealth, but the cum rights price is changed by the increase in the number of shares and by the transformation of cash wealth into security wealth from a shareholder point of view. The correct comparison is with the theoretical ex rights price, which was found earlier to be $.4. Dai Hing Co shareholders will experience a capital gain due to the business expansion of $..4 = cents per share. However, these share prices are one year apart and hence not directly comparable. If the dividend yield remains at % per year ( x 5./5), the dividend per share for will be 5. cents (other estimates of the dividend per share are possible). Adding this to the capital gain of cents gives a total shareholder return of 5. cents or 4.8% ( x 5./4). This is greater than the cost of equity of % and so shareholder wealth has increased. (d) In order to use the dividend growth model, the expected future dividend growth rate is needed. Here, it may be assumed that the historical trend of dividend per share payments will continue in the future. The geometric average historical dividend growth rate = x ((5./.8)^.5 ) = 4% per year. 4 5 (Alternatively, the arithmetical average of annual dividend growth rates could be used. This will be (5.5 +. + 7.4 +.5)/4 = 4.%. Another possibility is to use the Gordon growth model. The average payout ratio over the last 4 years has been 47%, so the average retention ratio has been 5%. Assuming that the cost of equity represents an acceptable return on shareholders funds, the dividend growth rate is approximately 5% x % = 5.% per year.) Using the formula for the dividend growth model from the formula sheet, the ex dividend share price = (5. x.4)/(..4) = $.. This is cents per share more than the current share price of Dai Hing Co. There are several reasons why there may be a difference between the two share prices. The future dividend growth rate for example, may differ from the average historical dividend growth rate, and the current share price may factor in a more reasonable estimate of the future dividend growth rate than the 4% used here. The cost of equity of Dai Hing Co may not be exactly equal to %. More generally, there may be a degree of inefficiency in the capital market on which the shares of Dai Hing Co are traded. Total 7 QP B Mock Exam Answers (Dec) Copyright Kaplan Financial
Answer 5 Pecking order theory suggests that companies have a preferred order in which they seek to raise finance, beginning with retained earnings. The advantages of using retained earnings are that issue costs are avoided by using them, the decision to use them can be made without reference to a third party, and using them does not bring additional obligations to consider the needs of finance providers. Once available retained earnings have been allocated to appropriate uses within a company, its next preference will be for debt. One reason for choosing to finance a new investment by an issue of debt finance, therefore, is that insufficient retained earnings are available and the investing company prefers issuing debt finance to issuing equity finance. Debt finance may also be preferred when a company has not yet reached its optimal capital structure and it is mainly financed by equity, which is expensive compared with debt. Issuing debt here will lead to a reduction in the WACC and hence an increase in the market value of the company. One reason why debt is cheaper than equity is that debt is higher in the creditor hierarchy than equity, since ordinary shareholders are paid out last in the event of liquidation. Debt is even cheaper if it is secured on assets of the company. The cost of debt is reduced even further by the tax efficiency of debt, since interest payments are an allowable deduction in arriving at taxable profit. Debt finance may be preferred where the maturity of the debt can be matched to the expected life of the investment project. Equity finance is permanent finance and so may be preferred for investment projects with long lives. Annual interest paid per foreign bond = 5 x. =.5 pesos Redemption value of each foreign bond = 5 pesos Cost of debt of peso-denominated bonds = 7% per year and the bonds will be redeemed in 5 years time Market value of each foreign bond = (.5 x 4.) + (5 x.7) = 48.55 pesos Current total market value of foreign bonds = m x (48.55/5) = 5,49, pesos (c) (i) Interest payment in one year s time = m x. = 97, pesos A money market hedge would involve placing on deposit an amount of pesos that, with added interest, would be sufficient to pay the peso-denominated interest in one year. Because the interest on the peso-denominated deposit is guaranteed, Bill Co would be protected against any unexpected or adverse exchange rate movements prior to the interest payment being made. Peso deposit required = 97,/.5 = 99,54 pesos Dollar equivalent at spot = 99,54/ = $54,9 Dollar cost in one year s time = 54,9 x.4 = $,8 (ii) Cost of forward market hedge = 97,/.7 = $,79 The forward market hedge is slightly cheaper 7 4 Total 7 QP B Mock Exam Answers (Dec) 7 Copyright Kaplan Financial
Answer Weighted average cost of capital (WACC) calculation Cost of equity of P Co = 4. + (. x (.5 4.)) = 4. + 7.8 =.8% using the capital asset pricing model To calculate the after-tax cost of debt, linear interpolation is needed After-tax interest payment = x.7 x (.) = $4.9 Year Cash flow $ % discount PV ($) 5% discount PV ($) Market value (94.74). (94.74). (94.74) to 7 Interest 4.9 4.88.85 5.78 8.5 7 Redemption.5 5..7 7. (9.59) 4.7 After-tax cost of debt = 5 + (( 5) x 4.7)/(4.7 + 9.59) = 5 +. =.% Number of shares issued by P Co = $5m/.5 = million shares Market value of equity = m x 4. = $ million Market value of bonds issued by P Co = 5m x 94.74/ = $4. million 4 Total value of company = + 4. = $4. million WACC = ((.8 x ) + (. x 4.))/4. =.% (i) Price/earnings ratio method Earnings per share of NG = 8c per share Price/earnings ratio of P Co = 8 Share price of NG = 8 x 8 = 4c or $.4 Number of ordinary shares of NG = 5/.5 = million shares Value of NG =.4 x m = $4 million However, it can be argued that a reduction in the applied price/earnings ratio is needed as NG is unlisted and therefore its shares are more difficult to buy and sell than those of a listed company such as P Co. If we reduce the applied price/earnings ratio by % (other similar percentage reductions would be acceptable), it becomes 7. times and the value of NG would be (8/) x 7. x m = $57. million (ii) Dividend growth model Dividend per share of NG = 8c x.45 = c per share Since the payout ratio has been maintained for several years, recent earnings growth is the same as recent dividend growth, i.e. 4.5%. Assuming that this dividend growth continues in the future, the future dividend growth rate will be 4.5%. Share price from dividend growth model = ( x.45)/ (..45) = 5c or $5. Value of NG = 5. x m = $5. million Total * * * END OF ANSWERS * * * QP B Mock Exam Answers (Dec) 8 Copyright Kaplan Financial