Page 1 of 17

THE HONG KONG INSTITUTE OF CHARTERED SECRETARIES THE INSTITUTE OF CHARTERED SECRETARIES AND

ADMINISTRATORS

International Qualifying Scheme Examination

CORPORATE FINANCIAL MANAGEMENT June 2014

Time allowed – 3 hours

Section A – Compulsory case study

Section B – 5 long questions (attempt any 3)

DO NOT OPEN THIS PAPER UNTIL

INSTRUCTED TO DO SO BY THE INVIGILATOR

Important Note: Candidates are allowed 15 minutes reading time to read through the question paper before the commencement of the examination between 9:15a.m.-9:30a.m. During the reading time, all candidates must be silent and must not write or mark anything on their question papers or answer books. Candidates must close all their reference books, notes or other unauthorised materials and put these under their chairs. If any candidates write or make any marks during the reading time, or if they speak or in any other way communicate with anyone either in or outside the examination hall during this period or read any unauthorised materials, they will be disqualified from continuing this examination paper. Once candidates have opened the question paper, they are not allowed to leave the examination hall until 10:00a.m.

Page 2 of 17

THIS IS A BLANK PAGE

Page 3 of 17

SUBJECT NO. 16J

CORPORATE FINANCIAL MANAGEMENT JUNE 2014

The examination paper is divided into TWO sections. Section A is a case study with compulsory questions and carries 40 marks. Candidates should attempt THREE questions from Section B, all of which carry 20 marks each. You should allow yourself approximately 70 minutes in total to answer the question in Section A, and 35 minutes for each of the questions attempted in Section B. Unless otherwise stated, $ denotes Hong Kong dollars. All interest rates are annual rates. Round your numerical answers to two decimal places. Friday morning, 6 June 2014 Time allowed: 3 hours

SECTION A

(Compulsory – answer ALL questions in this section)

1.

Pan Star Chemical Product Limited (PSCPL) is a medium-sized private limited company in

Hong Kong. PSCPL is planning to expand its production line by acquiring another production

plant in order to fulfill future foreseeable demand. At the last management meeting, the board

instructed the financial controller, David Tam, to submit two acquisition proposals for

consideration at the next management meeting.

After working in detail with the production manager, Rex Li, David made two proposals:

Project Alpha and Project Beta. The initial investments required for Alpha and Beta are $17

million and $12 million respectively. Both projects will last for five years. The initial outlays will

be made at the beginning of the year 1; and the residual amount of the plant, estimated as 5%

of their original cost, will be received at the end of year 6. The revenue generated and the

operating costs from year 1 to year 5 will be incurred at the end of each of those years. After

further thorough assessment, David estimates that the overall risk level of Alpha and Beta are

similar to the company’s existing investment projects.

SUBJECT NO 15M

Page 4 of 17

The details of the proposals are shown as below:

Project Alpha ($ m)

Year 1 2 3 4 5

Initial investment 17

Revenue 2 17 30 32 24

Operating costs 5 11 12 13 12

Project Beta ($ m)

Year 1 2 3 4 5

Initial investment 12

Revenue 6 18 10 30 18

Operating costs 4 10 11 11 9

Under local tax law, profits tax will be paid in arrears if there is a profit in an assessment year

(i.e. the profits tax payment for year 1 will be deducted in year 2). Any losses will be carried

forward and set off against the profits of next year: in other words, the profits of the following

year will be reduced.

The existing weighted average cost of capital (WACC) is 18%. The profits tax rate is 20%.

Under the tax law, a depreciation allowance of 30% calculated using the reducing balance

method can be applied in the tax computation. It is assumed that the WACC, the rate of

depreciation allowance and the profits tax rate will not change in the coming 10 years.

Recently, the board of PSCPL has been considering taking over one of its competitors,

Jackson Chemical Workshop Limited (JCWL), in order to increase its market share by

horizontal integration.

Extracts from the financial information of both companies are as follows:

PSCPL JCWL

Current year earnings after tax $88 million $9 million Outstanding shares 40 million 2 million Existing price-earnings ratio 15 12

David expects the earnings after tax of PSCPL will grow at a rate of 6% constantly. After

discussion with the board chairman, the board expects the company’s dividends will grow at

the same rate as that of the earnings after tax. If the acquisition of JCWL is successful, the

board projects the growth rate of both earnings after tax and dividends will increase to 9%. It

also expects that PSCPL shareholders will benefit from the extra gain derived from the

Page 5 of 17

acquisition. Meanwhile, the board is reviewing whether the acquisition should be made via a

cash offer or stock offer. The existing dividend per share is $1.80.

Page 6 of 17

REQUIRED:

(a) Evaluate Project Alpha and Project Beta and comment on how PSCPL should

select between them.

(23 marks)

(b) Evaluate the cost of capital of PSCPL.

(5 marks)

(c) How much extra gain will the shareholders of PSCPL gain from the acquisition of

JCWL? (Assume the cost of capital is constant.)

(5 marks)

(d) The board of PSCPL is considering whether to offer $600 in cash for each JCWL

outstanding share or 20 million of PSCPL’s shares in exchange for all JCWL’s

outstanding shares.

Evaluate which option the board of PSCPL should choose. Discuss what other

factors PSCPL should take into account in making its decision.

(7 marks)

(Total: 40 marks)

Page 7 of 17

SECTION B

(Answer THREE questions from this section)

2.

Amanda Trading Limited (ATL) is a local wholesaler which trades medical and health products. The business is continuing to grow steadily. The capital structure of ATL is 70% equity and 30% debt. The management of ATL adopts a financial strategy to give a required rate of return on assets (ROA) of 15%. The existing borrowing costs of ATL are 5%. These borrowing costs apply to different capital structures. Recently, management has decided to change the capital structure into 40% equity and 60% debt. REQUIRED:

(a) Evaluate the cost of equity and weighted average cost of capital (WACC) of ATL.

(Assume there is NO tax.)

(5 marks)

(b) Evaluate the cost of equity and WACC of ATL if the capital structure changes to

40% equity and 60% debt. Comment on the effect after the change. (Assume

there is NO tax.)

(7 marks)

(c) Now assume that the tax rate is 20% and ATL needs to pay tax.

Evaluate the cost of equity and WACC of ATL based on the capital structure in

part (a) and part (b) and comment on the effect after taking into account tax and

the change of capital structure.

(Hint: Using CAPM, risk-free rate = 3%, market return = 15%, beta under current

capital structure = 1.1 and beta under the new capital structure = 1.8)

(8 marks)

(Total: 20 marks)

Page 8 of 17

3.

Sammy Kwan is the investment consultant of Poway Jewellery Company Limited (PJCL), a

leading manufacturer in the jewellery industry. In the company’s recent board meeting, the

chief executive officer (CEO) of PJCL asked Sammy to prepare two investment projects to

utilise the company’s idle cash. The amount of idle cash is estimated at $100 million. Sammy

knows that PJCL’s required rate of return for investment projects is 13%. Sammy has settled

on two projects, Project One and Project Two, which have the following expected net cash

flows:

Expected Net Cash Flows

Year Project One Project Two

$ m $ m

0 ($50.0) ($50.0)

1 $32.5 $18.0

2 $16.0 $18.0

3 $15.0 $18.0

4 $6.0 $18.0

REQUIRED:

(a) Compute the payback period, net present value, internal rate of return and

discounted payback period of Project One and Project Two.

(14 marks)

(b) The board decided in its last meeting that $20 million of idle cash should be kept for

emergencies.

Advise whether the company should choose Project One and/or Project Two and

how the idle cash should be utilised if the two projects are (i) mutually exclusive,

(ii) independent or (iii) divisible in nature.

(6 marks)

(Total: 20 marks)

Page 9 of 17

4.

Creative Limited (CL) runs a number of chocolate shops selling “Supreme” chocolate in the

region. All CL’s shops accept cash sales only. Recently, the company has been appointed as

a sole agent for “Supreme” chocolate in the region. The management of CL is planning to be a

wholesale supplier of “Supreme” chocolate. However, many retailers ask for credit sales with a

one-month credit term. The sales manager has prepared the following information under two

proposed credit policies for the management’s consideration:

No credit policy New credit policy

Unit price $37.00 $40.00

Unit cost $24.00 $27.00

Sales per month (unit) 6,525 6,900

Probability of payment 1.0 0.9

The higher unit cost reflects the greater amount of expenses associated with orders on credit.

The higher unit price allows for a discount on cash sales.

REQUIRED:

(a) Briefly discuss whether CL should grant credit to retailers or not.

(5 marks)

(b) Explain how the receivables operate if CL adopts the new credit policy. (Assume

all receivables are collectable and the monthly information is the same and

continues forever.)

(7 marks)

(c) It is estimated that only 90% of retailers under credit sales will settle their payments.

For the 10% of uncollectable receivables, CL is considering using a debt collection

service from Sure Win Credit Agency Limited (SWCAL). The one-off basic charge is

$1,200. An additional fee of $5 will be charged for each $100 of sales value. SWCAL

claims that its debt collection service is good and guarantees at least 95% of the debt

can be received.

Advise whether CL should use the debt collection service or not.

(8 marks)

(Total: 20 marks)

Page 10 of 17

5.

Sporty International Limited (SIL) is a rapidly growing company which produces and sells sport

products. SIL issues a convertible debenture which carries a 10% coupon at par. The

debenture is redeemable in seven years and each unit of $1,000 is convertible into 200

ordinary shares at any time before the redemption date.

At the issue date, the yield of similar debentures without conversion is 13% and the market

price of SIL’s ordinary shares is $3.80.

REQUIRED:

(a) Calculate the conversion premium on the convertible debentures at the issue

date and discuss the relationship between the coupon rate and the conversion

premium on convertible debentures. (Assume the debenture is issued at par.)

(8 marks)

(b) If the growth rate in the share price is 12% annually:

i. Compute the conversion value of the debenture after four years, and

explain why the market value of the debenture exceeds the conversion

value of the debenture; and

ii. Discuss the relationship between the market value of the debenture and

SIL’s dividend policy.

(12 marks)

(Total: 20 marks)

Page 11 of 17

6.

Good Taste Italian Food and Beverage Limited (GTIFBL) is a famous food and beverage

importer in Hong Kong. GTIFBL will sell food products for €3.5 million to an Italian buyer on 1

January 2014. The credit term is three months, i.e. the due date will be 31 March 2014.

Tammy Chan, the financial controller of GTIFBL, is worried that this transaction carries foreign

exchange risk as she expects the euro will become weaker. The current spot rate of Hong

Kong dollars to euros is HK$10.58/ €. To minimise the company’s exposure to foreign

exchange risk, Tammy is considering hedging the risk.

The cost of capital of GTIFBL is 12%. Three hedging approaches are available: money market

hedge, forward contract hedge and currency option hedge. Each hedging method is detailed

below:

Money market hedge

The euro and Hong Kong dollar borrowing rates are 8% and 6% per annum

respectively.

The euro and Hong Kong dollar saving rates are 2% and 1.5% per annum respectively.

Forward contracts hedge

The 90-day forward exchange rate is $10.35/ €.

Expected spot rate in 90 days is HK$10.40/ €.

Currency option hedge The exercise exchange rate and option premium for a March 2014 put option for €3.5 million are HK$10.62/ € and 2.1% respectively. Assume the Italian buyer will settle the above transaction by €3.5 million cash exactly on 31

March 2014.

REQUIRED:

(a) If GTIFBL uses the money market hedging approach, i. Describe the procedures and suggested transactions; and ii. Determine the amount receivable by GTIFBL in Hong Kong dollars under

this hedging approach. (9 marks)

(b) Evaluate the Hong Kong dollar cash flow for GTIFBL if: i. Tammy uses forward contract hedging; and ii. Tammy does not use any hedging.

(5 marks)

Page 12 of 17

(c) Evaluate the Hong Kong dollar cash flows guaranteed by the currency option hedging. Which option should Tammy choose?

(6 marks)

(Total: 20 marks)

End of Examination Paper

Page 13 of 17

Page 14 of 17

Page 15 of 17

Page 16 of 17

Page 17 of 17

THIS IS A BLANK PAGE