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

ADMINISTRATORS

International Qualifying Scheme Examination

CORPORATE FINANCIAL MANAGEMENT

DECEMBER 2013

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.

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SUBJECT NO. 16J

CORPORATE FINANCIAL MANAGEMENT DECEMBER 2013

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 December 2013 Time allowed: 3 hours

SECTION A

(Compulsory – answer ALL questions in this section)

1.

RetailMart Limited (RL) is a public limited company with a financial year end of 31 March. The

company runs a number of chain stores selling various popular household items in Hong Kong

and China. In recent years, the company has experienced negative business growth due to the

economic recession. To boost its turnover, the company has made several plans.

At the October 2013 board meeting, RL management identified a merger target in Malaysia.

After the board meeting, all directors agreed to acquire Abnormal Trading Limited (ATL) to

increase RL’s shareholder wealth. Due diligence was performed. An independent financial

consultant estimated that the amount needed for the merger would be around $380 million.

Since the management plans to execute the merger in December 2013, RL was going to issue

shares to raise sufficient funds to complete the potential merger. The announcement of the

proposed merger and share issue would be made public at the same time. Some directors

raised concerns about the timing of the announcement as they believed that the timing would

have a big impact on RL’s share price. At the time, the share price was $2.00 per share.

SUBJECT NO 15M

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The outlook of external business environment was bleak. At the November 2013 board meeting,

the directors agreed to borrow $80 million at a fixed rate of interest to secure sufficient

resources to cope with the expansion. Since the company’s long-term debt is rated BBB Grade

by the credit rating agencies, RL’s bankers have agreed to grant a loan at a fixed interest rate of

9.25% per annum. Alternatively, the company could borrow floating rate funding at prime minus

2.25% per annum. The company is aware, however, that Good Supplies Limited (GSL), one of

its long-term business partners, is also looking to borrow $80 million at a floating rate; and its

AAA rating will enable it to borrow funds at a fixed rate of 7.50% per annum and at a floating

rate of prime minus 1.5% per annum. At the time, the prime rate is 5.5% per annum.

At its most recent meeting in December 2013, the board discussed not only concerns about the

sufficiency of its cash flow to meet its daily operational expenses but also whether there would

be enough cash available for future investment opportunities. To reserve its cash flows for

potential capital expenditure in the near future, the management decided to reduce the dividend

payment for the year ended 31 March 2013. Upon the release of the decision in reduction of

dividend payment, the high share trading volume signified that the market is sensitive to the

announcement.

Ten years ago, RL opened chain stores in Mainland China. This strategy had proved to be less

successful than expected and so in December 2013 RL’s directors decided to withdraw from the

China market and to concentrate on the local Hong Kong market. To raise the finance needed

to close the China stores, RL’s directors also decided to make a one-for-five rights issue at a

discount of 30% on the market value at that time. The most recent income statement of RL is as

follows:

Income statement for the year ended 31 March 2013

$ m Sales 14,000 Profit before interest and tax 520 Finance costs 240 Profit before tax 280 Profits tax 70 Profit after tax 210

Dividends paid for the year ended 31 March 2013

$140

The outstanding shares and reserves of RL as at 31 March 2013 are as follows:

$ m Ordinary share capital, $0.25 each 600 Revaluation reserve 1,400 Retained earnings 3,200 5,200

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RL’s shares currently trade on the stock exchange at a price-earnings ratio of 16 times. An

investor owning 100,000 ordinary shares in RL has received information about the forthcoming

rights issue but cannot decide whether to take up the rights issue, sell the rights or allow the

rights offer to lapse.

REQUIRED:

(a) Discuss the market reaction on the announcement date of the proposed

merger/share issue if the pending merger announcement has NOT been leaked.

(Assume that the market is semi-strong form efficient.)

(5 marks)

(b) RL is considering whether it would be worth entering into an interest rate swap with GSL.

Illustrate how an interest rate swap could be used so that both companies derive

equal benefit. (Assume that RL’s swap payment to GSL is 7.50% fixed per annum

under the swap agreement.)

(11 marks)

(c) Explain, with reasons, why some investors react positively but others negatively

when RL’s decision to reduce the dividend payment is released to the market.

(9 marks)

(d) Evaluate the theoretical ex-rights price of an ordinary share in RL, and the price at

which the rights in RL are likely to be traded.

(6 marks)

(e) Evaluate each of the options regarding the rights issue available to the investor

with 100,000 ordinary shares.

(9 marks)

(Total: 40 marks)

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SECTION B

(Answer THREE questions from this section)

2.

Fashion Design Holding Limited (FDHL) is a listed company with a principal business activity of manufacturing women’s clothes. The management is looking to expand its business into women’s fashion retail. The company has grown rapidly in recent years with consistent annual dividend growth; it expects that dividends will continue to grow in line with the trend in recent dividend payments. The seven-year dividend history, extract from statements of financial position and some related current market information are below:

Seven-year dividend history Year Dividends per share 2006 $17.00 2007 $19.50 2008 $22.00 2009 $26.00 2010 $29.00 2011 $31.00 2012 $33.50

Extracts from statement of financial position at 31 August 2013

$m

Equity Ordinary $100 shares 280 6% $1 irredeemable preference shares 200 Retained earnings 388

Total equity 868

Non-current liabilities 8% irredeemable debentures (at nominal value) 1,000 7% unsecured loan (at nominal value) 720

Total non-current liabilities 1,720

Current market information

Ex-dividend ordinary share price $ 400.00 Ex-dividend preference share price $ 0.92 Irredeemable debentures (Ex-interest) $ 89.00 per $100 debenture Redeemable unsecured loan (Ex-interest) $ 86.00 per $100 loan

FDHL’s current liabilities do not include any bank overdrafts. The profits tax rate is 16.5% and any interest paid in relation to debt financing generates tax savings. The unsecured loan will be redeemable at par in ten years’ time.

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REQUIRED:

(a) The board has decided that any financing arrangements should come from increasing

debt rather than increasing equity.

According to the above information, based on market value, evaluate the

company’s weighted average cost of capital. (Candidates may consider using the

interpolation approach in calculating the cost of unsecured loan with discount

factors 7% and 10% respectively.)

(15 marks)

(b) The company has taken out an overdraft, which is considered to be a permanent source

of finance and which is included in FDHL’s current liabilities.

Discuss the implications of the overdraft on the calculation of FDHL’s weighted

average cost of capital.

(5 marks)

(Total: 20 marks)

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3.

Great Precision Technology Limited (GPTL) is a gears manufacturer. It has entered into a

contract to produce high-precision gears. To do this, the company has to employ a gear-

grinding machine at the final manufacturing stage to remove the remaining few thousandths of

an inch of material left by other manufacturing methods. Since the gear-grinding machine is vital

to the company’s high-precision manufacturing requirements, GPTL plans to purchase a new

machine. Details of two machines under consideration offered by different machine suppliers

are:

Machine Super

Machine Quick

Initial cost $1,000,000 $1,800,000 Economic life (years) 5 8 Residual value $100,000 $140,000 Running costs per annum $150,000 $145,000

The discount rate is assumed to be 12% and taxation can be ignored.

REQUIRED:

(a) Replacement chain approach and equivalent annual cost approach are two methods

used for comparing projects with unequal lives.

Evaluate each approach and discuss why the equivalent annual cost approach is

the better approach in comparing Machine Super and Machine Quick.

(5 marks)

(b) Adopting the equivalent annual cost approach, advise the company which gear-

grinding machine should be purchased. Specify any assumptions if needed.

(15 marks)

(Total: 20 marks)

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4.

Forever Limited (FL) is a private limited company. The company uses a factoring service to

enhance its cash flow to meet its operational needs. The terms of the factoring service

agreement are as follows:

Service term: 2 years minimum (3 months cancellable notice) Annual turnover: $120 million evenly distributed in the year Sales nature: Credit only Basic factoring charge: 2% of annual turnover (paid in arrears) Annual saving of office or other expenses: (savings from basic factoring service)

$1.2 million at year end

Fund advancement service (optional): 90% of invoice value of factored debts Factoring commission on funds advancement:

3.0% deducted from the gross amount of the funds advanced Commission will be deducted from the funds advanced directly

Factoring interest on fund advancement: 10% per annum on monthly basis on gross funds (before deduction of the 3.0% commission) Interest will be deducted from the funds advanced directly

Existing average collection period: 75 days

REQUIRED

(a) Evaluate the effective annual factoring cost as a percentage of the improvement in

funds (i.e. ratio of total cost of factoring and fund advancement service to the

improvement in funds from the factoring and fund advancement) under the

following options, and advise which option should be chosen:

i. Option A: FL adopts the basic factoring service but does not use the fund

advancement service. As a result, the average collection period is reduced

to 60 days.

ii. Option B: FL ues both the basic factoring service and the fund

advancement service. The average collection period is reduced to 50 days.

(Assume a 360 day year split into 12 equal months. Taxation may be ignored.)

(15 marks)

(b) Some directors consider that it is not worth using factoring services.

Advise, with justification, whether or not FL should keep using factoring

services.

(5 marks)

(Total: 20 marks)

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5.

The management team of Columbia International Trading Limited (CITL) has decided to take

the company private through a leveraged buyout (LBO). The following information is extracted

from CITL’s books:

Current assets $200 million

Long-term debts $200 million

Liabilities other than debts $300 million

Equity $700 million

It is assumed that all other assets are non-current assets and suitable as collateral to secure a

loan; and they are saleable at their book values.

Currently, the company has 100 million outstanding shares with a market value of $10 per share.

The management team decides to make use of $500 million cash in hand as the management's

equity investment for the LBO and estimates that the shares in the hands of the public can be

purchased if a 10% premium over the market price is offered. The company pays interest at

12% per annum on its existing debt. However, the company is required to pay interest at 15%

per annum on any new debt offered by the bank.

REQUIRED:

(a) Evaluate the amount that CITL has to borrow. What percentage of the book value

of non-current assets must a bank be willing to advance to make the deal possible?

(7 marks)

(b) Compare the following:

i. CITL’s capital structures and debt to equity ratio before and after the

leveraged buyout if any debt for the LBO will be financed from debt

secured by the target company’s assets. Assume that the debt to equity

ratio of the trading business sector is 0.5. Discuss how investors will react

to new bond issue if CITL plans to issue the bonds at the same interest rate

as that of the industry bond market index after the LBO.

ii. The annual interest to be paid by CITL before and after the leveraged

buyout. Comment on the feasibility of the LBO.

(13 marks)

(Total: 20 marks)

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6.

Wing Trading Limited (WTL) is an importer and exporter of textile machinery and textile goods.

Its headquarters are in the UK but it trades extensively with Asian countries. The company has

a subsidiary in Hong Kong. It is about to invoice a customer in Hong Kong in Hong Kong dollars,

HK$750,000 payable in three months’ time. WTL is considering two methods of hedging the

foreign exchange risk.

Method A

Borrow Hong Kong dollars now, converting the loan into sterling and repaying the Hong Kong

dollar loan from the expected receipt in three months’ time.

Method B

Enter into a three-month forward exchange contract with the company’s banker to sell

HK$750,000.

The spot rate and the three-month forward rate are HK$12.3937 = £1 and HK$12.3178 = £1

respectively.

Annual interest rates for three months’ borrowing/deposits of Hong Kong dollars and sterling are

3% and 5% respectively.

REQUIRED

(a) Evaluate which of the two methods is the most advantageous financially for the

company.

(10 marks)

(b) “Before deciding the hedging approach, WTL should arrange the hedging plan based on

its risk strategy: risk-averse strategy, predictive strategy or best strategy.”

Discuss this statement and advise WTL’s management of other ways to reduce

foreign exchange rate risk.

(10 marks)

(Total: 20 marks)

End of Examination Paper

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