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

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1 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. Page 1 of 16

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3 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. Page 3 of 16

4 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 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 Page 4 of 16

5 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) Page 5 of 16

6 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 $ $ $ $ $ $ $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 $ Ex-dividend preference share price $ 0.92 Irredeemable debentures (Ex-interest) $ per $100 debenture Redeemable unsecured loan (Ex-interest) $ 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. Page 6 of 16

7 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) Page 7 of 16

8 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 geargrinding 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 geargrinding machine should be purchased. Specify any assumptions if needed. (15 marks) (Total: 20 marks) Page 8 of 16

9 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: Annual turnover: Sales nature: Basic factoring charge: Annual saving of office or other expenses: (savings from basic factoring service) Fund advancement service (optional): Factoring commission on funds advancement: Factoring interest on fund advancement: Existing average collection period: 2 years minimum (3 months cancellable notice) $120 million evenly distributed in the year Credit only 2% of annual turnover (paid in arrears) $1.2 million at year end 90% of invoice value of factored debts 3.0% deducted from the gross amount of the funds advanced Commission will be deducted from the funds advanced directly 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 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.) (b) Some directors consider that it is not worth using factoring services. (15 marks) Advise, with justification, whether or not FL should keep using factoring services. (5 marks) (Total: 20 marks) Page 9 of 16

10 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 Long-term debts Liabilities other than debts Equity $200 million $200 million $300 million $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) Page 10 of 16

11 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$750,000. The spot rate and the three-month forward rate are HK$ = 1 and HK$ = 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 Page 11 of 16

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