Revision 3 – Questions
Enhanced QP
Hong Kong School of Commerce
Module B – Corporate Finance
Revision 3
Part E Corporate Finance
(Learning Pack: Chapter 12 to Chapter 20)
Part I Investment Appraisal
Question 1 (22 marks – approximately 40 minutes)
Wonderplace is a hotel and resort group with operations in Hong Kong, China and Southeast Asia. In a senior management meeting held in last month, the Group Financial Controller raised the issue of staff turnover rate in the Accounting Department. He pointed out that in the previous six months, more than 20% of the department’s employees had resigned. He believed that apart from the improved job market for qualified accountants, a more serious problem was the long working hours in the department. The root cause, to a large extent, was the inability of the existing accounting system installed ten years ago to cope with many of the management reporting requirements in an environment where a series of new accounting standards had recently been introduced.
After learning of the situation, the CEO approved a request to replace the accounting system. Two vendors, York and Zola, submitted proposals to Wonderplace.
York is the market leader in accounting systems. It is well-known for system reliability and its experienced implementation team. To install the system, Wonderplace would need to invest $3.8 million in the system hardware. A consultancy fee of $1.4 million and a license fee of $800,000 would be charged at the beginning of the project. In each subsequent year, Wonderplace would still have to pay an annual maintenance fee equivalent to 17% of the license fee to York. Although the total investment would be sizeable, the Group Financial Controller estimated that the savings from enhanced efficiency in its operation would amount to $2 million each year. With a fast changing environment, he anticipated that the new system would become obsolete in five years’ time and without any residual value.
Compared to York, Zola is a much younger company. However, in the last two years, it has successfully added several reputable companies to its client list. These companies were impressed by the innovative design and flexibility of the system. Wonderplace would have to invest $2.75 million in its hardware before it could install Zola’s system. Zola’s aggressive bid offers attractive pricing. It quotes an upfront consultancy fee and license fee of $1 million and $750,000 respectively. Twelve months after installation, Zola would charge an annual maintenance fee equivalent to 15% of the license fee for each year afterwards. The Group Financial Controller estimated that Zola’s system could assist the Accounting Department to generate an operational saving of $1.5 million at the end of the first year. The vendor also assured Wonderplace that it would invest heavily in R&D and hence it is confident that savings would increase by 10% each year. To attain the full incremental savings, however, Zola stated that Wonderplace would have to put in an additional $1.25 million to upgrade its hardware in Year 3. The life and residual value of Zola’s system are expected to be the same as those of York. No matter which system is chosen, Wonderplace will not incur a maintenance fee for the last year in use.
Use an annual discount rate of 11% to carry out the following analysis:
Required:
(a) (i) Calculate the net present value (NPV) of each system. (8 marks)
(ii) Assuming that the internal rate of return (“IRR”) of York’s and Zola’s systems are 17.2% and 17.9% respectively, which system is financially more attractive? State your reasons. (4 marks)
(b) Apart from the reasons in (a)(ii), what non-financial factors would you consider before making a recommendation to the Group Financial Controller on the choice of system? (4 marks)
(c) Describe two situations where the use of IRR will result in incorrect or problematic decisions. Why is IRR still a widely used tool? (6 marks)
(HKICPA QP MB Corporate Finance May 2006 Q3)
Question 2 (20 marks – approximately 36 minutes)
In the wake of the global financial crisis in 2008, many businesses felt the full impact of the credit crunch. Financing, which used to be easily accessible, has now been unavailable even to the largest companies. In order to survive, many companies have tried their very best to cut their operating expenses to the bone and unlock cash from their businesses. According to a survey, more than 60% of the companies in the Asia Pacific region have reviewed their working capital to find ways to reduce inefficiency and improve cash flow.
DG-Star is a sneaker manufacturer in Dongguan, China. John Lee, the CFO of the company, is looking for ways to enhance the cash position of the company. After reviewing the balance sheet in detail, John is of the view that too many funds have been tied up in accounts receivable.
Under its current credit policy, DG-Star makes all sales on 90-day credit and offers no cash discount. On average, the company sells one million pairs of sneakers per month at the price of $120 for each pair at a cost of $95.
John has discussed with the Sales Manager and come up with two proposals:
Proposal 1: / To reduce the credit period to 15 days. However, due to this more stringent credit policy, the Sales Manager expects that some of the customers will be lost and sales will drop by 17%.Proposal 2: / To offer 7% discount to customers who settle the account within one month. The Sales Manager estimates that 80% of the customers will take advantage of this incentive, and the rest will continue to settle their accounts at the end of the 90-day credit period. As a result of the discount, sales are expected to
increase by 11%.
The company requires a return on investment of 20%.
Assume 360 days in a year and round up to 3 decimal points in discount factors.
Required:
(a) Use the NPV analysis to decide whether the existing policy, Proposal 1 or Proposal 2 is more advantageous to DG-Star? Show your calculations. (14 marks)
(b) Apart from shortening the payment collection period, what are the other possible areas that a company can consider for improving the working capital? (6 marks)
(HKICPA QP MB Corporate Finance September 2009 Q4)
Question 3 (22 marks – approximately 40 minutes)
John is a young entrepreneur who owns two companies in Hong Kong. One of his companies is Glitters Company Ltd which manufactures high-end festival decorations. However, since the U.S. and U.K. entered the economic downturn, Glitters has been facing an increasingly difficult business environment as these two markets account for about three quarters of its annual sales. Glitter’s funding shortfall by the end of the year will be HK$574 million.
To keep Glitters afloat, John has decided to sell his other company, Goldsteron. This company is a distributor of artificial jewellery products. Although Goldsteron is still making a decent profit, John believes that the competition will be keen in a few years time when more competitors from mainland China enter this market. Through the introduction of a banker, he has started discussions with Adam who is interested in buying the Goldsteron business. After conducting preliminary due diligence, Adam has obtained the following financial information:
l The current annual sales are HK$1,386 million, and growth rates for the next four years are estimated to be 12%, 11%, 10% and 9%. In Year 5 and thereafter, the growth rate will stabilise at 8%.
l The pre-tax profit margin is 13.5% and Adam expects that the margin can be maintained at this level in the future.
l Depreciation expenses are calculated as 11.5% of EBIT.
l The working capital requirements are about 20% of sales. At the end of June, the working capital stood at HK$165 million.
l The additional capital expenditure requirements are estimated to be 10% of sales for Year 1 and Year 2, reducing to 6% in Year 3 and 4 and thereafter.
l The tax rate is 17%.
l Goldsteron’s total external borrowing amounted to $133.5 million.
Required:
(a) Adam overheard from the market that John is in need of cash and thus Adam makes a conservative offer by applying a hurdle rate of 15.5% to calculate the enterprise value of Goldsteron. What is the price that Adam will offer if he is only prepared to pay only for the NPV of the equity value? (15 marks)
(b) John wishes to maintain a minimum cash level of HK$500 million after selling Goldsteron by the end of the year. Can this be achieved if he accepts Adam’s offer?
(2 marks)
(c) If not, what is the hurdle rate that John should counter-offer Adam in order to achieve the minimum cash level of HK$500 million? (5 marks)
(HKICPA QP MB Corporate Finance May 2010 Q5)
Question 4 (16 marks – approximately 29 minutes)
TTphone is considering an investment in a high-tech equipment. The useful life of this equipment is estimated to be four years. Mr. T.T. Chan estimates the cash flows as follows:
The depreciation is calculated on a straight line basis for tax purposes using the initial investment minus the disposal value of the equipment at the end of year 4. The company has a cost of capital of 10% and the applicable tax rate is 16%. It is also the company practice to use initial investment value and after tax results to measure the return of a project.
Assuming the tax benefit could be claimed in the year of use and the tax would be paid at the end of each year. There would be no balancing charge and allowance at the year of disposal.
Required:
(a) Calculate the net present value (NPV) and internal rate of return (IRR) of the project based on the above estimates and assumptions. (6 marks)
(b) Calculate two additional measures in order to reflect the liquidity and reported financial performance of the project. (4 marks)
(c) Identify the advantages and disadvantages of the two additional measures that you calculated. Make a recommendation for the project. (6 marks)
(HKICPA QP MB Corporate Finance June 2011 Q5)
Question 5 (16 marks – approximately 29 minutes)
ABC company is considering investing in a machine that costs $800,000. The incremental pre-tax financial impacts are summarised below:
Year / 0 / 1 / 2 / 3 / 4 / 5Investment / (800,000)
Sales / 800,000 / 840,000 / 882,000 / 926,100 / 972,045
COGS / 480,000 / 504,000 / 529,200 / 555,660 / 583,443
Expenses / 80,000 / 84,000 / 88,200 / 92,610 / 97,241
Depreciation / 160,000 / 160,000 / 160,000 / 160,000 / 160,000
EBIT / 80,000 / 92,000 / 104,600 / 117,830 / 131,721
Interest / 0 / 1,000 / 1,000 / 1,000 / 1,000
Life of project: 5 years
The machine is expected to reduce working capital requirements by $100,000 as soon as the machine is installed and starts operating.
The machine is expected to be sold at the end of 5 years at an estimated salvage value of $100,000 before tax. At that time, the machine is expected to have fully depreciated for tax purposes. The tax jurisdiction levies a profits tax and capital gains tax of 25%.
Required:
(a) Based on NPV and using after tax cost of capital of 10%, should the company invest in this initiative? (10 marks)
(b) IRR is another popular capital budgeting tool and usually gives the same result as NPV. Describe two circumstances in which IRR will give a conflicting result compared to NPV. (4 marks)
(c) What is capital rationing? Describe why the profitability index method can help a company to rank investment projects in a capital rationing situation. (2 marks)
(HKICPA QP Module B Corporate Financing December 2012 Q3)
Part II Cost of Capital
Question 6 (20 marks – approximately 36 minutes)
A firm’s cost of capital is not something that remains at a fixed level over the life of the firm. It can be influenced by a number of factors.
Required:
How would each of the following affect a firm’s after tax cost of debt, kd(1-T); its cost of equity, ke; and its weighted average cost of capital, WACC? Indicate by a plus (+), a minus (-), or a zero (0) if the factor would raise, lower, or have an indeterminate effect on the item in question. Assume other things are held constant. Please indicate the likely effects, since there may be more than one possible effect.
Present your answer IN YOUR SCRIPT BOOK in the form of the table below. The first item
(a) has been provided as an example.
4 marks for each row
(Total: 20 marks)
(HKICPA QP MB Corporate Finance May 2004 Q4)
Question 7 (15 marks – approximately 27 minutes)
Sonia Wong is the finance manager of Quickie, a public-listed fast-food restaurant group with 105 outlets in Asia. Sonia estimates that if the company raises funds in the bond market, it will have to pay 1.5% more than the 5-year government bond which offers a yield of 4.5%. Currently, the market value of Quickie’s outstanding debts stands at HK$900 million. Quickie’s shares are traded at HK$10.5 per share, with a total of 220 million shares outstanding. Sonia intends to calculate the cost of equity by using the Capital Asset Pricing Model. She works out that the company has a Beta of 1.2. The equity analysts in the market project that the average market return is 19%. The tax rate payable by Quickie is 17.5%.