EXECUTIVE TRAINING COMPANY (INTERNATIONAL) LTD
About the Lecturer LOGO Mr. William Ng ETC Training - QP Module B and FE Module B ACA (UK), FCCA and FCPA, Master of Accountancy, Master of Corporate Finance, BA (Business Studies)
More than 10 years working experience in managerial role Focus in subject as • Derivatives and Corporate Risk Management • Regulatory Framework and Compliance • Investment and Portfolio Management • Merger and Acquisition • Business Valuation; and • Global Financial Market etc A qualified Enhanced QP facilitator in the HKICPA, QP marker A mentor under a mentorship programme in a well-known professional accountancy body
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Basic Exam technique LOGO 1. Narrow the scope when answering questions by scanning through topics in tutorial notes and/or CLP. 2. Being a smart for ‘copy and paste’ skill by focusing on application of the theories and concept rather than direct copying from the LP or tutorial notes. 3. Proper time management, including identification of easy and difficult question. 4. Remember to write the answer in memo format with proper opening and sign off if such format is being asked. 5. Neat and tidy handwritten answers are required. 6. Answer on a new page when move to a new question. 7. Double check for accuracy of calculation to secure high marks. 8. Answer the key points, and you are not expected for long answer. 9. Give assumption for unknown elements. 10. Read the past exam paper and examination panelists which can be downloaded from the online QP Learning Support Centre.
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Topic Preview LOGO
Past Paper Review
JUNE 2011 SECTION B DEC 2011 SECTION B
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LOGO
Past Paper Review
JUNE 2011 SECTION B
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June 2011 Section B LOGO Case background
• The industry is television manufacturing which is a highly competitive industry. • Tiger TV Manufacturing Company Limited (TTV) is a listed company on HKEx. • The Group has recorded substantial profit growth due to: cost reduction in raw material and other related cost. entering the business into China market for recording double-digit growth rate. successful execution of the Group’s promotion and pricing strategies in China.
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June 2011 Section B LOGO Case background
• Investment plan Huge capital investment of HKD200 million in setting up LCD and LED Current source of finance: HKD100 million of short-term bank loan HKD50 million of overdraft facility Potential source of finance Long term finance Collection of account receivable amounted to HKD1,500 million as raised by Ms Tina So, the board member
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June 2011 Section B LOGO Case background
• TTphone Opportunity Subsidiary of TTphone Main business is the selling of mobile phones Propose to spin off TTphone in the HKEx • Declaration of Tina So (ethical issue) Selling of her shareholding of TTV right before public announcement
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June 2011 Section B LOGO Case : Tiger TV Manufacturing Company Limited - Question 4 Required: Assume that you are Mr. T.T. Chan and you are asked by the CFO to write a memorandum to the board addressing the following board members’ concerns: a. How does the early settlement discount work for turning the normal accounts receivable into cash as early as possible in terms of working capital management? What are the associated cost and benefits? b. Explain whether the Group should obtain long-term financing to fund the Investment Project even the Group could turn the accounts receivable into cash quickly. c. Advise on the reasons for spinning off TTphone in the Hong Kong Stock Exchange.
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June 2011 Section B Case : Tiger TV Manufacturing Company Limited - Question 4a
LOGO
a. How does the early settlement discount work for turning normal account receivable into cash?
• • •
By offering an early settlement discount. Set up the policy to allow customers on discount for early payment. Please do not confuse early settlement discount work with factoring.
Associated cost: Company would receive less cash from customers than expected • • •
Reduce the profitability level. Need the comparison of borrowing cost against the offering of the early settlement discount. Recalculation on the working capital requirement throughout the working capital cycle is needed as less amount is received than at a later stage.
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June 2011 Section B LOGO Case : Tiger TV Manufacturing Company Limited - Question 4a Associated benefits: • • • •
• • •
Cash collected will increase the cash balance. Improvement in liquidity position of the company. Borrowing from bank loan or overdraft would be reduced to save interest expenses. Since the risk of bad debts is eliminated by early settlement discount policy, the customer default risk is reduced to zero. The company’s credit risk to the banker may be lowered due to improved liquidity position. The overall cost of borrowing may be reduced accordingly. Pressure on the working capital is reduced.
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June 2011 Section B LOGO Case : Tiger TV Manufacturing Company Limited - Question 4a Additional points to note : Proper receivable management •
Good credit control policy on receivables
Factors to be considered: Administrative cost of debt collection Additional capital required to finance an extension of total credit provided to customers Credit terms offered by competitors Any savings or additional expenses in operating credit policy How the credit policy will be implemented Thorough analysis for balance between cost and benefit on determination of credit control policy
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June 2011 Section B LOGO Case : Tiger TV Manufacturing Company Limited - Question 4a Additional points to note : Proper receivable management •
Good credit control policy on receivables
Actions to be taken for a tight credit control: Periodically review the aging analysis on debtors. Issue letter for reminding client for payment on time. Send e-mail for conveying the message for company’s credit control policy. Penalty would be imposed on late payment.
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June 2011 Section B LOGO Case : Tiger TV Manufacturing Company Limited - Question 4a Additional points to note : Proper receivable management •
Factoring
Arrangement to have debts collected by the factoring company. Factoring involves turning over responsibility for collecting the company’s debts to a specialist institution. This involves the transferal for bad debts risk from one party to another. •
Invoice discounting It is the purchase of a selection of invoices at a discount. Arrangement would normally be involved into bills of exchange, acceptable credit, and hire purchase receivable.
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June 2011 Section B LOGO Case : Tiger TV Manufacturing Company Limited - Question 4b b. Explain whether the Group should obtain long-term financing to fund the Investment Project even the Group could turn the account receivable into cash quickly.
• •
• •
This question is related to selection of source of finance for funding requirement for timing interval. The answer is expected to explain the consideration in long term source of finance and short term source of finance. Candidates are expected to discuss short term source of financing on the basis of risk, uncertainty, and flexibility. A good way of presenting the answer mentioning different funding approaches in the discussion.
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June 2011 Section B LOGO Case : Tiger TV Manufacturing Company Limited - Question 4b b. Explain whether the Group should obtain long-term financing to fund the Investment Project even the Group could turn the account receivable into cash quickly.
• • •
Short term financing tends to be riskier than long term financing. Future interest rates fluctuate variably due to uncertainty in the market. Term structure of interest rate would be: Under normal cases, it is upward sloping, ie., short term interest rates are lower than long term interest rate. During financial tsunami, the short term interest rates appeared to be higher than long term interest rate.
•
Conclude that the uncertainty of short term bank financing is very high.
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June 2011 Section B LOGO Case : Tiger TV Manufacturing Company Limited - Question 4b b. Explain whether the Group should obtain long-term financing to fund the Investment Project even the Group could turn the account receivable into cash quickly.
•
Different funding approaches Maturity matching approach Enterprise should finance long-term assets by using long-term financing options, such as long-term debt, equity and leasing. Seasonal variation in current assets should make use of financing of short-term financing option for temporary asset requirements, such as short-term borrowing or payable finance option etc. Whether the company adopted long-term or short-term financing depend upon the duration of assets currently held.
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June 2011 Section B LOGO Case : Tiger TV Manufacturing Company Limited - Question 4b b. Explain whether the Group should obtain long-term financing to fund the Investment Project even the Group could turn the account receivable into cash quickly.
•
Different funding approaches Consecutive approach Involves finance long-term assets, all permanent current assets, and some temporary current assets with long-term sources of fund. This approach relies more heavily on long-term financing. Incurred higher interest expenses under normal circumstances due to long-term borrowing commitment.
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June 2011 Section B LOGO Case : Tiger TV Manufacturing Company Limited - Question 4b b. Explain whether the Group should obtain long-term financing to fund the Investment Project even the Group could turn the account receivable into cash quickly.
•
Different funding approaches Aggressive approach This is the opposite direction to that of conservative approach. Enterprise finances all temporary current assets, and some of its permanent current assets with short-term sources of financing. Enterprise may pay lower interest expenses under normal case as no long-term commitment is engaged.
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June 2011 Section B Case : Tiger TV Manufacturing Company Limited - Question 4b
LOGO
b. Explain whether the Group should obtain long-term financing to fund the Investment Project even the Group could turn the account receivable into cash quickly. •
Conclusion Consider overall financial position for determination of long term and short term financing option. Selection of financing option should not merely consider large sum of accounts receivable and cash available. Company should formulate the financial policy in consideration of short-term, and long term funding requirements. Need to assess the foreseeable future by taking into account for general micro and macro economic environment, such as expected interest rate change, expected sales volume, and expected supply of raw materials.
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June 2011 Section B Case : Tiger TV Manufacturing Company Limited - Question 4c
LOGO
c. Advise on the reasons for spinning off TTphone in the Hong Kong Stock Exchange. •
Recap the definition of spinning off A spin-off is the creation of a new company, where the shareholders of its original company own the shares. There is no change in the ownership of assets, as shareholders own the same proportion of shares in the new company as they did in the old one. Assets of the part of the business to be separated off are transferred into the new company, which will usually have different management from the old company. In a more complex case, a spin-off may involve the original company being split into a number of separate companies.
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June 2011 Section B LOGO Case : Tiger TV Manufacturing Company Limited - Question 4c c. Advise on the reasons for spinning off TTphone in the Hong Kong Stock Exchange.
You should consider the viewpoint for not only TTphone, but also TTV.
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June 2011 Section B LOGO Case : Tiger TV Manufacturing Company Limited - Question 4c c. Advise on the reasons for spinning off TTphone in the Hong Kong Stock Exchange. • Reasons for spin-off
It provides TTphone access to capital markets for growth independently It helps to cover broader shareholder base It provides a better employee incentives and commitment resulting from the grading of employee share option to tie in the TTphone’s key staff retention programme. The high profile and visibility in the capital market could generate reassurance among the company’s customers and suppliers. Provides the opportunity of TTphone to have separate credit rating, and assess loan independently this is of great beneficial if TTphone is having a sound financial record, which could result in obtaining loan borrowing at even lower interest rate.
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June 2011 Section B LOGO Case : Tiger TV Manufacturing Company Limited - Question 4c c. Advise on the reasons for spinning off TTphone in the Hong Kong Stock Exchange. • Reasons for spin-off
Good opportunity for increasing the valuation of TTV’s share price, as TTphone raises the fund from initial public offering due to the new injection of funds by issuing TTphone. It helps to increase the market valuation of TTphone. It reduces TTV cash pressure in supporting the expansion activities of TTphone. Rigorous disclosure standards demand TTphone to have improvement in its control, management information and operating system which result in greater efficiency for the company. TTV could sell the existing shares of TTphone in order to raise more fund for expansion, and to strength the liquidity position of TTV.
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June 2011 Section B LOGO Case : Tiger TV Manufacturing Company Limited - Question 4c c. Advise on the reasons for spinning off TTphone in the Hong Kong Stock Exchange. •
Reasons for spin-off TTV has large and multiple operational business units, they might not be able to support the management, financial and resources to TTphone. With the spin-off arrangement, TTphone could support by itself since it has got sufficient funding of capital. It helps TTV to focus its attention and resources on their core operations. Allow TTphone to negotiate management, finance, operation, and other resources issues and make its own decisions with its own board of director.
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June 2011 Section B LOGO Case : Tiger TV Manufacturing Company Limited - Question 5 TTphone is considering an investment in a high-tech equipment. The useful life of this equipment is estimated to be four years. Mr TT Chan estimates the cash flows as follows: Year end
Description
0
Initial equipment investment
1-4
Estimated annual operational cash flows
4
Cash inflow from disposal of equipment
Amount (HK$)
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$100 million $40 million
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June 2011 Section B LOGO Case : Tiger TV Manufacturing Company Limited - Question 5 •
Depreciation is calculated based upon • •
straight line basis initial investment minus disposal value at end of year 4 Cost of capital : 10% Tax rate : 16%
Assumption: Tax benefit could be claim at each year end No balancing charge and allowance for disposal
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June 2011 Section B LOGO Case : Tiger TV Manufacturing Company Limited - Question 5 Required: (a) Calculate the net present value (NPV) and internal rate of return (IRR) of the project based on the above estimates and assumptions. (b) Calculate two additional measures in order to reflect the liquidity and reported financial performance of the project. (c) Identify the advantages and disadvantages of the two additional measurement that you calculated. Make a recommendation for the project.
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June 2011 Section B LOGO Case : Tiger TV Manufacturing Company Limited - Question 5a (a) Calculate the NPV and IRR • This question comprises both NPV analysis and FCFF model calculation. • It’s bit tricky in the sense that data provided for calculation of FCFF by making use of annual operation cash flows rather than traditional EBIT. • Annual depreciation = (Initial machine investment – residual disposal value) / Number of estimated useful life of the assets = ($100,000,000 – $200,000) / 4 = $24,950,000 • •
You have to derive the FCFF from annual operating cash flows. Annual operating cash flows are generated after deduction of depreciation from EBIT because depreciation item is a non-cash item.
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June 2011 Section B LOGO Case : Tiger TV Manufacturing Company Limited - Question 5a (a) Calculate the NPV and IRR EBIT = annual operational cash flows + Depreciation = $40,000,000 - $24,950,000 = $15,050,000 Recall the formula of FCFF: FCFF = EBIT*(1-t) + Depreciation + Amortisation – Capital expenditure +/Change in net working capital Yearly FCFF arising from annual cash flow (excluding the disposal of asset in Year 4): FCFF = $15,050,000 * (1-16%) + $24,950,000 = $37,592,000
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June 2011 Section B LOGO Case : Tiger TV Manufacturing Company Limited - Question 5a (a) Calculate the NPV and IRR • NPV analysis • Year 0 : Cash outflow of $100,000,000 for initial investment • Year 1-3 : Yearly FCFF of $37,592,000 • Year 4 : Yearly FCFF of $37,592,000 plus disposal of equipment of $200,000 • NPV :
= -100,000,000 + 37,592,000 + 37,592,000 + 37,592,000 + 37,792,000 (1+10%) (1+10%)2 (1+10%)3 (1+10%)4 = 19,298,185
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June 2011 Section B LOGO Case : Tiger TV Manufacturing Company Limited - Question 5a (a) Calculate the NPV and IRR • Recap the definition of IRR Defined as that rate of return which equates the present value of the project’s expected cash inflows with the present value of the project’s cost. Defined as the rate of return for which the net present value of a project is zero. •
Approach to calculate IRR Use of financial calculator. Interpolation approach.
By any of the above approach , we get IRR at 18.63%
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June 2011 Section B LOGO Case : Tiger TV Manufacturing Company Limited - Question 5b (b) Two additional measures for reflecting the liquidity and financial performance of the project •
Payback The pay-back is usually used as one of the measures of the risks of the project. This is because the further in the future that an estimated cash flow is related, the higher the uncertainty. Therefore, projects with a shorter pay-back period are usually considered as less risky. The number of years required for a project to payback the original cost of the investment. The shorter the payback period the better. Project payback < the benchmark payback, accept the project. Project payback > the benchmark payback, reject the project.
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June 2011 Section B LOGO Case : Tiger TV Manufacturing Company Limited - Question 5b (b) Two additional measures for reflecting the liquidity and financial performance of the project • Payback Payback
Y0 HK$
Y1 HK$
Y2 HK$
Y3 HK$
Y4 HK$
Annual cash flows
(100,000,000)
37,592,000
37,592,000
37,592,000
37,592,000
Cum. cash flow
(100,000,000)
(62,408,000)
(24,816,000)
12,776,000
50,568,000
Payback period : 2 +
24,816,000 24,816,000+12,776,000
= 2.66 years
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June 2011 Section B LOGO Case : Tiger TV Manufacturing Company Limited - Question 5b (b) Two additional measures for reflecting the liquidity and financial performance of the project •
Accounting rate of return (ARR) The ARR expresses the profits from a project as a percentage of the capital cost. Could also be renamed as Return on Investment (ROI) or Return on Capital Employed (ROCE). The most common approach produces the following definition: Average annual accounting profits
ARR =
X 100% Estimated average investment
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June 2011 Section B LOGO Case : Tiger TV Manufacturing Company Limited - Question 5b (b) Two additional measures for reflecting the liquidity and financial performance of the project •
Accounting rate of return (ARR) Need to derive the annual after tax profit Annual after tax profit = (Annual cash flow from operation– Depreciation)*(1- tax rate) = ($40,000,000 - $24,950,000) * (1-16%) = $12,642,000 ARR = (Annual after tax profit) / Initial Investment = 12,642,000/100,000,000 = 12.6%
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June 2011 Section B LOGO Case : Tiger TV Manufacturing Company Limited - Question 5c (c) Advantages and disadvantages for the two additional measures and make recommendation •
Payback
Advantages:
Highlights the liquidity prospect of a proposed investment project. Essential for a company that requires quick cash payback on investments. Simple and easy to understand. Use of cash flow rather than accounting profit.
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June 2011 Section B LOGO Case : Tiger TV Manufacturing Company Limited - Question 5c (c) Advantages and disadvantages for the two additional measures and make recommendation •
Payback
Advantages: Screening those obviously inappropriate project prior to more detailed evaluation. Bias in favor of short term projects mean that it tends to minimize both financial and business risk. Useful under the capital rationing situation in order to identify project which generate additional cash for investment quickly.
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June 2011 Section B LOGO Case : Tiger TV Manufacturing Company Limited - Question 5c (c) Advantages and disadvantages for the two additional measures and make recommendation •
Payback
Disadvantages: Ignores the time value of money by assuming that future cash flows are equally valuable as current cash flows. Ignores cash flow after the payback period Means terminal or salvage value would not be considered. Unable to distinguish between projects with the same payback period. The choice of any cut-off payback period is arbitrary.
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June 2011 Section B LOGO Case : Tiger TV Manufacturing Company Limited - Question 5c (c) Advantages and disadvantages for the two additional measures and make recommendation •
Payback
Disadvantages: May lead to excessive investment in short-term projects. Only take into account for the risk of the timing of cash flow rather than the variability of those cash flows.
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June 2011 Section B LOGO Case : Tiger TV Manufacturing Company Limited - Question 5c (c) Advantages and disadvantages for the two additional measures and make recommendation •
Accounting rate of return
Advantages: It indicates the profitability of a proposed project during a period of time. It assumes fair treatment of bonus distribution, as the bonus can be linked to the realisation of profits. It is simple and easy to understand. It involves the familiar concept of a percentage return.
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June 2011 Section B LOGO Case : Tiger TV Manufacturing Company Limited - Question 5c (c) Advantages and disadvantages for the two additional measures and make recommendation •
Accounting rate of return
Disadvantages: It ignores the time value of money. Account results can be subject to manipulation of creative managers. Based on accounting profit as numerator, which are subject to a number of different accounting treatments which creates difficulty in making appropriate relative measurement. To ensure the consistency of accounting profit in measuring the ARR, the manager might need to spend extra time and effort for making adjustment in accounting profit. Length of the project is not considered.
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June 2011 Section B LOGO Case : Tiger TV Manufacturing Company Limited - Question 5c (c) Advantages and disadvantages for the two additional measures and make recommendation •
Recommendation Both NPV and IRR are attractive. The accounting rate of return is reasonable although lower than the IRR. Given the volatility of a high-tech industry, management may need to consider if the estimated payback period is reasonable or not. Need to consider other non-quantitative factors when accepting project or not.
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June 2011 Section B LOGO Case : Tiger TV Manufacturing Company Limited - Question 5c (c) Advantages and disadvantages for the two additional measures and make recommendation •
Recommendation
Factors which are difficult to quantity but relevant in evaluating projects are:
Improve customer satisfaction with product/services Generate business goodwill Improve quality Reducing quality cost Reduce lead time Increase flexibility to respond to changes in consumer demand
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June 2011 Section B LOGO Case : Tiger TV Manufacturing Company Limited - Question 6 TT phone now evaluates another investment project and considers investing in a project by using one of the following finance options: Issuing 25 million shares on top of the currently issued 100 million shares at HK$10 each. Issuing 250 million debentures at a rate of 3% per annum at par. Income tax rate : 16%
Required: (a) Calculate the operating profit at a point of indifference between issuing equity shares and issuing the debentures. (b) Calculate the earnings after tax per share for both method. (c) By interpreting the figures in (a) and (b), when would it be appropriate to decide to issue the shares or debentures.
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June 2011 Section B LOGO Case : Tiger TV Manufacturing Company Limited - Question 6a (a) Calculate the operating profit at a point of indifference between issuing equity shares and issuing the debentures Most students fail to attempt this question accurately as this question is not the typical question normally asked. This is the breakeven analysis to determine the amount of operating profit such that the earnings per share would be the same under equity financing and debt financing. EPS = Earning after tax / Number of ordinary shares issued. It is assumed that equity financing does not involve the payment of dividend, thus the operating profit remain unchanged. Equity financing would increase the number of issued ordinary share, ie., 25 million. Debt financing would increase the interest expenses which would reduce the operating profit. Interest expenses : 250 million * 3% = 7.5 million.
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June 2011 Section B LOGO Case : Tiger TV Manufacturing Company Limited - Question 6a (a) Calculate the operating profit at a point of indifference between issuing equity shares and issuing the debentures Assume X be the amount of operating profit: EPS under equity financing be: X * (1-16%) / (100m+25m) EPS under debt financing be: (X – 7.5m) * (1-16%) / 100m A handy equation for calculating the indifference point as below:
EPS under equity financing = EPS under debt financing X * (1-16%) / (100m+25m) = (X – 7.5m) * (1-16%) / 100m X = $37,500,000
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June 2011 Section B LOGO Case : Tiger TV Manufacturing Company Limited - Question 6b (b) Calculate the earnings after tax per share for both methods This part is actually continuation of part a. Both equity financing and debt financing would achieve the same EPS. Under equity financing, the calculation of EPS is as follows: Operating profit before interest * (1-tax rate) / number of ordinary shares issued 37,500,000 * (1-16%) / (100m + 25m) EPS = 0.252 Under debt financing, the calculation of EPS is as follows: (37,500,000 – 7,500,000) * (1-16%) / 100m EPS = 0.252
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June 2011 Section B LOGO Case : Tiger TV Manufacturing Company Limited - Question 6c (c) By making use of result of part a and b, when would it be appropriate to decide the issue of shares or debentures. Some students simply explain the analysis of basic concept of debt financing and equity financing. This question simply ask you the acceptable range of operating profit for determination of ways of financing approach. Operating profit above $37,500,000 would better for raising capital by means of issuing debentures. As this would increase the EPS, as the same shareholder base remains unchanged. Every dollar of earnings will be distributed between existing shareholders.
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June 2011 Section B LOGO Case : Tiger TV Manufacturing Company Limited - Question 6c (c) By making use of result of part a and b, when would it be appropriate to decide the issue of shares or debentures Operating profit below $37,500,000 would better for raising capital by means of issuing shares. As this would reduce the extend of reduction in operating profit after interest, as comparing with debt financing. The loss of each dollar will be shared by more shareholders. TTphone selection of source of financing. Depend upon the level of earnings generated. Variability of possible earnings limits. Variation would have great impact on earnings per shares.
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June 2011 Section B LOGO Case : Tiger TV Manufacturing Company Limited - Question 6 Additional Points to Note: Factors for determination of debt financing and equity financing Current gearing level of the company High gearing would better be used by equity financing, this would modernize the gearing position. Interest rate environment in the market. Stock market environment. Dilution of control Possibility of company being acquired by another firm if more equity is issued and held by outsiders. Depend upon the management of company would seek opportunity for being merged or resistant for being merged.
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June 2011 Section B LOGO Case : Tiger TV Manufacturing Company Limited - Question 6 Additional Points to Note: Factors for determination of debt financing and equity financing Management preference Related to management usual practice for raising fund. Cost of financing This relates to the cost of underwriting fee, legal fee, adviser fee etc under equity financing. This also involves the interest expenses, and other professional fee involved under debt financing. One need to have careful analysis for cost fee under alternative approach. Remember that time cost should be taken into account for analyzing the cost of finance.
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June 2011 Section B LOGO Case : Tiger TV Manufacturing Company Limited - Question 6 Additional Points to Note: Factors for determination of debt financing and equity financing Pecking Order theory This theory states that companies will prefer retained earnings to any other source of finance, and then choose debt, finally be equity. Ordering for raising fund should be as follows:
Retained earning Straight debt Convertible debt Preference shares Equity shares
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LOGO
Past Paper Review
DEC 2011 SECTION B
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Dec 2011 Section B LOGO Case background • • • •
ABC is a high growth company in mainland China involved in solar energy. Cash flow from operations is still in a negative position in the coming
three years. Need to raise fund for purchase of capital equipment for expansion of business. Management decides to make use of debt financing by issuing a 5 year USD non-redeemable zero coupon bond at 9.5% in the US capital market.
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Dec 2011 Section B LOGO Case : ABC Company - Question 4 Required: (a) Explain why it is favourable for ABC to issue a zero coupon bond rather than a conventional bond. (b) How much will ABC need to repay at the end of the 5 years to redeem the bond at maturity. Ignore issue cost. If ABC forecasts to have only US$80 million cash to repay the bond at maturity, what is the implied (breakeven) interest rate p.a. that the company should target in raising this US$80 million bond? (c) Given the bond is non-redeemable and can only be repaid at maturity, name four financial risks that ABC will encounter from the issuance of the zero coupon bond. (d) Identify one approach to manage each of the risks identified in (c). (e) What are the factors the investors in a zero coupon bond need to consider?
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Dec 2011 Section B LOGO Case : ABC Company - Question 4a Noted: • Overall question is related to the general concept of financial risk exposure. • Basic feature concept for zero coupon bond is examined in order to generate the solution for what the questions ask. • Very little calculation related to NPV analysis for bond valuation. Question 4a • Zero coupon bond means that there is no coupon payment to investors. • Bond holder would benefit arising from capital gain of holding the bond. • Usually zero coupon bond is sold at a discount in order to ensure positive yield earned for investors. • With negative operational cash flow in the next three years, zero coupon bond is suitable as it requires no cash payment until maturity.
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Dec 2011 Section B LOGO Case : ABC Company - Question 4b Question 4a (Cont’d) • Cash amount of redemption is known at issue and hence reducing cash flow risk. • As the implied interest rate is fixed (i.e., yield), there is no interest rate risk. Question 4b • Amount need to repay in five years is: US55m * (1+9.5%)5 = 86.58m, and thus ABC will not have enough cash to repay given the cash balance at US80m only. • •
ABC cannot repay the bond at maturity. Given the maturity amount at US80m, the implied interest rate should be (80/55) 0.2 -1 = 7.78%.
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Dec 2011 Section B LOGO Case : ABC Company - Question 4c Question 4c • Refinancing risk: Disability to refinance the bond upon maturity. •
Cashflow risk: Shortage of cash leading to liquidity problem with regards to insufficient cash to fund the redemption upon maturity.
•
Interest rate risk: As given the assumption that the bond is not callable for any business day before redemption, the company might not take advantage to redeem earlier if the market is in interest rate environment. Bear in mind that this risk analysis is not focus upon floating and fixed interest rate in this case.
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Dec 2011 Section B LOGO Case : ABC Company - Question 4d Question 4c (Cont’d) • Foreign exchange rate risk: Currency fluctuation between USD and RMB, as the repayment currency is in USD, while the base currency is in HKD. Question 4d • Refinancing risk: Careful monitoring of the bond market. Implement proper financial planning in order to ensure that risk profile does not deteriorate much.
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Dec 2011 Section B LOGO Case : ABC Company - Question 4d Question 4d (Cont’d) • Cashflow risk: Careful cash flow planning. seek ways by means of proper working capital management to turn the operating cash flow (OCF) to surplus at the end of the third year. •
Interest rate risk: Given low interest environment, the chance to drop further is absolutely low. ABC could consider partial repayment of loan outstanding, but need for proper cashflow planning.
•
Foreign exchange risk: Hedging financial instruments to reduce exposure, preferably with a term close to 5 years, such as forward contract, options, future etc.
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Dec 2011 Section B LOGO Case : ABC Company - Question 4e Question 4e • Factors to be considered when choosing zero coupon bond for investment:
Liquidity preference : whether investors accept to receive unstable income pattern or not. Risk attitude towards interest rate risk and liquidity risk in case bond is sold before maturity. Tax implications, related to tax on capital gain, largely depend upon local tax law.
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Dec 2011 Section B LOGO Case background for Question 5 • • •
Company P offers to buy 100% of Company S Consideration will be settled by new shares issuing Relevant financial information :
Profit after tax (Earnings) No. of shares outstanding Share price before acquisition EPS
P
S
$50,000,000
$10,000,000
5,000,000
2,000,000
$150
$60
$10
$5
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Dec 2011 Section B LOGO Case background for Question 5 •
Expected synergy after Merger and acquisition at $5 million, for which $2 million will result from cost reduction, and $3 million for additional profit generated
•
Position the Company P as industry leader after acquisition
•
Synergy materialised period : 12 to 24 months
•
Decision to acquire or not is based upon whether the Company P would be able to maintain or improve EPS after acquisition.
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Dec 2011 Section B LOGO Case : Company P - Question 5 Required: (a) Assume no synergy position, what is the combined EPS if P offers to buy all S’s shares at $65? Will this price be approved by P’s Board based non EPS maintenance strategy? (b) Similar to part (a), if the selling price is changed to $90, will the Board approve the acquisition? (c) Assume $5 million synergy materialises as planned. Calculate the maximum price P can offer which could maintain the post acquisition EPS to the pre-acquisition level of $10 between 12-24 months after acquisition? (d) As the CEO of P, how would you convince the Board to approve the acquisition price up to the amount calculated in (c). Show all calculations and state necessary assumptions. (e) As one of the member of P’s Board, how would you assess the reliability of the $5 million expected synergy. Assume the maximum price calculated in (c) is offered, what is the impact on future EPS if this synergy is not achieved, and if it is achieved?
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Dec 2011 Section B LOGO Case : Company P - Question 5a •
PE for P = Price per share / earnings per share = 150/10 =15
•
No of new shares issued by P : 65 * 2m / 150 = 866,667
•
Total no of shares after acquisition : 5m + 866,667 = 5,866,667
•
Post acquisition EPS = Total earnings/ No of shares issued after acquisition = (5m+1m)/ 5,866,667 = 10.23
•
Board will approve as the post acquisition EPS of 10.23 is higher than the original EPS of 10.
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Dec 2011 Section B LOGO Case : Company P - Question 5b •
No of new shares issued by P : 90 * 2m / 150 = 1,200,000
•
Total no of shares after acquisition : 5m + 1.2m = 6.2m
•
Post acquisition EPS = Total earnings/ No of shares issued after acquisition = (5m+1m)/ 6,200,000 = 9.68
•
Board will not approve as the post acquisition EPS of 9.68 is lower than the original EPS of 10.
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Dec 2011 Section B LOGO Case : Company P - Question 5c •
Assume the maximum price is p.
•
No of new shares issued by P : p * 2m / 150
•
Total no of shares after acquisition : 5m + (2m * p) / 150
•
Earnings of combined company with synergy = (50m+10m+5m) = 65m
•
Post acquisition EPS = Total earnings/ No of shares issued after acquisition 10 = (65m)/ 5m + (2m * p) / 150 P = $112.5
•
The maximum price that Company P be likely to acquire S at $112.5.
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Dec 2011 Section B LOGO Case : Company P - Question 5d • •
• • • •
Given the price offered as calculated in part c at $112.5. Assume no synergy benefit, No of new shares issued : 2m *112.5 / 150 = 1.5m Combined EPS : (5m+1m) / (5m+1.5m) = 9.23 Board would not approve the acquisition as the combined EPS of 9.23 is lower than original EPS of 10. In order to convince the Board, one has to persuade that expected synergy effect of 5m would be generated after acquisition. The expected synergy effect of 5m would be raised the EPS back to original EPS of 10. It helps to position the company as market leader which results in a higher share price.
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Dec 2011 Section B LOGO Case : Company P - Question 5e •
Assess the reliability of $5m expected synergy. $2m of synergy from cost of reduction is questionable since it involved some common fixed cost which is difficult to avoid, also the reduction in cost would sacrifice the quality of product as well as staff morale. $3m of synergy arising from increased profit depends upon the enhanced market position of company P. Further assessments of other factors are needed to be taken into account as this would involve higher uncertainty and risk exposure. If the $3m synergy does not materialise during the second year, the EPS of combined company might fall below the pre-acquisition level of 10. Even if synergy materialises as expected, there is no enhancement to EPS if maximum price of $112.5 is offered.
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Dec 2011 Section B LOGO Question 6 – Case background •
XYZ is a listed medium size real estate development company in Hong Kong Existing capital structure:
10,000 bonds face value of $1,000 2 million shares of 7% preference stocks with face value $100 5 million shares of common stocks
Yield to maturity of bond : 7% Market price of preference share : $60 per share Common stock has beta of 1.5 with market price of $50 per share Risk free rate : 3% Market return : 15% Tax rate : 16.5%
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Dec 2011 Section B LOGO Case : Company XYZ - Question 6 Required: (a) Calculate XYZ’s weighted average cost of capital? (b) XYZ is considering diversifying into the media business in mainland China and is considering a major investment proposal. The Board requires NPV as the quantitative evaluation tool and one of the Board members indicates that the firm’s WACC can be used to discount the project cash flow to arrive at the NPV. Write a memo to the Board, in your capacity as the Finance Director of XYZ, to explain the appropriateness of this suggestion. State reasons to justify your answers.
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Dec 2011 Section B LOGO Case : Company XYZ - Question 6a •
Rather straight forward question by asking the general concept for calculation of WACC Number
Price HK$
MV
Weight
10,000
1.000
10.000.000
2.63%
Preference stock
2,000,000
60
120,000,000
31.58%
Common stock
5,000,000
50
250,000,000
65.79%
380,000,000
100%
Bonds
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Dec 2011 Section B LOGO Case : Company XYZ - Question 6a •
Bonds : Rb (after tax) = 7% * (1-16.5%) = 5.85%
•
Preference share : Rp = (100*7%) / 60 = 11.67%
•
Common stock : CAPM Theory Rf+(Rm-Rf) * Beta 3%+(15%-3%)*1.5 = 21%
•
WACC = Ke x E/V + Kd(1-tc) x D/V = (0.6579*21%) + (0.3158*11.67%) + (0.0263*5.85%) = 17.65%
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Dec 2011 Section B LOGO Case : Company XYZ - Question 6b • • • •
•
WACC should not be used as discount rate for media business. WACC reflects the risk of the entire company’s business, i.e.., real estate development. WACC can be used to evaluate the investment proposal. WACC in this case represents the risk for real estate development, not the media business. It is not appropriate to use one standard WACC across different industries. In this case, XYZ is a HK company, and the media business is China-based company. Different geographical segment would mean that there are quite different aspects between two places in terms of everything, such as business and legal environment, which represents different risk profile. Hence, standard WACC for evaluation of media business in China is not appropriate.
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Common topics in MB LOGO Topics: •
Project appraisal technique: NPV analysis, IRR, payback period, accounting rate of return.
•
Hedging techniques covering exposure for interest rate risk and foreign currency risk.
•
Calculation of weighted average cost of capital (WACC).
•
Cash conversion cycle improve cashflow.
•
Dividend policy.
•
Valuation and characteristics of different types of securities instrument.
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Common topics in MB LOGO Project appraisal technique: accounting rate of return:
NPV
analysis,
IRR,
payback
period,
whether the project is mutually exclusive project . only one project will be accepted and others will be excluded.
Independent projects . projects are unrelated to each others, which could be accepted or rejected independently.
Pros and cons of different valuation technique.
Determination of appropriate cost of capital.
Use interpolation approach for calculation of IRR.
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Common topics in MB LOGO Hedging techniques covering interest rate risk and foreign exchange risk: Forward market hedge Money market hedge Futures hedge Option hedge •
• • •
If the questions simply ask what strategies to adopt, you could add one more point “Do nothing for hedging” in order to capture score. Of course if the questions ask the hedging strategies, then you could not add such point. Pros and cons for different valuation techniques. Understanding and practice some simple calculation questions for different hedging approach. Distinguish the role between borrowers and lenders. The focus would be the payment of foreign currencies/interest expenses, or the receipt of foreign currencies/interest income.
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Common topics in MB LOGO Calculation of weighted average cost of capital (WACC): General formula is: WACC = Ke x E/V + Kd(1-tc) x D/V where E = market value of equity [share price ex-div x number of shares] D = market value of debt [market value of debentures + nominal value of any loan amount] V=E+D tc = tax rate Involve NPV analysis and IRR approach for calculation of cost of debt when the debt has repayment period. Cost of equity would normally be provided in the question, in some case, we need to make use of CAPM for calculation of cost of equity. Market value of equity would normally be provided in the question. Since the transparency of debt market is still low, market value of debt and the coupon interest rate which is used to calculate the cost of debt might be presented in the statement of financial position.
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Common topics in MB LOGO Cash conversion cycle improve cashflow: Calculation of cash operating cycle. Inventory period + Accounts receivable collection period + Good taken to produce the goods + Time for goods taken in transit - Accounts payable period Comparison of calculated cash operating cycle with the industry average. Comparison of calculated cash operating cycle with two companies and make analysis based on data calculated. Suggestion of measurements for improving the cash operating cycle, i.e.., accounts receivable management, inventory management.
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Common topics in MB LOGO Dividend policy: Pros and cons for payment of dividend based on the concept of Residual theory Traditional view Irrelevancy theory Supporting figures for determination of whether dividend policy of the company is successful or not by reference to:
Growth rate of Earnings per share (EPS) Growth rate of dividend per share Growth rate of share price Growth rate of market index
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Common topics in MB LOGO Dividend policy: Based on the growth rate of profitability, and in comparison with market, to determine whether the dividend policy is financially sound or not. Pinpoint the fact as to whether the company’s share price performance outweigh than the market as a whole is solely dependent upon by dividend policy. Share price performance might be affected by other factors.
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Common topics in MB LOGO Valuation, characteristics and analysis of different types of securities instrument and source of finance: Bonds versus equity financing. Commercial paper (the latest version of CLP strength the content for commercial paper market). Short term borrowing versus long term borrowing. Credit rating for bond product. Loan covenant
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Expected topics in MB short questions
LOGO
Hedging techniques covering exposure for interest rate risk and foreign currency risk (either one of the risk). Students are expected to: Differentiate between internal hedging and external hedging instruments Money market hedging strategy for foreign currency Foreign currency option and future strategy Interest rate option hedge : caps, floor, and collar. Detailed calculation is expected • • • • • •
Cash conversion cycle improve cashflow Dividend policy & share repurchase Valuation of debt financing, with special focus on convertible bond Target costing and pricing strategies Investment appraisal technique, such as NPV, ARR, Payback period, and IRR Concept of loan covenant
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