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2022.06 Capstone FE Jun 22 Answerfinal
2022.06 Capstone FE Jun 22 Answerfinal
The sample solution for the Capstone Examination is provided for illustrative purpose only.
It is meant to help candidates in their revision and learning and to illustrate the expected
structure of the answers and the coverage and depth of knowledge relating to the particular
requirements. The sample solution may be longer than what the candidates are expected
to produce in the examination. As the Capstone Examination simulates real-life situations
based on an integrated case study, the sample solution may not and is not intended to cover
all the valid points that can address the requirements of the examination questions. In the
examination, candidates were awarded points for valid answers that may not be covered in
the sample solution.
Answer 1(a)
To: Tom Ho
From: Riz Chan
Date: XX December 2020
Subject: Review Analysis of the Closing Down Analytical Process
This memo details a review on the analyses previously done for the decision of closing down
certain restaurants.
In my opinion, the analyses carried out were necessary but not sufficient for making a proper
business decision of closing down restaurants during the Pandemic. The reasons are as
follows:
(i) The analyses failed to take into account other important elements such as the location
of branch restaurants. Although rental costs might have been considered in the relevant
cost analysis, location of existing restaurants should also be considered, as once
a restaurant was closed, the same location might not be repossessed if the economy
rebounded to normal. Important elements such as this need to be considered for the
longer term impact analysis.
(ii) More detailed cash flow analyses including other resources should be carried out to
arrive at a concrete judgement on the impact of the closing down. If the Company could
survive for 3 more years given other resources, for example, the closing down decision
would become unnecessary for the immediate moment.
(iii) The analyses that were carried out did not provide a clear picture on the impact of
closing down some restaurants to the business of other maintained restaurants.
We might wish to know if existing customers were willing to turn to other maintained
restaurants in case a restaurant were closed, or whether these customers were
expected to turn to other group restaurants. This analysis would provide important
information to the final decision.
(v) Alternative arrangement considerations and analyses were not done. Closing down
some restaurants and terminating some staff might not be the only option for BK. It
would often be better to consider all available options before making any decision. Only
if there is no better alternative option may the option of closing down restaurants be
chosen.
(vi) There was no information as to how staff was retained or relocated during the closing
down. It might be a fairer and better option to the Company to have staff laid off based
on individual performance across all restaurants, with the good-performing staff of
closing restaurants being relocated to other operating restaurants.
I hope the above-mentioned comments would be helpful for our review and analysis. Should
you require more information or further explanation of the above-mentioned issues, please
feel free to let me know.
Riz Chan
Finance Manager
A cash flow analysis should be carried out to a more detailed extent, and a cash
resources analysis is important when deciding on closing decisions. If there were good
funding resources with low financing costs, the closing decision may look different.
When a restaurant is closed within a restaurant chain, sometimes customers may switch
to a nearby restaurant of the same group, but sometimes they may not. We need to
carefully consider the replacement effect of such. This is also related to the location
analysis issue.
A corporation with a CSR objective will often take into consideration its CSR impact in
decisions affecting the benefits of stakeholders, in particular working staff. It is often
claimed that it is worthwhile to bear some more losses if doing so can maintain CSR to
a wider group of stakeholders including staff and customers.
Before deciding on any closing decision, there is always an alternative analysis process
to consider if there are other options and ways to help the corporation survive and pass
the hurdle. This is quite a standard procedure for many types of decisions including in
this case a closing decision.
Candidates can provide other proposed analyses with appropriate reasons. Marks will
be awarded on the merit of the reasons and argument of the proposed analysis rather
than on the title of the analysis itself.
To: Tom Ho
From: Riz Chan
Date: XX December 2020
Subject : CSR Consideration
In accordance with your instruction, I would like to submit the following comments in respect
to the CSR consideration of the closing down action we carried out about one year ago.
In my view, it was not a good decision from the CSR perspective and viewpoint, especially if
the company could afford to keep the existing restaurants and staffs without facing any risks
of corporate distress or collapse.
Although CSR could be interpreted in various ways, a major component of CSR must be
consideration of stakeholder benefits, including customers and staff. In an adverse economic
situation, we should try to maintain the economic benefits of staff so that they would still have
employment income sufficient to maintain basic economic needs. We should also consider
providing quality food to customers at more affordable prices, so that customers who might
also experience adverse economic conditions could still enjoy good quality foods at lower
costs. In this way we would have maintained good corporate social responsibility and
demonstrated responsible CSR actions to society.
Although CSR may not be a critical or important objective of the corporation, keeping good
CSR practices may impact on other important business objectives such as profitability and
corporate reputation. Thus, we should clearly understand that this is an irresponsible decision
from the CSR perspective.
A worst-case scenario analysis is performed below to help understand the impact of the
proposed business line of selling soup bases overseas:
Worst sales situation (HK$80 per bag and sold at 500 bags only) $40,000
Costs at assumed sales level: $20,000
Materials cost (HK$40 per bag, taking maximum cost base)
Packing costs:
Packing bag $1,500
Vacuum machine cost $5,555
Parcel cost 1,000
8,055
Delivery costs:
Freight cost 6,500
Local transportation cost 500
7,000
35,055
Contributions $4,945
(Note: Alternatively, candidates may calculate the unit cost contribution instead of monthly
base contribution as below:)
Profitability-wise, as seen in the summary calculations above, it is highly probable that the
proposed business line could produce sufficient contributions to justify its viability. Given
these estimations, it is profitable to start the proposed business line.
In summary, it is considered both feasible and profitable to start the proposed business line.
Net profits is an important KPI as this is related to the ability of survival and sustainability,
left alone the profit-making objective of a company. Thus, net profits for a business must
always be included as a KPI (except for charities and other non-profit-making institutions
such as government agencies).
For new and emerging businesses, the number of customers can be regarded in the
early years as an indication of whether the business could garner the attention of
potential customers in a short period. If it needs to take a much longer time to establish
a customer group, then an emerging business may risk running out of finance before the
business is self-sustainable.
Sales per customer could be a KPI to identify whether targeted customers are really
attracted to the business and to determine whether the initial success phenomenon
reflects a longer-term situation.
(vii) Other reasonable suggestions on KPI such as Accounts Receivable Collection Status,
etc.
Before this proposed expansion project can be executed, BK should first consider the possible
risks that are linked to the expansion project as follows:
Accounting:
1. All the budgeted or estimated costs are subject to estimation error, which may render
the calculated results not perfectly correct or reliable.
2. The budgeted income statement has not taken into account any administrative overhead
that might be charged to the project in actual operation. This may lead to a different
picture of its actual operational results.
Management:
1. There are still risks on cross-border operations including customs issues, legal
restrictions on entrance of products because of their nature (treating as medicine rather
than allowable food in some countries, etc.), and unforeseeable operational problems
during storage and delivery of products to customers overseas.
2. Management may not be able to estimate the litigation risk arising from these overseas
trading operations as different countries may have different laws on food safety and legal
responsibilities of sellers.
Strategy:
1. BK may cause an unhappy relationship with VC in the future given that VC does not
agree with this expansion plan. This may cause trouble to BK in the future in case any
help from VC is needed.
2. BK may lose the strategic opportunity for other expansion plans including the expansion
plan in the mainland, given that this proposed overseas expansion plan may lock up
and occupy available expansion funds of BK and restrict any other expansion plans.
The strategic perspective and opportunity loss need to be carefully considered.
Proposed Sale and Lease back of the Company's Property (Property Deal)
Background
The Company is suffering from the current economic downturn, and additional sources of
funds are required to support the daily operation and diversification of the business. Recently,
one of our shareholders, VC, offered to buy our property ("the Proposal") with the following
terms:
Purchase price of HK$25 million based on the latest valuation from a professional surveyor.
Agreement to lease back the property to the Company at a market rent of HK$1,000,000
p.a. for a fixed term of 5 years, with an option to renew for a term of 3 years at a maximum
of 20% increase in rental.
Granting of a buyback option to the Company at a markup of 20% from the VC’s purchase
price, exercisable only at the end of the first 5-year term
The property is now on a mortgage with a bank at an interest rate of 4% p.a., the outstanding
amount is HK$4 million to be repaid within the next 5 years, and no penalty is required if the
Company repays earlier.
Accounting Implication
The proposed transaction is a sale and lease back transaction, a combination of a sale of
property transaction and a lease arrangement of the property for a term of 8 years in total.
For the disposal transaction, the property and the related bank loan will be derecognized in
the Company's statement of financial position. The fair value gain arising from the increase
in property value to be recognized by the Company should only be the portion related to the
rights transferred to VC. The reason behind this is that, though the Company has sold the
entire property, from an economic standpoint, the Company has only sold its interest in the
value of the property at the end of the leaseback, that means the Company has retained its
right to use the asset for the duration of the lease.
The buyback option will only be recorded if and when it is exercised at the end of year 5, but
needs to be disclosed in the financial statements.
If comparing before and after the transaction, the Company will be subjected to depreciation
of the right-of-use asset and interest expenses according to the lease term, while as owner
of the property, depreciation based on the acquisition costs of the property was charged.
Tax Implication
Gain on the disposal of the property will likely be capital in nature, and hence not subject to
Hong Kong profits tax.
Interest on lease liability and depreciation on right-of-use asset charged in the profit and loss
account is allowable as deduction of expenditures for tax purpose. Alternatively, tax
deduction could be claimed on the basis of contractual payments so long as the basis was
consistently applied and there was no indication of any element of tax avoidance.
As compared to the existing mortgage arrangement, the bank loan interest and commercial
building allowance are allowed as deductions for tax purpose, and the amount is likely smaller
than the rental payment.
Strategic
The proposed transaction helps to improve the Company's financial position by reducing debt
and improving free cash flow for further business diversification.
In addition, by selling the underlying property, we can reduce exposure to real estate risk and,
in effect, partially reduce total risk to the Company.
The downside of the proposal is that the future appreciation, if any, of the property value is
no longer available to the Company.
Financially the Company is able to crystallize the capital gains, realize the appreciation of
value in the property, and reflect proportionally the gain in our financial statements.
With the conversion of long-term asset into cash, liquidity of the Company will significantly
improve, which will help to enhance the Company's financial strength.
The full amount of rental payment will likely be regarded as deductible expenses for tax
purpose, which will be larger than the current deduction of interest on bank loan plus
commercial building allowance.
However, the Company is required to bear the rental expenses as fixed overhead; hence, the
costs structure will be less flexible, and the Company is also exposed to rental price increase
in the future.
For a longer term prospective, potential relocation costs in the future will also form part of the
consideration, even though the landlord VC is our shareholder.
Recommendation
Assuming the Company would like to repossess the property and therefore exercise the
buyback option after 5 years, the total amount paid throughout the period is HK$35 million
($5 million rental + $30 million purchase price), or 140% of the current market value. As a
result, the Proposal is equivalent to a five-year term loan of HK$25 million, paying around 8%
p.a. as interest.
It appears that the Proposal is reasonable and matches with our existing business direction
and financial needs. If we aim to borrow a loan with the property, the loan amount will be
much lower than HK$25 million.
In view of the above consideration, it is recommended to accept the Proposal from VC.
Other terms that may help to improve the business flexibility of the Company:
Suggest to have the buyback option exercisable every year throughout the lease period,
with the markup amount proportional to the length of period covered, i.e., first year
markup 4%, second year 8%, etc. That will allow the Company to monitor the right timing
to exercise the option.
Propose the waiver of the reinstatement requirement at the end of the lease, which will
save the relevant costs.
Allow the Company to have the early termination right, or partial surrender right, or the
right to sublease, with a pre-agreed notice period. This provides more flexibility to the
Company on the lease arrangement.
Negotiate payment terms, preferably payment in arrears, and negotiate the prolonged
payment time interval, say every 3, 6, or 12 months in order to improve the cash flow of
the Company.
Background
One of the Company's long-term goals is to expand the business to mainland China. In a
recent meeting with a representative of our shareholder – the VC, their representative
proposed some business expansion opportunities in mainland China for our consideration.
VC owned a restaurant chain with six restaurants situated in prime locations in Guangzhou
and Shenzhen, primarily serving seafood and hotpot, sometimes serving game such as quail,
rabbits and deer. The restaurants targeted high-spending customers, with resplendent
decoration and luxury services.
1. Appoint the Company as general manager of the restaurant chain, in charge of the daily
operation and responsible for all financial and operational management, including
human resource arrangements and staff training. The Company will be entitled to 2% of
the turnover as management fee. (Management Deal)
2. The Company will acquire all six restaurants from VC, as the first step for the Company
to expand into the mainland Chinese market. Acquisition price will be based on a
valuation report completed right before COVID-19 with a 60% discount, i.e., priced at
about 40% of the valuation before COVID-19. The acquisition price will be settled by
issuance of the Company's new shares to VC and no cash payment is required.
(Acquisition Deal)
The Management Deal offers a nearly no additional costs opportunity for the Company to
enter the mainland China market. With little investment costs, it provides a more reliable
income source and low risk business model, and the management team get the chance to
accumulate experience in operating restaurants in mainland China. Without heavy
investment, the Company will retain more flexibility for future development. Especially under
the current market sentiment, the light investment, high flexibility, and reliable income source
will be significant advantages to the Company.
For the Acquisition Deal, it offers a great opportunity to enter the mainland China market at a
relatively low entry costs and quick pace, which fit into our strategy perfectly. The Company
is able to build its own brand and extend the market quickly. With full control of the new
restaurants, it will be more likely to create a synergy effect with current operations, even as
added distribution channels for our new soup package and shelf product business. If the
business runs well, the Company can enjoy the results fully as compared with the
Management Deal, where the Company could only share a small part of it.
However, the Acquisition Deal demands a much higher investment as it includes six
restaurants in one go. It definitely poses a higher risk to the Company, in particular, under
the current unfavourable market condition, which may last for an uncertain period of time.
Though the Company is not required to settle the price by cash, there may be additional
funding requirements for the newly acquired restaurants before they recover from the current
loss-making position. The other side effect is that VC's influence on the Company will
unavoidably be enlarged as their shareholding increases. Moreover, though the price of the
acquisition target is lower due to the market condition, as the suggestion is a share swap, it
means valuation of our Company's shares will be lower too. This will offset partly, if not all,
of the lower entry costs benefit in the acquisition transaction.
Areas of Concerns
The above discussion only covers the high-level pros and cons of the two options. Without
the details of the two options, the Company may not be able to make a clear decision. For
the on-going negotiation with VC, special attention should be drawn to the following areas:
After considering all of the above factors, the Management Deal appears to be more suitable
for the Company's development according to the current understanding. However, the
coming negotiation with VC may affect the situation, and once further details are clarified, we
would have better information for more fruitful discussion.
I hope the above provided all the necessary information for your consideration. Please feel
free to contact us for further clarification.
Signature
Name