HKICPA

Qualification Programme

Module B – Corporate Financing

Dec 2020

Mock
Answers

https://www.kaplan.com.hk/
 Answers

Answer 1
Marks
(a) (i) Working capital levels

Minimum working capital:

Maximum working capital:

Validity of assumptions

The cash conversion cycle concept supports the assumption that there is normally an increased
1
time delay period between additional purchases, higher inventory levels and higher sales
and receivables.

However, the above calculations based on the Financial Controllers assumptions are that the
1
maximum periods for inventories and receivables coincide with the minimum payables
period, but this relationship is unlikely.
1
Higher inventory and receivables would imply a period of higher volumes of business, which
should normally correspond to higher payables (and hence a longer period) as well.

(ii) Financing of working capital

Maximum financing requirements:

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Financing under each policy ($000):

Max 6
*Included for student explanation:

(b)
Advantages of an aggressive approach
Under the aggressive approach, the firm uses more short-term finance which should be
cheaper than the more expensive long-term finance, resulting in reduced overall financing 1
costs and higher profitability.

Short-term finance also provides greater flexibility to adjust the short-term finance needs
and match more easily cash requirements daily, weekly or monthly as required. 1

Disadvantages of an aggressive approach

Short-term finance has to be repaid sooner than long-term finance, resulting in higher cash
1
flow liquidity risk of the company running out of cash.
1
If the HPC are unable to pay debts as they are due, this brings a financial risk of business
failure and going into liquidation.

Heavy reliance on short-term finance will also require greater management time to manage
1
and renew short-term finance.

Appropriateness for MNO

The nature of MNO’s seasonal celebration card business with an emphasis on local flexibility
would suggest that a more aggressive policy would be better. This is further reinforced by
the expectation of large fluctuations in net current asset levels. 1
Max 4
Total 17

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Answer 2
Marks
(a) REPORT

Date : December 2020

To : Board of Directors
From : A. Accountant 1
Subject : Treasury structure and Listing requirements

Treasury Structure

HPC’s treasury structure is currently centralised, but it is said as businesses grow and
become more complex, there is evidence to support organisations can benefit from moving to 1
a decentralised treasury structure.

However, HPC’s cost and profitability problems appear to be as a result of rapidly increasing
their range of books and cards, not their current centralised treasury function structure. 1

Despite recent growth revenue at the desire to have their shares listed, HPC’s business
remains relatively simple with most production based in China and sales made in Hong Kong 1
and America.

Because of this simple business structure I would not recommend HPC consider moving to 1
decentralised treasury function.

I recommend instead HPC keeps its existing centralised structure as this is fine for current
business operations and will be providing many benefits to the organisation. 1

HPC’s centralised specialist treasury department in Hong Kong can employ experts with 1
specialised knowledge.

HPC can benefit from economies of scale as borrowing can be arranged in Hong Kong in 1
bulk, at lower interest rates.

Centralisation of the treasury function in Hong Kong avoids HPC having a mix of cash
surpluses and overdrafts in different foreign bank accounts. 1
Max 8
* Markers need to be flexible, since students may have discussed different ideas such as the
financing in the American division requiring a more decentralised approach – one mark per
relevant idea discussed.

(b)

Listing on the Main Board of Hong Kong

In order for HPC to be eligible to be listed for the Main Board, it must meet a number of
requirements.

In the opinion of the Stock Exchange of Hong Kong, the applicant (HPC) and its business must
1
be suitable for listing with a solid business strategy operating within the law.

As HPC is a company which specialises in the production of children’s books sold to HK

Government Schools and the export of celebration cards, the business may be considered
1
to be suitable for listing.

HPC must have a trading record of not less than three financial years. Since HPC has been
1
in business since 2001 they certainly it has a trading record of not less than three financial
years.

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It must also be able to demonstrate continuity of management for at least the three preceding
financial years and continuity of ownership and control for at least the most recent audited 1
financial year.

Since the Board of Directors have worked for HPC for many years in various senior
management roles they fulfil this listing requirement. 1

HPC must have a sufficient management presence in Hong Kong. For HPC, it seems that all
Board are based in Hong Kong and thus there exists a sufficient management presence in
Hong Kong.

At the time of listing, the minimum expected market capitalisation must be HK$500,000,000 1
with at least 25% (equivalent to HK$125,000,000) of the company's shares held by the
general public at all times.

There must be an adequate spread of shareholders and at least 300 shareholders.

A new applicant for listing to the Main Board must also pass one of the three financial tests:

1. Profits test

To pass the profits test, HPC must have reported a profit of at least HK$20,000,000 in its most
recent financial year and total reported profits of at least HK$30,000,000 in the two 1
preceding years combined.

The 2020 profits of HPC are HK$38,016,000 which is larger than the required HK$20,000,000,
and the total reported profits in the two preceding years combined (HK$41,613,000 + 1
HK$45,435,000 = HK$87,048,000) also exceed the required HK$30,000,000.

HPC can pass this first test.

2. Market capitalisation / revenue / cash flow test

To pass the market capitalisation/ revenue/cash flow test, HPC must have:

Market capitalisation of at least HK$2,000,000,000 at the time of the listing.

In order to achieve the required market capitalisation, the P/E, based on 2020 profit, would
have to be at least 52 times (HK$2,000,000,000 / HK$38,016,000), which compared to the 1
industry average of 12 times is unreasonably high.

Revenue of at least HK$500,000,000 from its main business operations for the most recent
audited financial year. Since HPC’s reported 2020 revenue is only HK$356,678,000, it cannot 1
fulfil this revenue requirement.

Positive cash flow from its operating activities of at least HK$100,000,000 in total for the
most recent three financial years combined.

Profit before tax + non-cash depreciation and amortisation expenses for the most recent three
financial years combined is (HK$54,407,000 + 49,832,000+ 45,526,000 + 10,068,000 + 1
6,890,000 + 9,898,000) = HK$176,621,000.

HPC can fulfil this cash flow requirement but fails on market capitalisation and revenue.

3. Market capitalisation / revenue test

To pass the market capitalisation / revenue test, HPC must have:

Market capitalisation of at least HK$4,000,000,000 at the time of the listing.

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In order to achieve the required market capitalisation, the P/E, based on 2020 profit, would
have to be at least 105 times (HK$4,000,000,000 / HK$38,016,000), which compared to the 1
industry average of 12 times is unrealistic.

Revenue of at least HK$500,000,000 from its main business operations for the most recent
audited financial year. Since HPC’s reported 2020 revenue is only HK$356,678,000, it cannot 1
fulfil this revenue requirement.

HPC cannot fulfil any of these market capitalisation and revenue requirements.

Conclusion

Since HPC can fulfil the first profits test and seems to meet the other listing requirements, 1
they are eligible to apply for a Main Board listing. Max 10

Total 18

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Answer 3
Marks

(a)

The following actions at the golf club dinner appear to be in conflict with fundamental ethical
principles.

Discussing the impending public share listing openly is likely to be confidential, discussing it in a 1
public place is inappropriate and likely to breach confidentiality.

The finance director needs to ensure that knowledge of the foreign country’s taxation regime is
understood and the task is not rushed prior to completing the return, otherwise there is the
1
possibility that the appropriate professional competencies and due care will be breached.

(b)

Environmental responsibilities for HPC.

Since HPC factory is located on the side of a lake they should closely monitor, record and report
any hazardous emissions, as well as following other relevant emission regulations related to 1
the use of hazardous waste products.

Since printing involves paper which comes from tree’s, HPC should report and have policies on
minimising the impact of its company's operations on the environment and natural resources, 1
such as using recycled paper where possible.

Social responsibilities for HPC

HPC employs nearly 300 people and is the largest employer in its area, so they should report on
compensation and dismissal, recruitment and promotion, working hours, equal opportunity, 1
diversity, welfare, as well as information on compliance and material noncompliance with
relevant labour regulations.

Cleaning machinery requires the use of hazardous chemicals, so HPC will need to provide
health and safety information on safe working environments by setting and monitoring
1
measures such as work place injuries and following relevant regulations on the safe handling of
chemicals.

Handling chemicals is hazardous and so HPC will need development and training system
policies in place to provide knowledge and training on the hazards at work by recording and 1
reporting annual training days provided per employee.

HPC could report on the ways it has community investment, such as projects minimising the
impact of traffic on local roads and village by building new roads, minimising the visual impact of 1
the factory on the area by planting extra tree’s or giving a fair price for books to be used in
schools.
1
Any other relevant aspect relevant to HPC’s business.

* Students may have discussed a wide variety of responsibility issues – one mark per relevant Max 5
issue discussed.

Total 7

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(c)

If no transfer pricing method is given in the requirement, the ideal optimal transfer price to
assist in profit maximising decisions where there are capacity issues, should be the marginal 1
cost plus the opportunity cost to the group.

If we apply this method to the three situations given we have:

(i) Since FSL has an external market, which is the opportunity foregone, the relevant
transfer price would be the external selling price of $15 per kg. 1

This will be adjusted to allow for the $1.50 per kg avoided on internal transfers due
to packing costs not required. 1

The transfer price should be $15 - $1.50 = $13.50 per kg. 1

(ii) In this situation FSL has no alternative opportunity for 3,000kg of its special ingredient Z.
it should, therefore, offer to transfer this quantity at marginal cost.

This is variable cost less packing costs avoided =$9 - $1.50 = $7.50 per kg. 1

*Student Note: total cost = $15 x 80% = $12, Variable cost = $12 x 75% = $9

The remaining amount of special ingredient Z should be offered to the MNO Division 1
at the adjusted transfer price of $13.50 per kg as in (i) above.

(iii) FSL has an alternative use for some of its production capacity, which will yield a
contribution equivalent to $3 per kg of special ingredient Z ($6,000/2,000kg). The 1
balance of its spare capacity (1,000kg) has no opportunity cost and should still be
offered at marginal cost.

FSL should offer to transfer:

2,000kg at $7.50 + $3 = $10.50 per kg; 1,000kg at $7.50per kg (=MC); and the balance 1
of requirements at $13.50 per kg.

Total 15

* * END OF SECTION A * *

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Answer 4
Marks

(a)

Porter says by considering activities within the value chain, it is possible to achieve a
competitive advantage through low cost / cost leadership / value for money as Ramon is 1
seeking to achieve in his hotel chain.

Primary Activities

These activities form the main part of the hotel service and need to be considered carefully in 1
order to achieve this competitive advantage.

Inbound logistics should be concerned with attracting customers to the hotels.

Relationships with property developers and agencies which are mutual beneficial will need to 1
be improved which should lead to increased and guaranteed hotel customers.

Internet website providing information, booking and payment should also lead to more 1
independent property buyers and guests staying at the hotel.

Operations should be concerned with the customer experience and satisfy customer needs ,
with price and quality factors should be considered here. 1

In order to be attractive, from the case it is suggested the hotel service needs to be value for
money basic cost leadership strategy. 1

To achieve this and remain competitive rooms should be basic and simple, and beds should
be comfortable – a regular problem with low cost hotels. 1

To keep the costs down further, each room should have simple basic facilities, say for
example a small fridge, kettle, microwave and TV. 1

The hotel should avoid offering expensive facilities such as bars or restaurants, as these
will push up the costs and overheads. 1

Outbound logistics could be considered as when customers leave the hotel at the end of
their stay. 1

Just like with the rest of the hotel activities, check-out needs to be quick, easy and simple
with the aim of trying to keep costs low. 1

Marketing and sales should help attract and provide satisfaction to customers who stay at
the hotel. 1

It seems the hotel has already established suitable attractive brand name by using “La
Familia Amable”, and it should be used on all marketing activities such as posters, 1
newspaper / property ads, their website, etc.

The ads will need to reflect the hotel service product needs, in that “La Familia Amable” is 1
low cost / value for money, but comfortable and “a home from home!”.

Suitable promotions and pricing will also need to be considered to attract interest and
promote the new brand. 1

After sales service could consist of a loyalty points scheme (free booking slots) could be
agreed with property developers / agencies which should encourage future use whilst 1
improving relationships and loyalty.

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Support Activities

These activities should help support the primary activities identified above.

Procurement would carefully consider the appropriate important factors regarding the 1
location of hotels.

The hotels location need to be positioned away from the noisy main building sites, and 1
located near to property developments where it’s quiet and relatively low cost.
The hotels should be easily accessible by road and provide ample space for parking as many 1
long stay residents may bring or hire a car.

When considering the Infrastructure and HRM, this should be simple / friendly teams who
can perform most duties within the hotel - husband and wife would be ideal.

1
Training could be provided to perform most of the hotel services and help to ensure quality
standards across all hotels within the La Familia Amable brand.
1
Technology could consider a centralised Internet website needs to be setup to provide
Information, booking and payment and should also be accessible and easy to use by hotel
staff (husband and wife teams).
Max 12

(b)

Franchising Advantages

Franchising is seen as a safer alternative to growing the business organically as the local
franchisee usually is the one who invests the capital in the assets of the business. 1

The franchise approach is particularly attractive because it can spread the brand quickly into
new markets and therefore a quick return for the franchisor. 1

Franchising is easier to terminate and a good way to test the market before full investment 1
minimising the investment and risk of the franchisor.

Cultural integration problems can be reduced, as the franchisee can share ideas about local 1
knowledge, customs and preferences.

Franchising Disadvantages

Franchising involves sharing profits and as the La Familia Amable is a new brand and will 1
initially be small, reducing the success of Ramon’s strategy

If the hotel operation is successful, there is the risk that the local investor will develop their 1
own alternative and set up on their own reducing Ramon’s market share.

There may be different goals or the loss of control leading to poorly ran outlets could
1
generate negative customer views and damage the overall brand name.

Care must be taken with the franchise agreement that creates consistency across the hotel
chain, with the right balance between freedom and control over the franchisees. 1

Max 6

Total 18

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Answer 5
Marks
The company's existing gearing is $458 million equity to $305 million debt, or 60% equity,
40% debt.

Cost of Capital

A change in gearing will result in a change in the equity beta. The ‘ungeared’ asset beta is
estimated by:

E 60
Asset beta = Equity beta x or 1.4 x = 0.9545 1
E + D(I – t) 60 + 40(1 – 0.3)

If gearing was 80% equity, 20% debt by market values, the 'ungeared' asset beta may be
regeared' to find the new equity beta:

E + D(I - t) 80 + 20(1 - 0.3)

Equity beta = Asset beta x or 0.9545 x =1.122 1
E 80

Using CAPM, Ke = Rf + beta (Rm - Rf) or 5.5% + 1.122 (14% - 5.5%) = 15.04% 1

If gearing was 40% equity 60% debt by market values, this may be 'regeared' to find the
new equity beta:

E + D(I - t) 40 + 60(1 -0.3)

1
Equity beta = Asset beta x or 0.9545 x = 1.957
E 40

Using CAPM, Ke = Rf + beta (Rm - Rf) or 5.5% + 1.957 (14% - 5.5%) = 22.13% 1

The cost of debt depends on interest cover and the credit rating.

80%E, 20%D 40%E, 60%D

Net operating income 110 110
Depreciation 20 20
Earnings before interest
and tax 90 90
Interest 12.21 (approx. $152.6m debt) 50.36(approx.$457.8m debt)
Interest cover 7.37 1.79 2
Cost of debt 8.0% 11.0%

The interest payable is found by examining different interest rates and interest cover
possibilities.

80% equity 20% debt must fall into the AA rating (if the interest rate was 9%, interest would
be $13.73 million and cover 6.55, still AA cover) 1

40% equity: 60% debt must fall into the BB rating (interest of 9% would be $41.20 million,
1
and cover 2.18 still in the BB rating).

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Weighted average cost of capital at 80% equity: 20% debt

1
WACC = 15.04% x 0.80 + 8.0% (1 - 0.3)x 0.20 = 13.15%

Weighted average cost of capital at 40% equity, 60% debt

WACC = 22.13% x 0.40 + 11.0% (1 - 0.3)x 0.60 = 13.47% 1

The existing cost of equity is: 5.5% + (14% -5.5%) 1.4 = 17.4%
1
The existing WACC is 17.4% x 0.60 + 9% (1 - 0.3)x 0.40 = 12.96%

The two alternative capital structures are expected to increase the cost of capital from 1
its current level.

Enterprise value
1
The current company free cash flows are = $90m (1 - 0.3) + $20m - $20m = $63m

The growth rate is unknown. However; existing enterprise value, free cash flows and
weighted average cost of capital are known, allowing the growth rate to be estimated.

$763m = $63m (1 + g)/(0.1296 – g) Solving g = 0.043 or 4.3% 1

Assuming this growth rate remains unchanged enterprise value with different gearing levels
is estimated to be:

63 (1 + 0.043)
80% equity, 20% debt = $742m 1
0.1315- 0.043

63 (1 + 0.043)
40% equity, 60% debt = $717m 1
0.1347 -0.04 3

Altering the capital structure to either of the two suggested levels is expected to reduce 1
enterprise value from its current level of $763 million.

It is recommended that the capital structure is kept at its current level of 60% equity, 1
40% debt.

Max 15

Total 15

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Answer 6
Marks
(a)

Pecking order theory suggests once available retained earnings have been allocated to 1
appropriate uses within a company, the Directors next preference will be for debt.

The reasons for choosing to finance a new investment by an issue of debt finance rather than
equity finance is because the issue costs are lower, and the degree of publicity and 1
questioning is usually significantly less than with equity finance.

Debt finance may also be preferred when a company has not yet reached its optimal capital
structure and it is mainly financed by equity, which is expensive compared to debt. 1

Issuing debt here will lead to a reduction in the WACC and hence an increase in the market 1
value of the company.

One reason why debt is cheaper than equity is that debt is higher in the creditor hierarchy than
equity, since ordinary shareholders are paid out last in the event of liquidation. Debt is even 1
cheaper if it is secured on assets of the company.

The cost of debt is reduced even further by the tax efficiency of debt, since interest payments 1
are an allowable deduction in arriving at taxable profit.

Debt finance may be preferred where the maturity of the debt can be matched to the
expected life of the investment project easier. Equity finance is permanent finance and so 1
may be preferred for investment projects with long lives.
7
(b)

Annual interest paid per foreign bond = 500 x 0.061 = 30.5 pesos 1
Redemption value of each foreign bond = 500 pesos 1
Cost of debt of peso-denominated bonds = 7% per year
Market value of each foreign bond = (30.5 x 4.100) + (500 x 0.713) = 481.55 pesos
Current total market value of foreign bonds = 16m x (481.55/500) = 15,409,600 pesos 2
4
(c)

(i) Interest payment in one year’s time = 16m x 0.061 = 976,000 pesos 1
A money market hedge would involve placing on deposit an amount of pesos that, with added
interest, would be sufficient to pay the peso-denominated interest in one year. Because the 2
interest on the peso-denominated deposit is guaranteed, Dryden Co would be protected against
any unexpected or adverse exchange rate movements prior to the interest payment being made.

Peso deposit required = 976,000/ 1.05 = 929,524 pesos

Dollar equivalent at spot = 929,524/ 6 = $154,921 1
Dollar cost in one year’s time = 154,921 x 1.04 = $161,118

(ii) Cost of forward market hedge = 976,000/6.07 = $160,790 1

The forward market hedge should be chosen as this is slightly cheaper. 1
6

Total 17

* * * END OF ANSWERS * * *

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2020