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A(i) What are the advantages and disadvantages of this JV arrangement in China? Show
calculation where applicable.

Advantages

1. Secure the sales from 2 major customers

Currently HCF was threatened by its 2 major customer, Kiki and Houida by their
intention to replace HCF to companies in China who are able to provide much
competitive prices than HCF.

Revenue from the Kiki and Houida represents 44% of the total sales of HCF,
amounting to a sum of RM 53 million, to make things worse, it is expected that the
remaining customers may pull out from the “contract manufacturing” if Kiki and Houida
were to do so.

In this case, if HCF is unable to retain these customers, HCF would be incurring
losses. This is proven in the Appendix 1, which illustrates a loss amounting to RM 14.21
million losses will have to be borne by HCF if Kiki and Houida were to withdraw.

2. New insights and expertise

Starting up a joint venture provides a good opportunity for HCF, as they can gain
new insights and expertise from the joint venture partner. HCF manufactures high quality
clothing but as a consequence, it has a high cost base; which is the reason to the
withdrawal of the two major customers.

Although the joint venture could only be for a short period, HCF could use this
opportunity to learn from others on how they could keep up with manufacturing of high
quality garments with low cost. Not only that, HCF could also learn from them on the
strategies they used to penetrate the world market.

Besides, it is beneficial for HCF as Celestial Clothes is an existing Chinese

manufacturer who had been in the market since 1995. Celestial Clothes would be able to
provide assistance such as compliance of laws and regulations, especially in the operation
of business and the current labor law in force in China.

Furthermore, Celestial Clothes is able to manufacture approximately 2 times

higher than HCF. HCF could then use this opportunity to learn how Celestial Clothes
achieve this.

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3. Sharing of risk and costs

Although the Financial Controller, Daniel had mentioned that the joint proposal
carries much higher risk than HCF running on its own, where he had used discount factor
of 12% in his evaluation of the joint venture proposal.

However, without the help from joint venture, HCF could incur much more costs
to wait for the factory to be ready. For example, before the factory is ready, the customers
of HCF could have already withdrawn from the ‘contract manufacturing’. This could
have led to HCF having great difficulties to maintain its sales and cash flow.

Moreover, with the help of joint venture arrangement, HCF will only have to
invest RM 2.4 million for the special purpose vehicle created under the joint arrangement
instead of the full amount of RM 8 million.

4. Option to venture into China on its own is unlikely

A sum of RM 15 million is required to build the factory in China; this option is

almost impossible because HCF does not have sufficient capital to do so.

One way to raise capital is through the use of issuing shares. This is unlikely to be
acceptable to the existing shareholders as it could dilute the shareholding. Even if the
family decides to acquire the additional shares by themselves, it is unlikely that the public
shareholders will accept this. Furthermore, issuance of shares would give an impression
to the public that HCF is facing great financial difficulties.

Another approach would be to borrow loans; but given that HCF faced decline in
sales amounting to 73% from year 2007 to year 2008. This could be one of the reason
banks’ refusal of the application for borrowings; this could then result in HCF unable to
borrow loans from financial institutions in order to raise funds for its building of factory
in China.

5. Better Net Present Value (NPV)

Using the post-tax cash inflow prepared by Daniel, the NPV calculated is
approximately RM 12 million is evidenced from Appendix 1. This doubles the amount of
NPV calculated if HCF were to go on with the proposal to build a factory with similar
capacity in China, which is RM 6.3 million.

This indicates that going on with the joint venture arrangement will benefit HCF
higher than HCF’s organic growth plan to China.

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Disadvantages

1. Lose Independence
The joint venture proposal is expected to be a 70/30 profit share with Celestial
Clothes; this would led to issues such as losing independence of HCF and possibly,
imbalance of management in working together.

An approximate 70% of profit will have to be shared to the new joint venture
partner; resulting HCF could only enjoy the remaining 30%. Given HCF were to maintain
its sales in 2009, HCF would only be receiving RM 732,600 of profit (RM 2,442
million*30%), if HCF were to go with joint venture.

2. Cost of Expansion

It is expected that RM 2.4 million is guaranteed for to set up a special purpose

vehicle, now the question is whether HCF had sufficient capital for such expansion.

Besides, it is important to note that HCF had a long term loan amounting to RM
4.5 million which has to be repaid in 2011. Even if HCF collaborate with the joint
arrangement, it would be difficult for HCF to collect such large sum to repay off the loan.

3. Time to set up the joint venture agreement

As mentioned earlier that the joint venture proposal is expected to be at the

expense of HCF, the management of HCF would try their best to negotiate with Celestial
Clothes for a better arrangement.

This takes time, and there is no guarantee that Celestial Clothes would agree to
such an arrangement. The worst case scenario would be Celestial Clothes is not interested
in collaborating with HCF anymore, resulting HCF had to look for another suitable
partner for joint venture.

4. Dispute in decision making

HCF is a family-run business, which makes it much more difficult for

management to accept ideas from someone outside the family. They may share different
objectives from the joint venture partner, Celestial Clothes.

It takes time and effort for HCF and Celestial Clothes to reach to a consensus.
This could be detrimental to the business as they could have missed out the timing to
expand or it could even lead to the withdrawal of management personnel.

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 If any one of the key management personnel were to withdraw from his position,
the company could face difficulties to look for substitute who were as capable as the
previous staff.

Given the proposal of the joint venture had already been opposed by some of the
members of the management team; disagreement is highly likely occur in the future.
Besides, the culture between HCF and Celestial Clothes may be different, which could
then lead to further deviation in opinions between the two companies.

A(ii) How can the JV arrangement be structured to the best advantage of HCF bearing in
mind HCF is listed in Bursa Malaysia.

There are mainly two purpose of a business to form a joint venture, either for a single
purpose such as a production, specific project, research activity or a continuing purpose.

The reasons of businesses forming joint venture include sharing resources, expertise, risk
and reward and saving money. By forming a joint venture, the entities will be able to grow their
businesses without the need to look for outside funding and extra expertise. The entities will also
save money on advertising, maybe at a trade show or in a trade publication. In HCF’s case, they
wish to form a joint venture with a China manufacturer, known as Celestial Clothes, in order to
retain their current two biggest customers by supplying clothes at a lower price. Besides, by
forming joint venture, HCF will incur lesser cost compared to setting up their own factory in
China. This is more likely a better choice since HCF is currently short of funds.

There are a few IAS that may be relevant regards to HCF.

According to IFRS 11 Joint Arrangements, there are two types of joint arrangements, which
are joint operations and joint ventures. Joint operation is whereby the parties that have joint
control of the arrangement have rights to the assets and obligations to the liabilities, relating to
the arrangement. Joint venture is whereby the parties that have joint control of the arrangement
have rights to the net assets of the arrangement. The main difference is joint ventures are
structured through separate vehicle, whereas joint operations are not.

In order to decide the classifications of joint ventures, joint control will need to be discussed.
Joint control refers to the contractually agreed sharing of control. It exists when decision about
the joint venture activities required unanimous consent of all parties.

When there is no joint control, the joint venture will be classified as financial assets under
IFRS 9 Financial Instruments, unless it has significant influences over joint venture. If there is
joint control, IAS 28 Investments in Associates and Joint Ventures will be used. Thus, equity
methods will be used to record the assets and profit sharing of joint venture.

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 According to IAS 28 Investments in Associates and Joint Ventures, there are four conditions
where the entity is exempt from applying equity method. Firstly, the entity is a wholly-owned
subsidiary or partially-owned subsidiary, and its owners have been informed and agree to the
exemption. Next, the joint venture debt or equity instruments are not traded in public market.
Thirdly, the entity does not file its financial statements for purpose of issuing it to the public.
Lastly, the ultimate parent will prepare the consolidated financial statements.

In short, HCF must apply equity method for the joint venture. HCF is a listed company in
Malaysia and they are required to submit their audited financial statements to Bursa Malaysia
within the deadline. Therefore, they do not fulfil the second and third criteria of the exemption to
apply equity method.

To form a joint venture, a written agreement will be required for legal purpose, The
agreement should spell out the details of purpose, how much each party will contribute, how the
parties involved share the profits and losses and how the parties will share the decision making
rights. The important content may include start and end date of joint venture, venture member
and their capital contribution, member duties and obligations, meeting and voting details,
assignment of interest details and dispute resolution clauses.

The reason of why HCF wish to obtain greater control in the joint venture may due to the
high cost of failure and lost of independence. As HCF does not have any experience in operating
their business in China, it increases the risk of failure. On the other hand, as a listed company,
HCF has a greater reputation risks. If this joint venture failed, HCF’s image and reputation will
be greatly affected. This may cause HCF’s share price to fall and difficulties in attracting
potential shareholders. In order to avoid these issues, right level of governance oversight and
discipline to manage risks is crucial. By having a greater control, HCF will be able to ensure
there is a sufficient level of governance and decisions are only made after proper considerations.

If HCF wish to obtain the highest possible benefits from the joint venture, the presence of
joint control towards the joint venture is very important. The first method to decide control is
using the Proportionate Model, in which each party’s level of control is proportionate according
to the capital contribution. This is the easiest model to communicate, govern and manage.

However, in reality, companies may want to negotiate the differences related to ownership
and control. For example, a company’s capital contribution may be lower than its partner, and
yet the company wish to have an equal controlling position. Besides, some companies may have
opposite views in managing the joint venture in the future. For instance, a company may be
willing to solely fund future capital investments in certain assets, and eventually throwing out-of-
balance initially equal contributions. For HCF, it only owned 30% of the ownership, but they
wish to gain further control on the joint venture. As a result, we can conclude that Proportionate
Model not relevant to be used.

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 One of the other model can be used is Contingent-ownership based on performance. Under
this construct, the parties structure the agreements as a contingent contract where joint venture
ownership has the potential to change in future. For example, let’s say if HCF contributes an
important technology to the joint venture in future, rather than focus on the valuation of these
hard-to-value assets, HCF may negotiate by increasing their ownership stake instead.

In forming a joint venture, effective communication is the key part to decide the success or
failure of this collaboration. Before drafting the agreement, the parties involved need to
understand what they each want from this relationship. Instead of having HCF’s “win” and the
other party’s “lose” situation, a “win-win” situation seems to be more relevant in the reality, as
no parties wish to “lose” after contributing such a huge amount of funds. Thus, the arrangement
needs to be fair to all parties.

There are a few considerations can be made for HCF to obtain the best advantage in this
venture.

Firstly, HCF may require having the right of appointing their own employees to be seated at
the joint venture board of directors through the agreement. By having their own employees in the
board, HCF will be able to have a better control and voting rights in the new joint venture.

Besides, HCF may select a counter-party that have a similar mind as them and willing to co-
operate. Both the partners should be supporting each while running the business at the best
advantage to the joint venture, instead of solely focusing on own benefits. HCF may also select a
partner that has similar size to them, in order to avoid domination by one of the party.

Next, HCF may require having the priority to acquire the shares of counter-party when they
wish to sell. This is important to ensure the ownership does not falls to other parties that HCF
does not wish to collaborate with. HCF may also increase their shareholding in the future
through this condition.

In a nutshell, drafting a suitable, appropriate and fair joint venture agreement is the most
important stage prior to the forming of joint venture. Any requirements by both parties should be
discussed and clearly written in the agreement. HCF is suggested to seek advice from solicitors
before signing the agreement.

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B. The BOD has a desire to obtain friendly control of this JV progressively over the
medium term(within 3-5 years). What are the advantages to HCF in gaining control of this
JV arrangement?

Control in the joint venture arrangement requires the exposure or right to variable returns
and the ability to influence those returns through power over the other parties as stated in IFRS
10 Consolidated Financial Statements.

In this case, although the Board of Directors (BOD) of HCF has only owned 30% stake in
the joint venture agreement with Celestial Clothes (CC), HCF can still take over the control by
reserving its voting rights in which it has the right to appoint directors with specific roles such as
chairman and the executive directors and the requirement for the board member to be present in
the quorum of the board meetings . Therefore, it helps the Board of Directors (BOD) of HCF in
ensuring they have a significant influence over this joint venture arrangements at various levels
by setting out the scope of board’s decision-making powers.

Furthermore, by gaining the control in joint venture allow the Board of Directors (BOD)
of HCF to obtain the priority right to veto issue of acquiring additonal shares of the counter-
party and to negotiate a list of reserved matters. The most common reserved matters comprising
of the issue of new shares and the creation of rights over shares, the intoduction of new
shareholders, the dividend payments and other financial matters. It is also including the entry
into major transactions and other significant changes to the joint venture business. These matters
can be reserved at either board level or at shareholder level.

As HCF only hold 30% stake in this joint venture, there will be resulted in specific
conditions in terms of transferring of shares which are usually comprises of certain restrictions in
order to protect the right on behalf of HCF as they are unlikely to want the other parties to be
able to freely transfer their shares to whoever they choose. Firstly is the pre-emption rights
involving ‘drag-along provisions’ in which the majority shareholder, Celestial Clothes (CC) will
have to require the minority shareholder, HCF to participate in any sale if its shares to a third
party on the equal terms. On the other hand, tag-along provisions is whereby to involve minority
shareholder’s stake on the same terms in any such sale to a third party. This is indirectly help to
preserve the percentage value of HCF’s shares in the joint venture itself.

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C. What are the strategic plans for HCF to acquire more shares from its JC partner so that
the 50% thresholds for consolidation purposes it met?

Under the second option, Haute Couture Fashions Bhd (HCF)’s management team had
discussed few ways to expand into China. One of the possible ways would be setting up
separate joint venture (JV) business with a Chinese manufacturer. Under the joint venture
agreement, HCF and Celestial Clothes would form a separate company with Celestial
Clothes taking 70% of the stake. In order to meet the 50% thresholds for consolidation
purposes, there are number of ways for HCF to obtain more shares from its JV partners.

Firstly, construct a written agreement which set out the terms and conditions under the JV.
A written agreement would normally include the structure and objective of the JV, how
problems will be resolved under certain circumstance as well as the management and control
in the operation.

HCF may include the pre-emption right on shares in the constructing stage of the
agreement. This contractual provision gives the existing shareholders (HCF) the right to
receive notice and acquire new shares before the new shares in a company being offered to
other potential investor. Therefore, HCF is given protection against the dilution of the shares
and have right of first refusal on the issue of new shares by Celestial Clothes.

Other than that, termination conditions can be included when forming the JV agreement.
This can be said as the key issue to be considered by HCF and Celestial Clothes. Under the
JV exist and termination provisions, it should set out the option where one party (HCF) can
buy the other (Celestial Clothes) out upon the termination of the JV. Hence, the pull out or
divest of Celestial Clothes from the contract allows HCF to hold more or become the
majority shareholder.

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D. What are the other important considerations in China that HCF should be aware of
before making the final decision to expand to China?

HCF intends to enter China and through joint venture agreement with Chinese
manufacturer, this is a better for HCF to enter China with lesser time. However, before
moving into China, there has some important consideration that HCF needs to be aware of.

The first consideration for HCF must be laws and regulations in China. HCF needs to
obtain an understanding on the laws and regulations for the foreign companies that intend to
enter China. HCF should review 2015 Catalogue of Sectors for Guidance of Foreign
Investment to consider which is encourage, restricted and prohibit. Thereafter, HCF can find
a suitable way to enter China without violating any laws and regulations.

As HCF intends to enter joint venture agreement with local partner, it needs to ensure that
the partner is the best choices and its business strategy is fit with HCF. As HCF had chosen
Celestial Clothes as possible partner, it needs to gain an understanding about Celestial
Clothes. Other than that, HCF needs to ensure Celestial Clothes is both trustworthy and
reliable as it will affect the future operation.

Moreover, HCF needs to obtain a better understanding about the market. HCF may
conduct a market research such as Porter Five Forces to analyze the market. HCF needs to
know what the customers wants and what suppliers can be found to fulfill their needs of the
raw materials. Other than raw materials, labor force also needs to be considered as one of the
supplies.

From the market analysis, HCF also needs to consider the local competition. As the
textile industry in China is still growing, HCF may not only compete with the current
competitors but also the new entrants. HCF needs to consider the solution in order to survive
in the market and how to establish a well-known brand for it.

As HCF intends to enter China, it needs to consider the foreign currency. The foreign
currency will not always be fixed, and it is fluctuated. Therefore, HCF needs to consider
there will have gain or loss in the exchange rate. It needs to consider whether any solution
can avoid a huge loss if the currency is disadvantage for HCF.

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