SECTION A – CASE QUESTIONS (Total: 50 marks)

Answer 1(a)

Number of shares after acquisition

= HK$50,000 million / HK$25 + 590 million
= 2,590 million

Stock price of merged firm after acquisition

= HK$75,000 million / 2,590 million
= HK$28.96

Answer 1(b)

Proportion of ownership of target firm’s shareholders after merger

= HK$15 billion / HK$75 billion
= 20%

new shares issued

= 20%
new shares issued + 2 billion

New shares issued = 500 million

That is 500 million: HK$10,000 million / HK$50

= 500 : 200
= 2.5 : 1

As a result, the proper exchange ratio should be 2.5 to make the stock offer ’s value to the
target firm shareholder equivalent to the cash offer of HK$15 billion.

Answer 1(c)

The stock offer in Question 1(b) is more preferred by the shareholders of Kowloon Motors.

It is because fewer shares (500 million versus 590 million) are offered to the target firm’s
shareholders.

The dilution effect to existing bidding firm’s shareholders is thereby mitigated.

Answer 1(d)

It will be a violation of Insider Dealing under Securities and Futures Ordinance (“SFO”)
if any person who possess information related to a takeover offer for a corporation, deals in
the listed securities of that corporation or their derivatives, or counsels or procures another
person to deal in those listed securities or their derivatives.

Module B (December 2018 Session) 1 of 8

Executives informed have to sign confidentiality agreements to keep the related
information secret. Creating a firewall between the deal team and the operating business
team of the corporation is necessary. Regular communication, from the top management
to staff, of the severe consequences related to SFO is expected.

Answer 2

The agency theory suggests that takeovers are primarily motivated by the self-interest of
the acquirer’s management. The theories put forward by the two professors highlight the
evidence of a positive relation between a firm’s acquisition and its growth rate.
In the case of Kowloon Motors, which seems to support the neoclassical view of
acquisitions, firms use acquisitions to reallocate corporate assets to more productive uses.
It emphasizes the importance of an acquisition strategy for a firm in order to keep a
sustainable growth rate. To the extent that Kowloon Motors just went public in 2016 which
was a well performing firm. It is expected that this young and high growth firm will have
more valuable assets and hence pursue more acquisitions with easier access to external
capital given it has successfully switch from a private to a public listed corporation.
In this regard, the growth theory of mergers highlights investment can take place through
capital expenditures as well as through acquisitions. High growth firms like
Kowloon Motors make acquisition in this target because Kowloon Motors is perceived to
exhibit higher level of productivity that they can transfer to the acquired firm.
Younger firms like Kowloon Motors have substantially higher growth than mature firms, and
thus are expected to undertake more acquisitions than mature firms.

Answer 3

(a) When we consider acquisitions paid for with cash, abnormal returns are expected
to be positive for acquisition firms. This is largely explained by the confidence of
Kowloon Motors to create value in the deal. As a result, the market will cheer
positively for the transaction where Kowloon Motors is going for the target
aggressively, typically indicating high level of synergies may happen.

(b) On the other hand, it is well known that acquisitions paid for with stocks are
associated with not positive, or even negative abnormal returns for the possible
dilution of earnings. Besides, capital market will also doubt the Kowloon Motors
executives’ level of confidence in the merit of the acquisition by issuing new shares
instead of using cash.

Module B (December 2018 Session) 2 of 8

Answer 4(a)

The accounting breakeven is the after-tax sum of the fixed costs and depreciation charge
divided by the after-tax contribution margin.

QA = [(FC + Depreciation) x (1 - tC)] / [(P - VC) x (1 - tC)]

= [(HK$860 million + HK$460 million) x (1 - 0.165)] / [(HK$400,000 - HK$80,000) x
(1 - 0.165)]
= 4,125 units

Answer 4(b)

When calculating the financial breakeven point, we express the initial investment as an
equivalent annual cost (EAC).

EAC = Initial Investment / PVIFA15%,5

= HK$1,000,000,000 / 3.3522
= HK$298,311,560

QF = [EAC + FC x (1 - tC) - D x tC] / [(P - VC) x (1 - tC)]

= [HK$298,311,560 + HK$860,000,000 x (1 - 0.165) - HK$460,000,000 x 0.165] /
[(HK$400,000 - HK$80,000) x (1 - 0.165)]
= 3,520 units

Answer 4(c)

Both the accounting and financial breakeven number suggest that the project could survive
if the firm sells around 3,500 to 4,200 units annually. As long as the number is feasible to
deliver, the firm should seriously consider investing in the hybrid car project.

15% is only the minimum threshold in the hybrid project that is related to the perceived risk
level. Investment decisions at the firm should be about allocation of long term capital to
the most attractive risk adjusted return project, among other projects availability.

Other future cashflow needs, such as dividend payout requirement, if there has been
stipulated dividend policy in place, will also likely determine the availability of capital at the
firm.

* * * END OF SECTION A * * *

Module B (December 2018 Session) 3 of 8

SECTION B – ESSAY / SHORT QUESTIONS (Total: 50 marks)

Answer 5(a)

To: Dr Simon Chan, Chairman

From: Ms Jenny Lee, CFO

Date: xxxxxxxx

Subject: A Corporate Treasury Centre (“CTC”) for BigCash Inc

Regarding your queries on the subject, below is my review for your consideration:

Foreign currency risk management: CTC helps net off foreign currency exposure and only
has to hedge the net exposure. Instead of hedging the exposure at subsidiary level,
CTC can coordinate the netting off of the long and short positions of each currency and
only hedge the net exposure to the market. The benefit is to reduce cost paid to banks.

Intra-group financing: CTC helps save interest costs. To the extent possible and subject
to regulatory restriction of the respective jurisdiction, CTC can facilitate intra-group
financing by acting as the “internal bank” in providing lending and borrowing services
between all entities of the BC group. CTC can also levy and / or pay interest to the
borrowing / lending entity with the possibility of charging and paying interest to the parties
of the financing arrangement. In doing so, CTC must ensure fair and proper interest
expenses and income are arranged so as not to violate any transfer pricing regulations
among the different tax jurisdictions.

Collection and disbursement services: CTC can collect and make disbursements on behalf
of the operating units and headquarters in order to reduce the transactions costs currently
incurred by using different external banks to perform such services.

Module B (December 2018 Session) 4 of 8

Answer 5(b)

The three suggested relevant performance measures are:

 payment and collection: Number of transactions processed / cost per transaction;

 financing: Budgeted net borrowing / lending rate compared to actual; and

 foreign exchange risk management: Budgeted foreign exchange rates compared

with actual.

Answer 5(c)

The three areas in which performance of treasury activities can be enhanced:

 Centralise banking relationships in CTC at Hong Kong for more effective services
and costing, and establish a relationship with one more major bank to reduce
centralisation risks.

 Written treasury policies need to be documented with explicit approval at board

level in order to formalise the treasury activities. Such a document and formal
approach will enhance accountability and transparency.

 Arrange internal audit to conduct annual performance review of CTC operations to

ensure compliance with regulatory as well as operational policies.

Answer 6(a)

Inventory holding period (days), IHP 103.48 Average inventory / Cost of sales
x 365 days

Accounts receivable collection 67.07 Average accounts receivable / Credit

period (days), ARC sales x 365 days

Accounts payable payment period 42.60 Average accounts payable / Cost of

(days), APP sales x 365 days

Cash cycle (days) 127.95 IHP + ARC - APP

Cash cycle is 128 days.

Module B (December 2018 Session) 5 of 8

Answer 6(b)

Recommended actions to reduce length of the cash cycle:

(i) Reduce inventory:

 Practice Just-in-time (“JIT”) procurement. To link up to suppliers

computerized system in order to take advantage of the enhanced inventory
management practice which are expected to reduce inventory level and
lead time. Practice of JIT is also particularly beneficial for high value
parts.

 Should review to reduce holding inventory of older models that are not in
high demand any more. The reduction can be offset by carrying more
popular models instead. This will speed up the inventory turnover.

 It should be noted that company’s performance of 103.48 days is better

than that of the industry norm of 110 days. As such, the company should
strike a balance between putting resources in further reducing this indicator
compared with the others.

(ii) Speed up collection and develop credit policy:

 Establish a collection policy to speed up payment particularly to its large

customers such as sending out reminders promptly, phone calls, offer early
settlement discounts, factoring.

 Establish a tighter credit policy to assess creditworthiness of new

customers in order to control the amount of accounts receivable to a higher
quality and reduced volume.

(iii) Delay payment to suppliers:

 It is not recommended to further push payments to the long time suppliers

as they are reliable and supportive. Since the payment days is already
longer than the industry average, no further action is recommended to
existing suppliers.

 It is possible to explore the possibility of delaying payment to new and

smaller suppliers, as they represent 35% of purchases and current
accounts payable days is only 30 days, which is at the industry norm.
Hence, it is possible to delay payment without affecting substantially the
relationship with such suppliers.

Module B (December 2018 Session) 6 of 8

Answer 7(a)

Years 0 1 2 3 4 5

HK$ HK$ HK$ HK$ HK$ HK$

Initial investment (20,000,000)
Sales [w1] 15,500,000 17,050,000 18,755,000 18,755,000 18,755,000
Contribution margin 6,200,000 6,820,000 7,502,000 7,502,000 7,502,000
(sales x CM ratio)
Fixed cost (300,000) (300,000) (300,000) (300,000) (300,000)
excluding
depreciation
Operating cash 5,900,000 6,520,000 7,202,000 7,202,000 7,202,000
flow before tax
Tax (973,500) (1,075,800) (1,188,330) (1,188,330) (1,188,330)
Depreciation tax 660,000 660,000 660,000 660,000 660,000
shield [w2]
Operating cash 5,586,500 6,104,200 6,673,670 6,673,670 6,673,670
flow after tax
Working capital (120,000) (20,000) - - - 140,000
movement
After tax salvage 835,000
[w3]
Net Cash Flows (20,120,000) 5,566,500 6,104,200 6,673,670 6,673,670 7,648,670
Discount rate 15% 15% 15% 15% 15%
(post tax)
Discount factor 0.86957 0.75614 0.65752 0.57175 0.49718
(post tax)
Present values (20,120,000) 4,840,435 4,615,652 4,388,046 3,815,692 3,802,741
NPV 1,342,566

Working
[w1]
Year 1 15,500,000 Expected no. of units sold x unit selling price
= (0.6 x 50000 + 0.4 x 80000) x 250
Year 2 17,050,000 Year 1 sales x (1 + growth rate)
Year 3 18,755,000 Year 2 sales x (1 + growth rate)
Year 4-5 18,755,000 no growth

[w2]
depreciation 4,000,000 4,000,000 4,000,000 4,000,000 4,000,000
tax rate 16.5% 16.5% 16.5% 16.5% 16.5%
tax shield 660,000 660,000 660,000 660,000 660,000

[w3]
gain 1,000,000 Project fully depreciated at year 5, salvage = gain
tax on gain 165,000
after tax salvage 835,000

The project should be accepted.

Module B (December 2018 Session) 7 of 8

Answer 7(b)

The propose method is sensitivity analysis.

This tool evaluates the change in NPV from the change of variables used in calculation.
Only one variable, e.g. sales volume, is changed at the time with other variables, such as
fixed cost, margin, etc., remain fixed and the respective change in NPV is calculated. The
process is continued when all variables are examined.

Management should then pay special attention to the estimation of the variable(s) that
caused the most changes in NPV because a minor error in such an estimation will result in
an incorrect NPV, hence the final decision.

* * * END OF EXAMINATION PAPER * * *

Module B (December 2018 Session) 8 of 8