Download PBE Paper II Management Accounting and Finance

Professional Bridging Examination
Paper II
PBE Management Accounting and Finance
December 2014 Session
Mock – Questions
Time Allowed
3 hours
Examination Assessment Allocation


Section A – The one question is compulsory
Section B – Answer 3 out of 4 questions
1
40 Marks
60 marks
SECTION A (COMPULSORY)
(Total: 40 marks)
Answer ALL questions in this section. Marks are indicated at the end of each
question. Together they are worth 40% of the total marks for this examination.
CASE
Mr. Stephen So has been employed as the Finance Manager. Stephen has been asked
to give advice to the board of directors of LED Expert Holdings Limited
(“LEDEHL”), a listed company in Hong Kong, which is principally engaged in
providing energy management contracts for changing the Toll Road lighting from
traditional lighting to LED lighting in mainland China.
LEDEHL draws upon three major sources of finance from the capital and finance
markets:
1.
Listed bonds = $3,400 million face value paying 9% coupon annually maturing
in 5 years currently trading at 90% of its face value, the identified after tax cost
of debt is 8.20%;
2.
Shares issued = 1,000,000,000 ordinary shares traded at the current market
value of $20, the identified cost of equity is 10.4%; and
3.
Finance leases = $1,000 million obligation to pay and the effective interest rate
after tax on the leases is 6%.
LEDEHL is now considering two toll road LED light projects, GZ project and SZ
project. The following are the expected saving on the value of the electricity
consumption for each project:
Year
1
GZ Project
$million
50
SZ Project
$million
60
2
3
4
5
6
55
60
65
-
63
66
69
72
75
During the negotiation process, LEDEHL has agreed the following benefits and
investments for the GZ project and the SZ project after using LED lighting:
2
Share of cash distribution by saving electricity
consumption
Initial investment incurred in year 0 ($million)
Proceeds received at year 0 of the lighting installed
GZ Project
SZ Project
40%
50%
120.42
200.00
40%
30%
Normally, LEDEHL requires an internal rate of return of 11% for a project.
The operations manager of the Company reported that one of the middlemen involved
in the GZ project has requested a 3% commission. The manager advises the Company
that the 3% commission could be recovered by putting the selling prices up by 5%.
Therefore, both parties will benefit from the transaction. The middleman also
requested the payment of the commission be made through a Hong Kong bank
account.
Question 1
(20 marks – approximately 36 minutes)
Assume you are Stephen So, prepare a memorandum to advise the board regarding the
following questions:
(a)
Why does a company need to know its cost of capital
(b)
What is the rate of the weighted average cost of capital (WACC) for
LEDEHL
(5 marks)
What are the net present values by using discounting rate of WACC and
IRR of the Company for both projects?
(12 marks)
(c)
Question 2
(a)
(3 marks)
(20 marks – approximately 36 minutes)
Base on the results obtained in part 1(c) above, which project, or both
projects, should the board accept or reject for the benefit of shareholders
under the following scenarios? Please note that no calculation is required.
(i) No capital restriction.
(3 marks)
(ii) With only $200 million in capital available.
(2 marks)
(iii) With only $200 million in capital available but the management will
borrow debt to finance two projects.
(5 marks)
3
(b)
What are the limitations in using WACC to evaluate projects and under
what conditions could WACC be applied properly for the evaluation of
projects?
(10 marks)
4
SECTION B (ANSWER THREE QUESTIONS ONLY)
Question 3
(Total: 60 marks)
(20 marks – approximately 36 minutes)
Company A, an all equity firm, plans to invest in equipment which has an NPV of
$2m and initial investment of $30m. Currently, the company has 100m shares
outstanding. Its investment banker offers two financing options.
1)
2)
Issue new shares at $2 per share. Total existing common shares outstanding is
100m shares.
Issue 5 year $30m bond with yield to maturity (YTM) of 5% per annum,
redeemable after 3 years at the option of the company.
Low interest environment is expected to last for at least another 2 years. Company A
has been paying 100% of its profit after tax as dividends. When going for debt, a
lender will require the company to limit its payout ratio to 50% until the debt is paid
off.
Current and expected EBIT is $10m.
Tax rate is 16.5%.
Required:
(a)
(b)
(c)
(d)
(e)
Calculate the EPS of each financing option. Which option should the
company choose based on EPS?
(4 marks)
At what level of EBIT (the breakeven EBIT) will both financing options in
(a) result in the same EPS? Calculate this EPS.
(3 marks)
The investment bank indicates that if the company is willing to give up the
redemption option, the YTM can be lowered to 3%. Advise with
justification what the company should choose under this scenario.
(6 marks)
Verify your recommendation in (c) by calculating the EPS under equity and
debt financing options.
(2 marks)
What other factors should the company consider in deciding which
financing option to use?
(5 marks)
5
Question 4
(20 marks – approximately 36 minutes)
XYZ has just obtained a big contract which has a very high chance of resulting in a
sustainable profit increase for at least 10 years. The company just also sold a major
asset and realised $100M in cash which the Directors are planning to return to
shareholders. The relevant information is not made known to the market.
The recent global financial crisis has caused a significant drop in the share price and
also led to uncertainty as to future profitability. The Directors consider the current
share price is undervalued.
Today the Directors meet and consider one of the following policy options:
(i)
Declare an increase in dividends over the last dividend payment.
(ii) Declare a one time special dividend.
(iii) Repurchase shares from the market.
Required:
(a)
What are the advantages and disadvantages of share repurchase?(5 marks)
(b)
Which of the two dividend policies should the company adopt for each of
the following two independent scenarios? Support your answers based on
the benefits and risks of each policy.
(i) as a result of winning a big contract and despite the financial crisis,
the company expects a permanent increase in profits starting next
year ;
(ii) despite the positive impact of winning a big contract, future profit
remains unstable due to the financial crisis.
(6 marks)
After careful deliberation, the Directors decide that there is a higher chance
of future profit remaining unstable. In this case, which of the three policy
(c)
(d)
options will you recommend to the company? Provide reasons to support
your answer.
(3 marks)
Assume XYZ at present has a long term debt of $350M and equity value of
$1,000M, i.e. a Debt/Equity (D/E) ratio of 35%. In addition, a debt
protective covenant indicates the D/E ratio cannot be higher than 37%.
What is the maximum amount of dividend payment or share repurchase
that XYZ can make, if total equity remains at $1,000M before the cash
distribution?
(6 marks)
6
Question 5
(20 marks – approximately 36 minutes)
TTV has an LCD and LED module making subsidiary TTM. As a group policy, and in
fact an industrial norm, TTM has the free autonomy to sell its products to TTV to
make “Tiger” LCD and LED TVs, or to other external TV or display manufacturing
companies to make other branded TVs or display products depending on the
profitability. Similarly, TTV could buy the modules on the open market if the price
offered by TTM is higher than the market price.
Three scenarios have been considered:
Scenario A = TTM has no spare capacity at all
Scenario B = TTM has spare capacity
Scenario C = TTM has a total 4,500,000 modules production capacity
Current TTM output and external sales
=
4,000,000
modules
per
modules
per
annum
TTM current selling price
=
$1,600/unit
TTM marginal cost
=
$867/unit
TTV total demand from internal/ external suppliers
=
10,000,000
annum
TTV purchase price from external suppliers
=
$1,400/unit
A discussion between TTM and TTV will be carried out in the next board meeting to
understand their logic for determining the departmental transfer pricing.
Required:
(a)
What should be the objectives in setting the transfer pricing system
between a group of companies or divisions?
(3 marks)
(b)
Set out the minimum transaction price(s) between TTM and TTV with an
explanation for each scenario.
(12 marks)
(c)
In which scenario do you think that negotiation may happen? If the
scenario fails, what should the Group management do? Justify your
decision.
(5 marks)
7
Question 6
(20 marks – approximately 36 minutes)
You have recently been hired by an investment bank in Hong Kong as a valuation
analyst. Your client has approached you for assistance to value the shareholding of his
business in Hong Kong, conducted through a Hong Kong private company called
XYZ Limited. The total number of shares outstanding is 20,000 and your client holds
75% (i.e. 15,000 shares). The other 25% shareholder is a close family relative. The
company was in a loss position but this year the business has started to turn around.
The latest audited earnings after tax are $40M. No dividends have been paid in the
past two years.
You have been given the following additional information about XYZ Limited.
 Audited Net Asset Value (NAV) including Goodwill = $535M
 Goodwill = $120M




Expected total dividends for the next 5 years (in millions): $26.5, $34.0, $39.0,
$37.5, $41.0.
Expected dividend growth rate after 5 years is 4% and cost of equity capital is
14%.
The PE ratio of a similar Hong Kong listed company with a lower Debt/Equity
ratio than XYZ Limited is 15 times.
Market discount for liquidity is 35%.
Required:
(a)
(b)
Value the client’s 75% (i.e. 15,000 shares) shareholding based on the
following methods:
(i) Net asset value (NAV)
(2 marks)
(ii) Price / Earnings ratio (P/E)
(4 marks)
(iii) Discounted cash flow on dividends
(10 marks)
(Note: Ignore control premium and capital structure difference)
Describe the challenges in estimating the various variables in part (a) in
arriving at the 75% share value of XYZ Limited. (Note: this question does
not ask for the advantages and disadvantages of the various methods
applied.)
(4 marks)
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