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THE HONG KONG INSTITUTE OF CHARTERED SECRETARIES

THE INSTITUTE OF CHARTERED SECRETARIES AND ADMINISTRATORS

International Qualifying Scheme Examination

CORPORATE FINANCIAL MANAGEMENT JUNE 2010

Time allowed – 3 hours

Section A – 10 short questions (compulsory)

Section B – 5 long questions (attempt any 3)

DO NOT OPEN THIS PAPER UNTIL INSTRUCTED TO DO SO BY THE INVIGILATOR

Important Note: Candidates are allowed 15 minutes reading time to read through the question paper before the commencement of the examination between 9:15am-9:30am. During the reading time, all candidates must be silent and must not write or mark anything on their question papers or answer books. Candidates must close all their reference books, notes or other unauthorised materials and put these under their chairs. If any candidates write or make any marks during the reading time, or if they speak or in any other way communicate with anyone either in or outside the examination hall during this period or read any unauthorised materials, they will be disqualified from continuing this examination paper. Once candidates have opened the question paper, they are not allowed to leave the examination hall until 10:00a.m. �

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SUBJECT NO 16J

CORPORATE FINANCIAL MANAGEMENT JUNE 2010

The examination paper is divided into TWO sections. Section A is compulsory and carries 40 marks. Candidates should attempt THREE questions from Section B, all of which carry 20 marks each. You should allow yourself approximately 70 minutes in total to answer the questions in Section A, and 35 minutes for each of the questions attempted in Section B. Unless otherwise stated, $ denotes Hong Kong dollars. All interest rates are annual rates. Round your numerical answer to two decimal places. Friday morning 4 June 2010 Time allowed: 3 hours

SECTION A (Compulsory – answer ALL questions in this section)

1. (a) Briefly explain interest rate swaps and the major risks involved with them.

(4 marks)

(b) The CEO of a Hong Kong-listed travel agency has announced that the company will invest in a project in Thailand that is expected to generate a high annual profit. Do you think that the company’s share price will rise upon the CEO’s statement? Explain.

(4 marks)

(c) Discuss TWO major advantages of having a dispersed ownership structure. (4 marks)

(d) A small firm runs into short-term liquidity problems.

Suggest FOUR ways of dealing with the liquidity problems.

(4 marks)

(e) Taigoo Ltd currently has 120,000 shares in issue that now sell for $60. The company has proposed:

(a) splitting each two shares into three shares, or (b) issuing a 20% stock dividend.

Compute the share price after the company conducts either option. Ignore tax.

(4 marks)

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(f) You have a friend who has found a new way of purifying water and who has recently set up a small firm named Environment Friend Ltd. He has heard that venture capital is a potential source of financing and wants to seek your advice on this. Explain to your friend how venture capital may be suitable for his business and what his business plan (to be presented to a group of venture capitalists) should focus on.

(4 marks)

(g) XYZ Ltd has $25 million loans outstanding at the start of 2009 and has $27 million loans outstanding at the end of 2009. XYZ paid $4 million loan interest in 2009. What is XYZ Ltd’s net cash flow paid to creditors in 2009?

(4 marks)

(h) Many initial public offering stocks experience a large price rise and offer investors a dramatic return on the first trading day.

Suggest TWO reasons for this phenomenon. (4 marks)

(i) Explain the idea and use of Altman’s Z Score.

(4 marks)

(j) Suggest FOUR debt covenants that bondholders may use to reduce the borrower’s default risk.

(4 marks)

(Total: 40 marks)

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SECTION B (Answer THREE questions from this section)

2. Peak Ltd is evaluating whether to invest in a machine to produce an optical computer

mouse. The machine will cost $400,000 and will be fully depreciated over its five-year economic life using the straight-line method. The machine will have no salvage value at the end of its economic life. The machine can produce 10,000 mice each year. The price of each mouse will be $40 in the first year and will increase by 5% per year. The production cost per mouse will be $20 in the first year and will increase by 10% per year. Annual fixed costs of production are estimated to be $50,000. The project also requires an immediate investment of $25,000 in net working capital, and this level of net working capital will be maintained during the project’s life. However, only 80% of the initial net working capital investment can be recovered when the project is over (e.g. due to estimated bad debts). The corporate income tax rate is 20%. Assume that the firm’s cost of equity is the appropriate discount rate for the project. The firm has an equity beta of 1.5. The risk-free rate of return is 6% and the expected rate of return in the market is 12%. Assume all tax effects occur in the same period as the corresponding income/expense. Use the following template to calculate cash flow: Year 0 Year 1 Year 2 Year 3 Year 4 Year 5

Operating cash flow (OCF)

Initial investment

After-tax salvage value

Change in net working capital

Total incremental cash flow

REQUIRED:

(a) What is the total cash flow in year 0? (3 marks)

(b) What is the total cash flow in years 1-4?

(7 marks)

(c) What is the total cash flow in year 5? (3 marks)

(d) What is the NPV of this investment project?

(4 marks)

(e) Suppose, due to the market competition and technology changes, the firm has some doubts over the expected growth rate in sales price. Suggest ONE technique that can help the company better evaluate the feasibility of the project.

(3 marks)

(Total: 20 marks)

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3. Dickson Ltd is a mature utilities provider and its business is very stable. Analysts believe

that the firm’s annual earnings before interest and tax (EBIT) can be treated as $600 million per annum in perpetuity. Its shareholders would require a 16% cost of capital if the firm were unlevered. The firm is able to borrow any amount at an interest rate of 10%. The corporate income tax rate is 35%.

Assume all relevant assumptions in the Modigliani-Miller theorem are met and ignore bankruptcy costs.

REQUIRED:

(a) If the firm has no debt, what is its firm value (Vu)?

(3 marks)

(b) Calculate the firm’s cost of equity (Re) and weighted average of cost of capital (WACC) for the following three capital structures. Rd is the borrowing cost.

Debt ratio Rd Re WACC

0 -

50% 10%

100% 10% -

(9 marks)

(c) Based on the results in (b), explain the pattern of changes in the cost of equity and

WACC. (4 marks)

(d) Calculate the firm’s value (Vd) when the debt ratio is 50%.

(4 marks)

(Total: 20 marks)

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4.

(a) What are the three forms of market efficiency and what are their implications for investment? Why can the market be efficient to some extent?

(10 marks)

(b) The following chart shows the market price reactions of 194 target firms to announcements of takeover bids (announced on day 0).

Source: Keown, A.J. and Pinkerton, J.M., 1981, “Merger Announcements and Insider Trading Activity: An Empirical Investigation”, The Journal of Finance, Vol. 36, No. 4, pp. 855-869

Discuss the information shown on the chart in relation to the appropriate forms of market efficiency.

(6 marks)

(c) An investor makes the following statement:

“In an efficient market where securities are fairly priced, you basically can pick any stock to invest in. In other words, there is no significant role for portfolio management.”

Do you agree or disagree with the above statement? Explain.

(4 marks)

(Total: 20 marks)

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5. Use the following information to answer this question. All bonds have a face value of

$1,000 and pay interest once a year.

Bond A B C D E F Maturity (years) 5 5 5 10 10 10 Coupon (%) 8 5 0 8 5 0 Yield to maturity (YTM) (%)

5 5 5 5 5 5

REQUIRED:

(a) Which bond should have the highest issue price? Give your reasoning.

(5 marks)

(b) Which bond should have the lowest issue price? Give your reasoning. (5 marks)

(c) If the market interest rate increases by 1%, how do the bond prices move? Why?

Which bond will be affected the most? Which bond will be affected the least? Explain.

(8 marks)

(d) If you are pretty sure that the market interest rate is going to fall and you want to buy a bond, which bond should you buy? Explain.

(2 marks)

(Total: 20 marks)

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6. You are the manager of a small sweet store. Encouraged by the success the business

has achieved in your town over the last two years, you are seriously considering obtaining a loan of $1,000,000 to open a new store in a nearby town. You have asked several large banks but they were not willing to lend the money to you. After learning this, a friend introduced to you a loan officer at a small bank who offered you the following loan package: You receive a loan of $1,000,000 now and need to make a monthly payment of $ 36,972.22 over the next three years. The manager has explained that this loan is attractive for a small business like yours given its relatively low monthly payment. Using an interest rate of 10%, in three years you owe the bank $1,000,000 * 1.103 = $1,331,000. Therefore, the average monthly payment is $1,331,000/36 = $36,972.22 REQUIRED:

(a) What is the approximate monthly interest rate of the loan?

(10 marks)

(b) Is this loan offer a loan at a 10% interest rate? (Hint: consider the annual percentage rate (APR) of this loan.)

(4 marks)

(c) What is the effective annual rate (EAR) of this loan? (3 marks)

(d) Explain which of APR or EAR is more informative when making investment

decisions.

(3 marks)

(Total: 20 marks)

End of Examination Paper

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