Hong Kong School of Commerce

Revision 2 – Questions

Enhanced QP

Hong Kong School of Commerce

Module B – Corporate Finance

Revision 2

Part D Treasury Operations

(Notes: Chapter 14 to 18)

(Learning Pack: Chapter 7 to Chapter 11)

Part I Working Capital Management

Question 1

(a) Tik-Tak Watch Co Ltd (“Tik-Tak’’) designs and manufactures low-end watches for sale in the US. The monthly sales are one million watches. The cost and selling price of each watch are HK$15 and HK$20 respectively. Currently, it makes all sales to its distributors on credit. The average collection period is three months.

After attending a seminar on Working Capital Management organised by the local trade council, the owner of Tik-Tak, Mr. Cheung, considered shortening the credit period to two months and offering a 5% cash discount for payment before the end of first month. Mr. Cheung estimated that the discount could boost overall sales to 1.15 million per month and that 80% of his distributors would take advantage of the discount. The Sales Manager, however, was not as optimistic as Mr. Cheung on the additional sales that this new policy could bring in.

Assume an annual discount rate of 9%.

Required:

(i) What is the net present value of the return from monthly sales under the existing policy? (2 marks)

(ii) What is the expected net present value of the return from monthly sales under the new policy? (2 marks)

(iii) Will the new credit policy be financially advantageous to Tik-Tak? (1 mark)

(iv) Taking the Sales Manager’s concern into consideration, what is the minimum monthly sales that Tik-Tak has to achieve under the new policy so that it will not be made worse off by the change of credit policy? (4 marks)

(b) Explain the basic factors that a company shall consider when setting credit terms on sales to its customers. (7 marks)

(HKICPA QP MB Corporate Finance May 2006 Q4)

Question 2 (15 marks – approximately 27 minutes)

Great Leap Company Limited is a small and medium-sized (SME) company engaged in the manufacture of electrical appliances and is owned by Roger Yan. The company has been in business for more than 30 years and has good relationship with its customers and suppliers. The manufacturing process is labour intensive due to its traditional set up. However, most of its competitors have already adopted state-of-the-art manufacturing technology.

Although Roger is pleased with the significant increase in sales performance (25% increase) in 2006, he is concerned about the company’s cash flow. He heard the term, Cash Conversion Cycle (CCC), from his friend, who is in the same industry. His friend told him that their company’s CCC was 60 days in 2006. Roger’s concerns were heightened today when he read the headlines about the financial difficulty of listed companies which had mismanaged of their working capital, especially relating to debtors, creditors and inventory. As Roger’s close friend and a qualified accountant, you have been consulted by him on CCC.

The company has the following working capital items in its statement of financial position.

Required:

(a) Explain the concept of the Cash Conversion Cycle and its relevance to working capital management. (2 marks)

(b) Assuming 365 days in a year, calculate the turnover times and days for stock, debtors and creditors in 2005 and 2006. (6 marks)

(c) Calculate the Cash Conversion Cycle in days in 2005 and 2006. (2 marks)

(d) Comment on the trend for the past two years. (3 marks)

(e) What are the financial implications for a longer cycle? (2 marks)

(HKICPA QP MB Corporate Finance September 2007 Q5)

Question 3

Chelsea Limited has been established for fifteen (15) years with over five hundred (500) employees. The company manufactures uniforms for industrial and commercial clients.

Mr. CS Ho is the founder and Chief Executive Officer of the company. He grew the company from a family size factory to its present size. He is the major shareholder and owns more than 60% of the issued shares. He and the other shareholders are also the directors of the company. However, Mr. Ho is in-charge of the daily operations. All the shareholders meet once a year at the annual general meeting (AGM).

Mr. Ho manages the company on a highly centralised basis. A weekly meeting is held every Monday morning. All department heads have to attend and this is the only formal channel through which managers can share information concerning their departments with others.

After reviewing the financial statements for the year ended 30 June 2008, Mr. Ho was very pleased with the growth in turnover (appendix 1). However, Mr. Paul Choy, the newly appointed Financial Controller, had a different opinion and he reported that the company was not as healthy as Mr. Ho thought. He also reported that during the last meeting with the Kowloon Bank, the company had been advised to reduce the size of its overdraft immediately or the bank would start to call back the overdraft facility. Mr. Ho was very surprised and asked Paul why this had happened. Paul said that the company might be suffering from liquidity problems as a result of overtrading.

Mr. Ho was very concerned about the cash flow problem facing the company. He instructed Paul to further talk to the Kowloon Bank to solve the problem.

Paul approached the Kowloon Bank for sources of financing. Ms. Crystal Hung, the Bank’s Customer Relation Manager, proposed factor financing as an alternative source of funds for working capital management.

Crystal further elaborated to Paul that, under this financing scheme, the Kowloon Bank would take over the administration of the company’s debts at an annual fee (factor charge) of 0.5% of turnover. In return, the Kowloon Bank would advance 80% of the book value of the debtors at an annual interest rate of 2% above the company’s current overdraft rate of 12% p.a. In other words, the factor financing cost would be 14% p.a.

Returning to the office, Paul reported the discussion with the Kowloon Bank to Mr. Ho. Paul advised Mr. Ho that factor financing could lead to a saving of HK$ 150,000 p.a. in administration costs. However, Mr. Ho was unsure whether this financing scheme would benefit the company as action had been taken by Paul to reduce the debtor collection period to 100 days.

Paul also reported the following financing information to Mr. Ho:

(i) Interest for overdraft facility : 12% per annum

(ii) Interest for medium-term bank loan : 10% per annum

Appendix 1

Extracts from the financial statements of Chelsea Limited:

Profit and Loss Account extracts for the years ended 30 June 2008 and 30 June 2007

Appendix 2

Statement of financial position extracts as at 30 June 2008 and 30 June 2007

Appendix 3

Average ratios for the business sector

1. Debtor days 100 days

2. Creditor days 120 days

3. Inventory days 210 days

4. Current ratio 1.35

5. Quick Ratio 0.55

Question 1 (21 marks – approximately 38 minutes)

(a) Please make a financial analysis on turnover, current assets, overdraft, trade creditors, activities ratios, liquidity ratios etc. which are useful to assess whether the company is overtrading. (6 marks)

(b) Assume you are Paul, the Financial Controller. You are requested to write a memorandum to Mr. CS Ho to support your suggestion that the company is overtrading. Specifically, you may want to discuss:

(i) What overtrading is;

(ii) Signs of overtrading;

(iii) Comparison with industrial sector;

(iv) Conclusion and recommendation.

(15 marks)

Question 2 (21 marks – approximately 38 minutes)

(a) What is factoring and what are the advantages of factoring debtors? (4 marks)

(b) Assume that, by entering into the factoring arrangement, the company is able to reduce the debtor collection period to 90 days for the year ended 30 June 2009. There are two methods of financing:

Alternative 1: Using the existing overdraft facility; and

Alternative 2: Using a new medium-term bank loan facility.

You are required to comment on whether the company should accept factor financing by Alternative 1 or Alternative 2. State your assumptions and support your answer with calculation.

(14 marks)

Question 3 (8 marks – appropriately 14 minutes)

FBJ Bank manager Mr. Lewis Cheung is a long-time friend of Peter, the management

accountant of Chelsea Limited reporting to Paul. Peter is also a member of the HKICPA. Mr. Ho is still very concerned about the liquidity problem facing the company. He wants to have financial assistance from the FBJ Bank. Knowing that there is a close relationship between Peter and Lewis, Mr. Ho asks Peter to manipulate some management accounting data when submitting the required company data to the FBJ Bank. He also encourages Peter to participate in more social activities with Lewis.

Required:

Use an appropriate ethical decision model and in the light of the Code of Ethics for Professional Accountants, how should Peter handle the requests from Mr. Ho?

(8 marks)

(HKICPA QP Module B Corporate Finance May 2008 Case)

Question 4 (20 marks – approximately 36 minutes)

VMC is a medium-sized exporter of pitaya (commonly known as dragon fruit) in Vietnam. The company purchases the pitaya from more than 100 pitaya farms in southern Vietnam. The pitaya is collected and processed centrally for export.

Over the years, VMC has been selling all the produce to the U.S. market through Fruit-Xpress, a U.S. importer of fresh and processed fruit. Fruit-Xpress resells the imported fruit to several chain stores and its own distribution networks in the U.S. Shown below is the information extracted from the financial statements of VMC and Fruit-Xpress:

The average cash conversion cycles for an exporter in Vietnam and importer in the US are 90 days and 20 days respectively.

Required:

(a) Calculate the length of time in VMC’s and Fruit-Xpress’s cash conversion cycle. Assume 365 days in a year and round up to the nearest day in your calculation.

(7 marks)

(b) Comment on the performance of these two companies in managing their cash conversion cycles. Which company is weaker in this aspect? State your reasons.

(6 marks)

(d) Apart from liquidity risk, what other financial risks is VMC facing? (2 marks)

(HKICPA QP MB Corporate Finance May 2010 Q4)

Question 5 (24 marks – approximately 43 minutes)

Assume that you are Mr. T. T. Chan and you are asked by the CFO to write a memorandum to the board addressing the following board members' concerns:

Required:

(a) How does the early settlement discount work for turning the normal accounts receivable into cash as early as possible in terms of working capital management? What are the associated cost and benefits? (7 marks)

(b) Explain whether the Group should obtain long-term financing to fund the Investment Project even the Group could turn the accounts receivable into cash quickly. (8 marks)

(9 marks)

(HKICPA QP MB Corporate Finance June 2011 Q4)

Part II Types and Source of Finance

Question 6 (15 marks – approximately 27 minutes)

State your views on the following statements:

(a) “Compared to the short-term loans offered by banks, a long-term bond will never be the preferred choice of financing due to its higher interest cost and the more complicated process of arrangement.” (4 marks)

(b) “Convertible bond is the cheapest way of financing. Not only can the issuer pay a lower coupon rate than on straight bonds, but also the sum owed to the bond holders can be repaid by issuing shares which essentially cost the issuer nothing.”

(6 marks)

(c) “Credit rating agencies provide investors with useful investment advice. A company attaining an investment-grade rating from the agencies will provide a better return than those with non-investment grade ratings because the former possesses better growth prospects.” (5 marks)

(HKICPA QP MB Corporate Finance February 2005 Q5)

Question 7 (12 marks – approximately 22 minutes)

YTTG Co. Ltd (“YTTG”) was listed in the Growth Enterprise Market five years ago. The founder and Chairman of the company is the largest shareholder who holds 42% of the company shareholdings. With its major business in the development of biopharmaceutical technology, YTTG is viewed by many analysts as a high-risk, high-growth company. However, many of them regarded it highly for its commitment to good corporate governance including a well-thought out succession plan.

Due to the recent death of the Chairman in a car accident, YTTG’s share price lost 18% last week. YTTG’s Finance Director believed that this incident, although sad and unfortunate, should not affect the company’s long-term prospects as it has been experiencing a 22% compound annual growth rate over the last five years. He anticipated that once the investors realised the ability of the existing management team to lead the company, the share price would rebound strongly. Meanwhile, he was considering raising funds to expand the business in the next five years. The Finance Director believed that the key to the success of this five-year plan was to preserve more financial resources. An investment bank proposed the issuance of preference shares or convertible bonds to YTTG.

Required:

(a) What are the major characteristics of preference shares and convertible bonds?

(6 marks)

(b) Assuming that these two sources of funds are the only choices available to YTTG, which one will you recommend to YTTG’s Finance Director? Give reasons to justify your argument. (6 marks)

(HKICPA QP MB Corporate Finance September 2005 Q4)

Question 8 (15 marks – approximately 27 minutes)

You have recently been elected as the honorary treasurer of a charity organisation. Your responsibility is to manage the donation money and the expenses of the organisation. On the morning of 1 September, a report on the projected cashflow for the week was sent to you. The report showed that the opening balance in the bank account was $188,000 and the net change of cash flow for each day of the week was projected as follows: