Qualification Programme Examination Panelists Report. Module B Corporate Financing (December 2014 Session)

Transcription

1 Qualification Programme Examination Panelists Report Module B Corporate Financing (December 2014 Session) (The main purpose of the following report is to summarise candidates common weaknesses and make recommendations to help future candidates improve their performance in the examination.) (I) Section A Case Questions General Comments The case study refers to a private equity fund acquiring an Asia based food company, Asian Foods Limited ("AFL"). Candidates demonstrated relatively fine mastery in technical calculation compared to practical application, primarily due to limited work experience. For analytical and qualitative types of questions, candidates continued to experience difficulties in handling them. Candidates have to read and understand the question requirements carefully to avoid any mis-interpretation. There is significant weakness for most candidates to apply the case information in answering the questions. Specific Comments Question 1(a) 3 marks The question required candidates to compute the net asset value per share of Asian Foods Limited (AFL). Candidates did not find it difficult to determine the net asset value per share. Most could get two and half marks for this part. However, some candidates missed goodwill in the calculation and some only picked bond exposure when determining liabilities. Question 1(b) 8 marks The question required candidates to name and explain the three common valuation bases of assets of AFL. The question also required candidates to explain which basis is the most relevant to Sunny Capital Partners to decide on the price to pay to shareholders of AFL and to justify any other valuation method that may be employed to ascertain AFL's firm value on top of asset valuation alone. Many candidates explained and named the valuation methods for firm valuation as the valuation basis. A lot of candidates failed to apply different valuation methods. Module B (December 2014 Session) Page 1 of 7

2 Question 1(c) 3 marks The question required candidates to explain the meaning of net asset value per share computed in part (a) to shareholders of AFL when Sunny Capital Partners decides to make an offer at $119 per share in cash. The question also required candidates to explain how the AFL's shareholders be expected to respond to the offer. Most candidates could interpret the meaning of net asset value per share to shareholders of AFL. However, some explained it from the buyers perspective. Question 2 9 marks The question required candidates to compute the debt ratio of AFL and explain if the debt ratio of AFL is a plus or minus from Sunny Capital Partners standpoint when the industry average debt ratio of a food processing firm is about 59%. The overall performance in this question was not satisfactory. Most candidates could not work out the debt ratio as total debt divided by total capital employed. Only a few candidates mentioned potential financial leverage expansion could allow the target firm to automate its operation further to generate a better financial result in the future. Most candidates failed to apply the details of the case in answering the question. Question 3(a) 5 marks The question required candidates to compute the manufacturing cycle efficiency of AFL in producing boxes of ice-cream, the process productivity of AFL in producing boxes of ice-cream and the process quality yield of AFL in producing boxes of icecream. The question also required candidates to state if AFL satisfies the throughput requirement of Sunny Capital Partners. Most candidates did not understand the concept of throughput clearly. Quite a large number of candidates did not know how to calculate the manufacturing cycle efficiency, process productivity and process quality yield of AFL. Question 3(b) 4 marks The question required candidates to explain if they would agree to the head of production of AFL that the importance of using throughput is to evaluate the performance of his unit, not earnings per share and return on equity. Most candidates did not do well in this part. Many tended to focus on a discussion of financial measurement, such as EPS and RoE, instead of throughput. Question 3(c) 3 marks The question required candidates to explain if AFL has performed well in managing the working capital by comparing inventory level and cost of sales. Some candidates could calculate inventory turnover and pointed out that working capital management should be improved. However, many still could not apply the case material in answering the question. Module B (December 2014 Session) Page 2 of 7

3 Question 4(a) 4 marks The question required candidates to explain why AFL s reported profits for 2013 would have tumbled because of rolling out new products. Candidates performed well in this part and explained the context of the cost increase. Question 4(b) 2 marks The question required candidates to state how AFL s reported profit would be different if the firm has used life cycle costing techniques to account for the costs of launching the new organic food products. Most candidates simply copied the contents from the learning pack of life-cycle costing without providing any explanation related to the case. Question 4(c) 3 marks The question required candidates to explain what message the CFO of AFL was trying to convey when he said that "it is the right time to switch gear when you are strong." Most candidates wrongly answered with reference to the gearing ratio change in capital structure. Many failed to identify the strong cash facts and their implication for the cash flow. Question 4(d) 3 marks The question required candidates to state what can be inferred about the motivational elements in AFL's management system based on the concept that normally management's willingness to proceed with launching new products may be limited for the reason that it may likely drag down reported profits for the current year. The majority of candidates could not infer the motivational elements of the management and they were inclined to give only a general view of the concepts, without referring to the case material. Question 4(e) 3 marks The question required candidates to identify and explain three difficulties managers of AFL face in applying the product life cycle concept. Most answers were too general, such as stating that it was difficult to calculate costs, and, again, this was not related to the case at all. Some candidates just copied from the learning pack. Module B (December 2014 Session) Page 3 of 7

4 (II) Section B Essay/Short Questions General Comments This section covered traditional topics in corporate finance such as mergers and acquisitions, capital structure and capital budgeting. The focus was on both theoretical understanding, technical calculations as well as the practical application of the theories. Outstanding candidates were able to provide satisfactory answers to all three aspects mentioned above. The application of principles to cases posted a challenge to candidates. Answers reviewed indicated inadequate reading and/or related work experience in the areas tested. It must be emphasized that since this module tests candidates professional knowledge and that academic training alone is not sufficient to pass. The best and recommended approach is, in additional to review of principles, broad reading of practical cases from journals, newspapers and listed companies announcements in the Hong Kong Stock Exchange website - HKEX News: ( A number of careless mistakes were observed in answering the paper and they are elaborated further in the relevant specific comments below. At the same time, direct copying from the learning pack was also noted and it must be emphasized that such answers did not and will not score any marks. It was apparent that a few candidates had difficulties in interpreting the questions and hence could not produce satisfactory answers. It was noted that time management was an improvement. Specific Comments Question 5(a)(i) 5 marks The question required the candidates to calculate the firm s weighted average cost of capital and was handled well by most candidates. The following problematic areas were observed in the answers of some candidates: (1) failure to account for the 97.5% pricing information when considering the bond price; (2) unable to calculate the cost of preference shares, the cash flow of which is perpetual and hence the cost (required returned) is simply annual dividend / current share price. Candidates must also be aware of the way bond prices are quoted internationally, i.e. as a percentage of par value. Module B (December 2014 Session) Page 4 of 7

5 Question 5(a)(ii) 3 marks The question required the candidates to explain why a company will only leverage to a certain level instead of exhausting its borrowing power before going to equity given that the cost of debt is generally lower than the cost of equity. Most candidates were able to mention the fact that increasing leverage will increase the liquidity risk. Only a few strong candidates could relate the answer to the impact on the capital investment capacity and dividend paying ability of the firm. Question 5(b)(i) 5 marks The question required the candidates to explain the capital structure theory on which the director based his suggestions and the characteristics of a company using this theory in managing capital structure. Most candidates were able to name Pecking Order Theory as the director s suggested theory. However, most candidates missed the requirement to elaborate the characteristics of a company employing Pecking Order Theory and instead gave a lot of irrelevant answers, indicating that they had not read the question carefully. Again, a good way to identify the characteristics of company using pecking order theory is research on real cases. Many relevant materials were available on internet. Question 5(b)(ii) 8 marks The question required the candidates to comment on the director s capital structure theory in part (i) from the perspective of its implications for company valuation, capital budgeting analysis, actual cost of financing and financial flexibility. The performance was far from satisfactory. Candidates pointed out, incorrectly, that retained earnings have no cost to the firm, or that companies practising Pecking Order are already at optimal capital structure. Good candidates were able to point out that the WACC of such companies are not optimal, hence affecting the valuation. Other practical implications such as the impact on capital budgeting analysis, actual cost of financing and financial flexibility were hardly discussed at all. Question 6(a) 4 marks The question required the candidates to explain with supporting calculations which target company will meet Company A s acquisition objective. The performance was below average. Only a small number of candidates did well in this part. Candidates failed to include the fair value adjustment and did not apply the Debt/Equity ratio formula correctly. Module B (December 2014 Session) Page 5 of 7

6 Question 6(b) 4 marks The question required candidates to explain four areas which Company A has to pay special attention to when performing the acquisition due diligence exercise in order to meet its acquisition objective of reducing its D/E ratio. It needed to be emphasized that the due diligence exercises should be focused on achieving the acquisition objective, which was to reduce the group s Debt/Equity ratio. Candidates simply copied from the learning pack the four generic areas of due diligence, which were not relevant to the question. A few good candidates were able to point out the importance of asset impairment, existence of potential (off balance sheet) liability as the focal points. Question 6(c) 2 marks The question required the candidates to identify the potential integration and due diligence problems that Company A will encounter during the acquisition process. Similar to 6(b), good answers should address the issues in the context of the case. Generic answers related to integration problems did not score high marks. Instead, the problems of evaluating and integrating a much larger private subsidiary should have been elaborated and would have received good marks. Question 7(a) 2 marks The question required the candidates to calculate the operating profits from year 1 to year 5. The methodologies for calculating operating profit posed no significant problems to the candidates except it was noted that incorrect inflation factors were employed. Question 7(b) 3 marks The question required the candidates to calculate the tax saved for each of the six years (year 1 to year 6) due to capital allowances. This question was quite well done but careless mistakes were observed indicating students that did not read the question carefully. Firstly, 16.5% was used as the tax rate for some reasons, whereas the question clearly indicated the rate was 30%. Secondly, the tax savings for Years 5 and 6 were added and included as cash flow for Year 5. Question 7(c) 3 marks The question required the candidates to calculate the changes in the working capital requirements for each year from year 0 to year 5. Again, candidates either were careless or did not have a clear understanding of the concept for the treatment of working capital in the analysis. It should have been be the changes in working capital that should affect and be included in the cash flow analysis. Instead, some candidates simply used the working capital each year, which was not correct. Module B (December 2014 Session) Page 6 of 7

7 Question 7(d) 11 marks The question required the candidates to state if Company P should invest based on the Net Present Value (NPV) analysis and state the reason for the recommendation. The question also required the candidates to state the other factors that Company P should consider before making a final decision. This part of the question carried 11 out of the 19 marks for the whole question. Only a few candidates addressed this question well by indicating the other qualitative factors to be considered for a capital budgeting questions. It was noticed that some candidates did not elaborate in enough detail corresponding to the significant number of marks awarded for this part of the question, indicating either that they did not have enough preparation or simply a matter of bad examination technique. Another observation, again related to examination technique, is that a number of candidates simply lumped their answers for 7a to 7d together, i.e., without identifying the answers corresponding to the question breakdown. This ran the risk of losing marks for the whole question. (III) Conclusion and Recommendation Similar to earlier examinations, candidates performed well in their calculations and failed to perform satisfactorily in addressing practical aspects of the question. This is a professional level paper, combining theory with practice. As such it is recommended that candidates, in addition to academic study, stay close to market practices in corporate finance by reading relevant articles from financial journals and newspapers, listed companies cases, and continuing education from which practical applications of the technical skills can be developed. Purely academic training is not sufficient to score high marks. It is also suggested candidates should polish their examination skills such as: - Carefully read the questions at least twice before answering them; - Write legibly; - Provide answers which correspond to the breakdown of the questions; - Do not waste time copying directly from the learning pack. Module B (December 2014 Session) Page 7 of 7