SECTION A CASE QUESTIONS Answer 1(a) To: CEO, Jason Chan From: Georgiana Lim Date: xxxxxxx Subject: Break-even points, profit margin, asset turnover and ROI for Kowloon Airlines Limited Contribution margin = $560 - $240 = $320 per passenger or 57.1% Break-even point (no. of passengers) = Fixed cost / Contribution margin = $9,600,000 / $320 = 30,000 passengers Break-even point (dollar revenue) = Fixed cost / contribution margin % = $9,600,000 / 57.1% = $16,800,000 Break-even point (number of flights) 120 x 75% = 90 seats filled per flight 30,000 / 90 = 333 flights Answer 1(b) Contribution margin = $560 - $320 = $240 per passenger Break-even point (no. of passengers) = $9,600,000 / $240 = 40,000 passengers 40,000 / 90 = 444 flights Module B (December 2013 Session) Page 1 of 11
Underlying assumptions in arriving at break-even points - Revenue and variable cost per unit of service rendered are constant / contribution margin is linear. - Total fixed cost is constant. - Labour productivity, production techonology, and market conditions will not change during the time period. Answer 1(c) Profit level = Revenue variable operating costs directed fixed costs = $272,000,000 - $139,200,000 - $115,200,000 = $17,600,000 Average assets = ($99,200,000 + $118,400,000) / 2 = $108,800,000 Net profit margin = $17,600,000 / $272,000,000 = 6.47% Asset turnover = $272,000,000 / $108,800,000 = 2.5x Return on investment = 6.47% x 2.5x = 16.18% Answer 2(a) The target ROI was 6% x 3.3x = 19.8%. However, the airline only delivered 16.2%. It exceeded its target profit margin but could not meet the target asset turnover. Since the asset turnover effect outweighed the profit margin effect, the ROI was below the target ROI by 3.6%. Answer 2(b) In the short run, the utilization of accounting income could be managed or manipulated, depending on the accounting methods selected to account for items such as depreciation. Furthermore, asset investment could be hard to measure properly. Some investments, for example R&D costs, might have value beyond the accounting period but are not capitalized and an understated base is then created. Module B (December 2013 Session) Page 2 of 11
Residual income = $17,600,000-15% x $108,800,000 = $1,280,000 After-tax profit level = $17,600,000 x (1-16.5%) = $14,696,000 EVA = $14,696,000 - $144,000,000 x 7% = $4,616,000 Difference between RI and EVA: a) RI is based on pre-tax, not after-tax income; b) RI is based on the book value of investments but EVA is based on market value of investments; c) target return rate is different. Answer 2(c) Monthly break-even point for the number of flights: Contribution margin = $680 - $240 = $440 per passenger 120 x 60% = 72 seats filled per flight Break-even point (no. of passengers) = $9,600,000 / $440 per passenger = 21,818 passengers 21,818 / 72 = 303 flights Monthly pre-tax income for Kowloon Airlines: Contribution margin for discounted fares = $400 - $240 = $160 per passenger No. of discounted seats per flight = 120 x (80% - 75%) = 6 Pre-tax monthly income contribution from discounted fares: = $160 x 6 x 50 flights/day x 30 days/month - $640,000 = $1,440,000 - $640,000 = $800,000 Module B (December 2013 Session) Page 3 of 11
Answer 3(a) Contribution margin = $600 - $240 = $360 per passenger 120 x 60% = 72 seats x $360 x 15 = $388,800 versus fixed costs increase of $800,000 Pre-tax monthly loss on new route is $411,200 Number of flights Kowloon Airlines would need to earn a pre-tax income of HKD400,000 per month on the new route: $600X - $800,000 - $240X = $400,000 $360X = $1,200,000 X = 3,333 passengers 3,333 / 72 = 46 flights Answer 3(b) Kowloon Airlines should consider the following issues: - Level of competition in the market. - Connecting flights to other Kowloon Airlines flights that might be made by these passengers. - Medium/long term potential to increase the load factors on this route. - Creation of customer goodwill in the new market. - Employment opportunities for airline workers in the region. - Whether the existing staff / cabin crew have the language proficiency in serving the Vietnamese passengers. Should Kowloon Airlines need to recruit staff locally in Vietnam, it has to comply with the local labour law and regulations. Module B (December 2013 Session) Page 4 of 11
Answer 4(a) After establishing that the fuel waste is toxic, the CEO has to consider business as usual versus the costs of treatment and/or proper disposal. The clean-up may result in rising costs and air fare prices, and have a financial impact on the bottom line of the firm. Equally important, is the preservation of the health of downriver water quality and positive effects on the fish and the environment as well as social responsibility. What if the dumping is discovered by the public? It affects the reputation of the airline. How would it affect the stakeholders? What would be the legal consequence of falsifying the reports? Answer 4(b) The CEO should take action to deal with the problem at once. The dumping should completely stop until the fuel waste is certified that it does not cause disease to living organisms. The firm should report its findings to the authorities and management should discontinue falsifying its reports. If the fuel waste could be hazardous to the health of living organisms or environmental well-being, the firm should immediately issue a policy statement that no additional dumping will take place. The costs of treating the waste to neutralize it should be compared to other possible alternatives that might exist. The firm could solicit the opinions of employees and people living along the river since they all have a vested interest in finding a solution. A study of how other airlines which produce the same waste handle the problem would be helpful. The government s environmental department should have some information available to help as well. The firm should also ascertain the clean-up costs of the waste it has dumped. It should recognize additional short run costs of the problem in order that it could operate and sustain the business in the long run. Module B (December 2013 Session) Page 5 of 11
Answer 4(c) PESTEL is a checklist of six general environmental factors. They are after interlinked and related to each other. Political: Vietnam government s invitation of new routes could be an opportunity for Kowloon Airlines. Kowloon Airlines has to react promptly to government policy changes that affect its business. Economic: favourable and overall growth of the economy implies increased demand for air travel services. Hong Kong has enjoyed steady and good economic performance over a decade which would provide a rosy business prospect in the travelling business. Socio-cultural: interest in individual leisure travel rather than in tour groups will sustain and support the services of discounted airlines. This major switch in travelling attitude and habits will benefit Kowloon Airlines which provide affordable air-tickets to individual consumers. Technological: affordable cost of airplanes is lower and could be a trade-off with safety in the eyes of some potential customers. Besides, information technologies make distribution cost of air tickets to end-users cheaper, e.g. by pass the role of travel-agents. This will increase the room of survival to Kowloon airlines. Environmental: the fuel waste disposal arrangement could be a big challenge to the airline to deal with seriously. It not handled properly, the reputation and goodwill of the firm will be at risk as the world is becoming more environmental-conscious. Legal: pollution control, waste disposal, employment law could all be involved especially on the handling of the fuel waste problem. Kowloon Airlines should look into any possible violation of law related to the waste disposal procedures and explore the remedies. * * * END OF SECTION A * * * Module B (December 2013 Session) Page 6 of 11
SECTION B ESSAY / SHORT QUESTIONS Answer 5(a)(i) NAV method: NAV 535,000,000 Less: Goodwill 120,000,000 NAV excluding GW 415,000,000 Value of 75% share holding 311,250,000 Answer 5(a)(ii) PE ratio method: P/E 15 Earnings after tax 40,000,000 100% value 600,000,000 Value of 75% share holding 450,000,000 Discount for liquidity (35%) 157,500,000 Value of 75% share holding 292,500,000 Module B (December 2013 Session) Page 7 of 11
Answer 5(a)(iii) Discounted cash flow on dividends: Year 1 2 3 4 5 Total dividend ($M) 26.50 34.00 39.00 37.50 41.00 No. of shares 20,000 20,000 20,000 20,000 20,000 Dividend Per Share 1,325 1,700 1,950 1,875 2,050 Value of shares at year 5* 21,320 Total cash flow 1,325 1,700 1,950 1,875 23,370 Discount rate at 14% 0.877 0.769 0.675 0.592 0.519 Present Value 1,162.03 1,307.30 1,316.25 1,110.00 12,129.03 Share price (sum of PV of dividends) 17,024.61 * Value of shares at year 5 Growth rate starting year 5 4% Cost of equity capital 14% Dividend at year 6 2,132 (= 2050 x (1 + 0.04)) Value at year 5 (per share) 21,320 (= 2132 / (0.14-0.04)) Value of 75% share holding 255,369,150 (17,024.61 * 20000 * 0.75) Module B (December 2013 Session) Page 8 of 11
Answer 5(b) Challenges in estimating XYZ Limited s 75% share value: 1. Difficulties in estimating cost of capital. 2. Future dividends estimation and future growth rate may not be reliable. 3. Liquidity premium estimation is determined by market instead of objective measures. 4. Having only one year of profit available in applying the P/E method may not be representative of the company s profitability situation, particularly if the company was in a loss-making position in prior years. 5. Difference in capital structure between the listed company and XYZ needs to be taken into consideration. 6. As 75% shareholding controls the company, a control premium can be added to the valuation. However, estimating the control premium for a private company is subjective due to a lack of market data. Answer 6(a) 2009/10: $0.60 / $1 = 0.6 (60%) 2010/11: $0.66 / $1.12= 0.59 (59%) 2011/12: $0.726 / $1.19 = 0.61 (61%) Average: (0.6 + 0.59 + 0.61) / 3 = 0.6 (60%) The company has been adopting a constant dividend payout policy, distributing on average 60% of earnings as dividends. Answer 6(b) Policy Special Dividend Regular Dividend Total ($) 1 0 2.76 = (4.793-0.2) x 0.6 2.76 2 3 0.956 = (4.793-3 - 0.2) x 0.6 3.956 3 3.29 = 3 + 0.484 x 0.6 0.665 = (4.793-3 - 0.2-0.484) x 0.6 3.955 Module B (December 2013 Session) Page 9 of 11
Answer 6(c) Policy (1) This dividend is misleading as the asset sale is a one off, giving the wrong signal to the market that this amount is recurring, leading to great disappointment next year when the dividend is back to its normal level. Policy (2) This signals good news (extra earnings to be recurring) prematurely. If the earnings are not repeated next year, dividends will be reduced, shareholders will be disappointed and then will depress the share price. Policy (3) Understate future recurring growth potential as the general dividend is lower than prior years as some dividends will be given to preference shareholders. The common shareholders may get the wrong message that future earnings will decline and this could result in pressure on the share price. Recommendation As the directors are very concerned about the share price due to these wrong signals, it is recommended to follow Policy 2. This is because even though it can be argued that the high earnings growth will be confirmed only one year later, the current assessment that it will be successful is high. Given the risk of an improper under-performing signal depressing the share price is higher than the risk of not meeting growth expectations, policy 2 is preferred. Answer 7(a) Z-Score Ratios: X1 Working capital / total assets 0.052893 (= (105-73) / 605) X2 Retained earnings / total assets 0.049587 (=30 / 605) X3 Earnings before interest and tax / total assets 0.082645 (=50 / 605) X4 Market value of equity / book value of total debt 0.359338 (=152 / (73 + 350)) X5 Sales / total assets 1.157025 (=700 / 605) Z-score = 1.2X1 + 1.4X2 + 3.3X3 + 0.6X4 + 1.0X5 = 1.778247 Module B (December 2013 Session) Page 10 of 11
Answer 7(b) The company should not follow the pecking order theory and not use debt to finance the acquisition. This is because before the proposed $270 debt financing, the D/E ratio is at 44% (80/182), which is not low. If debt financing is used, given its scale, it will increase this ratio to 192% (350/182) which is extremely high and poses undue financial risk. Further, at this level of debt, the Z-score is at 1.778 as calculated in 7(a), which is less than 1.81, indicating that the company has a high chance of financial distress. * * * END OF EXAMINATION PAPER * * * Module B (December 2013 Session) Page 11 of 11