Module B
Corporate Financing
Answers
The suggested answers are longer than what candidates are expected to give in the examination.
The purpose of the suggested answers is meant to help candidates in their revision and learning.
The suggested answers may not contain all the correct points and candidates should note that
credit will be awarded for valid answers which may not fully covered in the suggested answers.
SECTION A – CASE QUESTIONS (Total: 50 marks)
Answer 1(a)
According to Ansoff product market matrix, Reborn can use different strategies to enhance
their profitability and to grow their businesses.
Reborn can consider further penetration into existing markets by selling more robotic leg and
rehabilitation systems with competitive pricing, such as sales discounts, advertising and sale
promotion activities to rehabilitation hospitals and centers, doctors and clinics in existing
markets in Hong Kong and Asian countries. This strategy can be adopted by Reborn to
grow their short term sales revenue and market share, but these markets might already be
saturated with similar products from strong competitors; thus, this strategy could only be used
in short term. It is the lowest risk strategy with lower return and growth option.
Reborn can consider a product development strategy to develop and launch new products to
existing markets. It requires Reborn to make a significant amount of investment to develop
another robotic rehabilitation system to sell in existing markets. Since new innovative
robotic rehabilitation systems require a few years to design, test and seek government
approval before they can be sold to patients, it is not possible for Reborn to create a new
innovative robotic rehabilitation system to increase the profitability and grow the businesses
in short term. Reborn has to adopt this strategy with other strategies at the same time to
ensure long term survival.
Reborn can consider selling existing robotic leg and rehabilitation systems to new markets in
developing countries with less competition. Reborn may need to set up differential pricing
policies to attract different types of customers and create new market segments in different
countries. Reborn can either sell to different markets by setting up sales offices or selling
through different distribution channels to mitigate the initial set up investment. Since robotic
rehabilitation systems are a medical device, Reborn may need to understand different laws
and regulations on robotic rehabilitation systems and seek government approval before they
can sell to these new markets. This is a feasible strategy but with higher risk that can be
adopted by Reborn after a feasibility study.
Reborn can also consider adopting a diversification strategy to develop new products and to
sell in new markets. This is a growth strategy that requires a significant amount of
investment to develop new products and to explore new markets. It is therefore the most
high risk strategy. Reborn should not adopt this strategy as it is not possible to develop new
innovative robotic rehabilitation system in a short period of time and also it is difficult to find
new markets to satisfy all regulatory requirements to sell the new robotic rehabilitation
system.
Module B (December 2019 Session) Page 1 of 12
Answer 1(b)
Product life cycle can be divided into five phases, including development, introduction,
growth, maturity and decline. Sales revenue and profits change in different stages of the
product life cycle. To maximise sales revenue and profits, Reborn has to formulate different
strategies to maximise the total return over the product life cycle when they design and
develop a new robotic rehabilitation system.
In the development stage, Reborn should monitor and control design and development costs
by working with scientists carefully on the design and manufacturing processes of the new
robotic rehabilitation system. Reborn should set up budgets to avoid overrun of time and
costs in the process that erodes the profitability of the new product.
In the introduction stage, Reborn should try to shorten the launch time of the new robotic
rehabilitation system to the market so as to enjoy the first entry to the market without strong
competition and increase market share in the long run. Once competition becomes fierce,
the profitability would reduce due to pressure on selling price and quantity, subject to market
forces.
In the growth stage, Reborn should minimise the breakeven time of the new robotic
rehabilitation system to pay back fixed and research and development costs invested in
designing, developing and manufacturing of new product. Reborn has to use the return to
invest in developing another new innovative rehabilitation system before full maturity of the
existing robotic leg and rehabilitation system.
In the maturity stage, Reborn should maximise and extend the length of the product life cycle
of the robotic rehabilitation system by providing continuous new upgrades in hardware and
software. This can further optimise and upgrade the product to meet different needs of
customers and markets so that it can generate more sales revenue to maximise the
profitability of the product.
In the declining stage, Reborn should decide to leave the market or find new markets to sell
the robotic rehabilitation system.
Module B (December 2019 Session) Page 2 of 12
Answer 2(a)
The World Commission on Environment and Development defines sustainability as
development that meets the needs of the present without compromising the ability of future
generations to meet their own needs. Long term sustainability depends on the ability of
Reborn to preserve and enhance the following six capitals:
Financial resources and ability to raise finance are keys to business sustainability.
Since Reborn is in the high technology industry that requires significant amounts of capital
investments in scientific equipment and machinery for scientific research and production of
new robotic rehabilitation system, Reborn is required to use different financing methods to
acquire these facilities to strengthen the sustainability of the business.
Acquiring and maintaining manufactured capital of tangible assets to produce the products
or to provide services to customers is another factor to sustainability. As a high technology
company, Reborn has to maintain and keep updates of existing scientific and high technology
manufactured capital that are very significant to innovation and scientific development of the
robotic rehabilitation system and are keys to continue the business.
Intellectual capital is knowledge held by employees and intangible assets, such as patent and
trademark, owned by the company that are all critical to business sustainability. Reborn has
to spend resources to apply for patent and trademarks to protect scientific innovations and
intangible assets that are the foundation to further development of the business.
Human capital is the work force and capacity in Reborn. For a high technology company, a
majority of human resources are scientists or experts that are very difficult to recruit and to
retain. Reborn requires a huge amount of investment on scientific training and a high
technology development environment to support them to continue high technology product
development and scientific research. Long-term incentive plan could be introduced to retain
key personnel and talents.
Social and relationship capital includes the relationships with Reborn’s stakeholders,
reputation and images in the social community. The key internal stakeholders of a high
technology company are scientists and manufacturing workers who manufacture high
technology products and provide professional services to the customers. The key external
stakeholders of a high technology company are customers who acquire the company’s
products, suppliers who supply raw materials and scientific equipment and government who
provides research and development funding, facilities and research environment to support
scientific development and advancement.
The last sustainability issue is related to natural environment. Scientific research and high
technology development may utilise significant amount of natural resources, such as energy,
water, raw materials; it may thus produce pollution, hazardous wastes to the environment that
Reborn should pay more attention to protect the environment and to comply with
environmental laws and regulations.
Module B (December 2019 Session) Page 3 of 12
Answer 2(b)
An ESG report should be prepared based on the materiality that most significant issues and
events should be reported in priority. The work place incident case is related to a scientist
who was injured during the testing of new robotic rehabilitation system that is a significant
work place incident event. It was not handled properly by the testing laboratory that led to
a lawsuit to Reborn. This was a material and significant event that should be reported in the
ESG report.
Measurable KPIs and targets should be established in the ESG report and supported with
explanation so that ESG report users can use them for analysis and decision making.
Reborn should set up KPIs and targets on work place incident that should aim at zero incident
because one work place incident may cause significant monetary and non-monetary losses
to Reborn. The work place incident case should be reported to compare the numbers of
work place incidents in previous years so that ESG report users can assess the progress of
work place safety performance of Reborn.
The ESG report should be balanced and provide unbiased and factual assessment to all
items in subject areas. In this case, the omission to report the work place incident was a
biased assessment and must be reviewed by the Board of Directors. The management
should disclose the work place incident and also include numbers of employee days lost, the
extent of facilities damaged and the compliance of relevant safety and employment law and
regulations in the ESG report.
An ESG report should use consistent methodologies to allow for meaningful comparison of
ESG performance over time. All work place incident cases should be reclassified
consistently as health and safety under working quality in the ESG report for easy comparison
and analysis in coming years.
Answer 3(a)
2 shares at HK$10 = HK$20
1 share at HK$4 = HK$4
Theoretical ex-rights price is HK$24 / 3 = HK$8.
The value per share after the rights issue reduces from HK$10 to HK$8.
The amount of new funds raised will be 100 million shares / 2 = 50 million shares x HK$4
= HK$200 million.
Module B (December 2019 Session) Page 4 of 12
Answer 3(b)
Earning as a Additional Current Total Market Value Value per
% of money earnings earnings earnings after (P/E 5 x total Share
raised (HK$200m x the issue earning after
earning %) the issue)
(%) (HK$m) (HK$m) (HK$m) (HK$m) (HK$)
10 20 200 220 1,100 7.33
20 40 200 240 1,200 8
30 60 200 260 1,300 8.67
Implications:
Shareholders will take up the rights offer if they think the new funds will earn a higher rate of
return than the current funds. Shareholders will also take up the rights offer if they are
confident that Reborn will further develop new rehabilitation systems and technology to
generate higher returns on investment in future. Shareholders should take up the rights
offer if they want to avoid dilution in their shareholdings.
Answer 4(a)
USD
Operating loss (10,000)
Add back:
Amortisation of patents (25,000 x 80%) 20,000
Marketing cost (120,000 x 25%) 30,000
40,000
Tax at 30% (12,000)
Net operating profit after tax 28,000
Other non-current assets at replacement costs 4,000
Current assets 6,000
Amortised patents 90,000
Economic value of net assets 100,000
WACC 20%
Capital charge (100,000 x 20%) (20,000)
EVA 8,000
Since the EVA of the rehabilitation computer game project is positive, Wise should consider
further pursuing the project.
Module B (December 2019 Session) Page 5 of 12
Answer 4(b)
It is not advised to use the economic value added method to evaluate the financial feasibility
of the rehabilitation computer game project because it only focuses on the short term
performance of the project; it is not suitable to measure the long term performance of the
rehabilitation computer game project.
The economic value added method does not account for the time value of financial
performance that is not suitable to evaluate the financial feasibility of a long term project.
The economic value added method is based on historical financial figures that are backward
looking with limited use to evaluate future financial feasibility of a long term project.
The economic value added method also requires numerous adjustments to calculate NOPAT
and economic value of net assets that could be problematic when it is used to evaluate the
financial feasibility of a long term project.
Answer 4(c)
To: Board of Directors
From: Mr Lee, Chief Finance Officer
Date: day / month / year
Remarks: Listing Requirements of Hong Kong Stock Exchange
(i) For the Main Board listing, Wise needs to pass one of three financial tests; namely
profits test, market capitalisation / revenue / cash flow test and the market
capitalisation / revenue test.
Profits test requires Wise has profit of at least HK$20 million in its most recent
financial year and at least HK$30 million in aggregate in the two preceding years.
As Wise does not have profit yet, it cannot meet these requirements to list on the
Main Board.
Market capitalisation / revenue / cash flow test requires Wise has market
capitalisation of at least HK$2 billion with revenue of at least HK$500 million for
the most recent audited financial year and positive cash flow from its operating
activities of at least HK$100 million in total for the most recent three financial
years. Wise has no revenue and incurred negative cash flow with expected
HK$155 million market capitalisation, so it does not meet these requirements to
list on the Main Board.
Module B (December 2019 Session) Page 6 of 12
Market capitalisation / revenue test requires Wise has market capitalisation of at
least HK$4 billion and revenue of at least HK$500 million for the most recent
audited financial year. Wise has no revenue and insufficient market
capitalisation to meet these requirements to list on the Main Board.
For the GEM listing, there is no profit requirement. Wise must have market
capitalisation of at least HK$150 million at the time of listing. Moreover, there
should be positive cash flow from operating activities of at least HK$30 million in
aggregate for the two preceding financial years.
Wise has an expected market capitalisation of HK$155 million after the launch of
the computer game that will meet the market capitalisation requirement of the
GEM Listing Rules. However, Wise has negative cash flow which fails to meet
the positive cash flow from operating activities requirement of the GEM Listing
Rules. Hence, Wise is not eligible to list on the Main Board and GEM.
(ii) The Hong Kong Stock Exchange allows for weighted voting rights structure and
the listing of pre-profit / pre-revenue companies in the biotech industry to attract
new economy companies to list on the Hong Kong Stock Exchange.
Wise can consider listing on the Hong Kong Stock Exchange because it is a
biotech company that produces medical devices, i.e. rehabilitation computer
game, to facilitate the rehabilitation and recovery of cognitive impairment or
disorder patients. Wise is a pre-profit / pre-revenue company with weighted
voting structure that can satisfy the new listing requirements of a biotech company
in a new economy.
* * * END OF SECTION A * * *
Module B (December 2019 Session) Page 7 of 12
SECTION B – ESSAY / SHORT QUESTIONS (Total: 50 marks)
Answer 5(a)
Net assets basis (HK$’000)
(322,880 - 189,226) x 60%
= 80,192 (HK$80 million)
Dividend based valuation method (HK$’000)
Cost of equity Ke = 6.5% + 3% = 9.5%
Growth rate 4%
Current year dividend, d0 = 69,870
P0 = d0 (1 + g) / (Ke - g) = 69,870 (1 + 4%) / (9.5% - 4%)
P0 = 1,321,178
Consideration:
P0 x 60% = 792,707 (HK$793 million)
Earning based valuation method (HK$’000)
174,674 x 15 x (1 - 40%)
= 1,572,066
Consideration:
1,572,066 x 60%
= 943,240 (HK$943 million)
Answer 5(b)
The Target Company is a software company, which is a light asset company.
The Target Company is operating on going concern basis and the acquisition is not due to
any valuable tangible assets carried by the Target Company, so net assets valuation basis is
not applicable in this case. The shareholders of the Target Company will be reluctant to sell
with this offer unless they are in a cash flow problem; but, according to the financial position
of the Target Company, this is not the case.
The presumption of the dividend valuation model is a steady and perpetual growth rate.
Although the Target Company has maintained a steady grow rate in recent years, such steady
growth may not be applicable for a company in the software industry in the long run. As a
company in the software industry, it may need extra funding for developing new products or
research and development to maintain its competitive advantage so it may not be able to
keep the current dividend payout ratio. The shareholders of the Target Company will be
reluctant to sell with this offer, as the Target Company has a relatively low payout ratio to
reserve fund for research and development. The shareholders will consider this valuation
method does not reflect the true value of the Target Company.
Module B (December 2019 Session) Page 8 of 12
The P/E ratio method of valuation is a common method of valuating a company by referring
to the market P/E ratio of similar industry. However, it is subjective to decide the discount
rate of the P/E ratio for an unlisted company, especially a listed company may have a different
capital structure from the unlisted company. The owners of the Target Company may find
the valuation is less attractive after discounting the industry P/E although the valuation is
highest among the three methods. The owners of the Target Company may list directly
instead of selling off at this moment.
The P/E ratio method of valuation is relatively more appropriate in this case, as it is reflecting
the profitability of the Target Company and the market P/E ratio of similar industry.
Answer 6(a)
The foreign exchange risk that the Company faced is translation risk that the Company may
incur exchange losses when the accounting results of the Investment are translated into the
home currency. Translation losses can result from restating the value of the Investment at
the exchange rate on the reporting date.
The Company is exposed to the foreign exchange risk because of the purchase of an asset
in GBP, which is not the functional currency of the Company.
This exposure / risk can be mitigated, or partially hedged, by matching the assets and
liabilities as the Company had borrowed a loan in GBP which is in the same currency of the
Investment.
The GBP loan is GBP150 million, which covers 50% of the GBP300 million investment, and
the maturity of the loan is five years, which is longer than one year.
Therefore, the Company is complying with the Company’s policy.
Answer 6(b)(i)
The amount to be paid
(2.34% + 2%) x GBP150 million
= GBP6.51 million
The realised loss of the interest rate swap
(1.05% - 2.34%) x GBP150 million
= loss of GBP1,935,000
Module B (December 2019 Session) Page 9 of 12
Answer 6(b)(ii)
The transaction costs may be too high to terminate the existing loan and take out a new loan.
Terminating an original loan before maturity may involve a significant transaction fee. Taking
out a new loan may also put the Company at refinancing risk, and the Company may not be
able to get a new loan depending on the credit status and the market liquidity at that time.
The Company will face interest rate risk; that is, if the interest rates rise, more interest will be
payable on the loan. However, with interest rate hedging, the company will suffer a loss of
competitive advantage compared with the loan which is using floating rate if the interest rate
falls. At the end, it is normal to hedge as the objective is not to speculate.
Answer 6(c)
The procedures of money market hedge:
(i) Borrow the necessary Hong Kong Dollars (“HKD”) which is equivalent to GBP10 million
after including the potential GBP interest that the GBP deposits can generate (based on
the GBP interests rate) and the current spot rate of HKD to GBP.
(ii) Convert the HKD borrowed to GBP.
(iii) Put the GBP on fixed deposits for six months.
(iv) After six months, pay the GBP for renovation, and repay the HKD borrowing.
Answer 7(a)
There is no wholesales sales receipts until mid-February 2019
HK$
February rental payment 4,000,000
Rental deposits 12,000,000
Half of renovation fee to be paid on 1 February 2019 6,000,000
Total funding needed 22,000,000
Intercompany loan of HK$20,000,000 is insufficient.
Module B (December 2019 Session) Page 10 of 12
Answer 7(b)
HK$’000 HK$’000
Sales receipts
Sales to distributors (Wholesales) 183,040
with 45 days credit not received [(HK$183,040 / 365) x 45] (22,567)
Sales receipts from distributors (Wholesales) 160,473
Sales from the TST store (Retail)
Cash sales receipts 21,900
Sales paid by credit card 87,600
Less: Credit card not received [(HK$87,600 / 182.5) x 5] (2,400)
Credit card sales received 85,200
Total sales received 267,573
Purchase paid for Retail
Year end closing retail inventory (HK$54,750 / 6) 9,125
Cost for sales for retail 54,750
Total retail inventory purchased 63,875
60 days purchase in credit not yet paid [(HK$63,875 / 182.5) x 60] (21,000)
Purchase paid for Retail 42,875
Purchase paid for Wholesales [(HK$109,824 / 365) x 305] 91,771
Renovation 12,000
Rental deposits (HK$4,000 x 3) 12,000
Rental expenses (HK$4,000 x 11) 44,000
Operating expenses (HK$1,500 x 8) 12,000
Marketing budget 7,000
87,000
Total disbursement 221,646
Net cash flow 45,927
There is no cash shortage if there is no financing on 31 December 2019.
Module B (December 2019 Session) Page 11 of 12
Answer 7(c)
Negotiate with the landlord to provide a bank guarantee instead of paying rental deposits
by cash. A negative concern is that there are charges / finance costs for the bank
guarantee. The landlord, without getting cash rental deposits, may demand higher
rent.
Negotiate a shorter credit period from wholesale customers. A negative concern is that
the wholesalers may ask for higher margin or reduce their purchase from the
HK Company.
Shorten the retail inventory period. A negative concern is any inventory shortage may
result in loss of income and business opportunities.
Ask for a longer credit period from the Headquarter. A negative concern is that it may
shift the liquidity problem to the Headquarter, and the working capital does not improve
at the consolidated level.
Ask for a shorter settlement period from the credit card merchant. A negative concern
is that the merchant may increase the credit card commission rate.
Any two of the above measures with proper elaboration of the negative concern.
* * * END OF EXAMINATION PAPER * * *
Module B (December 2019 Session) Page 12 of 12