SECTION A – CASE QUESTIONS

Answer 1(a)

To: Derek Mohammad, CIO

From: Issac Chan
Date: xx/12/2014
Subject: Valuation of AFL

The following gives the calculation of net asset value per share of AFL, evaluation of the
common valuation bases of assets of AFL, and the shareholders' expectation to the
proposed offer.
$m
Total value of assets 6,503
Less current liabilities (1,666)
Less intangible assets (goodwill) (182)
Less long term liabilities (273 + 154 + 70 + 63) (560)
Net asset value of equity $4,095

Value per share = $4,095,000,000 / 29,197,000 = $140.25

Answer 1(b)

Historical basis: assets are valued at historical cost less depreciation expenses.

Replacement basis: cost that would be required to replace assets and continue using them
to operate the business.

Realisable basis: if assets are to be sold, or the business as a whole broken up, it would be
appropriate to value them at their realisable value.

In the case of Sunny Capital Partners, it seems that replacement cost basis is the most
relevant because it plans to operate the assets of target on a continuous basis, without any
immediate plan to dispose the assets.

Discounted cash flow method should be employed that reflects future earning power
projection of the target in M&A valuation. The difference between the purchase
consideration and the fair value is the goodwill upon acquisition. Any future impairment of
this goodwill has to be periodically assessed and immediately realised in profit & loss.

Module B (December 2014 Session) Page 1 of 9

Answer 1(c)

The net asset value per share may form the bottom line for the shareholders of Asian
Foods when Sunny Capital makes an offer to buy their shares at $119.

These shareholders may refuse to sell for less than the net asset valuation of $140.25.

Answer 2

Debt ratio = 2,226 / 6,503 = 34%

Its debt ratio is significantly lower than the industry average because of relatively low
reliance on machinery which would otherwise require more debt financing.

AFL has accumulated a high level of retained earnings which also explains the lower than
industry debt equity ratio. It has sufficient profit plowback without reliance on debt. AFL
actually has a net cash position.

Sunny Capital Partners would find it attractive because:

(i) A buyer has more room to increase the financial leverage of AFL after acquisition.

(ii) The buyer may acquire more machinery to improve its operating efficiency. The
buyer may expect AFL to deliver a stronger financial results with a better Asian
economic outlook.

(iii) The potential interest rate rise in the future is not likely to hurt AFL that much with its
low level of debt.

(iv) Long term tangible and intangible asset quality affects future impairment.

Answer 3(a)

Manufacturing cycle efficiency

= value-added processing time / total processing time
= 9,920 / 19,120
= 51.88%

Process productivity
= total boxes of ice-cream produced / value added processing time
= 1,850,000 / 9,920
= 186.49 boxes per minute of value added time

Process quality yield

= good boxes ice-cream produced / total boxes of ice-cream produced
= 1,731,000 / 1,850,000
= 93.57%

Module B (December 2014 Session) Page 2 of 9

Throughput
= MCE * PP * PQY
= 51.88% * 186.49 * 93.57%
= 91 boxes per minute > 79. Hence it satisfies the fund’s requirement.

Answer 3(b)

Throughput is one type of non-financial quantitative performance measure. It measures

useful information, quantities of boxes produced in a certain time interval contained in cost
management.

It makes sense as it is relevant to non-management employees who are generally more

familiar with non-financial items, such as time and quantities. Besides, it is controllable
by the employees, as an important performance measure criterion. It is also a good
reflection of the leading indicators of manufacturing quality boxes of ice-cream, that create
shareholder wealth.

Answer 3(c)

The level of inventory represented about three months of cost of sales.

It implies that the working capital management has room to improve. Not only is it
probably costly, raw material of a perishable nature such as milk can be subject to
contamination and require expensive refrigeration storage costs.

Answer 4(a)

Reporting earnings requires most costs incurred to developing new products to be

expensed as incurred. Nevertheless, the organic food products being introduced may
have a life cycle of six years or so. As a result, it may be appropriate to capitalise the
research and development costs and amortise them over the life cycle of the organic food
products. The current arrangement in accounting is that the research and development
costs get expensed earlier than revenues from new products are realised. This has the
effect of depressing current profits and overstating future profits.

Complexity of new markets (China, Japan and Korea) which introduce different language
requirement which raise marketing costs. The distribution agents may also be different so
scale benefit may not be achievable. The logistics of speedy delivery of high quality
refrigerated diary food products within a relatively short product expiry period may also be
a challenge.

Typically, there is a substantial start-up cost such as marketing, promotion, and

distribution-related expenses which the firm has to incur in order to build an infrastructure
for the potential scale of business to be achieved in the future.
Module B (December 2014 Session) Page 3 of 9
Answer 4(b)

The reported profits would have been higher for 2013. However, future profits would be
lower because the development costs would have been capitalised and amortised under
life-cycle costing rather than being expensed in the current period.

Answer 4(c)

Lee may simply have meant that the right time to invest heavily in future growth is when
current operations are generating surplus cashflows. In managing growth, one of the
objectives is to match the excess cash generated by sub-units charged with a harvest
mission with the cash needs of sub-units charged with a growth mission. In the food
processing context, this equates to matching excess cashflow generated by existing
product lines with the cashflow needs of new products being developed.

Answer 4(d)

It looks like there are motivational elements in AFL’s cost management system that
encourage growth. Managers are willing to invest in future products at the expense of
moderately depressing current reported profits. Managers would be very hesitant to act in
this manner if their incentives are tied entirely to current profits.

The existing sales growth seems to be not catching up with margin growth. The operating
margin appears to be attractive being over 35% in the past three years. Yet sales growth
has remained at a single digit level. Either there is a production efficiency problem that
limits the volume of products that can supplied to meet demand or the existing market is
saturated. In this connection, market extension in other Asian countries is a sound
business decision for a relatively high margin product. Future improvement in automation
may also enhance the margin and production efficiency further.

Answer 4(e)

It is not easy to recognise where a particular product stands in its life cycle.

There is a tendency for competitors to copy the leader very quickly.

The theoretical curve of a product life cycle does not always occur in practice. Some
products have no maturity phase, and go straight from growth to decline.

* * * END OF SECTION A * * *

Module B (December 2014 Session) Page 4 of 9

SECTION B – ESSAY / SHORT QUESTIONS

Answer 5(a)(i)

Market Value %
Bond: 200,000 x 1,000 x 0.975 = 195,000,000 25.243%
Preferred Stock: 2,250,000 x 50 = 112,500,000 14.563%
Common Stock: 7,500,000 x 62 = 465,000,000 60.194%
Total market value 772,500,000 100.000%

Rd = (after tax) 0.05636 [0.0675 x (1 - 0.165)]

Rp = 0.14 [0.07 x 100 / 50]
Re = 0.14056 [0.028 + 1.34 x (0.112 - 0.028)]

WACC = 0.119225 [25.243% x 0.05636 + 14.563% x 0.14 + 60.194%

x 0.14056]
i.e. 11.92%

Answer 5(a)(ii)

At a low level of debt, cost of debt, being cheaper than cost of equity will reduce the
WACC. Increased financial leverage (meaning higher fixed amount of periodic interest
expenses) will reduce the free cash flow available, thereby

(1) increasing the liquidity risk; and

(2) reducing dividend and capital investment capacity.

This results in a higher cost of equity which is more than offset by the lower cost of debt.
As such, a company would normally not borrow to the maximum level but instead strike a
balance between debt and equity as external sources of long term finance.

Answer 5(b)(i)

The Director’s suggestion is based on the Pecking Order Theory, which suggests the order
of financing should be retained earnings first, followed by debt then, by issuing new shares.
This priority is based on the magnitude of the issuing cost.

A company following this theory generally takes a conservative view in leverage and
prefers to stay low in debt. Such a company usually has a stable positive operating cash
flow as the source of financing, hence, generally does not need external financing.

Further, this company does not have or does not pursue a target capital structure.

Module B (December 2014 Session) Page 5 of 9

Answer 5(b)(ii)

While the order of financing based on the Pecking Order Theory will save issuing costs,
there are several implications that must be considered. In particular:

- The company will deviate from its current optimal capital structure. The WACC will
not be at the lowest level. This will reduce the company’s valuation and hence
adversely affect its current high share price.

- As WACC can be used as the discount rate for capital budgeting analysis, not having a
minimum WACC will cause profitable projects to be rejected. This is particularly
important since EFG expects to have further investment for expansion.

- Retained earnings carries cost of equity, which is more expensive than debt and hence
it is not cost efficient if used as a first source of finance.

- Deprive the company of financing flexibility to take advantage of capital market

opportunity, i.e. low interest rate, high share price etc. as it is very likely that the
company will have to opt for external financing as it has not accumulated a substantial
cash balance.

- A related point is that financing through a long term bond which may have maturity
over 10 years will provide funding stability. Using retained earnings first does not
provide such stability as borrowing power is not guaranteed and the company may not
be able to obtain the money in the future when retained earnings have been
exhausted.

Module B (December 2014 Session) Page 6 of 9

Answer 6(a)

Company A should acquire T1 since the D/E ratio of the group immediately after acquisition
is 33%, meeting the objective. Calculation is as follows.

A T1 T2
All in HK$'000 except %
Asset 20,000 100,000 5,000
Liability 15,000 20,000 450
Equity 5,000 80,000 4,550
D/E ratio 300% 25% 10%

Combined Company
A+T1 A+T2
Asset 120,000 25,000
Liability 35,000 15,450
Equity 85,000 9,550
Fair value adjustment 20,000 450

D/E ratio 33% 35,000 / (85,000 + 20,000)

155% 15,450 / (9,550 + 450)

Answer 6(b)

Since Company A wants to reduce the D/E ratio upon acquisition, in addition to the
traditional due diligence process, it needs to pay special attention to the liabilities and cash
flows of both T1 and T2. Company A needs to investigate to ensure that:

(1) no off balance sheet liabilities exist;

(2) no future loan, long term lease or other long term liability commitment have been made;

(3) bank debt should be properly reflected in the financial statements;

(4) free cash flow should be positive; and

(5) assets are of sound quality and have no impairment.

Answer 6(c)

The following areas should be considered:

(1) T1 is a much larger company, hence post acquisition integration can be

challenging. But given the purpose is to reduce D/E ratio, there should not be
much operational integration.

(2) Off balance sheet items may be difficult to evaluate given the target is a private
company.
Module B (December 2014 Session) Page 7 of 9
Answer 7(a)

Year 1 2 3 4 5
All figures are in $’000
Revenue 3,544 4,465 5,470 5,743 5,169
Cost of materials 709 893 1,094 1,149 1,034
Labour 1,164 1,607 2,258 2,597 2,715
Overhead 466 625 719 826 950
Total operating costs
2,339 3,125 4,071 4,572 4,699
(cash flow)

Total operating profit 1,205 1,340 1,399 1,171 469

Answer 7(b)

Tax Saved from capital allowances

Year 0 1 2 3 4 5 6
All figures are in $’000
Tax Base 2,700 2,025 1,519 1,139 854 641
Capital Allowance
(25%) 675 506 380 285 214 641
Written Down Value 2,025 1,519 1,139 854 640 0

Tax saved from capital

allowances 0 203 152 114 85 64 192

Answer 7(c)

Working Capital Requirements

Year 0 1 2 3 4 5
All figures are in $’000
Working capital
requirements 270 354 447 547 574 0

Change of working
capital requirements -270 -84 -92 -100 -27 574

Module B (December 2014 Session) Page 8 of 9

Answer 7(d)

NPV Analysis

Year 0 1 2 3 4 5 6
All figures are in $’000
Cost of investment -2,700
Operating profit 1,205 1,340 1,399 1,171 469 0
Tax effects
- Operating profit -361 -402 -420 -351 -141
- Capital Allowances 203 152 114 85 64 192
Working capital change -270 -84 -92 -100 -27 574 0
Net cash flow -2,970 1,323 1,039 1,010 809 757 51
Discount factor 1.000 0.833 0.694 0.579 0.482 0.402 0.335
Present Value -2,970 1,103 721 585 390 304 17
NPV 150

The investment should be done since NPV is positive.

Company P should consider the following qualitative factors:

- Competitive strategy: this investment may help in implementing the company’s

competitive strategies such as cost leadership / differentiation.

- Market share – the need to enhance or maintain market share.

- Barrier to entry / enter a market – the need to penetrate a new market or defend an
existing market.

- There are estimation errors in the NPV calculation. This is particularly important
when the NPV calculated is small.

- Any other investment that may offer a better return than this project.

* * * END OF EXAMINATION PAPER * * *

Module B (December 2014 Session) Page 9 of 9