SECTION A – CASE QUESTIONS

Answer 1(a)

To: Board of Directors

From: Angel Chan
Date: xx xxx xxxx
Subject: Finacial performance of Winning Tools Limited and loan covenants

We would need to resolve the dividend payout of Winning Tools Limited.

The company has to decide on a share repurchase programme which is appropriate given
the big drop in the stock price recently. The company is facing a financing constraint in
dividend payout and share buyback, coupled with signalling the future outlook on the
decisions and positioning of the stock’s price in the capital market.

There may be a cyclical downturn in the machine tool industry because the global
economy is heading into recession. Also, the business restructuring of the company may
not yield the expected positive financial results as new products incur a higher level of risk
to win market share.

The credibility of forecasts depends largely on the assessment of the management’s ability
to harvest potential profits. To support the new investment and resume dividend payout
will increase the chance of taking on new debt. In an increasing interest rate
environment, the risk of bankruptcy and financial distress cost are mounting.

Answer 1(b)

Return on investment (2013) = $12,992 / $674,582 = 1.93%

Return on investment (2014) = -$250,785 / $536,874 = -46.71%

Debt ratio (2013) = $273,411 / $674,582 = 40.5%

Debt ratio (2014) = $359,684 / $536,874 = 67.0%
(Alternative method of calculating debt ratio is acceptable.)

Current ratio (2013) = $489,242 / $200,318 = 2.44x

Current ratio (2014) = $447,083 / $267,367 = 1.67x

Asset turnover ratio (2013) = $815,979 / $674,582 = 1.21x

Asset turnover ratio (2014) = $656,638 / $536,874 = 1.22x

Overall the financial performance is worsening in 2014 compared with 2013, with a
negative return on investment, high debt ratio and tightening liquidity.

Module B (June 2015 Session) Page 1 of 10

Answer 1(c)

Dividend payout may affect the cash flow of the operation of the company where liquidity is
weakening in 2014.

It may further affect the repayment ability of the company to service the debt interest and
principal to the existing lenders or bankers, as the debt ratio is increasing in 2014.

Given the deterioration of the financial performance of the company in 2014, existing
lenders or bankers may have more reservations and may even restrict the aggressive
dividend payout ratio of the company by means of negative covenant clauses in the
lending agreement.

Loan covenants may also limit the company to sell assets to raise cash in order to make
dividend payments.

The creditors may even limit the capital expenditure of the company, which may affect the
long term growth of Winning Tools Limited.

Answer 2(a)

The company’s investment spending in research and development is likely to push up the
financing requirement. The traditional presses and molds segment might continue to
struggle in delivering profits while it will take time for the electrical industrial equipment
sections to contribute to the bottom line. In the short run, the profit picture is not rosy.

There is a good chance that a combined dividend payout in 2015 may still be higher than
projected earnings. There will be pressure on the company to raise money through
increasing debt levels to support the growth strategy and satisfy the dividend payment
promise at the same time. As a result, the capital structure is likely to be more leveraged.
Given the negative sentiment of the stock market, it may not be a good time to sell equities
in order to raise long term funding.

Answer 2(b)

The decision on whether or not to repurchase shares relies on the assessment of the
intrinsic value of the company versus the current market price. However, share
repurchase in this case may not solve the company’s dividend and financing problem. In
fact, it will compete with the dividend decision for limited cash internally if implemented.

Also, the message of share repurchase execution may not be consistent with the latest
strategy: generate growth from another business line with heavy long term investment in
research and development.

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Answer 2(c)

In general, a higher dividend payout usually signals anticipated good financial

performance ahead. As a result, the capital market may react positively to the stock price
when a higher than expected dividend payout announcement is made by the company.
Moreover, the profile of the company’s shareholders may influence the choice of dividend
policy as well.

Since the management of the company are largely family members of the founders, who
own the largest and major share of the company, and they have decided to generate new
growth by investing heavily. On top of that, there is a substantial increase in institutional
investors who would like the company to create value. These might support the company
not rushing to pay decent cash dividends before real and new growth starts to materialise.

Answer 3(a)

Post – repurchase stock price = pre- repurchase stock price + present value of interest tax
savings – present value of financial distressed costs + signaling value of private
information

The debt increase will enhance tax savings which will have a positive effect on the stock
price.

The management may be perceived to convey positive private information to the market
by share repurchase especially if the company used to maintain a high degree of
information asymmetry with its shareholders.

Yet, higher level of debt will increase the direct and indirect cost of bankruptcy and
financial distress which are negative for the stock price. Overall, the stock price after
share repurchase will be the result of these different forces.

Stock buyback reduces the supply of stock but the share price may not increase if demand
for stocks drops at the same time when investors are worried about the impact on future
earnings.

Answer 3(b)

The weighted average cost of capital is likely to drop: there will be a higher portion of debt
(additional financial leverage) being used relative to equity (reduction by stock
repurchase). The cost of debt is lower than the cost of equity.

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As a result, the weighted average cost of capital overall will go down, assuming that the
increased debt level will not push the cost of financial distress to a very high level, and that
outweighs the benefit of tax savings in taking on more debts. We also assume that the
increase in the stock price as a result of share repurchase will not push up the market
value of equity substantially.

The beginning of the interest rate increase cycle will raise the cost of debt, or potential
interest tax savings will benefit if the company is making a profit, not a loss.

Answer 3(c)

Andy’s purchase of the company’s stock based on his capacity as financial manager in the
repurchase decision means he could be charged with insider dealing under the Securities
and Futures Ordinance.

The company should inform and educate its staff regarding the ethical standards in using
information appropriately from time to time.

Also, staff involved in stock price-sensitive information may need to sign a confidentiality
agreement and make sure they are aware of the limitations of the use of information for
trading purposes themselves or passing such information to someone else for trading
purposes.

Answer 4(a)

Manufacturing cycle efficiency

= manufacture time / (manufacture time+ transport time + store time + inspect time)
= 7.2 / (7.2 + 3.2 + 4.8 + 1.2)
= 43.9%

MCE (Winning Tools) << MCE of industry average, coupled with the unsatisfactory latest
financial performance might suggest too much time is spent on non-value added activities
such as transport and storage. Relatively insufficient time is spent on the quality control
of the manufacturing process.

Answer 4(b)

Winning Tools Limited may fail to link the measure to the company’s goal or strategy. It
may not validate the link thoroughly. It may not set the appropriate performance target.
It may measure incorrectly.

* * * END OF SECTION A * * *

Module B (June 2015 Session) Page 4 of 10

SECTION B – ESSAY / SHORT QUESTIONS

Answer 5(a)

Actual profit margin:

Sales $1,000
Direct labour $190
Direct materials $320
Variable overhead $60
Allocated overhead $380
Gross profit margin $50 (or 5%)

Gross profit margin is 5% (1,000 - 950) / 1,000.

Therefore current cost structure is not acceptable.

The unit cost must be reduced from $950 to $930 in order to reach the 7% target gross
margin. The company can achieve the $20 per unit reduction by considering one of the
following three alternatives, (i) labour cost, (ii) materials cost and (iii) overheads.

As given in the case, the labour cost in mainland China is rising due to economic growth
and the increase is expected to be about 10% for TTC’s plan, so it is unlikely that this cost
can be reduced by $20 per unit or 10.5% (20/190).

The reduction in materials cost is also difficult to achieve given that the commodity prices
are determined by the market and TTC essentially has no control over it.

Also, as TTC is already an established manufacturer of mobile phones and it has a

reputation for being a low cost producer, a further increase in production efficiency is
unlikely to deliver a cost reduction equivalent to a 33.33% reduction (20/60) in variable
overheads.

However, as TTC has an extra fixed manufacturing overhead, it is worth exploring (1)
reduction of fixed manufacturing overhead, if possible, or (2) increase in the volume of
production to reduce the allocated fixed overhead.

As an illustration for (2), assuming total fixed overhead remains constant, in order to
reduce the unit allocated fixed overhead from $380 to $360, the volume of production
should be increased by 5.56% (380 / 360 - 1) or to 527,800 units. It is therefore
worthwhile for TTC’s management to explore with its customer the possibility of a higher
purchase volume in order to reach the 7% target gross profit margin.

Module B (June 2015 Session) Page 5 of 10

Answer 5(b)

Total Gross Profit

= $10,000,000 - $3,000,000
= $7,000,000

Traditional Gross Profit approach: ($’000)

Sales 10,000
COGS
Direct labour 900
Direct materials 1,800
Manufacturing overhead 300
Gross profit margin 7,000

Yes, Model X should be developed.

Life Cycle Costing approach

Traditional Gross Profit approach: ($’000)

Sales 10,000
COGS:
Direct labour 900
Direct materials 1,800
Manufacturing overhead 300
Gross profit margin 7,000

Brand building 4,000

R&D 2,900
Customer service (set up and running cost) 200
Termination cost (disposal of related assets, inventory write-off) 200
Abnormal wastage of materials due to learning curve 50
Life cycle profit / (loss) (350)

Excluded costs:
HR and admin support and legal support 300
Loss of disposal of idle equipment 500

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Model X is expected to suffer a loss of $350,000 during its life cycle when all relevant costs
in developing, marketing, manufacturing and servicing the product are included. Unless
Model X has significant strategic value to TTC, e.g. to develop an own brand to expand to
a new market, it should not be launched unless total life cycle costs can be reduced and
controlled to at least a breakeven level.

R&D, branding, customer service, termination cost and abnormal wastage are all part of
the life cycle costs incremental to Model X’s development, i.e. the company will not incur
these costs if Model X is not developed.

HR, administration and legal support are excluded since they are allocated and these
functions are shared by existing staff.

Loss of disposal of idle equipment is a sunk cost and is therefore irrelevant to the decision.

Answer 5(c)

Advantages:

- Give a better picture of the total performance of a product, particularly a new product.
- Help identify design costing problems at an early phase and therefore reduce future
maintenance and warranty costs.
- Help shape product strategy to establish early presence and create early mover
advantage.
- Provide an indication of financial return over the life of a product.
- Can be used to determine a target selling price at different stages of a product’s life
cycle.

Disadvantages:

- Additional cost may be needed to enhance accounting system to capture cost over
life cycle.
- Ignores time value of money.
- Substantial uncertainty in estimation of sales, cost, R&D etc. on a product with a long
cycle and / or when business is operating under a dynamic environment.
- Inclusion of some costs may be subjective such as the accounting system
development, product enhancement. This problem can be solved by applying
incremental cost analysis by asking the question: is this cost incurred or saved if the
product is launched?

Module B (June 2015 Session) Page 7 of 10

Answer 6(a)

All figures are in £’000.

Yr 0 Yr 1 Yr 2 Yr 3 Yr 4 Future
Sales 12,100 13,552 15,178 17,076 18,270
EBIT 2,178 2,440 3,036 3,416 3,472
Tax (30%) (653.40) (732) (910.80) (1,024.80) (1041.60)
Add depreciation 262 292 364 410 416
Capital
Expenditure (1,816) (1,490) (1,518) (1,708) (1,828)

Changes in working
capital (384) (306) (250) (76) (56)

Free cash flow (413.40) 204 721.20 1,017.20 962.40

Terminal value 12,030
Total cash flow (413.40) 204 721.20 13,047.20
PV factor 0.869565 0.756144 0.657516 0.571753
Total PV (359.50) 154.30 474.20 7,459.80
NPV 7,728.8
Less debt (950.0)
Equity value 6,778.8

Working:
Working capital 2,400 2,784 3,090 3,340 3,416 3,472
Changes (384) (306) (250) (76) (56)

Terminal value = [962.4 / (0.15 - 0.07)] = 12,030 (Constant Growth Model)

WACC 15%
Growth rate beyond
7%
5th year

Module B (June 2015 Session) Page 8 of 10

Answer 6(b)

Forward exchange rates:

1 month: 12.8488 + 0.0230 = 12.8718

3 months: 12.8488 + 0.0625 = 12.9113

Therefore , total HK dollar payment

= [ 7,000,000 x (0.3 x 12.8718 + 0.7 x 12.9113) ]
= HK$90,296,150

If WYZ does not hedge, how much would it pay if GBP appreciates by 2% on the
prescribed payment dates compared to the spot rate?

7,000,000 x 1.02 x 12.8488 = HK$91,740,432.

WYZ has to pay = 91,740,432-90,296,150 = HK$1,444,282 more if it does not hedge.

Answer 6(c)

Premium = £7,000,000 - 0.75 x £6,778,800 = £1,915,900.

Possible justification for premium:

 WYZ will derive cost savings due to increased economies of scale as it can act as the
supplier to T’s fashion business.
 Acquisition provides fast penetration into the UK market compared to organic growth.
 Since this is the first cross-border acquisition, WYZ will learn from this transaction for
future overseas expansion activities.
 The use of A’s brand will help enhance business.
 As a partner of a major UK company, WYZ may have the possibility of business
opportunities in the EU market in the future.

Answer 7(a)

Apply equity carve-out to SA

Equity carve out is a process in which a parent company sells the whole or part of a
subsidiary or business to a new or group of new shareholders for cash. The key features
of this transaction are actual cash inflow to the Group and a new shareholder. Existing
shareholders of HEE will not be able to participate.

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Reasons:

 As this action brings cash, it will immediately reduce cash flow pressure and provide
stronger liquidity for the Group’s future operating use.
 Selling partially to an independent new shareholder will help to establish a market
value for this business.
 The Group’s shareholding in SA, which is a cash cow, will be lower after the carve
out, therefore the attractiveness of the Group to a corporate raider will be reduced.

Apply spin-off to SB

Spin off is a restructure technique in which a parent company distributes its shareholding of
a subsidiary or business to its existing shareholders on a pro rata basis. After the
distribution, the effective holding of shareholders remains the same and there will be no new
shareholders. For example, the shareholders of HEE effectively hold 75% of SB through
HEE before distribution, if 35% is distributed, then HEE’s shareholders will hold 35% of SB
directly and 40% through HEE.

Reasons:

 The Group’s size is smaller after distribution, reducing the attractiveness and threat
of the takeover.
 Distribution will increase shares in trading.

Higher trading volume is expected to help reflect the internal value.

Answer 7(b)

The Board should further consider the following matters before implementation:

 Extent of restructuring considering whether the Group still wants control over either
one. This decision has to be taken in conjunction with the overall long term corporate
strategy.
 Listing rules compliance: the extent of downsizing should not jeopardise the listing
status of the Group and compliance requirements.
 Tax effect: will this action adversely affect the overall tax position of the Group? Also,
can the transactions be structured tax free?
 Morale of employees.
 Effect on overall viability of the Group after restructuring.
 How to communicate with the shareholders and stakeholders to ensure their support.
 Cost: both transactions may involve substantial professional fees.

* * * END OF EXAMINATION PAPER * * *

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