HKICPA

Qualification Programme

Module B – Corporate Financing

Dec 2020

Mock
Questions

https://www.kaplan.com.hk/
 Professional Programme Module Examination

Time allowed 3 Hours

Examination Assessment Allocation

Section A – Case Questions 50 marks

Section B – Essay/Short Questions 50 marks

YOU SHOULD ANSWER ALL THE QUESTIONS IN THIS PAPER

Copyright© Kaplan Financial (HK) Limited 2020

All rights reserved. No part of this examination may be reproduced or transmitted in any
form or by any means, electronic or mechanical, including photocopying, recording, or by
any information storage and retrieval system, without prior permission from the publisher.
SECTION A – CASE QUESTIONS (Total: 50 marks)
Answer ALL of the following questions. Marks will be awarded for logical argumentation and appropriate
presentation of the answers.

CASE

Hola Publishing Co (“HPC”) is a group of companies which specialise in the production of children’s books
sold to HK Government Schools and seasonal celebration cards which are produced in its main factory
located on the side of a lake in China, at the end of a single track road from a village.

Production is machine intensive and the print machines require regular cleaning involving hazardous
chemicals at its factory which employs nearly 300 people and is the largest employer within a 20 mile radius
in China. Because distribution, marketing promotions and sales of books are conducted in Hong Kong, HPC
has always centralised its treasury function in Hong Kong.

A summary of the consolidated results for the last four financial years, as extracted from the audited
consolidated financial statements for the years ended 30 June 2017, 2018, 2019 and 2020 are set out below:

Year ended 30 June

2017 2018 2019 2020
HK$’000 HK$’000 HK$’000 HK$’000
Revenue 312,676 341,390 345,562 356,678
Other income 1,345 2,102 1,898 2,342
Raw material costs (37,567) (40,123) (41,578) (38,423)
Labour payments (14,356) (15,012) (15,534) (15,604)
Rental expenses (43,967) (44,567) (46,672) (48,742)
Marketing and distribution expenses (132,779) (139,854) (146,777) (160,045)
Depreciation and amortisation (9,636) (10,068) (6,890) (9,898)
Other operating expenses (35,566) (37,898) (38,543) (38,995)
Finance costs (1,078) (1,563) (1,634) (1,787)
Profit before taxation 39,072 54,407 49,832 45,526
Taxation (6,445) (8,972) (8,219) (7,510)
Profit for the year 32,627 45,435 41,613 38,016

HPC have been in business since 2001, but over the last few years has offered an increasingly wide range
of books and more recently celebration cards in America to try to appeal to differing market segments.
Despite an in increase in sales revenue, HPC’s production, marketing and distribution costs have also
increased disproportionately. HPC’s costs are now around 22% higher than those of its nearest competitors,
and profits are suffering as a result. HPC’s industry average P/E ratio is 12 times.

In order to regain a competitive position Paul Tam, the CFO of HPC has been advised the problems may
have to do with the way the treasury is currently structured in Hong Kong. He has been told a change to a
decentralised structure should solve these problems and increase profitability but is unsure what to do.

Paul Tam and the other members of the Board of Directors of HPC have worked for the company for many
years in various senior management roles and are all based in Hong Kong. At a recent golf club dinner, the
directors openly discussed the impending share issue listing with some colleagues. The finance director was
not aware of this at the dinner as he had been busy for the first hour in a mad rush to understand and
complete the company’s taxation computation following the acquisition of an ink business in America.

MNO Division

The MNO Division is a subsidiary of the group that offers seasonal celebration cards for sale in America with
a seasonal fluctuating US customer demand using some US local suppliers. Some additional specialised
card printing is conducted in America.

Module B (Dec 2020 Session) – Mock Page 1 ©Kaplan Financial 2020

Figures for the MNO Division for year to 30 June 2020 were as follows:

Revenue $10 million

Gross profit margin 40% of revenue
Accounts receivable days minimum 20, maximum 30 days
Accounts payable days minimum 40, maximum 50 days
Inventories minimum 50, maximum 80 days
Non-current assets $8 million

The Financial Controller has been asked to carry out an analysis of MNO’s working capital levels, as
requested by the Treasurer using 365 days in the year. He is assuming that the peak period for accounts
receivable coincides with the peak period for inventories and the lowest level of accounts payable.

Internal pricing problems

To produce its most popular Christmas cards, the MNO Division requires a special ink ingredient called Z.
The MNO Division has been offered supplies of special ingredient Z at a transfer price of $15 per kg by FSL,
which is part of the HPC group of companies.

FSL processes and sells special ingredient Z to customers external to the group at $15 per kg.

FSL bases its transfer price on total cost-plus 25% profit mark-up. Total cost has been estimated as 75%
variable and 25% fixed.

Question 1 (17 marks – approximately 31 minutes)

(a) (i) Calculate MNO’s minimum and maximum working capital levels based on the Financial
Controller’s assumption regarding the timing of peaks and troughs in working capital
variables and discuss the validity of that assumption.
(7 marks)

(ii) Using the figures calculated in (i) above, calculate the short-term and long-term (permanent)
financing requirements of MNO under each of the following working capital financing
policies:
• Moderate policy, where long-term financing matches permanent net current assets
• Aggressive policy, where 30% of permanent net current assets are funded by short-
term financing
• Conservative policy, where only 40% of fluctuating net current assets are funded by
short-term financing.
(6 marks)

(b) Discuss the advantages and disadvantages of an aggressive financing policy and advise
whether or not such a policy would be appropriate for MNO’s business.
(4 marks)

Question 2 (18 marks – Approximately 32 minutes)

The Board have requested you to write a report to:

(a) Advise and recommend whether HPC should consider changing the treasury function structure?
(8 marks)
(b) Advise whether HPC is eligible to be listed on the Main Board of the Stock Exchange of Hong
Kong and if it can pass any of the three financial listing tests.
(10 marks)

Module B (Dec 2020 Session) – Mock Page 2 ©Kaplan Financial 2020

Question 3 (15 marks – Approximately 27 minutes)

(a) Explain what two actions at the recent golf club dinner appears to be in conflict with fundamental
ethical principles.
(2 marks)

(b) Environmental, Social and Governance (ESG) reports allow companies to demonstrate how well
they perform with regard to various corporate social responsibility (CSR) aspects. Identify and
discuss FIVE relevant CSR aspects HPC should report? (TWO environmental responsibilities
and THREE social responsibilities).
(5 marks)

(c) Identify and discuss the internal transfer prices at which FSL should offer to transfer special
ingredient Z to the MNO Division in order that group profit maximising decisions may be taken
in each of the following situations:

(i) FSL has an external market for all its production of special ingredient Z at a selling price
of $15 per kg. Internal transfers to the MNO Division would enable $1.50 per kg of variable
packing cost to be avoided.

(ii) Conditions are as per (i) but FSL has production capacity for 3,000kg of special ingredient
Z for which no external market is available.

(iii) Conditions are as per (ii) but FSL has an alternative use for some of its spare production
capacity. This alternative use is equivalent to 2,000kg of special ingredient Z and would
earn a contribution of $6,000.
(8 marks)

* * END OF SECTION A * *
(QUESTIONS)

Module B (Dec 2020 Session) – Mock Page 3 ©Kaplan Financial 2020

SECTION B - ESSAY / SHORT QUESTIONS (Total: 50 marks)

Answer ALL of the following questions. Marks will be awarded for logical argumentation and appropriate
presentation of the answers.

Question 4 (18 marks – approximately 32 minutes)

Ramon Silva is a Thai property developer, who has made a considerable fortune from the increasing
numbers of investors looking to buy new homes and apartments in the coastal regions of Thailand. His
frequent contact with property buyers has made him aware of their need for low cost hotel accommodation
during the lengthy period between finding a property to buy and when they actually move into their new
home. These would-be property owners are looking for inexpensive hotels in the same locations as tourists
looking for cheap holiday accommodation.

Closer investigation of the market for inexpensive or budget hotel accommodation has convinced Ramon of
the opportunity to offer value for money to his potential customers. He has the advantage of having no
preconceived idea of what his chain of hotels might look like. The overall picture for the budget hotel industry
is not encouraging with the industry suffering from low growth and consequent overcapacity. There are two
distinct market segments in the budget hotel industry; firstly, no-star and one-star hotels, whose average
price per room is between 30 and 45 US dollars. Customers are simply attracted by the low price. The
second segment is the service provided by two-star hotels with an average price of 100 US dollars a night.
These more expensive hotels attract customers by offering a better sleeping environment than the no-star
and one-star hotels. Customers therefore have to choose between low prices and getting a poor night’s
sleep owing to noise and inferior beds or paying more for an untroubled night’s sleep. Ramon quickly
deduced that a hotel chain that can offer a better price/quality combination could be a winner.

The two-star hotels typically offer a full range of services including restaurants, bars and lounges, all of which
are costly to operate. The low price budget hotels offer simple overnight accommodation with cheaply
furnished rooms and staffed by part-time receptionists. Ramon is convinced that considerable cost savings
are available through better room design, construction and furniture and a more effective use of hotel staff.
He feels that through offering hotel franchises under the ‘La Familia Amable’ (‘The Friendly Family’) group
name, he could recruit husband and wife teams to own and operate them. The couples, with suitable training,
could offer most of the services provided in a two-star hotel, and create a friendly, family atmosphere – hence
the company name. He is sure he can offer the customer two-star hotel value at budget prices. He is
confident that the value-for-money option he offers would need little marketing promotion to launch it and
achieve rapid growth.

Required:
(a) Using Porters Value Chain, show how the hotel service primary and support activities can
add value to the customer’s experience.
(12 marks)

(b) What are the advantages and disadvantages of using franchising to develop La Familia
Amable budget hotel chain?
(6 marks)

Module B (Dec 2020 Session) – Mock Page 4 ©Kaplan Financial 2020

Question 5 (15 marks – approximately 27 minutes)
The finance director of Kulpar plc is concerned about the impact of capital structure on the company's value,
and wishes to investigate the effect of different capital structures.

He is aware that as gearing increases the required return on equity will also increase, and the company's
interest cover is likely to decrease. A decrease in interest cover could lead to a change in the company's
credit rating by the leading rating agencies. He has been informed that the following changes are likely:

Interest cover Credit rating Cost of long term debt

More than 6.5 AA 8.0%
4.0 - 6.5 A 9.0%
1.5 - 4.0 BB 11.0%

The company is currently rated A.

Summarised financial data: $ million

Net operating income 110.0
Depreciation 20.0
Earnings before interest and tax 90.0
Interest 22.0
Taxable income 68.0
Tax (30%) 20.4
Net income 47.6

Capital spending 20.0

Market value of equity is $458 million, and of debt $305 million.

Kulpar's equity beta is 1.4. The risk free rate is 5.5% and the market return 14%. Profits tax rate is at 30%.

The company's growth rate in free cash flow may be assumed to be constant and to be unaffected by any
change in capital structure.

Required:
Determine the likely effect on the company's cost of capital and enterprise value if the company's
capital structure was:
(i) 80% equity, 20% debt by market values;
(ii) 40% equity, 60% debt by market values.
Recommend which capital structure should be selected.
Assume any change in capital structure would be achieved by borrowing to repurchase existing equity, or by
issuing additional equity to redeem existing debt as appropriate.
(15 marks)

Module B (Dec 2020 Session) – Mock Page 5 ©Kaplan Financial 2020

Question 6 (17 marks – approximately 31 minutes)
Three years ago, the Dryden Co built a factory in its home country costing $3.2 million. To finance the
construction of the factory, Dryden Co issued peso-denominated bonds in a foreign country whose currency
is the peso. Interest rates at the time in the foreign country were historically low. The foreign bond issue
raised 16 million pesos and the exchange rate at the time was 5.00 pesos/$.

Each foreign bond has a par value of 500 pesos and pays interest in pesos at the end of each year of 6.1%.
The bonds will be redeemed in five years’ time at par. The current cost of debt of peso-denominated bonds
of similar risk is 7%.

The spot exchange rate is 6.00 pesos/$ and the 12-month forward exchange rate is 6.07 pesos/$. Dryden
Co can borrow money on a short-term basis at 4% per year in its home currency and it can deposit money
at 5% per year in the foreign country where the foreign bonds were issued. Taxation may be ignored in all
calculation parts of this question.

Required:

(a) Briefly explain the reasons why a company may choose to finance a new investment by an
issue of debt finance.
(7 marks)

(b) Calculate the current total market value (in pesos) of the foreign bonds used to finance the
building of the new factory.
(4 marks)

(c) Assume that Dryden Co has surplus cash at the present time:

(i) Explain and illustrate how a money market hedge could protect Dryden Co against
exchange rate risk in relation to the dollar cost of the interest payment to be made in
one year’s time on its foreign bonds.
(4 marks)

(ii) Compare the relative outcomes of a money market hedge and a forward market hedge.
(2 marks)

* * END OF SECTION B * *
(QUESTIONS)

* * END OF EXAMINATION PAPER * *

Module B (Dec 2020 Session) – Mock Page 6 ©Kaplan Financial 2020