SECTION A – CASE QUESTIONS (Total: 50 marks)

Answer 1(a)

Wellgas’ strategy is to transform a fill-the-petrol tank routine into a delightful shopping

experience for service-oriented customers who are ready to pay above the average price
fuel. It aims to differentiate itself from other competitors in the marketplace.

The focus of the balanced scorecard is on the measures of process improvement, quality
of service, market share target and financial success through service differentiation. The
scorecard mainly monitors the service differentiation strategy implementation.

The scorecard seems to show Wellgas is doing a good job with this strategy. Apart from
market share target missing, it has achieved most of the other targets from different
perspectives.

From Financial perspective, in order to increase shareholder value, Wellgas’ operating

profit changes from price recovery and profit changes from growth have over achieved its
target performance. From Internal business process perspective, in order to improve
service delivery, Wellgas has over achieved its target quality index. Wellgas achieved
95% of refinery processes with advanced controls which means Wellgas has increased
refinery process capability and over achieved its target 89% which demonstrates Wellgas
has done a good job from learning and growth perspective.

Since Wellgas is focusing on a specific target market within the whole market, the slight
miss on the overall market share may not be that important.

Answer 1(b)

The following learning and growth perspective measures could enhance the
implementation and management of Wellgas’ strategy:

(i) Increase motivation, empowerment, and alignment such as the number of

suggestions per employee, number of suggestions implemented per employee,
employee turnover and employee satisfaction.

(ii) Increase employee capability measures like hours of in-house training per employee
and percentage of job requirements fulfilled.

(iii) Increasing information systems capabilities means providing more accurate and
timely information to employees to allow them to improve processes and to effectively
execute new processes such as the measurement of the percentage of customer
facing employees with on-line access to customer and service information.

(iv) Increase research and development, provide more advance technology to employees
to assist them to improve the processes.

Module B (December 2016 Session) Page 1 of 12

Answer 1(c)

Wellgas’ strategy is to focus on the service-oriented target market, not on the broad
market. Hence, it should measure its market share of the service-oriented target market
only, in order to reflect how well it has done.

Although Wellgas has failed the customer objectives in its balanced scorecard, Wellgas
has managed to achieve all its financial objectives. The reasons for Wellgas to fail their
customer objectives may be due to the limitation of the current balanced scorecard
mentioned above. Other reasons may be due to Wellgas has not put sufficient focus on
their customer services, the quality of their products is unable to meet customers’
expectation or its failure in marketing strategy etc. However, Wellgas might have adopted
a more responsible and discipline financial management strategy such as cost control,
good pricing to secure their gross margin, as a result Wellgas has increased their
shareholder value accordingly.

A customer satisfaction survey may also help with the results received. The number of
customer complaints, percentage of customers retained from last month, amount of new
customer data would all help in the balanced scorecard to understand the customer’s
perspective.

Answer 1(d)

Wellgas should put more measures on the scorecard to determine the linkage between the
internal business process and customer perspectives. The existing refinery operations
may not provide good evidence of the linkage.

Instead, some other measures of the petrol station such as the cleaniness of the facility,
turnaround time at the petrol pumps, service provided by the staff could be added to the
scorecard.

Random audits of the facilities could also enhance the retail outlets performance more
accurately.

Module B (December 2016 Session) Page 2 of 12

Answer 2(a)

Common shares: 80 million x HK$64 = HK$5.12 billion

Preferred shares: 20 million x HK $54 = HK$1.08 billion
Debt: $1 billion x 102% = HK$1.02 billion
Value = HK$7.22 billion

Re = 15%
Rp = HK$6 / HK$54 = 11.111%
Rd = 6.33%

WACC = 5.12 / 7.22 x 15% +1.08 / 7.22 x 11.111% + 1.02 / 7.22 x 6.33% x (1 - 15%)
= 13.059%

Answer 2(b)

CF0 = - HK$593 million

CF1= CF2 = + HK$126 million
CF3 = + HK$158 million
CF4 = + HK$158 million + HK$299 million
= + HK$457 million
Discount rate = 13.059% + 3%
= 16.059%
NPV = - HK$37.9 million

Wellgas should not proceed with the project as NPV is negative.

Alternative answer with tax consideration:

CF0 = - HK$593 million
CF1= CF2 = + HK$126 million x (1 – 15%) = + HK$107.1 million
CF3 = + HK$158 million x (1 – 15%) = + HK$134.3 million
CF4 = + HK$158 million x (1 – 15%) + HK$299 million x (1 – 15%)
= + HK$388.5 million
Discount rate = 13.059% + 3%
= 16.059%
NPV = - HK$121.2 million

Wellgas should not proceed with the project as NPV is negative.

Module B (December 2016 Session) Page 3 of 12

Answer 2(c)

For environmental responsibilities

Set stringent environmental targets and measure and report the performance against them
as the environmental regulations and the cost for non-compliance have increased
significantly.

The Shenzhen unit needs to report on its environmental performance as part of its social
responsibility disclosures since the successful treatment of environmental concerns is a
significant competitive advantage.

Make environment performance a line item on every employee’s appraisal report card as
the management needs fundamental inputs and causes to make sure environmental costs
are under control.

For ethical responsibilities

Codes of business conduct should be circulated to signal appropriate and inappropriate

individual behaviour. This will create strong customer and employee loyalty and thus help
the company to enjoy better than average financial performance.

The top management should communicate the absolute need for all staff to behave
ethically at all times, even at the expense of business opportunities, if the firm has a long
time vision in business performance.

Emphasise ethical behaviour through the routine evaluation and education of employees
against a business code of ethics with regard to what is right or wrong in the work
environment and to help them to choose what is right.

Answer 3(a)

Kowloon Gas

2014 Turnover = HK$2,800 / $2,160 Margin = HK$880 / $2,800 ROI = 0.407

= 1.296x = 0.314
Alternative answer using total assets to calculate Turnover:
2014 Turnover = HK$2,800 / $2,460 Margin = HK$880 / $2,800 ROI = 0.357
= 1.138x = 0.314

2015 Turnover = HK$2,120 / $2,140 Margin = HK$315 / $2,120 ROI = 0.147

= 0.991x = 0.149
Alternative answer using total assets to calculate Turnover:
2015 Turnover = HK$2,120 / $2,453 Margin = HK$315 / $2,120 ROI = 0.129
= 0.864x = 0.149

Module B (December 2016 Session) Page 4 of 12

Island Gas

2014 Turnover = HK$1,400 / $760 Margin = HK$304 / $1,400 ROI = 0.400

= 1.84x = 0.217
Alternative answer using total assets to calculate Turnover:
2014 Turnover = HK$1,400 / $993 Margin = HK$304 / $1,400 ROI = 0.306
= 1.410x = 0.217

2015 Turnover = HK$2,350 / $1,130 Margin = HK$503 / $2,350 ROI = 0.445

= 2.08x = 0.214
Alternative answer using total assets to calculate Turnover:
2015 Turnover = HK$2,350 / $1,393 Margin = HK$503 / $2,350 ROI = 0.361
= 1.687x = 0.214

Kowloon Gas’s ROI dropped substantially in 2015 as a result of a big decline in its
operating margin. ROI for Island Gas increased slightly in 2015 due to an improving
asset turnover compared with 2014.

Answer 3(b)

Issac is a better candidate than Kester for the CEO position of Wellgas. Both firms are in
the same industry.

The ROI of Island Gas is improving while that of Kowloon Gas is dropping in 2015.

Market research has given Island Gas the top ranking versus the declining ranking of
Kowloon Gas.

The customer feedback survey for Kowloon Gas is poor.

Answer 3(c)

The controllable principle is that Kester should only be held accountable for costs over
which he has some influence. From a motivation point of view, this is important because
it can be very demoralising for Kester who may feel that his performance is being judged
on the basis of elements where he has no control, such as the marketing cost decided by
head office.

The investment decisions of firms tend to have a long term impact, yet in the short term
they could affect the ROI due to the higher depreciation expense, everything being equal.
The continuous replacement of long term productive assets is important to keep a
business sustainable.

As a result, Kester has made a good point and the CEO selection committee of Wellgas
should take that into account in its decision making.

* * * END OF SECTION A * * *

Module B (December 2016 Session) Page 5 of 12

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

Answer 4

(a) To: Mr Chow, CEO

From: Mr Leo Li, Financial Controller
Date: XXX
Subject: Foreign currency risks

You asked me to provide recommendations about the company’s foreign currency

risks. The following are my recommendations:

The mechanisms of a currency option, future and natural hedge

Currency options: right of an option holder to buy (call) or sell (put) foreign currency in
exchange for another at a specific exchange rate on or before a specified future expiry
date. The purchase price for an option is called the option premium.

Currency futures: standardised exchanged traded contracts to buy or sell a specific

quantity of foreign currency, for settlement at a future date. The prices at which
futures are bought and sold are determined by the market (supply and demand) and
interest rate differentials.

Natural hedge: involves matching receipts and payments or assets and liabilities of a
foreign currency.

(b) Yen hedging strategies

(i) If the investment does not proceed and for each quarter

Options: as the direction of the Yen is unclear and the company has a net inflow of
Yen, it is worthwhile to consider buying a 12 month Yen put option or buy USD call
option on the net amount of revenue and expenses, say 120. If the Yen
depreciates to below 120, exercise the option. Otherwise, let it lapse and take
advantage of the strengthening of yen. An option premium is needed. The
frequency of hedging depends on the volatility of the Yen and management’s
discretion.

A natural hedge does not apply in this case because there is only a net inflow of
Yen.

Module B (December 2016 Session) Page 6 of 12

 (ii) If the investment proceeds

For the first quarter 2017:

Options: the company can buy a 3 month Yen call option or buy USD put option at
the exercise price at say, 110 since the overall amount of USD40 million is larger
than the annual net inflow of USD(20.5 - 0.5) million = USD20.0 million, the
company would like to be protected when the Yen appreciates. The company will
also have to pay an option premium so it has to be taken into consideration.
When the Yen appreciates above the exercise price, exercise the option,
otherwise let it lapse to enjoy the savings from the Yen’s depreciation.

For the second quarter and afterwards, use a strategy similar to the scenario if the
investment does not proceed.

Natural hedge

Alternatively, the company can borrow Yen equivalent to USD40 million, repayable
in two years time, using the net operating inflow to pay off the loan. No exchange
gain or loss will result.

(c) In this case, the company may want to negotiate with its suppliers in the PRC and
customers in Yen to use USD as the settlement currency. This may affect the
company’s competitiveness if its competitors do not follow this strategy.

If you have any questions, please let me know.

Answer 5(a)

Total number of shares before rights issue 1,000,000

Subscription price HK$50
Current share price HK$100
A’s ownership (%) 60%
Independent third parties’ ownership (%) 40%
A’s share before issue 600,000
Independent third parties’ share before issue 400,000
Amount of financing needed HK$12,000,000
No. of new shares to be issued 240,000
Total number of shares after rights issue with full subscription 1,240,000
A’s entitlement under rights issue 144,000
Independent third parties’ entitlement under rights issue 96,000

Module B (December 2016 Session) Page 7 of 12

Total amount of money A needs to fully subscribe
= no. of shares A is entitled to subscribe x subscription price
= 144,000 x HK$50
= HK$7,200,000

Answer 5(b)

Subscription ratio = 4.1667 rights to subscribe to one new share

= 1,000,000 / 240,000
Theoretical ex-right price = HK$90.3226 (4.1667 x 100 + 50) / (4.1667+1)
Value of one rights = HK$9.6774 100 - 90.3226

Shareholders’ wealth:
- before rights issue = 416.67 (no. of shares x share price)
= 4.1667 x 100
- after rights issue and sell = 416.67 (no. of shares w/o subscription x
the rights (no subscription) ex-right price) + proceeds from
selling rights
4.1667 x 90.3226 + 4.1667 x 9.6774
- after rights issue and full = 416.67 (no. of shares including subscription
subscription x ex-right price) - exercise price
(4.1667 + 1) x 90.3226 - 50

As the existing shareholders’ wealth is not affected by subscription, therefore the discount
on the exercise price is irrelevant. In other words, the shareholders’ wealth does not
benefit from the deep discount of the subscription price.

Answer 5(c)(i)

If Mr. A does not subscribe at all:

A’s ownership percentage = 48.39% original no. of shares / total number
after rights issue of shares after rights issue
600,000 / 1,240,000

If Mr. A would like to retain control, he has to have at least 51%. If he does not subscribe
at all, he will lose control of his company.

Module B (December 2016 Session) Page 8 of 12

Answer 5(c)(ii)

No. of new shares needed by = 632,400 0.51 x total number of shares after
him rights issue = 0.51 x 1,240,000
Additional shares needed : = 32,400 632,400 - 600,000
Additional money needed: = HK$1,620,000 additional shares x subscription
price
32,400 x HK$50

Answer 5(c)(iii)

Strategy

Mr. A can exercise some rights to obtain the necessary number of shares, financed
partially by selling the remaining rights.

Total rights entitlement = 600,000

(1 share 1 rights)
Total rights needed = 135,000 no. of shares needed to subscribe x
subscription ratio = 32400 x 4.1667
No. of rights that can be sold = 465,000 600,000 - 135,000
Proceeds from selling the = HK$4,500,000 465,000 x 9.6774
rights
Net cash inflow to him HK$2,880,000 proceeds from selling unneeded
rights - subscription money
= 4,500,000 - 1,620,000

To ensure 51% ownership

Ownership using this strategy:

New shares subscribed = 32,400

Original number of shares = 600,000
Total shareholding after rights = 632,400
issue
Ownership % = 51%

Advice to Mr. A

He has to subscribe 32,400 shares using 135,000 rights in order to maintain a 51%
ownership and hence control and sell the 465,000 rights from the 600,000 rights received
and cashing about HK$2.88 million net inflow.

Module B (December 2016 Session) Page 9 of 12

Answer 6(a)(i)

CS Limited QM Limited

No. of shares 100,000 100,000

Price per share HK$2.5 HK$1
Profit after tax HK$10,000 HK$10,000
EPS HK$0.1 HK$0.1
PE ratio 25 10

Market value HK$250,000 HK$100,000

Cash paid per share HK$0.5
Exchange ratio 5 CS share price / share
component of consideration
= 2.5 / 0.5

share component x no. of QM

New CS shares issued (N) 20,000
shares / CS share price
After acquisition: = 0.5 x 100,000 / 2.5
Total no. of CS shares 120,000 = 100,000 + 20,000

Total value of the combined group transferred to QM’s shareholders:

= N x market value of the combined group / (O + N)
= 20,000 x (250,000 + 100,000) / 120,000
= 58,333

N: new CS shares issued to QM shareholders O: existing CS shares

N = 20,000
O = 100,000

Answer 6(a)(ii)

Total consideration = cash price per share x no. of QM shares + total value of the
combined group transferred to QM’s shareholders
= 0.5 x 100,000 + 58,333
= 108,333.33

Module B (December 2016 Session) Page 10 of 12

Premium = total consideration paid - value of QM before acquisition
= HK$108,333 - HK$100,000
= HK$8,333.33

Answer 6(b)(i)

EPS after acquisition = total profit of the combined group / total no. of CS shares
after acquisition
= (10,000 + 10,000) / 120,000
= HK$0.167

Answer 6(b)(ii)

The EPS of the CS combined group after acquisition is $0.167, higher than that before the
acquisition of 10,000 / 100,000 = HK$0.1. This looks great at first sight as the EPS is 67%
higher. In fact, if this were an all cash deal, the EPS would have been even higher
i.e. 20,000 / 100,000 = HK$0.2.

In terms of shareholder value, the PE of CS before the acquisition is 2.5 / 0.1 = 25. If the
market still gives a PE of 25 to the combined group, the share price should be 25 x 0.167
= HK$4.18, up from HK$2.5 pre-acquisition.

However, the market should not be fooled by this dubious EPS growth from acquisition.
This is because there is no synergy and the increase in EPS is purely a numerical illusion.
The deal does not generate any value for the CS shareholders and its share price should
remain at (250,000 - 50,000 + 100,000) / 120,000 = HK$2.5. This implies the PE ratio of
the combined group is reduced to 2.5 / 0.167= 14.97.

Answer 6(c)

Revenue synergy: arises from increased market power, marketing synergies and strategic
synergies. Revenue synergy is more difficult to estimate and materialise.

Cost synergy: arises from economies of scale and elimination of overlapping capacity or
operation resources. Cost synergy is easier to estimate and materialise.

Financial synergy – diversification: acquisition by a private or closely held firm can help
owners diversify their holdings, therefore creating value. This is because owners of such
private or closely held firms cannot easily diversify the investments themselves since such
firms cannot be easily bought or sold.

Module B (December 2016 Session) Page 11 of 12

Financial synergy – cash slack: cash rich firms can acquire firms with good projects but
with insufficient capital to invest, therefore creating value for the combined firm. The
reverse is also true.

Financial synergy – tax benefits: combined firms can take advantage of tax benefits that
otherwise individual firms cannot enjoy. One such example is tax loss.

Financial synergy – debt capacity: diversification can help reduce the business risk of the
combined firms, hence providing more stable earnings. This may result in lower interest
costs or even higher borrowing capacity.

* * * END OF EXAMINATION PAPER * * *

Module B (December 2016 Session) Page 12 of 12