HKICPA Qualification Programme

Module 12
Business Finance

December 2021
Final Mock
Questions

Time Allowed 3 Hours

Examination Assessment Allocation

Section A – Case Questions 50 marks All FOUR questions are compulsory

Section B – Essay / Short Questions 50 marks All THREE questions are compulsory
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 Module 12 – Business Finance

This examination is divided into TWO sections.

• Section A (50%). This consists of FOUR compulsory case questions. You should allocate
approximately 1 hour and 30 minutes in total for Section A.

• Section B (50%). This consists of THREE compulsory essay / short questions. You should
allocate approximately 1 hour and 30 minutes in total for Section B.

Suggested time allocation (by marks):

Marks Approximate time in minutes

1 2
2 3
3 5
4 7
5 9
6 11
7 13
8 14
9 16
10 18
11 20
12 22
13 23
14 25
15 27
16 29
17 31
18 32
19 34
20 36
SECTION A – CASE QUESTIONS (Total: 50 marks)

Answer ALL of the following questions. Marks will be awarded for logical argumentation/ calculation and
appropriate presentation of the answers.
CASE
Sam and Annabelle Choi own and manage the firm Hair Care Ltd (“HCL”) based in Hong Kong. The firm
was formed in 2002 when Sam and his wife re-mortgaged their house in Pok Fu Lam and borrowed heavily
from the bank to buy out the company from a conglomerate organisation who were disposing of non-core
businesses. Sam had been a senior salesman with the hair-care subsidiary of the conglomerate. This
subsidiary bought hair care products, mainly small value items and consumables – scissors, brushes,
combs, hair nets, curlers and hair driers, from manufacturers and resold them to wholesalers and large
retail chemist chains within Hong Kong and Macao, mainly for use in hairdressing salons. The new
business has continued in this direction.
Main
Currency 2021 2002
Purchases from Asia
(mainly China, Vietnam and Thailand) US$ 66% 93%
Purchases from mainland Europe
(mainly Italy and Germany) Euro 29% 3%
Purchases from Australia A$ 5% 4%

The company has met with success very quickly and the initial loans have already been repaid ahead of
schedule. The company now owns the freehold of a large warehouse/distribution centre, which is five times
the size of the original depot, leased when the company first started trading five years ago. Sales revenue,
now in excess of $5 million, has increased by more than 50% each year and shows little signs of slowing
down. Despite this apparent rapid growth HCL only accounts for about half of the current market, leaving
some potential for growth. The company is run cost effectively, with minimum staffing. Sam, as Managing
Director is solely concerned with the marketing side of the business. He spends most of his time in the
selling role and in customer care, which he rates as a major contributor to the company’s success. The only
other key manager is his wife who is responsible for managing the warehouse staff, arranging distribution,
general administration and financial management. The company started with six employees, in addition to
Sam and Annabelle, and now has 15. Staff rarely leave the company. The staff is almost entirely employed
in the distribution and packaging function, although there are two other sales people apart from Sam, but
they only deal with the smaller buyers. With the continued growth in sales revenue it is inevitable that the
number of employees will have to increase. It is expected that there will have to be a total of about 30 staff,
all non-managerial, in two years if sales continue to increase at the current rate.

The success of HCL can be accounted for by a number of factors. Sam is a very good salesman who is
responsible for looking after all the major accounts. He is popular and much of the business is built on his
personal relationship with the key clients. There is a considerable amount of customer loyalty which is
mainly attributable to Sam, and both he and his wife are always accessible to customers and they go out of
their way to provide a first class service. Even on vacation the two owners are in daily contact with the
office. The company has been able to manage its purchases wisely. Most of the products, being purchased
abroad, require payment in a foreign currency. Hair Care has been able to benefit from the relative
weakness of the euro against the Hong Kong dollar for its European supplies.

Likewise, the strength of Hong Kong dollar has enabled Hair Care Pty Ltd to negotiate lower purchasing
prices with Asian suppliers. However, it is questionable as to how long this situation concerning foreign
exchange can be held.

Sam has also developed strong links with his suppliers and he has, until recently, attempted to trade with
only a few so that his lines of communication and control are kept as simple as possible. Most of his current
suppliers have been with him since the start of the company in 2002. This has provided the company with
reliable and good quality products. In fact, HCL often has exclusive access to certain products. For
example it has the sole rights to distribute an Italian hair-dryer which is generally recognised to be the best
on the market. This product strength has enabled the company to build on the customer loyalty. However, it
is inevitable that as demand has increased, existing suppliers have not been able to keep up with the
necessary volumes and Sam has had to look for, and buy from new manufacturers.

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The company has benefited from a period of relatively steady growth in the economy and even in the
current economic downturn Sam has argued that demand for hair care products is usually recession-proof.
Furthermore, HCL has currently no near competitors.

Many of the small competitors in the wholesale market-place have chosen to concentrate on other areas of
the hair care business – salon furnishings and the supply of cheap, low value items such as towels, razors
etc, leaving much of this basic business (sales of other relatively low-value and mainly disposable products)
to Sam’s company. Additionally quite a number of the small firms have even left the market. All this has
helped to contribute to the overall growth rate of HCL. There are some major international companies who
make shampoos, conditioners and other cosmetic type products who also buy-in consumer hairdressing
products such as the ones sold by HCL. They then sell these mainly to the retail trade for domestic use by
consumers and not directly to the hairdressing salons as does HCL. Furthermore these are large
companies and Sam believes that they do not currently see his company as a major threat.

The company has registered a brand name for its main products, which it re-packages, rather than using
the individual brands of the original manufacturers. This has enabled HCL to generate even greater loyalty
from its customers and often to obtain a price premium from these products.

Sam believes that part of the company’s success stems from the fact that he has an organisation with
minimal administrative overheads. He outsources all of his products, adding value mainly through branding
and the maintenance of customer care. He believes that strategy is not mainly about beating the
competition but in serving the real needs of the customer. The company has also been able to develop a
strong relationship with Hong Kong’s leading retail chemist chain, providing it with good quality, low-cost
disposable products such as hair nets and brushes to be sold under an own-brand label. Although the
margins are inevitably small, the volumes involved more than compensate for this.

The company has had to incur increased investment as a result of the large growth in sales revenue. The
building of the warehouse, the increased inventory-holding costs, capital expenditure on items such as
computing systems, fork-lift trucks and automated inventory control and retrieval systems could not be
financed out of current earnings, but the company’s bank was only too ready to lend the company the
necessary money considering that the original loan had been repaid ahead of schedule.

Sam is contemplating further investment by purchasing a re-branding machine for $280,000 which will be
used to produce 50,000 units of HCL plastic logo stamps per annum for five years. The machine will save
Sam having to pay $10 per stamp. However, each stamp has a unit variable cost of $6 and also requires
incremental fixed costs of $70,000 per annum for production costs and $25,000 per annum for other
overheads. Hair Care’s future cost of capital is estimated to be around 10% per annum after restructuring.

Table 1: Details of Performance of Hair Care Ltd: 2019–2022

(unless otherwise stated, figures are in US$’000)

2019 2020 2021 2022

(forecast)
$’000 $’000 $’000 $’000

Sales 2,300 3,500 5,010 7,500

Cost of Sales 1,450 2,380 3,507 5,250
Marketing Costs 200 250 290 350
Distribution Costs 300 400 430 500
Administration 50 55 80 120
Interest Payments 0 80 220 700
Net Profit 300 335 483 580
Loans 0 850 2,400 5,000
Number of suppliers (actual) 15 20 30 50
Range of products (actual) 35 85 110 130
Total staff including Sam and Annabelle 12 14 15 23
Inventory 230 400 700 1,400
Non-current assets 500 1,500 2,700 6,300

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Question 1 (14 marks – Approximately 25 minutes)

Evaluate the financial performance of Hair Care Ltd and conduct a SWOT analysis. Support the
financial performance evaluation with calculations.

Note: A maximum of 2 marks for communication skill and 2 marks for analytical skill will be awarded.
(14 marks)

Question 2 (10 marks – Approximately 18 minutes)

Acting as a strategic advisor, prepare a report for Sam identifying and assessing strategic choices
which he could consider in attempting to further the company’s development.
(10 marks)

Question 3 (16 marks – Approximately 29 minutes)

(a) Sam currently appears to have a successful formula for growth. Using the concept of the
value chain, demonstrate how he has been able to achieve this success.
(7 marks)

(b) By how many units must the estimate of production of stamps fall for Sam’s re-branding
machine to be regarded as not worthwhile financially?
(5 marks)

(c) Sam needs to make a number of estimations of the variables in the re-branding machine
project. In practise, some variables can affect the NPV more than the others. Explain one
method which can help Sam identify such key variables. Calculation is not required.
(4 marks)

Question 4 (10 marks – Approximately 18 minutes)

(a) Sam seems pre-occupied with growth. Identify reasons for potential business failure and
suggest ways that Sam could avoid them in the context of the case study scenario.
(6 marks)

(b) Based on MM theory with taxes and without taxes, and also the pecking order theory,
should Sam spend time on capital structure analysis?
(4 marks)

* * END OF SECTION A * *
(QUESTIONS)

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SECTION B - ESSAY / SHORT QUESTIONS (Total: 50 marks)
Answer ALL of the following questions. Marks will be awarded for logical argumentation/
calculation and appropriate presentation of the answers.

Question 5 (18 marks – approximately 32 minutes)

Prosper plc, a listed company on the Hong Kong Exchange is preparing a cash flow forecast for the three-
month period from January to the end of March. The following sales volumes have been forecast:
December January February March April
Sales (units) 1,200 1,250 1,300 1,400 1,500
Other information is as follows:
1. The selling price per unit is $800 and a selling price increase of 5% will occur in February. Sales
are all on one month’s credit.
2. Production of goods for sale takes place one month before sales.
3. Each unit produced requires two units of raw materials, costing $200 per unit. No raw materials
inventory is held. Raw material purchases are on one months’ credit.
4. Variable overheads and wages equal to $100 per unit are incurred during production, and paid in
the month of production.
5. The opening cash balance at 1 January is expected to be $40,000.
6. A long-term loan of $300,000 will be received at the beginning of March.
7. A machine costing $400,000 will be purchased for cash in March.

Prosper plc’s Annual Report extract

The following information is being considered for publication in the Prosper plc’s year-end 2021 annual
report.
Basic Outstanding
Board of directors: Salary share
$000’s options
Chairman and Chief Executive: HA Mefftord 210,000 500,000
Finance director: Mrs FM Barnfield CPA 120,000 100,000
Production director: Mr Choy 85,000 100,000
Other executive directors: Mr S Chan 75,000 50,000
PT Figler 80,000 50,000
Mrs Choi 100,000 100,000
Independent Non-exec directors: Dr P Dorecton 20,000 60,000
Mrs BD Mefftord 25,000 100,000

The agenda of a board meeting for Prosper plc is as follows:

- Apologies for absence
- Minutes of the last meeting and matters arising from the last meeting
- Proposed investment in Europe
- Consideration of the remuneration of board members 2022 / 2023
- Proposal for the formation of an audit committee, with Mrs FM Barnfield, PT Figler and Dr P Dorecton as
nominated committee members
- Any other business.

Required:
(a) Calculate the cash balance at the end of each month in the three-month period.
(6 marks)
(b) Calculate the forecast current ratio at the end of the three-month period.
(3 marks)
(c) Discuss what actions Prosper plc’s board of directors would need to take if it wished to
comply with the various requirements of Corporate Governance.
(9 marks)

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Question 6 (20 marks – Approximately 36 minutes)

BDJR Computers Global is a company that manufactures a range of personal computers that are sold to
retailers, and also directly to individuals and businesses through online sales.

Due to a number of technical problems the company’s sales have fallen significantly over the last year
resulting in an operating loss of $160,000. The company has, as a result, built up losses on its retained
earnings and there is a significant risk of insolvency. To avoid this, the company’s financial advisers have
proposed a scheme of reconstruction.

Statement of financial position as at 31 December 2021

Assets $000 $000
Non-current assets 1,100
Current assets
Inventory 410
Receivables 220
Cash 25
–––––
Net Current Assets 655
–––––
Total Assets 1,755
–––––
Equity and Liabilities
Share Capital (200,000 shares) 200
Retained Earnings (50)
–––––
Total Equity 150
Non-current liabilities – Bank loan 1,200
Current liabilities
Trade Payables 205
Overdraft 200
–––––
405
–––––
Total Equity and Liabilities 1,755
–––––
Notes:
(1) If the company was liquidated all of the assets could be sold for their book values except for
inventory. Following a review it was discovered that $220k of the inventory is obsolete but the
remainder could be sold for book value. In addition $90k of the receivables is irrecoverable.
(2) To be successful a scheme of reconstruction would need to raise $195k of cash to invest in new
manufacturing processes.
(3) The industry average PE ratio is 8 times.
(4) The current interest rates are 8% on the bank loan and 6% on the overdraft. The bank loan is
secured.

The following scheme of reconstruction is proposed:

(1) Goodwin bank (who provide both the overdraft and loan) will convert one third of the bank loan into
a total of 200,000 new shares. The overdraft will remain at $200k.
(2) New finance of $400k will be raised from a venture capital company, PC ventures, who will buy
new shares for $1.25 per share. In addition to investing in the new manufacturing process the
finance will also be used to repay the trade payables in full.
(3) Following the reconstruction it is expected that the company will generate $326k EBIT per annum.
Tax is payable at 28%. Assume no tax losses.

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Required:

(a) Determine how much each creditor will likely receive in the event the company is
immediately liquidated.
(5 marks)
(b) Following the proposed scheme of reconstruction, calculate the expected EPS, and based
on PE ratio advise whether the venture capital company is likely to invest in BDJR
computers.
(5 marks)
(c) Determine whether the existing shareholders, trade payables and the bank, are likely to vote
in favour and accept the scheme of reconstruction.
(10 marks)

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Question 7 (12 marks – approximately 22 minutes)

Rich Broadcasts Company (“RBC” or “the Company”) is an independent TV production company

incorporated and based in Hong Kong. It is listed on the Stock Exchange of Hong Kong. RBC, together with
its subsidiaries as a group (“the Group”), is principally engaged in making TV programme related media
services commissioned by various pay-per-view channels around Asia. RBC was established in 2006 by
two experienced TV programme directors, Mr. Peter Tau and Mr, Kenny Lai, who previously both worked
for TV broadcast companies in Asia. Directors of the Group consider the success in this industry is based
on nurturing creativity, good ideas and good production skills in making TV programmes of good quality. In
addition, the solid personal relationships with key members of staff and the ability to market the programme
ideas to TV broadcasting companies are vital to the success. Success is usually determined by externally
audited audience viewing and rating figures.
RBC earned good reputation last year with several new series of programmes in terms of audience viewing
and rating figures. Nevertheless, the problem now faced by the Group is of the significant level of debt
funding caused by the working capital delay requirements for financing TV programme production
operations and the capital expenditure required for acquiring the advanced programme-production
equipment. Covid-19 has had a devastating effect the economies not only in Asia, but around the world,
reducing consumers disposable income.
Too the top productions (“TTT”)
Eric Lau was employed as the production manager when Peter and Kenny first started the RBC business
back in 2006. His TV programmes have gained many top tv awards in recent years and is very proud of his
staff work and achievements. In 2015 Eric invented the TTT brand for RBC's special line of award winning
TV programmes. Eric Lau feels his skills of TV making are not being financially rewarded. After speaking to
several mangers in the TTT division who feel the same way, Eric has decided to buy-out TTT from the RBC
group. A business valuation expert has valued TTT at HK$350 million and Eric is currently looking at
putting together a finance package for a management buy-out (“MBO”) mainly through borrowing.

Required:

(a) Evaluate the financial and non-financial risks faced by Rich Broadcasts Company (“RBC”).
(6 marks)

(b) What problems are likely to be encountered in assembling a financing package in a

management buy-out of Too the top productions (“TTT”) service based business, as
opposed to a manufacturing company?
(6 marks)

* * END OF SECTION B * *
(QUESTIONS)

* * END OF EXAMINATION PAPER * *

(QUESTIONS)

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