Q1 $m Sales (all on credit) 10.00 Earnings before interest and tax (EBIT) 2.

00 Interst payments for the year 0.50 Shareholders' funds 2.00 (comprising $1m issued share capital, par value $0.25, and $1m revenue reserves) Debtors 0.40 Stock 0.70 Trade creditors 1.50 Bank overdraft 3.00

(a) Working capital = stocks + trade debtors - trade creditors = -0.4 working capital ratio = (stock + trade debtors - trade creditors) / sales = (0.7 + 0.4 - 1.5) / 10 = -0.04 Debtor days = (Debtor balance / Credit Sales) x 365 =(0.4/10)*365 = 14.6 days Stock days = (stock/cost of sales) x 365 = S as cost of sales not provided, it can't be calculated. But I assume it wouldn't be changed by the two proposals. Creditors days = Creditors / Sales x 365 =1.5/10x365 = 54.75 discount scheme:

Proposal by supplier would shorten the creditors days Since working capital cycle = stock days + debtor days - creditors days The supplier proposal will shorten the working capital cycle, suggesting better WC management So, based on this result, the arrangement should be accepted. (b) Assuming the company needs to get overdraft from bank for early payment to obtain the discount from supplier. The discount will give a better EBIT as cost of sales is lowered. Interest from bank overdraft does not affect EBIT Interest expense is larger as a result of larger bank overdraft discount as amount paid = 5/95 = 5.26%

Number of days to be shortened = creditors days - discount period = 54.75-15 = 39.75 days or = 1.325 months annualised saving % is 5.26% x (12/1.325) = 47.67% As such EBIT increase is greater than bank overdraft interset increase So EBIT/Interest would become greater, which suggests better Interest cover. So, based on this result, the arrangement should be accepted. ( c) As analysed above, the earnings effect is greater than the interest payment, i.e. savings from discount would be greater than interset expense In addition, interest from bank overdraft is tax deductible under HK tax laws, The Company will get additional saving from the tax deducted at the corporate tax rate of 16%, provided that the company remains profitable. So Profits after tax will increase, which is good. So, based on this result, the arrangement should be accepted. (d) Earnings per share is defined as (net income / average outstanding shares) It is normally same as (profit after tax / average outstanding shares) From the analysis above, there is positive impact with profit after tax when using the bank overdraft to shorten the repayment days to supplier. There is no change in average outstanding shares given that HK Ltd does not raise funds through issue of equity instead of taking the bank overdraft.

Accordingly, Earnings per share will increase which is good. So, based on this result, the arrangement should be accepted. (e) Return on equity is defind as (net income / common equity) net income is normally the same as profit after tax Similar to (d) above, there should be no change in common equity As net income is increased, ROE will be improvedby making the arrangement However, it is noteworthy that ROE does not have information about the gearing ratio as equity does not necessarily mean the total funds of the company ROE can be boosted if the Company raise a lot of debt to carry on its business Whenever the yield on the borrowed fund is greater than the interest rate ROE will be increased. Under these circumstances, given that the saving from repaying faster to supplier will have purchase cost saved more than the interest rate, so ROE of HK Ltd is increased But the impact or pressure to the management may as such be larger, which is not reflected in any financial ratios. If purely talking about better ROE as the acceptance criteria, this arrangement should be accepted.

Conclusion As (a) to (e) above analysed that taking the arrangement will have better ratio, the arrangement should be accepted.

Q2 Jan - Mar Apr - Jun Jul - Sep Oct - Dec Jan-98 Jul-98 Oct-98 Apr-99 Oct-99 Market Risk Premium Apex's equity beta (a) Required return: Kc = Rf + x E(Rp) annualised return 20.00% 18.20% 17.60% 17.20% 19.00% 17.00% 17.00% 16.60% 1998 5% 4.55% 4.40% 4.30% 7.50% 7% 6.75% 6.25% 6.00% 8.50% 1.25 1999 4.75% 4.25% 4.25% 4.15%

1998 Jan - Mar Apr - Jun Jul - Sep Oct - Dec 1999 Jan - Mar Apr - Jun Jul - Sep Oct - Dec

Rf 7.50% 7.50% 7% 6.75% 6.75% 6.25% 6.25% 6.00%

+ + + + + + + + +

beta 1.25 1.25 1.25 1.25 1.25 1.25 1.25 1.25

x x x x x x x x x

Rm 8.50% 8.50% 8.50% 8.50% 8.50% 8.50% 8.50% 8.50%

= = = = = = = = =

Kc 18.13% 18.13% 17.63% 17.38% 17.38% 16.88% 16.88% 16.63%

Accept? NO NO YES YES NO NO NO YES

Acceptance Criteria

It is reasonable that quaterly returns of the Apex shares are annualised by simply multiplying by 4. If the required return given by CAPM than the annualised return, the investor would get more than its required return, and hence the quarterly returns would be accepted.

DISCUSSION ON MY FINDINGS

(Please confirm whether mark will be given on each point below whenever it is not incorrect. The question did not give a scop my discussion. Accordingly, relevance should be judged by context, and there shouldn't be any model answer for grading my 1. If the risk free rate is high, then the required return calculated by CAPM will be high, then the more difficult the quarterly return will be 2. Although Apex recorded highest absolute return during Jan-Mar 1998 (5.00%), my finding show it is less than the accpetance thresh It shows that absolute return may be misleading if the systematic risk of the company has not been considered. 3. My findings is based on an assumption that future return is indicated by historical return. (b) My analysis in part (a) basically can be divided into three parts: 1. calculate using CAPM 2. return might have accepted 3. discuss my findings Each part has potential problems with accuracy for the reasons set forth below.

(Please not that due to the limited marks given, I cannot exhaust all potential problems, I was informed by lecturer that 4-6 cor will be sufficient. But to play safe, I will give 10 points. Similar to my remark above, please confirm whether mark will be given point below whenever it is not incorrect. The question did not give a scope for my discussion. Accordingly, relevance should by context, and there shouldn't be any model answer for grading my works. I should have the freedom to place extra emphas to certain area. As common practice, I further assume that no mark will be deducted for wrong answer.) 1. CAPM assumes the market is efficient, which is in so far no evidence for this 2. CAPM assumes lending and borrowing can take place at risk free rates, this is impossible in the real world 3. CAPM assumes investors are all risk adverse, again this is an idealistic assumption, not every investor is educated for this 4. CAPM assumes all investors are price takers, but in reality large volume can influence stock prices 5. CAPM assumes there is no transaction cost and taxation. If so, there will be no brokers and hence no trades. 6. CAPM assumes that all active and potential shareholders will consider all their assets and optimise one portfolio. This is clearly a pro 7. CAPM assumes that no preference between markets and assets for individual active and potential shareholders, and the active and shareholders choose assets solely as a function of their risk-return profile. However, this cannot be proved. 8. Annual Treasury Bill may not be a good proxy for risk free rate, common practise is to use long term treasury bond yields. 9. Annual market risk premium is normally not constant, so the belief that it is constant is problematic. 10. Part 2 and Part 3 of our analysis is true only if required return of equity is correctly measured by CAPM.

Q3 Annual credit sales cost of sales Current assets inventory accounts receivable two months credit to customers one month credit by suppliers operating cycle Current ratio: Cost of long term finance 3 month 1.4 11% $million 4.2 1.89 Current liabilities accounts payable overdraft with average interset rate 7% p.a.

(a) (i) As confirmed by lecturer, I just need to write 4-6 points for full marks. The question does not give a specific scope, I reasonably assume that marks will given for what is correct and relevant. As normal practice, there should not have mark deduction for irrelevant or incorrect answer. The question does not specifically require a quantitative illustration to support my discussion. Therefore, no marks must be attributed to numerical answer. Factoring The factor offers three ways to assist in the management of accounts receivable: 1. Debt collection and Administration With this form of factoring the factor takes over the whole of the company s sales ledger, issuing invoices and collecting debts. The company is relieved of all the administration associated with debt management and coollection. 2. Financing Provision Using this arrangement the factor will agree to buy the debts from the company, and at the same time will advance up to 80% of their value to the company; the remainder (minus interest) being paid when the debts are collected. In this way, the company is able to improve its cash position immediately. Funds may be advanced to the company prior to the debt being collected. 3. Credit insurance The factor may take the responsibility for bad debt, for this to be the case the factor would dictate to whom the company was able to offer credit to. This is called "without recourse" factoring. The Factor is often more successful at enforcing credit terms leading a lower level of debts outstanding. Factoring is therefore not only a source of short-term finance but also an external means of controlling or reducing the level of debtors. Advantages of factoring: 1. Saving in administration costs. 2. Reduction in the need for management control. 3. Particularly useful for small and fast growing businesses where the credit control department may not be able to keep pace with volume growth. Invoice discounting The way in which invoice discounting can assist in the management of accounts receivable: A service also provided by a factoring company. Selected invoices are used as security against which the company may borrow funds. This is a temporary source of finance repayable when the debt is cleared. The key advantage of invoice discounting is that it is a confidential service, the customer need not know about it. One use for invoice discounting is as a key financing tool for new businesses such as management buyouts (MBOs). The creditworthiness of their customers is probably higher than their own and is utilized to borrow funds. In some ways it is similar to the financing part of the factoring service without control of credit passing to the factor. (source: page 56-57, which is all about factoring and invoice discounting) (a) (ii) Assume the following:

Assume 1 month = 30 days Creditor days = 30 30 = (AP)/4.2 x 365 AP = (30 x 4.2) / 365 = Debtor days = 60

$m 0.34521

60 = (AR)/4.2 x 365 AR = (60 x 4.2) / 365 =

$m 0.69041

Operating cycle = 3 months = 90 days 90 = Stock days + Debtor days - Creditor days 90 = Stock days + 60 - 30 Stock days = 60 days 60 = (inventory)/1.89 x 365 $m inventory = 60 x 1.89 / 365 = 0.31068 current ratio = (current assets)/(current liabilities) 1.4 = (inventory + accounts receivable) / (accounts payable + overdraft) 1.4 = (0.31068+0.69041)/(0.34521+overdraft) $m overdraft = 0.36986 net working capital = current assets - current liabilities =0.69041095890411 + 0.310684931506849 - 0.345205479452055 - 0.36986301369863 $m net working capital = 0.28603 cost of financing current assets = (0.69041+0.36986)*7% $m = 0.07422 (b)

Co = cost per order D = annual demand Ch = cost of holding one unit per year Co = Ch = D= Q= 1200 6 0.5 60000

Number of orders = 50 Total cost of inventory for the raw material = 50*1200*12 = $ 720000 If Ch is changed to $ 2 then using the same formula, Q= 600 < 10000 Therefore, when EOQ is used, bulk purchase is not applicable.