The ideal target for a Leveraged Buyout (LBO) is typically a mature company with stable, predictable cash flows and substantial tangible assets. Statement II is a favourable attribute because the company’s physical assets (vehicles and warehouses) can be used as collateral to secure the large amount of debt required for the acquisition. This provides comfort to lenders. Statement IV is also favourable because a stable, experienced management team that is not close to retirement is essential for managing the company post-buyout and ensuring the business plan is executed effectively to generate cash flow for debt repayment. Conversely, Statement I is unfavourable; heavy reliance on R&D introduces uncertainty and risk, which is unattractive for a debt-heavy capital structure. Statement III is also a negative factor, as significant upcoming capital expenditure would drain cash flow that is critically needed to service the acquisition debt, increasing the risk of default. Therefore, statements II and IV are correct.

In the context of leveraged buyouts (LBOs), management buyouts (MBOs), and management buy-ins (MBIs), the financial structure relies heavily on debt. Therefore, the ideal target company must generate strong, stable, and predictable cash flows to service this debt. A key concern for investors is any factor that could disrupt or divert this cash flow. Significant, near-term capital expenditure (capex) is a major red flag because it consumes cash that would otherwise be used for debt repayment, thereby increasing the investment’s risk profile. Conversely, characteristics that support debt financing and operational monitoring are highly valued. These include substantial tangible assets that can serve as collateral for lenders, and a robust management information system that allows investors to track performance closely and make timely decisions.

This question assesses the understanding of the fundamental principles of conduct for a corporate finance adviser as stipulated in the Corporate Finance Adviser Code of Conduct and the general Code of Conduct for Persons Licensed by or Registered with the SFC.

Statement I is correct. A corporate finance adviser has a duty to act with due skill, care, and diligence (General Principle 2 of the Code of Conduct). This includes conducting thorough due diligence and providing competent advice on matters like valuation and risk assessment.

Statement II is correct. Managing conflicts of interest is a cornerstone of professional conduct (General Principle 6 of the Code of Conduct). If the advisory firm has a relationship that could be perceived as impairing its objectivity (like advising a key supplier), it must disclose this to the client and implement measures to manage the conflict, such as establishing information barriers.

Statement III is incorrect. A corporate finance adviser’s role is to provide professional advice and judgment based on their expertise and the information available. They are not required, nor is it standard practice, to provide financial guarantees on the future success or profitability of a transaction. Doing so would misrepresent the nature of advisory services and create an inappropriate liability.

Statement IV is correct. The duty of confidentiality is a critical professional obligation (General Principle 8 of the Code of Conduct). Advisers handle highly sensitive, non-public information and must have robust controls to protect it from unauthorized disclosure or misuse. Therefore, statements I, II and IV are correct.

Corporate failure is rarely a sudden event; it is typically preceded by a series of warning signals. A prudent corporate finance adviser must be able to identify these signals during due diligence. Statement I, consistent delays in publishing audited accounts, is a major red flag indicating potential accounting irregularities, internal control failures, or a desire to conceal poor performance. Statement II, high turnover of key personnel, especially independent directors, suggests instability, poor governance, and internal conflict, which can cripple a company’s strategic direction and oversight. Statement III, a sudden, high-risk strategic shift into an unfamiliar area funded by debt, often represents a desperate ‘go-for-broke’ gamble by a management team facing underlying business failure. Statement IV, maintaining high dividend payouts despite falling profits and cash flow, is an unsustainable practice that can mask deteriorating financial health. It may be done to appease shareholders in the short term but often drains the company of vital cash needed for operations and investment, accelerating its decline. All four are classic indicators of a company in distress. Therefore, all of the above statements are correct.

According to corporate governance principles, the board of directors has a fiduciary duty to evaluate investment proposals comprehensively. While strong financial returns are a key objective, they are not the sole criterion for decision-making, especially during the initial screening phase. A fundamental first step is to assess the proposal’s strategic ‘fit’—how well the potential acquisition aligns with the company’s long-term strategy, existing operations, and core competencies. Concurrently, the board must conduct a thorough assessment of non-financial risks. These can include geopolitical instability, regulatory hurdles, environmental liabilities, and potential damage to the company’s reputation or brand. Overlooking these qualitative factors in favour of purely financial metrics can expose the company to significant, unforeseen liabilities. The source of a proposal, whether internal or from an external intermediary like an investment bank, does not determine its validity; all proposals should be subject to the same rigorous screening process. The concept of capital expenditure relative to depreciation is more about maintaining the company’s existing capital base through routine investments, rather than a primary criterion for evaluating a major strategic acquisition.

The Accounting Rate of Return (ARR) is a capital budgeting method based on accounting data. Statement I is correct because ARR uses accounting profit, which includes non-cash items like depreciation, and is not based on actual cash flows. This can distort the true economic return. Statement II is correct; this is the most significant weakness of the ARR method. It does not discount future earnings, treating a dollar earned in the final year as having the same value as a dollar earned today, thus ignoring the time value of money. Statement III is also correct. Unlike the simple payback period, which only measures the time to recoup the initial investment, ARR considers the average profits generated over the project’s entire economic life. Statement IV is correct as well. One of the main advantages of ARR is its simplicity. It is easy to calculate from financial statements and the resulting percentage is intuitive for management and other stakeholders to understand. Since all four statements accurately describe characteristics of the ARR method, the correct option includes all of them. Therefore, all of the above statements are correct.

This question assesses the understanding of defensive tactics a target company’s board might employ in a hostile takeover, specifically focusing on what constitutes a ‘frustrating action’ under the Hong Kong Code on Takeovers and Mergers. The Takeovers Code, particularly Rule 21, restricts the board of a target company from taking certain actions without shareholder approval once a genuine offer has been communicated. The core principle is that shareholders, not the board, should decide the outcome of a bid. A ‘frustrating action’ is any action that could effectively block an offer or deny shareholders the chance to consider it on its merits. Actions such as appointing an independent financial adviser to evaluate the offer or communicating the board’s opinion to shareholders are not only permissible but are expected duties. Similarly, attempting to negotiate better terms with the initial bidder or seeking a ‘white knight’ to introduce a superior competing offer are considered legitimate strategies to maximize shareholder value. However, an action that fundamentally alters the company’s assets or financial structure to make it less attractive to the bidder, such as selling a key asset (the ‘crown jewels’), is a classic example of a frustrating action that would require prior approval from shareholders in a general meeting.

This question tests the ability to identify common ‘creative accounting’ techniques used to manipulate financial statements. Statement I is an example of aggressive capitalization, where expenses that should be written off are treated as assets to inflate profits and the balance sheet. Statement II illustrates the manipulation of depreciation schedules; extending an asset’s useful life without proper justification reduces annual expenses and artificially boosts reported income. Statement III describes the improper handling of liabilities; a probable and estimable loss should be recognized as a provision (a liability), and classifying it as a remote contingent liability serves to hide this obligation from the balance sheet. In contrast, Statement IV describes the percentage-of-completion method for recognizing revenue on long-term contracts, which is a standard and accepted practice under Hong Kong Financial Reporting Standards (HKFRS 15) and not a form of creative accounting. Therefore, statements I, II and III are correct.

In Hong Kong, the choice of business structure has significant implications for personal liability. Under the Partnership Ordinance (Cap. 38), a traditional partnership does not have a separate legal personality from its partners. Consequently, partners are subject to joint and several unlimited liability. This means that each partner is individually liable for the full extent of the partnership’s debts and obligations, including those incurred due to the negligence or misconduct of another partner. Creditors can pursue the personal assets of any partner to satisfy the firm’s debts. In contrast, a Limited Liability Partnership (LLP), which is a hybrid structure, offers a degree of protection. While a partner in an LLP remains fully liable for their own wrongful acts or negligence, they are generally not personally liable for the independent professional misconduct of other partners. In that scenario, their liability is typically limited to their capital contribution in the firm. This distinction is a critical factor for professionals in fields like finance and law when deciding on a business structure.

This question assesses the understanding of how different accounting measurement bases for financial assets, specifically fair value versus amortized cost, impact a company’s reported financial statements. Under Hong Kong Financial Reporting Standards (HKFRS), which are converged with International Financial Reporting Standards (IFRS), financial assets can be classified and measured in different ways. Assets held for trading are typically measured at ‘fair value through profit or loss’ (FVTPL), meaning any changes in their market value are immediately recognized in the income statement, leading to earnings volatility. However, under certain conditions (e.g., a change in business model for managing the assets), standards like HKFRS 9 permit reclassification. Reclassifying a financial asset from FVTPL to ‘amortized cost’ means it will no longer be marked-to-market through the income statement. Instead, it is carried at its original cost, adjusted for principal repayments and amortization of any premium or discount, and is subject to impairment testing. The primary effect of this change is to insulate the income statement from market price fluctuations of the asset, thereby smoothing reported earnings. This is a non-cash accounting change, so it does not directly affect operating cash flows. The reclassification does not mandate the sale of the asset, nor does it eliminate the need to test for impairment if there is objective evidence of a credit loss.

Under Hong Kong Financial Reporting Standards (HKFRS), specifically HKAS 16 Property, Plant and Equipment, when an asset comprises significant parts with different useful lives, these parts should be accounted for as separate items. For a property consisting of land and a building, these are treated as separate components. Statement I is correct because land is considered to have an indefinite useful life and is therefore not depreciated. Statement II is correct because a building has a finite useful life, and its cost must be systematically allocated (depreciated) over that period. Statement III is incorrect; the reducing-balance method results in a higher depreciation expense in the early years of an asset’s life and a lower expense in the later years, whereas the straight-line method results in a constant expense each year. Statement IV is incorrect because, as stated, land is not depreciated, so the entire cost cannot be depreciated as a single unit. The cost must be allocated between the land and building components. Therefore, statements I and II are correct.

Statement I is correct. Project sponsors, as the equity participants, bear the highest risk and are responsible for the initial development costs, including feasibility studies, design, and planning. These costs are incurred upfront to prove the project’s viability before senior lenders will commit capital. Statement II is correct. Primary lenders in infrastructure finance take a conservative approach because their repayment source is limited to the project’s future cash flows (i.e., limited or no recourse to the sponsors’ other assets post-completion). Consequently, they typically limit their financing to a loan-to-cost ratio of around 65-70%, requiring a substantial equity cushion from the sponsors. Statement III is incorrect. Subordinated lenders occupy a riskier position in the capital structure than primary (senior) lenders, as they are paid only after senior debt obligations are met. To compensate for this higher risk, they demand a higher rate of return, not a lower one. Statement IV is incorrect. An ‘off-take’ guarantee from a creditworthy entity, such as a government, is a key risk mitigation tool. It provides revenue certainty by guaranteeing the purchase of the project’s output, thereby significantly reducing risk for lenders, not enhancing it. Therefore, statements I and II are correct.

This question tests the ability to differentiate between corporate finance, commercial finance, and personal finance activities. Corporate finance, often a regulated activity (e.g., Type 6 in Hong Kong), involves advising corporations on capital structure, mergers, acquisitions, and raising capital through securities issuance like IPOs or private placements. Commercial finance typically involves providing loans and credit for business operations. Personal finance concerns the financial matters of individuals, such as mortgages.

Statement I is incorrect. A loan to open a single new branch is a standard business loan, which falls under commercial finance provided by a bank, not a specialized corporate finance advisory service.

Statement II is correct. Advising on and arranging the sale of a significant equity stake to a private equity fund is a form of capital raising and corporate restructuring. This is a classic corporate finance activity.

Statement III is incorrect. A mortgage for a personal residence is a prime example of personal finance, a retail banking product completely distinct from corporate finance.

Statement IV is correct. Advising a company on an Initial Public Offering (IPO) is a core function of corporate finance and is a regulated activity requiring a specific license (Type 6 sponsor work). Therefore, statements II and IV are correct.

Underwriting agreements are central to the IPO process, providing the issuer with certainty regarding the proceeds from the share offer. However, these agreements are not absolute guarantees. To protect themselves from catastrophic and unforeseen events, underwriters typically insist on including specific clauses that allow them to terminate their obligations. These are often referred to as ‘force majeure’ or ‘market-out’ clauses. Such clauses are triggered by specific, pre-defined events that occur between the signing of the agreement and the completion of the float. Common trigger events include the outbreak of war, natural disasters, the introduction of new laws that materially impact the issuer, or, significantly, a material adverse change in financial market conditions. A substantial and sustained fall in a major stock market index, such as the Hang Seng Index, is a classic example of a condition that would likely permit the underwriter to invoke this clause and withdraw from their commitment without penalty. The underwriter’s obligation is contractual, and while regulatory bodies like the SFC and SEHK oversee the listing process, the decision to terminate based on a contractual clause is a matter between the underwriter and the issuer. The underwriter is not obligated to proceed with the float at a lower price, nor are they required to absorb the losses from a market collapse if the agreement contains such a protective clause.

This question assesses the understanding of financial disintermediation versus financial intermediation. Financial intermediation involves using an intermediary, such as a bank, to channel funds from lenders (Fund Surplus Units) to borrowers (Fund Deficit Units). Intermediaries are crucial for managing credit risk (the risk of non-repayment) and liquidity risk for lenders. In contrast, financial disintermediation occurs when a borrower, typically a large and creditworthy entity, bypasses intermediaries to raise funds directly from the market by issuing securities like bonds. A key motivation for this is to lower the total cost of financing. This cost reduction is not just about avoiding the intermediary’s fees; it also relates to reducing ‘agency costs’ and the costs of ‘information asymmetry’. Agency costs arise from potential conflicts between a company’s management and its shareholders. When a company raises capital in the public markets, it subjects itself to the scrutiny of analysts, rating agencies, and investors. This market discipline helps align management’s actions with shareholder interests, thereby reducing agency costs. Information asymmetry exists when the borrower has more information about its prospects and risks than the lender. A public issuance of securities, governed by regulations like the Listing Rules and the Securities and Futures Ordinance (SFO), mandates extensive disclosure. This transparency reduces the information gap between the company and investors, allowing the market to price the securities more efficiently and lowering the risk premium demanded by lenders.

This question assesses the understanding of fundamental principles in corporate credit approval and management within a licensed corporation. Statement I is correct because sound internal controls, as expected under the SFC’s regulatory framework, require a clear credit approval hierarchy. Larger and more complex transactions carry higher risk and must be approved by more senior personnel or a dedicated credit committee, not by junior staff with limited delegated authority. Statement II is incorrect as it describes a clear conflict of interest and a breach of the principle of separation of duties. The individual responsible for originating a deal (deal origination) should be separate from the one approving it (deal approval) to ensure objective risk assessment. Statement III is correct and describes the proper post-approval workflow. To maintain segregation of duties and ensure proper execution, the legal and operations departments, not the relationship manager, are typically tasked with finalizing documentation and managing disbursements according to the approved terms. Statement IV is incorrect because while net profit is an important metric, the standard industry practice for assessing a company’s operating cash flow available for debt repayment is to start with EBITDA (Earnings Before Interest, Tax, Depreciation, and Amortization), as it provides a clearer picture of cash generation from core operations before non-cash charges and financing costs. Therefore, statements I and III are correct.

Statement I is correct. A fundamental initial step for any stakeholder, including creditors, lenders, and investors, when analysing financial statements is to assess the company’s liquidity. This measures the company’s ability to meet its short-term financial obligations as they fall due, which is a critical indicator of its immediate financial health. Statement II is correct. Hong Kong’s accounting standards are closely aligned with international standards. Specifically, Hong Kong Financial Reporting Standard 7 (HKFRS 7) on Financial Instruments: Disclosures is converged with the International Financial Reporting Standard 7 (IFRS 7), mandating specific qualitative and quantitative risk disclosures. Statement III is incorrect. While US GAAP is a significant influence, it is only mandatory for companies that wish to raise capital (debt or equity) in the US capital markets. A company listed solely in Hong Kong must comply with HKFRS, as issued by the Hong Kong Institute of Certified Public Accountants (HKICPA). Being a multi-national corporation does not automatically trigger a US GAAP requirement. Statement IV is correct. The HKICPA, as the statutory accounting body in Hong Kong, issues accounting guidelines and interpretations to address specific, complex, or emerging business issues that may not be adequately covered by existing formal accounting standards. This provides timely guidance to preparers of financial statements. Therefore, statements I, II and IV are correct.

This question assesses understanding of the fundamental principles of conduct for corporate finance advisers as stipulated in the SFC’s Code of Conduct. A licensed corporation has an overriding duty to act in the best interests of its client and to manage conflicts of interest effectively. When a material conflict, such as a team member having a beneficial interest in a transaction’s counterparty, is identified, the firm’s primary responsibility is to take immediate internal steps to control the situation. This involves preventing the conflicted individual from influencing the advice given to the client. Standard industry practice and regulatory expectation is to implement controls like removing the individual from the relevant duties and establishing information barriers (often called ‘Chinese Walls’) to prevent the flow of confidential or sensitive information. While disclosure to the client is also a crucial step, it should follow or be concurrent with the implementation of these internal controls. Simply obtaining client consent without managing the conflict internally is generally insufficient to ensure objectivity. Similarly, while divestment might resolve the financial conflict for the future, it does not address the potential for advice to have already been compromised. Reporting to the regulator is a separate consideration and is not the first operational step to protect the client’s immediate interests.

This question tests the fundamental concept of financial intermediation within the corporate finance industry. The primary economic function of a corporate finance adviser, particularly in a capital-raising exercise like an IPO, is to act as an intermediary. This means they connect entities that need capital (the issuing company) with entities that have surplus capital to invest (the investing public). They facilitate the flow of funds from savers/investors to borrowers/issuers, thereby making the market more efficient. While advisers perform many tasks, such as due diligence, documentation, and marketing, their core purpose is to bridge this gap. Providing capital directly is the role of a lender or principal investor, not typically an adviser in this context. Ensuring post-listing price stability is a specific, secondary function (stabilisation), not the primary capital-raising role. Finally, conducting the audit is the specific responsibility of an independent accounting firm (the auditor), not the corporate finance adviser.

To answer this question correctly, one must understand the specific definitions and distinctions between different types of corporate acquisition transactions, particularly those involving a company’s management team and the use of significant debt. A Leveraged Buy-Out (LBO) is a general term for an acquisition financed with a large proportion of borrowed funds, where the target company’s assets are often used as collateral. A Management Buy-Out (MBO) is a specific type of LBO where the company’s existing management team acquires the business. In contrast, a Management Buy-In (MBI) involves an external management team acquiring the company to replace the current leadership. Venture capital financing is a distinct form of private equity financing typically provided to early-stage, high-potential companies, rather than for the acquisition of established businesses.

Statement I is correct because higher financial leverage increases the volatility of a company’s earnings and, consequently, its stock price relative to the market. This increased systematic risk is reflected in a higher beta factor in the Capital Asset Pricing Model (CAPM). Statement II is correct as a fundamental principle of corporate finance. Debt holders have a priority claim on assets over equity holders, making debt a less risky investment. Additionally, interest payments on debt are tax-deductible in most jurisdictions, including Hong Kong, which lowers the effective cost of debt compared to the cost of equity, as dividends are paid from after-tax profits. Statement III is correct. A highly leveraged company like Alpha Corp has substantial fixed interest payment obligations. In a rising interest rate environment, its interest expenses would increase, putting downward pressure on its net income and sustainable earnings. Beta Ltd, with less debt, is less exposed to this interest rate risk. Statement IV is incorrect. While adding debt can initially lower the Weighted Average Cost of Capital (WACC) due to the tax shield, excessive leverage increases financial distress risk. This heightened risk will cause both lenders and equity investors to demand higher returns, eventually causing the WACC to increase beyond an optimal point. Therefore, statements I, II and III are correct.

This question tests the candidate’s ability to apply different Accounting Rate of Return (ARR) methodologies and understand their conceptual limitations.

Statement I is correct. The average annual net profit is calculated as ($300,000 + $400,000 + $500,000) / 3 = $1,200,000 / 3 = $400,000. The average return on initial investment is this average profit divided by the initial investment: $400,000 / $2,000,000 = 20%.

Statement II is correct. The average investment is calculated as (Initial Investment + Salvage Value) / 2. In this case, it is ($2,000,000 + $200,000) / 2 = $1,100,000. The average return on average investment is the average annual profit divided by the average investment: $400,000 / $1,100,000 = 36.36%, which is approximately 36.4%.

Statement III is correct. A fundamental weakness of all accounting rate of return methods is that they are based on accounting profits rather than cash flows and, more importantly, they do not discount future earnings. This means they ignore the time value of money, treating a dollar earned in year 3 as having the same value as a dollar earned in year 1, unlike methods such as Net Present Value (NPV).

Statement IV is incorrect. The calculation for average investment is (Initial Investment + Salvage Value) / 2. The statement incorrectly calculates it as half of the initial outlay only, which would be $1,000,000. This calculation is only correct if the salvage value is zero. Therefore, statements I, II and III are correct.

Statement I is correct because using short positions in broad-market index futures (like HSI futures) is a standard and direct method for hedging systematic risk in an equity portfolio that is highly correlated with that index. This strategy creates a position that is expected to gain value if the overall market falls, thereby offsetting losses in the long equity portfolio. Statement III is also correct as a critical component of any professional hedging programme is to assess its feasibility and efficiency. This includes analysing the direct costs (e.g., commissions, bid-ask spreads) and the indirect costs or risks, such as basis risk, which is the risk that the price of the hedging instrument (the future) does not move in perfect correlation with the value of the portfolio being hedged. Statement II is incorrect because it describes a portfolio re-allocation or de-risking strategy, not a hedging programme. While selling high-beta stocks and buying bonds reduces the portfolio’s overall market risk, hedging specifically involves taking an additional, offsetting position, typically with derivatives, rather than altering the core portfolio composition. Statement IV is incorrect because a primary principle of risk management is that hedging aims to mitigate or reduce risk to an acceptable level, not eliminate it entirely. Attempting to eliminate all risk is often impractical, prohibitively expensive, and ignores inherent risks like basis risk and counterparty risk. Therefore, statements I and III are correct.

This question assesses the understanding of the fundamental differences between operating as a sole proprietor and a private limited company in Hong Kong.

Statement I is correct. A sole proprietorship is not a separate legal entity from its owner. Therefore, the owner has unlimited liability, meaning their personal assets can be used to satisfy business debts. In contrast, a private limited company is a separate legal entity, and the liability of its shareholders is limited to the amount unpaid on their shares, thus protecting their personal assets.

Statement II is correct. A sole proprietorship’s existence is tied to the life of its owner; it ceases upon the owner’s death or retirement. A private limited company, as a separate legal person, has perpetual succession. It continues to exist even if its shareholders or directors change, providing business continuity.

Statement III is incorrect. The opposite is true. A private limited company is subject to more stringent statutory and compliance requirements under the Companies Ordinance, including filing annual returns, maintaining statutory records, and potentially preparing audited financial statements. A sole proprietorship has simpler compliance obligations, primarily revolving around the Business Registration Ordinance.

Statement IV is incorrect. It is generally more difficult for a sole proprietorship to raise capital from external investors. A private limited company can raise capital more formally and effectively by issuing new shares to investors, which is a well-understood and legally structured process. A sole proprietor typically relies on personal funds or bank loans. Therefore, statements I and II are correct.

This question assesses the understanding of recapitalization through an Initial Public Offering (IPO). Statement I is correct because the primary motivation for an over-geared company to issue new shares is to raise fresh capital. The prospectus must disclose the use of proceeds, which in this case would be for debt repayment to strengthen the balance sheet. Statement II is also correct; when a company issues new shares, the total number of shares outstanding increases, which inevitably dilutes the ownership percentage of the existing shareholders. Statement III is correct as this is the core objective of the recapitalization. By using the equity raised from the IPO to pay down debt, the company’s total debt decreases while its equity base increases, resulting in a lower gearing (or debt-to-equity) ratio. Statement IV is incorrect because the scenario describes a primary offering (an issue of new shares for subscription) to raise funds for the company itself. An offer for sale, where existing shareholders sell their shares, does not inject new capital into the company and is not the primary mechanism for recapitalization. Therefore, statements I, II and III are correct.

This question assesses the understanding of financial disintermediation versus financial intermediation. Financial disintermediation, or direct financing, occurs when a Fund Deficit Unit (FDU), such as a corporation, raises funds directly from Fund Surplus Units (FSUs), like investors, without going through a traditional financial intermediary like a bank. A primary motivation for a creditworthy corporation to do this is to reduce borrowing costs. By issuing bonds directly, the corporation can avoid the fees, interest rate spreads, and other charges that a bank would impose for its intermediation services. This path is most viable for well-known entities with strong credit ratings, as investors are confident in their ability to assess the associated risks and the issuer’s capacity to repay. The other options are incorrect. Public market issuance typically increases, not decreases, public disclosure and regulatory scrutiny. The process of disintermediation means the corporation is not relying on an intermediary for risk assessment; instead, the market and investors perform this function. Finally, while a corporation seeks to provide a liquid market for its securities, it does not rely on an intermediary to provide liquidity in a direct financing scenario; market forces determine liquidity.

Statement I is correct because the income statement is based on accrual accounting, which recognizes revenues and expenses when they are earned or incurred, not necessarily when cash is exchanged. A company can report a profit but have negative cash flow. Therefore, analyzing the cash flow statement is essential to assess a company’s actual liquidity and ability to meet its obligations. Statement II is correct as the notes on accounting policies provide crucial details on the specific principles and estimates applied by management in preparing the financial statements. These notes can reveal aggressive accounting choices or judgements that might be considered ‘cosmetic accounting’ to present a more favorable picture. Statement III is incorrect because different accounting standards (like HKFRS and another country’s GAAP) can have significantly different rules for valuing assets, recognizing revenue, and classifying liabilities. This means that financial ratios, such as the gearing ratio, are not directly comparable without careful analysis and potential adjustments. Statement IV is incorrect as it contradicts the historical cost principle, a fundamental accounting concept where assets are typically recorded at their original purchase price. While some standards allow for revaluation, the balance sheet does not universally represent the current market value of all assets. Therefore, statements I and II are correct.

In capital budgeting and project evaluation, the primary principle is to consider only incremental cash flows. These are the cash flows that will occur if, and only if, the project is undertaken. Any cost or revenue that the company would incur regardless of the investment decision is considered irrelevant to the analysis. Allocated overheads, such as a portion of the head office rent or corporate executive salaries, are classic examples of non-incremental costs. These costs exist with or without the new project and are merely assigned to different departments or projects for internal accounting purposes. Including them would incorrectly penalize the project’s financial viability. In contrast, direct project expenses (like marketing), changes in net working capital (like increased inventory), and side effects on other business lines (like sales erosion) are all direct consequences of the project and must be included in the cash flow forecast to accurately assess the project’s true economic impact.

This question assesses the understanding of early-stage equity financing and the fundamental rights of ordinary shareholders. Statement I is correct because angel investors specialize in providing seed or start-up capital to new ventures, accepting the high risk associated with unproven business models. Statement II is also correct; venture capitalists typically enter at a later stage (development or growth) when the company has a product, some market traction, and requires larger amounts of capital for scaling. They generally have a lower risk appetite than angel investors for pre-revenue ideas. Statement III is incorrect because ordinary shares do not entitle holders to a fixed or pre-determined dividend. Dividend payments are at the discretion of the company’s board of directors and depend on profitability and policy; fixed dividends are a characteristic of preference shares. Statement IV is correct as a fundamental right of an ordinary shareholder is to share in the profits of the company through dividends, when declared. These shares typically rank equally (‘pari passu’) with all other ordinary shares in respect of dividend rights. Therefore, statements I, II and IV are correct.

A comprehensive financial analysis requires evaluating multiple facets of a company’s performance and position. Statement I is correct because comparing asset utilization, such as inventory turnover, between similar companies is a key method to assess operational efficiency. A significantly higher inventory level relative to sales could indicate issues with stock management or sales. Statement II is crucial; financial comparisons are only meaningful if the underlying accounting policies are consistent. An analyst must always check the notes to the accounts to understand how figures like revenue and inventory are calculated, as different methods can distort comparability. Statement III is also correct as the gearing (or leverage) ratio is a fundamental indicator of financial risk. It shows the company’s reliance on debt versus equity financing and its ability to meet its obligations, especially during economic fluctuations. Statement IV is incorrect. While the balance sheet is a snapshot of a specific date, a diligent analyst must consider significant events that occur after the balance sheet date (subsequent events), which are often disclosed in the notes to the financial statements, as they can materially impact the company’s future financial position and performance. Therefore, statements I, II and III are correct.