Applied/Advanced

Management Accounting
Part 2

MAC4861/MAC4862
NMA4861/NMA4862
ZMA4861/NMA4862

F Benadé
WJ Coetzee
A Combrink
L Crafford
SK du Toit
TJ Matsoma
A Ravat
S Riekert
F Venter
A von Wielligh

University of South Africa

Pretoria
© 2014 University of South Africa

All rights reserved

Printed and published by the

University of South Africa
Muckleneuk, Pretoria

MAC4862/1/2015-2017

70217181
PART 2: FINANCIAL MANAGEMENT PAGES
QUESTION SOLUTION
UNISA EXAMS

QUESTION 1 MEDICO GROUP SA LIMITED 1 155

QUESTION 2 D&S TEC 8 173
QUESTION 3 ISIMBI LIMITED 15 185
QUESTION 4 FUNKY FASHIONS LIMITED 23 196
QUESTION 5 CWC SOUTH AFRICA LIMITED 27 204
QUESTION 6 RAPS GROUP LIMITED RAPS GROUP
LIMITED 36 217
QUESTION 7 THE ENTERTAINMENT GROUP 43 231

UNISA TESTS

QUESTION 8 BRAZILICA LIMITED 50 248

QUESTION 9 X-FACTOR HOLDINGS LIMITED 54 255
QUESTION 10 OSCAR LIMITED 57 263
QUESTION 11 ZIVA’S FASHION FANATICES LIMITED 61 270
QUESTION 12 BIDDER LIMITED 66 275
QUESTION 13 CHOCCI CHOCS LIMITED 68 282

QE I/ITC EXAMS

QUESTION 14 ITHEMBA ENGINEERING (PTY) LTD 74 289

QUESTION 15 H LIMITED GROUP 77 296
QUESTION 16 TIP TOP TRANSPORTS LIMITED 79 299
QUESTION 17 SAVUSA LIMITED 84 302
QUESTION 18 APEX ASSIST (PTY) LTD 89 308
QUESTION 19 SUPREMO TANKERS (PTY) LTD 94 311
QUESTION 20 ELECTRIBOLT LIMITED 99 314
QUESTION 21 CLOTH GROUP LIMITED 103 318

QE II/ITC
EXAMS

QUESTION 22 ZIMROD (PTY) LTD 106 322

QUESTION 23 FOODAGE LIMITED 114 330
QUESTION 24 ZAPPHIRE LIMITED 120 337
QUESTION 25 CATCON (PTY) LTD 127 347
QUESTION 26 SASSI STORES (PTY) LTD 133 352
QUESTION 27 BRAINZ (PTY) LTD 139 361
QUESTION 28 PALINDROME BRANDS (PTY) LTD 148 370
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QUESTION 1
132 marks
MEDICO GROUP
(Source: Exam 2013 MAC4861 and MAC4862- adapted)
Medico Group SA Limited (MGSA) is a pharmaceutical group based in South Africa and listed on the
Johannesburg Stock Exchange (JSE). The group’s operations comprise a chain of retail pharmacies
and three manufacturing facilities in South Africa. MGSA manufactures an extensive range of
branded and generic prescription drugs, in addition to some over-the-counter medicine. These
products are distributed through multiple channels, including the group’s own pharmacy chains, but
also other pharmacies, doctors, hospitals and convenience stores.

The group’s beginnings can be traced to five brothers who opened a small pharmacy in the city of
Johannesburg, nearly 80 years ago. From its small beginnings, the brothers slowly expanded the
company’s operations, to eventually turn it into a pharmaceutical group. As part of this process,
MGSA was first listed on the JSE in 1970. In recent years, MGSA adopted the following vision-
statement: “To be recognised as a leading, world-class, branded healthcare company”. In pursuit of
its vision, the company intends pursuing organic growth opportunities as well as acquisitions in
selected markets.

The most recent financial results for MGSA are summarised below:

Summary of the Consolidated Statements of Financial Position at 31 March:

2013 2012
R’000 R’000

Non-current assets 1 687 733 1 391 170

Property, plant and equipment 1 092 235 803 091
Other financial assets 97 826 98 147
Intangible assets 497 672 489 932
Current assets 1 438 350 1 672 512
Inventories 669 315 615 126
Trade and other receivables 424 134 392 001
Cash and cash equivalents 344 901 665 385
Total Assets 3 126 083 3 063 682
Capital and reserves
Share capital and share premium 500 000 500 000
Retained income 1 618 823 1 241 310
Total shareholders’ equity 2 118 823 1 741 310
Non-current liabilities 192 274 417 130
Long-term borrowings 120 937 347 411
Deferred tax 71 337 69 719
Current liabilities 814 986 905 242
Trade and other payables 588 512 697 853
Short-term portion of long term borrowings 226 474 207 389
Total equity and liabilities 3 126 083 3 063 682
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Extract and summary of the Consolidated Statements of Comprehensive Income for the years
ended 31 March:

2013 2012
R’000 R’000
Revenue 3 219 474 3 117 497
Cost of sales (1 753 617) (1 599 224)
Gross profit 1 465 857 1 518 273
Selling and distribution expenses (390 050) (351 004)
Marketing expenses (146 038) (134 887)
Research and development expenses (47 120) (39 506)
Fixed and administrative expenses (247 753) (184 830)
Operating profit 634 896 808 046
Finance income 12 798 16 645
Finance costs (45 368) (62 845)
Dividend income 18 810 21 510
Profit before tax 621 136 783 356
Income tax expense (117 786) (228 290)
PROFIT FOR THE YEAR 503 350 555 066

Additional information relating to Medico Group SA

1. Eighty percent of MGSA’s total revenue (in terms of value) is derived from credit sales. The
company’s official credit policy states:

• Credit limits are set for each debtor based on the debtor’s credit rating. Sales to debtors may
not exceed their credit limits; and
• Total exposure to a single debtor may not exceed 4% of the total outstanding receivables
balance.

2. During the 2013 financial year ended 31 March, one of MGSA’s debtors, Synchem Limited, was
liquidated. MGSA received 40c in the Rand from the liquidators, and the balance of R1,5 million
was written off. Synchem had a credit limit of R2 million.

3. Operating profit includes:

2013 2012
R’000 R’000
Credit losses 41 429 47 980

4. In terms of a recent Broad-Based Black Economic Empowerment verification, the group was
rated as a Level 5 Contributor.

5. Despite the decrease in profit from 2012 to 2013 the management of MGSA believes that profit
after tax will grow by 9% per annum from 2014 onwards (excluding the effect of any possible
merger or acquisition).

6. A dividend of 151 cents per share was declared in the 2013 financial year. In terms of the
group’s dividend policy, a constant dividend pay-out ratio is maintained.

7. MGSA has 100 million shares in issue on 31 March 2013, which are currently trading at R65 per
share.
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8. The long-term borrowing relates to a loan obtained from Drake Bank SA on 1 October 2009 for
an original amount of R1 billion. The period of the loan is five years and the loan is repayable, in
arrears, in 10 bi-annual equal instalments comprising capital and interest. The interest rate on
the loan is 1% above the current market-related rate of 8%, the latter being an annual
percentage rate (APR) for two repayments per annum. The loan qualifies as an instrument and is
deductible for tax purposes in terms of Section 24J of the Income Tax Act.

9. The group would like to start measuring its EVA® (Economic Value Added) as from the financial
year ended 31 March 2013.

10. The current South African corporate tax rate is 28%.

Industry background information

A central driver of this industry is the high cost of discovering, researching and developing
pharmaceutical drugs. This factor is exacerbated by the fact that only a very small percentage of the
compounds investigated are eventually approved for human consumption. To protect their
investments, the pharmaceutical companies therefore apply for patent-protection of their drugs.
These patents then afford an exclusive right to its holder, but normally only last a maximum of
20 years from the date of filing.

In the coming years, however, a large number of patents – protecting several prominent drugs – will
expire. This loss of patent protection is likely to affect future drug-pricing and is expected to create a
higher demand for generic medicine.

Yet, despite these challenges the companies in this industry are generally still performing strongly. At
present, lucrative government contracts for HIV/AIDS, tuberculosis and diabetes medication serve as
key drivers for the industry.

In South Africa there is strong competition between pharmacies, with dominant retail pharmacy-
chains and courier pharmacies controlling a large share of the market. Further challenges facing the
South African industry include the proposed National Health Insurance (NHI) scheme. The NHI
scheme will be introduced over a period of several years, but certain processes are already taking
place, including inter alia the introduction of a central procurement unit.

South African industry regulation and legislation

The pharmaceutical industry in South Africa is highly regulated and legislated. Legislation, such as
the Consumer Protection Act and the Medicines and Related Substances Act regulate the marketing,
distribution and packaging of pharmaceuticals.

The Medicines and Related Substances Act also regulates the price at which certain medicines and
scheduled substances can be sold, and further stipulates a principle known as “Single Exit Price”.
Single Exit Price dictates that medicine manufacturers may only sell products and its variants thereof
at a single price to all customers, regardless of sales volume. In addition, the Minister of Health
releases a Government Notice on an annual basis, stipulating the maximum annual price increases.

The government is currently in the process of establishing the South African Health Products
Regulatory Authority (SAHPRA), which will replace the Medicines Control Council (MCC). SAHPRA,
the new regulatory body, will be responsible for speeding up the drug registration process. SAHPRA
will also have more power and a greater range of responsibilities, which will include the approval and
licensing of pharmaceuticals and medical devices, and a mandate to conduct safety and efficiency
evaluations.
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Industry ratios

The following ratios, percentages and calculations represent averages for the South African
pharmaceutical industry:

2013 2012
Credit losses as a % of credit sales 2,5% 2,3%
Receivable collection days 53 days 50 days
Debt to equity ratio (based on fair market values) 20,6% 30,8%
Interest cover 8,7 times 8,5 times

Purchase of Acti-Pharm (Pty) Ltd

As part of its expansion drive, MGSA would like to purchase a 60% interest in the ordinary equity of
Acti-Pharm (Pty) Ltd (“Acti-Pharm”). To this end, the directors of MGSA have forwarded a letter of
intent to Acti-Pharm’s board of directors.

Acti-Pharm is a George-based manufacturer of active pharmaceutical ingredients and is one of

MGSA’s significant suppliers. Acti-Pharm’s current earnings per share are 624c and the company
has 10 million shares in issue. The company is an all-equity funded company.

Following a preliminary investigation and discussions, the directors of MGSA are planning to make
an offer of R24 per share for the indicated shareholding (this offer is likely to be accepted). The
directors are further confident that pre-tax annual synergies of R9 million would be realised within the
first year post acquisition and that integration cost over this period would equal R4 000 000 (pre-tax).
Furthermore, it is expected that Acti-Pharm’s earnings will grow by 7% over the next year.

If the offer for R24 per share is accepted, the acquisition will be financed as follows:

• 500 000 shares in MGSA will be issued.

• 5 million convertible debentures will be issued for a total consideration of R90 million. These
debentures will carry interest at a rate of 9,6% per annum and will be convertible at the option of
the holder in 4 years’ time at a rate of one ordinary share for every four debentures held. Any
debentures not converted will be redeemed at a premium of 4%. Similar convertible debentures
currently yield 9,5%. The management of MGSA has determined that the ordinary shares will
likely be worth R100 each, in four years’ time.
• The remainder will be paid from surplus cash reserves which currently earn interest at a rate of
5% per annum.

Before continuing, the directors of MGSA would like to know the likely impact that this will have on
certain key indicators or aspects of the group. Such an analysis would, of course, require a number
of assumptions. The directors have indicated that the following assumptions should be applied for
purposes of a preliminary analysis: (1) The offer for Acti-Pharm would be accepted at the indicated
price; (2) MGSA’s Price-Earnings multiple would remain constant over the course of the 2014
financial year; (3) the effective date of the transaction would be 1 April 2013; and (4) interest on the
debentures would not be deductible for tax as its proceeds would be used to purchase equity.

New drug development: ZDT

MGSA has its own World Health Organisation-approved research and development facility and the
production of a new generic antiretroviral (ARV) drug called ZDT was recently appraised using the
net present value (NPV) method. The calculations performed indicate that the production of ZDT will
create value for MGSA and consequently production was approved by the board of directors. This
project will support MGSA’s strategic goal of supplying affordable ARVs to patients across Africa.
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This commitment is also directed internally through MGSA’s own HIV/AIDS policy, voluntary testing,
counselling, support programmes and HIV/AIDS education for its employees.

Production of ZDT will require a new manufacturing machine worth R6 000 000. The directors of
MGSA are now faced with the decision of how to finance this machine. MGSA currently has very low
levels of debt and they would therefore like to use debt finance. The following alternatives have been
identified:

• The management accountant of MGSA is in the process of preparing a business proposal, which
will be presented to Drake Bank SA. In this regard, MGSA proposes a R6 million loan with
interest and capital repayable in one bullet payment in five years’ time at an interest rate equal to
prime plus 2%. The financial accountant provided the management accountant with financial
data and forecasts. The proposal is almost complete with the exception of the following two
sections, which the management accounting is struggling with: Industry analysis, and risk and
risk management.
• Alternatively, the machinery could be leased in terms of a finance lease for five years at R1,65
million per annum, payable annually in advance.

Maintenance and servicing will cost R500 000 per annum if the machine is purchased outright. The
lease charge includes maintenance and servicing.

SARS will most likely allow the new manufacturing machine to be written off in terms of section 12C
of the Income Tax Act (i.e. 40% in year one and 20% in the remaining three years). Unless otherwise
indicated, it is reasonable to assume that all cash flows during a year occur at the end of the year.

Foreign currency risk

Instead of locally obtaining the machine required to manufacture ZDT, it can be purchased from a
German supplier at a cost of €625 000. In this case the machine will be purchased immediately
(1 October 2013) but the purchase price is only payable on 30 September 2014. The following
spot/forward rates apply in the local currency market:

1 October 2013 30 September 2014

ZAR/€1 ZAR/€1
Banks’ selling rate R9,80 R10,20
Banks’ buying rate R9,40 R9,90

The management of MGSA is concerned that the Euro will strengthen against the Rand and would
like to use a Euro-option, traded on the JSE’s Yield-X, to hedge this risk.

A foreign exchange option contract exists – exercisable on 30 September 2014 – with the following
strike/exercise rates:

Call Option Put Option

ZAR/€1 10,3 9,9

The premium for the September call option is ZAR0,42/€1 while the premium on the September put
option is ZAR0,40/€1.
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Marks
REQUIRED Sub- Total
total
(a) Calculate the weighted average cost of capital for MGSA as at 31 March 2013
based on available information and ignoring any effect of a possible merger or
acquisition. (14) (14)
(b) Identify the key strategic risks facing MGSA and indicate ways in which the
risks could be mitigated with reference to the pharmaceutical industry and the
South African context. (9)
Communication skills – logical argument (1) (10)
(c) Draft a formal report directed to the directors of MGSA, highlighting the results
of:
• An assessment of the current opportunities and threats that could be linked
to the group; (9)
• Shortcomings in the group’s current vision-statement, if any. (2)
Incorporate knowledge of the group and pharmaceutical industry in your
answer, and specifically consider the South African context. Communication
skills – layout and structure; clarity of expression (2) (13)
(d) Discuss the benefits and limitations of MGSA’s current dividend policy. (4) (4)
(e) Discuss why the IFRS treatment of research and development costs is not
always appropriate for the purposes of calculating EVA®. (5) (5)
(f) Analyse and discuss the likely effect of the planned acquisition of Acti-Pharm
on the following important indicators/factors relating to MGSA, over the course
of one year and based on the directors’ assumptions (as mentioned):
• Basic earnings per share; (11)
• Return on equity; and (5)
• Financial risk (11) (27)
(g) Discuss the owner-level premiums and discounts that should have been taken
into account when valuing Acti-Pharm for the purposes of determining a fair
purchase consideration. (4) (4)
(h) Draft a memo to the management accountant of MGSA discussing:
• Possible reasons why the Acti-Pharm acquisition may not be successful. (5)
• The advantages and disadvantages of carrying out a post-acquisition
review with regard to the purchase of an interest in Acti-Pharm. (3)
Communication skills – appropriate style (1) (9)
(i) Explain, with supporting calculations, how the currency option could be used to
hedge against exchange rate movements with regard to the machine
purchased for the production of ZDT.
In your answer you should make use of the quoted rates and premiums.
Assume a spot rate in the currency market of ZAR10,9/€1 on the strike date. (8) (8)
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(j) List specific environmental and societal (social) footprint metrics that may be
used by MGSA to assess its impact in this regard and to communicate its
performance. (5)
Communication skills – logical argument (1) (6)
(k) Critically assess MGSA’s credit policies and procedures in respect of trade
receivables, supporting where appropriate your comments with calculations. (12)
Communication skills – layout and structure; clarity of expression (1) (13)
(l) Determine which source of finance for the machine is cheaper if the machine to
manufacture ZDT is obtained locally, by calculating the internal rates of return
(IRR). You can ignore the impact of section 24J of the Income Tax Act in your
answer to this part. (13) (13)
(m) Draft a memo to the management accountant of MGSA describing matters to
be included in the business proposal under the headings of:
• Industry analysis (3)
• Risk and risk management (2)
Communication skills – appropriate style (1) (6)
Total 132
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QUESTION 2 100 marks

D&S TEC
(Source: Supplementary exam 2012 MAC4862 - adapted)

D&S TEC was founded by Mr Anthony Dinozzo senior and his son in 1988. The company sells
computer software packages (including licence renewals) and provides clients with online support.
Since incorporation the company has grown to a multinational organisation. Anthony senior has since
retired and is no longer involved in the daily operating activities of D&S TEC.

Strategy

As part of D&S TEC’s growth strategy they aim to list on the JSE Securities Exchange Main Board
within the following 12 months.

Integrated Reporting

Mr Dinozzo is aware that as D&S TEC is currently an ALTX listed company, integrated reporting
requirements of King III for listed companies apply to it. However he does not see the need for
integrated reporting as the shareholders in his opinion are only interested in the bottom line.

Financial strategy of D&S TEC

The directors of D&S TEC have indicated that the company’s target debt : equity ratio is 65% equity
and 35% debt, which is in-line with the average capital structure in the IT industry. Management of
D&S TEC would like to compare Return on Capital Employed and Return on Invested Capital with
their Weighted Average Cost of Capital.

Competitor

IT MegGig Ltd is one of D&S TEC’s biggest competitors. As part of IT MegGig Ltd’s strategic plan to
expand they have initiated negotiations with Mr Dinozzo junior in an effort to successfully take-over
D&S TEC. Mr Dinozzo is not keen on handing their family’s heritage to outsiders. He therefore
proposes to repurchase shares at a 10% premium above the share’s market price as an anti-
takeover strategy. This repurchase will take the form of a specific repurchase and the 10% premium
will be certified as being reasonable by an independent valuator.

Financial analysis

Mr Anthony Dinozzo jnr. has provided you with an extract of the Statement of Comprehensive
Income, the Statement of Financial Position, as well as financial analysis and comments thereto.
The calculations performed in the analysis have also been detailed.
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Extract from the Statement of Comprehensive Income for Dinozzo and Son Technology Ltd.
for the year ended 31 March 2012.

2012 2011
Calc. R'000 R'000
Revenue F1 113 684 98 047
Direct operating costs (26 818) (25 925)
Employee benefits (15 961) (15 843)
Selling, distribution and marketing expenses (25 225) (24 649)
Other operating expenses (20 492) (17 837)
Operating profit B1 25 188 13 793
Finance income 2 077 4 420
Finance costs E1 (16 171) (12 230)
Profit before tax 11 094 5 983
Income tax expense (3 107) (1 675)
Profit after tax D1 7 987 4 308

R R
Basic earnings per share 4,00 2,15
Headline earnings per share 3,82 2,11
Dividend per share 1,75 0,90
Market price per share 26,05 12,10

Extract from the Statement of Financial Position for Dinozzo and Son Technology Ltd. for the
year ended 31 March 2012.

Calc. 2012
R'000
ASSETS
Non-current assets 98 466
Property, plant and equipment 63 361
Intangible assets 30 266
Loans and other non-current receivables 3 432
Deferred tax assets 1 407

Current assets 53 949

Inventories 1 589
Trade and other receivables 13 234
Taxation prepaid 681
Current portion of loans and other non-current receivables 2 499
Cash and cash equivalents 35 946

Total assets C1 152 415

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R'000
EQUITY

Ordinary shares and share premium (2 000 000 shares) 15 602

Retained earnings 56 253
Total equity A2 71 855

LIABILITIES
Non-current liabilities A1 40 995
Medium term loan (12%) E2 32 028
Deferred tax liabilities 8 967

Current liabilities C2 39 565

Trade and other payables 23 413
Provisions 11 423
Taxation liabilities 4 459
Bank overdrafts (prime+2%) A3 270
Total liabilities 80 560
Total equity and liabilities 152 415

Financial analysis comments based on the calculations below:

1. Gearing

• The company's gearing ratio has decreased since 2011 from 208,8% to 36,5%.
• This decrease is mainly as a result of the increase in borrowings.

2. Return on Equity

• The company's return on equity has improved significantly from 6,2% (2011) to 35,1%
(2012) mainly as a result of the increase in operating profit.

3. Return on Capital Employed

• The Return on Capital Employed has increased from 13,6% (2011) to 22,3% in 2012.
This indicates an improved distribution of earnings to shareholders and financiers.

4. Return on Invested Capital

• The return on invested capital has decreased from 16,8% (2011) to 7,1% in 2012. This is
mainly as a result of the major increase in non-current liabilities.

5. Interest cover

• The times interest covered has decreased as a result of the increase in borrowings.

6. Growth in revenue

• Revenue has increased above the inflation rate of 6,0% and one of the main reasons for
this good performance can be attributed to the effective advertising efforts of the
marketing department. The inflation outlook for the foreseeable future will not differ
materially from the current position.
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7. General

• The company achieved a sturdy performance in 2012 amidst a challenging environment

of increased competition and a mature market.

2012 2011
Calculations: May contain errors Assume correct

1.Gearing ratio 36,5 % 208,8 %

= (A1 + A3) / (A1 + A2 + A3)
2. Return on Equity 35,1 % 6,2 %
= B1 / A2
3. Return on Capital Employed 22,3 % 13,6 %
= B1 / ( C1 - C2)
4. Return on Invested Capital 7,1 % 16,8 %
= D1 / ( A2 + A1)
5. Interest cover 1,98 Times 1,13 times
= E2 / E1
6. Growth in turnover 13,8 % N/a
= (F1(2012) – F1(2011)) / F1(2011)

Expansion project: Customfit-IT

The computer software industry is an ever changing environment as clients demand improved
functionality from their software packages. D&S TEC is investigating a local expansion project called
Customfit-IT. This new software package will allow clients to specify their software requirements,
leaving programmers to adjust some of the off-the-shelf software packages. Due to the changing
nature of this market, D&S TEC plan to run this project for six years only.

Computer and other equipment required immediately for the project will amount to €1 000 000 and is
payable immediately as well. The shipping and commissioning costs will amount to R301 250 and
R65 000 respectively.

The company’s depreciation policy is to write computer and other equipment off over 6 years. SARS
will allow an annual 33,33% wear and tear allowance.

Initial working capital required will amount to R725 000.

The research performed by the marketing department to date has amounted to R1 200 000. The
research indicated that customised packages can be sold for R14 000 each and that each permanent
employee will have the capacity to complete one project per week. After the first year package prices
are expected to increase by 10% per annum. From the second year onwards, employees are
expected to increase their efficiency and hence output by 4%. No future improvements in efficiency
will arise thereafter. There are no work-in-progress or completed customised packages in inventory
at year end.
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This project will require D&S TEC to permanently employ 13 new employees with a monthly market
related salary of R37 000 each (current price/monetary terms). Annual salaries are expected to
increase by 8% with immediate effect in respect of the first year and by 10% per annum thereafter in
order to retain these employees.

These employees will have to be retrenched at the end of the project at a cost equal to one month’s
salary for each year worked, only if they cannot be redeployed to other departments within the
company. There is a high probability that seven staff members will be redeployed.

In addition D&S TEC will need to employ five general sales consultants on a contract basis to assist
with promoting and selling the new alternative packages to clients for the duration of the project.
These contract employees will receive R115 000 each, per annum in current monetary terms.

The project will be run from existing premises and will not require any additional office space to be
rented, however a cost of R300 000 (current monetary terms) will be allocated to the project due to
the space taken up by their workstations.

All additional annual administrative costs will amount to R39 000 in current monetary terms.

Other information:

• The R/€ current exchange rate is 1/ 0,095.

• Taxation liabilities are not considered to form part of the entities permanent capital structure.
• The current tax rate is 28% for companies.
• The expected market return is currently 16% and D&S TEC has a Beta of 1,25.
• The risk-free rate on RSA Treasury bonds is 9%.
• The 12% medium term loan is not publicly traded, however, analysts believe the effective pre-
tax cost to be 4,5% above the prime overdraft rate of 8,5%. The loan repayable by means of a
single bullet repayment in five years’ time. Until then, only interest will be paid annually in
arrears.
• Bank overdraft facilities are utilised for working capital.
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REQUIRED Marks
Part A - D&S TEC
(a) (i) Identify incorrect inclusions or exclusions made in the calculations performed as
part of the financial analysis (as well as improvements which can be made to the
calculations performed) and financial analysis comments received from Mr
Anthony Dinozzo jnr. (8)

(ii) Indicate the correctly calculated ratios, if applicable. (8)

(iii) Provide insightful comments to the corrected (if applicable) calculations. (8)

Structure your answer in the following tabular format:

Ratio (i) Errors in (ii) Correct (iii) Insightful

calculations ratio comment
and
comments
1. Gearing
2. Return on Equity
3. Return on Capital
Employed
4. Return on Invested Capital
5. Interest cover
6. Growth in turnover
You may assume that the calculations and ratios used for 2011 are correct.

(b) Briefly discuss the company’s actual funding strategy with supporting calculations or
ratios where relevant. (5)

(c) Calculate the following ratios for 2012 and 2011:

(i) Dividend cover (2)

(ii) Price earnings ratio (2)

(d) Provide value adding comments for the ratios calculated above, namely:

(i) Dividend cover (3)

(ii) Price earnings ratio (3)

(e) Describe how the suggested repurchase of shares will assist D&S TEC with their
anti-takeover strategy. (4)
(f) According to KING III; Integrated reporting is a holistic and integrated representation
of the company’s performance in terms of both its financial performance and its
sustainability.

(i) Describe to Mr Dinozzo what an integrated report should entail. (6)

(ii) Critisize Mr Dinozzo’s reason for his reluctance to commit to Integrated
reporting. (3)

(g) Identify the risks associated with D&S TEC. (7)

Total Part A 59
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Part B – Customfit-IT Marks

(a) Calculate the weighted average cost of capital (WACC) of D&S TEC at 31 March 2012
based on the target structure. (6)
(b) Without further calculations, explain the impact that a new bank loan, to finance the
investment, will have on D&S TEC’s

(i) cost of equity (3)

(ii) cost of debt; and (3)
(iii) weighted average cost of capital. (3)

(c) Use the discounted cash-flow model to determine what the resale value of the
computer and other equipment will need to be, to achieve a required return of 19%.

Your answer should include detailed calculations and indicate key assumptions or
items omitted from your evaluation.

(i) Calculations (14)

(ii) Assumptions (3)

• Cash flows occurring during the year can be assumed to have taken place at year
end unless specified to the contrary.
• You may ignore the effect of a scrapping allowance or recoupment for taxation
purposes.
• Assume that there is sufficient taxable income within any given year to absorb any
tax loss or deduction against taxable income
• There are 50 working weeks in a year.
• Round all amounts to the nearest Rand.

(d) Describe other important factors to be taken into consideration before making this
investment decision. (6)
Total Part B 38
Language, layout and logic 3
Total 100
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QUESTION 3 100 marks

ISIMBI LIMITED
(Source: Exam 2012 MAC4862- adapted)

Insimbi Limited (Insimbi) is an iron ore mining company operating an open-cast mine in the Limpopo
province. (Estimates of mining reserves indicated a 10-year life expectancy for the mine.) Insimbi
supplies iron ore predominately to the South African steel industry, with a smaller portion being
exported to countries in Western Europe.

Insimbi employs several full-time employees and makes use of both full-time and part-time
contractors. The company’s largest shareholder is Mr West, who is also the Chief Executive Officer
and Chairman of the company. Mr West formed the company seven years ago and has been the
central driving force behind the company. Mr West earns a substantial remuneration package. This is
not subject to the usual company review processes, since Mr West is of the opinion that it is well-
deserved.

A. BACKGROUND INDUSTRY INFORMATION

Insimbi operates within the Iron and Steel industry, which forms part of the larger Industrial Metals
and Mining industry.

Steel

Steel is a versatile material that is used on a global scale in several industries, including building and
construction, automotive, machinery, and mining. In South Africa (SA) the steel market is dominated
by a single large listed company, which in spite of its size, is struggling to make a profit under the
current local and international market conditions. A few independent steel producers also exist in SA.
Growth opportunities in the South African steel sector are limited due to the steel sector’s current
large size relative to the economy, its local excess capacity and lack of export competitiveness. Input
materials used in the production of steel include: coking coal, scrap steel, manganese and iron ore.

Iron ore

Iron ore is a mineral resource, which is mostly extracted from the earth by means of the opencast
method. The opencast method entails the removal of topsoil, stockpiling, followed by drilling and then
blasting. The ore may then be further separated or processed using further capital intensive
processes (referred to as “mining beneficiation”), which normally increases its value and/or potential
saleability.

Iron ore is a cyclical commodity, making worldwide prices (usually quoted in US dollars) fairly volatile.
The main exporters of iron ore are Australia, Brazil, India and South Africa; whereas major demand
for imported iron ore exist in China, developed Asia, Western Europe, and the Middle East. Due to
the geographic imbalance between iron ore supply and demand, and the fact that iron ore is cheaper
to transport than finished steel, there is a strong market for seaborne iron ore. (Seaborne iron ore is
iron ore transported by sea in a bulk carrier ship).
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The full cost of transporting iron ore (overland and by sea) is nonetheless significant. As a result, the
geographical location of the iron ore is a very important factor to its competitiveness in the market.
The geographical location of SA, as a country, makes it reasonably competitive with other countries
exporting iron ore (in terms of distances to the importing countries). The majority of South African iron
ore, destined for export, is shipped by a dedicated rail line from mines in the Northern Cape to the
port of Saldanha Bay in the Western Cape.

The South African iron ore mining industry produced approximately 50 million tons of iron ore
annually over the past couple of years. There are three dominant iron ore mining companies in SA,
but the industry also contains some smaller companies who are still ramping-up production or have
the potential to commence production. The South African industry supplies the domestic market’s full
demand for iron ore and the remaining volumes are exported (exports represent roughly 90% of total
production).

The selling price of iron ore worldwide is dependent on a number of factors, which include:

• Global iron ore prices (normally expressed in US dollar for a benchmark iron ore: dry iron ore, with
a fixed iron content, at a certain location).
• Consistency in the quality (greater consistency increases value as, amongst other benefits, it
necessitates fewer sorting operations).
• Composition of the ore (for example, greater iron concentration in the ore increases the value,
whereas a greater proportion of moisture makes it less valuable).
• Lump or fine iron ore. (Lump ore consists of particles between 6 to 30mm in size, whereas fine ore
has particles smaller than 6mm in size. Lump iron ore is more valuable than fine ore, since it
results in improved efficiencies during later steel manufacturing, thereby securing the higher
price.)
• Resistance to physical degradation. (Greater resistance to degradation increases the value as it
reduces handling costs and affects particle size – thus also the classification as lump or fine.)
• The location of the iron ore. (If located closer to local steel producers or importing countries then it
effectively increases the value of the ore, since lower distribution costs have to be incurred.)

Major components of operating expenditure of South African iron ore producers include:

• Cost of goods sold, which in turn, consists principally out of staff costs; raw materials and
consumables; outside services; depreciation on property, plant and equipment; repairs and
maintenance; and energy costs (fuel and electricity).
• Mineral royalty payable to the South African Revenue Services.
• Selling and distribution costs (including rail and port tariffs).

Relevant legislation

One of the pieces of legislation applicable to the mining industry is the Minerals and Petroleum
Resources Development Act. Since the implementation of this Act, all South African mineral rights
vest with the State as custodian of minerals resources on behalf of South African citizens. Certain
bills complementing this Act provide for compensation to the State, in the form of a royalty, for the
country’s permanent loss of non-renewable resources.

Another piece of legislation applicable to this industry is the Mine Health and Safety Amendment Act.
Section 54 of this Act allows the Mines Inspectorate to close down a mine following a fatality or other
safety incident (referred to as a “Section 54 work stoppage”), until a suitable inspection has been
completed. This Section of the Act originally aimed to remedy the unacceptable high number of
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mining-related deaths and injuries. However, it came under criticism for its heavy-handed application,
which contributed to the difficult operating environment within the mining industry in recent years and
a loss of production for those companies affected.

B. AN EXCERPT OF FINANCIAL AND OTHER INFORMATION OF INSIMBI

Estimates

Estimates for Insimbi, by management:

• Target debt-to-equity ratio equal to 0,03:1 (determined with reference to the industry).
• Beta coefficient equal to 1,5 (determined based on information for a similar listed company).
• The company’s marginal income tax rate is equal to 28%.

Existing interest-bearing borrowings

The company has a secured revolving credit facility with a maturity date of 31 August 2015. The
facility amount equals R3 million and the outstanding balance bears interest at a floating rate equal to
the 3-month JIBAR (Johannesburg Interbank Agreed Rate) plus 250 basis points. This facility is
currently only being partially used.

An excerpt of financial and other information of Insimbi:

2012 2011
Financial information R R
million million
Revenue for the year, by geographical area 71,7 76,0
• South Africa 53,8 52,5
• Europe 17,9 23,5

Cost of goods sold (COGS) for the year (18,6) (19,2)

Mineral royalty for the year (linked to revenue) (2,8) (3,0)

Selling and distribution costs for the year (2,7) (2,9)

Other information 2012 2011

Production volume, roughly equal to sales volume ('000 dry tons of iron ore) 78 83
Number of fatalities 2 2
Lost time due to injuries (equivalent number of full shifts lost due to injury – per
employee per year) 4 4
Enrolment of HIV-positive employees in disease management programmes (%) 100 100
Women employed (% of workforce) 1 1
Total amount spent on social and community development (R million) 0,1 0,1
Total carbon dioxide (CO 2 ) emissions ('000 tons) 3,0 2,5
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ANCILLARY INFORMATION REGARDING INSIMBI

The following ancillary information regarding Insimbi is available:

• Since Mr West discovered that his daughter is HIV positive, he is determined to educate society
on both the dangers and treatment options related to HIV/AIDS. As part of this drive, Mr West
made it compulsory for all employees of the company to undergo HIV testing once a year.

• Mr West eagerly wants to expand the mining operations of Insimbi and has spared little company
expense or effort in an attempt to secure additional mining rights in South Africa, within an area
already being mined by Kumbaya Limited (this company is further discussed below). The mining
rights in this area are under dispute, but Mr West intends on using his political connections to
ensure success.

• In addition, Insimbi is considering expanding its iron ore mining operations into Africa and has
earmarked the Republic of Guinea, a country on the west coast of Africa, for further investigation
(see location on map below). The Republic of Guinea has 10 million inhabitants and is nearly
250 000 square km in size. Once a French colony, its recent history included military rule
interspersed with elected leadership. (A fresh round of elections is planned for the latter half of
2012.) It is one of the poorest countries in the world and is largely dependent on agriculture and
mineral production, including iron ore, diamond and gold mining.

• A recently appointed director of Insimbi, who came from the retail industry, described the success
of his previous employer in raising debt finance through a bond issue (which was largely over-
subscribed). Based on his experience in the retail industry, but incorporating minor changes, the
director estimated that sufficient demand will exist for bonds issued by Insimbi, if the company
implemented the following proposal:

Issue R30 million fixed-rate secured bonds carrying interest of 7,5% per annum (payable
annually in arrears), maturing in five years’ time, at which point the bond should be redeemed
at 110% of the nominal value. Transaction and other expenditure is likely to represent 4% of
the nominal value and is payable on issue. The bonds will have to be secured by property,
plant and equipment. The director further indicated that restrictive debt covenants are likely to
be required.

A tax practitioner confirmed that the bond will qualify as an instrument in terms of Section 24J
of the Income Tax Act and that finance charges will be deductible in terms of this section for
tax purposes. Transaction and other expenditure will also be deductible for tax purposes.
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• Insimbi’s shares are not listed on a stock exchange, but Mr West craves the prestige of a listing on
the JSE. Encouraged by his enthusiasm, the owners of Insimbi are now contemplating the listing
of the company in the future. Numerous methods of listing exist, but early discussions with an
advisor indicated that a private placing with certain institutions may be a suitable method for
Insimbi, provided there is a sufficient public shareholding spread. Such a private placing would
imply an offer of shares by Insimbi to selected institutional investors, based on private
negotiations.

C. INDUSTRY AND MARKET INFORMATION

South African market information and estimates

Recent South African market information and estimates include:

• Equity risk premium: 5,5%

• Small-stock premium: 5,0%
• Current prime interest rate: 9,0% (an Annual Percentage Rate, “APR”)
• Current 3-month JIBAR: 5,6% (APR)
• Information on South African government bonds:

Maturity date Coupon Rate (%) Latest yield

(%)
R157 15 September 2015 13,5 6,3 (APR)
R208 31 March 2021 6,8 8,3 (APR)

Kumbaya Limited

Kumbaya Limited is a South African company and is listed on the main board of the JSE. Kumbaya is
the largest iron ore supplier in South Africa and has a presence in most areas of South Africa where
such mining ore exists, including the Limpopo province and the Northern Cape. (The iron ore that is
produced from its mines in the Northern Cape is of superior quality to that of its other mines.) The
company supplies local, inland steel manufacturers mainly from its mines in Limpopo, whereas
production from its mines in the Northern Cape is principally destined for export.

The size of the company’s mining operations allows for efficient production at most of its mines.
Moreover, the company makes extensive use of mining beneficiation to increase the value of its
product.

The company employs thousands of employees and, in addition, makes use of several thousand
contractors. Most workers in the mining industry belong to one of the country’s dominant labour
unions and, based on a particularly strong drive this year, strike-action was rife during 2012
throughout the mining industry. However, Kumbaya was more successful than the average mining
company in averting the negative impacts of the year’s strike-action.
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An excerpt, consisting of financial and other information from Kumbaya’s Integrated Report:

2012 2011
Financial information (based on rounded figures)
R 'million R 'million

Revenue for the year from the sale of iron ore, by geographical area 42 000 46 000
• South Africa 3 000 3 000
• China 29 000 30 000
• Europe 3 500 5 000
• Other 6 500 8 000

Cost of goods sold (COGS) for the year (8 000) (8 700)

Mineral royalty for the year (linked to revenue) (1 600) (1 800)
Selling and distribution costs for the year (3 400) (3 700)

Other information 2012 2011

Production volume, roughly equal to sales volume (million dry tons of iron
ore) 40,2 41,3
Number of fatalities 1 0
Lost time due to injuries (equivalent number of full shifts lost due to injury –
per employee per year) 0,1 0,2
Enrolment of estimated HIV-positive employees in disease management
programmes (%) 45 50
Women employed (% of workforce) 14 12
Total amount spent on social and community development (R million) 220 160
Total carbon dioxide (CO 2 ) emissions (million tons) 1,0 0,8

D. FACEBOOK INITIAL PUBLIC OFFERING

Facebook is a renowned social networking service and website, launched in the year 2004.
Facebook was founded by Mark Zuckerberg along with college roommates and fellow students, and
is operated by Facebook Incorporated.

In 2012, Facebook not only exceeded 900 million active users, but the company also held its initial
public offering (IPO) – one of the largest in the history of the technology industry. The IPO was used
to obtain a listing on the NASDAQ, an American stock exchange.

Following the IPO, Facebook shares lost over a quarter of their value in less than a month. This
triggered many analysts to label the IPO as unsuccessful and, of course, triggered a strong reaction
in the press. One journalist summarised the events, remarking that: “Facebook broke the cardinal
rule of listing. [In principle] a listing must be an invitation to purchase, not an offer for sale.” (M.
Barnes – Business Day, 31 May 2012). Other reports observed that institutional investors, in
particular, were weary of investing in a business without a clear economic model for the future –
especially one priced at the level of Facebook’s IPO.
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E. INTEGRATED REPORTING

A recent publication by Deloitte, an audit and advisory firm, highlighted that Integrated Reporting is
not just about financial reporting, but involves many other areas with the aim of meeting the needs of
a wider group of stakeholders – including employees, customers and suppliers.

The Integrated Reporting Committee of South Africa and the International Integrated Reporting
Council (IIRC) published a series of guidance notes to help listed companies practice Integrated
Reporting. In their guiding role, the IIRC described the different thinking behind Integrated Reporting:

Integrated Reporting reflects what can be called “integrated thinking” – application of the
collective mind of those charged with governance (the board of directors or equivalent), and
the ability of management, to monitor, manage and communicate the full complexity of the
value-creation process, and how this contributes to success over time. It will increasingly be
through this process of “integrated thinking” that organisations are able to create and sustain
value.
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REQUIRED Marks
(a) Calculate the weighted average cost of capital of Insimbi Limited based on available
information, using target weights and ignoring the proposed bond issue. (8)
(b) Analyse (for 18 marks) and interpret (for 16 marks) the performance of Insimbi
Limited for the year 2012, including a comparison with the market/competitors, in the
following three categories: Operational, social and environmental. (You are not
required to address the effect of fluctuations in the exchange rate for this part.) (34)
(c) For each of the risk factors indicated below, describe the reason why Insimbi Limited
may consider this a key risk factor and further suggest ways in which Insimbi could
mitigate these risk factors. In your answer you should make use of a table in the
following format: (24)
Risk factor Reason why this Mitigation
may represent a
key risk factor

• Regulatory, political and legal matters (2 marks) (2 marks)

• Inadequate supporting infrastructure (1 mark) (1 mark)
• Impact on the environment (2 marks) (2 marks)
• Foreign exchange (1 mark) (2 marks)
• Commodity price and demand (3 marks) (2 marks)
• Employees’ health and safety
(3 marks) (3 marks)
(d) Evaluate the circumstances of Insimbi Limited and the behaviour of Mr West from an
ethical and corporate governance perspective, and provide recommendations for
improvement. (5)
(e) List four country risk components that Insimbi Limited should consider before
investing in the Republic of Guinea. (4)
(f) Determine if Insimbi Limited’s proposed bond issue would represent a cost effective
form of debt finance to the company (for 8 marks), and critically evaluate the
appropriateness of the bond issue on matters besides cost, by considering the
company’s circumstances and operating environment (for 4 marks). You are required
to show the full impact of income tax in your calculations. (12)
(g) Generalise from the actual Facebook IPO whether Insimbi Limited should list on the
JSE in the near future and, if the company goes ahead, the conditions that would
increase the chances of a successful listing. (6)
(h) List eight key areas recommended for inclusion in an Integrated Report. (4)
Presentation (1)
Language (1)
Logic (1)
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QUESTION 4 62 marks

FUNKY FASHIONS LIMITED

(Source: Exam 2012 MAC4861 – adapted)

Funky Fashions LTD (“FFL”) is a South African retailer that sells fashionable clothing and all
sportswear. Its shareholders consist of a large number of minority shareholders. The company is
predominantly cash driven as it believes that this differentiates it from its competitors and provides
funds for its continued growth and dividend payments.

FFL currently receives 90% of its revenue stream from the retail of fashionable clothing and 10%
from sportswear. The management team of FFL have been exploring various investment
opportunities to increase net profit and expand operations.

The following financial information relates to Funky Fashions Limited:

Statement of profit or loss and other Comprehensive Income for the year ended
31 August 2012

2012 2011
R’000 R’000

Revenue 6 547 856 5 800 967

Cost of goods sold (3 756 249) (3 432 152)

Gross profit 2 791 607 2 368 815
Trading expenses (2 001 877) (1 816 021)
Operating profit 789 730 552 794
Interest received 36 139 24 890
Interest expense (3 343) 2 836
Profit before tax 822 526 574 848
Taxation (230 307) (160 957)
Profit for the year 592 219 413 891

Dividends 223 335 197 092

Additional information:

1. The following information relates to FFL:

Market value of Equity on 31 August:

2011: 205,686,900 shares trading at R30,65 per share
2012: 205,686,900 shares trading at R39,34 per share
2012 depreciation and amortization R131 000 600
Beta coefficient 1,5
WACC 15,5%
Market value of debt capital R150 000 000

Taxation is payable at 28% at the end of each financial year.

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2. The following market related information is available:

£1=R
12,06
R/£ Spot rate on 31 August 2012 £1=R
12 month forward rate 12,77
Risk premium on 31 August 2012 5%

Recent yields on government bonds:

Maturity United South Africa

Kingdom

2 year 0,44% 5,97%

3 year 0,55% 6,24%
4 year 0,8% 6,51%
5 year 1,05% 6,75%
10 year 2,14% 7,57%

3. The following relates to a competitor entity within the clothing industry:

2012 2011

Share price – 31 August 6 648 cents 5 099 cents

PE – ratio (multiple) 15 15

Fara clothing line

One of the directors of FFL, Mr Russell, worked in the clothing retail industry in the UK for a period of
10 years and has thus built strong relations with some of the large international fashion outlets.
During his recent visit to the UK he met with one of the directors, Mrs Kahn of a large international
fashion outlet “Fara”. During their meeting Mrs Kahn mentioned that Fara is considering expanding
their clothing line into South Africa. They are of the opinion that it will be a good idea to first retail
their clothing through South African outlets for a period of 5 years, as this will give them an indication
of whether it will be feasible to subsequently open Fara outlets in South Africa. Mr Russel saw this as
an opportunity and suggested that Fara consider retailing their clothing in FFL’s stores, since FFL
has years of experience as a clothing retailer and is quite in tune with the South African market.

During a follow up meeting between the management of FFL and Fara it was stated that FFL will
have to pay Fara a once off initiation amount of £15 million for the exclusive right to sell their clothing
line. Fara expects payment of this amount after the first year of sales.

Research to the value of R1 000 000 conducted by FFL indicated that sales of Fara’s clothing line will
probably amount to R400 million in year 2013 and is then expected to increase by 7% annually
thereafter for the remainder of the period. Fara clothing purchases by FFL will amount to £20 million
in 2013 and these sterling (£) costs are expected to escalate by 5% annually thereafter. FFL will have
to incur all costs relating to marketing and the refurbishments of stores in order to create a market for
Fara in South Africa.
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The following current cost schedule was determined by the research performed:

Description Frequency Cost

Marketing costs Upfront - once off R 25 000 000
Cost of Print Media Expected monthly cost paid in arrears R75 000 per month
Cost of television advertisement 100 advertisements per year R50 000 per ad
Store refurbishment Upfront-once-off R100 000 000

The above repeat costs are expected to increase by the estimated inflation rate of 6% per annum
thereafter.

Working capital requirements are expected to amount to 12% of sales per year and are incurred at
the beginning of each year.

The once off refurbishment costs will qualify for improvements and will be depreciated over 3 years.
SARS will allow a 20% per annum write off.

Assume for the purpose of this question, the initial upfront payment for the right to sell the Fara
clothing line qualifies for recognition under IAS 38, and can be amortized over the life of the project.
SARS will permit a 3 years allowance.

The following formula utilises relative interest rates to calculate forward exchange rates:

t
(ZAR/FC) t = (ZAR/FC) 0 x (1+r t )
t
(1+rF t )
Where:
(ZAR/FC) t = the exchange rate of South African rand compared to the foreign currency
at time t

(ZAR/FC) 0 = the current spot exchange rate

rt = the spot South African interest rate at term t (often determined based on the
yield to maturity of an appropriate South African government bond)

rF t = the spot foreign country interest rate at term t (often determined based on
the yield to maturity of an appropriate foreign government bond)

Round all Rand amounts to the nearest Rand and all other figures to 2 decimal places.
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REQUIRED Marks

(a) Identify and discuss the typical business risks that an entity operating in the clothing
retail industry in South Africa would be exposed to. Further advise the management
of FFL on the risk management techniques that could be implemented for each of the
risks identified.

Your answer should be presented in the following tabular format:

Risk identified Discussion of Risk Risk Management

(6) (6) (6) (18)

(b) Based on a comparison of the performance of FFL’s and its competitors’ share price
as well as its earnings potential, advise potential shareholders on an appropriate
investment decision. Marks will be awarded as follows:

● Ratios and calculations (6)

● Discussion and commentary (6)

(c) Discuss the advantages of FFL’s business strategy whereby they sell predominantly
on a cash basis. (5)

(d) Advise the management of FFL whether it would be feasible for them to retail Fara’s
clothing line on an exclusive basis, for a period of 5 years. Include a brief discussion
of qualitative aspects taken into consideration. Marks will be awarded as follows:

● Calculations (18)
● Qualitative considerations (9)
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QUESTION 5 100 marks

CASEYWALKERCARMICHAEL SOUTH AFRICA LIMITED

(Source: Supplementary Exam 2011 MAC4862 - adapted)

CaseyWalkerCarmichael South Africa Limited (CWC) was founded in 1978 by Mr Charles

Carmichael. This medium sized firm provides a wide range of services, including assurance, tax and
advisory. The firm aims to assist its clients in achieving their business objectives, managing their risk,
and improving or sustaining their performance by providing them with insightful business solutions.

The market

For the year 2011, CWC anticipated that their audit client base would decline as a result of the
implementation of the new Companies Act no. 71 of 2008, which became effective during 2011. The
new Act changed the legislation relating to the requirement for companies to be audited, leading to
an expected contraction in the market for audits. As CWC aims to grow its historic levels of revenue,
in the last six months of the 2011 financial year they have refocused their efforts to expand their
consulting function.

Audit function

The audit function historically contributed 70% of the firm’s total revenue and also included free
annual IFRS/IAS updates presented to clients. Each audit team consists of one director, one
manager and a team of article clerks (which varies depending on the size of the assignment). Since
the change in business-function focus, the audit function contributed only 60% of the total revenue
earned during this time.

Tax function

This function offers assistance to clients in the areas of: indirect tax, cross-border tax, individual and
business tax, employer tax and tax management services. The tax function’s contribution to the firm’s
total revenue for the 2011 financial year remained constant at 20%.

Consulting function

Before the change in business focus, the CWC consulting team had the intellectual capital to provide
clients with advice in the areas of: business valuations, mergers and acquisitions, restructuring,
listings, corporate treasury and corporate governance. From the second half of the 2011 financial
year the consulting function was expanded to include advisory services in the areas of: sustainability,
technology, risk and compliance. Some of the audit function staff were redeployed to the consulting
function. Mr Carmichael, the managing director of CWC, also appointed Mrs. Sarah Walker as the
new advisory expert on some of the new offerings along with a few other team members
recommended by her (Mrs. Walker was referred to Mr Carmichael by one of his trusted business
partners, Mr John Casey). Mrs. Walker has no previous experience in an advisory capacity, but has
significant experience as a risk and compliance officer.

The consulting function historically contributed 10% of the firm’s total revenue, but since its
expansion the consulting function has contributed 20% of the total revenue earned during this time.
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An extract of the annual financial statements of CWC Ltd appears below:

STATEMENT OF COMPREHENSIVE INCOME FOR CWC LIMITED FOR THE YEAR ENDED
31 AUGUST

Notes 2011 2010

R’ 000 R’ 000

Turnover 1. 243 100 258 000

Expenses and disbursements on client (23 200) (24 700)

assignments

Net revenue 219 900 233 300

Other operating expenses (34 800) (29 900)

Depreciation, amortization and impairment (2 400) (2 600)

Employee cost 2. (139 500) (97 400)

Operating Profit 43 200 103 400

Finance income 7 600 9 000

Finance cost 3. (9 100) (8 400)

Net profit before tax 41 700 104 000

Income tax expense 4. (19 950) (20 640)

Total comprehensive income for the year 21 750 83 360

Notes

1. Total revenue for the first six months of the 2011 financial year increased by 10% from the same
period in the 2010 financial year. Revenue was earned at a constant rate during the 2010
financial year.
2. An eight per cent increase on the 2010 remuneration packages was agreed to with staff for the
2011 year. The remainder of the increase relates appointment of Sarah Walker and her team in
the second half of the 2011.
3. CWC Ltd is currently borrowing at a 12,5% fixed rate and is of the opinion that a variable rate
would suit them better. They have negotiated with their finance providers and the best variable
rate currently available to them is equal to the prime lending rate (prime) plus 1%.
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Fulcrum Ltd, an independent company, is currently paying a floating rate equal to prime plus
0,5%. This company is of the opinion that it is highly unlikely that there will be any further rate
cuts by the Reserve Bank and, based on this viewpoint, they prefer a fixed rate. The best fixed
rate currently available to them in the formal financial market is 13,5%.

CWC Ltd and Fulcrum Ltd have thus come to the following agreement:

• CWC Ltd will pay interest at prime to Fulcrum Ltd.

• Fulcrum Ltd will pay interest at a fixed annual rate of 12% to CWC Ltd.

ENQUIRIES BY CLIENTS OF CWC

The firm’s clients range from small sole-proprietors to large listed companies and although CWC is
locally based, their client base includes both local and foreign entities.

Some of the most recent client enquiries include the following:

John Doe Ltd (JD Ltd)

As part of a growth strategy, JD Ltd recently merged with one of its competitors. However, since the
merger there have been numerous problems, including the compatibility issues with the two
companies’ accounting software packages, lawsuits from former employees claiming to be unfairly
dismissed, and an investigation by the Competition Commission. Mr Brice Larken, a majority
shareholder, regrets not seeking CWC’s assistance earlier as these matters are now causing him
sleepless nights.

BuyMore Ltd (BM Ltd)

BM Ltd is considering the acquisition of MegaMart Ltd., a competitor. The operating and risk
characteristics of MegaMart Ltd are very similar to that of BM Ltd, except that BM Ltd is a wholly-
equity financed company, whereas MegaMart Ltd’s capital structure consists of 70% equity and 30%
debt.

Other information:

• The beta coefficient of BM Ltd is 0,8.

• The expected return on the market is 14%.
• The following details refer to the RSA Government Bonds:

Bond Description Coupon rate Current yield Maturity

R157 13,5% 6,5% 15 September 2015
R186 10,5% 8,1% 21 December 2026

Captain Awesome Ltd (CA Ltd)

CA Ltd is considering expanding its shipping fleet by purchasing either the shipping fleet belonging to
Captain Moses Ltd or Captain Eye Ltd.
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The cash flow projections and other information pertaining to the operation of each shipping fleet are
as follows:

Captain Moses Captain Eye Ltd’s

Ltd’s shipping fleet shipping fleet

Initial investment required R150 000 000 R320 000 000

Fleet’s remaining lifespan – years 6 12
Projected annual positive Free Cash Flow (from R55 000 000 R70 000 000
year 1, in current monetary terms)
Associated nominal WACC 15% 18%
Associated real WACC 10% 13%

Mr Awesome, a majority shareholder in CA Ltd, initially obtained the opinion of his son-in-law who
offered the advice that Captain Eye Ltd’s fleet should be the better investment due to the higher
expected return captured in its associated WACC.

Wung & Brothers Ltd (W&B Ltd)

One of your clients, Wung & Brothers Ltd, performed their own valuation of a 100% equity
shareholding in an unlisted company called Wow-Disney.

W&B Ltd will utilise a long-term loan with a fixed interest rate of 12% per annum to finance the
purchase of Wow-Disney.

Mr Devan, the CEO of W&B Ltd, provided you with an annotated extract of Wow-Disney’s audited
financial statements:

Statement of Comprehensive Income for the year ended 31 August

Note 2011 2010

R’ 000 R’ 000

Turnover 189 000 173 500

Cost of sales (62 000) (67 000)
Gross Profit 127 000 106 500
Other operating expenses (34 800) (29 000)
Depreciation, amortization and impairment (12 400) (13 500)
Employee costs (37 000) (34 000)
Operating Profit 42 800 30 000
Finance income 1. 16 000 14 000
Finance cost 2. (19 000) (17 500)
Net profit before tax 39 800 26 500
Income tax expense 3. (11 940) (7 950)
Total comprehensive income for the year 27 860 18 550
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Notes

1. The interest received relates to cash invested in money market accounts.

2. Finance cost relates to interest paid on debentures and the bank overdraft.
3. The current effective company tax rate is 30%. The effective rate is expected to be 28% from
2012 onwards and, due to the effect of provisional tax, the actual payment is expected to largely
occur in the same year in which the related income was earned.

General information and projections for Wow-Disney

a. The total working capital requirements of Wow-Disney will be as follows at the end of each year:

Year 0: R 15 000 000

Year 1: R 17 250 000
Year 2: R 19 830 000
Year 3: R 22 810 000
Year 4: R 26 250 000
Year 5: R 30 170 000

b. Forecasted and comparator figures (including the effect of expected growth and inflation).

2011 2012 2013 2014 2015 2016

Description
R'000 R'000 R'000 R'000 R'000 R'000
Net Profit before tax 39 800 45 600 51 300 54 500 59 000 62 350
Tax expense
(effective) (11 940) (12 768) (14 364) (15 260) (16 520) (17 458)

c. The expected growth in free cash flow from the year 2017 onwards is expected to be 4% per
annum.

d. Debentures

Wow-Disney has 2 171 429, 8% R100 debentures in issue. Interest is payable bi-annually and
the principal at end of 2021 year. The market-related interest rate on similar debentures is 9%
per annum.

e. Preference Shares

There are currently 50 million, 10,5% redeemable preference shares (R1 each) in issue. These
shares are redeemable at a 6% discount in 3 years’ time. The current market-related yield for
similar redeemable preference shares is 9,5%.
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Valuation of Wow-Disney performed by W&B Ltd:

Year 0 Year 1 Year 2 Year 3 Year 4 Year 5

Description 2011 2012 2013 2014 2015 2016

Working R'000 R'000 R'000 R'000 R'000 R'000

Net Profit before

tax 39 800 45 600 51 300 54 500 59 000 62 350

Working capital (15 000 000) (17 250 000) (19 830 000) (22 810 000) (26 250 000) (30 170 000)
requirements
Working capital 131 310 000
released

Taxation W1 (3 623) (3 015) (382) (10 153) (5 186) (3 488)

Cash movement
in fixed assets W2 1 250 (1 750) 1 500 (3 800) 3 800 1 000

Free cash flows (14 962 573) (17 209 165) (19 777 582) (22 769 453) (26 192 386) 101 199 862

Calculator inputs Cf 0 Cf 1 Cf 2 Cf 3 Cf 4 Cf 5

Discount rate used i 12,00%

Net present value of

free cash flows 21 523 528
Final value R'000
Net present value of free
cash flow 21 523 528
Continuing value W3 843 332 183
Preference shares W4 (49 099)
Debentures UNKNOWN
Enterprise Value of Wow-
Disney
(excluding debentures) 864 806 612
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Below are the detailed workings used in the valuation:

Working 1 2011 2012 2013 2014 2015 2016

R'000 R'000 R'000 R'000 R'000 R'000
Total Tax
amount A (12 940) (10 768) (1 364) (36 260) (18 520) (12 458)
SARS liability
- opening balance (32 000) (31 000) (33 000) (46 000) (25 000) (23 000)
SARS Liability
- closing balance 31 000 33 000 46 000 25 000 23 000 28 000
Income tax expense
(effective) (11 940) (12 768) (14 364) (15 260) (16 520) (17 458)
Tax paid at
(A x 28%) W1 (3 623) (3 015) (382) (10 153) (5 186) (3 488)

Working 2 2011 2012 2013 2014 2015 2016

Cash movement
in fixed assets R'000 R'000 R'000 R'000 R'000 R'000
Opening balance
(Carrying amount) (18 000) (19 250) (17 500) (19 000) (15 200) (19 000)
Closing balance
(Carrying amount) 19 250 17 500 19 000 15 200 19 000 20 000
Purchased/
(Disposed) W2 1 250 (1 750) 1 500 (3 800) 3 800 1 000

Working 3
R’000
Calculation of continuing
Value
Cash flow year 5 101 199 862
Discount rate 0,12
Terminal value: 843 332 183

Working 4

Calculating value of preference share:

n = 3
i = 9,5%
PMT = (5 250 000) {50 000 000 x 10,5%}
FV = (47 169 811) {50 000 000 x 100%/106%)
PV = 49 098 829

(CIMA - adapted)
Note to candidates:

Pay particular attention to the exact wording of the required section, and the number of marks
allocated. Answers should be carefully planned before being executed and clearly numbered. The
length and extent of answers should relate to the allocated number of marks.
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PART A 59 Marks

REQUIRED: Marks

Assist with the enquiries by clients of CWC as detailed below. You should ignore
Secondary Tax on Companies (STC), dividend tax and Value-Added Tax (VAT).
(a) JD Ltd:

Recommend to Mr Brice Larken the procedure that CWC’s Consulting function

should have performed in order to identify possible issues and risks prior to the
merger and acquisition. (1)
Provide further details of the steps included in such a procedure and describe how
these steps could have assisted JD Ltd with identifying these issues and risks, in
advance. (8)
(b) BM Ltd:

Calculate the cost of equity of MegaMart Ltd from the information provided and offer
a reason why your answer is expected to be higher or lower than the cost of equity of
BM Ltd. (You are not required to calculate BM Ltd’s cost of equity.) (6)
You are provided with the following formula:

β G = β u x [E + D(1-t)]/E]

Where:
β G =beta coefficient (geared entity)
β u =beta coefficient (ungeared entity)
D = Proportion debt
E = Proportion equity
t = tax rate
(c) CA Ltd:

Calculate and comment on the acceptability of both fleets if evaluated separately

and conclude on the shipping fleet that would represent the best investment option
for CA Ltd. Take into consideration that CA Ltd will only invest in one of the two fleets
(the alternatives therefore being mutually exclusive). Assume that the fleets will not
have any value at the end of their remaining lifespan.
Marks will be allocated as follows:
• Calculations (6)
• Evaluation of acceptability in the case of CA Ltd and conclusion (5)
(d) CA Ltd:

Discuss whether this choice is in the best interest of CA Ltd’s shareholders.

Assume that CA Ltd decided to invest only in one of the fleets, not both, due to a
refusal to incorporate any debt into its capital structure. Your discussions should also
address how a mixture of funds would impact on your commentary regarding the (9)
choice being made.
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(e) W&B Ltd:

Evaluate the business valuation of a 100% equity shareholding in Wow-Disney

performed by W&B Ltd, by providing detailed comments on any possible errors in
calculation and application of principles.
You are not required to re-perform the valuation or to evaluate the choice of valuation
method. You may assume that all source data provided is reliable, but for the
valuation performed by W&B Ltd you cannot assume that the calculations performed,
inputs used, or principles applied, are reliable. (20)
(f) W&B Ltd:

Further assist W&B Ltd by calculating the market value of debentures to be

incorporated in the valuation of an 100% equity shareholding in Wow-Disney. (4)

PART B 41 Marks

REQUIRED: Marks
Assist with matters relating to CWC as detailed below.
(a) Identify general factors brought on by the implementation of the new Companies Act
no. 71 of 2008, that might increase CWC’s business risk. (5)
(b) Calculate and comment on the impact that the implementation of the Companies Act
no. 71 of 2008 and the company’s new strategy have had on CWC’s revenue and
employee cost. (8)

• Calculation of impact on revenue and employee cost

• Comment on the ratios and percentages calculated and identify probable
reasons for fluctuations. (15)

(c) (i) Determine on the basis of the various interest rates offered to the two companies
whether a swap arrangement is feasible. (4)
(ii) Calculate and conclude on the financial advantages for both CWC Ltd and
Fulcrum Ltd that will result from the suggested swap’s interest rate effects. (6)
(iii) Discuss other factors that CWC should have taken into consideration before
entering into a swap agreement with Fulcrum Ltd. (3)
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QUESTION 6 93 Marks

RAPS GROUP LIMITED

(Source: Exam 2011 MAC4862 - adapted)

RAPS Group Limited (“RAPS”) is listed on the main board of the JSE Securities Exchange SA and
operates a chain of South African retail food stores. These retail stores focus primarily
on convenience-shopping and are operated predominantly on a franchise-basis. The directors
of RAPS Group are investigating expansion options that would facilitate accelerated entry
into the growing Africa market. As part of these investigations, the directors have identified
OKAY (Proprietary) Limited as a potential target for acquisition.

OKAY (Proprietary) Limited (“OKAY”) is a private company operating a chain of supermarkets

located in South Africa, Zambia and Botswana. The company grew from humble beginnings in
the 1970s to being one of the largest privately-owned supermarket groups in southern Africa.
OKAY owns the businesses and is not operated on a franchise-basis. OKAY is still 75% owned
by its founding-family.

A. Retail industry information

In South Africa, an increasing percentage of food and groceries are sold by the large food
retail groups. These groups operate different types of food retail stores and wholesalers,
including convenience stores, supermarkets and hypermarkets.

The food and grocery market is set to grow in South Africa, but significantly greater growth is
expected in sub-Saharan Africa over the next two decades. The South African food-retail
industry experienced tough trading conditions in 2010 and 2011, due to the slow recovery from
the worldwide recession, the high levels of competition and the low levels of food inflation.

To curb costs, supermarket groups of sufficient size often buy directly from manufactures. These
supermarkets operate at low profit margins and thus rely on the sale of large quantities.

Gross profit margins are calculated easily, but supermarket groups often struggle to calculate
the net profit margins of individual items or groups of items, due to the large number of activities
and costs incurred. In an attempt to better quantify costs, some supermarket groups have
implemented Activity based costing (ABC) systems, which usually involve the following steps:

1. Identify major activities;

2. Assign costs to activity pools;
3. Determine cost drivers for each activity; and
4. Assign the cost of activities to individual items or group of items based on its demand
for the activity.

SELECT & SWIPE Limited

Most supermarket groups, including SELECT & SWIPE Limited (“S&S”) – a company listed on the
Alternative Exchange (AltX) of the JSE Securities Exchange SA – own only a small percentage
of the properties from which they operate; instead they enter into long-term lease contracts for
periods of between 10 and 20 years, normally renewable for a further 10 to 20 years. Retail
space is usually leased at shopping centres and the large quantities of floor space often leased
make it impractical for more than one such key-tenant to operate in the same centre. This
barrier to competition in the same place is normally further entrenched through a relevant
clause in the lease contracts, limiting a competitor supermarket to occupy space at the same
location.
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The operating rentals of S&S mostly comprise minimum monthly payments with additional
payments based on turnover levels. The turnover rentals, where applicable, average 1.5% of
turnover.

S&S owns the businesses and do not operate them on a franchise-basis. The company further
owns most of the vehicles used in its delivery fleet. S&S operates predominantly in South Africa,
but the company also owns a few supermarkets in southern Africa.

Relative to the food retail industry, S&S obtained particularly negative results in 2011,
due to difficulties in coping with the negative trade environment. Cost-control and other
measures have been put in place to counter these effects. Analysts are optimistic that S&S will
recover from this slump, to be in-line with the rest of the industry in 2012.

Over the past couple of years, no large changes have occurred in the shareholding of
S&S.

MASSMART HOLDINGS Limited

Recently, one of the most newsworthy events in the larger retail industry has been the
acquisition of Massmart Holdings Ltd. by Wal-Mart Stores Inc.

Massmart is a South African listed company and the owners of several brands, including
Game, Builders Warehouse and Makro. The acquirer, Wal-Mart Stores Inc., is a large retail
company based in the United States of America.

Following many developments, where Wal-Mart even at one time considered abandoning
their intentions, the deal was finally approved on 31 May 2011, subject to certain conditions.

B. Ratios and figures

At 31 August 2011 Relevant

to S&S

Closing share price (cents per share) 425

Headline earnings per share (cents per share) – most recent financial year ended 16

Headline earnings per share (cents per share) – analysts’ consensus forecast for
2012 financial year 21
Debt : Equity ratio (based on market values) 0,08:1
Before-tax interest paid as a percentage of earnings before interest and tax
Assume 365 days in one year 6%
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C. Information relating to OKAY (Pty) Ltd:

Summarised statements of comprehensive income for the year ended 31 August

2011 2010 2009

(draft) (audited) (audited)
R’m R’m R’m

Revenue 585,2 549,9 501,4

Cost of goods sold (474,0) (445,8) (404,0)
Gross profit 111,2 104,1 97,4
Trading expenses (86,0) (83,2) (75,5)
Depreciation (19,8) (19,7) (19,3)
Employees, occupancy and other
expenses (66,2) (63,5) (56,2)
Interest received 0,6 0,5 0,7
Operating profit 25,8 21,4 22,6
Taxation (7,5) (6,8) (7,0)
Profit for the year 18,3 14,6 15,6
Dividends paid (14,9) (13,9) (13,0)
Effect on retained income 3,4 0,7 2,6

Summarised statement of financial position as at 31 August

2011
(draft)
R’m
ASSETS
Non-current assets 38,5
Equipment 34,5
Vehicles 3,0
Other 1,0
Current assets 54,0
Inventory 33,3
Trade receivables 19,7
Cash and equivalents 1,0

Total assets 92,5

EQUITY AND LIABILITIES

Total shareholders’ equity 16,2
Current liabilities 76,3
Trade and other payables 74,0
Tax 2,3

Total equity and liabilities 92,5

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Additional information relevant to OKAY:

OKAY’s non-current assets are reflected in the statement of financial position at net
carrying values and are not shown on a revaluation basis. RAPS estimated the values of
OKAY’s non- current assets and inventory on 31 August 2011 are:

Replacement cost Net realisable value

R’m R’m

Equipment 50,0 33,0

Vehicles 5,0 2,9
Inventory 33,8 32,0

The average age of the equipment owned by OKAY is older than the same equipment of the
listed company, S&S. OKAY will have to replace some of its equipment sooner if the
company is to match S&S in this regard, which should have a corresponding accounting
impact of a 6% increase in OKAY’s depreciation expense.

An investigation revealed that the salaries of top management (included in employees,

occupancy and other expenses) are below market-related pay and will have to be increased
by R1 million (in current monetary terms) to match the market. An average rate of inflation
equal to 10% applied to management salaries over the past couple of years.

In accordance with common industry practice, OKAY also enters into long-term lease
contracts for its premises. Lease contracts comprise minimum monthly payments and, on
a v e r a g e , a n additional payment equal to 2% of turnover. Where a tenant selects a
greater percentage of its rental payment to relate to turnover, the fixed monthly amount is
usually lowered.

• OKAY have matched the growth in earnings of listed company, S&S, to a large extent,
except that OKAY achieved (relatively) superior results in 2011.

OKAY recently received negative publicity when it condoned the actions of one of its
exclusive egg suppliers, who allegedly mistreated male hatchlings as part of its usual
production processes. OKAY has since distanced itself from this supplier and now buys
eggs from an alternative supplier on a price-competitive basis, with a superior animal-rights
track r e c o r d . A due d i l i g e n c e investigation further revealed a contingent liability
relating to OKAY’s waste-disposal practices in the past. An expert was consulted, who
estimated the possible penalties and legal-settlement cost, and its corresponding probability
of occurrence:

Probability Cost
R’m

60% 6,0
40% 0,5

• Revenue of OKAY is expected to grow by 7% in 2012.

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D. Further information relating to the potential merger or acquisition of OKAY Limited

The directors of RAPS estimate that certain savings could be obtained should RAPS acquire
control of OKAY. The directors also expect some expenditure to be incurred. Specific details
include:

1. Expected savings (pre-tax) in distribution, marketing and accounting costs for years in the
future:

2012 2013 2014

R’m R’m R’m

0,8 1,2 1,5

Growth in this benefit from 2015 and later is expected to equal 5% per annum.

2. Expected integration and new software implementation costs for years in the
future:

2012 2013 2014

R’m R’m R’m

4,0 1,0 0,3

Should OKAY be acquired by another potential bidder, the net value of cost synergies
(after integration costs) is expected to equal R5 million after tax.

Note to candidates:

Pay particular attention to the exact wording of the required section, and the number of marks
allocated. Answers should be carefully planned before being executed and clearly numbered. The
length and extent of answers should relate to the allocated number of marks.
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REQUIRED Marks
(a) Analyse the working capital management o f OKAY (Pty.) Ltd. at 31 August 2011
based on the available information and discuss your findings using the following
format:

Analysis and calculations

Discussions Indicate whether levels are Possible reasons for your
typical/low or high a findings, considering the (5)
compared to the industry industry
… … (8)

(b) Analyse and discuss the expenditure reported in the supplied

statements of comprehensive income of OKAY (Pty.) Ltd. for the years ended
31 August 2009 to 2011.

• Pay particular attention to the behaviour of the following costs relative to

revenue;
• Cost of goods sold;
• Depreciation; and
• Employees, occupancy and other trading expenses. Analysis (9)
Discussion (8)
(c) Discuss briefly the reason for the requirement by the JSE Securities Exchange for
listed companies to calculate Headline Earnings. Include the typical types of
adjustments made in the calculation of Headline Earnings that are not made for basic
earnings per share. (3)
(d) Explain the relevance of a control premium relative to the usual key share-
holding levels affecting the level of control, when valuing a private
equity (unlisted) shareholding based on: (4)

1. A Price / Earnings (P/E) multiple method

2. An Enterprise Discounted Cash Flow Model, based on Free Cash Flow.
(e) Calculate the following values for OKAY (Pty.) Ltd. as at 31 August 2011,
based on available information:

1. Net asset value based on carrying values (1)

2. Net asset value based on replacement cost of items included in the
statement of financial position (2)
(4)
3. Net asset value on a liquidation-basis
4. Value calculated using the Gordon Dividend Growth Model, assuming a
cost of equity equal to 13%. (4)

Where appropriate, you should annotate calculations and possible required

adjustments, but ignore any possible effects of Secondary Tax on
Companies, Dividend Tax and Capital Gains Tax.
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REQUIRED (continued)

(f) Estimate the fair market value of a 100% equity shareholding in OKAY (Pty.) Ltd.
as at 31 August 2011, by using a valuation method based on a forward
Price / Earnings (P/E) multiple. (22)
You should annotate calculations and adjustments made, but ignore any possible
effects of Secondary Tax on Companies, Dividend Tax and Capital Gains
Tax. Round figures to the nearest R0,1 million.
(g) Explain the strengths and/or weaknesses of each of the following as
determined earlier, if used by RAPS Ltd. to estimate a probable purchase price for a
100% shareholding in OKAY (Pty.) Ltd.: (5)

1. Net asset value based on carrying values

2. Net asset value based on replacement cost of items included in the
statement of financial position
3. Net asset value on a liquidation-basis
4. Value determined based on the Gordon Dividend Growth Model
5. Value determined using a method based on a P/E multiple
(½) mark per valid point
(h) Determine the net benefit of the estimated savings, after expenditure, in the case
of acquisition of OKAY (Pty.) Ltd. by RAPS Ltd., using a method based on
discounted cash flow. Assume a discount rate of 12,5% (pre-tax) and round
figures to the nearest R0,1 million. (4)
(i) Generalise from the actual Wal-Mart / Massmart-case possible difficulties
and probable synergies, other than the savings already identified, that
should be considered before RAPS Ltd. acquires OKAY (Pty.) Ltd. (8)
(j) Identify any six of the foremost activities of a supermarket group that could serve
as activities for ultimately identifying the cost drivers in such a supermarket group,
if an Activity-Based Costing (ABC) system is to be implemented. (6)
TOTAL MARKS 93
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QUESTION 7 100 marks

THE ENTERTAINMENT GROUP

(Source: Exam 2010 TOE408W (MAC4862) EDCO SAICA – adapted)

The Entertainment Group (Pty) Ltd (“TEG”) operates nine theatres in major cities in South Africa. The
company first offered theatrical productions in a single theatre in Johannesburg. Its enthusiastic
owners have a lot of experience in theatrical productions and grew the company by opening a further
eight theatres over the past four years. TEG offers patrons the opportunity to enjoy high quality
theatrical shows. Except for the current year, the company has flourished at a time when theatre
attendance generally has been on the decline. TEG’s musical-theme shows have entranced
audiences due to the quality of productions and the brilliance of cast members. Patrons are permitted
to purchase alcoholic and other beverages on the premises to consume before and during shows.
However, the company does not serve food or meals.

The company commissions independent contractors to write and produce musical shows on an
annual basis. All rights to such shows are owned by TEG and these shows may only be staged at its
theatres. Independent contractors are paid a fixed amount per new show for their creative work. The
company has its own casting directors, musical directors and choreographers who select cast
members and direct and rehearse their performances. The company offers musicians and artists
contract employment for the duration of shows, and hence does not offer them permanent
employment.

TEG has approximately six different shows running at its 9 theatres nationally, at any point in time.
These shows are rotated amongst the different theatres and care is taken to ensure that the same
shows are not featured at theatres in close proximity to each other. The company commissions four
new shows per year to continually provide patrons with opportunities to see new productions.

Each existing theatre can accommodate 400 patrons and has standardised décor. The company has
historically leased premises and lease agreements are generally for nine-year periods with five-year
renewal options.

There are four individual shareholders who collectively own 100% of the shares in issue of TEG.
These individuals are all executive directors and are actively involved in the business.

TEG is planning to build and own its theatrical theatres in future and to diversify into the movie
theatre market. This change in strategy is motivated by the high cost of leasing theatrical premises
and to establish some form of diversification.

New theatres to be built for theatrical productions

TEG plans to build and open two new theatres to be used for theatrical productions (400 seats in
each) during the 2011 financial year. The cost of erecting such theatres is estimated at R18 million
each. Sound equipment and furniture and fittings for each theatre are expected to cost a further
R3 million per venue. In terms of the proposed construction contract, the following will be payable at
the date of signing (expected to be 30 September 2010): the full cost of the sound equipment,
furniture and fittings, and a deposit of R3.6 million. The balance is to be paid upon completion, which
is expected to be 31 March 2011.
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TEG is currently considering means of financing the cost of these theatres (excluding the cost of the
sound equipment, furniture and fittings, and deposit), either by means of a long-term loan from a
commercial bank repayable in annual instalments consisting of both a capital and finance cost
element or through a commercial bank loan repayable at the end of its term. The loan repayable in
annual instalments will bear interest at 2% above the prevailing prime overdraft lending rate
(currently 10% per annum), repayable in seven annual instalments on 31 March of every year at the
end of every period.

This loan will also require the payment of an upfront transaction fee equal to R200 000. The loan
repayable at the end of its term will bear interest at 2.5% above the prevailing prime overdraft lending
rate and will be repayable with interest on 31 March 2018 and will contain more restrictive covenants.

For both types of loan the commercial banks indicated that a fixed interest rate could be negotiated.
In either case, the following will be applicable: interest is to be calculated and compounded annually
in arrear, and capitalised into the outstanding loan balance; and the interest will be deductible for
income taxation purposes.

Commercial banks have adopted the view that theatre buildings provide limited security for loans due
to their specialised nature and use. Accordingly, loans are to be secured by a pledge of movable and
immovable assets of TEG, as well as personal surety ships from individual shareholders. The
shareholders have indicated they have reservations about doing this – this will be addressed later in
the scenario.

Potential acquisition

TEG is considering the acquisition of Movies (Pty) Ltd, a company that operates eight motion-picture
complexes (each with an average of four cinemas) situated in shopping centres in the Gauteng area.
Movies (Pty) Ltd is an independent concern not forming part of any of the South African cinema
chains. The directors have been considering the option of diversifying into the cinema theatre market,
ever since the price war between the large South African cinema chains ended in 2007. The recent
upsurge in the results of these chains further served to entice their interest. Exciting new
technologies, such as three-dimensional (3D) technology and digital projectors seemed to have
injected life in the cinema industry, but these have so far not been implemented by Movies (Pty) Ltd
due to the high cost (currently roughly R1 million per theatre).

However, seating and décor have recently been upgraded. Movies (Pty) Ltd holds the cinema rights
at several shopping centres and entered into long-term lease contracts with the owner of these
shopping centres.

Following the signing of a non-disclosure agreement, the directors of Movies (Pty) Ltd offered the
following information and projections relating to their company:
Statement of comprehensive income for the years ended 31 August:

2010 2009

Sales 24 192 000 22 837 248

Cost of sales (11 612 160) (10 789 066)
Gross profit 12 579 840 12 048 182
Operating expenditure excl. depreciation (9 595 008) (9 671 129)
Depreciation (2 230 400) (2 502 400)
Profit before interest and tax 754 432 (125 347)
Interest (400 643) (231 956)
Profit before tax 353 789 (357 303)
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The net working capital balance (excluding any short-term portion of long-term financing) at
31 August 2010 equalled R460 600. Included in this balance is R100 000 surplus cash.

Projected information for the years ending 31 August:

2011 2012 2013 2014

Sales (in Rand) 25 650 000 30 810 000 36 450 000 38 270 000
Depreciation expense (R) 2 565 000 3 081 000 3 645 000 3 827 000

TEG’s team responsible for the due diligence procedures identified the following information pertaining
to Movies (Pty) Ltd as well as other information that might be relevant:

The projected sales and depreciation figures are deemed acceptable, but cognizance should be taken of
the following additional information:

• Historically there seems to be a very strong correlation between the number of people supporting
the shopping centres and the amount of people purchasing movie tickets.
• It is expected that the shopping centres in which Movies (Pty) Ltd operates its theatres will
experience the following annual increase in support (year-on-year measured in terms of the
average number of people supporting the centres):

2011 2012 2013 2014 and

onwards
1% 3% 6% 0%

• Historically (but after the price-war) the ticket prices at the theatres of Movies (Pty) Ltd seem to
increase annually by a percentage equal to inflation (measured in terms of the consumer price
index).
• Historical and expected annual inflation rates (year-on-year measured in terms of the consumer
price index) were / are:

2008 2009 2010 2011 2012 2013 2014 and

onwards
11% 8% 6% 5% 6% 5% 5%

• Growth in sales in excess of those indicated by historical trends would only be possible if Movies
(Pty) Ltd invested in 3D technology and digital projectors for at least 1 cinema per complex. The
directors of TEG have indicated that they are willing to invest in such technology at all of the
Movies (Pty) Ltd cinema complexes.
• Except for any possible investment in new technologies, Movies (Pty) Ltd’s annual net capital
investment is expected to remain at 11% of sales.
• Movies (Pty) Ltd’s gross profit percentage is expected to remain at 2010’s levels.
• Regression analysis indicate that operating expenditure (incl. depreciation) (y) could be
explained by the following equation, which is expected to remain relevant for the forecast period:
y = 0.11x + 8 000 000, where x = sales amount, the slope represents the variable component of
this cost and the y-intercept the fixed component.
• The depreciation expense is expected to equal the taxation allowances granted by the South
African Revenue Services. The company tax rate is 28%.
• Movies (Pty) Ltd’s beta-coefficient is estimated at 1.1.
• The market risk premium is expected to remain constant at 6 percent.
• Movies (Pty) Ltd’s target debt: equity ratio is estimated at 40:60.
• Movies (Pty) Ltd’s current pre-tax cost of debt is estimated at 10%.
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• Information recently obtained pertaining to South African government bonds:

Maturity date Coupon rate Yield

(%) (%)
R153 31 August 2011 13,00 8,0
R207 15 January 2020 7,25 9,0
R209 31 March 2036 6,25 9,1

• A small stock premium for entities with a total market value below R250 million is considered to
be 5% (in addition to the cost of equity of a company with a market value in excess of R2 000
million).

• Not all risks were factored into the sales projections provided by the directors of Movies (Pty) Ltd.
It is expected that a specific risk premium of 2% should account for this.

• Movies (Pty) Ltd’s required working capital balance (excluding any short-term portion of long-
term financing) at the end of every year is expected to be 2% of that particular year’s sales.

Concerns

The shareholders and executive directors of TEG are concerned about the following issues facing the
business:

• The terms of the loan finance from the commercial bank. They are unwilling to provide
personal suretyships, on a joint and several basis, to secure loans. In addition, they consider
the interest rate to be very high in comparison to normal property finance rates. They are also
unsure whether to opt for a fixed or floating interest rate.

• The financial results of TEG for the year ended 31 July 2010 were significantly lower than the
budgeted results for this year.

The budget and actual financial results of TEG for the year ended 31 July 2010 as well as the draft
budget for the 2011 financial year are summarised below (the 2011 budget excludes the impact of
the acquisition of Movies (Pty) Ltd):
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DETAILED STATEMENT OF COMPREHENSIVE INCOME FOR THE YEAR ENDED /

ENDING 31 JULY
Budget Actual Budget
2010 2010 2011
R’000 R’000 R’000
Notes
Revenue 60 000 58 140 70 500
Ticket sales 1 50 000 47 561 57 500
Beverage sales 10 000 10 579 13 000
Cost of sales (21 700) (23 457) (25 200)
Ticketing agent commission 2 (1 500) (1 760) (2 200)
Contractors fees for new shows (900) (998) (1 000)
Beverage costs (4 000) (4 560) (4 500)
New show stage props 3 (300) (450) (500)
Musicians and artist fees (15 000) (15 689) (17 000)
Gross profit 38 300 34 683 45 300
Overheads (30 062) (35 910) (40 620)
Depreciation 4 (1 638) (1 788) (3 000)
Marketing costs 5 (900) (1 459) (1 900)
Salaries and wages (7 000) (7 305) (8 000)
Rental of premises 6 (18 000) (19 000) (20 520)
Travelling and accommodation 5,7 (3 000) (3 678) (4 000)
Utility costs 5 (800) (780) (1 000)
Other overheads 5 (2 000) (1 900) (2 200)
Profit from operations 8 238 (1 227) 4 680
Net interest income/finance costs 200 1 (4 600)
Profit before tax 8 438 (1 226) 80

Notes

1. Although TEG does sell tickets directly, the majority of sales are through an independent
ticketing agent who has a national call centre and internet-based infrastructure.
2. Commission of 4% of the face value of tickets is paid to the independent ticketing agent. Both
the budgeted and actual ticketing agent commission for the 2010 financial year amounts to
4% of said face value of the tickets. Budgeted and actual attendance statistics and ticket sales
are summarised below:

July year end Budget Actual Budget

2010 2010 2011
Seats 400 400 400
Tickets sold 714 285 650 432 766 664
Trading weeks at each theatre 48 48 48
Theatres open and trading for the year 9 9 11
Number of shows per week at each theatre 9 9 9
Maximum number of tickets available for sale 1 555 200 1 555 200 1 900 800

3. Construction costs of stage props for new shows are expensed in the year they are incurred.
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4. Leasehold improvements, sound equipment and furniture and fittings are depreciated over a
ten-year period. Depreciation is budgeted to increase significantly in 2011 because of the new
theatres being opened. Buildings are to be depreciated over 20 years.
5. Utility, marketing, travelling and accommodation, and other overheads costs are fixed in nature.
6. Budgeted rental escalations are 8% based on the terms of lease agreements.
7. Musicians and artists sometimes follow particular shows from theatre to theatre. The majority of
travelling and accommodation costs per the statements of comprehensive income relate to
expenses incurred by cast members travelling to different cities and their accommodation
costs.

The statement of financial position of TEG at 31 July 2010 is summarised below:

STATEMENT OF FINANCIAL POSITION AT 31 JULY 2010

R’000
ASSETS

Non-current assets
Property, plant and equipment 9 043

Current assets 819

Trade and other receivables 800
Cash and cash equivalents 19

Total assets 9 862

EQUITY AND LIABILITIES

Capital and reserves 7 694

Share capital and premium 1 000
Retained income 6 694

Current liabilities 2 168

Trade and other payables 1 856
Tax 312

Total equity and liabilities 9 862

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REQUIRED Marks
(You can ignore Value Added Tax, Secondary Tax on Companies and Dividend Tax.)
(a) Critically evaluate the decision of The Entertainment Group (Pty) Ltd to build and own
its theatres as opposed to leasing premises in future. Discuss the risk factors inherent
to this decision and indicate whether you agree with their decision, providing detailed
reasons for your conclusion. (6)

(b) Evaluate the two loans from commercial banks considered as finance for the
outstanding balance on the theatres that are to be newly constructed. Your answer
should include:

(i) A determination of the most cost-effective loan by calculating the internal rate
of return (IRR) of each; (11)
(ii) A discussion of other factors to be considered in deciding between the two
options. (4)
(iii) Discuss the factors to be considered in evaluating whether to opt for a fixed
interest rate as opposed to a floating interest rate on either of the loans. (5)
(iv) Critically comment on the concerns that the shareholders of The Entertainment
Group have expressed regarding the other proposed commercial bank loan-
terms. (5)

(c) Calculate the number of tickets that need to be sold in the 2011 financial year in order
to break even. Assume that 80% of all ticket sales will occur through the independent
ticketing agent and that finance cost is a fixed cost. (Perform calculations to 3 decimal
points.) (10)

(d) Critically analyse and interpret the actual and budgeted ticket sales of The
Entertainment Group (Pty) Ltd for the year ended 31 July 2010 in as much detail as
possible. Your analysis should include a variance analysis if appropriate. (Perform (12)
calculations to 3 decimal points.)

(e) Identify five key valuation issues applicable to the valuation of South African business
entities that are to be considered specifically given the current economic crisis. (5)

(f) Discuss the probable reasons for the recent improvements in the operating results of
South African cinema chains. (9)

(g) Determine the fair value of the enterprise of Movies (Pty) Ltd as at 31 August 2010
based on the information and projections provided by the directors, and other relevant
information of this company, using a discounted cash flow approach.

Marks will be allocated as follows:

(i) Calculation of a weighted average cost of capital. (7)

(ii) Determination of value by calculating free cash flows. (26)
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QUESTION 8 40 marks

BRAZILICA LIMITED
(Source: Test 3 2013 MAC4862- adapted)

Brazilica Ltd is a company based in South Africa, and is a manufacturer and wholesaler of sports-
related apparel and equipment. The company specialises in the production of soccer balls, but also
manufactures some peripheral sport apparel and gear, including supporter team shirts, which are
placed on order from time to time.

The company has experienced steady growth in its earnings up until the 2011 financial year. In the
2012 financial year, the company achieved an operating profit of R20 791 995 and paid interest equal
to R577 340.

The company appointed a new Chief Executive Officer (CEO) in the latter part of the 2012 financial
year, hoping to achieve accelerated growth and improved performance. The new CEO assumed his
new role in earnest and, within weeks of his appointment, unveiled a new business strategy and new
expansion plans. Implementation of these measures resulted in record levels of operating profit for
the 2013 financial year.

Currently, the sales outlook for the company remains positive, especially in light of upcoming soccer
tournaments, including the upcoming FIFA Confederation Cup and FIFA World Cup to be held in
Brazil in 2013 and 2014. The company also changed its accounts receivable policy recently in an
endeavour to further boost its sales, and following that, hopefully its profit.

Regarding its cost structure, the company managed to maintain a stable manufacturing cost structure
– despite strong, general inflationary pressures on costs in South Africa – through implementation of
tough cost-control measures. These measures also enabled the company to keep its selling prices
relatively stable.

In terms of the company’s future plans, it intends to continue with its present strategy of aggressively
pursuing a greater market share, both nationally and internationally. The company will also continue
to manage its foreign exchange risk by pricing its contracts in the local currency. In addition, the
company intends to strengthen its asset base for as long as interest rates remain relatively low.
However, at present, the company is against a new share issue because it still has debentures
outstanding, with the debenture holders having the option of converting to equity shares. (The
company believes that new shares will dilute earnings per share and will adversely affect the share
price.)
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The following is an extract from Brazilica Ltd’s latest audited Annual Financial Statements:

Statement of Cash Flows for the year ended 28 February 2013 (an extract)

R’000 R’000
Cash flows from operating activities
Operating profit before working capital changes 47 410,1
Increase in accounts receivable (37 664,0)
Increase in inventories (18 460,2)
Increase in accounts payable 8 069,1 (48 055,1)
Cash flows used in operations (645,0)
Interest paid (2 868,8)
Dividends paid (6 030,0)
Taxation paid (9 174,3) (18 073,1)
Net cash flows from operating activities (18 718,1)

Cash flows from investing activities

Purchase of property, plant and equipment (15 288,4)
Net cash used in investing activities (15 288,4)

Cash flows from financing activities

Borrowings raised 25 261,3
Net cash provided by financing activities 25 261,3

Net decrease in cash and cash equivalents (8 745,2)

Cash and cash equivalents at beginning of the year 3 385,0
Cash and cash equivalents at end of the year ( 5 360,2)

Ancillary information regarding Brazilica Ltd:

• The company has 2 800 000 ordinary shares in issue and recently paid a dividend of 210 cents
per share to its ordinary shareholders. The ordinary dividend is expected to grow by 15% for the
next year, where after it is expected to grow consistently by 8% per annum.

• The company’s cost of equity has recently been calculated at 15%.

• The company has 1 000 000 non-redeemable preference shares in issue. These shares have a
nominal value of R2 per share and carries a fixed preference dividend of 7,8%, payable on
yearend. (The shares have just paid a dividend.) Similar preference shares have a fair rate of
return of 8,4% per annum.

• The company has a secured long-term loan, with an estimated present fair value of R31 790 000
and a pre-tax, fair annual rate of return equal to 9,5%.
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Ancillary information regarding Brazilica Ltd (continued):

• The company also issued 250 000 unsecured convertible debentures with a total nominal value of
R7 500 000 almost a year ago. Interest is paid at a fixed 11,5% of the nominal value. These
debentures mature in two years’ time with the following options then exercisable by the holders:

Option 1: Redeem the debentures at a premium of 20% to the nominal value.

Option 2: Convert the debentures to new debentures with the same nominal value that will mature two
years later, at which point they are to be redeemed at a discount of 5% to the nominal value.
Interest is payable at a fixed 28% per annum based on the redemption amount.
Option 3: Convert the debentures to ordinary shares on a 1:1 basis.

Poor tax planning resulted in the classification of these debentures as ‘hybrid debt instruments’ by
the South African Revenue Services in terms of section 8F of the Income Tax Act. A reasonable
rate of return on the debentures is 11% per annum.

Industry information

Sourpaulo Ltd and Riojanero Ltd are two South African companies that also operate in the sports
apparel industry.

Sourpaulo Ltd has 1 000 000 shares in issue at a par value of 100c each. A block of shares was
recently traded at R3 per share and its cost of equity has recently been calculated at 27%. The
company has a long-term loan with an outstanding capital amount of R7 851 219. (The company
pays a fair interest rate equal to prime plus 10%.)

Riojanero Ltd is a large company with no debt in its capital structure. Its cost of capital has recently
been calculated at 14%.

Brazilica Ltd, Sourpaulo Ltd and Riojanero Ltd are all considering investment in the same local
project, known as ‘Project Roupa’. The project requires a capital outlay of R11 million and has an
estimated internal rate of return of 13,5% per annum.

Other information:

Companies are subject to income tax at the rate of 28% and this rate is likely to remain constant in
the foreseeable future.
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Marks
REQUIRED Sub- Total
total
(a) Calculate the current Weighted Average Cost of Capital of Brazilica Ltd and of
Sourpaulo Ltd, based on available information and using fair market values as
the weights. (17) 17

(b) Recommend which of the three companies of Brazilica Ltd, Sourpaulo Ltd and
Riojanero Ltd should pursue ‘Project Roupa’ when assessed quantitatively
based on earlier calculations and available information. (2) (2)

(c) Discuss other factors to be considered by Brazilica Ltd, Sourpaulo Ltd and
Riojanero Ltd, before investing in ‘Project Roupa’, assuming it would be
financially feasible for all companies. (4) (4)

(d) Supply two examples of how the under-valuation of ecosystems in project and
investment appraisals could ultimately undermine the performance of an
entity. (2) (2)

(e) Discuss the downfalls of using a constant discount rate over time to discount
projects with long time horizons, in terms of sustainability-related risks. (2) (2)

(f) Critically review Brazilica Ltd’s cash flow for the 2013 financial year. (6)
Communication skills – clarity of expression; logical argument (1) (7)

(g) Draft an executive summary directed to the directors of Brazilica Ltd,

highlighting the external opportunities and threats that could be linked to this
company (part of a SWOT-analysis). Incorporate general knowledge of
matters surrounding major sporting events into the summary, including the
economic effects of the 2010 FIFA World Cup held in South Africa. (5)
Communication skills – clarity of expression; logical argument; appropriate
generalisation (1) (6)

TOTAL 40
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QUESTION 9 40 marks

X-FACTOR HOLDINGS
(Source: Test 4 2013 MAC 4862/4861- adapted)

X- Factor Holdings Ltd (XFH) is a holding company of a group based in South Africa and is listed
on the Johannesburg Stock Exchange (JSE). The group operates a chain of retail clothing
stores in South Africa, offering a range of clothing, shoes and accessories, mainly under its own
brand name called “X-Factor”.

XFH started as a small fashion outlet in the early 1930’s in Cape Town. From its small beginnings,
the company gradually expanded to its present state; its success mainly attributed to a consistent
company focus: To provide customers with superior quality merchandise, at reasonable prices.

Updated strategy

Not being immune to change, however, XFH is interested in altering its lifelong strategic focus by
expanding its product offerings. The group is considering the introduction of food and grocery
items, with the emphasis on packaged food offerings and groceries that are of high quality, which
are healthy, and preferably organic. These would include fresh fruit and vegetables, basic everyday
groceries (such as bread, milk, sugar, tea and coffee), as well as some pre-packed and easy to
prepare nutritious meals.

If the new strategy is implemented, the food and grocery items would first have an initial roll-out at
some of its larger stores. If successful, it would then be rolled out to all group stores throughout the
country. Later, the offering could be expanded by providing customers with the option of purchasing
the food online and having it delivered directly to their homes. The directors believe this to be the
ideal solution, not only for single individuals, but also for the modern family. In the end, the
purpose of the updated strategy would be to make life more convenient for their customers.

Subsidiary company and potential acquisition

XFH owns a controlling interest in Countryside Ltd, a retailer of women’s, men’s and children’s
apparel in Australia. Countryside is listed on the Australian Stock Exchange (ASX) who,
despite tough economic conditions in Australia, experienced revenue growth in the current financial
year.

Countryside is interested in acquiring a controlling interest in a private fashion-company,

Bedazzled (Pty) Ltd. The management of Countryside believe that the acquisition would prove
synergistic.

Bedazzled is a medium-sized, privately-owned fashion company in Australia, which retails women’s

clothing in over 200 stores in Australia. A private equity investment group, The AAA Group, is one
of the major shareholders in Bedazzled; this group wishes to exit their investment to pursue other
opportunities.
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Bedazzled used to model their operations on that of Countryside – only on an informal basis and
where practical – but did not perform well in the 2013 financial year due to poor management
decisions. The CEO has, however, resolved these issues and is confident that total revenue will
increase by 4,9% in the 2014 financial year (this increase is independent of any potential
acquisition and has been probability weighted). It is expected that revenue growth will normalise in
years following the 2014 financial year.

Financial information relating to Bedazzled is as follows:

Extract of the unaudited statement of profit or loss and other comprehensive income for
the year ended 30 June:

In Australian Dollar (AUD): Note 2013 2012

Revenue 25 690 000 25 860 000

Cost of sales (10 532 900) (10 602 600)
Gross profit 15 157 100 15 257 400
Other income 1. 240 000 240 000
Expenses (14 136 096) (14 040 000)
Distribution expenses 2. 10 951 136 10 860 000
Other operating expenses 3 184 960 3 180 000
Operating profit 1 261 004 1 457 400
Finance costs (146 250) (146 250)
Profit before tax 1 114 754 1 311 150

Notes:

1. Other income relates to income from an investment held by Bedazzled. This investment
was however sold for AUD 4 650 000 on the 30 June 2013 and realised a profit on sale
equal to AUD65 000. The profit on sale was erroneously included in other operating
expenses. The full sale amount is reflected in the company’s bank account on 30 June
2013.
2. The distribution expenses are made up of a variable component equal to 20% of
revenue, whilst the remainder represents an inflation driven fixed component of the
distribution agreement. It has come to management’s attention that the accountant has
erroneously omitted the annual administration cost of AUD80 000 (in current monetary
terms) relating to the distribution agreement. This error occurred in both 2012 and 2013.

Additional Information:

(a) The historic, current and forecast Australian inflation rate and company tax rate at
each reporting date is 2,2% and 25% respectively.
(b) Countryside had a trailing EV/EBIT (enterprise value / earnings before interest and tax)
multiple of 12,22 as at 30 June 2013. (No large shareholding blocks were traded in recent
years and the company is not currently the target of any merger or acquisition.)
(c) Real growth in Countryside’s EBIT is expected to equal 1,8% for the next year.
(d) Bedazzled had interest-bearing debt equal to AUD4 500 000 on 30 June 2013.
(e) Based on preliminary research, the directors of Countryside claim that there is a potential to
realise synergies to the value of AUD2 000 000 should Countryside acquire Bedazzled.
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REQUIRED

Part A Marks
Sub- Total
total
(a) Discuss the factors XFH should consider in deciding on whether they
should alter their strategy by expanding their brand to include food and
grocery products. Incorporate general knowledge of the relevant industries
in your answer. (8) (8)
(b) Recommend a maximum bid price in Australian Dollar that
Countryside could offer for a 70% shareholding in Bedazzled as at
30 June 2013. Support your recommendation by calculating a value
using a method based on a forward EV/EBIT multiple and the available
information. Motivate the appropriateness of this valuation method, the
recommended price, the components of your calculation, and any
adjustments made. (21)
(1) (22)
Communication skills – presentation; relevancy of adjustments
(c) Describe some of the factors that would influence the eventual purchase
price that Countryside is likely to pay for Bedazzled (excluding the effect of (3) (3)
synergy)
(d) Draft a formal letter to the directors of Countryside, describing the
risks to the company paying for acquisition synergy-benefits, without
first performing detailed supporting calculations and without creating a
roadmap to its realisation.
(3)
Communication skills – layout and structure; clarity of expression;
logical argument
(e) Describe the limitations of a valuation method based on (any) earnings
multiple, in the case of Bedazzled. (3) (3)

(f) Indicate the potential sources of synergy should Countryside acquire

Bedazzled. Incorporate knowledge of these companies and general
knowledge of the clothing industry in your answer. (6) (6)
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QUESTION 10 40 Marks

OSCAR LIMITED
(Source: Test 2 2012 MAC4861/MAC4862 - adapted)
Company’s business and background

Oscar Ltd is an unlisted company that specialises in corporate image design, including web page
designs. It has been trading for 4 years and has obtained a reputation for being one of the most
innovative and technologically advanced operators in this particular field.

The company was formed in 2008 by Andile Bradley and Jolie Pitted. The company borrowed
R300 000 from the bank, secured on the two shareholders’ personal property. (Its market value is
also close to this value.) It is repayable in 2017.

When the company was launched it operated from rented premises and leased much of its
computing equipment. It has subsequently bought additional and replacement equipment, and other
assets such as furniture and fittings. It has also moved premises and has signed a 25-year lease on
office premises that are large enough to allow for significant expansion.

The company now employs 15 people and is planning to recruit additional designers and
programmers to handle a large new contract it is hoping to obtain from a supermarket group. Oscar
Ltd outsources most administrative and accounting functions.

Future plans

The company’s two owners/directors have been approached by the marketing department of an
investment bank and asked whether they have considered using venture capital financing to expand
the business. No detailed proposal has been made but the bank has implied that a venture capital
company would require a substantial percentage of the equity in return for a large injection of capital.
The venture capitalist would want to exit from the investment in 4 to 5 years’ time.

Neither Andile nor Jolie is wholly convinced that such a large injection of capital is appropriate for the
company at the present time. Their objective has been to obtain a stock market listing in 2 to 3
years’ time if their most optimistic expectations are realised. This would allow them to get some
money back on their investment by selling some of their shares and the same time raising additional
funds for the company’s expansion. However the two directors have little financial expertise and
have decided to take some independent advice from their accountants before responding to the
investment bank.

One possibility is for Oscar Ltd to expand its services into other African countries. This will take
expansion to the next level, but Andile and Jolie are concerned about the challenges of doing
business in the rest of Africa.
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Your role

Assume you are employed by Oscar Ltd’s firm of accountants. You have been asked to advise
Andile and Jolie about the company’s current financial situation, and the various financing and
expansion options available to maximise Oscar Ltd’s growth potential. You spend some time
reviewing the company’s financial affairs and discussing future prospects with the directors and staff.
You manage to obtain the following information:

Financial information

Past data:

Turnover has grown from R50 000 in the first year of operations to R750 000 last year, the year to
31 March 2012. However the company sustained losses in the first 3 years of operations and made
only a small operating profit last year. The apparent poor results are primarily because of high
research costs relative to sales. (These costs were written off during the year.) Expenditure on
research and development will continue but not at such high levels as before. Other financial data for
the year to 31 March 2012 is as follows:

Shares in issue (ordinary R1 shares) 10 000

Earnings per share 125 cents
Dividend per share 0
Net asset value (at carrying value) R385 000

Note

The net assets of Oscar Ltd are the net carrying values of purchased and/or leased equipment and
vehicles plus net working capital. The carrying values are considered a fair reflection of its current
realisable values.

Forecasts:

The company’s forecast sales turnover for the year to 31 March 2013 is heavily dependent on
whether or not the company obtains the new contract from the supermarket group. If it does,
forecast sales turnover is R1,8 million for the year. The company’s directors think they have a 50%
chance of getting this contract. Although this contract will be prestigious for Oscar Ltd and should
lead to a long-term business relationship, the terms will prevent Oscar Ltd from undertaking work for
the supermarket’s competitors, a number of whom have also shown interest in the company’s
designs. If Oscar Ltd does not get this contract it will bid for other work which is likely to be less
profitable.

The forecasts exclude any effect of expansion into Africa and assume that no new long-term capital
is raised, since these matters are still in the early stages of consideration.

Sales turnover for the following year to 31 March 2014 is dependent to some extent on the outcome
of the year to 31 March 2013. Estimated turnover and probabilities are as follows:
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Estimates for year to Estimates for year to

31 March 2013 31 March 2014
Probability Turnover Probability Turnover
R000 R000
0,5 1 800 (Outcome 1) 0,8 2 500
0,2 3 000

0,3 1 200 (Outcome 2) 0,5 1 700

0,5 1 400

0,2 800 (Outcome 3) 0,5 1 000

0,5 800

Operating costs inclusive of depreciation are expected to average 35% of turnover in the year to
31 March 2013, reducing to 30% in the year to 31 March 2014 as a result of economies of scale.
Interest costs will remain at the present level for both years.

Tax is expected to be payable at 28%. Assume book depreciation equals capital allowances for tax
purposes. Also assume that profit after tax (but before interest) equals free cash flow from the
enterprise.

Growth in free cash flow in each of the years to 31 March 2015 and 2016 is expected to be 40%,
falling to 10% for the years after that.

Oscar Ltd’s weighted average cost of capital has recently been estimated at 20%.

Competitor / industry information

This is a niche market and there are relatively few listed companies doing precisely what Oscar Ltd
does. However if the definition of the industry is extended to include all companies involved in
electronic design and associated products the following figures are relevant.

P/E ratios:
Industry average 27
Range (individual companies) 12 to 82

Increase in market capitalisation over the past 24 months:

Industry average 22%
Range (individual companies) -10% to +2 000%

Share price movements of competitor companies are extremely volatile. Recently two similar
companies, one listed in 2009 and one unquoted have gone into liquidation. These and other failures
of internet-style companies have caused widespread concern.
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REQUIRED Marks
(a) Write a report to the directors of Oscar Ltd that will address some of their concerns.
You should include the following in your report:

i. A list of the various methods (at least four) according to which an unquoted
company might be valued. (2)

ii. A calculation of a range of values on 31 March 2012 for the company that could
be used in preparation for the negotiation with a venture capitalist, using
whatever information is currently available and relevant. Make and state
whatever assumptions you think are necessary. Further include the following: (19)

• A brief discussion of the methods of valuation you have used;

• A brief explanation of the relevance of each method to a company such as
Oscar Ltd; and
• A brief discussion of other information that might be required.

iii. A discussion of the advantages and disadvantages of using either venture

capital financing to assist with expansion, or alternatively, a flotation on the stock
market in 2 to 3 years’ time. Include in your discussion likely exit routes for the
venture capital company. (5)

iv. A discussion of the alternative types of financial support that could be used by
Oscar Ltd to assist the company in expanding. Advise on the issues that the
directors should consider before deciding on the most appropriate type of (5)
finance.

(b) Advise the company’s directors on what actions/measures the company might take to
protect itself against the risk of loss of key staff with expertise. (4)
(c) Describe to the company’s directors the various country risk components that may be
relevant to investment in the rest of Africa. (5)

TOTAL 40
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QUESTION 11 40 marks

ZIVA’S FASHION FANATICS LIMITED

(Source: UNISA Test 4 2012 MAC4862)

Ziva’s Fashion Fanatics Limited (ZFF) has been providing women with fashionable and affordable
clothing, and accessories for over 45 years. ZFF operates and owns 20 stores, which are located in
prime shopping centres and various CBDs within South Africa. These stores offer clients a wide
variety of products, such as ladies-wear, footwear, accessories, jewellery, cosmetics, fragrances, and
children’s-wear.

ZFF manufactures 60% of all its products locally whilst importing the remainder from a single supplier
in Italy. Local and imported brands have developed a following, with customers displaying strong
brand loyalty. All local creditors provide ZFF with 15 days interest-free credit, whereas all
international purchases are in euro, payable upon delivery. ZFF sells mainly on credit as the
company provides credit to all walk-in clients, with a 30 day interest free term. ZFF finances their
day-to-day operating activities with a bank overdraft facility which bears interest at 5% above the
prime rate.

Financial Statement analysis

ZFF has been listed on the JSE for the past 18 years. The financial manager, Mr David has provided
you with the following investor ratios and corresponding calculations.

ZFF Investor ratios for the year ended 31 March

2012 2010
Earnings per share
2012: (R7,5 million / 3 million) 250 cps
2010: (R5,5 million / 2,5 million) 220 cps

Price earnings multiple

2012: (R12 / R2,50) 4,80
2010: (R9 / R2,20) 4,09

Dividend cover
2012: (R2,50 / R0,50) 5,00
2010: (R2,20 / R0,40) 5,50

Expansion initiatives

ZFF plans to open an additional store as soon as possible. Two possibilities have been identified of
which only one could be accepted. Both options have a similar risk.
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Store option 1

Management identified suitable vacated premises. However, the store would need to be refurbished
in-line with the company image. The property owners are prepared to initially enter into a seven year
operating lease agreement with ZFF and will thereafter decide on its renewal. Mr David performed a
Net Present Value analysis to ascertain whether it would be worthwhile for ZFF to lease and refurbish
the store, given the possibility that the lease may not be renewed. He found that the new store will
yield a positive Net Present Value of R976 234 over the lease period.

Store option 2

A second suitable premises exists. For this option the property owners are prepared to initially enter
into a five year operating lease with ZFF, at R55 000 per month with an escalation of 9% per annum,
where after they will decide on its renewal. ZFF will also have to refurbish the store to their image.
This is estimated to cost a once off R2 500 000. SARS will allow a deduction of this expense over a
four year period. Other operations derive sufficient taxable income for all deductions from this option.

The directors thought it would be worthwhile to explore this option and ascertain whether it would be
more feasible than the original consideration. They thus requested Mr David to evaluate this option
as soon as possible and advise them accordingly. As Mr David had many other commitments, he
delegated the task to one of the new trainees in his department. He provided the trainee with details
of the lease and the refurbishment, as outlined above, as well as with the following additional
information received from the marketing department:

Sales from this store is expected to reach R5 200 000 in the first year and is expected to increase by
8,2% per annum thereafter. Other indirect operating costs is expected to be R1 760 000 per annum,
increasing by 6,1% per annum (in line with current inflation rates). Working capital requirements are
expected to amount to R1 050 000 upon opening of the store and is expected to increase by 8,2%
(annually) thereafter.

Since ZFF do not have the funds to pay for the once off store refurbishing they would need to obtain
a loan from Capitan Bank. The Bank is willing to advance the R 2 500 000 to them on the following
terms:

• Interest would need to be paid annually in arrears at an interest rate of prime plus 2%.
• The capital must be repaid after 5 years.

Provisional result

The trainee analysed all the information provided to him and concluded that store option 2 will be the
better option as it has a higher NPV. He provided the following calculations to substantiate his
conclusion.
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Calc R'000 R'000 R'000 R'000 R'000 R'000

Year 0 Year 1 Year 2 Year 3 Year 4 Year 5

Refurbishment (2 500)
Sales 1. 5 200 9 464 17 224 31 348 57 053
Indirect operating costs 2. (1 760) (1 867) (1 981) (2 102) (2 230)
Interest expense 3. (275) (275) (275) (275) (275)
Lease expenditure 4. (55) (60) (65) (71) (77)
Working Capital 5. (1 050) (1 136) (1 229) (1 330) (1 439)
Cash flow before tax (2 500) 2 060 6 126 13 674 27 570 53 032
Taxation 6. 700 (402) (1 540) (3 654) (7 545) (14 849)
Cash flow after tax (1 800) 1 658 4 586 10 020 20 025 38 183
Discounted at the real rate
of 8,5%
Net Present Value 51 311
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Calculations:

1. Sales 5 200 5 200 x 1,82 9 464 x 1,82 17 224 x 1,82 31 348 x 1,82
= 9 464 = 17 224 = 31 348 = 57 053
(1 760) 1 760 x 1,061 1 867x 1,061 1 981x 1,061 2 102x 1,061
2. Indirect operating costs = (1 867) = (1 981) = (2 102) = (2 230)
3. Interest expense 2 500 x 11% 2 500 x 11% 2 500 x 11% 2 500 x 11% 2 500 x 11%
= (275) = (275) = (275) = (275) = (275)
4. Lease expenditure 55 x 1,09 -60 x 1,09 -65 x 1,09 -71 x 1,09
(55) = (60) = (65) = (71) = (77)
5. Working capital (1 050) 1 050 x 1,082 1 136x 1,082 1 229 x 1,082 1 330 x 1,082
= (1 136) = (1 229) = (1 330) = (1 439)
6. Taxation
Cash flow before tax (2 500) 2 060 6 126 13 674 27 570 53 032
Refurbishment allowance (625) (625) (625) (625)
Taxable cash flow (2 500) 1 435 5 501 13 049 26 945 53 032
Taxation at 28% (700) 402 1 540 3 654 7 545 14 849
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REQUIRED

This section consists of three independent parts. Answers should be planned and specific attention
should be paid to the number of marks allocated per section.

Part A – Risk identification and mitigation Marks

(a) Assist ZFF with improving their business model by identifying and explaining four
key risks arising from this model, and by indicating appropriate ways of mitigating the
risks. Your answer should be in tabular format and should contain the following
headings:

Risk Explanation of risk Mitigation of risk

(4) (4) (4) (12)

Part B – Investor ratios Marks

(a) Briefly explain the purpose and possible use of each investor ratio (for 3 marks) and
comment on any changes that occurred over the years (for 6 marks). (9)

(b) Discuss how ZFF’s investment, financing and dividend decisions will interrelate. (5)

Part C – Expansion initiatives Marks

(a) Critically comment on the trainees’ conclusion, including the calculations provided to
substantiate his conclusion. (10)

(You are not required to reperform the Net Present Value analysis.
Rounding differences should not be discussed.)

(b) Assume that the correct Net Present Value calculation of store option 2 resulted in
a positive NPV of R1 250 000.

Calculate and conclude which store option will represent the best investment option
for ZFF. (4)

(You should not make use of a profitability index).

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QUESTION 12 40 Marks

BIDDER LIMITED
(Source: Test 3 2011 TOE408W (MAC4862) ACCA- adapted)

Bidder Ltd (“Bidder”), a company listed on the FTSE/JSE Securities Exchange SA, has cash
balances of R24 million which are currently invested in short-term money market deposits. The cash
is intended to be used primarily for strategic acquisitions, and the company has formed an acquisition
committee with a mandate to identify possible acquisition targets. The committee has suggested the
purchase of Target Ltd (“Target”), a company in an unrelated industry that is listed on the AltX of the
JSE. Although Target is listed, approximately 50% of its shares are still owned by three directors.
These directors have stated that they might be prepared to recommend the sale of Target and they
consider that its shares are worth R23 million in total.

Summarised financial data (on an historical cost basis):

Bidder Ltd Target Ltd

R’000 R’000

Turnover 480 000 38 000

Pre-tax operating cash flow 51 000 5 300
Taxation (16 830) (1 749)
Post tax operating cash flow 34 170 3 551
Dividends paid 11 000 842

Non-current assets (net) 168 000 8 400

Current assets 135 000 4 700
Current liabilities (99 680) (3 900)
203 320 9 200

Financed by:
Ordinary shares (25 cents par) 10 000 (10 cents par) 500
Reserves 158 320 5 200
9% debenture (redeemable) 20 000
10% bank loan 15 000
11% bank loan 3 500
203 320 9 200

Target Ltd
R’000

Current share price (most recent trade data) 370 cents

Earnings yield (based on current share price) 19,2%
Average dividend growth during the last five years 8% p.a.
Unlevered beta coefficient 1,7
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Industry data: 6

Average P/E ratio 7

Average P/E of companies recently taken over, in this industry based
upon the offer price
The current risk-free rate of return is 8% per annum and the current market return is 14% per annum.
The current rate of inflation is 4% per annum and is expected to remain at approximately this level in
the foreseeable future.

In case of no merger or acquisition:

▪ It is expected that Target’s post-tax operating cash flow will grow by 4% above expected
inflation for 5 years, where after it would increase by inflation only.
▪ Target should maintain a constant post-tax operating cash flow dividend-cover.
▪ Target has a target debt: equity ratio of 0, 18:1.
▪ Net working capital and capital investments should maintain a constant ratio to operating cash
flows after tax.

In case of a takeover of Target by Bidder the expected cost synergies and costs to be incurred would
be:

▪ 50 employees of Target would immediately be made redundant at an after-tax cost of

R1,2 million. Post-tax annual wage savings are expected to be R750 000 (at current prices).
▪ Some land and buildings of Target would be sold for R800 000 (after tax) and do not need to be
replaced.
▪ Post-tax fixed advertising and distribution savings of R150 000 per year (at current prices)
would be possible.
▪ Legal and other take-over related cost at present value are expected to amount to R3 million.

REQUIRED Marks
(a) Based on available information, calculate the current value of a 100% equity shareholding in
Target, based upon:

• Market capitalisation. (3)

• A dividend valuation model, excluding synergies and related costs. (7)
• The use of comparative P/E ratios, including typical merger and acquisition
premiums and costs, but excluding specific synergies and related costs. (7)
• The present value of free cash flows, including expected synergies and
related cost, discounted at the weighted average cost of capital. (14)

Your calculation should also include an evaluation of each of the four valuation
methods/models, but for this section you should ignore Capital Gains Tax, Secondary Tax of
Companies and Dividend Tax.
(b) Recommend whether or not Bidder should offer R23 million for Target’s shares. (3)
(c) Should Bidder decide to acquire Target, briefly discuss the factors that should influence whether
or not Bidder Ltd uses its cash balances, rather than shares or debt, to make the payment for
Target. (4)
Presentation (2)
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QUESTION 13 40 Marks

CHOCCI CHOCS LIMITED

(Source: Test 4 2011 TOE408W (MAC4862)- adapted)
BACKGROUND

Chocci Chocs Ltd is an entity that retails Swiss chocolates. The entity was established 20 years ago
when Mr Brown went to Switzerland and was first introduced to the delectable taste of real Swiss
chocolate. Mr Brown was convinced that there was a market for these divine creations in South
Africa and quickly closed a deal with one of the Swiss chocolate manufacturers.

He has since managed to successfully start up “Chocci Chocs” and is quite proud of his past
accomplishments. However due to the recent economic downturn and increased competition, Chocci
Chocs have recently been experiencing a decline in sales and cash flow problems.

Mr Brown and his management team are extremely worried about the declining performance of the
company especially compared to industry norms and are exploring various options in order to get the
company back on track. The company has a very special place in Mr Brown’s heart as it brings his
two passions together (i.e. chocolate and wealth) and he is adamant on saving it.

The chocolate market

Market trends have been shifting in accordance with consumers’ preference towards dark and
premium chocolates. One of the main reasons for the shift towards darker chocolate is due to the
health benefits of cocoa. The main restrictions in this market are, however, caused by the rising cost
of raw materials and the unstable supply of cocoa.

Reorganisation

Mr White suggested to the board that since they are facing liquidity problems they must consider the
reorganisation of their capital structure. He is however concerned that he and his current
management team may not have the necessary knowledge and skills to successfully execute it. He
has read an article in a daily financial paper about a company, Genius Limited, which specialises in
company reorganisations. Genius Limited focuses on the operational and financial needs of a
company by performing a detailed needs analysis. The detailed needs analysis examines, amongst
others, the company’s financial ratios relating to liquidity, solvency, and working capital and utilises
these as the basis to steer the company in the right direction.

Environmental and social matters

In the last two years there have been numerous complaints from consumers accusing Chocci Chocs
of food poisoning and some claims that traces of salmonella were found. As these claims have not
been confirmed, Mr Brown has decided not to recall the product line in question. He is however
concerned with the possible damage that these accusations may have on Chocci Chocs’ reputation.
Mr White is also working on a project whereby chocolates which have not yet been sold and are
close to expiry are distributed to the local orphanages prior to the expiration date.
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Board of Directors

The Board consists of three executive directors and four non-executive directors. The Chairman is
included in the non-executive directors and is completely independent. The executive directors are
Mr Brown the Chief Executive Officer, Mr White the Finance Director and Mr Mint the Director of
Operations. The non-executive directors include Mr Nut - one of the majority shareholders, Mrs
Brown (the CEO’s wife), the chairman and one other member with no relationship to the firm.

Financial objectives

Shareholders are concerned with Chocci Chocs’ financial performance over the last few years; most
have however remained loyal as they still received the dividend they were expecting. They have
requested the board to come up with a financial plan to increase profitability and to improve liquidity.

The top 5 objectives as set out in terms of the firm’s five year financial plan include the following:

 Increasing profitability
 Growth through expansion: locally, organically and by any other means possible
 Improving liquidity and working capital management
 Increasing (or at least maintaining) the market share price
 Implementation of cost effective risk management techniques.

Competition

Some of Chocci Chocs’ biggest competitors include international companies such as Nestlé
(Switzerland), Barry Callebaut (Switzerland), Kraft Foods (U.S.), Mars (U.S.), Ferrero (Italy), Hershey
(U.S.) and large local companies such as the cheaper generic manufacturers.

In the last two and a half years competition has increased dramatically due to the large number of
cheaper generic chocolate manufacturers entering the market. These manufacturers have obtained a
significant market share by producing similar quality chocolate bars but at a fraction of the price.
Market research showed that their competitive advantage was as a result of them producing local
chocolates instead of importing expensive Swiss chocolates.

Mr Brown believes that Chocci Chocs competes mainly on the basis of its product quality, service,
marketing and advertising. Further Mr Brown would like to expand by introducing new locally
produced products.

Future local expansion option

The management of Chocci Chocs is therefore considering local production of cheaper generic
products in addition to importing Swiss chocolates. Management believes that the expansion will
assist the company in improving its cash flow problems. Mr Brown is of the opinion that over the past
20 years he has learnt a lot about the chocolate industry and that Chocci Chocs is in a position to
expand their operations and to manufacture their own chocolate. “It may not be Swiss but it will still
be fantastic”. Upon completion of a 2 year period Chocci Chocs will evaluate whether to continue
producing locally or to revert to solely importing.

This option will require the company to purchase a machine on 31 December 2011. The machine
can either be imported from Switzerland or can be purchased locally.

Imported machine Local machine

Cost CHF 25 000 000 R 150 000 000
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If the machine is imported Chocci Chocs will be required to pay the supplier on the
31 December 2012.

Mr Brown also sees this as an opportunity to provide work to the South African community.

Inventory Management

Mr Mint is concerned that the company is holding inventory for a long period of time and since
chocolates have a “sell by date” Chocci Chocs is currently running the risk of holding obsolete
inventory. He stressed the need to urgently revise their inventory holding policy at the previous
management meeting. Furthermore Chocci Chocs runs the risk of not having sufficient inventory to
fulfil its demand due to the unstable supply of cocoa.

The increase in importing costs has lead the sales department to increase the sales price per unit
slightly. This increase in sales price has however lead to a decrease in demand.

Seasonality

Some of the products are seasonal and are affected by holidays, changes in seasons or other annual
events, such as the Easter period. The overall sales are, however, evenly spread throughout the
year.

Distribution and Marketing

Products are generally sold to supermarket chains, wholesalers, convenience stores and petrol
stations.

Financial information

Below are extracts from the Statement of Comprehensive Income, Statement of changes in
equity and from the Statement of Financial Position for the 2 most recent years:

Statement of Comprehensive Income

Notes 2010 2009

R’000 R’000

Revenue 1 1 070 286 1 135 000

Cost of sales 2 (695 686) (737 750)
Gross profit 374 600 397 250
Other operating expenses 3 (145 000) (133 000)
Operating profit 229 600 264 250
Finance cost 4 (85 000) (70 000)
Profit before tax 144 600 194 250
Income tax expense (40 488) (54 390)
Total comprehensive income for the year 104 112 139 860
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Notes
Statement of changes in equity 2010 2009
R’000 R’000

Retained Retained
earnings earnings

Opening balance 39 860 -

Total comprehensive income for the year 104 112 139 860

Dividend 5 ( 100 000) ( 100 000)

Closing balance 43 972 39 860

Statement of Financial Position

ASSETS
Non-Current assets 1 304 720 1 161 095
Property, plant and equipment 7 1 304 720 1 161 095

Current assets 190 300 169 380

Debtors 45 300 35 880
Inventory 145 000 125 900
Cash - 7 600
TOTAL ASSETS 1 495 020 1 330 475

EQUITY AND LIABILITIES

TOTAL EQUITY 543 972 539 860
Share capital 6 500 000 500 000
Retained earnings 5 43 972 39 860

TOTAL LIABILITIES 951 048 790 615

Non-Current liabilities 707 248 696 115

Long-term borrowings 707 248 696 115

Current liabilities 243 800 94 500

Overdraft 8 106 300 -
Trade creditors 103 000 94 500
Short-term portion of long term borrowings 20 700 -
Current tax payable 13 800 -

TOTAL EQUITY AND LIABILITIES 1 495 020 1 330 475

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Notes

1. Chocci Chocs sells the imported chocolates for cash and on credit. Currently 30% (25% in
2009) of total sales are on credit. Management is considering changing its credit terms with
the aim of increasing sales. Currently no discounts are given to customers.
2. The Swiss manufacturers grant Chocci Chocs credit and currently R232 000 000
(R198 000 000 in 2009) of purchases are on credit.
3. Included in other operating expenses are depreciation and foreign exchange losses. Due to
the recent economic downturn and the constant fluctuation of the Rand, Chocci Chocs needs
to hedge their foreign exchange risk more effectively. Mr Brown plans to consult one of his
friends (a derivatives “guru”) for some advice.
Mr White has indicated that he has focussed a lot of his time and effort in reducing some of
these unnecessary expenses.
4. Finance costs pertain to the interest expense on all interest-bearing debt.
5. The company’s dividend policy has remained unchanged over the last ten years; in recent
years, however, the company has not been able to retain much of its earnings.
6. Issued share capital consists of 500 000 000 shares. The shares have been externally valued
by iValue Consultants Inc at R3 per share on 31 December 2010 (R3,20 in 2009).
7. On the 31st of December 2010 equipment to the value of R125 000 000 was purchased for
cash.
8. The overdraft limit is R200 000 000 and has a 14% fixed interest rate.

Additional information
2010 Industry averages
Growth in Turnover 27%
Return on capital employed 9%
Gross profit margin 36,4%
Current ratio 1,03
Acid test 0,69
Gearing ratio 42%
Times interest earned 2,8
Growth in share price 15%
Dividend per share R1,16
Dividend payout ratio 0,483
Earnings per share R2,40
Price earnings ratio – times 13

Terms of the new Credit policy

The new policy will be 5/10 net 60. This will result in a 30% increase in credit sales to new customers. It is
expected that 28% of existing credit sales customers and 17% of new credit sales customers will take
advantage of this discount. The remaining credit sales customers are expected to pay within 60 days. Bad
debts are expected to increase from 2% to 4% of total credit sales. The cost of financing accounts receivable
amounts to 10% per annum.

Hedging
Current exchange rates are as follows:
Bid CHF 1 = R 7,40
Ask CHF 1 = R 7,41

General consideration
Assume that the book values of long term liabilities are equal to the market values.
The 2010 inflation rate was 4,82%.
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REQUIRED Marks
(a) Based on the 2010 industry averages and the 2009 results, critically analyse the
changes that occurred in the company's 2010 results. Your answer should include:

(i) Calculation of the following ratios and percentages, motivating the figures
utilised in your calculations, where necessary;

• Growth in sales (1)

• Gross profit % (1)
• Operating expenses as a percentage of revenue (1)
• Operating profit margin (1)
• ROCE (1)
• ROA (1)
• ROE (1)
(1)
• Interest cover
(1)
• Gearing

(ii) Commentary on the ratios and percentages.

(12)
Round ratios to 2 decimal places
(b) Future local expansion

Calculate whether Chocci Chocs should take out a forward contract or use a money
market hedge. (6)

Chocci Chocs can currently obtain the following interest rates:

Switzerland 4% p.a.
South Africa 12% p.a. Interest rates are expected to decline by 0.5 basis
points on the 30.06.2012.

The forward R/CHF rate is trading at a Rand discount of 10,5% per annum.
Also advise management whether it will be more cost effective to purchase the
machine locally or internationally.
Assume South African interest rates declined as expected. (1)

Round calculations to 2 decimal places

(Source: Vigario)
(c) Mr Brown remains optimistic and would like to see Chocci Chocs listed within the
next 5 years. In the meantime he would like to start complying with some of the
King 3 requirements and has asked you to advise him on:

(i) changes Chocci Chocs will need to implement to its current operations and (3)
(ii) to indicate areas that should not change. (3)

He also indicated that you may ignore all JSE listing requirements for the time being
and only advise him on the King 3 requirements.
(d) Calculate whether it will be profitable for Chocci Chocs to change its credit policy.
Ignore the impact of local expansion for the purposes of this calculation.
Assume a 365 day year and round all “days” calculations to the next whole day. (10)
All other calculations should be rounded to 2 decimal places.
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QUESTION 14 55 marks

ITHEMBA ENGINEERING (PTY) LTD

(Source: SAICA June 2013 ITC paper 2 - adapted)

Ithemba Engineering (Pty) Ltd (‘Ithemba’) manufactures and distributes specialised products to
customers in the construction industry. Every year, Ithemba invests significantly in research and
development to improve existing product designs and to develop new products. Many of its products
and designs have been patented to protect the company’s intellectual property.

Although Ithemba develops its own products where possible, it entered into an alliance with
Innovative Engineering Incorporated (‘IEI’) in 2006. IEI is based in Chicago in the United States and
is a global leader in the supply of products to the construction and mining industries. Ithemba
obtained the right from IEI to manufacture and sell one of its products, namely an XE299 cable
anchor (‘XE299’), in sub-Saharan Africa. Ithemba pays IEI a fixed royalty in US dollar per XE299 unit
manufactured and sold. Royalties are paid quarterly in arrears. The XE299 product has proved to be
highly successful in South Africa and currently represents 30% of Ithemba’s annual revenue.
Ithemba focuses on supplying South African customers. It has supported customers’ expansion into
the rest of Africa and the Middle East and exports represent approximately 10% of annual revenue.
Foreign subsidiaries of South African groups are invoiced in US dollar.

The construction industry in South Africa has been under significant pressure in recent years due to
the slowdown in the global economy and limited infrastructure spend by the government. As a result,
Ithemba has struggled to grow revenue during the past three financial years. Steel is the major raw
material used by Ithemba in its manufacturing processes. The volatility of this commodity’s price in
recent years has placed additional pressure on the company’s gross profit margin.

Because of this situation working capital management has become increasingly important for
Ithemba. More and more customers are placing orders at the last moment, which is forcing Ithemba
to hold larger inventories. Customers are also delaying payment of accounts because of cash flow
pressures. All sales are on credit and Ithemba allows customers 60 days from invoice to pay
amounts due. The result is that Ithemba’s overdraft balance has steadily increased in recent years, to
the extent that this has become a permanent source of finance. Ithemba currently pays interest on its
overdraft at 10% per annum, compounded monthly.

Apart from the overdraft, Ithemba has had no other debt facilities since 2009. Bankers are reluctant
to grant Ithemba longer term finance due to concerns about the company’s cash flow generation and
the negative outlook for the construction industry in general.

The Board of Directors of Ithemba is considering the following two options to improve cash flows and
profitability:

1 Offering a 10% settlement discount to customers who pay within 30 days of invoice, which is
expected to lead to an annual increase in revenue of 5%. The company estimates that 20% of
customers by revenue value (after the expected increase in revenue) would make use of the
settlement discount. Bad debts are also expected to decline by 5% after the introduction of the
settlement discount; and

2 Discontinuing the manufacture of XE299 under licence from IEI and instead purchasing the
XE299 product directly from IEI. IEI has indicated that it will grant Ithemba payment terms of 30
days from invoice.
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The Board of Directors of Ithemba is concerned about the company’s increased exposure to
foreign currency movements if it were to pursue the option of purchasing XE299 from IEI.
Ithemba has been advised by its bankers that any foreign exchange risk could be hedged by
means of forward or option contracts.

The following are extracts from the annual financial statements of Ithemba for the year ended
30 November 2012:

EXTRACTS FROM THE STATEMENT OF COMPREHENSIVE INCOME

FOR THE YEAR ENDED 30 NOVEMBER 2012

2012 2011
R’000 R’000

Revenue 248 230 241 000

Cost of sales (157 580) (144 400)
Gross profit 90 650 96 600
Bad debts (5 100) (4 500)
Depreciation (19 800) (20 100)
Research and development costs (10 200) (11 100)
Other operating costs (28 750) (26 700)
Operating profit 26 800 34 200
Finance charges (12 750) (10 800)
Profit before tax 14 050 23 400

EXTRACTS FROM THE STATEMENT OF FINANCIAL POSITION

AT 30 NOVEMBER 2012

2012 2011
R’000 R’000

Trade receivables 51 000 42 900

Total assets 279 900 264 900
Shareholders’ equity 152 200 142 100
Bank overdraft 127 500 102 800

* Inventory balance (2012) R28 060

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REQUIRED Marks
Sub- Total
total
(a) Analyse and discuss the profitability and working capital management of
Ithemba during the financial years ended 30 November 2011 and 2012.
Support your answer with relevant calculations and ratios. (20)
Communication skills – layout and structure; clarity of expression (2) (22)

(b) Explain how forward and option contracts could be used to hedge
Ithemba’s current and future exposure to movements in foreign currencies. (7) (7)

(c) Estimate and conclude on the impact that the introduction of the proposed
settlement discount for customers could have on the profits and cash flows
of Ithemba. (12) (12)

(d) Identify and describe the key factors that the Board of Directors should
consider in deciding whether to discontinue the manufacture of the XE299
product and instead purchase it from IEI. (8)
Communication skills – clarity of expression (1) (9)

(e) Discuss how Ithemba should account for the 10% settlement discount that
the Board of Directors is considering. (4)
Communication skills – logical argument (1)

Total 55
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QUESTION 15 40 marks

H LTD GROUP
(Source: SAICA June 2013 ITC paper 1 part II - adapted)

Background of the H Ltd group

The H Ltd group is a multinational, diversified group listed on the Johannesburg Securities Exchange.
The year end of all the companies in the group is 31 December. The group has sophisticated internal
reporting systems.

One of the group’s strategies over the past five years has been to maximise growth and it has
achieved this by acquiring 12 businesses during this period. These acquisitions were funded by
borrowings. Prior to the acquisitions H Ltd only operated a motor vehicle rental business in South
Africa.

As a result of the acquisitions the H Ltd group now has invested in the following types of businesses:

● Importing and distribution of high-quality branded industrial products in the Southern African
region;
● Distribution and retailing of motor vehicles;
● Motor vehicle rental;
● Construction;
● Mining; and
● Manufacture and distribution of food products.

The businesses H Ltd acquired are based in South Africa, the United Kingdom (UK), Zimbabwe, the
United States of America (USA) and Nigeria.

The 2012 financial year has been challenging for the following reasons:

1 The revised broad-based black economic empowerment (B-BBEE) industry charters applicable
to the H Ltd group have changed the BEE requirements relating to ownership, management
and control in such a way that these would be the primary items assessed in the BEE
scorecard from 2014. To date the H Ltd group has focused on preferential procurement and
enterprise development and is highly rated based on these aspects.

2 The mining business has made huge losses as a result of a prolonged strike in which miners
were demanding much higher minimum wages. After unsuccessful discussions between
management and the unions, the employees initiated protest action. When these protests
became violent, several employees and journalists reporting on the strike were seriously
injured.

3 Management has spent significant time trying to sell four loss-making subsidiaries that were
acquired in 2010.

4 Five members of the executive team will reach retirement age within the next three years. The
Board of Directors plans to continue with its current approach to recruitment, namely that the
majority of the executives should be external appointees, to ensure a fresh approach to the
business.

5 A transport strike has resulted in delivery delays and loss of business in the food manufacturing
business.
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6 In the branded industrial products business, if the rand strengthens the purchase prices of the
products drop, and selling prices must therefore be reduced if the group is to remain
competitive. However, as many of the costs are rand denominated, the effect is that for each
5% by which the rand strengthens, operating profit decreases by R70 million per annum.

7 The South African Revenue Service (SARS) has disputed a deduction relating to an interest
expense of the group in 2010. SARS has indicated that it may disallow this interest deduction,
but wants further information from H Ltd before taking a final decision.

8 In the 2011 Worldwide Corruption Perceptions ranking of countries, South Africa, Nigeria and
Zimbabwe featured at the 63rd, 143rd and 154th positions respectively. The lowest ranking is
182.

9 According to the most recent real gross domestic product (GDP) growth rates, South Africa, the
USA and the UK all scored below the world average of 3,7%.

On 5 September 2012 Mr James Ermwee, the financial director, attended a seminar on The Code of
and Report on Governance Principles for South Africa (King III). He panicked when he heard that a
risk committee or audit committee should assist the Board in carrying out its risk responsibilities. He
was told that this would include identifying the key risks and the responses to address these key
risks. To date the H Ltd group has not complied with this requirement of King III.

REQUIRED Marks
(a) Identify and explain the key risks the H Ltd group faces with regard to its group
operations and describe ways, if any, in which the group could mitigate these risks.
(37)
Communication skills – layout and structure; clarity of expression; logical argument

(3) (40)
Total 40
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QUESTION 16 50 marks

TIP TOP TRANSPORT LIMITED

(Source: SAICA Jan 2013 ITC Paper 3 Question 2 -adapted)
All amounts exclude value added tax.

Tip Top Transport Ltd (‘TTT’) is a logistics group listed on the Johannesburg Securities
Exchange. TTT has the following operating divisions:

Division Focus area

Commercial Goods This division services the retail industry and is responsible for the
transport of fast moving consumable goods.
Fuel Logistics This division transports petrol and diesel from refineries and oil depots to
forecourts of fuel retailers.
Agricultural This division services the agricultural industry by transporting wheat,
Logistics maize, rice, sunflower seeds, sugar and flour.
FastLiner This division operates a fleet of luxury buses which transports paying
customers between major cities in South Africa.
Servicing and This division is responsible for all servicing and maintenance of TTT’s
Maintenance trucks and buses.

Return on investment (ROI) is one of the group’s key performance measures and divisional
management is incentivised on the basis of divisional ROI. TTT’s overall ROI has declined in recent
years mainly as a result of the challenging economic conditions and operating cost increases. The
operating divisions have been asked to propose initiatives to improve ROI as part of the group’s
efforts to enhance shareholder value and returns.

TTT expects each operating division to generate a ROI in excess of 25% on a before tax basis.
TTT’s operating divisions are also expected to generate returns in excess of the group’s
adjusted weighted average cost of capital (WACC) of 20% when making capital investments.
TTT’s actual WACC is lower than 20%. The operating divisions do not have control over the
payment of income tax and therefore tax cash flows are ignored when evaluating returns. As a
result, operating divisions are given a higher hurdle rate to compensate for ignoring income tax in
capital investment decision making.

Commercial Goods Division: Replacement of truck fleet and budgeted performance

The Commercial Goods Division (‘CGD’) is planning to replace its entire fleet of 70 trucks in the
financial year commencing on 1 January 2014. The fleet is standardised and each new truck is
forecast to cost R900 000. CGD has purchased all its trucks from the VIS Transport Group
(‘VIS’) in the past and has been negotiating with VIS about the replacement of the fleet in 2014.
VIS has agreed to sell the trucks to CGD and arrange financing for CGD as set out below:

• VIS will deliver all 70 trucks to CGD on 1 January 2014.

• CGD is to pay an upfront deposit of R180 000 for each truck and the balance of the
purchase consideration, namely R720 000 per truck, is to be financed on the following
basis:
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• CGD is to pay 60 equal monthly payments of R15 297,87 per truck commencing on
31 January 2014; and

• VIS undertakes to purchase the trucks for a consideration of R225 000 each on
31 December 2018. However, the trucks will need to be maintained and serviced on a
regular basis and have travelled no more than 600 000 km in order for CGD to
exercise this guaranteed buyback option. In the event that CGD does not meet
these criteria for any truck or chooses not to return the trucks, the balance of the
capital outstanding must be settled on 31 December 2018.

The proposed acquisition of the 70 trucks is a significant capital investment for CGD and the
TTT group. CGD has prepared an analysis of the proposed capital expenditure and the average
operating performance of each truck, which is summarised in the table below, for consideration and
approval by TTT’s Board of Directors.

You may assume that the mathematical calculations in the average profitability analysis table
below are correct.

Year ending 31 December 2014 2015 2016 2017 2018

Average profitability
Notes R R R R R
analysis per truck

Total revenue 1 404 000 1 466 600 1 609 200 1 701 000 1 792 800
Revenue 1 1 080 000 1 115 600 1 231 200 1 296 000 1 360 800
Fuel recovery charges 2 324 000 351 000 378 000 405 000 432 000

Operating costs (1 312 741) (1 380 207) (1 446 172) (1 511 807) (1 579 084)
Fuel costs 3 (360 000) (390 000) (420 000) (450 000) (480 000)
Insurance – vehicles 4 (45 000) (47 250) (49 615) (52 095) (54 700)
Other insurance costs 4 (65 000) (68 250) (71 665) (75 250) (79 015)
Driver costs 5 (120 000) (128 400) (137 400) (147 000) (157 200)
Back-up driver costs 5 (60 000) (64 200) (68 700) (73 500) (78 500)
Servicing and maintenance 6 (180 000) (192 000) (203 000) (213 000) (223 000)
Allocated overheads 7 (125 000) (135 000) (145 800) (157 500) (170 100)
Other operating costs 8 (156 000) (165 600) (174 000) (182 400) (192 000)
Depreciation 9 (135 000) (135 000) (135 000) (135 000) (135 000)
Financing costs 10 (66 741) (54 507) (40 992) (26 062) (9 569)

Operating profit per truck 11 91 259 86 393 163 028 189 193 213 716

Notes

1 Each truck travels on average 108 000 km per annum transporting customer goods
(‘productive km’). It is budgeted that customers will pay a fixed fee of R10 per km,
excluding fuel costs, to CGD in the 2014 financial year for the transportation of goods.
Although the fee per km will escalate in future years, the average productive km per truck
travelled is assumed to be 108 000 km in each year of the budgeted period.

2 Fuel costs incurred are billed separately to customers. All routes have been mapped and
standard distances agreed with customers. The average fuel consumed per km travelled by
trucks on each route is also agreed with customers. CGD invoices customers the prevailing
fuel cost per litre, multiplied by the pre-agreed number of litres consumed per km on routes.
CGD does not mark up fuel costs when invoicing customers.
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3 For a variety of reasons, fuel costs are forecast to be higher than that invoiced to
customers. The most common reason is that drivers deviate from pre-agreed routes or
take detours. In addition trucks have to travel from CGD depots to the TTT Servicing and
Maintenance Division’s workshops on a regular basis for servicing, repairs and maintenance.
Each truck is forecast to travel an average of 120 000 km annually, which is consistent with
distances travelled during prior years.

4 CGD insures trucks against theft and accident damage which is budgeted to cost R45 000
per truck in the 2014 financial year. In line with customer requirements, CGD also insures
itself against potential liability in the event of environmental damage as well as third party
claims for injury and consequential losses suffered as a result of negligence of truck drivers,
mechanical breakdown or truck malfunction. This insurance is estimated to amount to
R65 000 per truck in the 2014 financial year.

5 Drivers are budgeted to be paid R120 000 per annum on a cost to company basis in
the2014 financial year. Their salaries are expected to increase by approximately 7% per
annum thereafter. There is a pool of back-up drivers on standby, in the event that any of the
primary drivers become ill or to accompany drivers on long-distance trips. Back-up drivers
are full-time employees of CGD.

6 Each truck is required to be serviced after every 10 000 km travelled. The Servicing and
Maintenance Division marks up the costs of servicing and maintaining the CGD trucks by
50% in order to generate a reasonable return on its assets and efforts.

7 CGD analyses costs and allocates these to trucks using activity based costing principles. The
allocated costs in the budget represent divisional expenses incurred in dealing with customers
(e.g. Scheduling deliveries, customer service, complaints and queries), invoicing and
collecting amounts from customers, human resource management, and general management
and control of operations.

8 Other operating costs relating to the operation of trucks are variable in nature.

9 The acquisition costs of trucks less estimated residual values are depreciated evenly over
five years.

10 Financing costs have been correctly calculated on a monthly basis for the period 2014 to
2018 based on the proposed agreement with VIS.

11 Operating profit is analysed before taxation as CGD has no control over group tax
planning.
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CGD: Owner driver proposal

The CGD management is considering whether an ‘owner driver’ scheme be implemented

instead of acquiring the 70 new trucks in 2014. The key rationale for the scheme is to empower
drivers to become entrepreneurs and generate wealth.

CGD’s management has researched the owner driver scheme implications and has made the
following proposals:

(a) Drivers would acquire the new trucks directly from VIS on 1 January 2014 on the same
terms and conditions negotiated between CGD and VIS. In addition the Azania Development
Bank has agreed to guarantee the obligations of each driver to VIS and will stand surety in
favour of VIS in the event that drivers default on obligations to VIS.

(b) Drivers will cease to be employees of TTT on 31 December 2013 and instead enter into a
contractual relationship with CGD to perform transport services on behalf of CGD.

(c) Drivers will be paid a fixed fee (excluding fuel costs) per km travelled as per agreed
transport routes and distances. Fuel costs will be recovered and invoiced separately by
drivers to CGD on the same basis as agreed between CGD and its customers. The
proposed fixed fees are as follows:

Fees payable by CGD to

2014 2015 2016 2017 2018
owner drivers
Fee per km travelled in
transporting customer goods R8,00 R8,35 R8,70 R9,05 R9,40

(d) Drivers will contractually agree to have their trucks serviced and maintained by the
Servicing and Maintenance Division of TTT on the same basis as previously undertaken by
CGD. During the period 2014 to 2018 the Servicing and Maintenance Division will invoice
drivers for services rendered on the same basis as set out in the average profitability
analysis per truck.

(e) Drivers will take full responsibility for all operating costs of trucks except for other
insurance costs and allocated overheads set out in the average profitability analysis per
truck.

If the owner driver scheme is introduced, drivers are expected to travel an average total of
113 400 km per annum per truck instead of the 120 000 km assumed in the average profitability
analysis per truck. This is because there is likely to be an increased focus by drivers on
efficiency and improving operating performance. The average productive km travelled per truck in
the transport of CGD customers’ goods will, however, remain at 108 000 km per annum for the
period 2014 to 2018.

Drivers will need the services of accountants on an outsourced basis to handle the invoicing and
administration of their businesses. It is estimated that this will cost drivers R12 000 per annum in
2014, escalating by 5% per annum thereafter.

CGD estimates that its allocated overheads will drop by 80% following the introduction of the owner
driver scheme.
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REQUIRED Marks
Sub- Total
total
(a) Calculate the forecast ROI per truck used by CGD for each year over the
period 2014 to 2018 and the average RPI over the period, assuming that the
division acquires the 70 trucks and does not implement the owner driver
scheme. (6) (6)

(b) Identify and explain the potential merits and pitfalls of using ROI as a
measure to evaluate the performance of management. (9)

Communication skills – clarity of expression (1) (10)

(c) Calculate the expected internal rate of return (IRR) and net present value
(NPV) per truck of CGD over the period 2014 to 2018, assuming that the
division acquires the 70 trucks and does not implement the owner driver
scheme. (10) (10)

(d) Discuss the strategic considerations and factors that TTT should consider in
evaluating whether to implement the owner driver scheme in CGD. (12)

Communication skills – logical argument; clarity of expression (2) (14)

(e) Evaluate whether the drivers will be financially better off in 2015 following the
introduction of the owner driver scheme by CGD. (10) (10)

Total 50
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QUESTION 17 39 marks

SAVUSA LIMITED
(Source: SAICA 2012 QE I Paper 3 Question 1- adapted)

Savusa Limited (‘Savusa’) is a large media group listed on the JSE Securities Exchange.
The Board of Directors of Savusa has decided to follow a strategy of diversifying and
expanding through acquisitions. Numerous potential acquisition opportunities are being explored
including acquiring a controlling interest in Oxus Proprietary Limited (‘Oxus’).

Oxus

Savusa is considering the acquisition of a 60% shareholding interest in Oxus. The present
shareholders in Oxus are Mr Depp (the Chief Executive Officer) and Ms Grape (the Chief
Financial Officer), who jointly founded the business in 2000. Oxus publishes a range of magazines
which are distributed free of charge to target markets. One of their best known titles is Health
News, a 120- page A4 sized magazine distributed on a quarterly basis to doctors, specialists,
healthcare professionals and hospital managers across the country. Health News contains
articles about medical developments which may be of interest to anyone working in the
healthcare industry. Given the circulation of over 20 000 copies, the magazine attracts
significant advertising spend from manufacturers and distributors of medicines, hospital supplies
and products, and medical equipment and consumables.

Oxus owns and publishes 25 magazines which it distributes to the following industries:

• Healthcare (seven titles)

• Construction and engineering (three titles)
• Investment and asset management (four titles)
• Weddings (three titles)
• Automotive retail (two titles)
• Wine (two titles)
• Entertainment and arts (four titles).

Oxus has over the years developed various databases of individuals and businesses which may
be interested in their magazines, including a database of over 25 000 engineering and
construction professionals to whom their engineering titles are distributed.

Savusa approached Mr Depp and Ms Grape to find out whether they would be interested in
selling shares in Oxus. During initial discussions the two partners were convinced of the merits of
forming part of a larger media group and in realising some value for their efforts over the past
12 years. Mr Depp and Ms Grape are equal shareholders in Oxus and are willing to sell 30%
each to Savusa at fair market value (to be negotiated).

Ms Grape has performed a valuation of Oxus for purposes of the negotiations and has e-
mailed this to the directors of Savusa.
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Her valuation and explanatory notes are summarised below:

OXUS
YEAR END 31 DECEMBER
Notes 2010 2011 2012 2013 2014
R million R million R million R million R million
Advertising revenue 2 36,5 37,3 42,9 47,1 51,9
Cost of sales (17,1) (18,4) (20,6) (22,2) (24,1)
Printing costs 3 (9,1) (9,9) (11,1) (11,9) (12,9)
Sales commission 4 (3,6) (3,7) (4,3) (4,7) (5,2)
Mailing costs 3 (2,6) (2,7) (3,0) (3,3) (3,5)
Other costs of sales 3 (1,8) (2,1) (2,2) (2,3) (2,5)
Gross profit 19,4 18,9 22,3 24,9 27,8
Other income 5 0,2 0,2 0,2 0,3 0,3
Overheads
Employee costs 6 (10,9) (11,9) (9,5) (10,2) (11,1)
Freelance journalists 6 – – (2,5) (2,7) (2,9)
Premises rental costs (1,2) (1,3) (1,5) (1,6) (1,7)
Other overheads (1,1) (1,2) (1,3) (1,3) (1,4)
Earnings before interest, tax,
depreciation and amortisation
(EBITDA) 6,4 4,7 7,7 9,4 11,0
Depreciation (1,2) (1,5) (1,6) (1,7) (1,7)
EBIT 5,2 3,2 6,1 7,7 9,3
Interest income 0,1 0,1 0,3 0,8 1,3
Dividends received 5 0,1 0,1 0,1 0,1 0,1
Profit before taxation 5,4 3,4 6,5 8,6 10,7
Normal income tax (1,4) (0,9) (1,8) (2,3) (2,9)
Profit for the year 4,0 2,5 4,7 6,3 7,8

Ratios 7 % % % % %
Revenue growth 2,2 15,0 9,8 10,2
Gross profit margin 53,2 50,7 52,0 52,9 53,6
Annual change in overheads 9,1 2,8 6,8 8,2
EBITDA / revenue 17,5 12,6 18,0 20,0 21,2
Net profit margin 11,0 6,7 11,0 13,3 15,0

R million R million R million R million R million

Plant and equipment 8 4,6 5,5 5,2 4,8 4,3
Investments 5 2,5 2,7 3,0 3,2 3,5
Trade receivables 9 4,5 5,1 4,7 5,2 5,7
Cash and cash equivalents 1,6 2,6 8,7 15,1 22,9
Total assets 13,2 15,9 21,6 28,3 36,4

Share capital 0,1 0,1 0,1 0,1 0,1

Retained profits 10 10,8 13,3 18,0 24,3 32,1
Shareholders’ funds 10,9 13,4 18,1 24,4 32,2
Trade payables 2,1 2,4 3,2 3,6 3,8
Taxation 0,2 0,1 0,3 0,3 0,4
Total equity and liabilities 13,2 15,9 21,6 28,3 36,4
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OXUS (continued) YEAR END 31 DECEMBER

Notes 2010 2011 2012 2013 2014

Ratios 7
Trade receivables days 45 50 40 40 40
Trade payable days 55 60 65 65 65
Return on equity 36,7% 18,7% 26,0% 25,8% 24,2%

Discount rate 11 17,5%

Discount factor 0,851 0,724 0,616

R million R million R million R million

Net movement in cash 6,1 6,4 7,8
Eliminate: Interest income
(after tax) (0,2) (0,6) (0,9)
Free cash flow 5,9 5,8 6,9

Discounted free cash flow 13,5 5,0 4,2 4,3

Assumed growth into perpetuity
4,0%
Discounted continuing value 12 27,9
Enterprise value 41,4
Investments 2,7
Cash on hand 2,6
Equity value (100%) 46,7

Notes

1 The 2010 financial information has been audited. The 2011 financial information is based on
the latest management accounts. The forecasts for the financial years ending
31 December 2012 to 2014 have been reviewed by the directors of Oxus, who have
approved these for release to Savusa.

2 Revenue growth in the 2010 and 2011 financial years (‘FY2010’ and ‘FY2011’) was affected
by the poor economic condit ions. Oxus has entered into an agreement wi t h Savusa to
publish a 100-page glossy magazine to celebrate Savusa’s 50th anniversary in 2012. Oxus
expects to earn revenue of R2 500 000 from this once-off publication at a gross profit margin
of 40%.

3 Print costs are determined based on the quality and number of pages in the magazines.
Mailing costs vary according to the number of copies of the magazines distributed. Other
cost of sales items are largely fixed in nature.

4 Sales persons earn a commission of 10% of advertising sold. Oxus is considering changing
the commission basis to 20% of gross profit earned on particular magazines. However, it still
needs to engage with relevant employees before making this change. The forecasts are
based on the assumption that the current policy will remain in place throughout the forecast
period.

5 Investments represent a portfolio of listed shares that Oxus acquired in FY2008. The
company earns dividend income from the share portfolio. In addition, the annual increase in
the fair value of the share portfolio is recognised as ‘other income’.
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6 Oxus employs journalists to write articles for its numerous publications. As from FY2012,
Oxus will encourage its journalists to resign and enter into freelance contracts with the
company, thus only writing articles as and when required. The management of Oxus believes
that this will benefit both parties. Journalists will be free to work for other publications and
generate significantly more revenue than they currently earn at Oxus. The company will in
turn convert a fixed expense into a variable cost, and also reduce its operating costs.

7 You may assume that the ratios listed have been correctly calculated.

8 R2 500 000 was spent on upgrading the information technology infrastructure in FY2011 to
cater for growth over the next 5–7 years. Normal capital expenditure is in the region of R1
000 000 to R1 200 000 per annum.

9 Oxus’s policy is that clients should pay for advertising prior to publication of magazines, but
the company rarely enforces this policy and allows clients to pay amounts owed for
advertising within a reasonable period. However, from FY2012 Oxus plans to focus on
collections to improve cash flows and encourage clients to pay amounts when due.

10 Oxus normally declares a dividend equivalent to 50% of after tax profits. However, in FY2011
no dividend was declared or paid due to higher than normal capital expenditure.

11 The discount rate of 17,5% was derived from Savusa’s weighted average cost of capital of
12,5% (as disclosed by Savusa to Oxus) plus a 5% premium for the fact that Oxus is an
unlisted, smaller company. Savusa’s cost of equity is 16,0%, its after-tax cost of debt is
7,25% and the debt : equity ratio per its most recent audited statement of financial position
was 40,0%.

12 The continuing value (discounted cash flows from FY2015 onwards) was estimated using the
Gordon Growth Model [(cash flow FY2014 x 1,04)/(17,5% – 4%) x 0,524 (discount factor for
2015)].
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Marks
REQUIRED Sub-
Total
total
(a) Prepare a memorandum to the Board of Directors of Savusa in which
you critically review and advise on the valuation performed by Ms Grape.
(21)
Include an analysis of and commentary on the following:

• The financial forecasts of Oxus;

• Any errors of principle contained in the valuation;
• The discount rate used to discount future cash flows of Oxus; and
• The reasonability of the valuation derived.

At least half of your report should be devoted to an analysis of and

commentary on the financial forecasts included in the valuation.
Assume that the mathematical calculations in the discounted cash flow
valuation presented in the table in the scenario are correct.

Communication skills – structure and layout and appropriate style (3) (24)
(b) With regard to the proposed change in the commission structure for
sales persons at Oxus –
• discuss whether this will encourage more appropriate behaviour
within the company from Oxus’s perspective; and
• identify any issues that the sales persons may have with the
proposed scheme. (7) (7)
(c) Describe two potential benefits and two negative consequences for
Oxus of the proposed initiative to use freelance journalists rather than to
employ these individuals on a full-time basis. (8) (8)
Total 39
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QUESTION 18 50 marks

APPEX ASISST
(Source: SAICA 2012 QE I Part I Paper 1 Question 2)

Apex Assist Proprietary Limited (‘Apex Assist’) was founded in 1992 by two brothers, André and
Devon Visagie. The company designs and manufactures timber roof trusses, which are
triangular wooden frameworks used in roof construction to support roof decks. Apex Assist is
able to source the main raw material used in the manufacture of a roof truss, namely sawn
timber, from timber mills within close proximity to their factory premises in Port Elizabeth.

The company has traded successfully over the years, mainly as a result of limited
competition and the ability to source timber at reasonable prices. It has become the leading
supplier of timber roof trusses in the Eastern Cape. Apex Assist has expanded operations by
opening branches in other provinces. These b r a n c h e s are responsible for marketing, customer
relations and order processing within their regions. All products are sourced by branches from
Apex Assist’s factory in Port Elizabeth.

Recent performance

Apex Assist performed exceptionally well in the years leading up to and including the
financial year ended 31 August 2010, as a result of the boom in the construction industry.
However, revenue declined steadily during the second half of 2010 and in its 2011 financial
year (‘FY2011’) resulting in the company reporting its lowest profits in five years. The decline was
mainly due to the continued decrease in sales volumes which the entire construction industry has
experienced.

The directors of Apex Assist are concerned about the company’s investment in working
capital. Apex Assist has made a concerted effort to reduce inventory levels in line with
reduced demand. There has been a decrease in cash customers (cash sales as a
percentage of total sales decreased from 25% in FY2010 to 15% in FY2011), while credit
customers have taken longer to pay. Furthermore, creditors have demanded settlement of
outstanding accounts within a shorter period. These factors have resulted in an increased
investment in working capital.

The company increased its overdraft facility with its commercial bankers on
1 September 2010 from R250 000 to R1 000 000. The overdraft bears interest at 2% per
annum above the prevailing quoted prime overdraft lending rate (which is 9% per annum in
2011). Two of the conditions of the overdraft facility are that Apex Assist must have an
interest cover ratio of five times or more and that its debt : equity ratio not exceed 50%.
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Extracts from Apex Assist’s most recent annual financial statements are presented below:

APEX ASSIST
STATEMENT OF FINANCIAL POSITION AT 31 AUGUST
2011 2010
R’000 R’000
Non-current assets 5 140 4 940

Current assets 7 375 7 345

Inventories 2 935 3 700
Trade and other receivables 4 430 3 540
Cash and cash equivalents 10 105

Non-current liabilities
Deferred taxation 30 25

Current liabilities 3 610 3 895

Bank overdraft 720 15
Trade and other payables 2 800 3 650
Taxation 90 230

APEX ASSIST
STATEMENT OF COMPREHENSIVE INCOME FOR THE YEAR ENDING 31 AUGUST
2011 2010
R’000 R’000
Revenue 27 628 35 916
Cost of sales (19 480) (24 601)

Operating profit 748 4 113

Finance income 2 5
Finance costs (40) (10)
Profit before taxation 710 4 108

Profit for the year 510 2 960

New business opportunity

Apex Assist was recently approached by Mandlovu Limited (‘Mandlovu’) which obtained a local
government contract for the renovation of electrical substations within the Eastern Cape
Province. The contract period is three years and Mandlovu intends to purchase all the roof
trusses required for the replacement of the substations’ roofs from Apex Assist. Only one
shape and size of roof truss is required for this contract, namely the J815D truss. Mandlovu
requires a discount of 5% on the normal selling price of J815D roof trusses, which is
currently quoted at R500 each. Furthermore, Mandlovu requires that Apex Assist has
sufficient inventory of the J815D truss to ensure it is able to deliver to any destination within
the Eastern Cape within 48 hours of an order being placed. Apex Assist is under pressure to
make a final decision on the Mandlovu opportunity, as the start date of the local government
contract is 1 March 2012.
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The standard cost of the J815D truss is as follows:

Note R
Sawn timber 140
Other direct materials 105
Direct labour 1 35
Allocated overheads 2 70
Total 350

Notes

1 Factory labourers are full-time employees who earn a fixed weekly wage, irrespective of
their productivity levels, based on a 40-hour work week.

2 Manufacturing overheads are allocated to trusses at 50% of the sawn timber cost.
Based on past experience, 40% of manufacturing overhead costs are variable in
nature.

Further details relating to the potential supply of roof trusses to Mandlovu:

• Apex Assist will have to purchase two additional trucks dedicated to delivering the roof
trusses to Mandlovu sites, at a cost of R250 000 per truck. The trucks can be sold at the
end of the supply period for R85 000 each. Apex Assist will be able to claim a straight-
line wear and tear allowance of 33,3% per annum in respect of the trucks for income tax
purposes. Each truck will also require a driver with an expected annual cash cost each of
R117 000 to the company.

• Mandlovu has provided the following estimates of roof trusses required during the
duration of the contract:

Year ending 28 Quantity of

February J815D
2013 4 840
2014 5 640
2015 5 820

• Apex Assist is planning to hold inventories equivalent to 10% of the estimated order
quantities of roof trusses for the forthcoming year of the contract. Additional working
capital requirements, excluding inventory, are expected to amount to R20 000 once the
supply of roof trusses commences.

• A vacant warehouse on premises adjacent to the current factory will need to be rented
from the beginning of March 2012 for storing the required roof truss inventory and for
parking the delivery trucks. The annual rental will be R90 000, payable in advance. The
landlord requires that Apex Assist should enter into a four-year rental agreement. It is
unlikely that Apex Assist will need the space after the supply arrangement with
Mandlovu comes to an end. The company therefore intends to sub-lease the
warehouse from March 2015.

• Other cash operating costs arising from and associated with supplying Mandlovu are
expected to total R50 000 per annum.

• The company’s factory will have sufficient available capacity to manufacture the
required roof trusses.
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The Board of Directors of Apex Assist uses a hurdle rate of 20% to evaluate any investment or
expansion opportunities. This hurdle rate is used irrespective of the nature of the funding for
projects, whether it is in the form of equity, shareholder loans or external borrowings. The same
hurdle rate will be used to evaluate the after-tax cash flows of the Mandlovu
opportunity.

Financing options

Mr André Visagie estimates that Apex Assist will need additional funding of R750 000 inorder
to pursue the Mandlovu opportunity. The commercial bankers of Apex Assist have indicated that
they are not prepared to advance an additional R750 000 to Apex Assist given their current
exposure to the company.

Although the Board of Directors of Apex Assist has explored various financing options, only
one option is available at present. Mr Jeremy Greed, a friend of the Visagie brothers, has
offered to advance a loan of R1 million (the minimum amount he is prepared to lend) to Apex
Assist subject to the following terms and conditions:

• The loan will bear interest at a fixed rate of 12% per annum, payable bi-annually in
arrears;
• The capital amount of the loan will be repayable in a single bullet repayment three years
after the advance of the loan; and
• Apex Assist will be required to pay an initiation fee of 5% of the loan amount to Mr
Greed upon signature of the loan agreement.
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Marks
REQUIRED Sub- Total
total
(a) Calculate the net present value of the expected cash flows associated
with supplying Mandlovu with the required roof trusses. (25)

• Ignore inflation.
• Assume that, unless otherwise stated, cash flows occur at the
end of the year and that Apex Assist has sufficient taxable
income from its current operations to absorb any tax losses.

Communication skills – structure and layout (2) (27)

(b) Identify and explain the key business risks to which Apex Assist will be
exposed if the company decides to enter into a supply
arrangement with Mandlovu.
(16)
Communication skills – clarity of expression (1) (17)
(c) Calculate the effective interest rate on a pre-tax basis of the proposed
loan from Mr Greed (you may thus ignore the effects of section 24J) . (6) (6)
Total 50
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QUESTION 19
40 marks
SUPREMO TANKERS (PTY) LTD
(Source: SAICA 2011 QE1 Paper 1 Question 2- adapted)

Supremo Tankers (Pty) Ltd (‘Supremo’) operates a fleet of trucks and trailers to provide logistical
services to brick manufacturers in the Gauteng and Mpumalanga provinces. These services mainly
entail the transport of bricks on behalf of brick manufacturers to their customers.

Supremo owns 100 trucks together with ‘fIat-bed’ trailers. These transport vehicles have loading
equipment specially designed to load and unload bricks. The logistical services are offered to
customers on one of the following bases:

• An annual contractual basis to transport bricks from the brick manufacturer’s premises to
specified locations, based on a minimum number of loads per week. These contracts provide for
a fixed monthly charge subject to changes in diesel fuel prices. Contracts specify that diesel fuel
represents 20% of the total charge to customers and Supremo adjusts monthly charges to
customers with immediate effect in the event of a change in the retail price of diesel fuel; or

• A per load basis in terms of which Supremo charges an agreed transport fee per kilometre
travelled from the brick manufacturer’s premises to the delivery destination. These charges also
fluctuate depending on diesel fuel prices, based on the principle that diesel fuel costs represent
20% of the total per kilometre charge to customers.

The shareholders in Supremo are Sergio Parisse (70%) and BWI Holdings (Pty) Ltd (‘BWI’) (30%), a
black economic empowerment investment company owned by three prominent black
businesswomen. Mr Parisse started Supremo in 1985 and has been instrumental in developing the
business into the leading logistics provider to brick manufacturers in the provinces in which it
operates. Supremo focuses exclusively on services to brick manufacturers.

Supremo’s profitability has declined significantly in the 2009 and 2010 financial years, mainly because
of lower activity levels in the brick manufacturing industry. Research by an industry association
revealed that sales volumes of brick manufacturers were 25% lower in 2009 than in the previous year
and that sales volumes declined by a further 5% in 2010.

The decline in demand for its services that Supremo has experienced has also had an effect on its
capacity utilisation. Prior to 2009 Supremo was able to optimise load volumes and to ensure that it
carried full loads on most occasions. This changed in 2009 and now many of the trailers are empty on
one or more legs of a journey. For example, bricks may be delivered to a destination but the trailer
remains empty until the truck reaches the next customer.

DAB Bank is the commercial banker to Supremo. DAB Bank has exclusively financed the acquisition
of trucks and trailers by Supremo over the past five years on an instalment sale basis. DAB Bank
requires a deposit of 20% of the purchase price of new vehicles when financing Supremo’s
acquisition of trucks and trailers. The instalment sale is repayable in equal monthly instalments over
six years and the capital outstanding bears interest at the prevailing prime overdraft rate (assume
10% in 2010).
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The bank overdraft balance with DAB Bank at 31 December 2010 was R28 405 000. As a result of
the on-going operating losses, DAB Bank has informed Supremo that they are required to reduce
their bank overdraft balance to R5 million by 28 February 2011. If this overdraft balance is not
reduced then DAB Bank will withdraw the overdraft facilities.

Supremo has historically adopted a policy of trading in or disposing of trucks after five years.
Supremo has found that after this period, trucks become very expensive to maintain and repair costs
increase exponentially. This does not apply to trailers as Supremo has workshop facilities where it
overhauls and cost-effectively maintains trailers to extend their useful life to more than ten years.

The demand for used trucks has declined dramatically over the past two years, which has had an
adverse impact on disposal prices. The strength of the rand has also impacted on used truck prices.
The trucks that Supremo uses are imported and a strengthening rand (assume during the 2009 and
2010 period) has resulted in minimal price increases of new trucks, which in turn affects the resale
values of used trucks. Prior to 2009 Supremo generally disposed of trucks at prices which were
higher than the carrying values.

The financial results and financial position per the management accounts for the year ended
31 December 2010 are summarised below:

SUPREMO TANKERS (PTY) LTD

EXTRACTS FROM THE STATEMENTS OF PROFIT OR LOSS AND OTHER COMPREHENSIVE
INCOME

Year ended 31 December Notes 2010 2009

R’000 R’000

Revenue 1 102 920 128 650

Cost of sales 2 (66 120) (76 820)
Gross profit 36 800 51 830
Operating and administrative costs 3 (23 500) (21 400)
Loss on sale of vehicles (2 600) (2 500)
Earnings before interest, tax, depreciation and amortisation 10 700 27 930
(EBITDA)
Depreciation (14380) (16 750)
EBIT (3 680) 11180
Finance costs (12 400) (12 100)
Loss before taxation (15 780) (1 220)
Taxation - -
Loss after taxation (15 780) (1 220)
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SUPREMO TANKERS (PTY) LTDEXTRACTS FROM THE STATEMENTS OF FINANCIAL

POSITION

As at 31 December Notes 2010 2009

R’000 R’000

Non-current assets
Property, plant and equipment 4 157 200 149 200

Current assets 19 225 22 050

Inventories 925 950
Trade and other receivables 18 300 21 100
TOTAL ASSETS 176 425 171 250

Equity 31 970 47 750

Share capital 5 000 5 000
Distributable reserves 26 970 42 750

Non-current liabilities 83 650 86 400

Interest-bearing liabilities 5 80 050 82 800
Deferred taxation 3 600 3 600

Current liabilities 60 805 37 100

Trade and other payables 11 100 12 700
Current portion of interest-bearing liabilities 5 21 300 23 200
Bank overdraft 28 405 1 200
TOTAL EQUTY AND LIABILTIES 176 425 171 250

Notes

1. Revenue declined by 10% in the 2009 financial year compared to 2008. Supremo did not
increase annual or per kilometre charges to customers in 2009 and 2010 except for changes
relating to diesel fuel price fluctuations.
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2. Details of the cost of sales are set out in the table below:

SUPREMO TANKERS (PTY) LTD

Cost of sales breakdown
2010 2009
R’000 R’000

Fixed costs
Insurance, employee costs (truck drivers and workshop
employees), vehicle licenses and workshop fixed overheads 32 920 33 990
Variable costs 33 200 42 830

Diesel fuel 20 580 25 730

Other variable costs (oil, maintenance, tyre replacement costs) 12 620 17 100

Total cost of sales 66 120 76 820

Diesel fuel prices decreased on average by 35% during the 2009 financial year. In 2010, diesel
prices increased on average by 8%.

3. Operating and administrative costs are mainly fixed costs, with only 5% of these total expenses
being variable in relation to revenue and activity levels in the 2009 and 2010 financial years.

4. Supremo owns the property in Johannesburg from which it operates. The net book value and
tax base of land and buildings at 31 December 2010 was R17 120 000. The property was
acquired in 2002 for R19 million and a further R1 million was immediately spent on refurbishing
the premises. Buildings are depreciated to a zero residual value on a straight-line basis over 50
years (the depreciation charge for the 2010 financial year was R360 000). At 31 December
2010 the net book value of the vehicle fleet was R139 300 000 (2009: R130 900 000).

5. Interest-bearing liabilities represent the balance outstanding on instalment sale agreements.

Reduction of the bank overdraft

The shareholders of Supremo have met to discuss plans of action to reduce the bank overdraft to R5
million by February 2011. BWI has indicated that it has no cash resources available to subscribe for
shares in Supremo or to advance a shareholder’s loan to the company. Mr Parisse has in principle
agreed to purchase the land and buildings owned by Supremo for R30 million, which represents the
fair market value. He has furthermore agreed to lease the property to Supremo for five years at a
market-related rental of R200 000 per month, subject to annual inflation escalations. The proceeds
from the sale of the property will be used to reduce the company’s bank overdraft.
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REQUIRED Marks
(a) Analyse and comment on the revenue and gross profit performance of Supremo in the
2009 and 2010 financial years. Calculate relevant ratios in support of your comments.
Note: You are not required to adjust COS to correct for depreciation classification. (20)

(b) Identify and outline at least three possible actions that Supremo could take to return to
profitability on a sustainable basis and at least three possible actions that Supremo
could take to improve the cash flow generation of the business.
Exclude the property sale and leaseback from your discussion. (8)

(c) Critically discuss, from the perspective of Supremo, the proposed sale and leaseback
of the land and buildings. (9)

Presentation marks: Arrangement and layout, clarity of explanations, logical argument and
language usage. (3)

TOTAL MARKS 40
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QUESTION 20 40 marks

ELECTRIBOLT LIMITED
(Source: SAICA 2010 QE I Paper 2 Question 3 Part A - adapted)

Amounts in the question exclude VAT, except where indicated.

ElectriBolt Ltd (‘ElectriBolt’) is an independent electricity supplier with various power-generation

operations throughout South Africa. ElectriBolt is listed on the main board of the Johannesburg
Securities Exchange. The company’s most recent financial reporting date was
31 December 2009.

Background

On 1 January 1999, ElectriBolt entered into a unique hydro-electricity supply licence agreement
with the South African government (‘the government’). The licence agreement entitled
ElectriBolt to install three turbines at the Augrabies Waterfall, which is situated in the Augrabies
National Park, and generate and supply electricity for a period of 15 years. The licence agreement
provides that –

• ElectriBolt is required to pay the government a fixed instalment of R800 000 annually in
arrear for the right to use the site to generate electricity; and
• the agreement is not renewable at the end of the 15-year term.

ElectriBolt decided to grant the right of use of the abovementioned supply licence, from the
inception date of the agreement with the government (1 January 1999), to PowerSmart Ltd
(‘PowerSmart’), a large electricity supplier, for a period of 15 years. All licensing rights granted to
ElectriBolt by the government were transferred to PowerSmart in exchange for a fixed annual
instalment of R1 million, payable in arrear to ElectriBolt. By law the final operator of an electricity
supply business is solely responsible and liable for any related environmental site rehabilitation.
PowerSmart may not transfer or sell the supply licence to any other party. A cancellation penalty of
R900 000 is payable by PowerSmart to ElectriBolt should PowerSmart at any stage
unilaterally decide on the early cancellation of the agreement.

On 1 January 1999, ElectriBolt did not recognise any assets or liabilities in respect of the
hydroelectricity supply licence with the government and the right of use of the licence granted to
PowerSmart. The R800 000 per annum for the supply licence is expensed on an annual basis and
the R1 million per annum receipt from PowerSmart is recognised as revenue on an annual basis.
This accounting policy is acceptable in terms of International Financial Reporting Standards.

Feasibility study on PowerSmart’s Augrabies operations

ElectriBolt recently established that PowerSmart is underperforming at the Augrabies site and
believes that significantly more electricity can be generated during the last four years of the supply
licence. The major reason for PowerSmart’s disappointing performance is the regular labour
disputes experienced at the Augrabies operation. ElectriBolt conducted a feasibility study in
December 2009 to evaluate the possible acquisition of PowerSmart’s Augrabies operations.
Following this feasibility study, ElectriBolt proposed acquiring the PowerSmart Augrabies
division as a going concern, including all assets and liabilities of this division except for cash
and cash equivalents and taxation liabilities. The licensing agreement between ElectriBolt and
PowerSmart would be terminated as part of the acquisition.
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The Chief Financial Officer (CFO) of ElectriBolt prepared the following cash-flow projections,
following a detailed review of historic financial information of the Augrabies division of
PowerSmart and its budgets for the next four years, for the purposes of valuing the Augrabies
division:

Year ending
31 December Notes 2010 2011 2012 2013
R R R R
Turnover 1 18 000 000 18 000 000 18 000 000 18 000 000
Operating costs 1 (4 500 000) (4 500 000) (4 500 000) (4 500 000)
Opportunity cost 2 (1 000 000) (1 000 000) (1 000 000) (1 000 000)
Supply licence
agreement instalments (800 000) (800 000) (800 000) (800 000)
Operating cost savings 3 300 000 300 000 300 000 300 000
Cost of helicopter lease 4 (480 000) (480 000) (480 000) (480 000)
Depreciation: Turbines (700 000) (700 000) (700 000) (700 000)
Interest on long-term
loan 5 (897 536) (712 469) (503 344) (267 032)
Environmental site
rehabilitation costs 6 – – – (2 500 000)
Pending legal claim 7 – – – –
Taxation 8 (2 778 290) (2 830 109) (2 888 664) (2 254 831)
Net cash flows 7 144 174 7 277 422 7 427 992 5 798 137

Related calculations Notes

Weighted average cost of capital (WACC) 9 23,00%
Net present value of the future cash flows of the Augrabies
division of PowerSmart 9 R17 143 393

Notes to the cash-flow projections

1 Projected turnover includes a conservative estimate of the additional electricity that

ElectriBolt could generate and supply, assuming it acquired control of the operations.
Operating costs exclude annual supply licence payments due by PowerSmart to
ElectriBolt.

2 Opportunity cost represents annual instalments in terms of the supply licence agreement, to
which ElectriBolt will no longer be entitled.

3 PowerSmart incurred research and development costs during the period 2007 to 2009
aimed at improving operating efficiency. As a result thereof, PowerSmart expects a possible
annual operating cost saving of R300 000 from 2010 to 2013. The CFO of PowerSmart is of
the opinion that the cost saving is only 45% probable, resulting in the development costs not
meeting the recognition criteria in terms of IAS 38, Intangible Assets, for recognition as an
intangible asset. It follows that development costs were immediately expensed when
incurred.

4 PowerSmart leases an executive helicopter from Fly-with-Me Airways (Pty) Ltd at a fixed
instalment of R360 000, payable annually in arrears. The lease agreement was correctly
classified as an operating lease in terms of IAS 17, Leases. The lease agreement
commenced on 1 January 2008 and ends on 31 December 2012. On 31 December 2009, it
was reliably established that similar executive helicopters can be leased at a market-
related fixed instalment of R480 000, payable annually in arrear.
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5 PowerSmart obtained a long-term loan of R15 million on 1 January 1999 to finance this
particular operation. The long-term loan is repayable in 15 equal annual instalments,
which commenced on 31 December 1999. The loan bears interest at a fixed rate of 13% per
annum. The loan agreement provides that the loan cannot be repaid earlier than the agreed
repayment profile. On 31 December 2009, long-term loans with a similar risk profile and
remaining maturity were available at a fixed rate of 12% per annum.

6 This amount has been reliably estimated by an independent environmental rehabilitation

expert.

7 Labour unrest increased after the recent dismissal of a number of PowerSmart’s

employees as a result of increased operational inefficiency. The trade union to which
these employees belong has instituted a legal claim against PowerSmart on behalf of the
employees on the grounds of unfair dismissal. The legal advisers of PowerSmart are of
the opinion that –

• the dismissed employees have a valid claim against PowerSmart for unfair
dismissal;
• the trade union will not be able to prove the claim for unfair dismissal in court, due to a
lack of evidence; and
• it is possible but not probable that the court will require PowerSmart to make a
financial settlement to the dismissed employees.

The CFO did not include any amount relating to the legal claim in the forecast cash flows.
Should such a claim be successful, any amount paid by PowerSmart will not be deductible for
tax purposes. The fair value of the legal claim at 31 December 2009, as reliably
determined by an experienced actuary, is R450 000.

8 All items in the cash-flow budget have been assumed to be taxable or deductible for
income tax purposes, except as per point 7 above.

9 The nominal WACC of ElectriBolt is 23% and the forecast cash flows have been
discounted using this rate.

Financing alternatives

On 31 December 2009 the Augrabies division of PowerSmart was acquired by ElectriBolt as a

going concern, including all assets and liabilities of the division except for cash and cash
equivalents and taxation liabilities. The purchase consideration of R16 million was paid by
ElectriBolt on 31 December 2009. It was correctly established that the transaction between
ElectriBolt and PowerSmart constitutes a ‘business combination’ as defined in IFRS 3, Business
Combinations.
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ElectriBolt is considering various financing alternatives for the business combination transaction:

• Payment out of existing cash reserves of R16 million; or

• Obtaining a R16 million medium-term loan from ElectriBolt’s bankers. The loan is to bear
interest at 1% above the prevailing prime overdraft rate. This is the company’s incremental
cost of borrowing. The loan is to be repaid in one bullet payment at the end of four years.
Interest is to be calculated and compounded annually in arrear, and capitalised into the
outstanding loan balance. Transaction costs of 1% of the principal amount will be payable at
the inception of the medium-term loan. The interest to be incurred on such a long-term loan is
deductible for taxation purposes in terms of section 24J of the Income Tax Act; or

• The issue of compulsory convertible preference shares with a par value of R16 million.
Preference shareholders will be entitled to an annual dividend calculated as 80% of the
prevailing prime overdraft rate multiplied by the par value of shares held. ElectriBolt is
required to pay preference dividends annually in arrear and has no discretion with regard to
declaring these dividends. Each preference share will automatically convert into one ordinary
share after four years. Analysts predict that the value of the converted shares at the end of
year four will amount to R17 800 000.

Additional information

The current prime overdraft rate is 10% per annum, nominal and pre-tax.

REQUIRED

Marks
(a) Identify, with reasons, any errors in and omissions from the cash flow forecasts and
discounted future cash flows of the Augrabies division of PowerSmart Ltd as prepared
by the CFO of ElectriBolt Ltd. (16)

(b) Identify and describe any advantages and disadvantages of ElectriBolt Ltd settling the
purchase consideration due to PowerSmart Ltd using its own cash resources.
(6)

(c) With regard to ElectriBolt Ltd evaluating the financing of the acquisition of the
Augrabies division of PowerSmart Ltd through obtaining the medium-term loan or
through the issue of the preference shares –
(i) calculate and determine which instrument will be more cost effective for
ElectriBolt Ltd to use; and (10)
(ii) discuss any other factors ElectriBolt Ltd should consider in deciding which
instrument to use. (6)

Presentation marks: Arrangement and layout, clarity of explanation, logical

argument and language usage. (2)
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QUESTION 21 50 marks

CLOTH GROUP LIMITED

(Source: SAICA 2009 QE I Paper 1 Question 2- adapted)

Cloth Group Ltd (‘Cloth Group’) is a clothing retailer with 55 stores throughout South Africa.
These stores, which focus on fashion clothing, are situated in suburban shopping malls and
their target market is 25 to 45 year-old females and males. Approximately 75% of sales are on
credit and customers are granted 30 days’ interest-free credit from the date of the
statement. If payments are not made within this period, customers have to pay interest on the
outstanding balance, calculated from the date of purchase, at the prime overdraft lending rate
(currently 15,5% per annum) plus 4%. Customers are required to settle the full amount owing
on a purchase within six months.

Cloth Group is listed on the JSE Securities Exchange. The company has performed well
over the past two years, reporting revenue of R412 million for the year ended
31 January 2009 (2008: R357 million) and achieving a gross profit margin of 42% for the
2009 financial year (2008: 41%).

Cloth Group purchases clothing from foreign and local suppliers. Suppliers are selected
based on the quality of merchandise supplied, pricing and reliability. The majority of foreign
suppliers are based in Europe and invoice Cloth Group in euro (€).

The audited statement of financial position of Cloth Group at 31 January 2009, together with
comparative figures, is set out below:

CLOTH GROUP LTD

STATEMENT OF FINANCIAL POSITION AT 31 JANUARY
2009 2008
R’000 R’000
ASSETS
Non-current assets
Property, plant and equipment 102 280 89 180

Current assets 198 050 169 800

Inventories 49 800 43 340
Trade receivables 129 600 110 180
Cash and cash equivalents 18 650 16 280

TOTAL ASSETS 300 330 258 980

EQUITY AND LIABILITIES
Share capital 15 000 15 000
Retained earnings 192 875 153 000
Total equity 207 875 168 000
Current liabilities 92 455 90 980
Current borrowings (bank overdraft) 29 050 42 090
Trade and other payables 34 080 27 100
Shareholders for dividends 11 250 9 750
Taxation payable 18 075 12 040
TOTAL EQUITY AND LIABILITIES 300 330 258 980
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Raising of medium-term finance

The Treasury Division of Cloth Group has been tasked with raising finance of between
R100 million and R125 million. Cloth Group requires the funding to grow its trade receivables
and consequently revenue. The Treasury Division has received various formal proposals
and has short-listed the following two proposals:

1 Euro denominated bond

Total nominal value €9 600 000

Coupon (fixed) 6,9%
Issue date 31 March 2009
Maturity date 31 March 2012

Interest coupon on the bond is payable annually in arrears. The total nominal value is
repayable in full on the maturity date.

2 Syndicated loan

Principal amount R120 000 000

Nominal interest rate 3 month JIBAR plus 2,5%
Loan advance date 31 March 2009
Term 3 years
Upfront issuance cost 2% of the principal amount

Interest on the loan is to be calculated quarterly but paid annually in arrears. The current
Johannesburg Interbank Agreed Rate (JIBAR) is 12,5%. The principal amount is to be
repaid in three equal annual instalments, with the first repayment due on 31 March
2010. The upfront issuance cost is to be paid by Cloth Group on the loan advance
date, or the company can elect to receive 98% of the principal amount on the advance
date.

Cloth Group’s policy is to hedge all foreign currency exposure. Their commercial bankers
have quoted the following spot and forward exchange contract rates:

Current spot rate €1 : R12,50

12 months forward to 31 March 2010 €1 : R13,75
24 months forward to 31 March 2011 €1 : R15,10
36 months forward to 31 March 2012 €1 : R16,60

Capital structure

Cloth Group has historically funded its growth out of its own cash flows and through short-
term borrowings, mainly in the form of bank overdrafts. The Chief Executive Officer of Cloth
Group has asked the Financial Director to determine what impact the raising of medium-term
finance will have on the weighted average cost of capital (WACC) of Cloth Group.
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Information that may be relevant in determining Cloth Group’s WACC is set out in the
table below:

Cloth Group
Number of shares in issue 15 000 000
Current share price R24,60
Beta co-efficient 0,90
Effective normal income tax rate 28%
Dividend per share declared on 31 January 2009 75c

Other information
Current yield of the R204 RSA government bond,
maturity date 21 December 2018 9,0%
Current yield of the R153 RSA government bond,
maturity date 31 August 2010 9,4%
Premium for market risk 8,0%

REQUIRED

Marks
(a) Calculate and determine which debt instrument (euro denominated
bond or the syndicated loan) will be the most cost effective way for
Cloth Group Ltd to raise medium-term finance. (15)
Ignore all tax implications.
(b) Identify and describe the key factors that Cloth Group Ltd should
consider in evaluating which debt instrument to issue. (6)

(c) Calculate, with reasons, the weighted average cost of capital (WACC)
of Cloth Group Ltd at 31 March 2009, assuming that the company
elects to issue the euro denominated bond. (12)

(d) Assuming that Cloth Group Ltd elected to enter into the syndicated loan
agreement, discuss the key factors and issues that Cloth Group Ltd
should consider in evaluating whether to change from a floating interest
rate to a fixed interest rate. (5)

(e) Briefly describe the concept of asset-backed securitisation and indicate

what benefits, if any, could accrue to Cloth Group Ltd from securitising
its trade receivables. (5)

(f) Identify the key procedures that Cloth Group Ltd should follow in
assessing the creditworthiness of new customers. (4)

Presentation marks: Arrangement and layout, clarity of explanation, logical

argument and language usage. (3)
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QUESTION 22 100 marks

ZIMROD (PTY) LIMITED

(Source: SAICA 2012 QE I Part II Question 2 - adapted)

Zimrod (Pty) Ltd (‘Zimrod’) supplies corporate clothing and gifts to a diversified customer base
in South Africa. Zimrod’s head office is based in Midrand, Gauteng. This 4 500 m² facility
houses the company’s main warehouse and the procurement and administrative divisions,
together with an impressive showroom. Zimrod also has branches in Cape Town, Durban and
Port Elizabeth, which service customers in those regions.

Zimrod imports clothing from various suppliers based in India, China and Taiwan. The clothing
range includes T-shirts, golf shirts, lounge shirts, work wear, sweaters, jackets and track suits.
The company currently does not supply retailers, but sells directly to corporate customers
or marketing and promotions companies only. Clothing can be branded to customer
specifications using embroidery and printing.

The company also purchases and sells a range of corporate gifts to its customers, including –

• carry bags and luggage items;

• water bottles, coffee mugs and flasks;
• memory sticks;
• key chains;
• umbrellas;
• business card holders;
• stationery items, such as pens, pencils, folders and notebooks;
• iPad holders; and
• first-aid kits.

The gift range can also be branded with company logos and marketing
material.

The executive directors of Zimrod collectively own 100% of the shares in issue of the company
(there are 100 000 ordinary shares in issue). These shareholders have provided non-
interest- bearing loans to the company in proportion to their shareholdings. Shareholder
loans totalled R12 500 000 in 2011 and 2012.
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The statement of comprehensive income of Zimrod for the year ended 30 September 2012
and the statement of financial position at 30 September 2012 are set out below.

ZIMROD (PTY) LTD

STATEMENT OF COMPREHENSIVE INCOME FOR THE YEAR ENDED 30 SEPTEMBER
2012
2012 2011
R’000 R’000
Revenue 317 438 274 600
Cost of sales (183 479) (159 268)
Gross profit 133 959 115 332
Operating expenses (98 937) (87 710)
Operating profit 35 022 27 622
Finance costs (1 630) (1 500)
Profit before taxation 33 392 26 122
Taxation (9 350) (7 314)
Profit for the year 24 042 18 808

ZIMROD (PTY) LTD

STATEMENT OF FINANCIAL POSITION AT 30 SEPTEMBER 2012
2012 2011
R’000 R’000
Non-current assets
Property, plant and equipment 17 380 12 500

Current assets 111 496 91 554

Inventories 50 268 41 453
Trade and other receivables 60 878 48 901
Cash and cash equivalents 350 1 200

Total assets 128 876 104 054

Equity
Share capital 100 100
Retained income 65 917 41 875
66 017 41 975
Non-current liabilities
Loans from shareholders 12 500 12 500

Current liabilities 50 359 49 579

Current tax payable 1 402 1 096
Trade and other payables 32 674 30 545
Bank overdraft 16 283 17 938

Total equity and liabilities 128 876 104 054

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Ms Jennifer Ireland, the Chief Executive Officer (CEO) of Zimrod, is concerned about the cash
flow generation of the company. Operating profit grew by 26,8% in the 2012 financial year
(‘FY2012’) yet the net cash position only improved marginally. Ms Ireland is of the opinion that
the poor cash flow generation of the company is due to poor working capital management. She
would like her shareholder’s loan to be repaid as soon as possible, as she plans to buy
a holiday home in Cape Town.

Jaxx Work & Leisure Wear

Zimrod has historically adopted a strategy of importing and selling its own line of clothing,
branded ‘Zimrod’, or sourcing clothing to be branded to customers’ requirements. However, the
company has been in discussions with Jaxx Work & Leisure Wear (‘Jaxx’), a major North
American clothing group which sells Jaxx branded merchandise to clothing retailers in North
America and Europe. Jaxx also has its own retail outlets which sell its extensive clothing range
and related accessories (sunglasses, gloves, belts, headwear and socks).

Jaxx has offered Zimrod the exclusive right to distribute its product range in sub-Saharan
Africa. Jaxx currently does not have a presence in Africa and perceives an opportunity to
grow its global sales by entering emerging markets.

The opportunity to import and distribute the Jaxx product range is appealing to Zimrod for the
following reasons:

• It will provide its customers with access to a leading global work and leisure wear brand;
• It will diversify revenue streams, as Zimrod could supply branded merchandise to
South African clothing retailers; and
• It will enable Zimrod to enter the retail market directly, should Zimrod decide to open
its own retail outlets under the Jaxx brand.

Negotiations between Zimrod and Jaxx have progressed well and agreement has been
reached on the following key commercial arrangements:

• The initial licensing and distribution agreement will be for a three-year period
commencing on 1 January 2013. The agreement will be automatically renewable for
another three years thereafter, unless either party terminates the agreement by giving
three months’ written notice;
• Zimrod will order and purchase merchandise directly from Jaxx’s head office in Seattle
in the United States (US). Zimrod will not pay royalties to Jaxx but rather Jaxx will earn
its normal mark ups on selling its product range. Prices will be denominated in US dollar;
• Zimrod will be required to spend a minimum of 2% of its annual sales value of
Jaxx products on general marketing and promotion of the Jaxx brand in South Africa
and in other territories in which Zimrod will sell Jaxx merchandise;
• Jaxx will supply Zimrod with free samples of products and advertising materials to
assist Zimrod in marketing and promoting the brand. In addition, Jaxx will provide Zimrod
with access to all forthcoming clothing and product ranges while these are in the
planning stage to enable Zimrod to plan new product launches and place orders well in
advance of changing seasons; and
• Payment terms for products purchased from Jaxx will be 30 days from statement,
which will be e-mailed at the end of each month.
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The Financial Manager of Zimrod, Mr Jarred Kirchner, was tasked with preparing a
capital budget to assess the viability of importing and distributing the Jaxx product range. Mr
Kirchner obtained inputs from key management at Zimrod and Jaxx and has incorporated
these into the latest draft capital budget, which is summarised below.

For the sake of simplicity, the capital budget is based on the assumption that all cash
flows occur at the end of each calendar year unless otherwise indicated and that the
agreement with Jaxx will become effective on 1 January 2013:

JAXX VENTURE DRAFT CAPITAL BUDGET

Notes 2012 2013 2014 2015

R’000 R’000 R’000 R’000
Sales 1 0 65 625 103 500 123 038
Purchases – landed cost 2 0 (43 750) (69 000) (82 025)
Gross profit 0 21 875 34 500 41 013
Initial marketing campaign 3 (2 500) 0 0 0
Warehousing costs 4 0 (2 188) (3 450) (4 101)
Delivery costs 5 0 (1 531) (2 415) (2 871)
Operating costs 6 0 (7 560) (8 316) (9 148)
Finance costs 7 0 (1 398) (1 745) (1 207)
Net profit for the year (2 500) 9 198 18 574 23 686
Taxation 8 700 (2 576) (5 201) (6 632)
Inventory movements 9 (8 500) (5 884) (8 301) (4 282)
Trade receivables movements 10 (13 485) (7 783) (4 015)
Trade payables movements 10 5 394 3 113 1 606
Net cash flow for the year (10 300) (7 353) 402 10 363

Internal rate of return (IRR) –17,8%

Funding required
Opening balance 0 (10 300) (17 653) (17 251)
Net cash flow for the year (10 300) (7 353) 402 10 363
Closing balance (10 300) (17 653) (17 251) (6 888)

Notes

1 A mark-up on the landed cost of products of 50% has been assumed in the capital
budget.

2 The cost of purchasing Jaxx products has been based on the forecast rand : US
dollar exchange rates which were obtained from Zimrod’s bankers.
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3 Zimrod will need to launch a marketing campaign to introduce the Jaxx brand to
South African retailers and consumers. It has been assumed that the campaign will
be paid for by 31 December 2012.

4 Zimrod has sufficient capacity in its existing warehouse for storing Jaxx products and
does not expect to incur any additional costs in handling these products at its
warehouse. However, in order to evaluate the Jaxx project objectively, warehousing
costs of 5% of the landed cost of products has been included in the capital budget (5%
being the percentage Zimrod historical experienced for all product ranges).

5 Costs of delivering products sold to customers averages 3,5% of landed cost.

6 Zimrod plans to start a new division which will focus exclusively on Jaxx products.
The additional operating expenditure relates to this division and costs will largely be
fixed in nature and exclude advertising and marketing expenditure.

7 Zimrod will require additional funding to invest in initial inventory and to cover
marketing expenditure and ongoing working capital requirements until the venture is
cash positive. It has been assumed that loan finance will be obtained from commercial
banks to fund the venture. Finance charges at a rate of 10% per annum have been
assumed, based on the average loan balances during the forecast period. No interest
income has been included (Zimrod earns 5% on cash deposits) since the venture is
forecast to be cash negative for the first three years.

8 Taxation at 28% has been assumed on net profits generated by the Jaxx venture.

9 It has been assumed that Zimrod will initially purchase inventory to the value
of R8 500 000 to get the venture off the ground. Thereafter, year-end inventories have
been assumed to be 120 days’ worth of purchases, as follows:

2012 2013 2014 2015

R’000 R’000 R’000 R’000
Initial inventory 8 500
Year-end inventories, 2013 onwards (120 days) 14 384 22 685 26 967
Net movement for the year (8 500) (5 884) (8 301) (4 282)

10 Trade receivable days of 75 and trade payable days of 45 (based on landed cost
of goods) have been assumed throughout the period, and net movements have been
calculated as follows:
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2013 2014 2015

R’000 R’000 R’000
Trade receivables
Trade receivables at year end (75 days) 13 485 21 268 25 283
Net movement for the year (13 485) (7 783) (4 015)
Trade payables
Trade payables at year end (45 days) 5 394 8 507 10 113
Net movement for the year 5 394 3 113 1 606

Zimrod plans to delay the opening of any Jaxx retail outlets until 2016 to allow the company to
establish this brand in South Africa before embarking on the next phase of the plan.

The CEO of Zimrod has reviewed the above draft capital budget and is dismayed by
the negative forecast IRR. The Board of Directors of Zimrod has indicated that unless the
projected IRR is higher than 30%, the proposed licensing and distribution arrangement with
Jaxx will not be approved.

The directors derived the 30% hurdle rate on the following basis:

Zimrod weighted average cost of capital = [80% x cost of equity] + [20% x after tax cost
(WACC) of debt]
20% representing the target debt : equity ratio

Cost of equity = Risk free rate + market risk premium

= Government three-month treasury bill rate +
8,0%
= 6,6% + 8,0%
= 14,60%

Cost of debt = Current bank overdraft rate x 72%

= 9,0% x 72%
= 6,48%

WACC therefore = 12,98%

Adjustment for Jaxx venture risk = 17,02%
Hurdle rate = 30,00%

The Board of Directors has also indicated that the capital budget should be based on the
assumption that the Jaxx venture is a three-year project.
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Funding for the Jaxx venture

Zimrod has approached its commercial bankers and other banks to provide a R20 million term
loan to fund the Jaxx venture. All banks that were approached have declined the loan
application, based on their perception that it would be a high-risk business venture.
Zimrod’s poor cash flow generation in FY2012 also did not help their cause in their bank
finance application.

Morningstar Investments Ltd (‘Morningstar’), a listed investment holding group, recently

approached Zimrod with a view to acquiring a minority shareholding interest in the
company. Morningstar has been actively searching for an entry into the corporate clothing and
promotions industry and has received excellent feedback about Zimrod. Morningstar has
submitted a letter of interest to the Board of Directors of Zimrod, stating amongst others the
following:

• Morningstar is prepared to subscribe for a 30% shareholding in Zimrod based on

a valuation of four times the audited profit after tax for the year ended 30 September
2012, as a price-earnings multiple of four is what Morningstar usually pays for stakes in
private companies. In terms of this the value of Zimrod would be R96 168 000 based on
the profit for the year ended 30 September 2012, and Morningstar would inject R28
850 400 into the company in return for a 30% shareholding; and

• Morningstar requires the right to appoint two non-executive directors to the Board
of Directors of Zimrod.
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REQUIRED
Marks
Sub-
Total
total
(a) Analyse the working capital of Zimrod for the years ended 30 September
2011 and 2012 and indicate, with reasons, whether you agree with the
Zimrod CEO’s contention that the poor cash generation of the company is
due to poor working capital management. (7) (7)

• Calculate relevant ratios and show all workings.

• Use 365 days of the year for your calculations where relevant.
(b) Re-draft the capital budget to correct the errors and omissions that you
have identified in the draft prepared by the Financial Manager. Also
recalculate the projected IRR of the Jaxx venture. Briefly motivate each of
your adjustments. (20) (20)

Assume that the mathematical calculations of working capital in the original

draft capital budget are correct.
(c) Critically discuss the derivation of the 30% hurdle rate required by the
Board of Directors for the evaluation of the proposed licensing and
distribution arrangement with Jaxx. (10) (10)
(d) With regard to the proposed licensing and distribution arrangement with
Jaxx –
o discuss whether this is an appropriate strategy for Zimrod to
pursue, describing both the positive aspects of this alliance and
potential concerns you may have from a strategic perspective; and (14)
o identify and explain the key risks to which Zimrod will be subjected if
it enters into and pursues the proposed arrangement with Jaxx. (16)
Communication skills – clarity of explanation and logical argument (2) (32)
(e) Draft an executive summary to the Board of Directors in which you
recommend, with reasons, whether or not Zimrod should enter into the
licensing and distribution arrangement with Jaxx. (6)
Communication skills – appropriate and clear communication (2) (8)
(f) Discuss the factors that the Board of Directors should consider in evaluating
the Morningstar offer. (10) (10)
(g) Estimate the pro forma earnings per share of Zimrod for the year ending
30 September 2013, on the assumption that –
Morningstar subscribed for a 30% shareholding in Zimrod based on a pre-
subscription valuation of Zimrod of R120 million on 1 October 2012;
Zimrod’s operating profit, before consideration of the Jaxx venture
opportunity, increases by 15% in FY2013 in comparison to FY2012; and
Zimrod does not enter into the licensing and distribution arrangement with Jaxx. (12)
Communication skills – layout
(1) (13)
Total 100
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QUESTION 23 100 marks

FOODAGE LIMITED
(Source: SAICA 2012 QE I Part II Question 1 -adapted)

Foodage Ltd (‘Foodage’) is a company listed in the travel and leisure sector of the Johannesburg
Securities Exchange (JSE). Foodage was founded in 1994 by Mr Sipho Sithole, when he opened
the first ‘Eat Some More’ restaurant in White City, Soweto. The restaurant served traditional
African fare and charged affordable prices, thus providing a wholesome family-centred value-for-
money experience. Based on the success of this restaurant, Mr Sithole subsequently built up a
franchise chain of Eat Some More (‘ESM’) restaurants which offers large servings of healthy
inexpensive food. Today, there are over 250 franchised ESM restaurants spread throughout South
Africa, all of them aimed at the lower income market.

When Foodage listed on the JSE in 2000, Mr Sithole assumed the role of Executive Chairman,
while Mr Irvin Paddiachee became the Chief Executive Officer and Mr Fanie van der Merwe the
Chief Financial Officer. Presently, Mr Sithole still holds the position of Executive Chairman but both
Mr Paddiachee and Mr van der Merwe retired in January 2011 and now serve as non-executive
directors of Foodage.

In the early years Foodage invested heavily in developing a number of its own-brand sauces for
use in the preparation and serving of the various dishes offered in the ESM franchise restaurants.
Over time Foodage began to sell these ‘secret’ sauces to the public through various ESM
franchisees. This proved to be a success and in 2004 Foodage decided to commercialise the
range of Eat Some More sauces by offering the products directly to the general public through
large food retail chain stores.

In 2006, reasoning that further ESM franchise growth was limited and in a departure from the
existing business model, the Board of Directors of Foodage approved the opening of the first
Kolkata Night Biters (‘KNB’) restaurant, which was wholly owned and managed by Foodage.
Foodage currently owns and manages 28 KNB restaurants, which offer authentic Indian cuisine, in
South Africa. The KNB restaurant chain serves the higher income market and charges premium
prices for the ‘fine dining’ experience it offers.

In early 2007 Foodage further broadened its business model and opened its first themed Popinas
wine bar, again on a wholly-owned and managed basis, targeting customers under the age of 25
and serving inexpensive liquor and snacks. Foodage has since opened a number of Popinas wine
bars and this brand is perceived to be the rising star in the group.

In June 2010, in an effort to expand its geographic footprint, the company incorporated Foodage
International Plc (‘FI’), with Mr Paddiachee’s niece, Ms Samantha Paddiachee, as Managing
Director. FI opened its first KNB restaurant in October 2010 in England. FI currently owns and
manages six KNB restaurants throughout England. Although it is taking some time to establish the
KNB brand offshore, the Board of Directors of Foodage remains convinced that international
expansion in one form or another is going to be the key growth driver in the future.
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FINANCIAL YEARS ENDED 30 SEPTEMBER

Notes 2012 2011 2010 2009
R million R million R million R million
ESM franchise operations
Franchise licence fees 1 138,1 118,8 107,1 99,2
Marketing and procurement service fees 2 93,9 87,0 76,2 69,7
Total franchise revenues 232,0 205,8 183,3 168,9
Profit before tax from franchise operations 92,8 80,3 67,8 59,1

Products and merchandising 3

Revenue 231,1 206,9 192,4 180,7
Profit before tax 23,2 20,6 19,3 18,0

KNB – South Africa only 4

Revenue 78,3 61,6 55,1 48,0
Profit before tax 3,0 3,8 4,9 4,2

Popinas 5
Revenue 284,2 180,4 64,6 15,5
Profit before tax 38,6 25,2 9,1 2,3

Total group domestic revenue 825,6 654,7 495,4 413,1

FI
Revenue 28,9 21,6
Loss before tax (32,6) (17,8)

Total group revenue 854,5 676,3 495,4 413,1

Total group profit before tax 125,0 112,1 101,1 83,6

Notes

1 ESM franchise licence fees

Foodage grants operating licences to specifically selected franchisees. Each franchisee owns
and manages his or her restaurant, which is branded as an ESM restaurant. Foodage
provides each franchisee with upfront support on all aspects of locating, funding and
physically setting up the restaurant and, once established, provides on-going business advice
and training. In return for the Foodage support each franchisee pays annual licence fees to
Foodage, which are based on a percentage of actual revenue. The percentage charge used to
be negotiated annually, but after a particularly difficult round of negotiations in the 2009
financial year (‘FY2009’), the parties entered into a four-year contract that stipulates the
annual percentage of revenue charges.

Relevant details of the ESM franchise business are as follows:

2012 2011 2010 2009

Weighted average number of ESM
restaurants open during the year 251 264 255 248
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Average annual franchisee restaurant

revenue R3,4 million R3,2 million R3,05 million R2,95 million
2 Marketing and procurement service fees

In order to benefit from economies of scale and to leverage its core competencies, Foodage
provides centralised marketing and procurement functions for both its franchise and retail
operations.

Marketing services include managing and developing all aspects of the ESM, KNB and Popinas
brands. This involves selecting the marketing campaigns and media delivery channels as well as
dictating all facets of the dining experience, from the theme décor to menu offerings and prices, for
each of the brands.

The Foodage procurement function has total control of the various supply chains and selects and
manages suppliers based on agreed criteria, including BBBEE rating, cost, product quality and
sustainability issues, and reliability of supply.

Foodage charges each ESM franchisee a percentage of the franchisee’s turnover for the provision
of marketing and procurement services. The annual percentage charges are governed by the four-
year contract referred to in note 1.

3 Products and merchandising

This division houses the Eat Some More ‘secret’ sauce business. While Foodage retains
ownership of the various Eat Some More sauce recipes, all manufacturing and distribution of the
various products are outsourced, which allows Foodage to earn relatively consistent margins.
Limited ‘in store’ brand support is offered for these products in food retail chain stores, with brand
awareness mostly being generated from the ESM franchise marketing spend.

4 KNB – South Africa only

KNB has been a mixed success for Foodage. Initially the chain generated strong profits but
margins have since come under pressure. In response Foodage has implemented a number of
strategic changes, including eliminating a significant percentage of permanent jobs and replacing
these persons with temporary workers, aggressively opening new restaurants, changing locations,
and effecting on-going menu changes coupled with price ‘specials’ in order to increase revenues.

Other details of this business are as follows:

2012 2011 2010 2009

Weighted average number of KNB
restaurants open during the year 27 22 19 15
Annual average revenue per restaurant R2,9 million R2,8 million R2,9 million R3,2 million

5 Popinas

Modelled on the old Roman concept of ‘decadent’ wine bars, Popinas bars offer a range of
inexpensive beers, wines, shooters and spirit coolers along with a limited selection of snacks, in an
environment of loud electronic music and bold décor. Popinas bars have rapidly established a
reputation among the younger generation as the ‘in places’ to be and have been an outstanding
success, despite a number of clashes with local authorities relating to noise and nuisance
complaints. Foodage is planning to open a further 20 Popinas wine bars in South Africa during
FY2013.
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Other details of the Popinas business are as follows:

2012 2011 2010 2009

Weighted average number of wine
bars open during the year 58 41 17 5
Annual average revenue per wine bar R4,9 million R4,4 million R3,8 million R3,1 million

Historical data regarding shares in issue and share prices

The Board of Directors of Foodage has always believed that the creation of shareholder value is of
paramount importance and has consistently paid a great deal of attention to the Foodage share
price. The number of shares in issue has remained unchanged since listing and all growth has
been funded through a mix of retained profits and interest-bearing debt.

At 30 September 2012 2011 2010 2009 2008

’000 ’000 ’000 ’000 ’000
Total shares in issue 90 000 90 000 90 000 90 000 90 000
Shares held by controlled company
Own It (Pty) Ltd (see below) (5 740) (5 088) (5 088) (3 603) (1 641)
84 260 84 912 84 912 86 397 88 359
R R R R R
Closing share price 12,90 11,35 8,40 7,15 12,80

Own It (Pty) Ltd

Own It (Pty) Ltd (‘Own It’), a 100% wholly-owned subsidiary of Foodage, was incorporated in 2007
for the purpose of effecting share buybacks if and when, in the view of the executive directors, the
company had surplus cash and such acquisitions would create shareholder value.

Details of the share trading history of Own It are as follows;

2012 2011 2010 2009 2008

’000 ’000 ’000 ’000 ’000
Number of shares purchased on the open
Market 652 0 1 485 1 962 1 641
R R R R R
Average buying price per share 12,45 n/a 7,80 13,05 16,50

Management incentive scheme

As an entrepreneurial group, Foodage strongly incentivises its leadership in such a way as to align
the actions of those controlling the business with the needs of its shareholders.

In 2006 the shareholders of Foodage approved a cash or equity-settled management share

incentive scheme, in terms of which the company was authorised to utilise a maximum of 10%
(nine million shares) of the ordinary shares in issue for the purposes of the scheme.
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Immediately after the 2006 shareholders’ meeting, Foodage awarded nine million standard share
options to its senior management, executives and non-executive directors at an exercise price
which was equal to the then prevailing share price, of R5,10 per share. All senior management and
all directors earn in excess of R1 million per annum. The five-year vesting period of the options
ended on 30 June 2011.
In 2011 the company elected to settle the nine million share options in cash, based on the
prevailing share price of R10,50 per share. After paying transaction costs of R500 000 and
deducting relevant taxes, Foodage paid the net amounts due to the option holders to them.

Extract from the 2012 Chairman’s report on integrated sustainability

‘Foodage is committed to becoming a better company by making sustainability a business

imperative. To this end we have commissioned a number of initiatives which will result in
our operations becoming more environmentally and socially sustainable. While we are confident
we are at the forefront of social engagement, there is little doubt that our environmental
impact needs to be reduced, and we intend to accomplish this by reducing our carbon footprint. I
look forward to being able to provide concrete details of a number of successful reduction
programmes in our next annual report.’

Extracts from the 2012 corporate governance reports

‘The Board of Directors is chaired by Mr Sipho Sithole, an executive director. The King Report on
Governance for South Africa, and the King Code of Governance Principles (known as
King III) recommend that the chairman of the Board be independent. As the founder of the group
Mr Sithole has a holistic understanding of the group’s strategies and brands, and this deep
understanding, coupled with his strong entrepreneurial flair, provides an invaluable service to the
group which could not reasonably be expected of an independent person. Thus the group believes
it is in the best interests of all stakeholders that Mr Sithole chairs the Board.’

‘King III further recommends that the majority of the Board consists of non-executive directors, of
whom the majority should be independent. Currently the Board comprises of five executive
directors, two non-executive directors (Mr Paddiachee and Mr van der Merwe), and a single
independent non- executive director. Given the intricacies of the group, it has not been possible to
recruit suitably qualified independent directors and in any event the value added and collective
wisdom brought to bear by the executive and non-executive directors at the Board level is such
that the best interests of all stakeholders are well served by the current Board.’

‘King III also recommends that the Remuneration Committee be chaired by an independent non-
executive director and, further, that the majority of the Remuneration Committee members be
independent non-executive directors. The Foodage group’s Remuneration Committee is comprised
of two non-executive directors who act independently, one of whom chairs the Committee, and
three executive directors. Given the experience and knowledge necessary to appropriately
remunerate entrepreneurial executives and senior management in a fast-changing environment,
Foodage believes that the current committee composition is optimal. In addition, the integrity and
objectivity of the non- executive directors is such that the interests of shareholders cannot be
prejudiced. In this regard, it was somewhat surprising that at the 2011 annual general meeting,
there was a non-binding vote against the proposed 2012 remuneration structures by 21% of the
shareholders.’
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REQUIRED

Marks
Sub-
total Total
(a) Evaluate the various growth strategies that Foodage has followed since
listing on the JSE by –

(i) analysing, and commenting on, the financial performance of the

Foodage group and its various operating divisions and its international
subsidiary for FY2009–2012 (your answer should include relevant
(30)
ratios and calculations); and
(ii) critically discussing the success of the various business strategies
pursued by Foodage. (16)
Communication skills – presentation and layout, appropriate style and logical
t
(b) Estimate the net cash received (i.e. after tax) by senior management,
executives and non-executive directors in FY2011 with regard to the
settlement of the share options by Foodage. (6) (6)
(c) Critically discuss the effectiveness of Foodage’s share buyback programme
to date. Where relevant, support your answer with calculations. (16) (16)
(d) Identify and describe ways in which Foodage could reduce its environmental
impact in 2013. (12) (12)
(e) Discuss and conclude whether you agree with Foodage’s stated reasons for
their non-compliance with the King III requirements, based on the extracts
from the 2012 corporate governance report. (15)

Communication skills – appropriate style and logical argument (2) (17)

Total 100
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QUESTION 24 100 marks

ZAPPHIRE LIMITED
(Source: SAICA 2011 QE II Question 2 - adapted)

Zapphire Limited (‘Zapphire’) is a construction company listed in the Construction and Materials
Sector of the Johannesburg Securities Exchange. The company provides civil and building
construction, earthworks, road building and rehabilitation, as well as mechanical and electrical
installation services to the private and public sectors. The general construction sector has been
under pressure since early 2009 due to the prevailing economic conditions and the slowdown in
government infrastructural spending. Zapphire was not as severely affected by the industry
conditions as some of its competitors, because it performed significant work on constructing
stadiums for the FIFA World Cup leading up to 2010 and did extensive work for mining clients.

Mr Ian Williams started Zapphire in 1980 and has been instrumental in developing the company into
a formidable force in the local construction industry and in neighbouring countries. Mr Williams,
through his family trust, is a major shareholder in Zapphire and is the executive chairman of the
company.

Selected financial and other data

The most recent statements of financial position and of comprehensive income are summarised
below:

ZAPPHIRE LIMITED
STATEMENT OF FINANCIAL POSITION AS AT 30 SEPTEMBER
2011 2010
R million R million
Non-current assets 448 430
Property, plant and equipment 398 380
Investment property 50 50

Current assets 1 490 1 488

Inventories 35 33
Contracts in progress 70 65
Trade and other receivables 710 720
Bank balances 675 670

TOTAL ASSETS 1 938 1 918

Issued ordinary share capital 150 150

Retained income 558 508
Equity attributable to shareholders 708 658

Current liabilities 1 230 1 260

Trade and other payables 775 835
Provisions 425 380
Taxation 30 45

TOTAL EQUITY AND LIABILITIES 1 938 1 918

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ZAPPHIRE LIMITED STATEMENT OF

COMPREHENSIVE INCOME FOR THE YEAR
ENDED 30 SEPTEMBER
2011 2010
R million R million
Revenue 3 750 3 250
Contract costs (3 185) (2 700)
Gross profit 565 550
Other income 30 25
Operating costs (245) (215)
Earnings before interest, taxation and depreciation 350 360
Depreciation (55) (50)
Operating profit 295 310
Investment income 45 40
Profit before taxation 340 350
Taxation (110) (113)
Profit for the year 230 237

Earnings per share (cents) 153,3 158,0

Dividend per share (cents) 120,0 100,0
Number of ordinary shares in issue (million) 150,0 150,0

Zapphire has not issued any ordinary shares nor has it repurchased any shares through a share
buyback or on the general market during the past two financial years.

The shareholders of Zapphire at 30 September 2011 can be categorised as follows:

The Ian Williams Family Trust 40,0

Institutional investors 20,0
Management 12,5
Other shareholders 27,5
100,0

Hardrock Mining (Proprietary) Limited (‘Hardrock’)

As the nature of contract mining is closely related to some of Zapphire’s construction activities and
the company has a strong mining client base, the company has for some time considered entering
the contract mining industry.

Hardrock was a contract mining company with a large fleet of graders, excavators and dump trucks
which were used in open pit mining. Unfortunately, Hardrock was overly reliant on one client in the
diamond mining sector and when this particular client dramatically scaled down its open-cast
diamond mining activities in 2009 and 2010, Hardrock found itself in severe cash flow difficulties,
with the result that it has been placed in liquidation.
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The liquidator of Hardrock is seeking to dispose of the company’s plant and equipment, part of
which consists of a fleet of graders, excavators and dump trucks. The current replacement cost of
the fleet is estimated to be R1,8 billion and the estimated fair market value of plant and
equipment of equivalent age and usage is R1,4 billion.
The liquidator has invited all interested parties to submit bids for the Hardrock fleet and the
deadline is at 12:00 on 30 November 2011. Zapphire plans to submit an offer to acquire this
plant and equipment for R700 million.

If Zapphire is able to acquire the Hardrock fleet, it intends to offer contract mining services to
existing clients in the coal, platinum and gold mining sectors. In addition, Zapphire is exploring the
provision of services to mining groups based in Angola, the Democratic Republic of Congo (DRC)
and Ghana. Services rendered in these territories will be invoiced in US dollar.

Financing of the acquisition of the Hardrock plant and equipment

Zapphire has acquired 100% of a shelf company (‘Newco’) for a nominal consideration and intends
to use Newco to acquire the Hardrock fleet. In the event that Newco is successful in acquiring the
Hardrock fleet, Zapphire will advance a non-interest-bearing shareholder’s loan of R200 million to
Newco to fund working capital requirements.

Zapphire has been in discussions with various parties regarding the financing of the Hardrock plant
and equipment. The company has received the following three proposals but has not yet made a
final decision on which option to pursue:

1 AZN Bank Limited (‘AZN’), who has been Zapphire’s commercial bankers for the past ten
years, is prepared to advance a loan of R700 million to Newco. The loan is to bear interest at
2,75% above the prevailing three-month Johannesburg Interbank Agreed Rate
(‘JIBAR’), which is currently 5,575%. Interest will be payable annually in arrears. The loan
principal of R700 million will be repayable in a single payment at the end of four years.
AZN requires Newco to undertake to meet certain annual loan covenants throughout the term
of the loan. These loan covenants will include certain minimum financial ratios and an
undertaking not to repay any portion of the shareholder’s loan to Zapphire until such time as
the AZN loan has been repaid in full. In the event that Newco breaches any of the loan
covenants, AZN will be entitled to increase the interest rate on the loan to JIBAR plus 8%
until such time as Newco again fully complies with the loan covenant provisions.

AZN also requires that its loan advance be secured by a notarial bond over the Hardrock
fleet to be acquired by Newco.

2 Hacienda Hedge Fund (‘Hacienda’) has offered to advance a R700 million loan to Newco
subject to certain conditions. The loan will bear interest at a fixed rate of 4,85% per annum
and interest will be repayable quarterly in arrears. The loan principal will be repayable in five
equal annual instalments of R140 million each. Throughout the period of the loan, Newco will
be required to deposit R11 666 667 at the end of every month into a bank account,
called a debt service reserve account, which Newco will cede to Hacienda. At the end of each
year, R140 million will be transferred from the debt service reserve account to Hacienda to
effect the annual loan principal repayment obligations.
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As a condition of the loan advance to Newco, Hacienda requires a call option on 7,5
million Zapphire shares at a strike price of R9,20 per share. Hacienda will be entitled to
exercise the option at any stage during the loan period.

Like AZN, Hacienda also requires that its loan advance be secured by a notarial bond
over the Hardrock fleet to be acquired by Newco.

3 The third alternative is that Newco issue a €70 million high-yield Eurobond. The current R :
€ exchange rate is 10,00 : 1,00. The Eurobond will be secured by means of a notarial bond
over the Hardrock fleet acquired by Newco and a guarantee from Zapphire for €70
million. The bond will have a fixed coupon of 5,65% per annum payable semi-
annually in arrears. The Eurobond will be listed on various European bond exchanges.

The bond will be redeemable six years after issue at the par value of €70 million. The
other key conditions of the Eurobond issue are as follows:

• Newco may not incur any further debt obligations, repay any portion of the
Zapphire shareholder’s loan or pay any dividends to shareholders without the prior
approval of the majority of bondholders; and

• The Eurobond is redeemable at an earlier date provided it is redeemed in full and

Newco pays a premium of 2,4% of the par value of the Eurobond for each 12-month
period or part thereof that the bond is redeemed earlier than the scheduled date.

Hedging of interest rates

Should Newco wish to hedge its exposure to interest rate movements, AZN is prepared to enter
into an interest rate swap (to convert the three-month JIBAR into a fixed rate) with Newco to cover
R350 million of the loan principal at the following annual rates:

Term Fixed rate

2 years 6,66%
3 years 7,25%
4 years 7,63%

Alternatively, AZN has offered an interest rate cap for a four-year period to hedge interest rate
movements (three-month JIBAR) on R350 million of the loan amount at the following premiums:

Cap strike rate Premium payable

7,63% R8 228 122
8,13% R6 876 216
8,63% R5 767 727

Actions to secure the Hardrock acquisition

Mr Williams believes the acquisition of the Hardrock fleet will provide Zapphire with the opportunity
not only to diversify but also to boost its revenue and profits. Given the strategic importance of
the potential acquisition opportunity, Mr Williams has taken the following steps to improve Newco’s
prospects to win the bid for the Hardrock fleet:
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1 Mr Williams met with the former management team of Hardrock and offered them a sign- on
bonus of R2 million each if they enter into three-year service agreements with Newco and
agree not to be part of any opposing bid for the Hardrock fleet. These offers were made
subject to Newco’s successful acquisition of the Hardrock fleet within the next six months.

2 Mr Williams has played golf regularly with key employees of the liquidator of Hardrock.
After one of these social interactions, Mr Williams offered non-executive directorship
positions to two key individuals employed by the liquidator. Mr Williams added that these
appointments would only be made in two years’ time to avoid any controversy or conflicts of
interest.

3 Mr Williams met with the Chief Executive Officer (CEO) of BJL Civils (Proprietary) Limited
(‘BJL’) to discuss their interest in bidding for the Hardrock fleet. Mr Williams had heard
from reliable sources that BJL was the only other serious bidder for the Hardrock fleet. Mr
Williams intimated to the CEO of BJL that Zapphire would agree to submit inflated bids for
selected road tenders in the Free State during the next 12 months to ensure that BJL
secured such work on favourable terms, on condition that BJL submitted a bid of
R400 million for the Hardrock fleet. Zapphire and BJL are the two largest contractors in
the road building and rehabilitation sector in the Free State.

4 Mr Williams met with various journalists ‘off the record’ recently and made it clear that
Zapphire was nervous about bidding for the Hardrock fleet, as the initial technical due
diligence reports about the condition and value of the fleet were very negative. Mr
Williams further stated that the demise of Hardrock was no accident as the South African
contract mining market is highly competitive and mining groups have too much negotiating
power.

Strategy session: Hardrock

The executive directors and key management of Zapphire recently spent three days at a private
game lodge in the Kruger National Park. The former management team of Hardrock was also
present at the strategy session, which focused on various issues relating to the possible acquisition
of the Hardrock fleet. No expense was spared during the weekend, from the hiring of a private jet to
transport all executives to the game lodge to the ordering of the most expensive French
champagne available.

The following issues elicited the most debate:

• Whether Newco should be a ‘plant hire’ company which hires out its plant (together with
skilled operators) on an hourly basis or whether it should become a mining contractor and
charge for tonnages of ore extracted;

• Whether Newco should undercut existing plant hire companies and / or mining contractors in
South Africa by offering plant and equipment charge-out rates at lower than the market rates;
and

• What actions Newco could take to rapidly secure contract mining work in Angola, the DRC
and Ghana.

The Chief Financial Officer (CFO) of Zapphire made a presentation to the executives which
covered various financial issues. He explained that industry practice was to depreciate plant and
equipment on the following basis:
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‘The useful lives of plant and equipment are determined based on the estimated number of
productive hours to be worked by the plant and equipment. The rates at which plant and
equipment are depreciated are based on the estimated number of productive hours to be
worked which will reduce the cost of plant and equipment to their estimated residual
values over their expected useful lives.’

The former Hardrock management team provided useful insights into the industry, including various
costing and pricing issues. They stated that the major contracting cost relates to the hourly
charge-out rates for plant and equipment. Other costs, such as employee costs, fuel expenses
and repairs and maintenance of equipment, were important but insignificant compared to
plant and equipment charge-out rates. To illustrate their point, they used an example of the charge-
out rates for an excavator in the current Hardrock fleet which was used in contract mining
operations:

Cost of new Current fair Newco potential

excavator market value acquisition
Excavator FA1013
cost

‘Cost’ of excavator R1 600 000 R1 280 000 R640 000

Estimated remaining useful life (productive
hours) 12 500 10 000 10 000
Residual value at end of useful life R315 000 R315 000 R315 000
Plant cost per productive hour R102,80 R96,50 R32,50
Mark-up of plant cost 30% To be decided To be decided
Charge-out rate to client for each productive
hour of excavator use R133,64 To be decided To be decided

The former Hardrock management team explained that Hardrock had always acquired new
plant and equipment only and that it would then perform the exercise as outlined in the table
above. They explained that with regard to Excavator FA1013 (and other acquired equipment)
Newco would need to decide whether to charge the standard hourly rate of R133,64 or a lower
rate, given that the specific excavator was to be acquired at a discounted value to replacement
cost and current fair market value.

Hardrock and Zapphire have not previously operated in Angola, the DRC or Ghana, and the
strategy of how to penetrate these markets sparked much debate. During a discussion on the
rumour that bribes needed to be paid to secure work in these territories, Mr Williams stated
explicitly that the Zapphire group would never pay a bribe but was not averse to paying
commissions to external parties for introducing the group to potential mining clients in new
markets.

Share price performance of Zapphire

The shares of Zapphire have traded between R9,20 and R9,60 per share over the past 12 months.
The price-earnings ratios of listed competitors are currently between 8 and 12 times their
historic earnings. According to the CFO, investment analysts have indicated that
Zapphire’s shares have traded at a discount to those of competitors due to the company’s smaller
size and the perception that it is over-exposed to the mining sector.
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REQUIRED
Marks

(a) Critically evaluate the terms and conditions of the three financing proposals and
discuss the factors that Zapphire and Newco should consider in evaluating which
one of the proposals they should pursue. Where necessary, you should also list
additional information that may be required to clarify the terms and conditions of
the financing proposals. (28)

You are not required to perform any calculations (such as the effective interest
rates, net present values or internal rates of return) for any of the financing
proposals.
(b) With regard to the interest rate swap and the interest rate cap instruments
offered by AZN –
(i) explain how each of the instruments works and indicate how they could be
used to hedge against interest rate movements; and (12)
(ii) list the factors that Newco should consider in selecting one of the two
instruments in order to hedge its interest rate exposure. (8)
In your answer you should make use of the quoted rates and premiums.
(c) Describe the key factors that the Board of Directors of Zapphire should consider in
deciding whether or not the group should acquire the Hardrock fleet and enter the
contract mining industry. (20)
(d) Assuming that Newco acquires the Hardrock fleet for R700 million, discuss the
factors and issues it should consider in determining the charge-out rate, and
accordingly the pricing policy, to be followed by Newco with regard to this plant and (11)
equipment.
(e) Discuss the behaviour and actions of the directors of Zapphire from an ethical
and corporate governance perspective, and in particular –

• the actions of Mr Williams to secure the Hardrock acquisition; and

• the events leading up to and during the Hardrock strategy session. (16)
Presentation marks: Arrangement and layout, clarity of explanation, logical argument
and language usage. (5)
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QUESTION 25 100 marks

CATCON (PTY) LTD

(Source: SAICA 2011 QE II Question 1- adapted)

CatCon (Proprietary) Limited (‘CatCon’) manufactures ceramic catalytic converters for use in petrol-
and diesel-powered passenger vehicles and light-duty commercial vehicles. Catalytic converters
are able to destroy most harmful substances produced by vehicle engines, such as carbon
monoxide, unburnt hydrocarbons and nitrogen oxides, which are present in vehicle exhaust
emissions.

Basically, catalytic converters consist of a ceramic structure coated with a metal catalyst which is
attached to a vehicle’s exhaust system. Metal catalysts generally consist of a combination of the
platinum group metals (PGMs), namely platinum, palladium and rhodium.

CatCon is based in Port Elizabeth and sources the majority of the components required for the
manufacture and assembly of catalytic converters from suppliers in close proximity to its
operations. CatCon derives the vast majority of its revenue from exporting its converters to
European-based automotive assemblers. Exports of catalytic converters are a significant
revenue stream for South Africa, generating almost as much revenue as the export of
passenger vehicles.

The South African government introduced the Motor Industry Development Programme (MIDP) in
1995 to stimulate the local manufacture and export of vehicles and automotive components. The
MIDP provided the springboard for the rapid expansion of the South African catalytic converter
industry, as these components have a relatively high value. South Africa’s rich platinum
resources also assisted in developing the catalytic converter industry, for it provided an opportunity
for local manufacturers to add value to this precious metal prior to it being exported.

The local catalytic converter industry experienced significant growth in production volumes in
the period from 2000 to the middle of 2008. The industry produced a record 17,3 million catalytic
converters for export in the 2008 calendar year. However, the financial crisis which started in
late 2008 had a significant adverse impact on passenger vehicle sales globally. Demand for
catalytic converters decreased by approximately 40% in 2009. Although sales of new passenger
vehicles recovered in 2010 and 2011, global volumes have still not equalled the peak levels
reached in 2008.

CatCon spent R150 million in 2006 on the expansion of its manufacturing facilities to cater for an
anticipated growth in demand. The company raised a foreign loan of US $60 million in 2006 to
fund not only this capital expenditure but also expected future working capital requirements. The
foreign loan, which bears interest at a fixed rate of 7% per annum, is repayable in equal annual
instalments, payable in arrears. The first instalment was paid on 1 July 2007 and the final
instalment is due on 1 July 2013.

Manufacturing operations

CatCon manufactured 4,5 million catalytic converters in the financial year ended 30 June 2011.
The production capacity is eight million units per annum, and hence the company is currently
operating well below capacity. In the financial year ended 30 June 2008, CatCon manufactured
5,5 million catalytic converters and the decision to expand operations during 2006 appeared to be
sound.
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Despite the significant reduction in production and sales of catalytic converters in the 2009 financial
year, CatCon was able to report earnings before interest and taxation (EBIT) of R555
million. Profitability has been declining since 2009 and management is concerned about this
trend. There have been many challenges for CatCon management over the past three years
including the following:

• Production was increased in 2010 to meet resurging demand. Inventory levels were low at
the time and management was stretched to ensure that production and inventory levels
rapidly increased to meet the higher demand;

• Platinum prices have been very volatile over the period from January 2008 to June 2011.
In May 2008 the price of platinum was US $2 060 an ounce. This declined to
approximately US $850 in December 2008 following fears that demand for this precious
metal would decline as a result of the state of the global economy. Platinum prices slowly
recovered during 2009 and 2010, and by June 2011 the prevailing platinum price was US
$1 830 an ounce;

• PGMs used by CatCon in the manufacture of catalytic converters represent between 60%
and 70% of total manufacturing costs; and

• CatCon retrenched 20% of its manufacturing work force in early 2009 in response to the
declining demand for catalytic converters. Employee morale suffered following the
retrenchments and relations between workers and management remain strained.

Revenues

Global passenger vehicle sales declined in 2009 following the economic crisis in late 2008.
Lower demand was driven by limited access to vehicle finance and nervousness regarding
economic conditions by consumers.

CatCon’s sales volumes declined from a high of 5,2 million units in the 2008 financial year to
3,6 million units in 2009. Unit sales in the 2010 financial year were 3,9 million and 4,4 million in
the 2011 financial year. Ongoing challenges facing CatCon include –

• pricing pressure from European customers who are reluctant to accept price increases in
line with the increasing input costs (mainly PGM costs); and
• the strength of the rand against the US dollar. The prices of exported catalytic converters are
quoted in US dollar and a strengthening rand has an adverse impact on CatCon’s revenues.
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Financial performance

Extracts from CatCon’s recent annual financial statements and further details are set out below:

CATCON (PROPRIETARY) LIMITED

EXTRACTS FROM STATEMENTS OF COMPREHENSIVE INCOME
FOR THE YEARS ENDED 30 JUNE
2011 2010
Notes
R million R million
Revenue 1 5 852 5 039
Cost of sales 2 (5 389) (4 354)
Gross profit 463 685
Operating costs (350) (345)
Profit from operating activities 3 113 340
Finance costs 4 (39) (31)
Profit before taxation 74 309
Taxation (21) (89)
Profit attributable to shareholders 53 220

Notes

1 The average selling price per catalytic converter was US $170 in 2010 and US $190 in
2011. The average R : US $ exchange rate during 2011 was 7,00 : 1,00 (2010:
7,60 : 1,00).

2 Cost of sales comprised the following:

2011 2010
R million R million
Opening inventories (raw materials, work in progress
and finished goods) 839 406
PGM costs 3 812 3 288
Other manufacturing costs 1 726 1 479
Depreciation of manufacturing plant and equipment 25 20
Closing inventories (raw materials, work in progress and
finished goods) (1 013) (839)
Cost of sales 5 389 4 354

PGM costs are priced in US dollar. All other manufacturing costs are priced in rand.

Inventories of finished goods and units manufactured:

2011 2010
Units Units
Opening inventories 700 000 400 000
Units manufactured 4 500 000 4 200 000
Units sold (4 400 000) (3 900 000)
Closing inventories 800 000 700 000

CatCon used a consistent quantity and mix of PGMs per unit in the manufacture of
catalytic converters in the 2010 and 2011 financial years.
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CatCon uses the first-in-first-out (FIFO) basis to record inventories in its enterprise
management system and accounting records.

The R : US $ exchange rate at 30 June 2011 was 6,80 : 1,00 (2010: 7,65 : 1,00).

3 Profits from operating activities were arrived at after (crediting)/charging the following:

2011 2010
R million R million
Movement in provisions 5 10
Total depreciation (including manufacturing plant and equipment) 32 26
Foreign currency translation gain: Foreign loan (25) (13)

4 Finance charges comprise the following:

2011 2010
R million R million
Interest on foreign loan 14 20
Interest on bank overdraft 25 11
39 31

The bank overdraft bears interest at the prevailing prime overdraft interest rate (currently
9%).

CATCON (PROPRIETARY) LIMITED

EXTRACTS FROM STATEMENTS OF FINANCIAL POSITION
AS AT 30 JUNE
2011 2010
R million R million

Non-current assets 195 170

Property 15 15
Plant and equipment (manufacturing and non-manufacturing) 180 155

Current assets 1 895 1 667

Inventories 1 013 839
Trade receivables 882 828

Total assets 2 090 1 837

Issued ordinary share capital 100 100

Retained income 707 654
Equity attributable to shareholders 807 754
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2011 2010
Non-current liabilities R million R million
Interest-bearing liabilities 52 123

Current liabilities 1 231 960

Trade payables 759 587
Provisions 45 40
Taxation 3 13
Current portion of interest-bearing liabilities 85 101
Bank overdraft 339 219

Total equity and liabilities 2 090 1 837

Raising of capital

AZN Bank has been CatCon’s commercial bank since the latter’s inception. On 31 July 2011 the
account executive at AZN Bank responsible for the CatCon account, Ms Beezbubble, informed the
directors of CatCon that the overdraft facility would be reduced to R50 million with effect from
31 December 2011. According to Ms Beezbubble, her credit committee was uncomfortable with
various issues, including the following:

• The fact that AZN Bank financed the repayments of the foreign loan, as CatCon is not
generating sufficient cash flows to service this themselves;
• The debt : equity ratio of CatCon is far too high in the current economic climate; and
• The declining gross profit margin of CatCon, which is placing the business at risk.

CatCon shareholders are currently the executive directors, who hold 74% of the shares in issue,
and iBaai Holdings Limited (26%), a broad-based black economic empowerment group based in
Johannesburg. CatCon presently has 100 million ordinary shares of no par value in issue.

Listed companies similar to CatCon are currently trading at historic price-earnings (PE)
multiples of 12 and historic Enterprise Value to EBIT multiples of 8.

CatCon has been investigating two possible options to raise capital and has no other viable options
for raising equity or debt at present.

Option 1

The Black Swan Trust (‘BST’), a private equity fund based in Cape Town and incorporated as a
business trust, has offered to subscribe for convertible preference shares in CatCon on the
following terms and conditions:

• BST will subscribe for 90 million cumulative non-redeemable convertible preference

shares to be issued by CatCon on 15 December 2011 for a total consideration of
R315 million;
• The preference shares will have no par value;
• The preference shares will attract a dividend of 35 cents per share per annum;
• The preference shares will be convertible into ordinary shares at the election of the
preference shareholder(s) at any time at a ratio of one ordinary share for every two
preference shares held; and
• The preference shareholders will be entitled to sell their preference shares to any party
without first having to offer these shares to CatCon or its ordinary shareholders.
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Option 2

Wohlstand Investments (‘Wohlstand’), a development finance company based in Germany, has

offered to subscribe (through the issue of new shares) for a 40% shareholding in CatCon on or
before 15 December 2011. Wohlstand has placed a value of R900 million on 100% of the equity of
CatCon prior to its investment in the company. Wohlstand believes that the global catalytic
converter market will return to pre-2008 levels and is bullish on the long-term global automotive
market prospects.

REQUIRED

Marks
(a) Prepare a pro forma statement of cash flows for the financial year ended
30 June 2011 and state whether AZN Bank’s contention that it is financing the
repayment of the foreign loan is correct or not. (12)
(b) Debate and conclude whether you believe CatCon’s gearing levels were too high at
30 June 2011. (7)
(c) Discuss possible reasons for the deterioration of CatCon’s gross profit margin
percentage during the financial year ended 30 June 2011. (20)

You should perform detailed calculations to support your arguments including –

• an analysis of revenue and the components of cost of sales on a per unit
basis for the 2010 and 2011 financial years; and
• an analysis of the components of cost of sales as a percentage of revenue on
a per unit basis for the 2010 and 2011 financial years.
(d) Identify and describe eight key risks facing CatCon. (16)
(e) Analyse, discuss and conclude on the reasonability of the valuation placed on
CatCon by Wohlstand. (14)
(f) Prepare a report to the Board of Directors of CatCon in which you recommend,
with reasons, which of the capital-raising alternatives the company should pursue. (18)
Your report should include –
• an analysis of the debt : equity ratios of CatCon before and after the capital
raising;
• the implied equity values placed on the company in each option; and
• key factors relevant to the decision as to which option to pursue.
(g) Outline possible actions that CatCon could take to improve the company’s
financial performance and cash flow generation. (8)
Presentation marks: Arrangement and layout, clarity of explanation, logical argument and
language usage. (5)
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QUESTION 26 90 marks

SASSI STORES (PTY) LTD

(Source: SAICA 2010 QE II Question 2 -adapted)

Sassi Stores (Pty) Ltd (‘Sassi Stores’) was founded 20 years ago by the current chairperson, Ms Zeta
Sassoni, and the incumbent chief executive officer, Mr Roland Oliveira. The company has over 150
retail stores throughout South Africa, which all sell clothing and accessories. Sassi Stores has
positioned itself to sell quality high fashion apparel at exceptional prices, which are aimed
predominantly at 18–30-year-old customers. International fashion trends are closely monitored to
ensure that Sassi Stores is abreast of the latest trends.

The company has grown from humble beginnings to being a leader in its retail niche in South Africa.
Stores are located in large shopping centres and value centres situated close to major shopping
malls.

Generally, consumer spending in South Africa has been depressed over the past two years as a
result of the knock-on effect of the global financial crisis. However, Sassi Stores has managed to
increase revenue despite the prevailing economic conditions. Mr Oliveira attributes this to Sassi
Stores’s retention of loyal customers and its ability to attract new customers who do not want to
spend exorbitant amounts on quality clothing. Apparel is sourced both locally and internationally from
suppliers who manufacture ‘Sassi’ branded apparel.

Financial performance

Financial highlights of the 2009 and 2010 financial years and extracts from the latest forecast for the
year ending 31 March 2011 are set out below:

SASSI STORES
YEARS ENDED/ENDING 31 MARCH

2009 2010 2011

Audited Audited Forecast
R million R million R million
Revenue 1 704 1 908 2 194
Gross profit 674 736 867
Earnings before interest, tax, depreciation and amortisation
(EBITDA) 166 181 179
Profit after tax 97 106 98
Shareholders’ equity 266 312 410
Cash and cash equivalents 75 80 170

The board of directors of Sassi Stores has set the following targets for the company over the next five
years:

• Annual revenue growth of at least 12% per annum; and

• EBITDA/revenue margin of at least 10%.
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Shareholders and distributions

The shareholders of Sassi Stores are The Sassoni Family Trust (50%), Mr Roland Oliveira (25%), Ms
Gabriella Madiba (10%) (the chief financial officer of Sassi Stores), and The Sassi Stores Employee
Share Trust (15%). The company consistently pays dividends on an annual basis to its shareholders,
the most recent being R60 million paid to shareholders in March 2010.

Rolling forecasts

Ms Madiba recently attended a full-day workshop on the use of rolling forecasts as a budgeting tool.
She attended the workshop in order to acquire continuing professional development points, and was
impressed by the high quality of the content and the relevance of the workshop. The workshop
presenters emphasised that –

• rolling forecasts are a far more effective management tool than traditional annual budgeting
processes;

• rolling forecasts generally involve the preparation of quarterly forecasts for the next 18 months
which are updated as frequently as required by the company, depending on the nature of its
business;

• rolling forecasts alleviate the need for companies to prepare annual budgets;

• rolling forecasts encourage companies to realistically estimate what they should achieve over
the next 18 months as opposed to unrealistic financial targets being forced down by top
management;

• the future is impossible to predict and therefore variance analysis between actual results and
budgeted results is flawed. Organisations should rather focus on improving their forecasting
accuracy than spend countless hours on comparing actual results to annual budgets; and

• rolling forecasts are less detail orientated than traditional annual budgets, encouraging
management to focus on the key value drivers in their business. Traditional budgets require far
too much time to prepare and contain too much detail.

Utilisation of cash resources

Sassi Stores generates positive cash flows annually. The board of directors of the company has been
exploring various options over time to utilise cash resources more effectively. Current deposit rates
are low and Ms Sassoni is of the firm opinion that retaining cash on Sassi Stores’s balance sheet
destroys shareholder value. She believes that surplus cash should be paid out to shareholders and
Sassi Stores should furthermore gear its balance sheet towards the enhancement of shareholder
value.

Ms Madiba believes that Sassi Stores should always have a reasonable level of cash on its balance
sheet as a buffer. She believes that retailers should never be in a net gearing position (in which
interest-bearing debt exceeds cash resources) as retail companies generally have extended trade
terms from trade creditors.
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Credit division

Sassi Stores has for a number of years considered providing credit to customers. During 2010 this
opportunity was investigated further and a detailed business plan has been formulated for
consideration by the board of directors. It is proposed that a new division, a credit division, be
established to take responsibility for the credit assessment of customers, advances, collections and
monitoring of customer balances. The salient features of the business plan are as follows:

• Customers will have the opportunity of opening a Sassi Stores account from 1 April 2011.
Potential account holders will be required to produce identity documentation as well as proof of
permanent residency and monthly income. In addition, potential account holders will be required
to submit a declaration of monthly income and expenditure, a personal statement of financial
position and three credit references;

• The credit division will assess the credit-worthiness of each potential account holder based on a
standardised credit scoring system. Credit limits per individual account holder will be set at 10%
of their after-tax monthly income;

• Account holders will each be charged a monthly service fee and for the 2012 financial year this
will amount to R10 per month. Account holders will each receive a Sassi Stores card which will
contain a five-digit pin code. They will be required to produce these cards and enter their pin
code when making purchases on account at any Sassi Stores outlet;

• Account holders will be required to make minimum monthly payments of 15% of outstanding
balances. Interest at 24% per annum, capitalised monthly, will be levied on customer balances;
and

• Monthly statements will not be posted to customers. Instead, customers can elect to receive
statements via e-mail or notification of account balances and minimum payments due by sms on
their cellular phones. Account holders will also be able to request statement printouts at any
Sassi Stores outlet. The business plan includes detailed financial forecasts for the credit division
and related assumptions which are summarised below:
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SASSI STORES CREDIT DIVISION
FORECASTS AND ASSUMPTIONS FOR THE YEARS ENDING 31 MARCH

Notes 2012 2013 2014 2015

Account holders

New accounts opened 1 63 000 36 000 9 600 4 800

Total number of account holders at year end 63 000 99 000 108 600 113 400
Weighted average number of account 2 41 500 82 500 103 800 111 000
holders during the financial year
Charges to account holders
Finance charges (nominal annual, 24% 24% 24% 24%
compounded monthly)
Monthly service fees R10,00 R11,00 R11,50 R12,00
Pin card issue fee (once off) R15,00 R15,75 R16,50 R17,50

R’000 R’000 R’000 R’000

Forecast revenue and expenditure

Finance charges earned 9 159 32 050 52 352 65 101

Monthly service fees 4 980 10 890 14 324 15 984
Pin card issue fees 945 567 158 84
Total revenue 3 15 084 43 507 66 834 81 169
Pin card expenses 4 (630) (378) (106) (56)
Provision for bad debts 5 (6 986) (8 926) (5 825) (3 992)
Depreciation 6 (8 000) (8 000) (8 000) 0
Other operating costs
Variable operating costs 7 (5 188) (10 808) (14 324) (16 095)
Fixed operating costs 8 (4 500) (4 770) (5 056) (5 360)
Operating (loss)/profit (10 220) 10 625 33 523 55 666
Taxation 9 - (3 455) (10 610) (16 425)
(Loss)/profit after taxation (10 220) 7 170 22 913 39 241
Gross trade receivables 10 69 863 159 125 217 372 257 294
Provision for bad debts 5 (6 986) (15 912) (21 737) (25 729)
62 877 143 213 195 635 231 565
Information technology (IT) equipment
and system 6 16 000 8 000 - -
Total assets 78 877 151 213 195 635 231 565

Notes

1 The projected number of account holders has been based on detailed industry research.

2 The weighted average number of account holders during the year is based on a forecast
number of new accounts opened in each month.

3 The board of directors of Sassi Stores believes that the incremental gross profit arising from
credit sales should not be taken into account in evaluating the feasibility of the credit division.
4 The estimated cost of each pin card in the 2012 financial year is R10, increasing to R11,60 in
2015.

5 The provision for bad debts throughout the planning period is estimated to be 10% of gross
year-end trade receivables.
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6 The initial investment required in the IT equipment and system is forecast to amount to R24
million and will be incurred and paid for at the end of March 2011. This expenditure will be
amortised on a straight-line basis over three years. It has been assumed that the South African
Revenue Service (SARS) will permit this deduction on the same basis for income tax purposes.

7 Variable operating costs include amounts to be paid to an outsourced call centre. After
investigating the cost of establishing and operating an internal call centre, it was decided that
outsourcing this function would be far more cost effective. The selected external call centre
operator will be responsible for following up on overdue amounts and contacting account
holders when necessary.

8 Fixed operating costs comprise mainly employee costs.

9 Income tax has been provided for on the assumption that all income will be taxable on the
same basis as recorded above and that all expenditure, apart from the provision for bad debts,
will be deductible for income tax purposes. It has been assumed that SARS will only permit a
deduction of 25% of the accounting provision for bad debts in terms of section 11(j) of the
Income Tax Act. A normal income tax rate of 28% has been assumed throughout the planning
period. Taxable income has been estimated as follows:

Years ending 31 March 2012 2013 2014 2015

R’000 R’000 R’000 R’000

(Loss)/profit before taxation (10 220) 10 625 33 523 55 666

Add back: Net movement in 6 986 8 926 5 825 3 992
provision for bad debts
Section 11(j) allowance (1 747) (2 231) (1 456) (998)
Tax loss brought forward - (4 981) - -
Taxable (loss)/income (4 981) 12 339 37 892 58 660

10 The forecast annual movement in gross trade receivables is summarised below:

Years ending 31 March 2012 2013 2014 2015

R’000 R’000 R’000 R’000

Opening balance 0 69 863 159 125 217 372

Credit sales to account holders 116 200 254 100 325 104 373 632
Monthly service fees 4 980 10 890 14 324 15 984
Pin card issue fees 945 567 158 84
122 125 335 420 498 711 607 072
Finance charges 9 159 32 050 52 352 65 101
Repayments (61 421) (208 345) (333 691) (414 879)
Closing balance 69 863 159 125 217 372 257 294

11 You may assume that the mathematical calculations in the financial forecast and the
assumptions included in the business plan are correct.
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Evaluation of proposed credit division

The board of directors of Sassi Stores has stated that it will evaluate the feasibility of the proposed
credit division using a capital budgeting approach. The benchmark internal rate of return for the free
cash flows of the credit division has been set at 20% and the division will need to exceed this return
for the project to be approved. The board has requested that the capital budget cover the years
ending March 2011 to March 2015 and that the terminal value at 31 March 2015 be based on the
estimated net asset value of the division at that date.

The board of directors has agreed to extend an interest-free loan to fund the establishment of the
credit division and its ongoing cash flow requirements. This loan can be repaid as and when the
division generates surplus cash flow.

REQUIRED Marks
(a) Indicate, with reasons, whether or not you agree with the workshop presenters’ views on
rolling forecasts. (10)

(b) Critically discuss Ms Sassoni’s view that surplus cash should be paid out to shareholders
and that Sassi Stores should introduce gearing onto its balance sheet. (8)

(c) Critically analyse and comment on the financial forecasts and related assumptions included
in the business plan of the proposed credit division. Where appropriate, support your
comments with relevant ratios and calculations (utilise averages where appropriate). (27)

(d) Calculate and estimate the internal rate of return of the forecast cash flows of the credit
division for the period 2011 to 2015, based on the assumptions set out in the business plan. (12)

(e) Identify and describe –

(i) the key business risks, including any key financial risks, to which the credit division will
be exposed; and (16)
(ii) any other key issues the board of directors should consider in evaluating whether or
not to approve the establishment and operation of the credit division. (12)

Presentation marks: Arrangement and layout, clarity of explanation, logical argument and
language usage. (5)
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QUESTION 27 100 marks

BRAINZ (PTY) LTD

(Source: SAICA 2010 QE II Question 1 - adapted)

Brainz (Pty) Ltd (‘Brainz’) was formed in 1991 by two young professionals, Steve Smith and Horatio
Adams, with the aim of providing advice to companies in southern Africa on general economic and
financial issues. Mr Smith and Mr Adams are the joint chief executive officers of Brainz.

Over the last 19 years Brainz has grown and changed significantly and now comprise a head office
and three wholly-owned subsidiary companies. The group also has an investment in an associate
c o m p a n y . The group offers a broad array of products and services. The shareholdings in and
group structure of Brainz (Pty) Ltd is set out in appendix A (separate hand-out).

For some time now the shareholders of Brainz have considered listing the group on the
Johannesburg Securities Exchange (JSE). Although the economic downturn has delayed the
potential listing, the directors of Brainz have been taking steps to improve the general state of
corporate governance within the group.

Brainz has nine directors in total, of which five are executive directors. Four of the executive
directors of Brainz serve as chairmen of the Brainz associate and subsidiary companies. The four
non-executive directors are appointed by the Smith and Adams family trusts. Brainz pays market-
related fees to all its directors.

The board of directors meets twice a year to approve the annual budgets and governance
frameworks for the group companies, to consider reports from the audit committee (which is the only
subcommittee of the board) and to decide on strategy.

All Brainz directors and all the directors of the subsidiary companies participate in a cash-settled
phantom share option scheme. Tranches of phantom shares are notionally awarded to scheme
participants every year, at a price based on a pre-determined discount to the prevailing JSE
average price-earnings (PE) ratio for the Support Services Sector. These phantom shares vest over
a two-year period, after which the shares are revalued using the current average Support Services
Sector PE ratio. Thereafter participants can elect to exercise the notional share options, in which
case the company settles the difference between the initial valuation and the newly determined
share price.

At present the tranches of share options granted on 1 January 2009 and 1 January 2010 are under
water (that is, out of the money) and the board of directors of Brainz is concerned that this will have
a negative impact on the directors of the group companies. Accordingly, the board is considering
revising the initial allocation prices of the options by increasing the pre-determined discount factor.

The current chairman of the board, who is also the chairman of the audit committee, is retiring in
December 2010. The board is considering paying a gratuity of R5 million to the outgoing chairman in
recognition for his work in providing superior strategic leadership during his tenure.
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Brainz Services (Pty) Ltd

Brainz Services (Pty) Ltd (‘Services’) provides information technology, group reporting, internal
audit, legal and treasury services to the Brainz group, as well as advice on funding, risk
management and debt collection.
The internal audit function has a total staff of six and is led by the former chief executive officer of
Brainz Learning (Pty) Ltd, Nigel Herd. Internal audit staff visits each of the Brainz subsidiaries at
least once a year and conduct compliance-based audits to ensure that the internal control
systems are operating effectively. To maintain independence Mr. Herd has direct access to the
external group auditors and reports directly to the chairman of Brainz. Mr. Herd is the only other
member of the Brainz audit committee.
Brainz Advisory (Pty) Ltd
Brainz Advisory (Pty) Ltd (‘Advisory’) forms the core of the Brainz group and provides a full
range of economic and financial advisory services to clients in southern Africa.
Advisory currently employs 196 full-time consultants and a number of contract workers.
Advisory works on a project basis and, depending on the nature of each particular assignment,
sources a mix of own employees and contractors to undertake each project.
Advisory uses proprietary methodologies which are sourced from IQ International Inc. (‘IQ’), an
American research institute. IQ charges a fixed quarterly US dollar royalty for access to their
methodologies.
Advisory benchmarks its marketing activities against a carefully selected group of benchmark
partners who compete in the same market. The September 2010 Advisory management accounts
reflect the following benchmarked marketing measures:
(a) Percentage of total revenue sourced from existing clients (that is, clients for whom work
has been undertaken previously):
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(b) Success rate of total rand value of assignments quoted for:

(c) Total rand value of future contracted work for the next six months (work in the pipeline) at
period end as a percentage of the past six months’ revenue:

Advisory markets its services through the following channels:

• The Brainz executive directors who spend significant time networking and developing new
contacts in order to source opportunities;

• Direct referrals from any third party, for which Advisory pays 2% of the quoted fee on
project presentation to a potential client, and if successful, a further 2% at project
inception; and
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• Umfolozi (Pty) Ltd (‘Umfolozi’), which is wholly owned by three black lawyers and tenders
for public sector assignments in its own name. When a tender is awarded to Umfolozi, it
immediately subcontracts the assignment to Advisory, which in turn pays Umfolozi 7, 5% of
the total quoted revenues for handing over the assignment.

Extracts from the audited 2008 and 2009 annual financial statements and related ratios, and
from the latest forecast results and ratios for 2010 (based on the year to date (to September
2010) plus the forecast for the remaining three months), for Advisory are as follows:

BRAINZ ADVISORY (PTY) LTD

31 December 31 December 31 December
2008 2009 2010
Notes
Audited Audited Forecast
R’000 R’000 R’000
Key items from the statements of
comprehensive income
Gross revenue 1 1 005 000 1 250 000 814 450
Work in progress provisions and
write-offs 2 (53 265) (81 250) (97 700)
Net revenue 951 735 1 168 750 716 750
Employment costs 3 (399 202) (466 453) (369 660)
Marketing costs 4 (48 240) (68 750) (48 650)
Royalties 5 (134 820) (134 123) (128 150)
Office rental 6 (36 160) (40 861) (46 173)
Administration costs 7 (80 400) (88 750) (94 960)
Interest charges 8 (28 024) (33 567) (25 270)
Sundry income 9 7 350 9 050 10 000
Profit before tax 232 239 345 296 13 887

Key items from the statements of

financial position
Work in progress (net of provisions
and write-offs) 129 400 178 080 138 345
Trade receivables 79 850 109 590 87 023
Bank overdraft 107 890 135 000 65 000

Calculated ratios
Days Days Days
Days in work in progress 10 47 52 62
Days in receivables 10 29 32 39

Notes

1 Gross revenue represents estimated billings to clients which are debited to work in
progress, including billing to group companies, based on monthly employee and
contractor time sheets at an average standard charge-out rate per hour, which is determined
annually in advance.
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The 2010 standard charge-out rate and those used in the 2009 and 2008 years are as
follows:

2008 2009 2010

Charge-out rate per hour R1 800 R2 100 R2 400

2 Advisory makes a general provision of 3% of gross revenue against work in progress. If

necessary additional amounts are written off at the point of final project invoicing to clients
when work in progress is transferred to trade receivables.

3 Employment costs represent the cost to the company of its own employees as well as all
amounts paid to contractors. In the last two years Advisory has aggressively followed a
strategy of shifting its employment profile to more highly qualified professionals, and at
present more than 90% of professional employees have at least a masters degree.

Relevant details of employment costs are as follows:

31 December 31 December 31 December

2008 2009 2010
Audited Audited Forecast
Weighted average number of full-
time employees 191 205 196
R’000 R’000 R’000
Full-time employee costs to the
company 143 250 170 150 240 430
Contractor costs 255 952 296 303 129 230
Total employment costs 399 202 466 453 369 660

4 Marketing costs consist mainly of payments made to third parties and to Umfolozi for client
referrals.

5 Details of royalty payments to IQ are as follows:

31 December 31 December 31 December

2008 2009 2010
Audited Audited Forecast
US dollar charges (US $’000) 15 750 16 538 17 364
Rand dollar exchange rate 8,56 8,11 7,38
Total rand costs (R’000) 134 820 134 123 128 150

6 With effect from 1 January 2007 Advisory entered into an eight-year lease agreement with
Xtreme Properties Ltd for the provision of rental office space in all the major cities in which
Advisory operates.

7 Office administration costs include all costs of the accounting, legal and human resource
functions as well as intercompany charges from Services.
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8 Interest is paid at prime plus 3% on both the bank overdraft from MBR Bank and loans
from shareholders. In 2009 MBR Bank became increasingly concerned about the extent of
its exposure to Advisory, despite having a cession of trade receivables, and insisted that
the overdraft facility be reduced to R65 million by 30 September 2010.

9 Sundry income represents receipts from Brainz Learning (Pty) Ltd for the provision of
training material.

10 Ratios are based on gross revenue.

Brainz Learning (Pty) Ltd

Brainz Learning (Pty) Ltd (‘Learning’) offers a number of generic training courses in finance and
economics. Learning has consistently yielded the highest return on equity of all the companies in
the Brainz group.

Learning is run by a small group of people which provides leadership and handles all marketing
and course administration activities. The copyright of each of the training courses vests in Advisory
and Learning pays Advisory a fixed rate of 50% of all attendance fees for the use of the training
materials. Learning has exclusive rights to all Advisory courses until 2018.

The presentation of training courses is outsourced to freelance lecturers who are contracted as and
when needed. The frequency with which individual training courses are offered is determined by
the response rates to the various marketing initiatives. Courses are presented in all major centres
in South Africa, Botswana, Namibia and Zambia at venues which are hired specifically for each
course.

Training course evaluations indicate that Learning is one of the foremost training companies in
southern Africa and that the calibre of the administration, training materials and teaching personnel
is of the highest order.

Smile Inc.

Smile Inc. (‘Smile’) offers a member-based internet dating service. Members pay a monthly fee of
US $10 to Smile for access to the portal and to list their personal attributes, including
photographs if they wish to do so. Smile also matches each member with potential partners
using a patented mathematical algorithm that predicts compatibility based on 25 different variables.

Smile was incorporated in January 2008 and is registered in the Bahamas, a tax-free haven.
The initial shareholders were the Smith Family Trust (45%), Adams Family Trust (45%) and Algiers
Adams (10%). Algiers Adams is the managing director of Smile and is the son of Horatio Adams.
Smile has to date spent US $3 million on developing its business and marketing its site to potential
members.

The Smile website is hosted by Services. The portal development activities have been outsourced
to Whale Computing (Pty) Ltd (‘Whale’), which also owns the patented mathematical algorithm that
Smile uses to match potential partners. Whale was wholly owned by Advisory until August 2010
when it sold 100% of the shares in issue to a third party. The sale of shares agreement provides for
profit warranties for a three-year period. Advisory used the initial proceeds on the sale of shares
in Whale of R35 million to reduce its overdraft. If Whale achieves its profit targets, Advisory is
set to receive a further R30 million in three years’ time.
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Brainz acquired a 40% shareholding interest in Smile in December 2009 from the Smith Family
Trust and the Adams Family Trust for an aggregate consideration of US $12 million.

Brainz requested Algiers Adams to perform a valuation of Smile at 30 September 2010 with the
intention of revaluing its investment in its financial statements for the year ending
31 December 2010. Extracts from the valuation performed by Algiers Adams are set out below:

SMILE INC.
INDICATIVE VALUATION AT 30 SEPTEMBER 2010
Year ending 30 September
Notes Total
2011 2012 2013
Number of members 1 271 520 481 680 664 750
US $’000 US $’000 US $’000 US $’000
Membership fee revenue 1 32 582 57 802 79 770
Advertising revenue 2 999 2 996 4 993
Total revenue 3 33 581 60 798 84 763
Operating expenses 4 (27 102) (48 855) (67 802)
Earnings before interest, tax, 5
depreciation and amortisation
(EBITDA) 6 479 11 943 16 961

EBITDA/total revenue 19,3% 19,6% 20,0%

Discount factor 6 0,830 0,689 0,573
US $’000 US $’000 US $’000 US $’000
Discounted EBITDA 5 378 8 229 9 719 23 326
Terminal value 7 66 264
Valuation of 100% of Smile 89 590

Notes

1 Smile’s internet dating service had 63 250 members at 30 September 2010. Smile expects
membership numbers to increase to 271 520 in the 2011 financial year. Monthly membership
fees are forecast to remain at US $10 per month for the foreseeable future.

2 Smile signed up its first advertiser on the portal in September 2010 for an annual fee of
US $59 000. Given the expected increase in members over the next three years, Smile
expects to derive significant revenue from selling advertising space on its website.

3 Smile incurred an operating loss of US $17 000 for the year ended 30 September 2010.
Algiers is convinced that Smile will exceed the profit projections, as membership numbers
are increasing significantly on a month on month basis.
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4 The forecast operating expenses are based on the assumption of a reduction in the
following expenses:

• A 20% reduction in the website hosting fees currently charged by Services. Smile
currently pays a variable fee of US $2 per member per month to Services. Algiers
Adams assumed that there would be no annual increase in fees after the reduction has
been negotiated; and

• A 20% reduction in royalties payable to Whale. Smile presently pays Whale a fixed
annual fee of US $5 million. Algiers Adams assumed that there would be no annual
increase or decrease in the royalty fee payable from 2011 onwards.

5 Algiers has assumed that the annual EBITDA is equivalent to the free cash flow.

6 A weighted average cost of capital (WACC) of 20,4% has been used to discount future
cash flows. WACC has been derived on the basis of the following:

• A target capital structure of 20% equity and 80% debt;

• A cost of equity of 30%; and
• A cost of debt of 18% per annum with no tax relief.

7 The terminal value has been estimated based on an annual growth in cash flows of
5%into perpetuity.

You may assume that the mathematical calculations of Algiers Adams to discount future cash
flows and determine the terminal value are correct.
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REQUIRED

Marks

(a) List areas, from the information provided and with reasons, in which Brainz does not
comply with the King Code of Governance Principles for South Africa, 2009 (King
III) requirements for corporate governance practices. (18)
(b) Review and discuss the marketing strategy and marketing performance of Advisory,
based on the benchmarked marketing measures from 2006 to September 2010, as
disclosed in the management accounts of Advisory.
(12)
(c) Critically analyse and comment on the historical and forecast financial performance
of Advisory. Where appropriate, support your comments with relevant ratios and
calculations. (30)
(d) Identify the reasons why Learning has consistently yielded a high return on equity
and comment on the sustainability of the business. (7)

(e) Identify and describe any possible conflicts of interest that may have or could arise
from Brainz’s investment in Smile. (8)

(f) Critically review and comment on the valuation performed by Algiers Adams of
Smile at 30 September 2010. Where appropriate, support your comments with
relevant ratios and calculations.
(20)
Presentation marks: Arrangement and layout, clarity of explanation, logical argument
and language usage. (5)

APPENDIX A

The current ownership structure of Smile

Brainz 40%
Smith Family Trust 25%
Adams Family Trust 25%
Management – Algiers Adams 10%
Total 100%
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QUESTION 28 100 marks

PALINDROME BRANDS (PTY) LTD

(Source: SAICA 2009 QE II Question 1- adapted)

Palindrome Brands (Pty) Ltd (‘Palindrome Brands’) imports and distributes a range of internationally
branded apparel to retail customers in South Africa. Palindrome Brands was established in 1995 by
Ms Eve Tenet who remains involved in the business as Chief Executive Officer (CEO) and major
shareholder. Ms Tenet is a South African citizen and resident. Ms Tenet was recently
interviewed by South Africa’s leading business newspaper and the following are extracts from
the published article:

I started Palindrome Brands in my garage at home with limited capital. At the time, many
global clothing brands were not available in South Africa, either because of the political
stance taken by these global groups or because of ignorance regarding the potential of
selling their brands on the African continent. I had a vision of securing the distribution
rights for leading international apparel brands and bringing these to South Africa. I had
previously been the chief buyer for the largest clothing retailer in the country and
understood both the challenges and the potential of selling branded clothing ranges at
retail outlets.

We were fortunate in securing the rights to import and distribute the world’s leading
brand of jeans in 1997. This placed Palindrome Brands on the local map. Over the past
12 years we have expanded our product range to 25 leading global clothing brands,
targeting both male and female consumers. We import branded jeans, casual trousers,
sportswear, formal shirts, T-shirts, sweaters, jackets and underwear. There are five key
aspects to our success:

• We supply high quality, price competitive merchandise. We target end consumers

who are prepared to spend a bit extra on our branded merchandise because they
know that they will be able to wear these clothes for a couple of years and still
look good in them;
• Palindrome Brands is not overly dependent on any single supplier in terms of how
much it represents of Palindrome Brands’s turnover;

• We import directly from our suppliers’ accredited factories in China and other
Asian countries. We used to order from our suppliers who in turn sourced apparel
from their manufacturers, but it is far cheaper to pay our suppliers a royalty on
revenue than purchase directly from them. We thereby avoid their additional
mark-up on clothing and reduce the time from placing an order to shipping;

• We support our brands locally by spending a fixed percentage of our revenue on

advertising and promotions. We ensure advertising is consistent with our suppliers’
global marketing messages but that the campaigns also have a local flavour; and

• Palindrome Brands continually invests in its staff by ensuring the working

environment is a ‘home away from home’. We have found that flexible hours do
not work but that we should support employees where possible in saving time on
domestic and personal chores. For example, Palindrome Brands employs drivers to
collect and transport employees’ children to and from school. Employees are not
charged for these services, nor do we allocate any amount of their remuneration to
these perks. All employees are shareholders of Palindrome Brands, which ensures a
further alignment of interests.
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Palindrome Brands supplies all the major clothing retail groups in South Africa and does
not supply independent retailers. We treat our customers as partners in our business.
If they make money from selling our clothing ranges, we will reap the benefits, too.
Likewise, if our clothing does not sell in their stores, we all have a problem. We
regularly meet with our customers to ensure consistency in retail pricing. It would be
disastrous if retail prices of our branded clothing varied in the market. Ultimately this
would erode our customers’ margins and eventually place us under pressure to
reduce our gross profits margins.

Potential acquisition opportunity: Zoosh Footwear (Pty) Ltd

The sole shareholder and CEO of Zoosh Footwear (Pty) Ltd (‘Zoosh Footwear’), Mr Bob Toot,
recently approached Ms Tenet regarding the potential acquisition of his business. Zoosh Footwear is
well established in the South African market, and imports and distributes branded footwear to major
retail outlets. The company grew rapidly over the past five years and has struggled to fund this
expansion. Zoosh Footwear mainly used a bank overdraft to fund this organic growth. Zoosh
Footwear is currently experiencing cash flow difficulties which may be ascribed to various factors,
including the slowdown in consumer spending. Mr Toot has proposed that Palindrome
Brands acquires a controlling interest in the business of Zoosh Footwear and also provides
funding support to enable the business to trade itself out of its current cash flow predicament.

Mr Toot has forwarded a formal written proposal to Palindrome Brands which included the
following terms and conditions:

• Palindrome Brands is to acquire 75% of the issued shares of Zoosh Footwear for R15 543
900, payable in cash;

• Palindrome Brands is to advance a shareholder’s loan of R7 500 000 to Zoosh

Footwear. This will be repayable in five equal annual instalments commencing on
1 January 2011. The loan is to bear interest at the prime overdraft lending rate (currently
10,5%); and

• Palindrome Brands agrees to purchase Mr Toot’s remaining 25% shareholding in Zoosh

Footwear at fair value, to be determined by an independent investment bank, on
1 January 2016.

In his formal proposal Mr Toot stated that the financial results of Zoosh Footwear for the year ended
30 September 2009 were an aberration and not indicative of the sustainable earnings of the
business. The suggested valuation of Zoosh Footwear was calculated as six times the audited profit
for the year ended 30 September 2008. In Mr Toot’s opinion, a price-earnings multiple of six is
reasonable for a private company which has the stature that Zoosh Footwear does in South
Africa.
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Extracts from the audited financial statements of Zoosh Footwear are set out below:

ZOOSH FOOTWEAR (PTY) LTD STATEMENT OF

COMPREHENSIVE INCOME FOR THE YEAR ENDED 30
SEPTEMBER 2009
Notes 2009 2008
R R
Revenue 1 25 640 000 32 050 000
Cost of sales (19 230 000) (22 435 000)
Gross profit 6 410 000 9 615 000
Administrative and distribution expenses 2 (3 805 935) (4 006 250)
Other expenses 3 (415 000) 0
Finance costs 4 (945 000) (811 250)
Profit before tax 1 244 065 4 797 500
Income tax expense 5 (366 539) (1 343 300)
Profit for the year 877 526 3 454 200

Notes

1 Zoosh Footwear sells footwear imported from suppliers based in Europe and North America.
The range of male and female footwear imported from Rosselini Inc. (Italy) has proved
very popular and represents approximately 40% of the revenue generated by Zoosh
Footwear.

2 The company managed to reduce overheads in the 2009 financial year by

retrenching staff and cutting back on advertising expenditure.

3 Other expenses represent penalties and interest of R65 000 paid to the South African
Revenue Service (SARS) in respect of late payment of value added tax (VAT) and a bad
debt of R350 000. Zoosh Footwear was experiencing cash flow difficulties during 2009 and
decided rather to incur penalties and interest than to pay over various VAT amounts when
due.

The bad debt was incurred when an independent retail store to which Zoosh Footwear
occasionally supplied was liquidated during the year. After this write-off, Zoosh Footwear took
a policy decision only to supply larger retail customers.

4 Zoosh Footwear pays interest at a rate of 2% above the quoted prime overdraft lending
rate.

5 The penalties and interest paid to SARS of R65 000 were not deductible for income
tax purposes in the 2009 financial year. The only temporary differences relate to rental
expenditure on premises (SARS permits a deduction of rental actually paid whereas the
rental payable over the rental period is averaged for accounting purposes).
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ZOOSH FOOTWEAR (PTY) LTD

STATEMENT OF FINANCIAL POSITION AS AT 30 SEPTEMBER 2009
Notes 2009 2008
R R
ASSETS
Non-current assets 981 617 899 508
Plant and equipment 6 905 000 850 000
Deferred tax 5 76 617 49 508

Current assets 10 097 945 11 327 260

Inventories 6 585 616 7 375 890
Trade and other receivables 3 512 329 3 951 370

Total assets 11 079 562 12 226 768

EQUITY AND LIABILITIES

Share capital 10 000 10 000
Retained earnings 5 639 500 4 761 974
Total equity 5 649 500 4 771 974

Current liabilities 5 430 062 7 454 794

Trade and other payables 7 1 328 700 1 051 986
Short-term borrowings 8 3 899 539 4 990 000
Current tax payable 201 823 1 412 808

Total equity and liabilities 11 079 562 12 226 768

Notes

6 The company acquired plant and equipment totalling R230 000 during the 2009 financial
year. There were no disposals of plant and equipment during the year.

7 Included in trade and other payables was VAT due to SARS of R275 000 (2008:
R130 000).

8 Short-term borrowings represent the bank overdraft Zoosh Footwear has with ABZ Bank.
During 2009 ABZ Bank reduced the overdraft facility limit from R5 500 000 to R4 000 000
as the bank was concerned about Zoosh Footwear’s cash flow difficulties and the
company’s lower profitability in 2009.
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The initial response of the board of directors of Palindrome Brands to the Zoosh
Footwear acquisition opportunity

The board of directors of Palindrome Brands met during October 2009 to consider the formal
proposal of Mr Toot and to discuss the potential acquisition of Zoosh Footwear. The following
issues and matters were raised during the board meeting:

• Palindrome Brands had previously considered importing and distributing footwear, but had
decided against this on numerous occasions. The reasoning was that distributing footwear
required a significant investment in inventories. Research had indicated that an investment in
footwear inventories would be higher than in their clothing ranges because –

o there is a wider range of footwear sizes compared to clothing sizes. For example,
the men’s range in a particular style would be from size 6 to 11 and ½ sizes would also
have to be included; and

o retail customers will probably order lower volumes of footwear as these are slower
moving items than apparel. Unfortunately, minimum order volumes from foreign
suppliers would translate into a sizeable investment in footwear inventories.

• The directors were concerned about how Palindrome Brands would finance any
acquisition. The company had cash resources of about R10 million at 30
September 2009 and had no interest-bearing borrowings. However, to fund a sizeable
acquisition Palindrome Brands would need to obtain a medium-term loan from a commercial
bank. The company has unencumbered property with a market value of R25 million which
could be used as collateral. The Chief Financial Officer (CFO) of Palindrome Brands
suggested that the company enter into a ten-year sale and leaseback arrangement with
regard to the property to finance any acquisition. According to the CFO, Palindrome Brands
would pay interest at the prime overdraft rate (currently 10,5%) on a five-year term
loan from a bank whereas the effective yield on a property sale and leaseback
transaction is currently 9%.

The directors identified numerous synergies and cost saving opportunities which would flow from
the acquisition of a footwear distribution business such as Zoosh Footwear, including the following:

• Many of the company’s existing international suppliers have footwear ranges which could be
introduced into the South African market;

• Palindrome Brands and Zoosh Footwear have many customers in common.

Supplying footwear would increase Palindrome Brands’s product basket with customers;

 Palindrome Brands’s infrastructure (procurement, logistics, warehousing, finance

and administrative functions) could cope with increased product volumes and hence,
the company/group could unlock significant cost savings. The directors estimated
that by acquiring the business of Zoosh Footwear and integrating this into the
operations of Palindrome Brands, the current administrative and distribution expenses
of Zoosh Footwear could be reduced by R2 million per annum. However, achieving
these cost reductions would require once-off costs of R2 500 000 to terminate the
property rental agreement and to pay retrenchment costs; and
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 Palindrome Brands’s average payment terms with international suppliers are 30 days
from date of delivery. Zoosh Footwear is not able to negotiate such terms due to its
smaller size and shorter track record. Zoosh Footwear generally pays a 50% deposit on
order of goods and the balance on delivery. The directors of Palindrome Brands have
estimated that if they controlled the company, the ‘normal’ level of trade payables of
Zoosh Footwear would be R2 300 000 (based on the 2009 financial year).

• The directors of Palindrome Brands are concerned about the possibility of a protracted
decline or stagnation in consumer spending as a result of the current economic conditions.

• Ms Tenet stated that the Palindrome Brands shareholders should not be required to fund
any acquisition opportunity. Her shareholding in Palindrome Brands is held through an
offshore trust in which she is the major beneficiary and she would be averse to remitting any
capital from offshore to finance a transaction of this nature. In addition, Ms Tenet is
concerned that the Reserve Bank and SARS may be informed of her interest in an offshore
trust if this entity subscribes for more shares in Palindrome Brands. Ms Tenet was also
adamant that the dividend policy of Palindrome Brands should remain unchanged, as the
employees rely on this income stream.

High level overview of Palindrome Brands’s financial position and trading

performance

The financial position and recent trading performance of Palindrome Brands is

summarised below:

At 30 September 2009 2008

R’000 R’000
Cash and cash equivalents 10 050 12 650
Total assets 164 640 145 600
Total equity 150 200 126 400

Year ended 30 September 2009 2008

R’000 R’000
Revenue 273 200 235 500
Gross profit 88 825 82 425
Interest income 850 780
Profit for the year 36 800 32 970
Dividends declared and paid to shareholders 13 000 13 000

A large volume of information is provided in the scenario. It is important that you read all the information
carefully and clearly mark which information relates to Palindrome and which relates to Zoosh.
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REQUIRED
Marks
(a) Calculate the ratios required to analyse the financial position and financial
performance of Zoosh Footwear (Pty) Ltd for the 2008 and 2009 financial years. (12)
(b) Identify, with reasons, any adjustments which may need to be made to the 2009
reported profits of Zoosh Footwear (Pty) Ltd in deriving its sustainable earnings. (8)
(c) Identify and describe differences between the business practices and strategies
adopted by Palindrome Brands (Pty) Ltd and Zoosh Footwear (Pty) Ltd. (10)
(d) Identify and explain five key business risks currently faced by Zoosh
Footwear (Pty) Ltd. (10)
(e) Reconcile the earnings before interest and tax of Zoosh Footwear (Pty) Ltd to the
net movement in its cash and cash equivalents for the year ended 30 September
2009. (8)
(f) Identify and describe the potential advantages and disadvantages of Palindrome
Brands (Pty) Ltd entering into a property sale and leaseback transaction as a
method for financing the acquisition of Zoosh Footwear (Pty) Ltd. (8)
(g) Prepare a report to the board of directors of Palindrome Brands (Pty) Ltd in which
you advise them on the potential acquisition of Zoosh Footwear (Pty) Ltd. Your
report should cover the following:
(i) The approach and methodology that Palindrome Brands should follow in valuing
Zoosh Footwear (Pty) Ltd; and (7)
(ii) A critical assessment of the transaction structuring proposed by Mr
Toot, whether this is in the best interests of Palindrome Brands (Pty) Ltd and
whether there are any changes to the structure you would
recommend. (6)
(h) Calculate and determine the pro forma effect of the acquisition of Zoosh Footwear
(Pty) Ltd on the profits and return on equity of the Palindrome Brands (Pty) Ltd
group, assuming that –
• the acquisition is structured on the terms proposed by Mr Toot;
• the acquisition was made effective from 1 October 2008; and
• Palindrome Brands (Pty) Ltd raised a medium-term loan to partially fund the
acquisition.
In your answer you should explicitly state any other assumptions that you made. (12)

(i) Identify and outline any potentially unethical behaviour by and any contraventions of
laws and regulations by Palindrome Brands (Pty) Ltd, Zoosh Footwear (Pty) Ltd
and/or any of their shareholders and directors. (8)
(j) Discuss the advantages and disadvantages of using a bank overdraft as a primary
source of business funding. (6)
Presentation: Arrangement and layout, clarity of explanation, logical argument
and language usage. (5)
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QUESTION 1
SUGGESTED SOLUTION
MEDICO GROUP
(Source: Exam 2013 MAC4861 and MAC4862- adapted)
(a)

Many students failed to identify that section 24J is applicable and necessary for the calculation of the
NPC and did not calculate the market value of debt and equity for weighting purposes.

Equity: R’000

MGSA market capitalisation = market value of equity (in this case) 6 500 000 (1)
= R65 x 100m

Ke = D ¹ / PV + g
= (164 595 450 / 6 500 000 000) + 9%
= 2,5% + 9%
= 11,5% (1)

Alternative:
Ke = D ¹ / PV + g
= (1,51 (1 + ,09)/65) + 0,09 (2)
= 11,5% (1)

EPS = 503 350 000 / 100 000 000 = 503,35 cents per share
Dividend pay-out ratio = 151c / 503,35c = 30%
Future earnings = 503 350 000 x 1,09 = R548 651 500
Future dividend = 548 651 500 x 30% = R164 595 450
(2)
Alternative shortcut: Future dividend: R1,51 x 100m x 1,09 (difference due to rounding)
= R164 590 000 (2)

Debt:

Calculate payment:

PV = 1 000 000 000

N = 5 x 2 = 10 (1)
I = 9/2 = 4.5 (1)
FV = 0
PMT = 126 378 822*
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The below signs (+/-) and period must be correct.

Period 8/10 Period 9/10 Period 10/10

30 September 31 March 30 September
2013 2014 2014
CF1 CF2 CF3
Installment (126 378 822) (126 378 822) (126 378 822) (1)
Tax effect of section 24J at 28% 4 377 377 2 981 986 1 523 802 (1)
24J accrual amount (A = B x C) 15 633 489 10 649 949 5 442 150 (1)#
Pre-tax YTM (B) [9%/2] 4,5% 4,5% 4,5% (1)#
Adjusted initial amount (C) 347 410 876 (1)#
Adjusted initial amount (C) 236 665 544 (1)#
Adjusted initial amount (C) 120 936 672 (1)#
Total cashflows (122 001 445) (123 396 836) (124 855 020)
Discount @ 2.88% x 0.972 or x 0.945 or x 0.918 or (1)
/1.0288 /1.0288^2 /1.0288^3
(118 585 405) (116 610 010) (114 616 908)

After tax cost = 8% x 72% = 5,76% per annum (1)

Discount rate = 5,76% / 2 = 2,88%
NPC=R349 812 323 or R 349 831 330 (calculator steps shown, or discount factors used) (1)

# Alternative to the section 24J interest calculation:

Calculator inputs must be shown and period (2)# (must be correct):

8 Input 2ndF Amort = interest of 15 633 489 (1)#
9 Input 2ndF Amort = interest of 10 649 949 (1)#
10 Input 2ndF Amort = interest of 5 442 150 (1)#

MV Weighting Cost WACC

Equity R6 500 000 000 94,9% 11,5% 10,9%
Debt R349 812 323 5,1% 5,76% 0,3%
R6 849 812 323 100% 11,2%
(1) (1)
MAX 14 MARKS
(b)
Identification of key risk Mitigation
Risk of non-compliance with • Team/committee to ensure that a compliance policy
pharmaceutical related as well as other in place and is adhered to. (1)
laws and regulations. • Staff should be trained on legislative issues and up
OR to date with changes in legislation / adequate
Risk of non-compliance with new knowledge of appropriate laws & regulations. (1)
requirements of NHI and SAPHRA. (1) • The use of external legal services for specialist
areas of compliance. (1)
No flexibility with regards to setting profit • Improve profit margins through tight control over
margins due to “single exit price” and costs, increasing sales volumes and increasing
restricted price increases. (1) product variation. (1)
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Ineffective integration of Acti-Pharm • An integration plan for new acquisitions should be
and other acquisitions into the group / in place / corporate culture as a merger screening
mismatch in corporate cultures / risk that criteria. (1)
the group’s strategic vision of growth • Experienced and competent leadership teams
through acquisitions will not be should establish strategies to align objectives
achieved. (1) throughout the group. (1)
• Proper due diligence investigation. (1)
Only small percentage of compounds • Products only launched after all legal regulatory
investigated are eventually approved and legislative requirements are met. (1)
for human consumption / risk that the • Product launch managers and effective product
group’s organic growth strategy will launch systems should be in place across the
not be achieved. OR group. (1)
High research and development costs • Experienced personnel involved in R&D. (1)
do not always result in revenue
generating drugs. (1)
Consequences of adverse drug effects, • Increased focus on quality assurance/ proper
including monetary loss (business risk) initial drug tests. (1)
and reputational risk due to law suits. • Crisis management plans should be in place. (1)
(1) • Product liability insurance should be taken out. (1)
Machinery purchased abroad exposes • Hedge the risk (forward cover, a foreign currency
MGSA to currency risk. (1) option, money market hedge, futures contract,
currency swap, etc.) (1)
80% of sales are on credit which • Policy and procedures to evaluate the credit
exposes MGSA to credit risk. (1) worthiness of potential customers and a formal credit
policy should be in place. (1)
• Hedging via derivatives. (1)
Inability to attract and retain critical • Retention strategies for key members of staff
skills and talent. (1) (share incentive schemes / bonus incentives, etc.)
(1)
• Skills transfer and succession planning (training
programmes / coaching and mentorship
programmes, etc.) (1)
Slow transformation (low B-BBEE • Active B-BBEE-rating improvement plan / EE
rating). (1) policy (1)
Patents are expiring, which may belong • R&D focussed on profitable drugs and registration
to MGSA. (1) of patents / offset branded medicine market loss
with increased generic focus. (1)Purchase patents
from other companies. (1)
Strong competition between • Geographic diversification / supermarket
pharmacies. (1) partnerships / product diversification. (1)
MAX 9 MARKS
Communication – logical argument: 1
Total Max: 10
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(c)

Students failed to identify that these opportunities and threats form part of the SWOT analysis and
relates to the external environment.
Many students calculated ratios and discussed the internal environment.

To: Directors of MGSA

Date: 15 September 2013
From: David Manning

The purpose of this report is to highlight the results of an assessment of the current opportunities and
threats that could be linked to the group as well as any shortcomings in the group’s current vision-
statement.

Current opportunities:

• A large number of patents (protecting several prominent drugs) will expire in the coming years.
This is expected to create higher demand for generic medicine. (1)
• Lucrative government contracts for the supply of HIV/AIDS, tuberculosis and diabetes
medication. (1)
Current threats facing the group:

• Strong competition between pharmacies (with dominant retail pharmacy-chains and courier
pharmacies controlling a large share of the market). (1)
• Increasing number of patients requiring chronic care (HIV/AIDS and tuberculosis (TB)) has led
to significant pricing pressure as governments and funders try to contain prices and improve
patient access to medicines. (1)
• Single Exit Price squeezing margins. (1)
• Maximum price increases squeezing margins. (1)
• In response to the evolving nature of pharmaceutical science and other developments that impact
on safety, quality and efficacy the regulatory environment in South Africa is evolving and
becoming more stringent (NHI scheme and SAHPRA). This leads to an increasingly more
challenging environment for registering medicines and increases the associated costs. (1)
• The above threat is further compounded by the long registration timelines. (1)
• Government contracts: Government’s preferential procurement policies. MGSA’s current B-
BBEE rating is low. (1)
• The proposed National Health Insurance (NHI) scheme places further pressure on MGSA to
obtain a better B-BBEE rating. (1)
• High cost of discovering, researching and developing pharmaceutical drugs and only a very
small percentage of the compounds researched are eventually approved for human
consumption. (1)
• Any other valid point. E.g. B-BBEE rating criteria to be more stringent in future. (max 1)
MAX 9 MARKS
Shortcomings in current vision statement:

A vision statement is a long term view, whereby an organisation outlines what it wants to be. (1)

• It does not reflect the current business model of MGSA: no differentiation between branded &
generic medicine, and does not identify the retailing or manufacturing of pharmaceutical
products. (1)
• It focuses only on branded pharmaceuticals. (1)
• MGSA should guard against ignoring the potential benefit to be gained from the sale of generic
medicine. (1)
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• Especially because a large number of patents are about to expire creating higher demand for
generic medicines and other/competitor South African pharmaceutical companies also
pursuing growth in this area. (1)
MAX 2 MARKS
Communication – layout and structure of report; clarity of expression: 2
Total Max: 13
(d)

Many students erroneously discussed a constant dividend amount. The appropriate policy was a
constant dividend payout ratio which is not the same as a constant dividend amount. The first is a
percentage of earnings and the second a fixed Rand amount. These policies have a completely
different effect on benefits and limitations.

Benefits:

• In periods where earnings are low sufficient money is still retained in the business for
growth. (1)
• A constant dividend pay-out ratio will result in dividends tracking the performance of the
company. (1)
• Shareholders know what to expect - constant pay-out ratio. (1)

Limitations:

• Lack of stability/ volatile as the dividend will fluctuate with earnings. (1)
• Certain investors, such as retail investors and certain institutional investors such as pension
funds, may prefer dividends showing lower variation over time. (1)
• Investor preference i.t.o. dividend vs. capital growth must be considered. (1)
• Fluctuations in the dividends from one period to another may adversely affect the share
price due to the information content (signalling effect) of dividends. (1)
• Financing of profitable capital investments (Capital growth) is not considered. If sufficient
equity is not retained in the business for investment opportunities then new equity (shares) will
need to be issued to fund projects which will dilute control. (1)
• This causes a dilution in key indicators. (1)
• Profitable investments might be rejected in favour of dividend payments which have to be
made, which entails sub-optimal behaviour & value destruction. (1)
• The availability of cash to honour the dividend payment is not considered. Profit does not
necessarily mean positive cash flows / could have impact on liquidity. (1)
MAX 4 MARKS
(e)

Many students do not understand the purpose of EVA.

• In terms of IFRS, research cost is never capitalised (always expensed), whereas

development cost may be capitalised if it meets the recognition criteria in IAS38. (1)
• EVA promotes capitalising (and amortising) both research and development costs. (1)
• EVA can serve as a management performance management tool and its treatment has
benefits which are not available using another tool (which incorporates the standard IFRS
treatment). (1)
• Reasoning for EVA’s capitalisation (and amortisation) of R&D cost:
o Spread the impact of this cost over long term, creating a better match between R&D cost
and benefits. (1)
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o Management will be less inclined to not limit spending money on research / Promotes
R&D expenditure, which is normally important to innovation and the growth / survival of an
enterprise. (1)
o Align management’s goals and behaviour to that of the enterprise. (1)

MAX 5 MARKS
(f)

• Many students failed to calculate the ratios (analysis) as required and only discussed the
possible effect on earnings, ROE and financial risk without supporting calculations.
• Ratios must be calculated using market values and not book values
• Students were also requested to compare 2013 and 2014 ratios in their analysis as the
question stated “over the course of one year”.
• Discussion of ratios should add value and thus include whether the ratio has improved, etc.
• Please note that tax should not be deducted from the debentures as the following was
indicated in the question: Interest on the debentures would not be deductible for tax as its
proceeds would be used to purchase equity.

EARNINGS PER SHARE:

Financing components of the purchase consideration of Acti-Pharm:

(1)
Purchase consideration (R24 x 10m x 60%) R144 000 000 (1)
Shares (500 000 x R65) (R32 500 000)
Debentures (R90 000 000) (1)
Cash R 21 500 000

Basic earnings per share

Number of MGSA shares in issue = 100m + 0,5m = 100,5 m (1)

MGSA total group earnings over one year: R

Present MGSA earnings grown by 9% (R503 350 000 x 1,09) 548 651 500 (1)
Acti-Pharm’s earnings grown by 7% (R6,24 x 6m x 1,07) 40 060 800 (1)
Synergy benefits (R9 000 000 x 72%) 6 480 000 (1)
Integration cost (R4 000 000 x 72%) (2 880 000) (1)
Interest on debentures (R90 000 000 x 9,6% = 8 640 000) (8 640 000) (1)
Lost interest on cash (R21 500 000 x 5% x 72%) (R774 000) (1)
Total 582 898 300

Alternative:

MGSA total group earnings over one year:

Present MGSA earnings 503 350 000
Lost interest on cash (R21 500 000 x 5% x 72%) (774 000) (1)
Grown by 9% (502 576 000*1,09) 547 807 840 (1)
Acti-Pharm’s earnings grown by 7% (R6,24 x 6m x 1,07) 40 060 800 (1)
Synergy benefits (R9 000 000 x 72%) 6 480 000 (1)
Integration cost (R4 000 000 x 72%) (2 880 000) (1)
Interest on debentures (R90 000 000 x 9,6% = 8 640 000) (8 640 000) (1)
Total 582 828 640
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2013 2014
Earnings per share = 503 350 000 / 100 000 000 = 582 898 300 / 100 500 000
= 503 cents (1) = 580 cents (1)
OR: = 582 828 640 / 100 500 000
= 580 cents (1)

Interpretation: Based on the assumptions, the acquisition of Acti-Pharm will lead to an

improvement in EPS. (1)

RETURN ON EQUITY:

Market value of equity:

Current P/E ratio = R6 500 000 000 / R503 350 000 = 12,9 (1)
OR:
EPS = R503 350 000 / 100 000 000 = R5,03
R65 / R5,03 = 12,9 (1)

Market value of equity after acquisition = R582 898 300 x 12.9 = R7 519 388 070 (1)
OR:
New EPS after acquisition = R5,80
Market value = R5,80 x 12,9 = R74,82 per share (1)
x 100 500 000 shares = R7 519 410 000 (rounding difference)

Debentures:

Will the debentures be converted into ordinary shares or redeemed?

If redeemed: R90 000 000 x 1,04 = R93 600 000 (1)

If converted: 5 000 000 x ¼ = 1 250 000 x R100 = R125 000 000 (1)
Therefore the debenture holder would opt for conversion (highest). (1)

Calculate the fair market value of the debentures at 31 March 2014

FV = 125 000 000
N=3 (1)
PMT = 8 640 000 (R90m x 9,6%) (1)
I = 9,5% (1)
PV = 116 883 686 (1)

Debentures have, until actual conversion, a higher risk profile due to interest
payments that have to be met. It should therefore be classified as debt. (1)

2013 2014
Return on equity = 503 350 000 / 6 500 000 000 = 582 898 300 / 7 519 388 070
= 7,7% (1) = 7,8% (1)
Alternative 1: = 5,8 / 74,82
= 7,8% (1)
Alternative 2: = 582 828 640 / 7 519 388 070
= 7,8% (1)

Interpretation: Based on the assumptions, the acquisition of Acti-Pharm will lead to

an improvement in return on equity. (1)
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Alternative:

The debentures would be treated as equity because the holder would opt for (1)
conversion.
Market value of equity after acquisition (excl debentures) = (R582 898 300 + (1)
8 640 000) x 12,9 = R7 630 844 070
Market value including the value of debentures = R7 630 844 070 + R116 883 686 = (1)
R7 747 727 756
2013 2014
Return on equity = 503 350 000 / 6 500 000 000 = 582 898 300 / 7 747 727 756
= 7,7% (1) = 7,5% (1)
Alternative: = 582 828 640 / 7 747 727 756
= 7,5% (1)

Interpretation: Based on the assumptions, the acquisition of Acti-Pharm will cause

return on equity to deteriorate slightly. (1)

FINANCIAL RISK:
Market value of debt:

Acquisition takes place on 1 April 2013 per the scenario and the required wants you to analyse and
discuss the likely effect over the course of one year and thus 31 March 2014. Therefore you need
to calculate the market value of the loan as on 31 March 2014.
To determine the market value at 31 March 2014, the present value of the remaining cash flows
thereafter has to be determined.
Long-term loan (refer to PART A):

Calculate fair market value at 31 March 2014 (1)

FV = 124 855 020 (CF3)
N=1 (1)
I = 8% x 72% = 5,76% / 2 = 2,88%
PV = 121 359 856

Increase in earnings:

(582 898 300 + 8 640 000) – 503 350 000 = 88 188 300 x 100/72 = 122 483 750 -
8 640 000 = 113 843 750

Alternative: (582 828 640 + 8 640 000) – 503 350 000 = 88 118 640 x 100/72 =
122 387 000 - 8 640 000 = 113 747 000

Interest on loan in 2014 = 15 633 489 + 10 649 949 = 26 283 438 (PART A - both
periods relate to the March 2014 year)

Consistent with the reasoning above debentures are classified as debt

2013 2014
Debt to equity ratio = 349 812 323 Part A / 6 = 121 359 856 +116 883 686 /
500 000 000 7 519 388 070
= 5,4% (1) = 3,2% (1)
Or Gearing ratio = 349 812 323 Part A / (349 812 = 121 359 856 +116 883 686 /
323 + 6 500 000 000) (121 359 856 + 116 883 686 +
= 5,1% (1) 7 519 388 070
= 3,1% (1)
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Interest cover = (621 136 000 + 45 368 000) / = (621 136 000 + 45 368 000 + 113
45 368 000 843 750 + 8 640 000) / (26 283 438
= 14,7 times (1) + 8 640 000) = 22,6 times (2)
Effective interest = 2013 finance cost / Total = 2014 finance cost / Total interest
rate interest bearing debt for 2012 bearing debt for 2013
= X% (1) Bonus = X% (1) Bonus

• The decrease in the gearing (alt. debt to equity) ratio and the increase in interest cover
indicates that financial risk will decrease as a result of the purchase of Acti-Pharm. (1)
• This is because a portion of the purchases price is funded through equity (the issue of
shares). (1)
• In addition to this, because the long-term loan is reaching maturity there has been a
significant decrease in debt from 2013 to 2014. (1)
• Debt to equity levels remain significantly lower than the industry averages of 20,6% (2013)
and 30,8% (2012). (1)
• Perhaps they are not financed at their target D:E ratio. (1)
• The interest cover of 22,6 times is exceptionally strong and shows an improvement due to
the increase in earnings as a result of the acquisition as well as the decrease in interest on the
long-term loan. (1)
• The decrease in the effective interest rate also indicates a decrease in financial risk. (1)
Bonus
• Compare effective interest rate to prime lending rate and discuss. (1) Bonus
• General observations, e.g. that Acti-Pharm’s financial risk exposure (credit risk, liquidity risk,
etc.) will change the risk of MGSA. (1)

Alternative: Consistent with the alternative argument above debentures are classified as
equity.

2013 2014
Debt to equity ratio = 349 812 323 / 6 500 000 000 = 121 359 856 / 7 747 727 756
= 5,4% (1) = 1,6% (1)
Or Gearing ratio = 349 812 323 / (349 812 323 + = 121 359 856 / (121 359 856 +
6 500 000 000) 7 747 727 756)
= 5,1% (1) = 1,5% (1)
Interest cover = (621 136 000 + 45 368 000) / = (621 136 000 + 45 368 000 + 113 843
45 368 000 750 + 8 640 000) / (26 283 438 + 8 640
= 14,7 times (1) 000) = 22,6 times (2)
Effective interest = 2013 finance cost / Total = 2014 finance cost / Total interest
rate interest bearing debt for 2012 bearing debt for 2013
= X% (1) = X% (1)

MAX 27 MARKS
(g)

• Owner level premiums and discounts are discussed in Chapter 11, Managerial Finance,
FO Skae.
• The appropriate premium is the control premium, which by implication excludes the minority
discount.
• The marketability discount is not the same as transferability as transferability often refers to restr
i.t.o. the memorandum of incorporation.
• Many students erroneously discussed the typical adjustments to the comparator P/E multiple.
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• Control premium:

A control premium reflects the percentage added to the value of a non-controlling interest to reflect
the benefits of control. MGSA plans to purchase 60% of Acti-Pharm which represents a
controlling interest. (1)

If the valuation of Acti-Pharm was performed using a method which does not reflect control
(i.e. the dividend growth model or earnings multiples where the multiple of a similar listed
company does not reflect control) then a control premium should be added to the final market
value of equity calculated. (1)

If the valuation was performed using the Free Cash Flow method then the value calculated
already reflects control and a control premium should not be added. (1)

• Marketability discount:

A marketability discount reflects the percentage deducted from the value of a shareholding to
reflect the shares lack of liquidity (limited marketability). Acti-Pharm is a private company and
hence its shares will be more difficult to sell than a listed company. (1)
Since most approaches – albeit an Income Approach or a Market-comparable Approach – make
use of certain market observations of listed companies to value a non-listed company a
marketability discount should be subtracted from the final market value of equity calculated
here. (1)

In both cases, the applicability of owner-level premiums and discounts are dependent on the case
in hand: the exact valuation methodology applied and the market observations utilised. (1)

• Small stock premium

Since Acti-Pharm is a small/private company a small stock premium should be added to the cost
of equity (ke). (1)
MAX 4 MARKS
(h)

Memorandum

Date: 15 September 2013

To: Management Accountant
From: David Manning
Subject: Reasons why the Acti-Pharm acquisition may not be successful and the advantages and
disadvantages of a post-acquisition review

Reasons why the Acti-Pharm acquisition may not be successful:

• The purchase consideration does not reflect the true value of Acti-Pharm:

 In determining the value of Acti-Pharm assets may have been over-estimated or

liabilities overlooked / hidden material debts / contingent liabilities (liabilities
understated). (1)
 Expected synergies of R9 million do not materialise / purchase price could have been
overstated due to inclusion of synergy benefits. (1)
 Integration costs are higher than expected. (1)
 Acti-Pharms earnings do not grow as expected. (1)

• Lack of managerial fit / conflicting management styles between the two companies. (1)
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• Acti-Pharm’s core business is different to that of MGSA. The management of MGSA may not
have the required knowledge and skills to effectively run Acti-Pharm. (1)
• Acti-Pharm may not have the product range/market share (position) that was initially
predicted. (1)
• Problems in personnel management / integration of business culture. The acquisition may
create unease amongst employees as well as problems resulting from differences in
remuneration levels, pay scales, fringe benefits and corporate culture. (1)
• Lack of goal congruence. Disputes on how to proceed with Acti-Pharm in crucial functional
areas. (1)
• Inability to manage change. Either company may not be prepared to depart from established
routines and practices which may compromise an otherwise good investment. (1)
• Lack of lock-in agreement in respect of key management/staff at Acti-Pharm, which might
be one of the strategic drivers of the acquisition. (1)
• MGSA may not have sufficient financial resources to fund the acquisition. (1)
• Decline in demand of locally produced products due to cheap imports. (1)
• Directors’ assumptions may not be financially sound. (1)
• The shareholders of Acti-Pharm may not be willing to sell their shares for R 24/share. (1)
• Competition Commission may prohibit the acquisition. (1)

MAX 5 MARKS
Advantages and disadvantages of a post-acquisition review:

The advantages of a post-acquisition review in the context of the planned Acti-Pharm acquisition
would be:

• It enables MGSA management to monitor whether the actual post-acquisition results were
as planned. If results are worse than expected, management should take prompt action to
remedy the problem. If the problem cannot be remedied, then MGSA should consider exiting
from the investment. (1)
• It assists managers of MGSA in future acquisitions. Mistakes will always be made, but the sign
of a good manager is that they learn from their mistakes. Experience gained in reviewing
previous acquisitions should lead to better decisions being made in the future. (1)
• Knowing that a post-acquisition review will be carried out in due course will prevent the MGSA
managers from making overoptimistic assumptions in their evaluation of Acti-Pharm. They
know that they will be held accountable for any decisions that they take. (1)

The disadvantages of a post-acquisition review in the context of the planned Acti-Pharm acquisition
will be:

• The whole process can be expensive in terms of the management time involved. (1)
• It requires accurate data to be collected over a period of time. (1)
• Some managers may believe that a post-acquisition review is a method of pinning blame for
poor decisions on particular individuals, rather than being a value-adding activity to learn from
past mistakes and improve performance in the future. (1)
• The above could make management more risk averse going forward which could hinder
value creation. (1)
MAX 3 MARKS
Communication – appropriate style 1
Overall max 9
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(i)

• Many students failed to decide between the bank’s buying or the selling rate.
• They further failed to decide between a Put or a Call option.
• This onus should lie on the student and not the marker as it indicates that the student
doesn’t know the correct treatment.
• The question further required you to explain and not only to calculate.

• If the Euro does strengthen against the Rand as anticipated this will result in a foreign
currency loss of R250 000 (R10,2 – R9,8 x €625 000) on the underlying transaction. (1)
The bank’s selling rate is used above as we are purchasing € and thus the bank is selling €
to us. (1)
This option allows MGSA to fix in a strike rate which is better than the spot rate on exercise
date, which effectively results in a gain being made. (1)
• MGSA must decide whether they need to purchase a put or a call option. As the currency
options are denominated in Euros and MGSA needs to purchase Euro’s with the risk of the
Euro strengthening, MGSA will need to purchase CALL OPTIONS to hedge itself. (1)
This Call option give MGSA the right, but not the obligation, to buy Euro on 30 September
2014 at a strike price of R10,3. (1)
• The standard size of an options contract is 1 000 units. Therefore, MGSA would need to
purchase 625 contracts (€625 000 / 1 000). (1)
• Premium: The currency option contract will cost MGSA R262 500 (625 contracts x €1 000 x
0,42). (1)
This premium has to be paid regardless of whether the option is exercised or not. (1)

• On the strike date MGSA must decide whether they would like to exercise their option or
not. (1)
The spot selling rate in the currency market is indicated at ZAR10.9/€ on strike date.
Therefore because the spot rate exceeds the strike price MGSA is in-the-money and would
exercise their option to buy currency at R10,3 and then sell it at R10,9. (1)

This will result in a profit of R375 000 (R10,9 – R10,3 x 625 x €1 000). (1)

If the spot rate in the currency market was less than the strike price of R10,3 then MGSA
would not exercise the option as it would result in a loss. (1)

• The net gain on the currency option contract R112 500 (R375 000 – R262 500) is then
offset against the loss on the underlying transaction resulting in a reduced loss of
R137 500 (R250 000 – R112 500). (1)
MAX 8 MARKS
(j)

Metrics must be measurable and linked to the pharmaceutical industry. Many students failed to
answer i.t.o. a metrics.

Environmental footprint metrics:

• Volume of electricity consumed. (1)

• Volume of water used. (1)
• Volume of greenhouse gas emissions produced. (1)
• Volume of hazardous waste produced. (1)
• Volume of waste recycled. (1)
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Societal footprint metrics:

• Percentage of employees who had to be booked off work due to work related injuries or
illnesses. (1)
• Number of permanent disabling injuries. (1)
• B-BBEE contributor score. (1)
• Average staff turnover. (1)
• Training-spend per employee. (1)
• Number of CSI beneficiaries reached through providing primary healthcare support to
communities. (1)
Any other valid metric (max (1))

MAX 5 MARKS
Communication – logical argument 1
Overall max 6
(k)

Students’ comments should add value and not merely restate the information from the question.

Sales:

• Current policy: Not all sales are on credit (20% of sales are cash).
Assessment: MGSA is not completely dependent on credit sales. (1)
Alternatively, MGSA should promote additional cash sales.

• In 2013 bad debts decreased by 13,7% (41 429 – 47 980 / 47 980) or R6 551
(alternative) which shows an improvement from 2012 as its debt collection (1)
policy and procedures were adhered to. (1)

Bad debts/Credit Losses: 2013 2012

• Bad debts as a % of credit sales: 41 429 / 47 980 /
(3 219 474 x 80%) (3 117 497 x 80%)
= 1,6% (1) = 1,9% (1)
Alternative: as % total sales 41 429 / 3 219 474 47 980 / 3 117 497
= 1,3% (1) = 1,5% (1)

This decrease shows an improvement from 2012 for MGSA. (1)

MGSA shows better performance than the industry in both years (2,5% in (1)
2013 and 2,3% in 2012).

• The 2013 bad debts as a % of credit sales could also be calculated by

eliminating the Synchem bad debt of R1,5 million where the credit policy
was not adhered to. This will result in an even bigger improvement from (1)
2012 to 2013.

Credit Limit:

• Current policy: Credit limits are set for debtors based on their credit ratings.
Assessment: The risk of bad debts is reduced as this is linked to a credit (1)
rating.

However, this will only be effective if updated periodically / upon certain (1)
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triggers.

Synchem Limited:
Outstanding balance when liquidated (R1,5m x 100 / 60) R2,5m (1)
Credit limit R2m

Obviously Synchem was allowed to purchase goods in excess of their credit

limit, which points towards non-compliance of policies. (1)

• Current policy: A single debtor may not exceed 4% of the total outstanding
receivables balance.
Assessment: As long as this policy is adhered to, possible losses due to a (1)
single debtor going bad are limited.
However, this will limit sales to a large customer / to the government. (1)
4% is a high amount, if concentrated in one debtor perhaps 4% is too (1)
high.
2013 2012
Receivables collection (424 134 / (392 001 /
period: (3 219 474 x 80%)) x 365 (3 117 497 x 80%)) x 365
= 60,1 days (1) = 57,4 days (1)

The receivables collection period has worsened in 2013 and in both years (1)
MGSA debtors take longer to pay than the industry average of 53 days in
2013 and 50 days in 2012 which is negative. (1)

• Revenue increased by 3,3% (3 219 474 – 3 117 497 / 3 117 497) which
resulted in an 8,2% (424 134 – 392 001 / 392 001) increase in the accounts (1)
receivable outstanding balance.
This, as well as the increase in debtors days is concerning because (1)
increased debtors days & balances will result in increased finance costs (to
fund working capital) for the company. (1)
The longer a debtor’s balance remains unpaid the higher the risk that the
debtor will default on payment. (1)
However, with the decrease in bad debts above this does not seem to be (1)
the case.

MAX 12 MARKS
Communication – layout and structure; clarity of expression: 1
Total Max: 13
(l)

• Many students failed to calculate the IRR as required.

• Wear and tear should be included in cash flows at 28%. Including wear and tear at 100% is a
principle error as that is in essence including depreciation (which is non-cash).

Loan:

PV = 6 000 000
N=5
I = 8,5% + 2% = 10,5% (1)
PMT = 0
FV = 9 884 681 (1)
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The below signs (+/-) and period must be correct.

0 1 2 3 4 5
R’ 000 R’ 000 R’ 000 R’ 000 R’ 000 R’ 000
Capital borrowed 6 000 (1)
Bullet payment (9 885) (1)
Maintenance & servicing (500) (500) (500) (500) (500) (1)
Tax at 28% 140 140 140 140 1 228 (1)
Taxable income (500) (500) (500) (500) (4 385)
Interest (3 885) (1)
Maintenance & servicing (500) (500) (500) (500) (500) (1)
Total cash flows 6 000 (360) (360) (360) (360) (9 157)

IRR = 13,17% (calculator steps shown) (1)

Finance lease:
0 1 2 3 4 5
R’ 000 R’ 000 R’ 000 R’ 000 R’ 000 R’ 000
Machine 6 000 (1)
Lease payments (1 650) (1 650) (1 650) (1 650) (1 650) (1)
Tax at 28% (210) 126 126 126 462 (1)
Taxable income 750 (450) (450) (450) (1 650)
Lease payments (1 650) (1 650) (1 650) (1 650) (1 650) (1)
S12C forfeited 2 400 1 200 1 200 1 200 (2)
Total cash flows 4 350 (1 860) (1 524) (1 524) (1 524) 462

IRR = 15,8% (calculator steps shown) (1)

Alternative 1: 0 1 2 3 4 5
Loan: R’ 000 R’ 000 R’ 000 R’ 000 R’ 000 R’ 000
Capital borrowed 6 000 (1)
Bullet payment (9 885) (1)
Tax at 28% 1 088 (1)
Taxable income (3 885)
Interest (3 885) (1)
Total cash flows 6 000 (8 797)

IRR = X% (calculator steps shown) (1)

Finance lease: 0 1 2 3 4 5
R’ 000 R’ 000 R’ 000 R’ 000 R’ 000 R’ 000
Machine 6 000 (1)
Lease payments (1 650) (1 650) (1 650) (1 650) (1 650) (1)
Maintenance and servicing 500 500 500 500 500 (1)
Tax at 28% (350) (14) (14) (14) 322 (1)
Taxable income 1 250 50 50 50 (1 150)
Lease payments (1 650) (1 650) (1 650) (1 650) (1 650) (1)
Maintenance and servicing 500 500 500 500 500 (1)
12C forfeited 2 400 1 200 1 200 1 200 (2)
Total cash flows 4 350 (1 500) (1 164) (1 164) (1 164) 822

IRR = X% (calculator steps shown) (1)

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Alternative 2: 0 1 2 3 4 5
Loan: R’ 000 R’ 000 R’ 000 R’ 000 R’ 000 R’ 000
Capital borrowed 6 000 (1)
Bullet payment (9 885) (1)
Tax at 28% 672 336 336 336 1 088 (1)
Taxable income (2 400) (1 200) (1 200) (1 200) (3 885)
Interest (3 885) (1)
12C (2 400) (1 200) (1 200) (1 200) (2)
Total cash flows 6 000 672 336 336 336 (8 797)

IRR = X% (calculator steps shown) (1)

Finance lease: 0 1 2 3 4 5
R’ 000 R’ 000 R’ 000 R’ 000 R’ 000 R’ 000
Machine 6 000 (1)
Lease payments (1 650) (1 650) (1 650) (1 650) (1 650) (1)
Maintenance and servicing 500 500 500 500 500 (1)
Tax at 28% 322 322 322 322 322 (1)
Taxable income (1 150) (1 150) (1 150) (1 150) (1 150)
Lease payments (1 650) (1 650) (1 650) (1 650) (1 650) (1)
Maintenance and servicing 500 500 500 500 500 (1)
Total cash flows 4 350 (828) (828) (828) (828) 822

IRR = X% (calculator steps shown) (1)

Alternative 3: 0 1 2 3 4 5
Loan: R’ 000 R’ 000 R’ 000 R’ 000 R’ 000 R’ 000
Capital borrowed 6 000 (1)
Bullet payment (9 885) (1)
Maintenance & servicing (500) (500) (500) (500) (500) (1)
Tax at 28% 812 476 476 476 1 228 (1)
Taxable income (2 900) (1 700) (1 700) (1 700) (4 385)
Interest (3 885) (1)
Maintenance & servicing (500) (500) (500) (500) (500) (1)
12C (2 400) (1 200) (1 200) (1 200) (2)
Total cash flows 6 000 312 (24) (24) (24) (9 157)

IRR = X% (calculator steps shown) (1)

Finance lease: 0 1 2 3 4 5
R’ 000 R’ 000 R’ 000 R’ 000 R’ 000 R’ 000
Machine 6 000 (1)
Lease payments (1 650) (1 650) (1 650) (1 650) (1 650) (1)
Tax at 28% 462 462 462 462 462 (1)
Taxable income (1 650) (1 650) (1 650) (1 650) (1 650)
Lease payments (1 650) (1 650) (1 650) (1 650) (1 650) (1)
Total cash flows 4 350 (1 188) (1 188) (1 188) (1 188) 462

IRR = X% (calculator steps shown) (1)

Therefore the loan is cheaper than the finance lease. (1)
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MAX 13 MARKS
(m)

This question relates to the business plan as dealt with in Managerial Finance, by FO Skae.
Many students incorrectly performed a financial analysis in this section.
Memorandum

Date: 15 September 2013

To: Management Accountant
From: David Manning
Subject: Matters to be included in the business proposal

Please find described below the matters that should be included in the business proposal under the
requested headings.

Industry analysis:

• The total market size/demand for ARV drugs. (1)

• ZDT’s expected market share. (1)
• Growth potential. (1)
• Porter’s Five Forces looks at the competitive environment within an industry. (1)

This includes :

Threat of new entrants (1)

Threat of substitute (generic) products (1)
Bargaining power of suppliers (1)
Bargaining power customers and (1)
Rivalry amongst existing competitors (1)

• Barriers to entry (government regulation/competition/drug registration requirements). (1)

• New developments / regulations within the industry such as the NHI scheme and SAPHRA.
(1)
Risk and risk management:

A complete picture of risk and risk management is required within this section. This would include
the following:

• SWOT analysis (1): The business proposal should include:

 how MGSA intends to maintain strengths and manage weaknesses within the internal
environment; (1)
 and how they plan to take advantage of opportunities and manage threats within the
external environment. (1)
• PESTEL analysis (1): Whereby political, environmental, socio-cultural, technological,
economical and legal factors are considered and addressed. (1)
• Risk management structure in place. (1)
• Enterprise Risk Management (ERM) (1)
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This includes:

Internal environment which looks at the entities risk appetite (1)

Objective setting which must be in-line with the entities mission (1)
Event identification which refers to risk identification (1)
Risk assessment (1)
Risk response and how to avoid these risks (1)
Control activities determined by risk policies and procedures (1)
Information and communication via the risk report (1)
Continuous monitoring of risks (1)
Communication – appropriate style 1
Overall max 6
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QUESTION 2 SUGGESTED SOLUTION

D&S TEC
(Source: Supplementary exam 2012 MAC4862 - adapted)

PART A: 59 Marks

(a) Financial analysis 24 Marks

The “Required” for this section is quite lengthy and can be overwhelming. Students should
however break it down into smaller parts i.e.

Part (i)

 Identify errors in the calculations and financial analysis commentary provided.

 Suggest improvements that can be made to the calculations and financial analysis
commentary provided.
Part (ii)

 Where ratios have been incorrectly calculated, calculate the ratios correctly.
Part (iii)

 Provide financial analysis commentary relating to the correctly calculated ratios per
part (ii)

(iii) Workings:

The first step would be to calculate the market value of Debt and Equity as this will be required to
calculate a large number of the ratios.
Market value of equity:

R 26,05 x 2 000 000 shares = R52 100 000 (1)

Optional: + control premium (between 10% and 25%) e.g. 10% = R5 210 000 (1)
= R57 310 000

Market value of medium-term debt:

Kd = 8,5% (prime) + 4,5% = 13% (1)

=13% x 0,72
i = 9,36% (1)
n =5
PMT = (R 2 767 219) {32 028 000 x 0,12 x 0,72} (1)
FV = (R 32 028 000) (1)
PV = R31 139 356
N = 5; FV = (32 028 000); any after-tax pmt and after-tax i or any before-tax pmt and before-
tax tax i; PV? (1)
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Common errors made:

 The tabular format specified was sometimes not adhered to or difficult to follow.
 Students often did not calculate the ratios as required by (ii) using market values.
 Commentary provided as required by (iii) was often not insightful.

NB! Commentary provided for financial statement analysis should illustrate a student’s understanding of
(1) the purpose of the ratio and (2) its impact.

Ratio (i) Errors in calculations (ii) Correct ratio (i) Insightful

and comments comment (relative
to candidate’s
calculation)
• This calculation should be = MVD/(MVE+MVD) • The correct calculation
based on the market value of amounts to (e.g.
debt and equity (1) E.g: 31 139 356 37,4%) which is an
• Bank overdraft should be (31 139 356 + improvement from
excluded as it is used for 52 100 000) 208,8% (2011) (1)
1. Gearing

working capital purposes only/ = 37,4% (1)

does not form part of the as it is more in-line
permanent capital with D&S TEC’s target
structure.(1) capital structure. (1)
• Decrease in gearing ratio is as
a result of a relative decrease
in borrowings / increase in
equity, not an increase in
borrowings. (1)
• The calculation should rather Total H-E:(3,82x2m) • Shareholders of D&S
be based on headline MVE (1) TEC may find that due
earnings, not operating to the improved ROE
profit. (1) = 7 640 000 from 6,2% (1)
• e.g. 52 100 000 they are now more
2. Return on Equity

Alt: Based on basic earnings

per share as South Africa is = 14,7% (1) satisfied with their
one of the few countries who return in relation to the
calculate HEPS. (1) risk they are exposed
• This calculation should be Alt: PAT: 7 987 000 to. (1)
based on the market value of MVE • Thus indicating that the
equity. (1) = 7 987 000 net effect in 2012 of
e.g. 52 100 000 company performance
= 15,3% (1) and gearing
utilisation was more
beneficial to equity
holders (1)
• This ratio does not refer to the = 22,3% or • In 2012 (22,3%) the
3. ROCE

distribution of earnings but unchanged company has utilised

to the effective utilisation of (1) their assets more
assets. (1) effectively than in
2011 (13,6%).(1)
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• ROIC should be (25 188 000x0.72) • Exceeds the
calculated based on Net (MVD+MVE-cash) companies WACC of
Operating Profit After = 18 135 360 19%. (1)
Tax (NOPAT), not profit e.g (31 139 356 + 52 • ROIC improved from
after tax. (1) 100 000 - 35 946 16,8% (2011) to 38,3%
• By calculating the ROIC 000 ) (2012), thus indicating
on an after tax basis, = 38,3% (1) that their investment
ROIC may be compared Alt: capital (excl cash) was
4. ROIC

to WACC. (1) 7987000+(16171000x used effectively. (1)

• This calculation should be 0,72)-
based on the market (2077000x0,72) (MVD
value of debt and +MVE-cash)
equity. (1)
= 18134680
e.g (31 139 356+
52 100 000-35 946
000 )
= 38,3% (1)
• Times interest earned =25 188 000 • The interest cover has
does not take the 16 171 000 improved since 2011
balance sheet (loan) =1,56 times (1) from 1.13 to 1.56 times
5. Interest cover

amounts into in 2012 mainly as a

consideration and should result of the improved
be calculated by dividing operating profit and
EBIT with finance cost. thus interest is now
(1) covered with more
ease (1)
• The interest cover of
1,56 times is low for a
company in the IT
industry (considering
risks). (1)
• Formula correct, but = (113684k - 98047k) • N/a. The comment
6. Growth in
turnover

incorrectly calculated in 98047k) remains valid.(1)

2012. (1) = 15,95% (1)

Overall max: 24
(b)

 Students were required to consider the impact of the different funding components on the business.
 A good starting point is to compare the actual funding strategy (debt to equity) with the target debt to
equity.
 The cash available should also be considered as part of the funding strategy.
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Supporting calculations Debt: Equity

• Target D:E 35%: 65%

Or 0,54: 1

• Actual D:E (2012) MVD: MVE (1)

e.g. R31 139 356 R52 100 000
= 37,4%: 62,6%
or 0,60: 1

R
• Finance income percentage earned on cash 2077k/35946k
5,8% (1)

• Excess cash – after immediate / short-term obligations

(considering the high risk IT industry) – an estimation only
Cash and cash equivalents 35 946 000 (1)
Less: Tax liabilities (4 459 000) (1)
Bank overdraft (270 000) (1)
Interest for one year {32 028 000x0.12x0.72} (2 767 219) (1)
Portion of trade and other payables (?) or discussed (1)
Portion of provisions (?) or discussed (1)
Reserved for pending capital projects (?) or discussed (1)
~ 28 449 781 or less

Discussion

• D&S TEC’s actual D:E ratio (2012) is close to / slightly above the target D:E ratio. (1)
• Due to the strong upward movement in D&S TEC’s share price in 2012 this is an improvement
from what the actual D:E ratio of 2011 would have been. (1)
• It is positive to have an actual D:E close to the target, as the target D:E takes account of:

o The business and other risks inherent to the company. (1)

o Industry factors. (1)
o Should represent the optimum capital structure, thereby minimising WACC. (1)

• D&S TEC’s bank overdraft does not form part of the funding structure as it is used for
working capital purposes only/ does not form part of the permanent capital structure. (1)
• D&S TEC’s medium term loan offers a cost/tax benefit due to interest expenditure that is
deductible ito Section 24J of the Income Tax Act. (1)
• D&S TEC’s medium term loan offers a reprieve ito repayment of capital (only due in 5
years’ time), minimising effect on cash flow in short/medium term. (1)
• D&S TEC has high levels of excess cash, earning a low return (5,8%) – far below WACC).
(1)
• D&S TEC should consider uses for excess cash: other capital projects / repaying a portion of
the medium term loan. (1)
• Some excess cash may be required given risks of IT industry / economic crisis effect on
access to finance. (1)
Max: (5)
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(c) Ratio calculations 4 Marks
2012 2011

(i) Dividend cover =Headline earnings per share = 3,82 = 2,11

Dividends per share 1,75 0,9
= 2,18 (1) = 2,34 (1) r/w
Alternative = Basic earnings per share = 4,00 = 2,15
Dividends per share 1,75 0,9
= 2,29(1) = 2,39 (1) r/w

(ii) PE ratio = Market price per share = 26,05 = 12,10

Headline Earnings per share 3,82 2,11
= 6,82 (1) = 5,73 (1)

Alternative = Market price per share = 26,05 = 12,10

Basic Earnings per share 4,00 2,15
= 6,51 (1) = 5,63 (1) r/w

Max: (4)

These basic ratios remain problematic, with numbers switched around or designations incorrectly used.
Dividend cover represents the number of times earnings cover dividend and should not be expresses as a
%, similarly the PE ratio is a multiple and not a Rand amount. These errors indicate a lack of
understanding.

Students should strive to understand the purpose of the ratios first; this will then assist them in
remembering how to calculate them.

(d) Comments 6 Marks

(i) Dividend cover

• The dividend cover ratio has worsened, indicating that dividends are now covered by a
smaller earnings figure. (1)
• This is as a result of DPS increasing more than the H-EPS. (1)
• The dividends are increasing with a higher percentage than the earnings indicating that the
dividend payment may not be sustainable. (1)

(ii) PE ratio

• (The (trailing) PE multiple shows that, at present, investors are willing to pay 6,82 (or 6,51)
times the most recent historical H-EPS, for a share. (1)
• The PE multiple has increased/strengthened to 6,82 (or 6,51) (2012) from 5,73 (2011). (1)
• Indicating that investors likely expect higher relative-growth in future (1)
and/or that an investment in D&S TEC has reduced in risk relative to 2011 (less likely). (1)
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• In 2012 investors may have been influenced by the signalling effect/ information content
of: (1)
o The increase in the DPS/H-EPS. (1)

• D&S TEC’s PE multiple is relatively low for an IT company. (1)

Max: (6)

Issues not related to the ratios should not be discussed e.g. leverage.
Value added comments should focus on the possible reasons for the change and in this case, the
signaling effect.

(e) Anti-takeover strategy 4 Marks

Effect of repurchase of shares Effect as a defensive strategy

• The share price of D&S TEC may increase due to • Making shares in D&S TEC more expensive.
the signalling effect (information content) indicating (1)
that shares may be undervalued / 10% premium
offered. (1)
• Will reduce the high excess-cash level. (1) • May reduce the attractiveness of D&S TEC to
the competitor. (1)
• If shares are cancelled, fewer shares will be • More difficult for an acquirer to obtain a
available in the market / fewer minority shares. (1) sufficient number of shares. (1)
• If shares are repurchased through a subsidiary, it • A hostile takeover will be impossible. (1)
may be resold – possibly to the majority
shareholder. (1)
Max: (4)

(f) Integrated reporting 9 Marks

(i) Should entail:

An integrated report should involve / incorporate the following key areas –

• Organisational overview / Business model / Governance structure (½)

• Operating context / Risks / Opportunities (½)
• Objectives / Strategies to achieve those objectives (½)
• Competencies / Remuneration (½)
• Targets / KPIs (Key Performance Indicators) / KRIs (Key Risk Indicators) (½)
• Historical performance / Annual report (½)
• Future performance objectives / Future outlook (½)
• Sustainability / Environmental, social, governance (ESG) information (½)

An integrated report should cause/result in the following –

• Integration of financial information with sustainability information (½)

• Sustainability being embedded in the organisation / integrated with daily business (½)
processes
• Reflection upon the community impact (½)
• Indication of how positive aspects can be enhanced / negative aspects can be negated (½)
• Vision and commitment towards matters other than profit (½)
• Substance over form (½)
Max: (6)
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(ii) Critique – Mr Dinozzo

• Mr Dinozzo emphasises only a single interest (bottom line: profit) of a single stakeholder
(shareholders). (1)
• Thereby ignoring other interests, e.g. the triple bottom-line (profit, but also people and the
planet). (1)
• Thereby ignoring other stakeholders (such as employees, suppliers, customers, regulators,
environment, community, etc.) (1)
• Mr Dinozzo is therefore not considering a stakeholders inclusive model. (1)
• Stakeholders are also interested in the following: The impact the company has on the
environment and community, and vice versa. (1)
Max: (3)

Students did not understand the ‘required’ i.e. this section required students to criticise Mr Dinozzo’s
reasons for non-compliance and not why non-compliance was not in the best interest of the company.

(g) Identify risks associated with D&S TEC 7 Marks

It is important to discuss the risks specific to D&S TEC taking into account the industry within which it
operates i.e. IT

• Business / Operating risk: D&S TEC operates in the competitive / fast-changing IT

industry. (1)
• Country risk: D&S TEC is a multinational entity, which may result in risks associated with
different cultures, languages, laws and regulations. (1)
• Financial risk: D&S TEC makes use of debt financing and is therefore exposed to the risk
posed by fixed repayment terms / calling-up of a facility. (1)
• Technological risk: D&S TEC operates in the IT industry with short life-cycles and fast
obsolescence. (1)
• Piracy / Hacking risk: D&S TEC’s software may be hacked, rendering security features
useless and thereby allowing the sale of pirated or illegal copies / software may be stolen.(1)
• Fraud / Theft risk: D&S TEC’s employees could bypass software security features. (1)
• Malware / virus risk: D&S TEC’s software may contain viruses and other malware thereby
spreading it to customers’ systems. (1)
• Patent and copyright infringement / legal risk: D&S TEC’s customised software may infringe
patents / copyrights of others, with an associated legal exposure. (1)
• Currency (exchange rate risk): D&S TEC is a multinational entity and certain foreign sales /
costs may be incurred in a currency other than ZAR. (1)
• Interest rate risk: D&S TEC’s bank overdraft is linked to a variable rate (prime), creating
uncertain future interest payments. (This is not applicable to the medium-term loan as it has a
fixed interest rate.) (1)
• Risk of a loss of management focus / key-person risk: D&S TEC’s management could lose
focus on operations due to the current hostile takeover situation / D&S TEC’s already saw
Anthony Senior’s retirement and other key-persons may leave after a takeover. (1)
• Governance risk: D&S TEC seems to be dominated by a strong leader with little regard for
matters other than profit. (1)
Max: (7)
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PART B - Customfit-IT Marks 38

(a) WACC: 6 Marks

Cost of equity (K e )

Ke = R f + β (R m – R f ) + small-stock premium (optional)

= 9% + 1,25 (16% – 9%) + 5%

(1) (1)
= 17,75% + 5%
= 22,75%

Gordon’s Dividend Growth Model cannot be used to determine K e here, as D 1 is unknown

Cost of debt (K d )

Kd = 8,5% (prime) + 4,5% = 13% (1)

=13% x 0,72
= 9,36% (1)

Target weighting Required return WACC

Equity 0,65 22,75% 14,79%

Debt 0,35 (1) 9,36% 3,28%
1,0 18,07% (1)
Max: (6)

The weighting should be based on the target structure per the Required, calculating market values was
therefore not required.

(b) New bank loan 9 Marks

(i) Impact on Cost of equity:

• A new loan will increase D&S TEC’s financial gearing and thereby the company’s financial /
credit risk (payments are obligatory and may be difficult / impossible to make in certain
instances). (1)
• The claim of equity holders on benefits (e.g. dividends) and in the case of liquidation ranks
junior to (below) all other forms of finance. (1)
• Thus, cost of equity will increase as investors require a higher return to compensate for the
increased risk. (1)
(ii) Impact on Cost of debt:

• The exact cost of the new loan will depend on its terms, the security offered and the
associated debt covenants. (1)
• Due to the low value of second-hand computer equipment, such equipment is unlikely to
offer sufficient security on a new loan, which may increase the cost of this new debt. (1)
• Since the claim of debt holders ranks senior to (above) that of equity holders and because
interest is normally deductible for purposes of income tax, the cost of debt is usually cheaper
than equity. (1)
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• The new loan will increase the level of the company’s overall debt and risk, and will therefore
result in a higher cost of debt (relative to the existing debt – all else being equal). (1)

(iii) Impact on WACC:

• Theoretically, the WACC is minimised when D&S TEC reaches an optimum capital structure –
often taken to be the target level (an entity should therefore strive towards the target). (1)
• New debt will affect the following variables within the calculation of WACC: (a) increase the
k d ; (b) increase the K e ; and (c) change the proportion (weight) of debt and equity. (1)
• The new loan amount (EUR 1 million plus some other expenses) will be relatively small
compared to the existing value of debt and equity, and will therefore not have a significant
impact. (1)
• A new bank loan will result in weights that are further away from / closer to the target capital
structure. (1)
• As a result, D&S TEC’s WACC will increase / decrease. (1)
• The strong movements (e.g 2011 to 2012) in the share price will affect the weight of equity
within the capital structure and indicates the riskiness of the industry and the limited ability
of D&S TEC to make use of extensive debt finance. (1)
Max. for part (b): (9)

Students performed poorly within this section, indicating that despite knowing how to calculate WACC they do
not understand the core principles underlying the concept of WACC. Common errors made by students are as
follows:

 Many students are under the impression that a new loan is a debt instrument and will therefore not
impact the cost of equity.
 Although students were aware that the new loan will increase the cost of debt, their reasons for it were
often incorrect.
 Students often provided a long winded answer for this part but many failed to get to the crux of the
matter i.e. should the new bank loan result in weights that are closer to the target capital structure,
WACC will decrease and vice versa.
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(c) Investment decision 17 Marks
CF0 CF1 CF2 CF3 CF4 CF5 CF6 Notes
Initial capital expenditure on computer and other equipment
(€ 1 000 00/0.095) (10 526 316) (1)
Shipping cost to South
Africa (301 250) (½)
Commissioning cost (65 000) (½)
Landed cost (10 892 566) 1
Sales income 9 100 000 (1)
 (13x14 000x 50)
 x1.1 x1.04 10 410 400 (1) 2
 X1.1 11 451 440 12 596 584 13 856 242 15 241 867 (1)
Additional annual
administrative costs
 (39 000x 1.06)
(41 340) (43 820) (46 450) (49 237) (52 191) (55 322) (1) 3
Employment cost (6 233 760) (1) 4
 (13x37 000x
12)x1.08
 x1.1 (6 857 136) (7 542 850) (8 297 135) (9 126 848) (10 039 533) (1)
Retrenchment cost
(Year 6 salary 10 039
533x 6/13 x 6/12) (2 316 815) (2) 5

Sales consultants (609 500) (646 070) (684 834) (725 924) (769 480) (815 648) (1)
 (5 x 115
000)x1.06
Office rental expenditure 0 0 0 0 0 0 (Assumption 2)
Marketing department
research cost 0 (Assumption 3)
Depreciation
0 0 0 0 0 0 (Assumption 1)
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(10 892 566) 2 215 400 2 863 374 3 177 306 3 524 288 3 907 723 2 014 549 Notes
Initial working capital (725 000) (1) 6
Working capital released 725 000 (1)
(11 617 566) 2 215 400 2 863 374 3 177 306 3 524 288 3 907 723 2 739 549
:
Taxable income before tax (1) 7
and wear and tear 2 215 400 2 863 374 3 177 306 3 524 288 3 907 723 2 014 549
Wear and tear allowance (3 630 492) (3 630 492) (3 630 492) (1) 8
Taxable income (1 415 092) (767 118) (453 186) 3 524 288 3 907 723 2 014 549
Tax@28% 396 226 214 793 126 892 (986 801) (1 094 162) (564 074)
Net cash flow before
resale (11 617 566) 2 611 626 3 078 167 3 304 198 2 537 487 2 813 561 2 175 475

Assumptions:

1. Depreciation is irrelevant as this is an accounting entry only, thus has no cash flow effect.. (1)
2. Office space rental is irrelevant cost as existing premises are used and the R 300 000 represents an allocated cost/ non –
3. cash item. (1)
4. Research cost is irrelevant as the expense has already been incurred (historic /sunk cost). (1)
Discount rate (given) 19% (1)
NPV = (2 078 002) (1) if calculator steps / discount factors shown 9

Resale value (ignoring tax

recoupment)
PV= (2 078 002)
n= 6
i= 19%
FV= 5 901 030 (1) 10

Conclusion: The resale value should amount to R5 901 030 for the project to provide the required return of 19%.
Max: (17)
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It is important to read the information in the scenario carefully; this will enable you to apply the increases in the
correct period.
(1) The all-in cost to commence operations is relevant and an outflow before business starts.
(2) The efficiency improvement applied only to year 1.
(3) Costs are given in current monetary terms therefore inflation should be taken into account from year 1.
(4) The salary increase was (already) applicable to year one.
(5) This represents the monthly costs for 6 employees multiplied by 6 for the 6 years worked.
(6) Working capital incurred upfront and must then be shown as being recovered at end (unless specifically
instructed otherwise).
(7) Taxable income not applicable to year 0 and excludes working capital.
(8) Wear and tear on the full cost as specified per (1).
(9) Calculator steps or factors must be shown. The CF o layout accommodates this.
(10) A future value was required, many did not realise this.

(d) Other important factors 6 Marks

• The appropriateness/reasonableness of marketing research performed: i.e. sufficient

demand, pricing of packages, staff capacity utilisation etc (1)
• Will the selling price allow for sufficient product/coding testing time? (1)
• Influence of foreign competition, e.g. inexpensive programming services offered by firms in
India. (1)
• Computer equipment is unlikely to have a high resale value (due to high level of obsolescence
/ short life-span) (1)
• How realistic is the probability of employees being redeployed within the entity? (1)
• Possibility of any disputes arising with unions due to retrenchment. (1)
• The impact of this project and the possible retrenchment may have on D&S TEC’s reputation.
(1)
• Additional consideration should be paid to the most sensitive cash flows, identified by
performing a sensitivity analysis. (1)
• Additional consideration should be paid to the determination of the 6 year period. As an
extended/ shortened period may drastically affect the investment decision. (1)
• Consider the most appropriate form of finance for the project: that will move company closer
to its target capital structure / use excess cash. (1)
• Other available projects deriving a positive NPV should be considered. (1)
• Consider if the project is in-line with D&S TEC’s long-term strategy. (1)
• Training cost of staff may be required (due to fast-changing environment) – has been omitted
from analysis. (1)
• Any other valid factor (max 1). (1)
Max: (6)

These factors focus on the main variables of a project evaluation, taking cognisance of the industry.
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QUESTION 3 SUGGESTED SOLUTION

ISIMBI LIMITED
(Source: Exam 2012 MAC4862- adapted)

Part (a) Calculation of WACC for Insimbi

Calculate WACC based on target weights:

WACC = (K e x e%) + (k d x d%)

= [21,6% x (1 / 1,03)] + [5,8% x (0,03 / 1,03)]
(1) (1) Total: (2)
= [21,6% x 0,971] + [5,8% x 0,029]

= 21,1% Be careful not to use 3% and 100%.

Note that even though the full debt facility is not currently used by the
company the target weighting is applied here.

Calculate K e based on the adjusted Capital Asset Pricing Model:

Include small stock premium
Ke = Rf + ß(ERP) + SSP
= 8,3% + 1,5(5,5%) + 5%
(1) (1) (1) Total: (3)
=21,6%
Tax could be taken into account.

Calculate the after tax cost of debt:

Kd = 3-month JIBAR + 250 basis points, after tax

= (5,6% +2,5%) x (1-28%)
(1) (1) (1) Total: (3)
= 8,1% X 0,72
= 5,8%
Max (8)

This tested the key principles of cost of capital.

Beware and take note of the following:

• Using the correct risk free rate i.e. The calculation is done in 2012, utiling a bond with a maturity in 2015
does not make sense as it represents a short term rate, therefore the R208 should be utilised.
• The treatment of the small stock premium, many students incorrectly incorporated it into the CAPM
formula by adding it to the ERP.
• Converting the 250 basis points into a percentage, do not convert the 250 basis points to an incorrect
percentage e.g. 25%.
• Calculation of weighting, many students incorrectly weighted equity at 100% and debt at 3%.
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Part (b) Analysis (figures and percentages may not total due to rounding)

All “–“answers must show “–/+“, and correct denominator

Insimbi 2012 2011 2012 2012 2011

R R % % %
million million change revenue revenue
Revenue for the year 71,7 76,0 -5,7% (½) 100,0% 100,0%
· South Africa 53,8 52,5 2,5% (½) 75,0% 69,1% (½)
· Europe 17,9 23,5 -23,8% (½) 25,0% 30,9% (½)
Cost of goods sold (COGS) for the year (18,6) (19,2) -3,1% (½) -25,9% -25,3% (½)
Gross profit (GP) 53,1 56,8 (½) -6,5% (½) GP% 74,1% 74,7% (½)
Mineral royalty for the year (linked to (2,8) (3,0) -6,7% (½) -3,9% -3,9% (½)
revenue)
Selling and distribution costs for the year (2,7) (2,9) -6,9% (½) -3,8% -3,8% (½)
Operating profit 47,6 50,9 (½) -6,5% (½) OP% 66,4% 67,0% (½)
Production volume / Sales volume 78 83 -6,0% (½)
('000 dry tons of iron ore)

Kumbaya 2012 2011 2012 2012 2011 Kumbaya %

R '000 R '000 % % revenue % revenue revenue: Only
million million change 2012 required
Revenue for the year 42,0 46,0 -8,7% (½) 100,0% 100,0%
· South Africa 3,0 3,0 0,0% (½) 7,1% 6,5% (½)
· China 29,0 30,0 -3,3% (½) 69,0% 65,2% (½)
· Europe 3,5 5,0 -30,0% (½) 8,3% 10,9% (½)
· Other 6,5 8,0 -18,8% (½) 15,5% 17,4% (½)
Cost of goods sold (COGS) for the year (8,0) (8,7) -8,0% (½) -19,0% -18,9% (½)
Gross profit (GP) 34,0 37,3 (½) -8,8% (½) GP% 81,0% 81,1% (½)
Mineral royalty for the year (linked to revenue) (1,6) (1,8) -11,1% (½) -3,8% -3,9% (½)
Selling and distribution costs for the year (3,4) (3,7) -8,1% (½) -8,1% -8,0% (½)
Operating profit 29,0 31,8 (½) -8,8% (½) OP% 69,0% 69,1% (½)
Production volume / Sales volume 40,2 41,3 -2,7% (½)
(million dry tons of iron ore)
Kumbaya Insimbi
Kumbaya: Only 2012 required
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2012 2011 2012 2012 2011 2012
% %
change change
Selling price per dry tonne (Rand) 1045 1114 (½) -6,2% (½) 919 916 (½) 0,3% (½)
Production cost (COGS) per dry tonne (Rand) 199 211 (½) -5,7% (½) 238 231 (½) 3,0% (½)
GP per dry tonne (Rand) 846 903 (½) -6,3% (½) 681 684 (½) -0,4% (½)
Selling and distribution cost per dry tonne (Rand) 85 90 (½) -5,6% (½) 35 35 (½) 0,0% (½)
Operating profit per dry tonne (Rand) 721 770 (½) -6,4% (½) 610 613 (½) -0,5% (½)

Social and community development as % of sales 0,5% 0,3% (½) 0,1% 0,1% (½)
CO 2 emissions per production (tons CO2 per ton 0,025 0,019 (½) 31,6% (½) 0,038 0,030 (½) 26,7% (½)
dry iron ore production)

Analysis max: (18)

Comments:
• Compare year on year, good place to start, for each company
• And then from company to company
• Remember that one company is listed, so info needs to be manipulated
• State the obvious, like performed better or worse
• Choose one company as basis
This section required students to calculate ratios for Insimbi for 2011 and 2012 and for the competitor (Kumbaya) for 2012 and then comment thereon. There
were thus a large number of marks available, however most students did not read the “required” carefully and therefore either only compared Insimbi’s 2011
results with that of 2012 or compared Insimbi’s 2012 results with Kumbaya’s 2012 results.
Furthermore a ratio analysis question of this nature requires students to manipulate the financial information provided to make it meaningful and allow them
to make value added comments. Since Insimbi is an unlisted company with relatively low production levels and information was provided for a large
competitor who is listed and has large production levels, comparing the results of 2 entities will not be very meaningful. Calculating operating results per
tonne thus allows for better comparison and more insightful commentary. This was overlooked by many students.
The commentary provided by most students was vague and valid reasons for movements were not provided. Students also tend not to be explicit with their
comparisons i.e. they do not explicitly state that Kumbaya performed better/worse than Insimbi.
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Interpretation of performance

INSIMBI (I) 2012 VS. INSIMBI (I) 2011 INSIMBI (I) 2012 VS. KUMBAYA (K) 2012
RELATIVE REASON / POSSIBLE REASON
PERFORMANCE
(must be explicit)
OPERATIONAL: Revenue (R) / Selling prices (SP) / Sales volumes (SV ~ PV)
• R mainly due to SV/PV (-6%), with SP having little (1) • R: • net effect of I’sS ( P a nd  S V/P V) trum pe d K’ s (1)
effect (0,3%). I better (less (SP and SV/PV)
negative
change) (1)
• SV/PV possibly as a result of strike action. (1) • SV/PV: • I’s strike action not averted as effectively. (1)
I worse (more
negative
change) (1)
•  due to in export sales – probably due to EU economic • K has a more diversified market – in a better position
crisis (1) to weather changes in SV across markets / less
exposed to EU economic crisis (1)
•  in local sales good in light of difficult local market (1) • I had more injuries/fatalities/Section 54 work (1)
stoppages.
• Absolute level • I has lower ore quality (Limpopo vs Northern Cape) (1)
of SP per dry and/or applied less mining beneficiation.
tonne: • I exported a lower % and/or the dominance of the
I worse (1) single large SA steel producer dictating local pricing.
OPERATIONAL: Production cost / COGS / GP / GP%
• in total GP due to R , and smaller  in COGS / GP% (1) • Total GP • Mainly due to I’s R not declining as much (1)
change:
I better (less
negative
change) (1)
• GP% due to significant in the cost of electricity and fuel (1) • Absolute • I’s operations of smaller scale / I’s quality of iron ore (1)
during 2012 GP%: I lower / greater injuries/fatalities/Section 54 work
worse(1) stoppages.
• GP% due to  SV/PV / Section 54 stoppages / strike (1) • Change in • I had greater reduction in SV/PV / more Section 54 (1)
action / above-inflation wage increases GP%: stoppages / more strike action
I worse (more
downward) (1)
• Mining operations in general has high operating leverage / (1)
high % fixed cost, making gross profit sensitive to changes in
SV/PV
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OPERATIONAL: Mineral royalty
• in-line with revenue. (1) • Similar • Seems Act imposes the same mineral royalty on iron (1)
performance (1) ore, calculated as +-3,9% of revenue.
OPERATIONAL: Selling and distribution costs
• more-or-less in-line with revenue. (1) % of R: • I has lower exports (thereby necessitating less port (1)
I better (lower %) tariffs and seaborne shipping)
(1)
OPERATIONAL: Operating profit (OP)
• OP mainly due to  SV/PV (1) • Total OP: • Net effect of variables had smaller impact
I better (less negative on I; K reduced mainly due to reduction in (1)
change) (1) SP
• OP per dry tonne / OP%: • Mainly due to K’s higher SP & lower (1)
I worse (1) production cost per dry tonne

SOCIAL
• Negative performance in 2012: Fatalities and lost time due to • Safety standards / social • I has lower standards / less focus on (1)
injuries the same in spite of reduction in production volumes (1) investment / gender CSI (Corporate Social Investment)
equality: I worse (1)
• Efforts in HIV programmes, employment of women, social (1) • HIV employee’s enrolment in • Due to CEO’s drive (1)
and community matters all showed no improvement. programmes: • But not allowed to force employees to (1)
I better (1) undergo testing.
• Negative performance in corporate governance & ethics in (1)
2012 (mining rights – excessive spending / unethical /
possible bribery)
ENVIRONMENT
• CO 2 emissions per dry tonne of production increased: poorer (1) • Total CO 2 emissions & • K has greater carbon footprint due to (1)
performance for 2012. impact on environment: larger scale / greater % exports
I better (1)
• CO 2 emissions per dry • I has less efficient processes / I uses (1)
tonne: I worse (1) more polluting technology
TRIPLE BOTTOM LINE PERFORMANCE IN GENERAL
• Profit, people and the planet represent the “triple bottom line” (1) • I: weaker performance
• Triple bottom line performance generally worsened in 2012 (1) generally, compared to K (1)
Interpretation max (16)
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Part (c)

The scenario provides a large amount of information. This section provides a good opportunity for students to practice how to utilize the information to
support their discussions and earn more marks.

Key risk factor Reason why may represent a key risk Mitigation
Regulatory, • There is extensive mining regulation and legislation / reports • None for South African operations but
political and highlighting a lack of transparency and governance in (1) consider diversification of operations into other (1)
legal matters allocating SA mining rights. countries with good track record.
• Possible increase in SA mining tax and royalties / department • Early engagement with all relevant stakeholders. (1)
could revisit SA mining rights – affecting viability of operations. (1) • An effective Enterprise Risk Management system (1)
being in place to govern risk.
• Non-compliance by Insimbi could lead to legal action / • Monitor regulatory and legislative developments,
penalties / reputational harm / more Section 54 stoppages (1) and update policies and procedures to ensure (1)
compliance.
• SA political environment unstable / threat of nationalisation of (1)
mines / J. Malema / ‘wildcat’ strikes
• Possible expansion to Guinea – country ris k e xpos ure (1)
Inadequate • Would affect sustainability and growth of Insimbi’s business. (1) • Early engagement with all relevant stakeholders /
supporting • Insimbi likely to be very dependent on electricity provision / foster good working relationships (e.g. with (1)
infrastructure infrastructure for transport of iron ore.) (1) Transnet).
• Could increase production costs (e.g. more expensive (1) • Negotiate risk-mitigating agreements (e.g. ESCOM (1)
transport / electricity). electricity price linked to iron-ore / commodity pricing)
Impact on the • Through associated blasting, dust, noise and storage of waste • Intimate knowledge of laws and regulations / foster
environment water, operations may harm the environment; and/or affecting a culture of compliance and risk management. (1)
water purity, air purity, employees and communities. (1) • Implement a sustainability unit / hire
an environmental specialist. (1)
• Non-compliance by Insimbi could lead to legal action / • Obtain insurance against key risks (but consider the (1)
penalties / reputational harm. (1) cost-benefit)

• Impact on earnings/exposure from impairment of assets / (1) • Any valid environmental recommendation (1)
underestimating rehabilitation cost.
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• Foreign • Accounting issues and / or economic losses from exposure to (1) • Apply foreign exchange hedging techniques, e.g. (1)
exchange changes in foreign exchange rate (exports are not priced in currency futures, currency forwards, currency swaps,
rands, but in US dollars). or currency options.
• Attempt matching of US dollar inflows from
exports, to US dollar outflows (e.g. shipping costs) (1)
and to finance denominated in US dollars
(but consider low debt in target debt:equity ratio) (1)

• Commodity • Fluctuations in the price of iron ore and/or freight rates could (1) • Constant monitoring of markets (local and foreign) (1)
price and occur. • Negotiate long-term supply agreements. (1)
demand
• Commodity price and demand could vary due to global (1) • Consider diversify mining operations (e.g. in the
economic growth / product substitution (steel replaced for a Northern Cape) to facilitate easier export / diversify
different material). export markets (consider exports also to China) (1)
• Insimbi is more exposed due to a limited client base (SA and (1) • Hedging the foreign currency input cost of any (1)
Western Europe only). commodities used by Insimbi.
• Base of operations (Limpopo) is not well geared towards (1)
exports (infrastructure / further from the port).
• Growth projects may not be viable at weak commodity prices (1)
(projects take a long time to implement).
• The financial woes of the large SA steel producer may impact
on demand of Insimbi’s iron-ore / possible government
regulation of iron-ore prices. (1)
• Employees’ • Significant injury or fatalities can occur due to hazardous • Promote continuous safety awareness / provide
health and operations. (1) proper training / implement proper safety policies and (1)
safety procedures.
• High occupational health risk from continuous exposure to (1) • Provision of proper occupational safety
noise and dust. equipment, facilities and medical surveillance (1)
programmes.
• Compliance risk from failure to comply with developing • HIV/AIDS: Provide easy access to ARV drugs,
standards and proper health management (HIV/AIDS) (1) confidential counselling (1)
• These matters could lead to legal action / penalties / • Do not force employees to go for HIV testing / run
reputational harm / lower staff morale / lower productivity. (1) education and awareness programmes (1)

Overall max. (24)

(With acknowledgment to the 2012 Integrated Report of Kumba Iron Ore which was consulted in the preparation of this part.)
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Part (d) Corporate governance and ethical behaviour
Marks
• Negative aspect: Several recommendations of the King Code of Governance Principles for
South Africa 2009 (King III) are not implemented by Insimbi. (½)
Recommendation: While compliance remains essentially voluntary, Insimbi should preferably
apply the recommendations, and preferably explain where it did not. (½)
• Negative aspect: Insimbi’s CEO is also the chairman. (½)
Negative aspect: Insimbi’s CEO is not independent and is a key shareholder. (½)
Recommendation: Per King III – chairman should be a non-executive director. (½)
• Negative aspect: CEOs salary not approved by the remuneration committee and may be (½)
excessive.
Recommendation: Per King III – sufficient committees tasked with governance should exist in
the company (including a remuneration committee). (½)
• Negative aspect: Mr West forces employees to undergo HIV testing. This may (½)
represent intimidation and is illegal, increasing the legal risk of the company.
Recommendation: Promote confidential counselling and testing to employees with HIV/AIDS. (½)
• Negative aspect: Possible excessive company spending on acquiring mining rights in SA by Mr
West. (½)
Negative aspect: Leveraging of political connections to obtain rights possibly illegal / a bribe.
This may be unethical and may expose the company to legal action / penalties / reputational
harm. (½)
Recommendation: Expenditure should be approved and only legal and ethical methods used to
obtain additional mining rights. (½)
Max. (5)

Every negative aspect should be followed by a clear and realistic recommendation.

Part (e) Country risk components to be considered before investing in the Republic of Guinea

• Currency risk and the risk resulting from inflation, including devaluation and volatility in (1)
the local currency.
• The credit risk of the government and related credit rating, including the possibility of (1)
defaulting on international debt funding.
• Social tensions or political problems. (Specifically resulting from the fact that it is a poor (1)
nation.)
• Possibility of government expropriation and nationalisation of private assets. (There are (1)
strong rumours of seizures of mining rights there)
• The mining regulatory environment and possible revisions in the near future. (Guinea’s (1)
Mining Code offers the government free participation making it restrictive.)
• Potential barriers to free capital flow in and out of the country. (1)
• Skills shortage (1)
• Lack of supporting infrastructure (specifically electricity, railways and ports) (1)
• International perceptions and sanctions (1)
• Guinea is a former French colony, which may create a cultural and language barrier. (1)
Max (4)
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Part (f) Cost effectiveness of bond issue

Factors to consider:

 At a CTA level it is important for you to understand S24J and its application. Many students either incorrectly applied S24J or did not take into account at all.
 The “Required” states that you should determine whether the proposed bond issue is cost effective, therefore you cannot only perform calculations but also need to conclude on the results
of the calculation in conjunction with the information in the scenario.
Marks
Step 1: Determine the yield to maturity (YTM) on the instrument on a pre-tax basis for purposes of Section 24J
Period: 0 1 2 3 4 5
R'm R'm R'm R'm R'm R'm
30,000
Bond issue price
(2,250) (2,250) (2,250) (2,250) (2,250) (½)
Interest 7,50%
(33,000) (½)
Redemption 110%
30,000 (2,250) (2,250) (2,250) (2,250) (35,250)

I/YR or IRR/YR: Correct calculator steps shown (1)

YTM pre-tax per annum 9,165%
Step 2: Determine the after tax YTM on all finance-related cash flows (incl tax effect)
30,000 (2,250) (2,250) (2,250) (2,250) (35,250)
Cash flows from above
(1,200) (½)
Transaction and other issue cost 4%
0,336 Or 0,336 (½)
Tax on issue cost (28%) 28% Incl in period 0 or 1
0,770 0,783 0,797 0,812 0,829
Tax effect of S24J 28% (1)
2,750 2,795 2,845 2,900 2,959
Accrual amount for this period (A = B x C) (2)
30,000 30,000 30,500 31,045 31,640
Opening balance
0,000 2,750 2,795 2,845 2,900
Prior accrual amounts (2)
0,000 (2,250) (2,250) (2,250) (2,250)
Prior actual interest payment
Closing balance (C) 30,000 30,500 31,045 31,640 32,290
Pre-tax YTM (B) 9,165% 9,165% 9,165% 9,165% 9,165%

28,800 (1,144) (1,467) (1,453) (1,438) (34,421)

Finance-related cash flows
I/YR or IRR/YR: Correct calculator steps shown
YTM post-tax per annum 7,302% (1)
Conclusion on cost-effectiveness:
• This rate far exceeds the rate of the revolving credit facility (of 5,8% calculated in (a)), indicating that it may be cost-prohibitive. (1)
• But bank may not be willing to increase the size of the revolving credit facility, in facility amount, or at this rate. (1)
• However, in the case of an upwards slope in the yield curve, as is the case for SA (yields on government bonds increase as maturity increases), one would expect a slightly higher rate in (1)
the case of a longer maturity date (all other factors being equal).
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Appropriateness of bond issue (matters besides cost) Marks

• Due to large operating risk Insimbi has a low target debt:equity ratio, indicating that little debt can (1)
be accommodated. Insimbi may far exceed its target ratio if the bonds are issued.
• Increased debt (fixed interest payments and redemption in 5 years) could put additional pressure (1)
on cash flows, which is risky considering high operating risk.
• The bond issue terms and conditions are largely based on that of the retail industry, not the (1)
mining industry. As a result there may be insufficient demand for these bonds based on these
terms and conditions.
Perhaps if the bonds were changed to convertible bonds it may be more appropriate. (This would (1)
then represent hybrid capital – closer to equity in form.)
• The liquidity risk on the bond issue would be lower than for the revolving facility (which is (1)
repayable on demand).
• What will the company use the financing for? The market is often hesitant to invest in equity or (1)
bonds, where no clear purpose exists.
• Will sufficient security be available, since the revolving credit facility is also secured? (1)
• The impact of the security clause and debt covenants on the company should be analysed in (1)
detail.
• The current revolving-credit facility is not fully utilised (1)
But a bond issue would extend the maturity date (which may offer cash flow relief if necessary). (1)
• The bond’s fixed interest – decreased interest rate risk and offers more certainty (1)
Max. for this section (4)

Ensure that the above factors focus on matters other than costs as per the “Required.”

Part (g) Listing arguments based on Facebook IPO Marks

Argument against listing in the very near future:

• Issue: Timing of the listing. (1)

Discussion: Given its recent history, if Insimbi is attempting to list in the very near future, like the
Facebook IPO it might also be attempting to “push” the sale of its shares, rather than “pulling”
investors in an invitation to purchase. Insimbi’s current competitive position may not support a
listing in the near future. (1)

Argument for listing in the very near future:

• Not an issue: Insimbi has a clear investment plan (expanding mining) (1)
Discussion: Facebook raised capital without a clear investment plan. Insimbi should
therefore raise capital for a specific purpose. (1)
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Conditions for a successful listing:

• Pricing of share issue: Judging from the loss in value of its shares within one month, Facebook (1)
overpriced its shares. Insimbi should price its shares reasonably.
• The way to future growth: Facebook’s route to future economic growth is unclear. Insimbi
should clearly outline and demonstrate its ability to implement a growth strategy. (1)
• Proper balance of institutional and other shareholders: So far, few institutional investors exist for
Facebook. Insimbi should focus on obtaining a proper balance of shareholders. (1)
(For example, a private placing may help to ensure a stable, long term shareholding and may also
facilitate future rights offer.)
• Proper management team / governance: Facebook has strong leadership in the form of Mark
Zuckerberg. Does Insimbi have proper corporate governance and is Mr West a strong
leader, especially considering his potential unethical behaviour? (1)
• Must comply with JSE listing requirements (1)

For example: Any correct example below (1)

Main Board / Africa Board AltX
Share capital R25m R2m
Profit history 3 years None
Pre-tax profit R8m N/A
Number of shareholders 300 100
Max: (6)

Do not place a mind dump of what went wrong with the Facebook IPO. Identify why the Facebook IPO was not
very successful and then advise Insimibi on how they could avoid making similar mistakes. Note also the three
clearly identified sections i.e. arguments against, arguments for listing and conditions for a successful listing.

(h) Key areas to be included in an Integrated Report

1. Organisational overview / business model / governance structure Either of these

(½)
2. Governance / remuneration Either of these
(½)
3. Operating context / risks / opportunities Either of these
(½)
4. Strategic objectives / strategies to achieve those objectives Either of these
(½)
5. Competencies / KPIs (Key Performance Indicators) / KRIs (Key Risk Indicators) Either of these
(½)
6. Account of the organisation’s historical performance / annual report Either of these
(½)
7. Future performance objectives (½)

8. Future outlook (½)

9. Sustainability / environmental / social matters Either of

these (½)
Max: (4)
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QUESTION 4 SUGGESTED SOLUTION

FUNKY FASHIONS LIMITED

(Source: Exam 2012 MAC4861 – adapted)
Part (a)

Students often applied their book knowledge without reference to the given scenario and industry: e.g.
Students discussed forex risk as the weakening of the Rand and did not make the link to the buying activity
of this business.

Risks Discussion Risk management

Identified
Increased Various international FFL should ensure that they sell the right (6)
competition fashion retail chains have fashion in their stores so as to continuously
(1) been entering the South attract customers. (1)
African market (i.e. Zara, Furthermore FFL is considering retailing one
GAP etc.) and are expected of the international clothing lines (Fara),
to continue to do so. (1) should this prove to be successful they will
OR obtain a competitive edge. (1)
Chinese products cheaper. Source quality at value. (1)
(1)
Rapid The clothing retail industry FFL should manage their inventory by (5)
changes in is exposed to rapid changes frequently reviewing itemized sales reports by
fashion and in fashion and trends, store and clothing type. The buyers can then
trends. rendering inventory use this information to identify popular
(1) obsolete within a short items as well as slow moving stock. This
period of time. (1) will enable them to maintain a high level of
turnover, keeping clothing in the stores up to
date. (1)

FFL needs to ensure that demand and

supply management function optimally
and effectively thereby reducing product
obsolescence. (1)

Furthermore FFL should implement efficient

distribution facilities to ensure that the
supply chain remains fast and reactive to the
needs of stores and customers. (1)
Misinterpre- If fashion trends are not Since South Africa predominantly follows (3)
tation of correctly interpreted, this fashion trends of the US and Europe, which
fashion could result in the purchase is one season ahead, FFL should ensure that
trends of inappropriate inventory sufficient research is conducted within
(1) and large financial losses these continents to identify the latest fashion
and reputational damage trends. (1)
could occur. (1)
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Risks Discussion Risk management
Identified

Or said differently but still making the

same point:
Fashion trends are predominantly conceived
in European and US markets, and developing
countries such as SA usually follow these
trends. It is therefore important that
international research is conducted
thoroughly.

Crime/ South African retail stores Increased attention should be paid to (5)
Security are increasingly being improving security measures and controls
breach (1) targeted by criminal and staff should be required to be more
activities such as theft, vigilant and alert. (1)
robbery and fraud. This FFL should provide staff training on how to
results in large losses and deal with armed robberies (1)
can prove to be very FFL should encourage the use of an
traumatic for staff. (1) anonymous toll-free whistle-blowing facility
for the reporting of criminal acts. (1)
Bad Debts Most fashion retail outlets Since FFL is predominantly a cash business (4)
(1) supply clothing on credit. their risk exposure to bad debts is limited. (1)
Given current economic They should however ensure that credit is
conditions the risk that a granted in a responsible manner taking
large number of customers into account customer affordability in light of
will not pay or will not pay the National Credit Act. (1)
on time will increase. (1)
Compliance With the introduction of the FFL should have a compliance team/ (4)
with new Consumer Protection division to ensure that the entity implements
legislation Act, the risk of legal the required systems and procedural
(1) liability has increased for changes and that staff are adequately trained
retailers supplying to the to ensure compliance with the applicable
public. (1) legislation and changes thereto. (1)
Health and safety compliance (1)
Shop Accessibility/pricing (1) Client profile accommodated (1) (4)
location (1) Transport routes available (1)
Forex risk (1) Imports of clothing material Hedge by way of FEC contract, options (3)
exposes entities in the futures etc (1)
industry to changes foreign
exchange rates.(1)
Additional risks to be considered: supply, economics, brand, cash sales.
1 each Max (3)

Available (38)
Max (18)
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Part (b)

Where two years are given, it is sound practice to compare the years to one another, but also to consider
the movement from the base year. This broadens the scope for discussion.

2012 2011 Movement

1. Growth in share price

FFL 39,34 - 30,65

30,65
28% (1)

Competitor 66,48 - 50,99

50,99

30% (1)

Growth must not be measured against the incorrect base eg. R39,34.

2. Earnings per share

FFL 592 219 000 413 891 000

205 686 900 205 686 900
R2,88 R2,01 43,28%
(1) (1) (½)
3 Price Earnings multiple

FFL 39,34 30,65

2,88 2,01
13,66 15,25 -10,43%
(½) (½) (½)
4 Competitor EPS

Price = PE
Earnings
66,48/x = 15 50,99/x =15

Therefore EPS = R4,43 R3,40 30,29%

(1) (1) (½)

Available 8,5
Max 6
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Discussion and commentary

At this level it is not acceptable to state the obvious eg: ‘the EPS increased from 2011 to 2012’.
Insight is required and consistent reading of financial matter will assist.

• FFL's share price is growing at a lower rate (28%) than that of its competitor (30%).
This implies that the FFL share is not performing as well as that of its competitor. (1)
• FFL’s EPS is however growing much faster than that of its competitor (43% vs.
30%). The growth in the share price is therefore lagging the growth in EPS, which can
be seen from the negative growth in FFL's PE multiple. (1)
• On the other hand the growth in competitor's share price (30%) is consistent with
its growth in terms of EPS (30%) of and it thus has a constant PE multiple. (1)
• This raises the question as to FFL’s ability to sustain a high earnings growth of
43%. (1)
• The lower PE multiple confirms that the market does not believe that the current
high growth in earnings of FFL is sustainable. The low PE multiple indicates that
lower growth or higher risk is expected in the future of FFL compared to its
competitors. (1)
• All the information taken together implies that the competitors share price is a
reasonable market value, whereas the share price of FFL is mostly likely trading at a
discount. (1)

Conclusion

Investing in FFL may not be a good idea as earnings growth may not necessarily be
maintainable, therefore future growth in the share price is unlikely. Investors should thus (1)
invest in FFL’s competitors.
Available (7)
Max (6)

Part (c)

Students must be able to distinguish clearly between organisations operating on a cash, credit or hybrid
system and how it impacts on their business model. When you shop, think about what happens from the
businesses’ perspectives.

The following advantages arise from selling predominantly on a cash basis:

• During bad economic times FFL will not struggle to collect a large debtor’s
book/bad debt low. (1)
• FFL are likely to have large cash inflows and these can be utilised to expand
(reinvest) or reducing the need for financing (e.g. Overdraft). (2)
• FFL are likely to have less legal compliance issues, specifically with regards to the
National Credit Act. (1)
• FFL can save costs as they wouldn't be required to spend large amounts on
debtors, i.e. Statements, collections etc. (1)
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• FFL can offer cheaper prices to customers as credit risk and timing mark-ups do
not need to be added to the price of goods, i.e. Cheaper than credit retailers. (1)
• FFL would have a better liquidity position as cash is received at the time of sale
for the majority of sales while purchases can be made on credit.
• Can pay suppliers cash or earlier and receive discounts. (1)
• Dividends can be paid regularly. (1)
• FFL are not likely to have any provision for bad debts, this result in improved
profits. (1)
Available (9)
Max (5)

Part (d)

Calculations

1. Forward rates

(ZAR/FC)t = (ZAR/FC)0 x (1+rt)^t

(1+Ft)^t

(ZAR/FC)2 = 12,06 x (1+5,97%)^2

(1+0,44%)^2
13,42

(ZAR/FC)3 = 12,06 x (1+6,24%)^3

(1+0,55%%)^3
14,23

(ZAR/FC)4 = 12,06 x (1+6,51%)^4

(1+0,8%%)^4
15,03

(ZAR/FC)5 = 12,06 x (1+6,75%)^5

(1+1,05%%)^5
15,87

Students were generally unable to calculate these rates and often got the same rate throughout the period.
This was clearly not sensible.
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2013 2014 2015 2016 2017
Part (d) Calculation: R R R R R
Cost of Sales
Note CF0 CF1 CF2 CF3 CF4 CF5
1 20 000 000 21 000 000 22 050 000 23 152 500 24 310 125 (1)
12,77 13,42 14,23 15,03 15,87 (1)

255 400 000 281 820 000 313 771 500 347 982 075 385 801 684 (2)
Working Capital
Sales 2 400 000 000 428 000 000 457 960 000 490 017 200 524 318 404
12 % of sales 48 000 000 51 360 000 54 955 200 58 802 064 62 918 208 (1)
Movement 3 (48 000 000) (3 360 000) (3 595 200) (3 846 864) (4 116 144) 62 918 208 (3)

Incremental Movement (1) LOGIC MARK

Tax Calculation
Sales 400 000 000 428 000 000 457 960 000 490 017 200 524 318 404
Cost of sales (255 400 000) (281 820 000) (313 771 500) (347 982 075) (385 801 684) (1)
Print media (900 000) (954 000) (1 011 240) (1 071 914) (1 136 229)

Television ads (5 000 000) (5 300 000) (5 618 000) (5 955 080) (6 312 385) (1)
Marketing cost (25 000 000) (1)

Wear and tear on

refurbishments 4 (20 000 000) (20 000 000) (20 000 000) (20 000 000) (20 000 000) (1)
Wear and tear on
license 5 (63 850 000) (63 850 000) (63 850 000) (1)
Taxable income 29 850 000 56 076 000 53 709 260 115 008 131 111 068 106
Tax@28% 6 8 358 000 15 701 280 15 038 593 32 202 277 31 099 070 (1)
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2013 2014 2015 2016 2017

R R R R R
CF0 CF1 CF2 CF3 CF4 CF5
Exclusive right (12,77) 7 (191 550 000) (1)
Research cost (sunk cost) 8 (1)
Sales 400 000 000 428 000 000 457 960 000 490 017 200 524 318 404 (1)
Cost of sales (255 400 000) (281 820 000) (313 771 500) (347 982 075) (385 801 684) (1)
Upfront marketing costs 9 (25 000 000) (1)
Print media (900 000) (954 000) (1 011 240) (1 071 914) (1 136 229) (1)
Television ads (5 000 000) (5 300 000) (5 618 000) (5 955 080) (6 312 385) (1)

Store refurbishments 10 (100 000 000) (1)

Working capital (48 000 000) (3 360 000) (3 595 200) (3 846 864) (4 116 144) 62 918 208
Tax (8 358 000) (15 701 280) (15 038 593) (32 202 277) (31 099 070)
(173 000 000) (64 568 000) 120 629 520 118 673 803 98 689 710 162 887 244
NPV@ 15,5% 73 244 534 (1)
Since the project yields a positive NPV it should be accepted (1)
MAX 18
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(11) No increase in cost of sales is unrealistic.

(12) Sales should follow the same pattern as COS.
(13) The initial working capital has to be paid upfront before production/sales start. Thereafter it is an
incremental change which a vast number of students cannot
comprehend. At the end of the period this investment must be shown as recovered (cash inwards)
unless it is stated that the inventory has been used.
(14) W & T specified, but often incorrectly calculated.
(15) W & T on license ignored or not calculated in terms of specification.
(16) Tax rate often not shown; where the question has a tax rate other than normal, it becomes
especially problematic.
(17) This is the equivalent of the cost plus transport/installation in manufacturing scenarios.
(18) The research cost is incurred before the project is assessed and consequently irrelevant as it has
no impact on the outcome.
(19) Often listed in the incorrect period; this cost is directly related to the project and its outcomes.
(20) The stores must be refurbished before trading can start.

Qualitative considerations

• Potential increased competition to FFL's existing clothing line, if Fara becomes a

competitor or is sold by a competitor. (1)
• If FFL accepts the investment proposal from Fara they will be exposed to volatility in
earnings due to the impact of foreign exchange. (1)
• The relationship with Fara could open doors for FFL i.e.:

 It can provide advertising in foreign markets as the sole South African retailer of
Fara – expand the current operations of FFL into new regions. (1)
 Their clothing could to be exported to the foreign market via Fara [sales]. (1)

• FFL's sales could possibly increase due to their affiliation with a large international fashion
house, i.e. improve market perception of FFL [association].
- Expand FFL as a branch. (1)
• A large number of upfront costs are required to be incurred; FFL would need to consider
whether they are in a financial position to incur such costs and what the effect would be on
their liquidity. (1)
• Logistic implications of holding the stock and the risk of obsolesence. (1)+(1)
• Potential refurbishments of stores after the 5 year period. (1)
• FFL may have to consider having to change their business model as there may be an
increased demand for credit sales. (1)
• Inflation remain as estimated. (1)
• Any other relevant issue (1)
• Time, contract, impact, etc Max (2)
Available (14)
Maximum (25)
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QUESTION 5 SUGGESTED SOLUTION

CWC LIMITED
(Source: Supplementary Exam 2011 MAC4862 - adapted)

Exam technique notes:

Remember to stick to the time allowed per allocated marks. Also do not look at the solution before
the allocated time has expired and you have attempted the question in full.

Note 1: What were you provided with in this question? (N1)

N1: By asking yourself this, it will allow you to process all the information in the scenario thereby assisting
you to analyse the facts.

• Background information about the client:

 Founded in 1978
 Provides the services of tax, assurance and consulting
 Medium size firm

• Implementation of the Companies Act (less companies require audits) required a change in
business focus:

 Change implemented in the last 6 months of 2011

 Expansion of consulting function to include advice regarding technology, sustainability,
risk and compliance
 Appointment of new staff members in advisory, incl. Sarah Walker who has no advisory
experience
 Advisory income increased from 10% of total revenue to 20%
 Audit income declined from 70% of total revenue to 60%
 Tax income remained at 20% of total revenue

• Extract from the Statement of Comprehensive Income (N2):

N2: Potential for questions to be asked regarding analysis of revenue.

 Revenue in the 1st 6 months of 2011 increased by 10% compared to the 1st 6 months of
2010
 Revenue was earned consistently in 2010
 Salaries increased by 8%, the reaming increase
in salaries relate to the appointment of advisory staff

• Current interest rates (N3):

N3: Potential for questions to be asked regarding an assessment of the swap agreement.

CWC Fulcrum
Fixed interest rate 12,5% 13,5%
Variable interest rate Prime +1 Prime + 0,5%
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• Details of a swap agreement:

 CWC Ltd will pay interest at prime to Fulcrum Ltd.

 Fulcrum Ltd will pay interest at a fixed annual rate of 12% to CWC Ltd.

• Client enquiries

N4: Potential for questions to be asked regarding how the advice of CWC could have helped avoid these
issues.

 JD Ltd merged with a competitor and is experiencing problems post-merger (N4).

The following problems experienced have been mentioned:
 Compatibility of software
 Employees claiming unfair dismissal
 Investigation by the Competition Commission

N5: Potential for questions to be asked regarding the calculation of required return.

 BM Ltd (wholly equity financed), considering purchasing Megamart (70% equity, 30%
debt) (N5). The following information is provided:
 Risk free rate
 market return
 Beta of BM Ltd

N6: Potential for questions to be asked regarding an assessment of the acceptability of each fleet.

 CA Ltd wishes to purchase one of two fleets i.e. Captain Moses or Captain Eye. The
following information relating to each fleet is provided (N6):
 Initial investment
 Remaining lifespan
 Annual cash flow (current monetary terms)
 WACC (real and nominal)

N7: Potential for question to be asked regarding the critical analysis of the valuation performed.

 W&B Ltd performed a valuation of a 100% shareholding in Wow-Disney (N7).

 The following information relating to Wow Disney is provided:
 An extract of the Statement of Comprehensive Income and
notes relating thereto
 General information and projections
 A free cash flow valuation and supporting calculation

Note 2: Read the required carefully

Keep in mind:

1. The required section usually follows the same flow as the scenario.
2. The marks shown will be indicative of the time to be spent on a particular section. It is essential
for you to calculate the amount of time you should spend per section and to stick to these time
limits. Pay attention to the critical words e.g. calculate, evaluate, advise and so on.
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Note 3: What is required? (N8)

N8: This will enable you to break down the “Required” and obtain a thorough understanding of what is
required.
Students often provide valid arguments that do not relate to the required and thus does not earn marks.

Part A:

(a) This part relates to JD Ltd. It firstly requires the identification of a procedure that should
have been performed prior to the merger to identify any risks and then an explanation of how
the steps in this procedure would have assisted JD Ltd with the problems they are
encountering.
(b) This part relates to BM Ltd, it requires the calculation of the cost of equity of Megamart and
an explanation of why this would be higher or lower than BM Ltd. You would therefore need to
explicitly state whether the ke of BM Ltd is expected to be higher or lower.
(c) This part relates to CA Ltd, it requires an evaluation of the acceptability of each fleet and a
conclusion on the best option. Both calculations and a discussion are required.
(d) This part relates to CA Ltd, it requires a discussion of whether it would be in the best interest of
the shareholders to only accept one fleet based on the fact that the company refuses to
incorporate debt into their capital structure. Note only discussion required thus no
calculations.
(e) This part relates to W&B Ltd, it requires an evaluation of the valuation performed by providing
comments on errors in calculation and principle made. Note only commentary is required,
not a re-performance of the valuation.
(f) This part relates to W&B Ltd, it requires a calculation of the market value of the debentures.

Part B (N9):

N9: This part relates to CWC Ltd.

(a) How will the implementation of the new Companies Act increase the business risk of the
entity?
(b) Calculate and comment on the impact of the new companies act on revenue and employees
costs.
(ci) Determine whether a swap agreement would be feasible
(cii) Calculate and conclude on the financial advantages of the proposed swap for both parties
(ciii) Discuss other factors CWC should have considered before entering into the swap

PART A

(a) JD Ltd
CWC could have assisted JD Ltd by performing a due diligence investigation prior to the
merger and acquisition. (1)
Max 1
The first step is identification, where information is gathered and risks are
identified. (1)
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By performing this step JD Ltd would have identified the initial risks prior to the
merger. (1)

It would in this case have included reviewing minutes of management and board
meetings – this may have identified the issues which now have come to the fore. (1)

• The second step is the consideration of legal aspects, compatibility issues

(business, culture, ITC, etc) contractual aspects and insurance. (1)

By performing this step JD Ltd could have obtained legal advice with regards to
the dismissal of certain employees and could have avoided the lawsuits from
employees claiming to have been dismissed unfairly. (1)

This step would have also assisted to ensure that approval is first obtained from the
Competition Authorities before the merger is pursued. (1)

• The third step includes the summarising and analysing of all the financial
data. (1)

This step would assist in further identifying JD Ltd’s exposure to risk and includes
a comparison between old and new insurance policies. (1)

• Step four only occurs after the merger and acquisition was finalised and includes
visiting the new location and streamlining compatibility and administration
issues. (1)

This step would have assisted JD Ltd to successfully plan and budget for the
integration between the two accounting software packages. (1)
Max 8
Available 10

The information in the scenario highlighted the issues being experienced i.e.
compatibility of software, lawsuits from employees and approval from the Competition
Commission. Students were thus required to use this information to develop steps that
would identify the issues prior to the merger and thus prevent them from occurring.

(b) BM Ltd

A: Calculating MegaMart’s beta

β G = β u x [E + D (1-t)]/E
β G = 0,8 x [70 + 30 (1-0,28)]/70]
= 1,047 (2)

B: Calculating cost of Equity

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Many students stated that since debt is cheaper than equity the cost of equity of Megamart would be lower;
this is incorrect as the cost of equity will be higher but the WACC will be lower.
Remember that Ke is the return that equity investors expect for their risk.

Ke = Rf + β (Rm – Rf)
= 8,1% + 1,047 (14% - 8,1%)
= 14,28% (2)

MegaMart’s cost of equity is expected to be higher than that of BM Ltd (1)

as the incorporation of debt in the capital structure exposes the equity holders of MegaMart
to greater systematic risk (in the form of financial risk). (1)
Max 6
Available 6
(c) CA Ltd

It is important to show your calculator inputs and to indicate correct in/outflow

Calculating projects NPV

Captain Moses Ltd’s Captain Eye Ltd’s

fleet Fleet
Cf 0 (150 000 000) (320 000 000)
Cf1-6 (CM) 55 000 000
Cf1-12 (CE) 70 000 000
I 10% 13%
(1) (1)
NPV 89 539 338 94 235 291
(1) (1)

Calculation of Annualised NPV (on the assumption that the fleet will be replaced in
future)
Captain Moses Ltd’s Captain Eye Ltd’s
fleet fleet
PV (89 539 338) (94 235 291) (1)
N 6 12 (1)
I 10% 13% (1)
PMT =? 20 558 893 15 924 453
(1) (1)

Max 6
Available 9
Alternative :
NPV
Annuity factor
Available 5
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Evaluation and conclusion:

• Given sufficient funds both fleets would represent good investments and should have
been accepted, as both have an NPV > R0. (1)
• As CA Ltd will only invest in a single fleet, Captain Moses Ltd’s fleet will represent a
better investment as it offers a higher annualised NPV, given its risk profile. (1)
• CA Ltd should consider their appetite for risk (Captain Moses Ltd’s fleet represents
lower risk than Captain Eye Ltd’s fleet). It should also consider its target WACC and the
effect of the fleet investment thereon. (1)
• CA Ltd should consider the effect of the fleet on existing operations: are their
opportunities for synergy, diversification, expansion, etc. (1)
• The opinion of Mr. Awesome’s son-in-law cannot be accepted unilaterally, but should
take into account other aspects such as lifespan, risk appetite, risk-return relationship,
etc. (1)
• CA Ltd’s available funds and alternative investment opportunities. (1)
• Any other valid point. (1)
Max 5
Available 7

Many students incorrectly utilised the nominal WACC to discount the cash flows, since annual cash
flows were provided in current monetary terms, a real WACC had to be utilised.
Furthermore many students based their conclusions on NPV only. The fleets were mutually exclusive
and had different life spans therefore the conclusion had to be based on annualised NPV.
Comments were often not applicable to the given scenarios.

(d) CA Ltd

• Shareholders’ best interest normally means to maximize shareholder’s wealth via the
share price. (1)
• A target debt:equity ratio should be formulated for CA Ltd taking cognizance of:

o The company’s business risk and volatility of its operating cash flow. (1)
o Ability to absorb finance risk: If business risk is high / operating cash flow volatile
additional gearing will increase risk as there would be a greater possibility of not
meeting a fixed repayment schedule. (This might decrease shareholder value.) (1)
o The capital structures of similar listed entities (if any), industry factors,
competitors, etc. (1)

• If CA Ltd applies an actual capital structure equal to the target structure, it should
maximize shareholder value. (1)
• The company would want to undertake all positive NPV projects if it had sufficient
finance. (1)
• This, in theory, would increase the share price. (1)
• Consider the cost and availability of debt finance for the shipping fleet (specialized
debt finance is normally available where these assets are used as security). (1)
• Raising additional debt finance might involve issue costs which will increase its
associated cost. (1)
• Consider the tax position as debt interest is deductible for tax purposes but if the
company does not have taxable income to set it off against, it makes debt finance less
attractive. (1)
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• The need to respond to situations (issue of flexibility) as they arise may be important in
the industry. Debt financing is often long term with structured repayments and
interest, which can then affect operational choices and limit opportunities to undertake
more profitable projects in the future. (1)
• Consider how the incorporation of gearing will affect the company’s existing dividend
policy and shareholder preferences in this regard. (1)
• Valid discussion from an equity point of view (2)
Max 9
Available 14

This part was poorly answered by students as most students only took into account the fact that
debt would result in a higher financial risk and would thus be bad. While debt does increase
financial risk if it is incorporated at or close to the target debt to equity ratio, it results in many
benefits as discussed.

(e) W&B Ltd

This part required students to go through the provided free cash flow valuation line by line and identify
the errors made by making use of the supplementary information and the calculations provided. Note
the flow of items listed to avoid haphazard comments.

Calculation / principle errors

1. The figures used for the working capital are all inflated by 1 000 times (“R‘000”). (1)
2. The working capital balances are incorrectly included as cash flow movements, thereby
grossly misstating the cash flow. (1)
3. The working capital will not be recovered in year 5 as the company is not expected to
close down at the end of the 5 year period (we incorporate a continuing value also). (1)
4. Based on the (incorrect) free cash flows the calculation of NPV results in a negative
value of R21 523 528k, instead of a positive value shown. (1)
5. Depreciation, impairment and amortisation or non-cash items/ accounting entries
should be added back to the Net Profit before tax. (1)
6. The long-term finance cost should be excluded (added back to Net Profit before tax) as it
forms part of the calculation of the WACC. (1)
The valuation performed included the effect of interest expense in the forecast (reducing
value) and again deducted the value of debentures in determining value. Based on
available information it is not possible to differentiate between long and short-term
interest expense. We should therefore rather exclude total interest paid as part of
projections and then deduct the market value of debentures and bank overdraft on the
valuation date, in determining the value of equity. (1)
7. Finance income/interest received should rather not be included in the forecast; the
investment should preferably be valued and added separately. (1)
8. Surplus cash should also be added separately. (1)
9. The fixed assets cash movement (W2) should be adjusted for depreciation. (1)
10. The purchase of fixed assets should be a cash outflow and not an inflow (and inverse
for disposal). (1)
11. Tax paid should be adjusted for the long term interest (or all interest) and investment
income (linked to discussion above). (1)
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12. The taxable amount is already included at 28% and should thus not be multiplied by
28% twice as done in W1. (1)
13. The cash flow should not include the 2011 figures as the cash flow should be based on
future cash flows (it was incorrectly included in the calculation of the NPV as Cf0). (1)
14. The 12% loan rate was incorrectly used to discount the cash flows, as this rate is pre-tax
and further ignores other forms of capital. (1)
The target WACC should have been used. (1)
15. Gordon’s growth method was not applied in the calculation of the continuing value
• Cf year 5 should increase with growth (1)
• the discount rate should be reduced with the growth rate (WACC – g) (1)
• incorrect discount rate of 12% was used – WACC should have been used (1)
16. Terminal value was not discounted /not accounted for in the correct period. (1)
17. Calculation of market value of preference share:
• The FV should not be multiplied by 100%/106%; rather should be multiplied by
(100%-6%), giving -R47 000 000 as the preference shares are being redeemed
at a discount. (1)

18. Net value after preference share incorrectly shows “enterprise value”. (If value of
debentures also deducted then this should be “unadjusted value of 100% equity
share.) (1)
19. Valuation failed to incorporate a marketability discount, which might be relevant here.
(1)
Max 20
Available 23
(f) W&B Ltd

Market value of debenture

FV = - 217 142 900 (1)
P/YR = 2
N = 10 x 2 = 20
I/YR = 9% x 0,72 = 6,48% (1)
PMT = 217 142 900/2 x 8% x 0,72
= -6 253 716 (1)
PV = 205 766 888 (1)

Alternative 1
FV = -100 (1)
p/yr = 2
n = 20
I = 6,48 (1)
PMT = -100/2 x 8% x 0,72 = -2,88 (1)
PV = 94,76 x 2 171 429
= 205 766 881 (1)

Alternative 2
FV = -217 142 900 (1)
p/yr = 1
n = 20
I = 6,48/2 = 3,24% (1)
PMT = -6 253 716 (1)
PV = 205 766 888 (1)
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Since interest on the debentures was paid bi-annually, your calculator would need to be set to
compound interest twice a year. Alternatively the interest rate should be divided by two. Note
specifically the period, after tax rate and the calculation process.

Max 4
Available 4
PART B

(a) Identification of factors increasing business risk

It should be noted that business risk relates to the risk that affects the day to day running of the entity.
These will be factors that will affect items such as revenue, staff, clients, etc.

• CWC’s main revenue stream (70% of total revenue), derived from the audit function
is expected to decline. (1)
• This is a result of the deregulation of certain firms’ audits caused by the
implementation of the new Companies Act no. 71 of 2008 and uncertainty in the audit
market. (1)
• CWC is therefore planning expansion into their Consulting function; they may not have
the
necessary expertise. (1)
• Mrs. Walker does not have expertise as an advisor and only has experience in risk
and compliance and she may therefore not have the necessary expertise to be in
charge of the expansion project. (1)
• Some of the audit staff may become redundant as there may not be sufficient
turnover derived from the audit function to justify their employment. (1)
• CWC’s audit clients may manipulate their accounting records to fall out of the
scope of on audit. This will increase their clients risk profile.
• Risk of CWC losing their market share. (1)
• Any other valid point. (Max 1) (1)
Max 5
Available 7

(b) CWC Ltd

This part required students to analyse revenue and employee costs only, thus analysis of profit and
profit margins were not necessary. Furthermore the scenario stated that the company changed its
strategy during the last six months of 2011, it thus makes sense to analyse revenue per 6 monthly
periods.
Comments must add value and should indicate more than increase/decrease. Reasoning should be an
indication of a students applied reasoning skills.
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Employee cost:

Total First 6 Second 6 6 month 2010 Movement

2011 months months movement 2010
2011 2011 (%)
Employee cost

139 500 52 596 86 904 65,2% (1) 97 400 43,22% (1)

(97 400 x (139 500 (86 904 – (139 500 – 97 400 /

1,08 / 2) – 52 596) 52 596 / 97 400)
52 596)

Alternative : (movement above 8% increase)

97 400 x 1,08 = 105 192- 139 500/105 192 = 32,6% (1)

• Employee cost has increased drastically with 43,22% in 2011 from 2010 as a result of
employing Sarah and her team, thereby depleting net profit further. (1)
• In addition the salaries paid to the audit team has not declined despite the decline in their
service function revenue. (1)
• Some of the audit team may be redundant and must be presented with severance
packages. (1)
• Some of the audit team members may be employed permanently, or under a three-year
training contract, thus complicating their dismissal. (1)

Revenue:

2011 First 6 months Second 6 2010 First and

Revenue 2011 months Revenue second 6
2011 months 2010
Total 101 200 258 000 129 000
revenue 243 100 141 900 (258 000 (243 100-141 (258 000 / 2)
/ 2 x 1,1) 900)
Auditing 160 050 99 330 60 720 180 600 90 300
(99 330 + 60 720) (70%) (60%) (70%) (180 600 / 2)
Taxation 48 620 28 380 20 240 51 600 25 800
(28 380 + 20 240) (20%) (20%) (20%) (51 600 / 2)
Consulting 34 430 14 190 20 240 25 800 12 900
(14 190 + 20 240) (10%) (20%) (10%) (25 800 / 2)
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nd
2 6 month Alternative: 2010-2011
nd
movement (%) 2 6 months compared to Movement (%)
2010 period

(28,68) (1) (21,55) (1) (5,78) (1)

(101 200 – 141 900 / (101 200 – 129 000 / (243 100 – 258 000 /
141 900) 129 000) 258 000)
(38,87) (1) (32,75) (1) (11,38) (1)
(60 720 – 99 330 / 99 (60 720 – 90 300 / 90 300) (160 050 – 180 600 /
330) 180 600)
(28,68) (1) (21,55) (1) (5,78) (1)
(20 240 – 28 380 / (20 240 – 25 800 / 25 800) (48 620 – 51 600 / 51 600)
28 380)
42,64 (1) 56,9 (1) 33,45 (1)
(20 240 – 14 190 / (20 240 – 12 900 / 12 900) (34 430 – 25 800 / 25 800)
14190)

Despite the total revenue increase of 10% ((141 900-129 00)/129 000) in the first 6 months of
2011 from the same period in 2010, the change in service mix (revenue streams) caused an
undesirable decline of 28,68% in the second half of the year (compared to the first 6 months of
2011) and (1)
caused an overall revenue decline of 5,78% (deterioration of growth/ negative growth) for total
revenue 2011 compared to 2010. (1)

• Change in service mix:

Audit:

o The total decline in audit revenue in 2011 is 11,38% compared to 2010 despite the 10%
((99 330-90 300)/90 300) increase in the first 6 months, (1)
o this is due to the 38,87% decline in the audit revenue in the second half of the year, caused
by the deregulation of audits from the implementation of the Companies Act of 2008. (1)
o This indicates that CWC correctly anticipated the change in the audit market deteriorating,
but that it may be deteriorating at a faster rate than expected and that they may need to
increase their consulting function further. (1)

Tax:

o Total tax revenue has decreased in 2011 by 5,78% from 2010, despite the 10% ((28 380 -
25 800)/25 8000)increase in the 1st 6 months, and is inline with the total revenue decline
for the year of 5,78%. (1)
o The 28,68% decline in the 2nd six months of 2011’s revenue is also in line with the overall
six-month revenue decline. (1)
o The decline in taxation revenue is probably caused by the decline in audit clients, and
increase in consulting clients. (1)
o Clients often prefer appointing one audit/consulting firm to service their accounting and
tax, or consulting and tax requirements, where allowed. (1)
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Consulting:

o The revenue attributed to consulting fees has overall showed good growth of 33,45% for the
2011 year from 2010, and a significant growth of 42,64% over the last 6 months of 2011. (1)
o Thereby contributing to the total revenue only decreasing with 5,78%, despite the
moderate decline in tax revenue and the significant decrease in audit revenue from 2010. (1)
o The significant increase in consulting revenue was however not sufficient to counteract
the decrease in audit and tax fees. (1)
Available for Calcuations 10
Max Calculations 8
Available for Discussion 16
Max Discussion 15

(c) (i) Interest rate swap

In order for the swap arrangement to be feasible, there has to be a discrepancy in the
differential between the rates offered to the two companies.
CWC Ltd Fulcrum Ltd Difference
Fixed rate 12,5% Fixed 13,5% Fixed 1%
Floating rate 8,5% + 1% = Prime + 1% 8,5% +0,5% = Prime + 0,5% 0,5%
9,5% 9%
Discrepancy (gain as a result of swap) 1,5%

• Fulcrum Ltd is comparatively worse off with regard to the fixed rate (1% more expensive
than CWC) but prefers a fixed rate agreement. (1)
• CWC Ltd is comparatively worse off with regard to the floating rate agreement (0,5%
more expensive than Fulcrum Ltd, but prefers a floating rate agreement. (1)D
• To create the 1% gain on the fixed rate CWC has to borrow at a fixed rate. Therefore in
in order for the swap agreement to work Fulcrum will need to borrow at a floating rate
of prime plus 0,5% which will result in a gain of 0,5%. Therefore the overall gain
(discrepancy) from the interest rate swap agreement is 1,5%. (1)D
• CWC and Fulcrum will then swap cash flows (but not legal obligations with the bank)
in terms of the underlying borrowings. (1)D

Conclusion: A swap agreement is therefore feasible. (1)

Max 4
Available 5

(ii) Students were required to identify the fact that there was a discrepancy in the differential between the
rates offered to the 2 parties. Based on their discussion students should explicitly conclude as to
whether the swap agreement would be feasible or not.

CWC Ltd Fulcrum Ltd

Pays to bank (12.5%) Fixed (8.5% + Prime + (1)
0.5% = 9%) 0.5%
Pays to counterparty (8.5%) Prime (12%) Fixed (1)
Receives from counterparty 12% Fixed 8.5% Prime (1)
Net effect 9% Prime + 0.5% 12.5% Fixed (1)
Would have paid to bank 9.5% Prime + 1% 13.5% Fixed (1)
(if no swap)
Change from original terms 0.5% 1% (1)
(benefit of swap)
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The overall gain of 1.5% is shared between the parties as follows:

• CWC Ltd has obtained a floating rate and has managed to better the variable rate
offered by the bank by 0.5% (from prime plus 1 to prime plus 0.5) (1)

• Fulcrum has obtained a fixed rate and has managed to reduce their interest rate
by 1% (from 13.5% offered by the financial market to 12.5%) (1)

Conclusion: Both parties managed to reduce their interest rate and more important, both
parties are borrowing according to their preferred agreement with regard to fixed/variable
interest rates. (1)
Max 6
Available 9

Students must ensure that they are familiar with general financial information such as the prime lending
rate.
Students were required to calculate the net effect of the swap agreement for both parties. The results
of the calculation should then have been discussed.

(iii) Other factors that CWC Ltd should have considered as part of the swap agreement with

Fulcrum:

• Comparability of maturity dates of original loans of CWC Ltd and Fulcrum Ltd. (1)D

• Credit worthiness of Fulcrum Ltd. (1)D

• Repayment schedules of original loans of CWC Ltd and Fulcrum Ltd compared
to those per swap agreement (align cash settlement dates of swap with those of loans);
(1)D
• CWC’s strategic intent with the agreement (1)D

• Other (max 2) (2)

Max 3
Available 6
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QUESTION 6 SUGGESTED SOLUTION

RAPS GROUP LIMITED

(Source: Exam 2011 MAC4862 - adapted)

Comments – Raps Group

Limited

This question is set within the retail industry – an industry which students should be familiar
with, at least from a consumer point of view. (It would be exceptional to find a student who has
not yet purchased foodstuff from one of the outlets of the large retail groups.)

Overall comments

Students should apply their existing knowledge of the retail industry in formulating their
answers. This means to display the necessary competency in applying your knowledge.

Part (a) Working capital management of OKAY (Pty) Ltd

Analysis and calculations (Amounts in R’m)

Working capital ratio

Total current assets: Total current liabilities 54,0- 1,3 NRV adj: R76,3 (1)
= R52,7: R76,3
= 0,69: (1) (1)

Net Realisable Value (NRV) adjustment of inventory to the lowest of cost price or NRV

Quick ratio
Total current assets (excl. inventory): (19,7+ 1): R76,3
Total current liabilities 0,27: (1) (1)

Cash as % of current liabilities

= R1,0 / R76,3
= 1,3% (1)
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Inventory days
= Inventory (@NRV)/ COGS x 365 =(33,3 – 1,3 NRV adj) ( 1)
(474,0 + 1,3 NRV) x 365 ( 1)

= 24,6 days ( 1)

Receivable days
= Receivables / Revenue x 365 =19,7 / R585,2 x 365
= 12,3 days ( 1)

Payable days
= Payables / COGS x 365 = 74,0
(474,0 + 1,3 NRV) x 365 ( 1)
= 56,8 days ( 1)

Cash conversion cycle (operating cycle)

= (24,6 + 12,3 – 56,8) days
= -19,9 days ( 1)

Other valid Max: 1

Maximum: 5

Many students did not utilise the tabular format provided thus indicating that the
‘REQUIRED’ section was not read properly. Unstructured in that calculations were all over the place.
Furthermore students commented on OKAY’s working capital in general and did not take into account
factors that influence the industry in which it operates.

Discussion:

Discussion of findings Levels are Possible reasons for your findings, considering the
typical / low industry
/ high for
the
industry
6. The working capital management seems 7. Typical 8. The unique circumstances of the food retail industry
very aggressive due to the low working (1 ) allows for an aggressive working capital management (in
capital ratio (or quick ratio). terms of the investment into working capital and the
financing thereof). (1)
9. High inventory levels, but most items are 10. Low/ 11. A supermarket group will typically carry high inventory
expected to sell within a relatively short Typical levels that have a high rate of turnover due to the nature
period (in this case a low/typical 25,6 (1 ) of goods: fresh produce and baked goods are expected
days). to have a very high turnover (but high levels of spoilage);
other goods, such as household goods may have a
lower turnover (but low levels of spoilage). (1)
12. Trade receivables appears low in absolute 13. High (1 ) 14. A supermarket group should not have high levels of
terms (equivalent of 12,3 days), but high trade receivables as most customers pay cash (1)
for a supermarket group. 15. Or pay with bank cards (which should reflect in the
bank account of the supermarket within 1-3 days). (1)
16. Trade receivables should be low where not operated on
a franchise-basis (1)
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19. A supermarket group will typically purchase all

17. Payables are a high 57 days, but typical 18. Low/ inventory and other trade items on credit and
for a supermarket group. Typical normally pay within 60 days. Trade payables
(1) therefore provide effective free financing to the
business. (1)
20. Cash as a percentage of current liabilities 21. Low (1) 22. A supermarket group will usually carry a larger %
is low at 1,3% offering very little security cash, especially considering that most sales are on a
should inventory turnover slow down. cash-basis and cash-floats will have to be kept. (1)
23. The cash conversion cycle is negative: 24. High/ 25. A supermarket group has specific circumstances
therefore accounts payable finances more Typical allowing a high level of current liabilities relative to
than only current assets (1) current assets. (1)
Maximum: 8

Part (b)

Ratios on revenue per se, operating profit and taxes were irrelevant and not required and so were
the comments thereon.

Analysis of OKAY’s expenditure and cost behaviour

(No adjustment for net realisable value of inventory based on wording of required.)

2011 2010 2009

(draft) (audited) (audited)
As a % of revenue -
Revenue 100,0% 100,0% 100,0%
Gross profit / Cost of goods sold 19,0%/81,0% 18,9%/81,1% 19,4%/80,6% (1)
Trading expenses 14,7% 15,1% 15,1% ( 1)
Depreciation 3,4% 3,6% 3,8% ( 1)
Employees, occupancy 11,3% 11,5% 11,2% ( 1)
&other (EO & O) (Rounding
difference)

Alternative 1: As a %of total 2011 2010 2009

expenditure - (draft) (audited) (audited)
Total cost (474 + 86 + 7,5) 100,0% 100,0% 100,0%
Cost of goods sold 83,5% 83,2% 83,0% (1)
Trading expenses 15,2% 15,5% 15,5% (1)
Depreciation 3,5% 3,7% 4,0% (1)
Employees, occupancy & 11,7% 11,9% 11,6% (1)
Other (EO & O) (Rounding
difference)
Alternative 2: Growth in -
Revenue (585,2- 549,9)/ 549,9 6,4% 9,7% (1)
Cost of goods sold 6,3% 10,3% (1)
Trading expenses 3,4% 10,2% (1)
Depreciation 0,5% 2,1% (1)
Employees, occupancy &other 4,3% 13,0% (1)
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Depreciation as a percentage of
replacement cost at the beginning 19,8
of the year 50,0+5,0+19,8 ( 1)
= 26,5% ( 1)
Effective tax rate
Tax / operating profit 29,1% 31,8% 31,0% ( 1)

Fixed and variable nature of cost (based on high – low method):

(Amounts in R’m)
2011 vs. 2009
Cost of goods sold
Changes in revenue (R585,2 – R501,4) R83,8
Change in cost of sales (-R474,0 – -R404,0) -R70,0
Variable cost component R70,0/R83,8 -0,8353 ( 1)
Total variable component if sales = R585,2 -0,8353xR585,2 -R488,8
Fixed cost component -R474,0 – -R488,9 R14,9 ( 1)
(positive)
Depreciation
Changes in revenue (R585,2 – R501,4) R83,8
Change in depreciation (-R19,8 – -R19,3) -R0,5
Variable cost component -R0,5/R83,8 -0,0060 ( 1)
Total variable component if sales = R585,2 -0,0060xR585,2 -R3,5
Fixed cost component -R19,8– -R3,5 -R16,3 ( 1)

Employees, occupancy and other (EO & O)

Changes in revenue (R585,2 – R501,4) R83,8
Change in cost (-R66,2 – -R56,2) -R10,0
Variable cost component -R10,0/R83,8 -0,1193 ( 1)
Total variable component if sales = R585,2 -0,1193xR585,2 -R69,8
Fixed cost component -R66,2– -R69,8 R3,6 ( 1)
(positive)

Alternative: using financial calculator to perform regression analysis – steps shown

Cost of goods sold

Intercept (fixed cost component) (positive) 15.3 ( 1)
Slope (variable cost component) -0.8369 ( 1)
Correlation -0.9998

Depreciation
Intercept (fixed cost component) -16.3 ( 1)
Slope (variable cost component) -0.0061 ( 1)
Correlation -0.9707

Employees, occupancy and other

Intercept (fixed cost component) (positive) 4.2 ( 1)
Slope (variable cost component) -0.1212 ( 1)
Correlation -0.9858
Maximum: 9
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This part specifically required students to pay attention to the behaviour of the costs relative to
revenue. Thus to comment on the fixed (depreciation) and variable (COGS and EO + O) nature
of costs. General comment like: ‘cost increased year on year’ does not earn marks.

Discussion

COST OF GOODS SOLD (COGS) is a very large portion of total costs and has a very
large (1)
component that is variable to revenue, which is to be expected for a food retail
company where small margins are expected to be the order of the day / COGS
increased by a greater % than revenue in 2010 (almost the same in 2011), indicating
declining margins in 2010 in-line with S&S (margins maintained in 2011 – better
than S&S).

DEPRECIATION is largely a fixed cost and a rough indication is that assets are
replaced (1)
every 4 years (1/26,5%), which according to the information provided, is below that of
a similar listed company / The increases in depreciation are lower than the increases
in revenue due to its (predominant) fixed cost nature.

EMPLOYEES, OCCUPANCY AND OTHER (EO&O) trade expenses is largely variable

to (1)
sales, but with a fixed-element / EO&O increased by a greater % relative to the
increase in revenue in 2010 (lower in 2011), indicating improved cost management
in 2011 – possibly supporting the better results relative to S&S in this year.

Based on the high/low analysis (or linear regression analysis) the costs include fixed
and (1)
variable components (strangely, the results show a fixed income portion; this is
possibly due to scale advantages). In actual fact the expenditure might include
stepped-fixed cost and semi-variable costs.

Should OKAY expand by opening new supermarkets, the high/low analysis might (1)
not accurately reflect the capital investment required (e.g. increase in
depreciation).

Unlike the similar listed company, the variable component in trade expenditure of OKAY
is higher due to (1)

o a greater variable proportion of rentals (2% Okay vs. 1,5% S&S linked to sales) and
(1)
o the vehicle fleet which must be predominantly under operating lease.

The effective tax rate differs from the tax rate on companies (28%) possibly due (1)
to permanent differences (and / or STC component)
The effect of the economic crisis on the reported expenditure (any, if logical) (1)
Max 8
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Part (c)

This section tested basic accounting theory as there may be some integration between subjects.
Note: HEPS Circular 2/2013 was issued more recently.

Reason for the JSE requirement to calculate Headline Earnings:

• Aim is to offer an earnings figure that is more reflective of operating/trading (1)

• performance of a company (SAICA, 2009).
• For valuation purposes, the “normalised” version of the earnings per share is a (1)
better basis than basic earnings for valuing the company’s shares / makes
results of listed SA companies more comparable.
• Adjustments relate to items affecting the performance of the current period that (1)
could be extrapolated into the future (SAICA, 2009).
• Headline Earnings should preferably be used to calculate P/E multiples of (1)
companies, in which case it could offer a more consistent picture of operating
performance.

Typical types of adjustments made and not made to EPS:

• Re-measurements of a capital nature are ignored (SAICA, 2009), e.g. gains on (1)
the disposal of plant and equipment, impairment of these types of assets, etc.
• Re-measurements relating to the operations of the entity (SAICA, 2009), e.g. (1)
impairment of the carrying value of inventories, etc.
Maximum: 3
Part (d)

Relevance of a control premium when performing valuation using –

P/E multiple method:

• A P/E multiple method calculates the value of a company relative to a (1)

comparator listed entity. Where the published closing price per share
(incorporated in the comparator P/E multiple) is not reflective of a controlling
share (which could often be the case), it is appropriate to add a
control premium for shareholdings of 50,01% and up.

• If relevant, the control premium will be higher in steps relative to (1)

shareholdings with greater powers of control (e.g. higher for a 75% - 100%
shareholding relative to a 50,01% - 74,99% shareholding).

Enterprise Discounted Cash Flow Model, based on Free Cash Flow (FCF):

• This model entails projection of enterprise FCF and therefore implies a (1)
control-perspective.
• It is therefore not appropriate to add a control premium when applying this (1)
model (however, a minority discount might be called for in appropriate cases.
4

Students should revise their prescribed literature regarding premiums and discounts applicable in a
business and enterprise valuation.
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Part (e)
R’m

1) Net asset value (NAV) based on carrying values

Carrying value of total shareholder’s equity = carrying NAV (92,5-76,3) 16,2 (1)
Adjustment: Inventory to be shown at lowest of cost & NRV (1,3) Bonus:1
14,9

2) NAV based on replacement cost

R’m
Equipment 50,0 (½)
Vehicles 5,0 (½)
Other non-current assets (assume same as carrying value) 1,0
Inventory 33,8 (½)
Trade receivables (assume same as carrying value) 19,7
Cash and equivalents (assume same as carrying value) 1,0
Current liabilities (assume same as carrying value) (76,3)
34,2 (½)
3) Net asset value based on a liquidation-basis
R’m
Equipment 33,0 (½)
Vehicles 2,9 (½)
Other non-current assets (assume same as carrying value) 1,0
(Reduce if this includes assets such as a deferred tax asset) (½)
Inventory 32,0 (½)
Trade receivables (assume same as carrying value) 19,7
(Possibly reduce by a margin as debtors less willing to pay in
case of liquidation)

Cash and equivalents (assume same as carrying value) 1,0

Current liabilities (assume same as carrying value) (76,3)
Contingent liability (0.6 X 6)+(0.4 X 0.5) (3,8) (1)
Other liabilities: Severance pay / lease penalties ? (½)

9,5 (½)
(max 4)
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4) Fair market value based on Gordon’s Dividend Growth Model

(Amounts in R’m) 2011 2010 2009

Profit for the year (A) R18,3 R14,6 R15,6

Profit for the year with NRV R17,0 R14,6 R15,6
adjustment (A)
Dividends paid (B) (R14,9) (R13,9) (R13,0)
Dividend cover (A)/(B) 1,14 times / 1,05 1,20 times (1)
1,23 times
Growth in dividends paid 7,2% 6,9% (1)
Growth in profit 16,4%/ -6,4% (1)

Conclusion

• OKAY does not maintain a constant dividend-cover / Growth in dividends (1)

does not relate to growth in profit.

• OKAY’s dividends grow is between 6,9 and 7,2% per annum – assume future (1)
growth in dividends will equal the average growth of ≈ 7% (deduction explained)
/ growth must be sustainable into the future.

Gordon Growth Model

P0 = D1/(ke-g),

or

P2011 = 2012/(ke-g),

= R14,9m x (1+0,07) (1)

(13% - 7%) (1)
= R265,7m
4
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Part (f)

1) Fair market value based on a forward P/E multiple

Determine maintainable projected earnings (from an operating perspective)

2012 2011 2010 2009

R’m R’m R’m R’m
Revenue (R585,2x1,07) 626,2 585,2 549,9 501,4
COGS (R626,2x -0,8353)+R14,9 (508,2) (474,0) (445,8) (404,0)
Impairment adjustment – Inventory
(33,3 – 32,0) (1,3)
Adjustment made for impairment of an
operating/trading nature only
Gross profit 118,0 109,9 104,1 97,4
Depreciation
- existing b): (R626,2x -0,0060)-R16,3 (20,1) (19,8) (19,7) (19,3)
- Additional x 0,06 (1,2) (1,2) (1,2) (1,2)
Adjustment made in order for state of assets
to be comparable to S&S
Emp, occ b): (R626,2x -0,1193)+R3,6 (71,1) (66,2) (63,5) (56,2)
Adjust salary of top management (1,1) (1,0) (0,9) (0,8)
R1x1,1 R1,0/1.1 R1,0/1.12
Adjust salaries to market-related level
Adjusted earnings before tax 24,5 21,7 18,8 19,9
Interest paid at 6% (or > 6% for increased risk)
% x adjusted earnings before tax (1,5) (1,3) (1,1) (1,2)
Adjust interest to match D:E of S&S
Interest received (valued separately) - - -
Adjusted earnings before tax 23,0 20,4 17,7 18,7
Taxation – resulting new effective % Say 30,4% 30,4% 33,3% 32,6%
– given (7,5) (6,8) (7,0)
(7,0)
– on adjustments x 28% 1,3 0,9 0,9
Assuming depreciation = tax benefit and 4,8x28% 3,2x28% 3,2x28%
other deductable for tax

Profit for the year 16 14,2 11,7 12,6

Growth in profit 12,7% 21,4% (7,14)

Option 1
Due to increasing trend (ignoring 2010), the estimated figure for 2012 should be maintainable.

Maintainable earnings – 2012 16 (1)

Option 2
Due to varying growth rate use weighted average to determine maintainable earnings (also possible to
ignore exceptional year 2010):
2012 2011 2010 2009
Weight 10 4 3 2 1
Maintainable earnings - 2012 14,3 (1)
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Adjust the comparator P/E multiple for differences in risk and growth factors

Key: (x) large negative adjustment x large positive adjustment Forward

(x) negative adjustment x positive adjustment
- no adjustment PE

COMPARATOR FORWARD PE MULTIPLE 425c/21c 20,2

Adjusted for entity-level differences:

DIFFERENCES IN ENTITY-LEVEL RISKS

• Level of excess cash OKAY less (x)
• Size of the entity / level of competition / market dominance OKAY smaller (x)
• Access to financing OKAY less (x)
• Reliance on key-employees (few members of founding family) OKAY more (x)
• Reputational risk attached to condoning of actions of OKAY only (x)
supplier and OKAY’s waste-disposal practices
• Level of operating leverage (delivery trucks owned/leased; OKAY lower x
variable portion of rent)
• Credit risk OKAY more risky (x)
Alternative:
• Level of gearing (if not adj. at earnings and/or below) Okay not at target (x)
Okay assets older
• Age of assets (if not adj. at earnings) (x)

ADJUSTED FOR DIFFERENCES IN GROWTH EXPECTATIONS

• Growth expectations Same -
Similar growth is expected for years following 2012.
Alternative: also adjusted for shareholder-level differences
An allowed, but non-suggested treatment is to include the following adjustments here, but
only if not adjusted again below.
• Marketability of shares OKAY shares less (x)
• Control premium OKAY controls x

ADJUSTED PE MULTIPLE Acceptable range: 10-18 Within range: 1

This section requires students to base their valuation on a forward price/ earnings multiple,
thus a forward maintainable earnings needs to be calculated and should not be based on historic
earnings.
o The risk adjustments to the forward P/E multiple must be in the correct direction.
o Review the practical risks listed and their impact carefully – general ‘cut and paste’ risks
earns no marks.
Remember to incorporate a control premium, marketability discount, synergy and contingent liability
into the valuation, especially so in the final value determination.
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DETERMINE VALUE OF A 100% EQUITY SHAREHOLDING:

All amounts in R’m

Say R16,0 x 15 R240,0 (2)
Maintainable earnings incorporating 2012
(Not based
earnings x adjusted P/E multiple only on hist.
earnings)
Excess cash R1,0 (1)
R241,0

Adjustment for difference in D:E; inflow of 0,08 debt level x R241 R19,3 (1)
If not adj at PE
new debt (interest accounted for at
earnings)
Value of 100% equity (assuming no shareholder-level R260,3
differences
Control premium Say 23% x R260,3 59,9 (1)
Added (but not
also at PE)
320,2
Marketability discount Say 5% x R320,2 (16) (1)
Deducted (but
not also at PE)
Market value of 100% shareholding adjusted for shareholder-level differences
Value of cost synergies available to market (
Value contingent liability (60% x R6,0 + 40% x (
Fair market value of a 100% shareholding
Maximum 22
Part (g)

STRENGTHS WEAKNESSES

1. Net asset value based on carrying values

• None in this case. • These carrying values represent (1)

predominantly its depreciated historical
cost, which has very little bearing on
probable purchase price here.
2. Net asset value based on replacement cost of items included in AFS

• This gives the cost of setting up (1) • In this case intangible assets and (1)
a similar business, but only if leased tangible assets are not included,
tangible and intangible assets understating the true replacement cost.
are considered.

• May serve as a reasonability (1) • Will go into competition with existing (1)
test here. business and long-term lease contracts
make it difficult to replicate a similar
business as new areas will have to be
found.
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3. Net asset value on a liquidation-basis

• None in this case. • This represents the value to be realised (1)

in a forced-sale scenario and should
give a poor indication of price for a
going-concern business.

4. Value based on the Gordon Dividend Growth Model

• May serve as a reasonability (1) • Will provide an indication of value for a

test here. non-controlling share, but in this case
we require value of a controlling share.
• Value of a non-controlling share might (1)
be overstated in this case, as the
dividends might not be sustainable.

5. Value determined using a method based on a P/E multiple

• This method will give an (1) • Adjustments made to comparator PE (1)

indication of fair market value and multiple to account for differences are
probable price subjective and have a large influence
on the price determined.
• Method on its own usually also (1)
excludes the value of specific
synergies between acquirer and
target, which may be factored into the
price where there is demand from
several potential buyers.
Maximum 5
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Part (h)
Net benefit of savings after expenditure
Discount rate after tax (say 12,3%) Any calc (except 12,5% x 0,72 = 9%) (1)
2011 2012 2013 2014 2015
R’m R’m R’m R’m R’m
Expected savings (pre-tax) 0,8 1,2 1,5 1,6 (1)
1,5 x 1,05

Taxation (at 28%) (0,2) (0,3) (0,4) (0,4) (1)

0,6 0,9 1,1 1,2
P 2014 = Saving 2015 /(WACC-g) 1,2
12,3%-5% (1)
=16,4 Incl in yr 2014 (or n=3) (1)
Expected costs (4,0) (1,0) (0,3) (1)
Taxation (at 28%) 1,1 0,3 0,1 (1)
Net (2,3) 0,2 17,3
Discounted 10,3 Discount factors or calculator steps shown: (1)
Maximum: (4)

• The 12,5% (pre-tax) represents the WACC (pre -tax) and thus consists of Kd and Ke.
Kd may be adjusted for tax at 0.72 but not Ke.
• Students should practice calculating the terminal value correctly.
• Students should also remember the tax impact.
• Discount factors or calculator steps need to be shown.

Part (i)

RAPS MAY FACE SIMILAR DIFFICULTIES, INCLUDING:

 The deal might be subject to approval by the Competition Authorities – locally

and/or in other African countries.

 Possible conditions to the approval by the competition authorities, including:

O Limitation on retrenchments for a certain time-period (1)

O Entrenching the power of existing labour unions for a certain time-period (1)
O Forced development programme of local suppliers for a certain time- (1)
period

 Even without competition-concerns or conditions, RAPS may face labour action and
labour union opposition. (1)
One mark max (1)
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RAPS MAY OBTAIN SIMILAR SYNERGIES (OTHER THAN ALREADY ESTIMATED),

SUCH AS:

 Cost synergies from renegotiation of supplier contract terms afforded by larger (1)
volumes.
 Cost synergies from consolidation and increased scale of private-label offerings. (1)
 Revenue synergies as a result of increased sales and margins through offering of (1)
increased choice and better in-store presentation to customer. (1)
 Cost synergies from savings in logistics, including: better inventory management (1)
and fill-rate improvement. (Distribution savings were already identified, but
might result from improved distribution centre productivity and savings from
shared regional distribution centres.)
 Cost synergies from operational savings from improved price communications and store (1)
productivity.
 Cost synergies from import product-substitution resulting in lower cost, and revenue. (1)
synergies from increased choice as a result of imports.
 More effective advertising campaigns could result in growth in revenue. (1)
 Cost synergies from disintermediation, whereby larger scale might facilitate direct (1)
relationships with suppliers, without intermediaries.
 Expedited entry into the growing Africa market. (1)
Maximum 8

Students shouldn’t merely identified general difficulties and synergies, but those that arose from
the Wal-Mart/Massmart case.

Part (j)

Six foremost activities of a supermarket group that could serve as the first step in
operating an ABC system (1 each):

 Negotiating supplier contracts and terms

 Ordering goods from various suppliers
 Checking inventory levels on shelves
 Receiving goods at distribution centres
 Managing distribution centre / warehouse
 Transferring goods to stores (despatching)
 Receiving goods at stores
 Placing goods on shelves
 Pricing goods (bar-code based or stickers)
 Customer assistance / service
 Cleaning of store
 Management of inventory sell-by date and waste disposal
 Facilitating payment at registers / packing
 Customer dispute resolution / exchanges
 Other relevant action (maximum one)
Maximum 6

Students must read the ‘REQUIRED’ carefully and identify activities not costs.
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QUESTION 7 SUGGESTED SOLUTION

THE ENTERTAINMENT GROUP

(Source: Exam 2010 TOE408W (MAC4862) EDCO SAICA – adapted)

Part (a) Decision to build or lease

Focus on build and own, leasing and risk factors. Students gave unstructured answers which often
discussed both alternatives without a recommendation. One should ideally have taken a particular
view and motivated it.

Risk factors

• Risk of theatres costing more to construct than R36 million (R18 million x 2). (1)
• TEG assumes ownership risks (area becomes unsuitable, costs associated with (1)
repairs and maintenance, etc.).
• Specialised buildings – effect on residual value as buyers may not be interested (1)
in the décor etc. of a theatre.
• Increased gearing, taking on R42m [(R18 million + R3 million) x 2] of debt; (1)
• How will TEG’s actual capital structure compare to target structure afterwards? (1)
• Finance risk will increase due to increased interest payable – can the company (1)
really afford this given poor performance in 2010 and budgeted results for 2011?
• Cash flow risk: In addition to interest cost, TEG needs to fund capital repayments (1)
from cash flows/ Mismatch of cash flows to business operation requirements.
• Build and own opens TEG up for ownership associated risks such as repairs and (1)
maintenance.

Conclusion and reasons

I disagree with decision to pursue acquisition of theatres:

• Current results do not encourage immediate further expansion.

• Owning property is not their core business.
• Owning the theatre will probably increase the breakeven point due to higher fixed costs,
which will place the business in jeopardy if the new theatre is not viable. If renting, a
settlement and alternate tenant could be found and negotiated.
• Increased cash flow commitments may jeopardise further expansion plans.
• TEG has managed to expand without owning property, so why change strategy?
• Current exposure to possible decline in the business performance would be exacerbated
by purchase option.
• Other reason. (Maximum 1)
Reasoning: (3)
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Alternative:

I agree with decision to pursue acquisition of theatres:

• 9 year lease agreements are long-term financial commitments therefore acquiring

building is not significantly increasing company's existing commitment.
• Instead of paying rent, repay loan and own building.
• Provides security for company in terms of venue. If lease agreements terminate, business
continuity may be threatened?
• After 9 years lease costs to continue.
• Limited benefit due to specialized nature of building, but owning property could diversify
business risk; and the building could appreciate in value.
Reasoning: (3)

Maximum 6
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Part (b) (i) IRR and most cost effective loan

• The IRR was poorly answered as students failed to identify finance – related cash flows only and often ignored the tax implications. Students are
requested to review this thoroughly.
• It is important for students to know what the current prime rate is. At the question date the prime rate was 10% per annum.

31-Mar-11 31-Mar-12 31-Mar-13 31-Mar-14 31-Mar-15 31-Mar-16 31-Mar-17 31-Mar-18

Finance option 1: Annual payments 0 1 2 3 4 5 6 7

Initial advance (R42m- R6m - R3,6m) 32 400 000 (1)

Transaction fee ( 200 000) (1)

Tax on transaction fee* 56 000 (1)

Payment (7 099 415) (7 099 415) (7 099 415) (7 099 415) (7 099 415) (7 099 415) (7 099 415) (2)
PV 32 400 000 ; I 12%; P/YR 1; FV 0; N 7; PMT = ? Calculator steps shown

Taxation saving (interest x 28%)* 1 088 640 980 736 859 884 724 530 572 933 403 145 212 982 (2)
Loan balance – opening 32 400 000 32 400 000 29 188 585 25 591 800 21 563 401 17 051 594 11 998 370 6 338 759
Interest 3 888 000 3 502 630 3 071 016 2 587 608 2 046 191 1 439 804 760 651
Payment 0 (7 099 415) (7 099 415) (7 099 415) (7 099 415) (7 099 415) (7 099 415) (7 099 415)
Loan balance – closing 32 400 000 29 188 585 25 591 800 21 563 401 17 051 594 11 998 370 6 338 759 ( 5)

Shortcut calculation of Interest per year (only possible in certain circumstances):

After calculating the PMT as 7 099 415 above per your financial calculator enter
1 Input 2ndf Amort = = = 3 888 000; 2 Input 2ndf Amort = = = 3 502 630; etc.

Finance-related cash flows 32 200 000 (5 954 775) (6 118 679) (6 239 531) (6 374 885) (6 526 482) (6 696 270) (6 886 433)
IRR 8,773% Calculator steps shown or IRR appears reasonable: (1)
* A profit history is implied - the taxation benefit is therefore incorporated every year as the company is unlikely to have an assessed loss.
Finance option 2: Single payment
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Internal rate of return (IRR) = 12,5% x (100-28%)*
= 9,000% (2)
* A profit history is implied - the taxation benefit is therefore incorporated every year as the company is unlikely to have an assessed loss.

Alternative:

31-Mar-11

31-Mar-12

31-Mar-13

31-Mar-14

31-Mar-15

31-Mar-16

31-Mar-17

31-Mar-18
Finance option 2: Single payment 0 1 2 3 4 5 6 7

Initial advance (R42m - R6m - R3.6m) 32 400 000

Repayment (closing loan balance below) (73 894 595) (1)
Taxation saving (interest below x 28%)* 1 134 000 1 275 750 1 435 219 1 614 621 1 816 449 2 043 505 2 298 943 (1)

Amortisation schedule
Loan balance - opening 32 400 000 32 400 000 36 450 000 41 006 250 46 132 031 51 898 535 58 385 852 65 684 084
Interest 4 050 000 4 556 250 5 125 781 5 766 504 6 487 317 7 298 232 8 210 511
Payment 0 0 0 0 0 0 0 0
Loan balance - closing 32 400 000 36 450 000 41 006 250 46 132 031 51 898 535 58 385 852 65 684 084 73 894 595

Calculate the repayment: PV= 32 400 000; N=7; i=12.5; PMT=0; FV= 73 894 594

Shortcut calculation of Interest per year (only possible in certain circumstances):

After calculating the FV as 73 894 595 above per your financial calculator enter
1 Input 2ndf Amort = = = 4 050 000; 2 Input 2ndf Amort = = = 4 556 250; etc.

Finance-related cash flows 32 400 000 1 134 000 1 275 750 1 435 219 1 614 621 1 816 449 2 043 505 (71 595 652)

Internal rate of return (IRR) 9,000%

Conclusion: the most cost-effective loan is option 1 (annual payments), with the lower IRR (1)
Maximum 11
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• A logical sequence flowed through (ii) to (iv). Comments (same) were often repeated in the
3 sections, but as a rule this should be avoided.
• Many students failed to differentiate between the two loans.

Part (b) (ii) Other factors

• Cash flow position of TEG: will the company be able to pay the capital portion of (1)
loan annually (option 1) or prefer settlement in 2018 (option 2) – cash flows
should match business operating requirements.
• Effect of potential acquisition of Movies (Pty) Ltd: how will this be financed and (1)
its effect on cash flow position and target capital structure? Possibly favouring the
use of option 2 here as cash flows are delayed till the end of the 7 years.
• More restrictive covenants for option 2 – detail and effect on daily running of (1)
The Entertainment Group
• Fixed vs. variable rate option comparable between the two options? (1)
• Another valid factor. (Maximum: 1) (1)
Maximum 4

Part (b) (iii) Factors: Fixed vs. variable rate

• Fixed rate: for how long a term can the interest rate be fixed for? (1)
• Fixed rate: differential cost as the fixed rate is traditionally higher than the floating (1)
rate
• Fixed rate: any hidden fees and costs? (1)
• Historic trends in prime interest rates, current yield curve and general views (1)
about future interest rates and inflation rates?

o The prime interest rate displayed a declining trend since latter half of 2008 and
decreased from 10% to 9,5% (on 10 September 2010). It is now at the lowest
level in more than 30 years. (1)

• Expected length of the recession, the shape of any recovery to come and its effect
on TEG? Existing high fixed cost makes the company sensitive to rate
movements. (1)

o With a negative outlook for TEG, they would favour the certainty of fixed rates. (1)
o When the outlook becomes more positive for TEG, they would favour a lower
cost variable rate, but could still create a buffer by paying the fixed-rate-
differential additionally every year into an access-facility (if available). (1)

• Consider interest rate swap with third party or any alternative hedge. (1)
Maximum 5
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Part (b) (iv) Concerns: Suretyships and interest rate

• Theatres are special purpose buildings therefore higher finance risk. (1)
• Company has limited assets available for security therefore, banks reasonably
looking to individual shareholders for collateral. (1)
• Theatre business may be correctly perceived as high risk because of declining
audiences & high fixed costs. (1)
• Joint & several suretyships might be unfair. (1)
• The high interest rate might be reasonable, given the perceived loan/ finance (1)
risk.
• In the unlikely event that the banks will accept, the shareholders could pledge
their shares in the company, instead of providing suretyships. (Suretyships are
onerous obligations.) (1)
• Another valid comment. (Maximum: 1) (1)
Maximum 5
Part (c) Break even number of tickets for 2011

• Breakeven shouldn’t be calculated for the 2010 year as 2011 was required
• Breakeven sales amount erroneously calculated and not number of tickets as required.
• Instruction re 80% sales through agent, thus an 80/20 split in ticket sales.
• Contribution should be calculated for tickets and beverages.
• Calculate the contribution not only the sales.
• The layout given allows for a step by step process which can be used in other scenarios.
• Guideline: The high-low method often used to determine fixed and variable cost is not
relevant in this case as sufficient guidance was supplied in the question on which
components were fixed and which were variable.

Fixed costs 2011

R
Contractors fees for new shows 1 000 000
New show stage props 500 000
Musicians and artists fees (doesn’t
change per ticket sold) 17 000 000
Interest expense 4 600 000
Overheads 40 620 000
Depreciation 3 000 000
Marketing costs 1 900 000
Salaries and wages 8 000 000
Rent of premises 20 520 000
Travelling & accommodation costs 4 000 000
Utility costs 1 000 000
Other overheads 2 200 000

63 720 000 ½ each, maximum: 3

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Contribution per patron Direct sales Ticketing
agent
Ticket contribution per patron R R
Ticket price (Rands) (R57 500k / 766 664) 75.000 75.000 (1)
Ticketing agent’s commission (4% x 75) - (3.000) (1)
Contribution from tickets 75.000 72.000

Beverage contribution per patron

Beverage sales (R13 000k/ 766 664) 16.957 16.957 (1)

Beverage variable cost (R4 500k / 766 664) (5.870) (5.870) (1)
Contribution (profit) from beverages 11.087 11.087

Weighted Direct sales Ticketing

contribution agent
Total contribution per patron 86.087 83.087 (1)
Weighted based on revenue mix 83.687 20% 80% (2)
(86.087x0.2)+(83.087x0.8) = 83.687
Alternative (7 marks)
Contribution per patron Total
R’000
Ticket price (Rands) 57 500
Ticketing agent’s commission
(R57500kx80%x4%) (1 840)
Beverage sales 13 000
Beverage variable cost (4 500)
Total contribution 64 160
Number of units / 766 664 (must be correct)
Weighted contribution per unit R83.687

Breakeven number of tickets:

Formula: Fixed costs

Weighted contribution per patron

= 63 720 000
83.687

= 761 408.6 tickets (1)

Rounded-up to nearest integer 761 409 Tickets (calculation shown) (1)
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Alternative
Formula: Fixed costs / Price per ticket
PV (CM) ratio
= 63 720 000 / R75.000
(R83.687 / R75.000)

= 761 408.6 tickets C (1)

Rounded-up to nearest integer 761 409 tickets
C (1)
The company has adequate capacity
Breakeven tickets vs available 761 409 vs. max.2011: 1 900 800 (1)
Maximum 9

Part (d) Critical analysis of actual and budgeted ticket sales for the year ended 31
July 2010

Request is for the analysis of ticket sales with variances indicated as part of the solution.

• Students should read the required properly: Many students provided a critical analysis for
the incorrect year (an analysis for 2010 was required). Furthermore, many candidates
offered an analysis of items that was not required (e.g. gross profit and changes in certain
expenditure); an analysis of only actual and budgeted ticket sales was required.

• When calculating a percentage change, candidates should ensure that they understand
which figure represents the benchmark. In this case we compare actual to budget – therefore
the budget represents the benchmark. As a result we use the budgeted figure as the
denominator in calculating the percentage change.

• The volume variance and its’ mix and quantity parts should also be answered.

• General comments and rewording of calculations are not acceptable in the discussion
section. Some measure of insight in cause and effect is necessary on this level.

• Indicating an increase +/- is necessary to earn marks for calculation of variances and also
indicating “favourable” or “unfavourable” variance
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Analysis Budget Actual % Variance
R R
- 63 853 tickets or
% variance - number of tickets sold 714 285 650 432 -8,9% (1)
R50 000k R47 561k (650 432-714 285)
Price per ticket 714 285 70.000 650 432 73.122 714 285 (1)
- % variance 4,5% (1)
(R73.122-R70)
R70
% variance - revenue from ticket sales 50 000 000 47 561 000 -4,9% (1)
(R47561k - R50000k)
R50000k
Ticket revenue mix R R
Ticketing agent R1 500k/4% 37 500 R1 760k/4% 44 000 (2)
Direct ticket sales (balance) 12 500 (balance) 3 561
Total 50 000 47 561

Ticket revenue mix (% of total)

(2)
Ticketing agent (R1 500k/4%)/R50 000k 75,0% (R1 760k/4%)/R47 561k 92,5%
Direct ticket sales (balance) 25,0% (balance) 7,5%
100,0% 100,0%
Alternative 1

Ticket revenue mix (number of tickets)

(2)
Limited
Tickets – agent 535 714 601 733 rounding
Total – direct (balance) 178 571 48 699 difference
714 285 650 432
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Aq x Asp (from statement of comprehensive

income) or 650432 x R73.122 47 561 000 (1)
Am.
Ticket sales price variance 2,030,760 Favourable (1) Fav.
Aq x Bsp 650 432 x R70 45 530 240 (1)

Budgeted gross profit per ticket - ticketing

agent [75,0% x (R50000k+R10000k-R900k-R4000k-R300k-R15000k)-R1500k] / 535 714 52.920 (1)
Budgeted gross profit per ticket – internal [25,0% x (R50000k+R10000k-R900k-R4000k-R300k-R15000k)]/178 571 55.720 (1)
Budgeted gross profit per ticket - actual mix [(92,5% x R52,920) + (7,5% x R55.720)] 53.130 (1)

Ticket sales mix and quantity variance / volume variance

R R R
Aq x Bgp (650 432 x 53,13) 34 557 452 1
A
Ticket sales mix variance 318 712 1
(650 432 x 75,0% x 52,92)+(650 432 x 25,0% x
Aq in budgeted mix x Bgp 55,72) 34 876 164 1 3 742 548 A Volume variance
Ticket sales quantity variance 3 423 836 1 1
Bq x Bgp 38 300 000 1
(from statement of comprehensive
income) or 714 285 x R53.620

Note:

“Aq” represents actual quantity

“BgP” represents Budgeted gross profit
“Bq” budgeted qauntity
“A” represents adverse variance
Maximum marks for analysis: 8
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Interpretation

Interpretation should relate to ticket sales only (not beverage sales or other items). Interpretation
should display applied thinking and not merely describe each analysis point (e.g. “this variance
increased / decreased”).

• TEG has high operating leverage / a high breakeven point. It is therefore critical
to the success of this company to meet its budgeted sales. (1)
• Overall revenue from ticket sales reduced by 4,9% principally due to a lower
number of tickets sold (8,9% below budget) / Lower sales resulted in a R3 742 548
adverse sales volume variance. This is likely principally as a result of the effects on
South African spending habits during the international financial crisis / effects of a
recession. (1)
• Average selling prices for tickets were 4,5% higher than budgeted (R73,122 vs.
R70) / higher ticket sales prices resulted in a R2 030 760 favourable price variance.
This increase in selling prices might have slightly exacerbated the effects of the
financial crisis / recession on sales volumes. (1)
• TEG sold a greater proportion of actual tickets through the ticketing agent
(92,5% actual vs 75,0% budgeted), resulting in higher sales commissions being
paid, thereby reducing profitability (or gross profit per ticket, or a R318 712 adverse
sales mix variance). (1)
Maximum for interpretation 4

Part (e) Key valuation issues in current economic crisis

This question was very poorly answered as the majority of students ignored the required ‘key
valuation issues … specifically given the current economic crisis’ and simply listed the
valuation methods.

1. What will the length of the recession be and the shape of any recovery to come? (1)
2. Has the crisis changed the way that we should look at the key components of our (1)
cost of equity calculation?
3. How did the tightening of credit markets affect our view of the debt components of (1)
the weighted average cost of capital (possible higher cost of debt percentage /
lower debt-component in target debt-to-equity ratio)?
4. Has the volatility in equity markets lowered the level of reliance we can place on the (1)
market multiple approach?
5. Has the volatility in equity markets resulted in differences between market prices
and intrinsic values?
6. What has been the impact on South Africa versus other countries in the developed (1)
and developing world?
7. Ability of a company to expand (grow) might be limited where access to credit is
limited, thereby possibly affecting its value. (1)
8. Another key valuation issue (only if directly relevant to the economic crisis). (1)
(Maximum: 1)
Maximum 5
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Part (f) Probable reasons for the increase in results

Guideline: no marks allocated if a condition already existed for a few years e.g. loyalty programs,
etc.

Another poorly answered section as students ignored the information presented under the
heading of ‘potential acquisition’, especially the first paragraph. The impact of these issues on
the operating results was required.

1. Ticket price normalisation following the price war. (1)

2. Many cinemas have recently been revamped, thereby offering greater appeal. (1)

3. Increased audience attendance due to:

• The allure of 3D technology / implementation of digital projectors; (1)

• South Africans look to secure environments such as shopping centres for (2)
entertainment, rather than nightclubs and pubs;
• Strength of the content that has come out over the past couple of years, including (2)
big blockbusters;
• Popular SA-themed international productions such as District 9 and Invictus, (2)
and locally produced movies.
• Alternative content has expanded the appeal of the cinema to new markets, for (2)
example: major international ballet, theatre and opera productions filmed live for
cinema exhibition.

4. Increased advertising revenues e.g. from the additional flexibility that digital
projectors give cinemas and advertisers. (Digital projection allows ads to be added or
removed easily, whereas ads need to be manually spliced into 35mm film reels). (2)

5. Another reason (only if specifically relevant and applicable to recent developments.

Note that an increase in DVD / Blu-Ray sales is not actually the case, but if properly
(1)
motivated could earn a mark here.) (Maximum: 1)

Maximum 9
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Part (g)(i) Calculation of the WACC of Movies (Pty) Ltd

Rf
This should be representative of the return that will be received on a risk-free investment.

• Here we match the maturity to an assumed investor horizon of +- ten years as one can
argue that a bond with a longer date to maturity is subject to illiquidity, which could result
in yield premiums and stale prices (R207 yield in this case); or
• Here we match the maturity of the risk free instrument to the profile of the cash flows
(R209 yield in this case).

Small stock premium

This is relevant here as Movies (Pty) Ltd qualifies as a small stock (low value shares).
Empirical evidence indicates that that small market capitalisation stocks seem to earn higher
returns than predicted by the traditional capital asset pricing model.
The Ke is higher to reward shareholders for additional risk inherent to small stocks/shares.

Specific risk premium

Risks should be taken into account in calculating the discount rate or the cash flows, not
both.

In the WACC calculation, the (risk) premiums are added to the normal calculation of K e ; this is
the risk adjustment and no further consideration of risk factors was required. Many students
utilised the incorrect risk-free rate in their calculation.

K e = R f + ß(MRP) + small stock premium + specific risk premium

(1)[R207] (1) (1) (1) Alt: 9% x 0,72

= 9,0% + 1,1(6%) + 5% + 2% or 9,1%
= 22,6% or 9,1% x 0,72

WACC = [K e x weighting %] + [K d x weighting %]

(1) (1)
WACC = [22,6% x 60%] + [(10%x0,72) x 40%] (1)
= 16.44%
≈ 16%
Alternative:

Ke = R f + ß(MRP) + small stock premium + specific risk premium

(1)[R209] (1) (1) (1)
= 9,1% + 1,1(6%) + 5% + 2%
= 22,7%

WACC = [K e x weighting %] + [K d x weighting %]

(1) (1)
WACC = [22,7% x 60%] + [(10%x0,72) x 40%] (1)
= 16,50%
≈ 17%
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Part (g) (ii)

In preparing the cash flow statements, the following came to the fore:

• Remember free cash flows excludes the current year as it is a forward-looking valuation instrument.
• You are valuing Movies (Pty) Ltd and should thus ignore TEG’s statement of financial position.
• Direction +/- of cash flows are necessary to earn marks.
• The 2010 gross profit percentage not applied.
• Depreciation (is not a cash flow) should be subtracted after applying the given regression formula.
• Remember to include a wear and tear deduction if a separate tax calculation is applied.
• Cash must be excluded from the opening balance of the working capital as it is added separately after NPV calculation.
• Working capital must be calculated on an incremental basis i.e. the balances do not represent a cash flow movement.
• Capital investment is a pre-condition of growth and should be included in NPV calculation.
• Remember to add the terminal value.
• Terminal value cash flow should be included in the 2014 year.
• Final value includes the surplus cash in the company.
• Show the discount rate used and the calculator inputs determining NPV to earn marks.
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2011 2012 2013 2014

Sales 25 650 000 30 810 000 36 450 000 38 270 000

(1)
Sales with existing nominal
growth expectations based on
24 192 000 (2010 sales) 25 655 616 28 010 802 31 176 023 32 734 824 (1)
Growth in people (r) 1,00% 3,00% 6,00% 0,00%
Growth in inflation (h) 5,00% 6,00% 5,00% 5,00%
Nominal growth (R) 6,05% 9,18% 11,30% 5,00% (1)
(I.e. Investment required for 3D & digital projectors at end 2011 (or beginning 2012) to ensure higher growth in 2012.
See below **)
Cost of sales 48%
(12 312 000) (14 788 800) (17 496 000) (18 369 600)
Or for 48%
Gross profit 52% (1) COS
13 338 000 16 021 200 18 954 000 19 900 400 (1)
Operating expenditure incl. depreciation: y
= 0,11x+ 8 000 000 Show
(y= (0,11x(25 650 000))+ 8 000 000 (10 821 500) (11 389 100) (12 009 500) (12 209 700) (3) calculation
Profit / Taxable income 2 516 500 4 632 100 6 944 500 7 690 700
1 For using
Taxation @ 28% (wear and tear 28%; 1 if W&T
saving is thus taken into account) (704 620) (1 296 988) (1 944 460) (2 153 396) (2) = depr incl
Depreciation – add back non cash 2 565 000 3 081 000 3 645 000 3 827 000 (2)
Interest –included as R0 as it has
been included in the calculation of
WACC and debt is deducted
separately after the NPV calc. - - - - (1)
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Investment in net working capital (outflow) ( 152 400) ( 103 200) ( 112 800) ( 36 400) (1)
Opening balance (R460 600 – 360 600 (1) For 2011
R100 000) No marks if
this balance
shown as a
513 000 616 200 729 000 movement
Closing balance 2% 513 000 616 200 729 000 765 400 (1) No marks if
this balance
shown as a
movement

Net capital investment (outflow) 11% (2 821 500) (3 389 100) (4 009 500) (4 209 700) (1)

2011 2012 2013 2014

Capital investment (3D & digital projectors)** (8 400 000)
(2 for
amount; 1
for correct
= In 2010 monetary terms: 8 complexes x R1m (8 000 000) (3) year)
Inflation growth (assumed at CPI of 5%) (400 000) (1)
Free cash flows 5 118 204

FcF2015 = FcF2014 (5 118 204) + g (5%)= 5 374 114

g 5%
WACC 16%
Terminal value P2014=FcF2015 /(WACC-g) = 48 855 582 (3) (2 for calc; 1 for
= 5 374 114/ (0.16-0.05) correct year)
Alt:
Also if separate calc
(separately
discounted)
Free cash flows incl terminal value (6 997 020) 2 923 812 4 522 740 53 973 786

Free cash flows including (6 997 020) 2 923 812 4 522 740 53 973 786
terminal value
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2011 2012 2013 2014

Discount rate 16% 0,862 0,743 0,641 0,552 (1) applying rate as
calculated in (g) (i)

Discounted values (7 635 079) 846 871 1 809 030 20 051 330
Total net present value 28 847 724 (1)

Surplus cash 100 000 (2)

Fair value at 31 August 2010 28 947 724
Maximum 24

FcF2015 = FcF2014 + g 5 374 114

G 5%
WACC 16%
Terminal value alternative P2014=FcF2015/(WACC-g)= 48 855 582 (3) (2 for calc; 1 for
correct year)
FV = 48 855 582
n=4 Also if separate calc
i = 16% (separately
PV = 26 982 473 discounted)

Insufficient information was provided relating to Movies non-operating assets, value of debt and shareholder level premiums and
discounts.
Ensure that you revise your prescribed textbook to ensure you know how these are dealt with as part of the free cash flow valuation.
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QUESTION 8 SUGGESTED SOLUTION

BRAZILICA LIMITED
(Source: Test 3 2013 MAC4862- adapted)
(a) Determine the WACC

BRAZILICA LTD

DETERMINE CURRENT FAIR MARKET VALUE OF ORDINARY SHARES

Future year: 0 1
(Valuation
date) R
Dividend in 1 year's time
= -2,1x(1+15%) x
2 800 000 (6 762 000) (1)

Present cost of dividends after year 1:

P 1 = D 2 /(K e -g)
P 1 = -6 762 000 x (1+8%) (1)
(15%-8%) (1)
(104 328 000)
(111 090 000)

Discounted or
Fair rate of return 15% 0,86957 calculator steps shown (1)
R
Net present cost (96 600 000) (96 600 000)
Note: figures may not total correctly due to
rounding

DETERMINE CURRENT FAIR MARKET VALUE OF THE NON-REDEEMABLE PREFERENCE

SHARES
Future year: 0
(Valuation
date)
Present cost of future dividends
P 0 = D 1 /(R-g)
P 0 = -1 000 000 x R2 x 7,8% (1)
(8.4%-0%) (1)
R

P0 = (1 857 143)

DETERMINE CURRENT FAIR MARKET VALUE OF THE CONVERTIBLE DEBENTURES

Note: Classification as 'hybrid debt instruments' for income tax purposes implies that (1)
interest is not deductible for purposes of income tax
(the Dividend Tax implication should be ignored in this case, per the question)

Determine the most likely option to be taken in two years' time (highest value in two years' time)
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Determine the value of option 1: Redemption payment

Future year: 2
(Valuation
date here)
Redemption payment R
= -R7500000x(1+20%) (9,000,000) (1)

Determine the value of option 2:

Value of new debentures in 2 years' time

Future year: 2 3 4
(Valuation
date here) R R
Redemption payment = -R7500000 x
(1-5%) (7,125,000) (1)

Interest = -28% x
R7125000 (1,995,000) (1,995,000) (1)

(1,995,000) (9,120,000)

Reasonable rate of return 11,0% 0.90090 0.81162 (1)

R
Net present cost in 2
years' time (9,199,294) (1,797,297) (7,401,997)

Note: figures may not total correctly due to

rounding

Determine the value of option 3: Value of ordinary shares in 2 years time

0 1 2
(Valuation
date here)
Calculation of dividend
amounts only:
Dividend year 1
= -2,1x(1+15%)x2 800 000 15% (6,762,000)

Dividend year 2
= -R6 762 000*(1+8%) 8% (7,302,960)
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Present cost of future dividends in Year 2:

P2 = D3/(Ke-g) R
P2 = -7302960x(1+8%)/ (2)
(15%-8%) (1)
(Net present cost in 2 years' time) (112,674,240)

Value for a single share in Year 2:

=-112674240 / 2800000 -40.2408 (1)

Number of shares converted to 250,000

Total value of debentures converted to shares (10,060,200) (1)

Determine the present cost of convertible debentures given most likely final cash
flow (option 3)

Future year: 0 1 2

(Valuation date) R R
Cost of highest option likely
to be chosen by holder (option 3) (10,060,200) (1)

Interest = -11,5% x R7500000 (862,500) (862,500) (1)

(862,500) (10,922,700)

Reasonable rate of return 11.0% 0.90090 0.81162 (1)

R

Net present cost (9,642,135) (777,027) (8,865,108)

Note: figures may not total correctly due to
rounding
Brazilica Ltd
Fair market Fair rate
Calculate the WACC value of return Weighted
R
Ordinary shares (96,600,000) 15.00% 0.1036
Non-redeemable
preference shares (1,857,143) 8.40% 0.0011
Long-term loan (31,790,000) 6.84% 9,5% x 0,72 (1) 0.0155

Debentures (likely to be Between 11%-

converted to equity) (9,642,135) 15.00% 15% (1) 0.0103
(139,889,278) 0.1305 (1)
13.05%
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SOURPAULO LTD

Calculate the Fair market Fair rate

WACC value of return Weighted
R
1000000xR3
Ordinary shares (3 000 000) (1) 27.00% 0.0746
(8,5%+10%) x
Long-term loan (7 851 219) 13.32% 0,72 (1) 0.0964
(10 851 219) 0,1710 (1)
17,10%
Max (18)
(b) Pursual of Project Roupa

QUANTITATIVE ASSESSMENT

Company Calculated WACC Expected IRR WACC < IRR

Brazilica Ltd 13,05% 13,5% Yes
Sourpaulo Ltd 17,36% 13,5% No
Riojanero Ltd 14,00% 13,5% No
(1)

Based on the available information and calculations, only Brazilica Ltd should pursue the project as
it could possibly earn a return in excess of its WACC. (1)

Max: (2)
(c) Other factors: general for all companies

• Are the risks inherent to ‘Project Roupa’ comparable to each company’s existing risk profile?
(1)
• If ‘Project Roupa’ has a higher risk rating than the company’s existing risk portfolio, the project’s
IRR should exceed the company’s WACC by a margin and vice-versa (alternatively, the
WACC used to perform the project appraisal should be increased from the company’s existing
WACC, and vice-versa, or a specific WACC for the project should be calculated and used in the
appraisal). (1)
• How accurate is the project tender / proposal price in the project assessment?
• What are the tender / proposal criteria and pricing formula, and how does this impact the
company? (E.g. B-BBEE ratings.) (1)
• Is ‘Project Roupa’ of strategic importance to the company’s future or its survival? (1)
• Does the project allow for joint ventures to enable each company to focus only on its areas of
strength? (1)
• How should the project be financed? How does the company’s existing capital structure
compare to the target structure for this industry? (1)
• Does existing debt covenants allow for further debt finance? Can the timing of cash flows on
the project be coordinated with cash payments on the finance? (1)
• The social and environmental impact of the project. (1)
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Other factors: specific to some companies

• Will Sourpaulo be able to join forces with another company because its small size might make
it difficult to pursue on its own. (1)
• Sourpaulo Ltd likely has too much debt in its capital structure and should probably use equity
finance for the project, if possible. (1)
• Riojanero Ltd may take this opportunity to introduce some debt into its 100% equity-based
capital structure to obtain some benefit from financial gearing / tax deductibility of interest (if
allowed by its shareholders). (1)

Max: (4)

(d) Supply two examples of how the under-valuation of ecosystems in project and
investment appraisals could ultimately undermine the performance of an entity.

It could result in failing to:

• identify new cost-saving or revenue-generating opportunities, or (1)

• highlight potentially expensive liabilities. (1)

Max: (2)
(e) Downfalls of using a constant discount rate over time

• Lower importance is given to future generations effecting intergenerational equity. (1)

• Benefits and synergies arising as a result of improved sustainability performance may be
penalised in situations where the outlay is larger and the payback periods longer. (1)

Max: (2)
(f) Critical review of Brazilica’s cash flow for 2013

1. Operating profit

The operating profit has increased dramatically from the previous year.

2012 Operating profit R20 791 995

2013 Operating profit R47 410 100

This is very positive as long as the profits have been converted into cash. (1)

2. Working capital: Negative R48 055 100

The working capital cash flow is very distressing as the increase in working capital requirement
has exceeded the operating profit. As a result the cash generated from operations is a negative
of R645 000. The company cannot continue to increase profits without a positive increase in cash (1)
flow from collections.

The increase in trade receivables and inventory is indicative of poor trade receivables payment
and excessive holdings of closing inventory. (1)
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3. Fixed assets:

Fixed assets are required for sustainable long-term growth. The problem in this instance is that
there is no cash from operations to finance new fixed assets. As a result a huge cash burden
has been placed on debt finance. (1)

4. Net cash outflow from operating activities – R18 718 100

The company has made large payments in interest, dividends and tax, all of which have been
funded by borrowing. Long term consequences could be disastrous. (1)

The substantial increase in net interest paid from R577 340 to R2 868 800 demonstrates that
company financial risk has increased via debt borrowing. The company does not make enough
cash profit to cover interest payment. (1)

5. Financing:

The company has financed fixed assets, current assets, dividends and tax payments from long
term borrowings. A total of R25 261 300 long term debt has been raised to finance operations,
interest payments, dividends and tax. The cash surplus of R3 385 000 has turned into an
overdraft of R5 360 200 further demonstrating the company has a severe cash shortage.
(2)

Conclusion:

Brazillica Ltd cannot sustain the level of borrowing as incurred in 2013 for much longer. Growth
needs to come from retained profits first before increasing debt. Of serious concern is the dramatic
increase in trade receivables as I would question the ability of the company to collect outstanding
balances. (2)

Communication skills – clarity of expression; logical argument (1)

Max (8)

(g) Executive summary

TO: The Directors of Brazilica Ltd

FROM: Consultant
DATE: 8 June 2013
RE: Executive summary of the of the external opportunities and threats that could be linked
to Brazilica Ltd

This executive summary is drafted in response to your request dated xx/xx/2013. It sets out – in brief
– the external opportunities and threats that could be linked to this company. It forms part of a SWOT
analysis, the detailed results of which will be presented in due course.
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Opportunities

Brazilica Ltd could capitalise on:

• Huge demand for soccer balls due to the upcoming major soccer tournaments, viz. the 2013
FIFA Confederation Cup and 2014 FIFA World Cup and others, offering additional sales
opportunities to Brazilica Ltd. (1)
• Contracts for custom, premium-priced balls which will have to be developed and manufactured
for the 2013 and 2014 cups, as for the 2010 FIFA World Cup. (1)
• Opportunities sprouting from the 2010 South African World Cup legacy trust (R450 million),
which was launched in 2012 to harness football for sports development and other causes. (1)
• Likely increase in the demand for respective national soccer jerseys definitely increase due to
major tournament fever (an increase in avid soccer fans and patriotic followers). (1)
• Prevailing low interest rates, which may ease the entity’s cost of capital and supports its asset
capitalisation activities. (1)

Threats

Brazilica Ltd should be weary of the effects and manage the following matters as far as possible:

• The relatively low expected global economic growth and economic woes such as debt crises
in major EU countries (which are also soccer giants (e.g. Spain, Portugal)) and related austerity
measures could result in lower-than-expected demand for soccer balls and apparel. (1)
• Forecast poor economic outlook, both nationally and internationally will increase competition
within a co nstrained market, hindering the entity’s strategy of increasing market share. (1)
• Forecast poor economic outlook will make it more likely for debtors to default, especially in light
of the relaxed debtor’s collection policy. (1)
• Pervasiveness of bribery associated with major sporting events in the past, and the difficulty in
obtaining contracts honestly by following due-process. (1)
• Increasing capacity increases operating leverage, which represent a threat to the company in
future years with lower expected sales (after the 2014 World Cup). Many South African
companies had to deal with this problem after the 2010 World Cup. (1)

Communication skills – clarity of expression (incl. format); logical argument; appropriate

generalisation (1)
Max (6)
Total (40)
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QUESTION 9 SUGGESTED SOLUTION

X-FACTOR HOLDINGS
(Source: Test 4 2013 MAC 4862/4861- adapted)

(a)

Read the required carefully: Students should incorporate general knowledge of the relevant food and
grocery products industries in their answer.

• Nature of the product -food products are perishable; XFH would have to ensure that they order
the correct quantities of food to avoid wastage. Given the fact that this is a new business venture it
might take a while before they get it right. (1)
• Given the current trends of society it has become more common/ acceptable for people to buy
pre-packed or easy to prepare food, there is thus a demand for their products. (1)
• Food and clothing will be within the same store making it convenient for their consumers (a one
stop shop). (1)
It could also result in an increase in clothing sales as a result of the increased traffic in the store.
(1)
• Profit margins are much smaller with food products compared to clothing; XFH would thus have
to ensure that sales volumes are large in order to be profitable. (1)
• Food and clothing are very different products, does management have the necessary skills and
knowledge to enter the food market. (1)
• Stores would have to be adapted or even expanded to cater for the sale of food. This may be
time consuming and costly. (1)
• Capital investment would be required to purchase fridges, shelves, delivery vehicles etc.
XFH should have sufficient capital available/ accessible. (1)
• XFH would need to ensure that they comply with all the Department of health Regulations
relating to the storage and possibly preparation of food. (1)
• XFH may experience competition from established businesses like Woolworths that have
already incorporated the sale of food and grocery products into their business model. (1)
• XFH should consider whether their new strategy will be compatible with existing operations e.g.
compatibility with existing distribution centres. (1)
• Given the fact that Pick and Pay’s e-commerce option has achieved lower success, XFH
should consider the reasons for this and how they potentially, if at all, can overcome these
problems. (1)
MAX 8
(b)

Common errors made:

 Many students utilized valuation methods other than the forward EV/EBIT multiple method despite the
“Required” specifically stating the method to be used.
 Many students failed to incorporate motivations for the valuation method and for their
calculations/adjustments. This cost them a large amount of marks. This emphasises the importance of
reading the “Required” carefully.
 A large amount of the calculation marks was awarded for forecasting 2014 values, most students
utilised historic information for their valuation and therefore did not earn any of these marks.
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• Per the “Required a maximum bid price is to be calculated.

This should include the fair market value/intrinsic value of the target on offer date (viewed
independently from any merger and acquisition) (1)
Plus the value of specific synergies available in a merger between the target (Bedazzled) and
bidder (Countryside) entities. (1)*
• The second important consideration is whether a minority or a majority valuation should be
• performed. Based on the fact that Countryside is acquiring a majority shareholding (70%
shareholding) in Bedazzled a majority valuation should therefore be performed. (1)
• The earnings multiples (EV/EBIT) method of valuation is to be used per the “Required” and
would be appropriate as earnings information is available for Bedazzled. (1)
• Bedazzled is a going concern and thus the earnings multiples (EV/EBIT) method of valuation
is appropriate. (1)
• Furthermore the EV/EBIT multiple of Countryside, a comparable entity within the clothing retail
industry, is readily available as it is a listed entity. (1)
• Given the current conditions of Bedazzled, i.e. poor performance due to poor management
decisions, Bedazzled performed badly in the 2013 year, this is however seen as an exception
and it may be more appropriate to include 2014 earnings in the valuation and utilise a forward
EV/EBIT multiple. (1)
• It is expected that revenue growth will normalise in years following the 2014 financial year,
further motivating the use of a forward EV/EBIT multiple. (1)

Recommend a maximum bid price in Australian Dollar that Countryside could offer for a 70%
shareholding in Bedazzled as at 30 June 2013. Support your recommendation by calculating a value
using a method based on a forward EV/EBIT multiple and the available information.
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Calculating 2014 expected earnings:

2012 2013 2014 Motivation
AUD AUD AUD
Sales 25 860 000 25 690 000 26 948 810 (1) (25 690 000 * 1.049)
Revenue is expected to increase by 4.9%

Cost of sales -10 602 600 -10 532 900 -11 049 012 Balancing figure
Gross profit 15 257 400 15 157 100 15 899 798 (1) (26 948 810 * 59%)
Since a GP% of 59% applied in 2012 and 2013, the
same percentage was assumed for 2014.
Other revenue 0 0 0 (1) Relates to investment income and is excluded as
investments should be valued separately.

Expenses -14 118 278 -14 281 096 -14 734 006 Calculated
Distribution expenses 10 938 278 11 031 136 11 412 547 2012:(10 860 000+(80 000/1.022))
Omitted expenses should be included in maintainable
earnings and adjusted for inflation. (1)
2013:(10 951 136+80 000)
Omitted expenses should be included in maintainable
earnings.
2014: Refer to calculation 1.

Other operating costs 3 180 000 3 249 960 3 321 459 (1) 2013:(3 184 960+65 000)
Profit on sale of investment is added back
as it is non-operating income. (1)
2014: 3 249 960*1.022
2014 is adjusted for inflation.
EBIT 1 139 122 876 004 1 165 792 Calculated
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Calculation 1 2013 2014

Variable component (20% x sales) 5 138 000 5 389 762
Fixed component 5 893 136 6 022 785
(10 951 136 – (5 893 136*1.022)
5 138 000+80 000)
Total Distribution expense 11 031 136 11 412 547

Due to the increasing trend (ignoring 2013 as it is an exception) and since revenue (2)
growth is expected to normalise in years following the 2014 financial year, the
estimated figure of 2014 should be maintainable.
(R1 165 792)

Alternative
Due to varying growth rate use weighted average to determine
maintainable earnings

EBIT 1 139 122 876 004 1 165 792

Weighting 1 2 3 (1)
1 139 122 1 752 008 3 497 376
Weighted average 1 064 751 (1)
( (1 139 122+ 1752 008+3 497 376)/6)
Mark not allocated if divided by 3

• Calculating forward EV/EBIT

The 18% represents real growth and is therefore adjusted for inflation.
The inflationary adjustment is made by dividing as the EBIT per the EV/EBIT multiple is the denominator.

Trailing EV/EBIT multiple of Countryside = 12.22

Forward EV/EBIT multiple of Countryside = 12.22x1/(1.018*1.022)
= 11.75 (1)
Countryside’s forward EV/EBIT multiple must now be adjusted for entity level differences between
Countryside and Bedazzled to make the multiple applicable to Bedazzled. (1)
The adjustments will be as follows:
Comparator multiple 11.75 (1)

Differences in entity-level risks and growth Impact on EV/EBIT

Bedazzled is small (size of entity) in comparison to Country side which is Decrease (1)
listed / level of competition/ market dominance
Bedazzled’s diversity of products, products are limited to women’s clothing Decrease (1)
Access to financing is less for Bedazzled Decrease (1)
Any other valid points (max1)

Adjusted comparator forward EV/EBIT multiple = 10 (can range between 8-10) (1)
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Value of 70% shareholding in Bedazzled Motivation

Maintainable EBIT x adjusted forward EV/EBIT multiple 11,657,920 1c

(1 165 792* 10)
Investment 0 The investment was sold on the 30 June 2013. (1)

Cash 4,650,000 This includes the proceeds from the sale of the (1)
investment which reflects in the company's bank
account on 30 June 2013.

Enterprise value 16,307,920

Debt -4,500,000 Given
Value of 100% equity 11,807,920
Shareholder premiuims and discounts
Control premium (assume 15%) 1,771,188 (1) Countryside plans to acquire a controlling interest (1)
(70%) in Bedazzled
Subtotal 13,579,108
Marketability discount (assume 8%) -1,086,329 (1) Since the shares of Bedazzled are unlisted, they are (1)
not easily marketable.
Value of 100% equity shareholding in Bedazzled 12,492,779
Synergies 2,000,000 (1) Synergies are included as the maximum bid price is (1)
being calculated.
Subtotal 14,492,779
Value of 70% equity shareholding in Bedazzled 10,144,945 (1) Countryside intends acquiring 70% of the shareholding (1)
in bedazzled
Maximum bid price for 70% shareholding 10,144,945

MAX
22
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Sections c-f requires students to apply the information in the scenario as well as their general knowledge of the
clotting retail industry to add value to their discussions and maximize their potential to earn marks.

(c)

This portion of the valuation provided students with an opportunity to earn a large number of easy marks. Most
students however did not include these calculations.

Other bidders

The presence of other market participants interested in purchasing Bedazzled may result in
Countryside having to offer a higher price and vice versa. (1)

The effect that the purchase of Bedazzled by another party will have on the existing operations of
Countryside, e.g. should it be acquired by another large clothing retailer this may increase the
competition which Countryside is exposed to. In this case Countryside may be willing to pay more for
Bedazzled. (1)

Reason for sale

The AAA group wish to exit their investment in Bedazzled to pursue other opportunities. Countryside
should establish the reason for this change and consider the potential impact this may have on the
future operations of Bedazzled. The change in shareholding and potentially management may have a
negative impact on the operations of Bedazzled and may cause Countryside to reduce the price it may
be willing to pay. (1)

Risk

The price paid for Bedazzled should consider if the risk (financial and business/operating) of Bedazzled
is in-line with Countryside’s risk profile and risk appetite. (1)

Financial position of the buyer

The amount of cash or access to capital/finance Countryside has and is willing to spend on a single
deal will influence the price it will pay for Bedazzled. Consider Countryside’s target debt to equity ratio.(1)

Expected growth rate

The CEO is confident that Bedazzled’s revenue will increase by 4.9% in the 2014 financial year. (1)

Debt capacity

Should Bedazzled have capacity to take on debt, Countryside will find it more attractive and may be
inclined to pay more for it. Bedazzled currently has debt to the value of R 4 500 000, this should be
compared to the target debt and equity ratio for Bedazzled to ascertain their capacity to support
additional debt. (1)
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Strong management

Bedazzled performed poorly in 2013 due to poor management decisions. This reflects negatively
on Bedazzled’s management and may cause Countryside to pay a lower price. (1)
General attractiveness (excluding synergies in this case)
ito cash flow position, liquidity, pending litigations, tax, undervalued tangible/intangible assets.
(1)
Max 3
(d)
XXX Consulting
500 Blackburn Road
Notting Hill
Australia
3168

Directors of Countryside
45 Archerfield Road
Darra
Australia
4076

27 June 2013

Dear Sirs

Per your request we have identified the risks in Countryside paying for acquisition synergy-benefits,
without first performing detailed supporting calculations and without creating a roadmap to its realisation.
These risks are described below:

• Expected synergies equal to AUD 2 million may not realise and Countryside may then have
overpaid for the acquisition. (1)
• If Countryside pays for the full AUD 2 million, even if it is realised, the full benefit would have
been given to prior shareholders of Bedazzled. (1)
• Paying the full benefit represents the maximum bid (which includes specific synergies) and not
the fair value (which includes only general synergies). (1)
• In the absence of detailed supporting calculations and a roadmap to its realisation there is no clear
way for Countryside to evaluate its progress in achieving its expected benefits/synergies. (1)
• If synergy benefits cannot be justified and quantified it is also likely that there will be an IAS 36
impairment of goodwill (which may include synergy benefits) affecting consolidated Annual
Financial Statements. (1)

I therefore suggest that an all inclusive due diligence investigation should be performed to support
synergy calculations (1)

We trust that you find this information useful and will contact us should you have any further queries.
Yours Faithfully
Student
Max 4
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(e)

Comparability

Earnings multiple method of valuation utilises the earnings multiple of a similar listed entity and adjusts
it for entity level differences. Bedazzled is a medium sized firm that retails only woman’s clothing in
Australia. Finding a listed entity similar to it may prove to be difficult. (1)

The result of this is that a large number of entity level differences have to be made. These
adjustments are highly subjective (assumptions are subject to manipulation) and may result in an
inaccurate multiple utilised for valuation purposes. (1)

Short term

Multiples are usually based on historic information or short term forecasts. (1)

Even though the valuation of Bedazzled is based on a forward EV/EBIT multiple, this forecast is short
term (only takes into account growth in EBIT for one year) and thus may not take into account
differences over the longer term. (1)
Max 3
(f)

• Improved economies of scale – Countryside could source clothing for both companies from the
same suppliers and thus negotiate better prices. (1)
• Improved efficiency/Scale economies in non production areas such as marketing, distribution,
research and development etc. This could be achieved through reduced marketing costs, obtaining
larger advertising discounts, single supply chains etc. (1)
• Removal of redundancies, since both Bedazzled and Countryside retail clothing, cost savings could
be achieved by eliminating certain redundancies such as personnel, office space, accounting and
auditing services etc. (1)
• Bedazzled’s and Countryside’s systems can be integrated and this could result in an improved
system. (1)
• By acquiring Bedazzled, the group’s combined market share can increase (1+1=3). (1)
• Strategic benefits as the acquisition could result in reduced competition, particularly in Australia,
as Bedazzled retails women’s clothing in over 200 stores in Australia. (1)
• As Bedazzled was partially modelled on Countryside, culture and other factors are likely to create a
better fit, giving greater confidence in realisation of synergy. (1)
Max 6
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QUESTION 10 SUGGESTED SOLUTION

OSCAR LIMITED
(Source: Test 2 2012 MAC4861/MAC4862 - adapted)

(a) Report

To: Directors of Oscar Ltd

From: An Accountant
Date: 28 April 2012 (1)

Subject: Company valuation as at 31 March 2012 and financing for expansion

Introduction and terms of reference

XXX

(i) Valuation methods

These include:

• The price of recent investment;

• Multiples;
• Methods based on discounted cash flow; and
• Net assets
(½ each, max: 2)
(ii) Calculation of a range of values and discussion

The valuation methods that could be applied in this case is limited based on the information
available and circumstances, and therefore do not include all the methods mentioned.

NET ASSET VALUE

This value has little relevance except in specific circumstances, such as a liquidation. In your
company’s situation it has even less relevance than in a company with a high level of tangible
assets, as much of your value is in your employees’ expertise, or intellectual capital. We
need not therefore consider the book value of assets further. (1)

However, as the amount in the statement of financial position does reflect realisable value, this
is a “floor” level valuation, equal to R385 000. (1)

P/E MULTIPLE

In a listed company, the P/E multiple is used to describe the relationship between the share
price (or market capitalisation) and earnings per share (or total earnings). It is calculated by
dividing the price per share by the earnings per share. (1)
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Market capitalisation is the share price multiplied by the number of shares in issue. Market
capitalisation is not necessarily the true value of a company as it can be affected by a
variety of extraneous factors, but for a listed company it provides a benchmark that cannot be
ignored in, say, a take-over situation. (1)

In the case of an unlisted company, a P/E ratio that is representative of similar quoted
companies might be used as a starting point for arriving at an estimated market value. The
potential market capitalisation would be the company’s latest earnings multiplied by the
benchmark P/E ratio. (1)

The P/E ratio can be viewed as indicative of expected growth, which is why some companies
in your industry have very high P/E ratios at the present time. A relatively high P/E would
suggest that investors are prepared to pay a premium for the company’s shares, based upon
present earnings, because they anticipate growth in future earnings beyond growth rates
expected in comparable companies. I show below the potential value of your company using the
average and range of P/Es for your industry as comparator: (1)

Range of P/E multiple – used as comparator 12 27 82

Adjustments for probable differences:

• Smaller size - - - (1)
• Less access to finance - - - (1)
• Reliance on key employees - - - (1)
Any other valid adjustment (1)
Max 3
Adjusted P/E multiple 7 16 49
Acceptable range 6-10 14-22 41-66 Within
range
(1)
(R’000)
Value before adjustment of owner-level differences 88 200 613
(10 000 R1,25 x P/E multiple)
Control premium (say 23%) 20 46 141 (1)
Marketability discount (say 5%) (4) (10) (31) (1)
Range of values 104 236 723
The specifics of the comparator multiples to be investigated, including:

• The impact of the change in spending on research and development in future. (½)
• The impact of different levels of debt in the capital structure. (½)
• Growth prospects. (½)
• The impact of the different business areas. (½)
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The values of R104 000 and R236 000 are below the net asset value and may not be relevant.

This valuation is very rough and ready and takes no real account of your own specific
circumstances and potential.

ENTERPRISE DISCOUNTED CASH FLOW MODEL, BASED ON FREE CASH FLOW

This method values your company using your own enterprise’s cash flow forecasts. (1)

The approach is as follows:

1. Estimate sales income using your forecasts and estimated probabilities for the year to
31 March 2013 and 2014.
2. Calculate earnings/cash flows for the years to 31 March 2015-2016 based on your
estimates of growth.

Note: Assuming earnings equals cash flows is a simplification for examination purposes. In reality,
this would be affected by, for example: depreciation, movements in working capital, and sale and
purchase of non-revenue items.

3. Calculate discounted cash flows using the supplied WACC.

4. Estimate the present value of cash flows for 2017 to infinity using Gordon’s dividend
growth valuation model.
5. Calculate the present value of all future estimated cash flows.

Estimation of earnings and cash flows for 2013-2014

Year to: 31 March 2013 31 March 2014

Probability Turnover Expected Probability Turnover Expected

Turnover Turnover
R’000 R’000 R’000 R’000 R’000

50% 1 800 900 50% x 80% 2 500 1 000

50% x 20% 3 000 300

30% 1 200 360 30% x 50% 1 700 255

30% x 50% 1 400 210

20% 800 160 20% x 50% 1 000 100

20% x 50% 800 80
Total 1 420 1 945 (2)
Operating costs
(35% and 30%) (497) (584) (1)
Profit before interest 923 1 361
Tax at 28% (258) (381) (1)
Earnings/cash flow 665 980
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Specific forecast Continuing

value base
2013 2014 2015 2016 2017
R000 R000 R000 R000 R000
Free cash flow 665 980
R 980 000 x 1,40 1 372 (1)
R1 372 000 x 1,40 1 921 (1)
R1 921000 x 1,10 2 113 (1)
Free cash flow 665 980 1 372 1 921 2 113
Gordon Growth Model
P 2016 = FcF 2017 2 113 (1)
(WACC-g) 20%-10%
21 130 Correct year (1)
Totals 665 980 1 372 23 051
0,579 0,482
0,833 0,694
554 680 794 11 111
(1)
R’000

Value of operations 13 139

Value of debt (300) (1)
Value unadjusted for 12 839
owner level differences
Marketability discount (770) (1)
(say 6%)
Fair market value 12 069

Other information required:

• Detail of continuing value base, including working capital investment requirements, and research
and development investment required. (½)
• Detail supporting the growth prospects. (½)
• Value of excess cash and other non-operating assets. (½)

The DCF method is the most likely to be reliable, but the figures produced are very rough and ready.
A more detailed exercise needs to be undertaken.

Summary of range of values per method

R000 R000

Net asset value 385

P/E based value 104 - 723
DCF value 12 069
___
Maximum (19)
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(iii) Venture capital finance versus listing

If we accept a company valuation of around R12 million, this is still relatively small for a full listing. A
listing on the Venture Capital Market might be an acceptable alternative and less expensive
although the relative length of the “queues” for listing (controlled by the Stock Exchange) needs to be
considered. The main advantage of any sort of listing is that it provides a readily available
benchmark valuation for the shares. However, the number of shares to be sold needs serious
consideration. If a small percentage of the shares is sold, this may deter institutional investors as
there may not be a ready market in the shares if they want to sell. If a high percentage is issued,
control is lost. (3)

However, if venture capital finance were to be sought, control would be surrendered anyway as these
organisations typically require a large equity stake, high returns and an assured exit route.
Normally, an exit route would be to sell the shares on the market either via a placing or offer for
sale or to another venture capital company. The original owners of the company might be able to
buy back their shares via an earn-out basis. This method allows the venture capitalist to sell shares
back to the owners on the basis of the company achieving certain levels of return. (2)

No details of what investment would be required to allow the company to grow at a faster rate is given
in the question. In a company such as this, the value is in the intellectual capital and this might be in
short supply.
Any other valid point (1)
Max (5)
(iv) Alternative types of finance

At present you are considering only two alternatives: to use venture capital money to aid expansion
beyond the present projects, with the implications for control, or to wait until you have built up your
profits over the next year or so and then float the company. Alternatives you could consider are:

• Increase your bank loan, secured on your assets or possibly in exchange for a stake in the
equity of the company. (1)

• Issue new shares and sell a non-controlling proportion to private investors. There are
schemes available to encourage investment in small, growing companies. (1)

• Conduct a review of your terms and conditions for sale - it could be that there are
opportu nities for substantial increases in revenue by entering into revenue-sharing agreements
with Internet providers. (1)

• Accelerate the float of the company, perhaps on the Altx. Given the growth potential of
companies in your sector, it is possible a much higher P/E ratio might be awarded to your
company than suggested earlier in this report. (1)

(But consider the Altx listing requirements, including the number of non-executive directors,
the public must hold a minimum of 10% equity shareholding, and share capital and reserves
must equal at least R2 million.) (1)
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Before deciding on a course of action, you must clarify your own short and long-term objectives. If
your aim is to maximise your own personal wealth in the shortest possible time, then an early flotation is
probably the best alternative. If you would prefer to retain control of your company, then the other
alternatives might be more appropriate. (1)

Other issues to consider are:

• Timing and cost of a flotation, and how many other similar companies might be coming to
market at the same time. (1)

• The implications of the proposed changes in regulation, both on your existing business and
potential market value. (1)

Conclusion and recommendation

Venture capital financing would almost certainly involve loss of control of the business in the short- term,
but would avoid the costs and delays involved in a stock market listing. Alternative methods of financing
growth should also be considered. (1)
Maximum (5)

(b) Protection against loss of technical expertise

The risk is that the company’s employees might sell the company’s ideas to a competitor, which
is a high risk for them as it is illegal, or move to another company taking their ideas and designs
with them. The highest risk would be if a group of employees left to join a competitor or set up
on their own. (1)

A number of actions could be taken:

1. Key person insurance to provide cover if a key member of staff falls ill over a long-term or
leaves. This could be expensive and the terms of insurance, if it is to be worthwhile, may be
difficult to arrange. (1)

2. Provide good working conditions and adequate remuneration to try and retain key staff. If the
company plans to go public, share options are an ideal method of retaining staff loyalty, at least
as long as the share options are valid and valuable. (1)

3. Contracts that restrict what staff can do if they leave to join a competitor or set up on their own.
These, however, are difficult to enforce. (1)
(4)
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(c) Possible country risk components when investing in the rest of Africa:

• Currency risk and the risk resulting from inflation, including devaluation and volatility (1)
in the local currency.
• The credit risk of the government, including the possibility of defaulting on (1)
international debt funding.
• Social or political problems. (1)
• Possibility of government expropriation and nationalisation of private assets. (1)
• Potential barriers to free capital flow in and out of the country. (1)
• Skills shortage (1)
• International perception and sanctions (1)
• Tax legislation differences (1)
• Technology not up to date (1)
Maximum (5)
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QUESTION 11 SUGGESTED SOLUTION

ZIVA’S FASHION FANATICS LIMITED

(Source: UNISA Test 4 2012 MAC4862)

Part A - Risk identification and mitigation 12 marks

 Mitigation techniques should always consider cost versus benefit. (1)Bonus

Risk Explanation of risk Mitigation (1 method per risk)

Currency /exchange Importing products from (1) Currency future, currency option, (1)
rate risk (1) Italy will expose ZFF to currency swap, forward exchange
currency fluctuations rate (forward contract), or
between ZAR and the money-market hedge.
Euro.

Payable on delivery will (1)

expose ZFF to currency
fluctuations as there is a
time gap between order
and payment date.
Country (economic) ZFF doesn’t diversify (1) Diversify suppliers. (1)
risk /Concentration risk their international
(1) suppliers geographically Consider introducing additional (1)
as they only purchase brands
from a single supplier in
Italy.

Italy’s economy is under

pressure and is (1)
experiencing a recession,
which may put supplier
(and brand security) at
risk.

ZFF is reliant on an Italian

supplier and thus runs the
risk of the goods not being (1)
delivered on time leading
to loss of sales.
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Interest rate risk (1) As cash shortfalls are (1) Interest rate future, (1)
financed using a bank interest rate option,
overdraft, ZFF is exposed interest rate swap, interest rate
to changes in the prime cap, interest rate floor, or interest
interest rate. rate collar.

However the practicality should be

considered. (1)
ZFF should consider matching long
Finance risk(1) Long term vs. Short term term financing needs with long
financing. ZFF is only term finance and not only make (1)
making use of a short term use of short term debt
overdraft facility to finance
working capital
Furthermore overdraft
facilities are callable at
any time by the bank. (1)
Credit risk (1) All walk-in clients receive (1) Perform a credit check/ credit (1)
credit. Credit should only rating.
be provided to credit
worthy clients after a
credit check has been
done.
Credit terms may not be
met and ZFF may
experience a profit loss
due to the bad debt write-
offs. (1)
Business risks ZFF operates in the There should be a quick turnover (1)
associated with fashion industry which between the manufacture of the
experiences frequent clothing and the sale thereof./
• changes in fashion changes in fashion trends Buyers should be aware of fashion
trends this could lead to them trends and purchase accordingly./
• client base limited to holding obsolete stock. (1) The quantities of clothing ordered
women only should be managed appropriately.
• Operating from
prime shopping Diversify client base into different
centres only (1) sectors to include men’s and
children’s clothing/ Diversify
shopping centres geographically. (1)
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Part B – Investor ratios

(a) Explanation and comments 9 Marks

Earnings per shares:

• This ratio looks at the profits available per share for distribution. (1)
• As the number of shares increased from 2,5 million to 3 million these results are not directly
comparable, however shareholders may still refer to this ratio to determine the performance of
their shares. (1)
• Since earnings have increased with 36% compared to the no of shares which increased with 20%,
the money raised from the share issue was successfully applied. (1)
• The Cumulative Average Growth Rate of EPS is 6.6% which is more or less in line with inflation of
6.1% (PV = 220c; N = 2; PMT = 0; FV =-250; thus I = 6,6%) (1)

Price earnings ratio

• The P/E multiple links the share price to the earnings per share. (1)
• This ratio gives and indication of the relationship between the share price and most recent
historical earnings per share and of future expectations. It incorporates growth and risk factors.(1)
• As the P/E of 2012 (4.8) exceeds that of 2010 (4.09) it indicates that the market now expects
higher performance (growth) or lower risk. (1)

Dividend cover

• Dividend cover indicates the ease with which dividends can be covered by earnings generated in
the year. (1)
• This ratio will tend to fluctuate as profits are more volatile than the usually steady dividend policies
followed and thus a long-term trend needs to be analysed. (1)
• Dividend cover has decreased from 5.5 (2010) to 5 (2012), however a dividend cover of 5 is fairly
safe. This however doesn’t mean that the entity will always have cash available to maintain the
dividend and the ratio should be monitored. (1)

(b) Interrelation between the investment, financing and dividend decisions 5 Marks

• Investment in positive NPV projects will increase the present value of cash available to the firm,
ZFF. In an effective market this will lead to an increased enterprise value and increased share
price and thus increase in shareholders’ and other capital holders’ wealth. (1)
• These investments will require cash or debt finance. ZFF will need to consider its target capital
structure (D:E ratios). (1)
• Theoretically cash is considered to form part of retained earnings in which case it would be more
expensive than debt (Kd<Ke) however if an entity uses cash invested in the market, financing
through debt is more expensive than cash due to the associated issue cost. (1)
• Dividends: The financial management of ZFF need to take shareholders preference into account
and must find a balance between capital retention for capital growth purposes (reinvestment)
and payment of dividends to shareholders. (1)
• Using ZFF’s available cash will reduce the cash available for dividends. Due to the information
content of a decrease in dividends it may offer a negative signal to investors’ which may reduce
the share price. (1)
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• A low return will be generated on excess cash however keeping excess cash may reduce risk of
lower access to finance. (1)

Part C – Expansion initiatives

(a) Critically comment on NPV 10 Marks

• As these options are mutually exclusive the trainee cannot compare the two stores based on Net
Present Value only. (1)
• The two options are not for the same time period (5 yrs vs. 7 yrs) and it would thus be necessary to
first calculate the annualised NPV for each option. This can be done by dividing the NPV by the
annuity factor or Profitability Index. (1)
• Sales have been incorrectly calculated, sales should increase annually with a factor of 8.2%, and
the trainee has increased sales by 82%. (1)
• Cost of sales has been excluded, this is relevant for a clothing and accessory store and these
details should be obtained from the marketing department. (1)
• Long term finance cost/ Interest expense should be excluded as it relates to the separate
financing decision and the cost of debt is already included in the discount rate (WACC). (1)
• Only R55 000 has been included as lease expense, this represents the monthly charges and
should thus be multiplied by 12. (1)
• Working capital balances have incorrectly been included in the NPV analysis, only the cash
movement in working capital should be included in the NPV calculation. (1)
• Working capital is incorrectly included from year 1 to year 5, it should however be included from
year 0 to year 5 as working capital is required upon opening of the store, therefore the beginning
of each period. (1)
• Since there is no certainty regarding the renewal of the lease beyond 5 years , the total working
capital of R 1 276 282 should be expected to be recovered in year 5, thus a cash inflow. (1)
• The trainee has incorrectly utilised the real rate as discount factor. The correct rate should be a
nominal rate ((1+0.085)*(1+0.061))-1 = 15.12%. (1)
• The cash flows used in the NPV calculation represent nominal cash flows (cash flows have been
adjusted with inflation) thus a nominal discount rate (which includes inflation) should be used. (1)
• The taxable amount should exclude working capital movements, the initial capital outlay and
interest. This was incorrectly included in the taxation calculation. (1)
MAX 10
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(b) Annualised Net Present Value and conclusion 4 Marks

Calculation of the nominal rate:

((1 + 8.5%)*(1 + 6.1%))-1 = 15.12% (1)

Option 1:

PV = (976 234)
N =7
i = 15.12
PMT = 235 493 (1)

Option 2:

PV = (1 250 000)
N =5
i = 15.12
PMT = 373 954 (1)

Conclusion: As ZFF can only invest in one option ZFF should select option 2 as it offers a higher
annualised NPV, given the same risk profile. (1)
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QUESTION 12 SUGGESTED SOLUTION

BIDDER LIMITED
(Source: Test 3 2011 TOE408W (MAC4862) - adapted)
(a)

This section required the calculation of the current value of a 100% equity shareholding in Target, based on the
available information and the specified methods and models, as well as an evaluation of the specified methods
and models.

Candidates frequently neglected to offer a proper evaluation, as required.

Furthermore, candidates often failed to consider the following aspects:

• The fact that an unlevered Beta coefficient should increase where there is debt in the capital structure
(specific calculations were, however, not required);
• The impact of the different growth rates on projections for years 1 to 5, and on years thereafter.

Current value of a 100% shareholding in target based upon:

MARKET CAPITALISATION (FULL)

370 cents x 5 000 000 shares (500 000 / R0,10 par value)
= R18 500 000 (1)

Evaluation

This measure will not be a good basis to value a 100% shareholding for the following reasons:

• This measure uses the market price per share of free-float shares (roughly 50% of
shareholding) and applies this to all issued share capital. (1)
• Depending on whether an announcement re the potential takeover was made public
yet, the market may or may not have priced-in the effects of the takeover on: (1)

 A control premium (1)

 Expected synergy benefits (1)
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DIVIDEND VALUATION MODEL, EXCLUDING SYNERGIES AND RELATED COSTS

Here we calculate the present value of dividends based on an expected dividend for 5 years (linked to
expected operating cash flows and dividend cover), where after we apply Gordon’s Constant Growth
Model.

Cash dividend cover: R3 551k / R842k = 4,22 times (1)

Ke = Rf + levered ß(Rm-Rf)
= 8% + 1,92a (2) if ß >1,7 used
x (14%-8%) (1)
= 19,5%
Or = 19,5% + 5% small stock premium = 24,5% Bonus: (1)

a
This will only be asked if the formula is provided:

Unlevered β (aka asset β) = Levered β (aka equity β)

1 + [(1 - Corporate tax rate) x (Debt / Equity)]
1,7 x {1 + [(1 - Corporate tax rate) x (Debt /
Equity)]} = Levered β (aka equity β)
1,7 x {1+[0,72 x 0,18/1]} = Levered β (aka equity β)
1,92 = Levered β (aka equity β)

1 2 3 4 5 6
R’000 R’000 R’000 R’000 R’000 R’000

Expected post-tax operating cash

flow (nominal)

• Grow by 8.16% or 8% (simplified)

1

[e.g. previous year x 1,0816] 3 840,8 4 154,2 4 493,2 4 859,8 5 256,4 (1)

• Grow by 4% [5256,4 x 1,0816] 5 466,7 (1)

Expected dividend
(figure above / 4.22) 910,1 984.4 1 064,7 1 151,6 1 245,6 1 295,4 (1)

Alternative – direct
1
Dividend grow by 8.16% or 8% 910,7 985,0 1065,4 1152,3 1246,3 1 296,2 (3)
(rounding difference)
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Gordon Growth Model

1 295,4 (1)
P 0 = D 1 /(Ke-g), or (19,5% - 4%) (1)
P 5 = D 6 /(Ke-g)
= 8 357,4
9
910,1 984.4 1 064,7 1 151,6 603,0
Discount at Ke ( 19,5%) 0.8368 0.7003 0.5860 0.4904 0.4104

PV = R6 580,2 k (1)
for discounting factors or calculator (steps shown)– exclude yr 6
1
Growth: 1,04 x 1,04 = 8,16%

Evaluation

This model will not be a good basis to value a 100% shareholding for the following reasons:

• The future benefit to shareholders is unlikely to consist only out of dividends; capital growth should
also play a role. (1)
• This model will give an indication of intrinsic value but will obviously exclude the synergy-effect. (1)
• A takeover could result in a change in dividend-policy and expected growth. (1)
• This model has a viewpoint of the benefits to a minority shareholder, not a controlling one (implied by
a 100% shareholding).
(1)
COMPARATIVE P/E RATIOS, INCLUDING TYPICAL M&A PREMIUMS AND COSTS

• Average P/E ratio in industry 6

• P/E ratio of Target: 1/19,2% = 5,2 (1)

• Target thus trades at a 13,3% discount [(6-5,2)/6] to the average of its industry (1)

• Average takeover premium paid in this industry: 16,7% [(7-6)/6] (1)

• Target historical earnings per share: 370c x 19,2% = 71,04c

• Target share price including discount and takeover premium:

o 71,04c x 5,2 x (1+0,167) = 431,1c (1)
• Or 71,04c x 6 x (1-0,133) x (1+0,167) = 431,3c (rounding difference)
• Or 370c x 7/6 = 431,7c (rounding difference)

• Value of all shares: = 431,1c / 100 x 5 000 000 shares (1)

= R21 555 000
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Evaluation

This measure will give an indication of the value of a 100% shareholding in Target in the case of a
takeover, but is subject to the following limitations:

• This measure did not consider the specifics of the specific takeover, e.g. (1)

o unique matchup (1)

o growth expectations (1)
o reasons why Target was trading at a discount (1)

PRESENT VALUE OF FREE CASH FLOWS, INCLUDING EXPECTED SYNERGIES AND RELATED
COSTS

WACC = Kd x (d%) + Ke x (e%)

Where

• kd = 11% x (1-28%) = 7,92% (1)

Or = 11% x (1-33% actual effective rate) = 7,37% (1)
• d% = 0,18 / (0,18+1) = 15,3% (1)
• e% = 1 / (0,18+1) = 84,7% (1)
• Ke = 19,5% (as calculated before)
Or = 19,5% + 5% small stock premium = 24,5%

WACC = (7,92% x 15,3%) + (19,5% x 84,7%) (1)

= 17,7%
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1 2 3 4 5 6
R’000 R’000 R’000 R’000 R’000 R’000
Expected post-tax operating
cash flow (nominal)
• Grow by 8,16%1 or 8%
[e.g. previous year x 3 840,8
1,0816] 4 154,2 4 493,2 4 859,8 5 256,4 (1)
• Grow by 4% [5 256,4 x 1,0816] 5 466,7
(NCA + net working capital) /
Operating cash flows after tax
= 9 200 / 3 551 = 259%
Required: NCA + NWC
Operating cash flow x 9 947,7 10 759,4 11 637,4 12 586,9 13 614,1 14 158,8
259%
Change
• (R9 200k – R9 947k) (747,7)
• Difference this year (811,7) (878,0) (949,5) (1 027,2) (544,7)
4 229,2 4 922,0
Gordon Growth Model
P0 = CF1/(WACC-g), or 4 922,0 (1)
P5 = CF6/(WACC-g) (17,7% - 4%) (1)
= 35 927,0
3 093,1 3 342,5 3 615,2 3 910,3 40 156,2
Discount at WACC (e.g. 0.8496 0.7219 0.6133 0.5211 0.4427
17,7%)
PV = R27 072,9 (1)
for discounting with factors or calculator –
exclude yr 6
PV of synergies and related cost 0
R’000
Employees – retrenchment (1 200,0) (1)
Present value of wage, admin & distribution 32,1 (3)
savings:
Gordon Growth Model (750+150)x1,04
P0 = Cf1/(WACC-g) (17,7%-4%)
Land and buildings 800,0 (1)
Legal and other cost (3 000,0) (1)
3 432,1 (2)
Contributed by Target (most represent savings in 50% less than
duplicated capacity so benefit should be shared) 100%
PV of synergy 1 716,0
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Current value of a 100% shareholding

R’000

Present values of free cash flows 27 072,9

Present value of debt (3 500,0) (1)
Indication of intrinsic value of 100% equity 23 572,9
Present value of synergies and related costs 1 716,0
Current value of a 100% shareholding 25 288,9

Evaluation

This measure will give a good indication of the value of a 100% shareholding in Target in the case
of a takeover, as:

• Target company-specific factors are taken into account (1)

But be careful to overpay for synergies – especially synergies that are not available to other
market participants (1)
Available: (52); maximum: (32)
(b) Recommendation

Final price should be a matter of negotiation. (1)

The price should depend on the interest shown by other market participants and eagerness of
shareholders of Target to sell (price of R21 555 000 should give an indication)
(1)
Maximum bid price is equal to intrinsic value plus value of specific synergies (in this case
R25 288,9k) (1)

Consider other other qualitative factors:

• What is the strategic reason for takeover as Target is in an unrelated industry?

Possible reduction in duplicated costs (as indicated in cost synergies above) &
diversification? (1)
• Does Bidder have an unique ability to operate Target? (1)
• Other relevant (maximum 1) (1)

Recommendation: Given sufficient interest by market participants, bidder should acquire Target
for R23m as this is less than intrinsic value plus synergies. (1)
Maximum: (3)
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(c) Factors influencing payment form

Cash position

A cash offer would effectively use up all of Bidder’s cash deposits. Bidder must therefore consider
its overall cash flow projections (especially considering the state of the economy) when deciding
the form of the bid, so as to avoid possible liquidity problems. (2)

Capital structure

Bidder must also consider what its desired target capital structure should be in terms of gearing
level, type of debt used etc, and try to structure the bid to fit these requirements. (1)

Long-term costs

Both the long-term costs of the different sources of finance, and the transaction cost of raising the
finance in relation to the size of the bid must be taken into account. (1)

Target shareholders

The requirements of Target’s shareholders must also be considered (e.g. their preference,
implications on their capital gains tax liability, etc). (1)
Maximum (5)
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QUESTION 13 SUGGESTED SOLUTION

CHOCCI CHOCS LIMITED

(Source: Test 4 2011 TOE408W (MAC4862)- adapted)
Part (a)

General commentary such as: ‘cost increased year on year’ does not earn marks.

 Commentary must add value by indicating an improvement or a weakening of the ratio.

 Utilise the industry averages, information in the scenario relating to Chocci Chocs and the industry as well
as your general knowledge to provide value added comments.
 The length and extent of answers should relate to the number of marks allocated.

Sales

(i) Decrease in sales -5,7% ((1 070 286 + 1 135 000)/1 135 000)) (1)

(ii) The 2010 sales showed no growth and have in fact decreased with 5.7%. This is mainly caused by
the increased competition and current economic climate. (1)
This is concerning as the industry has shown a 27% growth rate in these troubling times. The
decline in sales may be an indication that Chocci Chocs have lost some of their market share to
cheaper manufacturers. (1)
Chocci chocs may need to undertake further market research to ascertain if there is sufficient
demand for their product, prior to deciding whether they should expand locally. (1)
It also seems as though Chocolates are highly elastic as the slight change in price resulted in
the decrease in sales. (1)

2010 2009
R’000 R’000

(i) Gross profit percentage 35.00% 35.00% (1)

(GP/Sales)

(ii) As the sales decreased we would have expected the gross profit percentage to decrease at a
faster rate due to a loss of economies of scale (loss of quantity discounts no longer obtained),
this was however not the case. (1)
Gross profit percentage remained constant despite the increase to the raw material cost (cocoa).
(1)
This indicates that Chocci Chocs have a fixed mark-up on products. (1)
What is further concerning is that, included in closing inventory is obsolete stock that has not yet
been written off , this will worsen both the gross profit and net profit ratios and emphasizes the
need to improve inventory management. (1)
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(i) Operating expenses as a percentage of revenue

Percentage of sales = 13.55% = 11.72% (1)

(ii) Operating expenses increased despite the decrease in sales. This indicates a loss of economies
of scale (marketing cost per item will increase) (1)
It also indicates that urgent attention should be given to foreign exchange losses and that the
management efforts by Mr. White have not been as effective as planned. (1)
Operating expenses as a percentage of sales has increased from 11.72% to 13.55% in 2010, this
leads to a decline in profit for the year. (1)

(i) Operating profit margin = Operating profit/Sales

= 21.45% = 23.28% (1)

(ii) Operating profit has decreased as a result of a decrease in sales and an increase in operating
expenses.

(i) ROCE

Always utilise the market value of debt and equity to calculate ratios.

Preferred
2010 2009

= EBIT
= Capital Employed
= 229 600 264 250
707 248 + 106 300*+ (500 000 x 3) 696 115+ (500 000 x 3.2)
= 9.92% 11.51% (1)

Alternative = EBIT
Total Assets – Current liabilities
= 229 600 = 264 250
1 495 020 – 243 800 1 330 475 – 94 500
= 0.18 = 0.21
= 18,35% = 21,38%

* Includes bank overdraft as it was used to finance more than working capital and not consistent with
2009 usage

ROA = EBIT
Total Assets
= 229 600 = 264 250
1 495 020 1 330 475
= 15.36% = 19.86% (1)
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(ii) The return on capital employed/return on assets has decreased from 11.51% to 9.84% / 19.86%
to 15.36% indicating that assets are being utilised less effectively than in the past, but that
Chocci Chocs is still outperforming the industry norm of 9%. (1)

(i) Return on equity (ROE) = Profit after tax and Interest

Shareholders value
= 104 112 = 139 860
1 500 000 1600 000
= 6.94% = 8.74% (1)

(ii) Return on equity has decreased and some shareholders may find the risk of their investment in
Chocci Chocs now exceeding their return. (1)

(i) Interest cover = EBIT

Interest
= 229 600 = 264 250
85 000 70 000
= 2.7 = 3.78 (1)

(ii) This ratio measures the ability of a company to meet its interest obligations. Chocci Chocs ability to
pay its debt is deteriorating compared to the prior year. (1)
This is due to the decrease in EBIT and the increase in interest expense. However compared to
the industry (the industry average of 2.8) they still seem to be in a good position to pay their
interest obligations. (1)
This ratio should however not be considered in isolation and the cash flow position of the company
should also be taken into account. In addition the overdraft facility was only utilised at the end of
2010 and therefore the effect of its high interest rate will only be experienced in 2011. (1)

(i) Gearing
Interest bearing debt
Interest bearing debt + equity
= 707 248+ 106 300 + 20 700
834 248 + (500 000x3) = 696 115
= 834 248 696 115+(500 000 x 3.2)
2 334 248 = 696 115
= 35.74% 2 296 115
= 30.32% (1)

(ii) The company’s gearing ratio has worsened from 30.32% to 35.74% (35.16%) in 2010, but it is not
overly concerning as the industry norm is 42%. (1)
What is concerning though is the decrease in share price. (1)
An additional point of concern should be that the company has drastically increased its use of
short-term debt (bank overdraft) compared to long-term debt. The bank overdraft was utilised to
finance equipment, which indicates inappropriate financing of non-current assets with current
liabilities. (1)
The high overdraft rate indicates that Chocci Chocs is deemed to have a high risk. (1)
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Part (b)

Money market hedge

Swiss Franks required today

FV= CHF 25 000 000
N= 1
I= 4%
PV = CHF 24 038 461.54 (1)

Rands required today

Buy today: CHF 24 038 461.54 x R 7.41= R 178 125 000.01 (1)
Total cost over a year’s time:
178 125 000.01x 1, 12^0.5 = R188 509 780.93 (1)
R 188 509 780.93 x 1.115^0.5 = R 199 054 189.41 (1)

OR,
PV= 178 125 000.01
N= 0.5
I= 12%
FV = R188 509 780.93 (1)

PV = R188 509 780.93

N= 0.5
I= 11.5%
FV = R 199 054 189.41 (1)

Forward contract

Calculate the forward rate: R 7.41*1.105 = R8.19 (1)

OR,
PV= R7.41
N= 1
I= 10.5%
FV = R8.19
(1) r/w

Payment in one year’s time: R8.19 x CHF 25 000 000 = 204 750 000 (1)

Conclusion: the money market hedge is less expensive than the forward contract, thus Chocci Chocs
should prefer a money market hedge above a forward contract. (1)

As the local machine costs only R 150 000 000, this will be the most cost effective option compared to
both the money market and forward contract options of the imported machine. (1)

Available 8
Max 7
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Part (c)

Theory:

The Board of directors should consist of majority non-executive directors, of whom the majority should
be independent.
The company will need to report on its social, economic and environmental impacts in terms of King 3’s
integrated reporting requirements.

(i) Implement change:

Only two of the four non-executive directors are independent (chairman and one other member), thus an
additional independent non-executive director should be appointed to ensure that the majority of
non-executives are independent. (1)
Mr. Brown would be required to give urgent attention to the food poisoning and salmonella claims as
he will need to report on it as it falls within the social and environmental impacts requirements of
integrated reporting. (1)
In addition Mr. Brown would need to consider the irreparable damage that could be done to the
company’s reputation. (1)
Chocci Chocs should establish committees i.e. Audit, Risk, Nomination and Remuneration committees.
Max 3

(ii) Should not change:

The current board consists of three executive directors and four non-executive directors, the
majority of the directors are non-executives thereby meeting the first requirement. (1)
In addition the chairman is not the CEO and is independent and a non-executive. (1)
Should Chocci Chocs expand its operations and manufacture chocolates locally, they will be providing
work for the South African community, this could be seen as being socially responsible and this can be
reported in their integrated report. (1)
The donations to orphanages could also be reported as part of the company’s corporate social
responsibility as a positive reflection in their integrated report. (1)
Other valid point for should change and should not change (max 1) (1)
Max 3

Part (d)

Common errors made in the section are as follows:

 Days were not rounded to the next whole day as required, it is therefore important to read the “Required”
carefully.
 Students calculated bad debts per the new policy based on new sales only as opposed to total sales as
provided in the information.
 The calculation of investment in accounts receivable is calculated for the purposes of determining the cost
of financing. Therefore the calculation includes only the cost component (65%) of accounts receivable and
not the sales value.
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R’000

Increase in profit before tax 33 714.01 W3 * 35% (1)

Increase in bad debts -10 274.74 W6
Increase in discount allowed -5 313.97 W5
Finance costs of Accounts
receivable -844.5 W8
Profit before tax per new policy 17 280.8
Since profit before tax increases by R 17 280.8 it would be advisable to change the credit policy. (1)

Workings:
(1)
GP% 35% (374 600/ 1 070 286) W1
CP + GP = SP
65 + 35 = 100

New credit sales

Current credit sales 321 085.80 (30% * 1 070 286) W2 (1)

Increase in credit sales 96 325.74 (30% * (W2)) W3 (1)

Total new credit sales 417 411.54 W4

Discount allowed
(1)
Existing customers 4 495.20 (28% * W2 * 5%)
(1)
New Customers 818.77 (17% * W3 * 5%)
Total Discount allowed under new policy 5 313.97 W5

Increase in bad debts

Currently 6 421.72 (2% *W2) (1)
(1)
New policy (16 696.46) (4% *W4)
Increase 10 274.74 W6
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Investment in Accounts receivable

Debtors days
Current policy 52 days (45300/321 085.8*365) (1)
New policy (old customers) 46 days (0.28 * (10)) + (0.72* (60)) (1)
New policy (new customers) 52 days (0.17 * (10))+ (0.83* (60)) (1)
Decrease in current accounts (1)
receivable 5 278.12 (((52-46)/365)*W2)
Increase in accounts receivable (1)
(new) 13 723.12 ((52/365)* W3)
Net increase in accounts receivable 8 445.00 W7

(1)
Finance costs of Accounts receivable 844.5 (W7*10%) W8

Available 15
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QUESTION 14 55 marks

ITHEMBA ENGINEERING (PTY) LTD

(Source: SAICA June 2013 ITC paper 2 - adapted)
Part (a)

Analysis should be done first to enable critical and relevant discussion. Profitability should cover the main
contributors as indicated by the extracted information – this is always the key. The line items should all be
covered. Giving two years’ info will enable a % change line/column for comparison against peer/bench marks/other
than line items.

Analyse and discuss the profitability and working capital management of Ithemba during the
financial years ended 30 November 2011 and 2012, supported with calculations and ratios.

Summary of ratios Notes 2012 2011

Revenue growth 1 3,0% (½)

Gross profit margin 36,5% 40,1% (1)
Bad debts/Revenue 2 2,1% 1,9% (1)
Operating costs/Revenue 3 11,1% 11,6% (1)
Change in operating costs
Research and Development 4 -8,1% (½)
Depreciation -1,5% (½)
Other operating costs 5 7,7% (½)
Total operating costs 6 2,3% (½)
EBITDA/Revenue (alternative PAT/Revenue) 7 18,8% 22,5% (1)
Change in EBITDA 8 -14,2% (½)
Cost (rate) 9 10,0% 10,5% 1
Change in profit before tax -40% (½)
Inventory days 10 65 55 (1)
Trade receivable days 11 75 65 (1)
Assuming a 28% tax rate
Return on total assets 12 9,6% 12,9% (1)
ROE 13 6,6% 11,9% (1)
ROCE 14 9,6% 14,0% (1)
Calculation – maximum 10

● Revenue

 A growth rate of 3% in FY2012 indicates a slowdown in the construction industry (1)

 This growth rate is also below the CPI (target is 6% max per annum). (1)

● Gross profit margin

 The decline from 40,1% to 36,5% is a concern, given the limited revenue growth (1)
 The reasons for declining margins need to be investigated as a matter of urgency (1)
 There is a possibility that steel price volatility played a role in declining margins (1)
Decline in GP margin due to lack of economies of scale
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● Operating costs

 The decline in spending on research and development is a concern, as Ithemba should continue (1)
investing to boost future revenue growth
 Bad debts have increased relative to revenue, which is indicative of credit issues within either the
customer base or construction industry, or both (1)
 Depreciation has also declined, which could be indicative or less investment in infrastructure
(1)
 Other operating costs increased by 7,7%, which may reflect wage pressure and inflationary
increases (1)

● Financing

 The overdraft has increased, which indicates that there was negative cash flow generation in
FY2012 (1)
 Above is supported by the decline in EBITDA (1)
 As the Bank overdraft is considered permanent finance, the gearing (or debt; equity) of Ithemba
has deteriorated, which indicates a higher risk profile. (1)
 The totals for equity and OD given (279 200/244 900) vs total assets given, would indicate high
settlement of trade creditors, contributing to the increase in the overdraft. (1)

 OP has decreased while Profit Before Tax declined by 40% indicating the extent to which
finance costs is depleting profits. (1)
 The large finance costs could be attributed to the fact that Ithemba makes use of short term
debt only which is costly due to less security offered and also as a result of their increased
finance risk. (1)

● Working capital

 The pressure from customers to hold more inventories is evident in the higher inventory days. (1)
 Trade receivable days has increased from 65 to 75, reflecting cash flow pressures faced in the (1)
construction industry.

● Return on assets / equity

 Returns have declined from low levels to ones which are distinctively unattractive (1)
 The decline in profit before tax of 40% is the key reason for the low return on the asset base (1)
Maximum 10
Max 20
Communication skills – layout and structure (year vs year and change);
clarity of expression 2
22
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Part (b)

Explain how forward and option contracts could be used to hedge Ithemba’s current and future
exposure to movements in foreign currencies

● Foreign exchange exposure

 A weakening ZAR against the US$ will result in higher royalties being paid (1)
 Exports into Africa may partially offset existing foreign currency risk (1)
 The importation of item XE299 (30% of total products sold) will significantly increase the
company’s foreign exchange exposure (1)

● Forward contracts

 Such contracts will fix the rate, which will provide more certainty for Ithemba (1)
 Ithemba will obliged to purchase US$ at the contracted rate, which may move either favourably
or unfavourably (1)
 The cover period (3 months/12 months) can be negotiated, but the longer the cover period, the
higher the forward rates are likely to be (1)

● Options

 Ithemba will have the right but not an obligation to purchase US$ at specified rates (1)
 The option premium is payable regardless of whether Ithemba exercises it (1)
 If exchange rate movements are unfavourable, Ithemba can exercise the option and in so doing (1)
minimise adverse movements
 If exchange rate movements are favourable, Ithemba would merely pay the premium and benefit
from the strengthening of the ZAR (1)
Maximum 7

Part (c)

Estimate and conclude on the impact that the introduction of the proposed settlement discount
for customers could have on the profits and cash flows of Ithemba

Impact on profit: R’000

Forecast revenue 260 642 (½)

Incremental gross profit [(260 642 – 248 230) x 36,5%] 4 533 (1)
Bad debts [2,05% x 95% x 260 642] 5 076 (1)
Settlement discount [260 642 x 20% x 10%] (5 213) (1)

Although the line items in the SCI directly affect working capital, the disclosure and impact should be kept apart.
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Inventory days:

New cost of sales [63,5% x 260 642] 165 459 (½)

Adjusted inventory balance [65/365 x 165 459] 29 465 (1)
Trade receivables balance 47 130
20% settling earlier [20% x 260 642 x 30/365] 4 285 (1)
80% paying as previously [80% x 260 642 x 75/365] 42 845 (1)
Incremental impact on cash flows
Higher gross profit 4 533
Settlement discount (5 213)
Bad debts 24 (1)
Inventories (1 405) (1)
Trade receivables 3 870 (1)
1 809
*Lower finance charges [1 809 x 10%] 181 (1)
Net cash flow effect 1 990 (1)

Impact on profits [4 533 – 5 213 + 24 + 181*] (475) (1)

Maximum 12

Part (d)

Identify and describe the key factors that the Board of Directors should consider in deciding
whether to discontinue the manufacture of the EX299 product and instead purchase it from IEI

● Profitability

 The prices IEI will charge per unit versus current manufacturing costs and royalties could be a
determining factor. (1)
 There will be a greater exposure to foreign exchange risk (1)
 Discontinuing manufacturing could entail closure costs (employee retrenchments, losses on sale (1)
of machinery, etc.)
 There is no guarantee that IEI will not increase prices in the future (1)
 The costs associated with importing goods, such as import duties, freight charges and insurance,
need to be taken into consideration (1)
 There are likely to be costs attached to funding higher inventories, as order lead times likely to
be longer than when the product is manufactured in-house. (1)
 The credit terms granted by IEI may relieve some cash flow pressure and lower the company’s
finance costs (1)
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● Strategic issues

 The IEI order lead times could be critical, as Ithemba needs to supply its clients promptly. If
XE299 not readily available it could result in lost sales/customers (2)
 The company’s increased reliance on IEI may weaken its negotiating position and increase
business risk (1)
 The lay-offs are likely to have a negative impact on employee morale. (1)
Maximum 8
Communication skills – clarity of expression 1
Total for part (d) 9
Part (e)

Discuss how Ithemba should account for the 10% settlement discount that the Board of Directors
is considering

The following literature is applicable in determining the appropriate accounting treatment of the 10%
settlement discount in the account records of Etemba:

1. IAS 18, Revenue, (1)

2. Circular 09/06 as issued by SAICA

Therefore the 10% settlement discount should be taken into account in the revenue of Etamba

Paragraph 32 of Circular 09/06 states that discounts given for the prompt settlement of invoices should be
estimated at the time of sale and presented as a reduction of revenue recognised.
Therefore Etemba should estimate the amount of settlement discount expected to be given based
on past history and market expectations. This is indicated a 20% of customers based on revenue (1)
value.

Any differences with regard to the amounts estimated should be treated as a change in accounting
estimates in accordance with IAS 8, Accounting Policies, Change in Accounting Estimates and Errors. (1)
Maximum 4
Communication skills – logical argument 1
Total for part (e) 5
Total marks for question 55
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Supporting calculations - %’s rounded to once decimal

2012 2011

248 230 – 241 000

1. Revenue growth 241 000
= 3,0%

2. Bad debt / Revenue 5 100 4 500

248 230 241 000
= 2,1% 1,9%

= 28 750 26 700
3. Other operating costs/Revenue 248 230 241 000

= 11,6% 11,1%

= 10 200 – 11 100
4. Change in R & D costs 11 100

= -8,1%

= 28 750 – 26 700
5. Change in other ops costs 26 700
= 7,7%

6. Change in total operating costs = (90 650 – 26 800) – (96 600 – 34 200)
96 600 – 34 200

= 63 850 – 62 400
62 400
= 2,3%

7. EBITDA*/Revenue = 26 800 + 19 800 34 200 + 20 100

248 230 241 000

= 18,8% 22,5%

*: EBITDA – rough indication of cash flow. Should the R & D cost not be a direct cost, but
the amortisation of R & D, this will be added back as well. D & A will also be considered in
calculating EVA.
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46 600 – 54 300
8. Change in EBITDA = 54 300

= -14,2%

12 750 10 800
9. Interest cost (rate) = 127 500 102 800

= 10% 10,5%

28 060 21 750
10. Inventory days = 157 580 x 365 144 400 x 365

= 65 days = 55 days

51 000 42 900
11. Trade receivables = 248 230 x 365 241 000 x 365

= 75 days = 65 days

26 800 34 200
12. Return (EBIT) on total assets = 279 900 264 900

= 9,6% = 12,9%

14 050 x 0,72 23 400 x 0,72

13. ROE (Equity given) = 152 200 142 100

= 6,6% = 11,9%

26 800 34 200
14. ROCE (**) = 152 200 + 127 500 142 100 + 102 800

= 9,6% = 14,0%

** - Assuming the OD is treated as long-term permanent funding.

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QUESTION 15 SUGGESTED SOLUTION

H LTD GROUP
(Source: SAICA June 2013 ITC paper 1 part II - adapted)

The main risk categories should be covered. It will be good practice to start each category (business, financial etc)
on a new page, which would enable you to add items as they come up, rather than a haphazard approach. Also
note the identification of the risk, this approach should always be followed, even when not specifically required.

THE H GROUP

Risk Explanatory note Mitigation

Business risks

1. Acquisition risk ● Complexities of operating in foreign ● Use experts to provide relevant advice.
territories in terms of culture, politics, Limit acquisitions to targeted territories
tax, etc. and core business.
● Acquisition may not perform to ● Perform full due diligence exercise
expectation – loss-making. before acquisition.
subsidiaries acquired in 2010.
● Acquisition not in H Ltd’s core ● Ensure oversight of operations by H
business field - from motor vehicle Ltd management member.
rental to various different industries /
no clear acquisition strategy.
● Perform fewer, more targeted
acquisitions

2. BEE risk ● Requirements may change or are ● Compliance offices to ensure

industry specific eg mining. This may continued compliance ito charters.
impact on growth .
● Monitor and measure BEE linked
transactions for compliance and
impact.

3. Operating risk ● Exposure to crime and political risks ● Implement preventative and corrective
(Or country risk) in RSA Zimbabwe and Nigeria. risk management strategies.
Conduct in-depth risk assessments
prior to investment decision.

4. Any other valid risk: ● Any other valid comment

max 1
Max 1
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5. Funding structure ● Pure debt funding used for ● Full due diligence covering also
skewed (also finance acquisitions – significant increase in scenario what if’s
risk) finance risk.

H Ltd’s funding structure doesn’t ● Use alternative combinations of

align with their target capital finance. H Ltd group should realign
structure. their funding structure to align with
their target capital structure.
6. Currency risk ● Currencies are volatile and for each ● Implement group treasury policy iro
5% by which Rand strengthens OP hedging/financial instruments.
decrease by R70m. ● Apply forward or option contracts
Due to the complexity of foreign Employ staff with appropriate skills to
transactions incorrect translations capture foreign transactions and
may occur (translation risk). decide on appropriate hedging
instruments.

Economic risk

7. Economic recovery ● Slow world-wide recovery impact on ● Reduce costs and improve operating
group businesses may be negative. efficiencies (management should
report on efficiencies and inefficiencies
on a regular basis).
● Reduce working capital and limit
capex to improve cash flow.
● Lower commodity prices will increase ● Consider H Ltd’s continued
the going concern risk of mining involvement in this sector.
operations.

● Any other valid comment ● Any other linked comment

– max 1 - max 1

Strategic, governance
and sustainability risks

8. Regulatory ● Extensive and different regulations in ● Employ compliance officers to monitor

Environment countries and industries. regulations, laws etc.
(compliance risk)
● Compliance with King 3 in RSA a ● Specific officer(s) for specific
challenge iro committee structure. H industries or countries with appropriate
Ltd is listed on the JSE and should skills.
thus “apply or explain” in terms of Use knowledgeable/experienced
King III. directors for specialist committees.
● Any other valid comment ● Any other valid comment
- max 1 - max 1
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9. Skills loss ● Five members of the executive team ● Succession plans to be reviewed,
to retire within 3 years, loss of implemented by HRC
corporate knowledge.
● External appointments may not fit ● Identify and train suitable internal
corporate culture and cause candidates to transfer knowledge to.
operational disruption.
● Re-assess policy to employ mainly
external candidates.

10. Reputation risk Injuries due to violent protests. Early negotiations with Unions and
associated with employees, etc.
mining industry.
Prolonged strikes lead to huge losses Consider selling off high risk
in the mining business. businesses after performing a risk
assessment and comparison with H
Ltd’s risk appetite.
(1/2 each; Max 6) (1 each; Max 13) (1 each; Max 19)

- Layout and structure: headings and

key risks (1)
- Clarity of expression (1)
40
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QUESTION 16 SUGGESTED SOLUTION

TIP TOP TRANSPORT LIMITED

(Source: SAICA Jan 2013 ITC Paper 3 Question 2 -adapted)

Students should pay attention to the wording of the “Required” and break it down as follows:

 Calculate ROI per truck for each of the years 2014 to 2018
 Calculate the average ROI over the period

Students could score easy marks in part a and b if they understood the core principles underlying
ROI.

Part (a) 2014 2015 2016 2017 2018

Operating profit 91 259 86 393 163 028 189 193 213 716 (1)
Financing costs 66 741 54 507 40 992 26 062 9 569 (1)
Adjusted Operating Profit 158 000 140 900 204 020 215 255 223 285
NBV Truck (year-end) 765 000 630 000 495 000 360 000 225 000 (1)
NBV Truck (average) 832 500 697 500 562 500 427 500 292 500 (1)
NBV Truck (opening balances) 900 000 765 000 630 000 495 000 360 000
Discussion re replacement cost (1)
more appropriate
ROI 20.7% 22.4% 41.2% 59.8% 99.2% (1)
ROI (Ave NBV) 18.9% 20.2% 36.3% 50.4% 76.3%
ROI (Opening balances) 17.6% 18.4% 32.4% 43.5% 62.0%
Average ROI over period [(158 000 + 140 900 + 204 020 + 215 255 + 223 258)/5] / (1)
[(765 000 + 630 000 + 495 000 + 360 000 + 225 000)/5] 38.0%
Maximum 6

Part (b) – Pitfalls

(2)
 ROI results can vary depending on which valuation basis used for assets (opening or
average or closing balances) (1)
 ROI as a evaluation tool may lead to non-congruent behavior; divisions may not act in best
interests of group as a whole (2)
 Positive NPV projects may be rejected for example, ROI < 25% but > WACC of 20% (2)
 Many projects take time to deliver attractive returns. Focusing on ROI in the short term may
result in viable long term projects being rejected (ROI < 25% in 2014 & 2015) (2)
 Purely a financial measure and ignores qualitative issues (1)
 ROI does not take into account the risks of a division/project in measurement/evaluation of
performance (2)
 Accounting treatment of assets may impact on ROI eg. impairment of assets could lead to
higher ROI in future (2)
 ROI not suited to service based industries as capital investment may be limited (1)
 Divisions may be evaluated based on non-controllable costs if these included in ROI (1)
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Merits

 Enables easy comparison of performance between divisions & external benchmarking (1)
 Linked to assets under control of division which may be more informative than simply
evaluating profits and cash flows in isolation (2)
 Widely used in practise (1)
Clarity of expression (1)
Maximum 10

Utilise the profitability analysis provided in the scenario to guide your answer.

Part (c) 2013 2014 2015 2016 2017 2018

Acquisition of trucks -900 000 (1)
Sale of trucks 225 000 (1)
Discussion re R225k; risk
that value not received or (1)
discussion re < 600,000km
Operating profit 91 259 86 393 163 028 189 193 213 716
Depreciation 135 000 135 000 135 000 135 000 135 000
Finance charges 66 741 54 507 40 992 26 062 9 569 (1)
Service & maintenance (1)
60 000 64 000 67 667 71 000 74 333
(x50/150 to eliminate internal
profit margin)

Net cash flows -900 000 353 000 339 900 406 687 421 255 657 618 (1)

NPV @ 20% (zero if tax 332 993 (1)

included in capital budget)
34.3% (1)
IRR
Debate re allocated O/H’s Reasons should be provided for the inclusion/exclusion of allocated
overheads (1)
Max 10

Part (d)

 Financial impact on TTT ? (1)

o Will Group need to downscale operations? (1)
o Impact on group profit? (1)
o TTT may have more cash available to pursue other opportunities (1)
 Is scheme is line with overall group strategy re outsourcing of logistics? (1)
 Will owner driver scheme be implemented in other divisions? (1)
 TTT may not be able to control service levels of drivers & delivery schedules given
they are not employees (2)
 Drivers may operate more effectively and efficiently – goal congruence. Drivers’
financial well being dependent on limiting costs and being efficient (2)
 Strategic outsourcing may be positively seen as community upliftment/empowerment (1)
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 Drivers may offer services directly to end customers at lower rates (undercut) (1)
 Risk that drivers may service competitors? (1)
 HR implications
o Trade unions reaction? (1)
o Will all drivers elect to participate? (1)
o If not, potential retrenchment costs? (1)
o Easier to terminate services of contractors in future than employees (1)

 Fixed costs now become variable expenses, changing operating leverage (2)
 Will drivers be able to afford R180k deposit to VIS? TTT may have to assist (2)
 Risk that drivers unable to pay for regular maintenance &/or vehicle insurance
costs of trucks resulting in increased breakdowns and unhappy end customers (2)
 Is the owner driver scheme sustainable in the long run? Will it be renewed in 2018? (1)
 Who will bear any costs of Azania Development Bank? (1)
 What will transpire in event of death or disability of drivers post scheme? (1)
 Branding of trucks? Free advertising however, poor driving/dirty trucks could hurt TTT
Image (1)
Logical argument (1)
Clarity of expression (1)
Maximum 14

Consider all relevant costs and revenues. Utilise the profitability analysis provided in the scenario to guide
your answer.

2015
Part (e)
Revenue [108,000 x R8.35] 901 800 (1)
Fuel recovery ((R390 000/120 000km)x108 000) 351 000 (½)
Fuel costs [R390,000 ÷ 120,000km = R3.25; x 113,400km] -368,550 (2)

Servicing & maintenance

[192,000 ÷ (120,000/10,000)] = R16k per service
113 400km / 10 000km = 11 services pa
R16k per service x 11 services -176 000 (2)

Vehicle insurance -47 250 (½)

Back up driver costs -64 200 (½)
Debate whether full cost of back up driver required (1)
Other operating costs -165 600 (½)
Accounting fees (12 000x1.05) -12 600 (1)
VIS repayments (15 297.87x12) -183 574 (1)

Cash available for driver’s salary 235 026 (1)

Any other costs which should be considered/included? (1)
Tax implications for drivers? (1)
Impact on driver’s NAV (owns asset & liability) (1)
Conclusion (1)
Maximum 10
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QUESTION 17 SUGGESTED SOLUTION

SAVUSA LIMITED
(Source: SAICA 2012 QE I Paper 3 Question 1- adapted)

Part (a)
Memorandum to the Board of Directors of Savusa Limited Dear Sirs/Madams,
As requested, I have reviewed the valuation of Oxus (Proprietary) Limited prepared by Ms Grape
and set out my comments below thereon.
Reasonability of forecasts
All forecast line items should be assessed for reasonableness by:
• Testing the growth assumptions based on prior performance. (1)
• Checking the applicability of inflation, in line with forecast rates, PPI etc. (1)
• Comparing the forecast to industry indicators. (1)
Revenue
• Revenue is forecast to increase by R5.6m in FY2012 of which R2.5m is attributable to the
planned Savusa publication. Revenue, excluding Savusa publication, is forecast to (1)
increase by 8.3% (42.9 – 2.5 – 37.3 / 37.3) in FY2012. This would appear to be reasonable.
• The Savusa publication is a once off event, and correctly included in the 2012 year (not (1)
abnormal).
• We must ensure that Ms Grape did not include this revenue into perpetuity in her forecasts. (1)
• Oxus is actually assuming a revenue growth of 16.58% (47.1 – 42.9 + 2.5 / 42.9 – 2.5) in 2013 if (1)
the once off event is ignored.
• Revenue growth forecasts from FY2013 onwards appear to be high given Oxus’ recent (1)
financial performance, prompting investigation as above.
Cost of sales & gross profit margin
• Printing costs increased by 8.8% (9.9 – 9.1 / 9.1) in FY2011 (compared to a revenue increase (1)
of 2.19% (37.3 – 36.5 / 36.5)), by 12.1% (11.1 – 9.9 / 9.9) in FY2012, 7.2% (11.9 – 11.1 / 11.1)
in FY2013 and 8.4% (12.9 – 11.9 / 11.9) in FY2014, linked to point below.
• Increases in printing costs may not track revenue growth as these are dependent on the (1)
number of pages and print quality in magazines. Advertising revenue dependent on extent (1)
of advertising sold and not necessary number of pages in magazines.
Alt: revenue may be influenced by printing costs. The quality of printing influences the printing
costs. If the costs are reduced by reducing the quality of the magazines, revenue from (1)
advertisers may be lost.
• The likelihood of a change in the sales commission structure should be investigated and (1)
resulting approach included in the FCF valuation, instead of status quo.
• The effect of changing the journalists to freelancers has been included, although outcome of (1)
this is uncertain. Should consider probability of the change being made.
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• Journalists may demand a retrenchment package, change in conditions of service, this should (1)
be included in forecast.
• Mailing costs increased by 3.9% (2.7 - 2.6 / 2.6) in FY2011. Forecast increases are 11.1% (3 (1)
– 2.7 / 2.7) in FY2012, 10% (3.3 – 3 / 3) in FY2013 and 6.1% (3.5 – 3.3 / 3.3) in FY2014. (1)
Increases in mailing costs appear to be related to changes in revenue, remaining relatively
constant as a % of sales.
• Mailing costs are driven by the number of publications distributed and these should be
supported by Oxus’ detailed forecasts in this regard. In addition, it would be interesting to (1)
review the assumptions regarding price increases by couriers and the Post Office.
• Gross profit margin increasing from FY2012 onwards due to revenue growth out stripping (1)
cost increases. We need to investigate this in more detail to ensure it is achievable. (1)
• It is comforting that gross profit % forecast is in line with FY2010, seems reasonable. (1)
• The expected gross profit on the Savusa contract is 40% which is much lower than overall (1)
average of 52% in FY2012. Has this lower margin been included in the forecasts? (1)
Operating costs
• The major overhead is employee costs. Oxus is assuming that these costs will increase by (1)
only 0.8% (9.5 + 2.5 - 11.9 / 11.9) in FY2012 and 7.5% (10.2 + 2.7 – 9.5 – 2.5 / 9.5 + 2.5) in (1)
the following year. This is probably due to their planned initiative.
• The dividends are forecast at 0.1, and don’t increase, yet the market value of investments (1)
does increase, which implies dividend yield will fall. This does not appear to be reasonable.
• The taxation implications of all adjustments should be taken into account by recalculating the (1)
taxation.
Working capital & capital expenditure
• Trade receivables days at 40 from FY2012 may not be achievable given historical average of (1)
45 to 50 days.
• The reduction in trade receivable days through stricter enforcement of credit policy may have (1)
a negative impact on revenue- advertisers who prefer to pay after publication may reduce (1)
advertising spend with Oxus or advertise elsewhere where they can obtain more favourable
credit terms.
• Oxus is forecasting to increase average payment terms with its suppliers from 60 to 65 days
on a sustainable basis. Is this achievable and has it been agreed with suppliers? Stretching (1)
creditors may be possible but it could have an impact on service levels/reputation and (1)
support from their trade partners (suppliers).
• Oxus recently upgraded its IT infrastructure and hence, would not be expecting to spend (1)
significant amounts on capital expenditure for the next 3 years. However, when will the next (1)
major upgrade take place?
• The forecasts into perpetuity assume that capital expenditure is limited to the normal R1 (1)
million range, and no inflationary adjustment is considered.

2011 2012 2013 2014

Opening balance 4.6 5.5 5.2 4.8
Depreciation -1.5 -1.6 -1.7 -1.7
Acquisitions 2.4 1.3 1.3 1.2 (*BAL)
Closing balance 5.5 5.2 4.8 4.3
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• The decreasing value on the PPE line item raises concern that the company has not (1)
adequately considered asset replacement in the cash flows.
Overall comments on forecasts
• Management are shareholders – The forecasts should be checked for arms’ length (1)
transactions, management could be taking lower salaries, and higher dividends for tax (1)
efficiency – this is supported by the high dividend payout ratio.
• Oxus is anticipating increasing its operating margins significantly over the next 3 years. In (1)
particular the EBITDA/revenue margin is forecast to grow from its current 12.6% to 21.2% (1)
in FY2014. Is this attainable?
• The forecasts have been based on management accounts which are not audited. Reliability (1)
should be questioned.
• Dividend payout of 50% will apply, but full profit after tax has been retained in the forecast. (1)
Maximum for Financial Forecasts 15

Errors of principle
• No date is provided for when the valuation is effective. (1)
• Ms Grape included future dividends and other income from investments in forecast cash flows (1)
and then added current value of investments to Enterprise Value. The correct approach would (1)
be to exclude dividends and other income from forecast cash flows and add the fair value of
investments to Enterprise Value derived.
• Continuing Value has incorrectly been calculated using the discount factor for 2015. The correct (1)
approach would be to use the discount factor for 2014. (1)
• Ms Grape has estimated Oxus’ cost of equity using (‘WACC’), the company is not geared, (1)
should use the cost of equity. (1)
• The valuation adds cash on hand to the value calculated. This presumes that this cash is
available for distribution, and is not necessary to generate the cash flows. If cash is required for (1)
operational purposes then this portion of the cash balance should not be brought into the (1)
valuation since it is by definition part of working capital.
• The final equity value calculated should be adjusted for limited marketability of shares. (1)
Discount rate
• The WACC of 12.5% ((16% x 60%) + (7.25% + 40%)) for Savusa is based on a debt/gearing (1)
ratio of 40%, whilst the debt: equity ratio is 40%. The recalculated WACC is 13.5% ((16% x (1)
71.4%) + (7.25% + 28.6%)).

Explanation:
Debt / gearing ratio = D / (D + E) = 40 / (40 + 60) = 40%
Restate this into D:E ratio = 40:60 = 66.67%
Therefore if D:E ratio = 40% = 40:100
Restate this into a debt / gearing ratio = D / (D + E) = 40/140 = 28.6%
• As previously mentioned, Ms Grape has erroneously used Savusa’s WACC as a basis to
estimate Oxus’ cost of equity. Savusa’s actual cost of equity is 16% which is significantly higher (1)
than 12.5% assumed in the valuation.
• Oxus is not levered, therefore Ke should be determined by unlevering Savusa’s beta. (1)
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• Alternatively, because Savusa is a more diversified group than Oxus. It may be more (1)
appropriate to establish what the beta coefficients of similar listed publishing groups are and (1)
estimate Oxus’ beta accordingly.
• If Savusa’s cost of equity is used as the starting point to estimate Oxus’ cost of equity the (1)
following adjustments should be made:
o Oxus is a smaller company therefore increase the Ke.
o Oxus has less access to finance therefore increase the Ke.
o Oxus relies on a small number of key employees therefore increase the Ke.
Overall comments on valuation
• The valuation has been performed by the sellers which may not be objective. They will (1)
directly benefit from a higher value. Transaction should be subject to a due diligence
investigation. (1)
• Growth rate into perpetuity of 4% is reasonable in comparison to expected country GDP
growth and inflation forecasts. (1)
Alt: Growth rate is not reasonable, including justification. (1)
• The implied historic PE multiple by the free cash flow (‘FCF’) valuation is 18.7 (46.7/2.5) and (1)
the forward PE multiple is estimated to be 9.9 (46.7/4.7). These ratios need to be
benchmarked against similar listed companies multiples. (1)
• The FCF valuation translates into a market to book ratio of 3.5 (46.7/13.4) and value to
revenue multiple of 1.25 (46.7/37.3). (1)
• These need to be reviewed in comparison to similar listed entities. Valuation should be stress
tested with other methods. (1)
Maximum for Financial Forecasts 15
Maximum for discussion 21

Conclusion:
I trust that my commentary and insights are useful for your purposes. Please contact me
should you have any further queries or require any further assistance. Yours sincerely
Handwriting, neatness, style and structure. (1)
Communication skills: Appropriate tone and language usage in memorandum to directors (1)
Memorandum format (1)
Overall Maximum 24
Overall available marks 68

Part (b)
Discussion on Oxus's perspective:
• COS expenses are largely unrelated to advertising revenue and/or fixed except for sales
commissions. Print costs are dependent on number and quality of pages. Mailing costs are
determined by the number of magazines distributed. Other COS overheads are unrelated to (1)
advertising revenue and/or fixed in nature. It follows that COS expenses (except for sales (1)
commissions) are unrelated to advertising revenue generated. Costs will still be incurred
whether R1 or R51 million of advertising sold.
• It is debatable whether measuring of GP margin is currently correct. Editorial and journalist (1)
costs should perhaps be included in COS? (1)
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• The current incentivisation structure is appropriate and drives the correct behaviour as the
majority of Oxus’ costs are fixed in nature and the more advertising is sold, the higher profits (1)
the company will generate. Or discussion about why inappropriate as alternative. (1)
• Current GP% is 50.7% and forecast to be 52% in FY2012. By changing sales commission (1)
structure, sales persons will be better off if actual GP > 50%. Calculating the effect FY 2012 (1)
commission will be 5.3 (22.3 + 4.3 = 26.6 x 20%) instead of 4.3.
• Alt: If sales commission is calculated on 20% gross profit before taking sales commission into
account it would be beneficial, however, if calculated to be 20% of gross profit after deduction (1)
of calculated sales commission, it may not.
• The new proposed incentivisation structure may encourage inappropriate behaviour on the
part of salespersons:
o Gross profit margins are a cumulative number (total sales less costs) and hence, (1)
individuals may not be rewarded for outstanding individual performance as their efforts (1)
could be negated by poor performers. Under- achieving salespersons could be rewarded
from the efforts of others.
o Salespersons will be encouraged to focus on the profitable titles and ignore selling
advertising for less profitable magazines. This may result in a decline in overall company (1)
profitability.
o Contracts such as Savusa with a lower GP% would be discouraged incorrectly because of (1)
lower GP%.
o To increase GP%, they may try and influence advertisers to design/include
advertisements with lower colour content (lower quality ads) in order to save printing cost. (1)
This may benefit the company (lower cost), however, it will affect the look of the
magaofine
Identification issues salespersons may have:
• COS expenses may be beyond the control of sales persons so they would rightly feel that they (1)
may be prejudiced by other parties inefficiencies.
Available 15
Maximum 7

Part (c)
Potential positive consequences
• Journalist costs are fixed whether they write articles or not. Converting these costs into a (1)
variable expense would lower fixed costs and decrease operating leverage. (1)
• Oxus may be able to reduce other costs by not employing journalists full time for example, (1)
less office space required, lower telecommunication costs etc. (1)
• May encourage journalists to be more efficient – if they are paid by the article then they will be (1)
less inclined to waste time but rather to produce as many quality articles as possible. (1)
• Oxus may be able to exert more influence over the quality of journalism – if standard of (1)
articles is unacceptable, Oxus would be able to switch to other journalists. If these journalists (1)
were employed by Oxus, the company would have to work on improving their performance.
• Oxus could limit costs per article as opposed to paying by the hour, an effective way to (1)
contain costs. (1)
• Oxus will be able to increase its access to talented journalists – previously Oxus would (1)
have to manage its team internally. (1)
Maximum for positive consequences 4
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Potential negative consequences

• It may be more difficult to enforce deadlines and performance if journalists are not (1)
employees.
• Outsourcing journalism may result in higher costs for Oxus as the better journalists could (1)
demand higher hourly rates for work done.
• Better journalists could be poached and permanently employed by other media groups (1)
thereby reducing the talent pool available to Oxus. (1)
• Journalists may work for competitors thereby reducing Oxus’ competitive advantage. (1)
• There is no guarantee of availability of journalists – if all journalists are busy when Oxus (1)
requires service, this could leave the company in a very vulnerable position. (1)
• If the company fails to source quality articles as finding people takes time, advertising revenue (1)
may be lost. (1)
• Staff morale may decrease, particularly if the journalists preferred the stability of a fixed salary. (1)
(1)
Maximum for negative consequences 4
Overall Maximum 8
Overall available 26
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QUESTION 18 SUGGESTED SOLUTION

APPEX ASISST
(Source: SAICA 2012 QE I Part I Paper 1 Question 2)
Part (a)

Per unit
Revenue 475 (1)
Variable overheads (40%*70) -28 (1)
Direct material (105+140) -245 (1)
Contribution 202 202 202 202 (1)
Identifies direct labour & fixed overheads are irrelevant
Forecast cash flows 2012 2013 2014 2015
Revenue 0 2,299,000 2,679,000 2,764,500
Sawn timber 0 -677,600 -789,600 -814,800
Other direct materials 0 -508,200 -592,200 -611,100
Allocated overheads 0 -135,520 -157,920 -162,960 (1)
Contribution 0 977,680 1,139,280 1,175,640 (1)
Incremental cash costs -50,000 -50,000 -50,000
Warehouse rental
Rent paid in advance in first 3 years -90,000 -90,000 -90,000 (2)
Include in 2015/exclude with discussion/include + rental income -90,000 (1)
Driver costs -234,000 -234,000 -234,000 (1)
Trucks
Upfront cost -500,000 (1)
Subsequent disposal 170,000 (1)
Taxation 25,200 -122,364 -167,612 -225,392
Inventories -132,132 -21,840 -4,914 158,886
Other working capital movements
Initial investment in 2012 -20,000 (1)
Release of working capital in 2015 20,000 (1)
Net cash flows -716,932 459,476 592,754 925,134
NPV 612,978 (1)
Taxation workings
Profit from contract -90,000 603,680 765,280 801,640 (1)
Wear & tear allowance (R166,500 acceptable) -166,667 -166,667 -166,667 (1)
Recoupment - Trucks 170,000
Taxable income -90,000 437,013 598,613 804,973
Income tax payable @ 28% 25,200 -122,364 -167,612 -225,392 (1)
Working capital calculations
Materials 1,185,800 1,381,800 1,425,900 0 (1)
Variable overheads 135,520 157,920 162,960 0 (1)
Materials & variable overheads 1,321,320 1,539,720 1,588,860 0
Inventory based on 10% of next year's forecast 132,132 153,972 158,886 0 (1)
Net movement in Inventories -132,132 -21,840 -4,914 (1)
Release of working capital in 2015 158,886 (1)

Communication skills
Structure & layout of answer (2)

Maximum 27
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Part (b)

Utilise the information in the scenario and your general knowledge to add value to your discussion.

Risks associated with Mandlovu

Credit risk - risk that Mandlovu will not pay amounts when due, resulting in Apex
(1)
suffering financial loss and placing strain on Apex's cash flows

Government terminating contract with Mandlovu due to tender rigging, fronting etc. (1)
Apex will suffer losses due to ongoing operating costs incurred and investment in
trucks

Mandlovu failing to honour contract with Apex and ordering from other suppliers, (1)
adversely impacting on Apex's profitability and cash flows
Reputational risk of doing business with Mandlovu - e.g. Any unethical business (1)
practices may by association tarnish Apex's credibility and reputation. Knock on impact
could be severe affecting Apex's entire business (loss of business etc.)
Strategic risks related to entering into supply arrangement (1)
Apex is currently experiencing cash flow problems, entering into contract may add to
liquidity issues. If the contract is not profitable or cash flows are negative, this could
place entire business at risk

Other customers may become aware of 5% discount offered to Mandlovu and insist (1)
on similar discount, reducing Apex's overall profitability

Apex may lose focus on existing customers due to pressure to deliver & perform on (1)
Mandlovu contract. Result could be that existing customers turn to other suppliers,
resulting in a loss of business for Apex and lower profitability

Although Apex has sufficient capacity at present, market conditions may improve and (1)
Apex could experience capacity issues. Impact may be that existing customers cannot
be serviced or opportunities foregone = long term loss of market share
Manufacturing staff may be unhappy working under intense pressure to meet 48 hour (1)
deadlines or working overtime. Result could be strikes, demands for higher wages and
inefficiency = lower margins for Apex, lower output/profits

Apex may not be able to meet 48 hour lead time between order and delivery resulting (1)
in penalties or higher costs such as overtime, reducing contract profitability

Apex's suppliers may not be able to cope with increased volumes resulting in Apex (1)
failing to deliver on time to Mandlovu and other customers. Impact could be loss of
business or penalties
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Finance risk
Apex will be raising additional debt - loan covenants re overdraft may be breached (1)
due to debt levels or lower profitability. Bank withdrawing overdraft facility due to
breach of covenants may result in going concern risk

Identifies the issue - R1m raised yet only R750k required, additional financing costs (1)
The interest rate of 12% is considered high as 2011 is 9%. Indicating that Apex has a
high finance risk.

Commercial bank is not willing to provide further financing thus indicating increased finance (1)
risk WACC of 20% should perhaps be higher given risk of project (high Kd will also
increase WACC)

Contract specific risks for which a sensitivity analysis must be performed.

Apex may not be able to increase selling price to cover increasing costs, resulting (1)
in lower contract profitability
Mandlovu may have over-estimated demand - contract not as profitable as forecast (1)
Manufacturing costs may have been under-estimated, resulting in lower contract (1)
profitability/or standard costs inaccurate
Have all costs associated with contract been identified? Repairs & maintenance etc. (1)
Impact = lower profits than forecast
Working capital investment may have been under-estimated - further drain on cash (1)
flows
Failure to sub-let warehouse in 2015 will result in R90k less profit (1)
Inventory is separate warehouse - more susceptible to theft/damage (1)
Sale value of trucks in 2015 may have been over-estimated - lower overall contract (1)
profitability
Communication skills - clarity of expression (1)
Maximum 17

Part (c)

Cash flow direction must be correct to earn marks

Pre-tax (per the required)

PV 950 000 (less 5% fee)
FV -1 000 000
N 6 (2 times as PMT are bi-annual) (1)
PMT -60 000 (1 000’ x0.12 x 6/12) (1)
Nominal rate (bi-annual) 7.05% (1)
Nominal annual rate 14.10% (7.05%*2) (1)
Effective annual rate 14.6% (1)
(2 P/YR;14.1; 2ndFNOM%; 2ndFEFF%)
Maximum 6
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QUESTION 19 SUGGESTED SOLUTION

SUPREMO TANKERS (PTY) LTD

(Source: SAICA 2011 QE1 Paper 1 Question 2- adapted)
Part (a)

Direction of increase/ decrease is important and must be indicated +/(-)

Revenue 2009 2010

Revenue change (10,0%) (20,0%) (1)

Diesel price changes (35,0%) 8,0% (1)
• Impact on revenue (20% - portion of total contract price) (7,0%) 1,6% (1)
(35%x0.2)/(8%*0.2)
Therefore, revenue change due to business volumes (no other price
increases or decreases) (3,0%) (21,6%) (1)
(10-7)%/ ((20%)-1.6%)

The decline in Supremo revenue does not correlate with the brick manufacturing industry.
Supremo’s revenue declined by 10% in FY2009 whilst brick manufacturing volumes decreased by 25%.
In 2010, Supremo’s revenue declined by 20% whilst brick manufacturers volumes decreased by 5%.
(1)
Supremo’s prices are adjusted for diesel fuel price changes. In 2009, the major reason for Supremo’s
declining revenue was lower diesel prices (7,0% decline). (1)

In 2010, diesel prices increased and had a positive impact on Supremo’s revenue (1,6% increase).
(1)
Supremo did not increase monthly charges or per kilometer charges in 2009 and 2010, management
should at least have made inflationary increases to maintain their profit levels./
Overheads would have increased during this period and hence, gross margins would have eroded.
(1)
The 21,6% decline in revenue due to lower volumes in 2010 is concerning. A reason for this could
include customers switching from fixed monthly contracts to per delivery charges. (1)

Supremo is increasingly not optimizing loads (trucks empty on one leg of their journeys). This could
be another reason for decline in revenue if customers are charged per delivery as opposed to a fixed (1)
monthly charge.

A significant portion of Supremo’s costs are fixed which are not being covered at present by gross
margins. Supremo made a loss in FY2009 when revenue was R128,7m and loss increased as revenue
declined to R102,9m. (1)
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2009 2010
Gross profit
GP% 40,3% 35,8% (1)
Change in gross profit amount (29,0%) (1)
- Due to lower sales volumes (20,0%) (1)
- Due to changing GP% (9,0%) (1)
Change in fixed costs component of COS (3,1%) (1)
Total variable COS/revenue 33,3% 32,3% (1)
- Diesel portion/ revenue 20% 20% given

The key reason for the decline in GP% was lower sales volumes (1)
Fixed COS represent a significant portion of total COS therefore declining sales volumes will translate
into lower GP% and conversely, higher volumes will boost GP%. (1)
This is known as high operating leverage which increases Supremo’s operating risk ito difficulty to (1)
break-even.

Supremo’s management improved cost efficiencies (as volumes decreased it is expected to result
increased costs, due to loss of quantity efficiencies). Despite this Management performed well by (1)
reducing fixed COS in FY2010 and lowering variable costs as a % of revenue.

Actual diesel fuel costs were 20% of total revenue in FY2009 and FY2010 which indicates that
Supremo followed their policy of changing charge out rates based on diesel fuel price movements.
(1)
Depreciation of vehicle fleet is incorrectly excluded from COS – this should form part of COS as
vehicles represent a key cost component of providing services to customers. (2)

Maximum 20

Part (b)

Actions to improve profitability

Supremo should diversify revenue streams; currently it is solely focused on servicing brick
manufacturers and hence is dependent on activity levels in this sector. (2)

Company should consider ways in which to reduce fixed costs as contribute to high breakeven revenue
levels. Perhaps consider paying drivers based on distance travelled as opposed to a fixed monthly
salary. Consider legal and Union implications, etc. (2)

Gearing levels are too high and placing pressure on profits and cash flows. Supremo should consider
raising equity capital to reduce debt levels and enable business to trade without constant pressure from
lenders. (2)

The policy to replace trucks after 5 years fuels gearing levels and is currently resulting in losses from
disposal of vehicles. Supremo needs to explore using trucks for extended periods and finding ways to
reduce maintenance & repairs costs over the useful lives of trucks. (2)

Actions to improve cash flow generation

The major drain on cash flows is the continual reinvestment in new trucks. Supremo should explore
alternate ways to contain this cash outflow for example, lease trucks on a full maintenance basis. (2)
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Alternatively, Supremo should find ways to use trucks for extended periods to avoid reinvestment
every 5 years. Perhaps find suppliers who can more cost efficiently maintain trucks and extend useful
lives. (2)

Supremo could consider factoring its debtors book to raise capital. (2)

Trade debtors days are high – explore ways to reduce days to free up cash flow. (2)
Raising equity to reduce gearing is not per se going to improve cash flows!
Maximum 8
Part (c)

Students are expected to know what the current prime rate is.

Supremo may not have any other option to reduce the bank overdraft and hence, could be forced into
pursuing this option. (1)

Bank overdraft has increased drastically in 2010 which indicates that Supremo is utilising its bank
overdraft for more than its working capital requirements. This indicates an inappropriate financing
method as short term liabilities should not be utilized to finance non-current assets. (1)

Selling the land & buildings will result in Capital Gains tax (1)

Supremo will also pay income tax on recoupments of building allowances ([R 30m- 17,120]=R 12,88m x
28%). (1)
The yield on property (8%) [200’x12=2 400’] [2400’/ 30 000’] appears lower than 2010 interest rates
(2010 prime 10%), so cheaper for Supremo to ‘borrow’ R30m by selling property than raising loan
finance. (2)
The debt-equity ratio of Supremo will improve following the sale of the property however, (1)
gearing levels may still be too high. Consider the effect on Supremo’s target capital structure. (1)

The cash inflow from selling property will be offset by commitment to pay lease rentals. (1)

Supremo may have less flexibility to stay in current premises on a long term basis given the 5 year
lease. The property positioning could be a strategic advantage which could be lost in the future. (1)

Entering into a lease with a related party (major shareholder) may result in issues eg. recovery of
property costs may not be at arms length. (2)

Other valid points include:

Raise higher amount from sale & leaseback than a normal loan (banks usually require a deposit for
loans).
No responsibility for maintenance and repairs (no ownership risks).
Hidden costs at end of lease.
Locked into 5 year lease, difficult to move premises.
Limited flexibility re early repayment of “loan“ - locked into 5 year arrangement.
No participation in future capital growth or capital appreciation of property.
Higher fixed cost base thus higher operating leverage and higher breakeven point.

Maximum 9
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QUESTION 20 SUGGESTED SOLUTION

ELECTRIBOLT LIMITED
(Source: SAICA 2010 QE I Paper 2 Question 3 Part A - adapted)
Part (a)

Errors/omissions Reasons
No indication of perspective of valuation: PowerSmart may not transfer supply licence i.e.
fair market value, or intrinsic value? (1) no other potential bidders. PowerSmart’s
alternative to selling to ElectriBolt is intrinsic
value (current arrangement with future
expectations as originally anticipated). I.e. (1)
quantify intrinsic value.
Projected turnover includes additional Specific synergies should be quantified
electricity generated and supplied (thus separately, but excluded from the intrinsic
incorporating efficiencies/synergy (1) valuation. (Synergies preferably not paid for as
contributed by ElectriBolt). fully contributed by ElectriBolt). (1)
Forecast revenues and operating costs Revenue and/or costs are likely to change
do not change over forecast period annually due to inflation/tariff increases/rain fall
Or A nominal WACC has been used to expectations etc.
discount future real cash flows. (1) Or Cash flows have not been adjusted for
inflation (real cash flows) therefore a real WACC
should be used to determine the NPV. (1)
Including R1m & R800 000 outflow relating Business of PowerSmart is being valued hence,
to supply licence and the description of (1) only costs & revenue relevant to this business
‘opportunity cost’. should be included in FCF (only R1m outflow
which is the actual annual fixed installment
payable by Powersmart and not an opportunity (1)
cost).
Operating costs savings included. (1) Probability of achieving cost savings ~45%,
insufficient to justify including in FCF
Or (45%*300,000=135,000) But rather include
this potential in a sensitivity analysis. (1)
- Helicopter lease payments included at PowerSmart has negotiated a contract hence
market value. (1) use actual contractual cash flows until expiry of
- Question unclear as to what will happen contract (end of 2012). Thereafter, use
to the lease on acquisition/ probably be estimated costs for 2013 at fair market values. (1)
transferred over. (1)
Depreciation included in forecasts, is not a The tax effect of wear and tear should be
cash flow item. (1) included. (1)
Interest on long term loan included. (1) Interest should be excluded for these cash flows
should exclude all fin costs, as it should be
distributable to all capital providers / interest is
incorporated in WACC. Market value of long-
term debt should be deducted from discounted
cash flows to derive equity value. (1)
Taxation projections will be incorrect due Estimated tax to be paid should be based on
to changes in cash flows indicated here. (1) amended forecasts taking into account
adjustments. (1)
Cash flow movements in assets ignored. (1) Cash flows for purchase/disposal of assets
should be included in cash flow. (1)
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Changes in working capital ignored. (1) - Forecasts should include estimated changes in (1)
inventories, accounts receivable and trade
payables as these are cash flows.
- Recoupment of working capital should be
included.
ElectriBolt’s WACC used to discount cash (1) - PowerSmart’s WACC should be estimated (1)
flows. Or ElectriBolt’s WACC should be adjusted for
higher risk associated with Augrabies operation/
smaller size.
- WACC appears to be too high, not explained
why.
Potential costs associated with labour (1) To be conservative, estimated costs of settling (1)
action ignored. dispute should be included as a cash outflow.
Use actuarial calculated value (R450 000).
Other valid points (Must be core) (1) (1)
Available 31
Maximum 16

Part (b)

Advantages

Interest earned on cash is currently low (1), hence utilising cash for acquisitions should yield
higher return on equity than having cash on deposit (1) (2)
PowerSmart division should generate positive cash flow (1) hence using cash to settle
purchase consideration should not have adverse impact on overall cash resources / cash required (2)
for day-to-day requirements (1)
Less time, effort (1) and cost (1) is devoted to reviewing loan agreements/drafting preference
share agreements & obtaining necessary approvals form shareholders/JSE (2)
Cash purchase will avoid dilution in control from convertible preference shares (2)

Disadvantages

Using cash will void opportunity to move closer to target WACC (where a firm minimises finance
cost) (2)
Or A reasonable degree of debt lowers WACC and enhances shareholder value (using cash will (2)
negate this) (2).
Preserving cash allows more flexibility to pursue growth/acquisitions (2). (2)
In the current liquidity crisis / recessionary environment, company should be retaining cash for
liquidity strength (1) in a period where it is costly and difficult to obtain finance (1) (2)
Available 14
Maximum 6
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Part (c)(i)

Medium term loan:

0 1 2 3 4
Initial advance 16 000.0
Transaction costs (1)
(16m x 1%) (160.0)
Tax on transaction costs 44.8 (1)
Bullet payment (1)
PV = 16 000.0
N=4
I = 11%
FV = (24 289.1)
Tax effect of section 24J @ 28% 492.8 547.0 607.2 674.0 (1)
24J accrual amount (A = B x C) 1 760.0 1 953.6 2 168.5 2 407.0 (1)
Pre-tax YTM (B) 11% 11% 11% 11% (1)
Adjusted initial amount (C) 16 000.0 17 760.0 19 713.6 21 882.1
Cash flows 15 840.0 537.6 547.0 607.2 (23 615.1)

IRR = 8.11% (1)

OR
Kd = 11% x 0.72 = 7.92%
NPC (@ 7.92%) = - R118 488

Preference shares:
0 1 2 3 4
Preference share issue 16 000.0
Annual dividend (1 280.0) (1 280.0) (1 280.0) (1 280.0) (1)
(R16m x 10% x 80%)
Dividends tax (10%) (128.0) (128.0) (128.0) (128.0) (1)
Conversion into equity (17 800.0) (1)
Cash flows 16 000.0 (1 408.0) (1 408.0) (1 408.0) (19 208.0) (1)

Discussion regarding the value of equity at the end of year 4:

The amount is an estimate of the value of the share on that date only. Sensitivity should be
performed. (1)
IRR = 11.18% (1)
OR
NPC (@ 7.92%) = - R1 794 160
Therefore the medium term loan is cheaper than the preference shares based on the information
provided. (1)

Available 12
Maximum 10
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Part (c)(ii)

Factors to consider
Matching cash flows to business operation acquired (1)
- Medium term loan: repayable in one bullet payment at end of 2013 – Augrabies should
generate sufficient cash
but financial discipline required to ensure sufficient reserves kept in anticipation.
- Preference share: automatically convertible hence no cash outflow to repay capital in 2013.
- Site rehabilitation costs in 2013: Preference shares better cash flow match than medium-term
as loan’s bullet payment also payable in 2013.
Automatic conversion of preference shares into equity will dilute shareholding of ordinary(1)
shareholders.
Current dividend yield of ordinary shareholders? If < 8% then preference shareholders receive(1)
higher yield with less risk.
Impact on EPS (1)
- Medium loan will not dilute number of shares and may have minimal impact on EPS
- Preference shares are dilutive and impact on EPS needs to be determined
Other terms of preference shares – any restrictive covenants? May reduce the flexibility of the firm(1)
to pay dividends and/to, acquire or dispose assets, raise further finance.
JSE requirements regarding the issue of preference shares? (1)
Loan covenants may restrict use of debt financing. (1)
Shareholder approvals required? (1)
Does ElectriBolt have STC credits ( other investments yielding dividends) if so the preference(1)
shares may be cheaper.
Consider the firm's current vs. target capital structure. In medium term both will increase(1)
gearing, but only preference option will guarantee increase in equity in 4 years’ time.
Available 13
Maximum 6

Presentation - Language and clarity of expression (1)

- Structure and appearance (1)
Maximum 2
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QUESTION 21 SUGGESTED SOLUTION

CLOTH GROUP LIMITED

(Source: SAICA 2009 QE I Paper 1 Question 2- adapted)
Part (a)
2009 2010 2011 2012
Euro denominated bond
Upfront receipt 120,000,000
Interest paid (9 600k x 6,9 (9,108,000) (10,002,240) (10,995,840) (2)
%x R13,75; R15,10; (1)
R16,60) (159,360,000)
Capital repayment (960k x (1)
120,000,000 (9,108,000) (10,002,240) (170,355,840)
R16,60)

IRR 17,50% (2)

Alternatively
Discount rate (say 15%)
Discount factor 1,00 0,870 0,756 0,658
Discounted cash flows 120,000 (7,924) (7,562) (112,094)
(R000’s)

Sum of discounted cash (7,580) (2)

Flows

Syndicated loan Nominal:

12,5%+2,5% = 15%
Effective annual interest 15,87% N=4
4 x per jaar
rate (1)
Effective = 15,87%
Upfront receipt 120,000,000
Issuance cost (2,400,000)
Interest paid (1)
- 2011 [80,000 x 15.87%] (19,044,000) (1)
- 2012 [40,000 x 15.87%] (12,696,000) (6,348,000) (1)
(1)
Capital repayment (40,000,000) (40,000,000 (40,000,000)
117,600,000 (59,044,000) (52,696,000 (46,348,000) (1)
(1)
IRR 17,16% (2)
Alternatively
Discount rate (say 15%)
Discount factor 1,00 0,870 0,756 0,658
Discounted cash flows 117,600 -51,368 -39,838 -30,497

Sum of discounted cash flows -4,103 (2)

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Conclusion

o Syndicated loan the cheaper of the two instruments (1)

o However, Syndicated loan has a variable rate and may not be directly comparable to
Euro bond which has fixed interest rate (2)
o Also syndicated loan has different cash flow profile, start repaying after 1 year. Cash (1)
flows need to be considered
Max (15)
Part (b)

o Syndicated loan has a variable/floating interest rate. To make this loan directly
comparable to the Euro bond, Cloth Group should obtain a quote for a fixed interest
rate over the period (1)
o The euro bond repayments of interest and principal are more favourable to Cloth
Group from a cash flow perspective:
(1)
" Interest payments are annually in arrear versus quarterly for the syndicated loan
" Repayment of principal is on 31 March 2012 versus 3 annual repayments of R40
million in terms of the syndicated loan (1)

o What are the detailed terms of the bond and loan? Any covenants or restrictive
conditions? (1)
o The quoted forward rates re Euro significantly add to the cost of this bond. Is there
any other hedging mechanisms that could be used to cover Euro exposure eg.
currency options or currency swaps? (1)
o History of exchange rate movements ZAR versus Euro and economists opinions re
future rates (1)
o The syndicated loan “cost” of 17,16% is significantly above the prime overdraft
lending rate. Are there any other means to raise debt finance at a lower cost eg.
asset backed securitization? (1)
o Which debt instrument has the lowest effective interest rate? (1)
Max (6)
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Part (c)

Cost of equity
Risk free rate = R204 bond (long term yield) 9,00% (1)
Beta co-efficient of Cloth Group given 0,90
Insufficient information given in the question to determine
whether the quoted beta is levered or unlevered beta (2)
Market risk premium given 8,00%
Cost of equity therefore 16,20%

Cost of debt
Euro bond interest rate
Cost of forward cover however, increases this to an effective 6,90%
17,50% (2)
Cost of debt therefore (after tax)
12,60% (1)
Relative weightings
No mention is made of target capital structure in question, therefore (29 050- 18 650)
need to estimate weightings (1)
Weightings should be based on market values of equity & debt
R000’s (1)
Market value of equity = R24.60 x 15m shares
Net interest bearing debt at 31/1/2009 369,000 (1)
Alternative is to use bank overdraft assuming that cash is (1)
10,400
required for working capital
Assuming that Cloth Group can productively utilize bond proceeds
then debt would increase by R120m
120,000 (1)
Relative weightings therefore – equity - debt 73,9%
(1)

o Cash flow forecasts over next 3 years of Cloth group required to more accurately (1)
o Also, market reaction to bond issue needs to be monitored. If share price declines due
to perceived risks attached to debt issue this may affect weightings (1)
o Bond issue should not negatively affect share price as Cloth Group has low gearing (1)

WACC therefore [26,1% x 12,60%] + [73,9% x 16,2%] =15,26% (1)

Max (12)

Part (d)

• The volatility of interest rates recently and current yield curves. (1)
• The cost of swapping into a fixed rate – how much higher is fixed rate? (1)
• Cloth Group has an inherent hedge against interest rate movements – it lends to
customers at prime + 4%. So if rates move higher than its income will also increase to
cover higher debt costs. (2)
• Fixed rate provides certainty for Cloth Group in terms of future payment commitments.
• Cloth Group’s exposure to interest rate movements will decline over time as debt is to be
repaid in equal instalments. Hence, swap into fixed interest rate for next year or 2 may
be more cost effective.
Maximum (5)
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Part (e)

There are generally 3 main parties involved in a securitization, a seller, an issuer and
investor(s) (1)
• Securitisation involves seller transferring income yielding assets to another party/SPV (1)

• Issuer generally purchases securitised assets (1)

• Issuer also issues negotiable debt instruments to investors allowing investors to
participate in the income stream of underlying assets (1)

The terms of collateral offered is negotiable, seller may retain some or all of credit risk or sale
of assets may be without recourse (1)
A credit enhancer may provide some protection for investors by guaranteeing some or all of
the credit risk associated with underlying assets. (1)
The potential benefits to Cloth Group could include
• Sell assets (being the receivables) therefore no interest charge on capital raised (1)

• Creating a future channel for further raising of capital (1)

Maximum (5)

Part (f)

Key procedures should include checking the following:

• The financial position of new customer (proof of salary, personal balance sheet, ownership
of fixed property etc) (1)

• Credit history which can be established by independent credit checks with bureaus (1)

• Requirements of the National Credit Act & FICA (proof of residency & ID documents) (1)
• The amount of credit applied for versus surplus monthly cash flow (1)
• Assess the attitude of debtors towards the commitment of honouring debt (1)

• Security provided by the debtor (1)

• Other valid procedures (1)
Max (4)
(3)
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QUESTION 22 SUGGESTED SOLUTION

ZIMROD (PTY) LIMITED

(Source: SAICA 2012 QE I Part II Question 2 – adapted)
Part (a)

The three critical areas are the inventory and the trade receivable and payable numbers, not the current assets
and liabilities. Where an opening inventory for the first year (2011) is provided, this will be an indication that
purchases need to be worked with. Two years: look at change in the core issues and the related impacted items
in the SCI. The net movement will be critical in answering the statement made.

2011 2012
Inventory days [vs COS] 95 100 (1)
Trade receivable days +65 +70 (1)
Trade payable days [vs COS, no opening 2011 inventory] -70 -65 (1)
90 105
Cash ratio (Cash and cash equivalents/Current liabilities) 2.4% 0.7%

Annual change

Revenue 15,6% (½)

Trade receivables* 24,5% (½)
COS 15,2% (½)
Gross profit 16,2% (½)
Trade payables* 7,0% (½)
Inventories* 21,3% (½)
*Critical movements, even (if only) vs revenue

Net movement

Inventories (8 815)
Trade receivables (11 977)
Trade payables 2 129
(18 663)

• Bank overdraft declined by only R1.7 million in FY2012 despite profit for the year of R24 (1)
million
• The cash ratio has declined quite significantly as a result of the decrease in cash and the
increase in current liabilities.
• Cash cycle is now 15 days longer (105 versus 90 previously) (1)
• Debtors has increased by more than revenue, which needs further investigating (1)
• Inventories have increased by 21,3% versus COS ↑ of 15,2%, indicating slower inventory (1)
turn. Also evidenced by ratio above. Question this.
• CEO’s contention is correct that the major reason for poor cash generation was increase (1)
in working capital (net R18,7 million higher)
• Property, plant & equipment increased by R4,9 million after depreciation which also
contributed to lower net cash movement for the year (1)
Maximum 7
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Part (b)

• Capital budget deals with relevant (and/or) cash costs only. There is also reference to ‘errors and
omissions’, both should thus be identified. Operational costs are described as fixed – it would thus be
good practise to use a format where contribution and fixed costs are easily identifiable.
• Pay attention to the wording of the “Required” as not only calculations are required but also motivations
for any adjustments made.

R’000 Notes 2012 2013 2014 2015

Sales 0 65,625 103,500 123,038

Purchases - landed cost 1 0 (43,750) (69,000) (82,025)
Delivery costs 2 0 (1,531) (2,415) (2,871)
Contribution 0 20,344 32,085 38,142 (1)
Initial marketing costs 3 (2,500) 0 0 0
Marketing & promotional costs 4 0 (1,313) (2,070) (2,461) (1)
Operating costs 0 (7,560) (8,316) (9,148)
Net profit for the period (2,500) 11,472 21,699 26,533 (1)
Taxation 7 700 (4,860) (8,400) (8,628) (1)c
Net profit after taxation (1,800) 6,612 13,299 17,905
Inventory movements 5 (8,500) 0 0 0 (1)
Trade receivables movements 0 (13,485) (7,783) (4,015)
Trade payables movements 0 5,394 3,113 1,606
Release of working capital at 0 0 0 42,136 (1)
project end 6
Net cash flow for the period (10,300) (1,479) 8,629 57,632 (1)
IRR 8 88,2% (1)c

Tax calculation
Profit for the period (2,500) 11,472 21,699 26,533 (1)c
Opening inventories 0 (8,500) (14,384) (22,685) (1)
Purchases (8,500) 0 0 0
Closing inventories 8,500 14,384 22,685 26,967 (2)
Taxable income (2,500) 17,356 30,000 30,815
Tax payable 28% 700 (4,860) (8,400) (8,628) (1)c

Notes:
1. Purchases (cash) in full – in line with budget ‘rules’. It does imply however that the change in
inventory has to be accounted for to determine the profit for tax purposes.
2. Delivery costs are variable and directly related to sales, above the line. (Note that profit
changes to contribution).
3. The initial marketing costs are an integral part of this project and its operations and thus
relevant.
4. M & P costs are variable (2% of sales).
5. The upfront inventory acquisition is a cash outflow. The remainder as given are not relevant
for cash flows, refer notes 1 and 7, and should be ignored.
6. Release of working capital at the end of the three year period is inventory (R26 967), TR
(R25 283) and TP (-R10 113).
7. The cash profit based on purchases is adjusted for the inventory holding to obtain the
accounting profit (a basic issue that required some neat thinking).
8. Ensure that you can obtain the IRR on your personal calculator and in exam situations show
the calculator steps clearly.
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Explanations:

 Zimrod is required to spend 2% of sales value on marketing and this was not (1)
included
 Warehousing costs are sunk costs and irrelevant to decision making (1)
 Inventory movements are allowable for determination of taxable income, initial (1)
draft ignored this
 Inventory movements irrelevant to cash flow – cash effects reflected in purchases (1)
 Working capital release at end of period required as board wants to evaluate it on (1)
a 3 year project basis
 Finance costs should be ignored, financing decision is a separate evaluation (1)

Correctly including sales, purchases, delivery and operating costs, initial marketing costs, (1)
trade receivables & payables in redrafted capital budget.
Structured layout of budget (1)
Maximum 20
Part (c)

This section requires you to comment on the calculation of each component of the hurdle rate i.e Kd, Ke,
WACC etc.
Evaluate the process in terms of the components being correctly applied and adjustments being reasonable.

Cost of equity

 3 month Treasury Bill rate is inappropriate, Zimrod should rather use long term (1)
government bond yields as a risk free proxy
 8,0% market risk premium has not been justified – source of this data? (1)
 No risk adjustment through a beta co-efficient – ignored in calculation (1)

Cost of debt

 Bank overdraft is a short term rate, Zimrod’s cost of debt should be based on the cost of (1)
longer term borrowings (3+ years)
 Given that Zimrod has been unable to raise a term loan for the Jaxx project and has no (1)
other long term debt, this rate would need to be estimated
 Using the after tax cost of debt is appropriate (1)

WACC

 Was the target debt: equity ratio properly researched – i.e. benchmarked against other
companies in the industry and will Zimrod be able to obtain/sustain this ratio given the new
business venture
o Could also use Debt: Enterprise Value ratio & Equity: Enterprise Value (1)
 In any event, no adjustment has been made to Zimrod’s cost of equity to take into (2)
account the higher financial risk associated with the target capital structure

Adjustment for risk

 Adding 17,02% to the derived WACC for risk associated with the Jaxx venture seems (1)
arbitrary – appears to be an attempt to reach a 30% hurdle rate
 The Jaxx venture is related to Zimrod’s core business, therefore the risk adjustment (1)
should be lower than if it was a diversification into a different industry
 Impact of the duration of the venture (3 years) – increase the required return? (1)
Maximum 10
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Part (d)

The ‘”Required “is quite bulky an it would be wise to break it down as follows before attempting to answer it:
 Discuss the approprateness of the overall strategy
 Discuss the positive aspects of the alliance
 Discuss the concerns regarding the alliance
 Explain the key risks Zimrod will be exposed to should it pursue the Jaxx agreement
 Structure with clear headings show logical thought process and important for soft skill marks.

Overall strategy

 Jaxx alliance will entail importing their brand and diversifying into supplying retail chains (1)
 The extent to which existing customers will purchase a global brand as opposed to Zimrod (1)
or their own branded clothing is unknown
 Jaxx alliance represents a major shift in business focus (customer base, own brand versus (1)
3rd party brands)
 Current strategy appears to be delivering financial rewards (revenue up 15.6% in FY2012 (1)
and gross profit margin increasing from 42.0% to 42.2%)
 Cash flow generation is under pressure and is this the appropriate time to be entering into (2)
new alliances until working capital management has improved?

Positive features of new strategy

 Potentially high revenue and profit growth, materially higher than if status quo remains as is (1)
 Leverage current infrastructure eg. warehousing able to cope with higher volumes (1)
 Could be a stepping stone to acquiring the right to distribute other global brands into the (1)
retail sector?
 May strengthen Zimrod’s position having multiple brands to distribute (more options (1)
available to customers who purchase more from Zimrod)
 Cross selling opportunities – supply retailers own branded clothing together with brand (1)
offerings
 Expanded product range (sunglasses, headwear, belts and socks) (1)

Concerns re new strategy

 Gross profit margin (33% (21 875/65 625)before advertising and distribution costs) is
much lower than the current 42.2% (133 959/317 438) earned. It may encourage the (2)
company to lower margins over time.
 Working capital investment in Jaxx venture is higher than current ratios (inventory 120
versus 100, debtors days 75 versus current 70 and creditors of 45 days versus current 65).
Current working capital management can be improved, however new venture will result in
further deterioration (2)
 Clothing retailers are notorious for being slow payers, Zimrod may be required to invest
more capital in sustaining revenue to this sector (1)
 May result in loss of focus on core business and neglecting customer base (1)
 Could result in an over-reliance on Jaxx if venture succeeds as forecast (1)
 Agreement is for 3 years whilst Zimrod may be investing in divisional infrastructure to (1)
support business in the longer term
 Jaxx merchandise could cannabalise existing product range/reduce customer spend on
existing products (1)
 Zimrod will develop and establish Jaxx brand in SA without owning the intellectual property
– Jaxx could enter market directly themselves in 3 years time (2)
 Price points of Jaxx may be different to existing product range – difficult to sell T-shirts at
say R200 when existing range sells for R60? (1)
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 Jaxx is USA based, time differences may result in it being very difficult to communicate
effectively (1)
 Although option to renew exists, notice period short. (1)
Maximum 14
Project risks

 Jaxx brand not currently in SA and it may not be well received by retailers and existing (2)
customers
 Establishing the Jaxx brand and penetrating market may take longer than anticipated (2)
 Financial forecasts may prove to be overly ambitious (revenue overstated, costs (1)
understated)
 Jaxx brand falters internationally due to lack of R&D spend/reputational issues (2)
 Order lead times with Jaxx may result in frequent ‘stock outs’ or overstocking (1)
 Over-reliance on Jaxx – if they are liquidated, Zimrod would have invested a significant (1)
amount without adequate return
 Retail customers may not permit frequent selling price adjustments and could place (1)
pressure on gross profit margins
 Jaxx enters SA market directly after 3 years once Zimrod

Financial risks

Zimrod exposed to exchange rate movements (unable to pass on unfavourable movements, (1)
liability to Jaxx unhedged)

 Increased liquidity risk given investment in project and existing gearing (1)
 Retail customers do not pay on time/bad debts, placing further pressure on cash flows (1)

Impact on existing business

 Cannabalise existing product range/customer base (1)

 Lose focus on existing business & customers (1)
 Raise equity to finance venture and it fails – would have diluted existing shareholders’ (1)
holding
Maximum 16
Logical argument & clarity of expression (1 for strategy and 1 for risks) 2
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Part (e)

Take note of the following:

 An executive summary is required so ensure you provide the correct format.
 Utilse the discussions and calculations you provided in parts a,b and d to motivate the recommendation
you make.
 A recommendation is required so ensure that you make a final conclusion i.e.Zimrod should/shouldn’t
enter into the arrangement.

ABC Business Consultants

26 Rivonia Road
Sandton
2146

Recommendation regarding the licensing and distribution arrangement with Jaxx

12 March 2013

Executive Summary

The report reveals the results of an evaluation of the licensing and distribution arrangement with Jaxx.
Some of the key outcomes are highlighted below:

• Based on the above discussion (part d) regarding the appropriateness of the strategy to peruse
the Jaxx arrangement it was clear that there are many more concerns and risks as opposed to
positive aspects. (1)

• This results in the arrangement carrying a high risk and would place a further strain on the
already poor working capital management/ cash generation. (1)

• The fact that all the banks that were approached by Zimrod to fund the arrangement have declined
on the grounds of the arrangement being a high risk further emphasises the risk of the project. (1)

• Although the Jaxx arrangement does have potential to generate large profits and has yielded an
IRR much higher than the hurdle rate, (1)
the accuracy of the forecasts also needs to be considered i.e. financial forecasts may prove to be
overly ambitious (revenue overstated, costs understated). (1)

• Other valid point - banks declined to fund venture etc. max 2

We therefore recommend that the Jaxx licensing and distribution arrangement should not be accepted.
(1)

Maximum 6
Communication skills 2
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Part (f) Valuation factors

Valuation issues

 Morningstar’s general offer of a 4 PE is not supported by a specific valuation of Zimrod (1)

 Profit after tax growth in FY2012 of 27.8% should justify a slightly higher earnings multiple? (1)
 Jaxx venture could be a major boost to profitability – Is Morningstar prepared to place any (1)
value on this project?
 How does a 4 PE compare to similar listed company multiples? (1)
 Perhaps a more suitable valuation method would be a forward PE multiple i. e. Calculated (1)
based on FY2013 budget and taking into a conservative view on Jaxx venture
 FCF valuation could also be performed which might be more technically sound (1)
 Current NAV of Zimrod including shareholder loans = R78,5 million(128 876 – 50 359) – (1)
Morningstar offer not much higher.
 What options does Zimrod have besides Morningstar – if other options then negotiating (1)
position stronger.
 The Calculation of the amount (i.e. R 28 850 400) required to subscribe for 30% is erroneous (2)
x/(x+96.2m)=30%
x=0.3(x+96.2)
x=0.3x+28.86
x=41.2m
Therefore the 30% stake is worth R41.2m and not R29m as calculated.

Other factors

 Zimrod needs funding to pursue Jaxx venture – may not have any other option but to accept (1)
Morningstar offer.
 Credibility & reputation of Morningstar (1)
 30% shareholding will result in existing shareholders not being able to approve any major (2)
corporate action without Morningstar’s consent – special resolutions may be required.
 Morningstar’s exit plans? Also may sell to an unwanted 3rd party in future? (1)
 Any other valid point – max 1
Maximum 10
Part (g)

Note the given instructions, in particular referring to operating profit. As the Jaxx transaction is to be ignored,
cash received will be utilised in the business.
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Number of shares in issue pre issue of new shares to Morningstar 100,000

Valuation of Zimrod pre capital raising 120,000
Amount to be invested by Morningstar
(same principle as calc in part f, i.e. solving for x) x/(x + R120m) = 30%
Therefore x = R 51,429
No of shares to be issued to Morningstar ((51 429/120 000) x 100 000 shares) 42,857
or [100 ÷ 0,7 – 100]
No of shares in issue post share issue 142,857
(2)
[Check: 42 857/142 857 = 29,999%. It is not 100 x 1,3] (1)
(1)
Operating profit FY2013 (35 022 x1.15) 40,275
Interest income (Working1x5%) 1,775
42,092
Taxation (28%) -11,774 (1)
Profit after tax FY2013 30,318
(1)
Working 1

Bank overdraft 1 October 2012 -16,283

Cash on hand 1 October 2012 350 (1)
Share issue 51,429
35,496 (1)
Free cash flow FY2013 (additional?) ?
Jaxx venture – possible
Repayment of shareholder loans ?
Surplus cash 35,496

Interest income (Net cash: R35 496 @ 5%) 1,775

(1)
EPS – calculation (30 318/142 857) 21,223
Stating EPS in cents 1

Max 12
Layout 1
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QUESTION 23 SUGGESTED SOLUTION

FOODAGE LIMITED
(Source: SAICA 2012 QE I Part II Question 1 -adapted)
Part (a)(i) 2009 2010 2011 2012
Group
Revenue growth (495,4-413,1)/(413,1) 19.9% 36.5% 26.3% (½)
Revenue mix (1)
ESM (168,9/413,1) 40.9% 36.9% 30.4% 27.2%
Product & merchandising (180,7/413,1) 43.8% 38.8% 30.6% 27.0%
KNB (48/413,1) 11.6% 11.3% 9.1% 9.2%
Popinas (15,5/413,1) 3.8% 13.0% 26.7% 33.3%
International (0/413,1) 0.0% 0.0% 3.2% 3.4%

Profit before tax mix

ESM (59,1/83,6) 70.7% 67.1% 71.6% 74.2%
Product & merchandising (18/83,6) 21.5% 19.1% 18.4% 18.6% (1)
KNB (4,2/83,6) 5.0% 4.8% 3.4% 2.4%
Popinas (2,3/83,6) 2.8% 9.0% 22.5% 30.9%
International (0/83,6) 0.0% 0.0% -15.9% -26.1%

Profit before tax/Revenue (83,6/413,1) 20.2% 20.4% 16.6% 14.6%

Annual change in PBT (101,1-83,6)/(83,6) 20.9% 10.9% 11.5%
ESM
Revenue growth (183,3-168,9)/(168,9) 8.5% 12.3% 12.7% (½)
Annual change in weighted average # of restaurants
(255-248/248) 2.8% 3.5% -4.9% (1)
Annual change in average revenue per store
(3,05m-2,95m)/(2,95m) 3.4% 4.9% 6.3%
(1)
Franchisee revenue (Rmillions) (248xR2,95m) 731.60 777.75 844.80 853.40
License fees/Franchisee revenue (99,2/731,6) 13.6% 13.8% 14.1% 16.2%
Marketing & procurement fees/Franchisee revenue (1)
(69,7/731,6) 9.5% 9.8% 10.3% 11.0%
23.1% 23.6% 24.4% 27.2% (1)
Profit before tax/Revenue (59,1/168,9) 35.0% 37.0% 39.0% 40.0%
Annual change in PBT (67,8-59,1)/(59,1) 14.7% 18.4% 15.6% (1)

Comments
 Limited growth in average revenue per franchisee, Foodage’s revenue driven by (2)
change in number of underlying franchisees & fee % charged
 Franchisees may be increasingly unhappy due to their limited revenue growth and cost (1)
pressures (food inflation, labour costs etc)
 Foodage’s margin has steadily increased to 40% whilst underlying franchisees (1)
are struggling
 Fees charged as a % of Franchisee revenue has increased from 23.1% of their (1)
revenue to 27.2% in FY2012
 Foodage fees to be renegotiated in 2013 and may decline given franchisee (2)
performance & imbalance in profit sharing between franchisor & franchisees
 Profits from ESM represent 74.2% of total group profit – material contributor (1)
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Product & merchandising

Revenue growth (192,4-180,7)/(180,7) 6.5% 7.5% 11.7% (½)

Profit before tax/Revenue (18/180,7) 10.0% 10.0% 10.0% 10.0% (1)

Annual change in PBT (19,3-18)/(18) 7.2% 6.7% 12.6% (½)
Comments
 Revenues increasing slowly (economic conditions may be reasons) (1)
 Foodage’s margin from this division has been constant since 2009 (1)
 Limited capital investment in this division given outsourced business model hence, (2)
ROA is excellent
 Division’s contribution to overall group profits is significant (18.6%) (1)
 Are there any conflicts of interests? Foodage sells to its own franchisees? (2)
KNB
Revenue growth (55,1-48)/(48) 14.8% 11.8% 27.1% (½)
Annual change in weighted average # of restaurants
(19-15)/(15) 26.7% 15.8% 22.7% (1)
Annual change in average revenue per store
(2,9-3,2)/(3,2) -9.4% -3.5% 3.6% (1)

Profit before tax/revenue (4,2/48) 8.8% 8.9% 6.2% 3.8%

Annual change in PBT (4,9-4,2)/(4,2) 16.7% -22.5% -21.1% (1)
Comments
 Revenue growth driven largely by new stores openings (1)
 Margins & profitability of this division has declined significantly over the past 3 years (1)
 Contribution to group profits is insignificant (2.4%), perhaps division should be closed (1)
down or stores franchised?
Popinas
Revenue growth (64,6-15,5)/(15,5) 316.8% 179.3% 57.5% (½)
Annual change in weighted average # of restaurants
(17-5)/(5) 240.0% 141.2% 41.4% (1)

Annual change in average revenue per store 22.6% 15.8% 11.4%

(3,8-3,1)/(3,1) (1)

Profit before tax/revenue (2,3/15,5) 14.8% 14.1% 14.0% 13.6%

Annual change in PBT (9,1-2,3)/(2,3) 295.7% 176.9% 53.2% (1)

Comments
 High revenue growth has been driven by new store openings from 2009 (1)
 Change in average revenue per store is slowing down to 11.4% from 22,6% in 2010 (1)
 Foodage’s margins from this division has been steady over the past 3 years declining (1)
slightly to 13.6% in FY2012/profit growth tracked revenue increases
 Popinas is currently a significant contributor to group profits (30.9%) from <3% in 2009 (1)
 Average revenue per store is significantly higher than ESM and KNB as one would (2)
expect in a ‘bar’ vs. meal environment
 Wine bar market more fickle than restaurant’s → higher risk business (2)
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International
 Subsidiary’s results have been very poor denting group profits (1)
 Why have only 6 stores been opened in past 2 years? (1)
 Loss eclipsed revenue in FY2012 – very concerning! Fixed costs too high? (1)
Overall group
 Group profit growth from 2009 driven largely by success of Popinas (1)
 Overall profit margins have declined due to failed offshore expansion and shift from (1)
high margin franchising into own stores (KNB and Popinas)
 Compound annual growth in revenue 2009 to 2012 has been 27.4% (PV = -413,1 FV = (2)
854,5 n = 3 compute I) whilst profit before tax growth has been 14.3% (PV = -83,6 FV
= 125 n = 3 compute I).
 International losses have neutralized profit growth from Popinas and ESM (1)

Calculation marks available 21

Discursive marks available 34

Comments:
• Discuss all the relevant segments and not just the overall group
• Year on year percentage change is a good place to start
• Stating what was calculated, is good way to tackle the comments

Part (a)(ii) – Success of business strategies

Franchising
 Foodage group built on franchising model which is a high margin business focusing on (1)
supporting the success of underlying franchisees
 Foodage has perhaps been guilty of squeezing higher fees out of ESM franchisees over (1)
the past 3 years at their expense
 Difficult fee negotiations in 2009 reflect a growing unhappiness amongst franchisees (1)
 Focus on growing its own restaurant chains (KNB and Popinas) may have resulted in a loss (1)
of focus on the core business (franchising)
 Flat revenue growth of ESM franchisees may present a major strategic issue going (2)
forward. Unhappy and declining profitability may result in the decline in number of
franchisees and permit competitors to erode market share
Product & merchandising
 Expansion into selling its own sauces has been a successful strategy – value add to (1)
franchisees and diversification into the retail sector
 Outsourcing of manufacturing is also to be applauded as it has limited investment and (2)
maximized return on capital
 Downside of this strategy could be creating conflicts of interests – force franchisees to (1)
purchase from Foodage and increase profit margins
 Stable operating margins indicates a desire to generate a fair return without squeezing (1)
franchisees and manufacturers
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Own stores
 Owning and managing own stores (KNB and Popinas) represents a significant
departure from franchising model. Success of franchise operations related to
entrepreneurs managing their own stores. Foodage is a corporate and that flair may be lost
in own stores. (2)
 Foodage directly exposed to operating losses of own stores and contingent liabilities
(property leases). (1)
 Own stores requires significant capital investment, group returns have probably
declined due to own store expansion. (1)
KNB
 Foodage historically focuses on the lower income groups. Did group have expertise to
manage expansion into high income focused stores? (1)
 KNB’s results have been poor, profit margins are low and profits declining. (1)
 With hindsight, this diversification has not reaped benefits for the group. (1)
 Foodage should explore franchising KNB or discontinuing operations – immaterial to
group profits and may not justify continued management involvement. (1)
Popinas
 Wine bar market is very different to ‘value for money family orientated’ dining
experience. (1)
 Popinas has however been very successful, currently contributing ~31% of group
profits. (1)
 Reputational damage from noisy bars and unruly customers is a threat – upset
suburbia turning away potential customers to other group stores? (2)
 Wine bar is a fickle market and may not be sustainable long term? (2)
 Profit before tax margin of ~14% seems low given the high margins on alcohol –
perhaps needs to be investigated? (1)
International
 Offshore expansion ill advised given different customer base and culture, and ability to
manage operations in a different geography. (1)
 Operating losses are increasing and Foodage should exit this business sooner rather
than later. (1)
Group
 Foodage needs to decide whether to focus on being a franchisor or operator of
restaurants/wine bars. (2)
 ESM remains the core of the group however, focus on Popinas & KNB may erode
profitability over time as disgruntled franchisees seek opportunities elsewhere. (2)
 Perhaps Foodage should franchise KNB and Popinas making capital profits on sale of
stores and developing a larger franchisee base? (2)

Available 34
Maximum 16
Layout 1
Communication marks 2
Total 49
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Part (b) R000

Option value on settlement (10,50 x 9 000) 94 500 (1)
Cost at strike price (5,1 x 9 000) -45 900 (1)
Transaction costs -500
Net profit 48 100
PAYE @ 40% -19 240 (2)
Net proceeds received by executives 28 860 (1)

Part (c) 2008 2009 2010 2011 2012

Annual mark to market of all shares owned
(12,80 x 1 641), (7,15 x 3 603) 21 005 25 761 42 739 57 749 74 046 (1)
Cumulative acquisition costs
(16,50 x 1 641), ((13,05 x 1 962)+27 077) -27 077 -52 681 -64 264 -64 264 -72 381 (1)
Cumulative (loss)/profit -6 072 -26 920 -21 525 -6 515 1 665 (1)

Annual (loss)/profit movement -6 072 -20 848 5 395 15 010 8 180 (1)

Annual profit/(loss) from acquisition activity

(12,8-16,5 x 1 641), (7,15-13,05 x 1 962) -6 072 -11 576 891 0 293 (1)
Annual profit/(loss) from mark to market
(7,15-12,8 x 1 641), (8,4-7,15 x 3 603) 0 -9 272 4 504 15 010 7 887 (1)

Average cost per share

(27 077/1 641), (52 681/3 603) R16.50 R14.62 R12.63 R12.63 R12.61 (1)
Comments
 Share buybacks should be implemented to create value for shareholders by buying (1)
shares. Objectives include:
o Signaling to the market that share price is undervalued
o Shareholders make a capital gain on share acquisition (1)
o Enhance EPS
 Overall, the share buyback programme has not been successful given the cumulative (1)
losses incurred until 2012
 2008 global financial crisis would have affected share prices and this was (1)
not anticipated. Difficult to criticize management’s share purchases in 2008 based on
this factor
 Stock market ignored the share buyback signals (share underpriced) in FY2008 and
FY2009 (2)
 However, closing share in 2008 of R12.80 versus average buying price of R16.50 that
year should have sent a clear signal that share price momentum was downwards. (1)
 Average share acquisition cost of R16.50 implied a forward PE multiple of 24.7 in 2008, (2)
which is high compared to the historical average on JSE.
Calc:
EPS = 83 600 000 x 72/100 / 90 000 000 = 0.6688
Forward P/E multiple = 16.5/0.6688 =24.7
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 Management’s judgment in share acquisitions has to be questioned:

o Average purchase price of R13.05 in FY2009 versus price of R12.80 at (1)
September 2008 (1)
o FY2009 closing share price of R7.15 versus average acquisition cost of R13.05
o No buybacks in FY2011 (although group bought back (cash settled) options (2)
 Total number of shares acquired is material → 6.4% of total shares in issue in FY2012 (1)
 Mark to market losses were material in FY2009 and FY2010 which would have
impacted on reported profits, adding to negative market sentiment? (2)
 Did the management incentive programme play any role in share buybacks?
Possibly an incentive to drive share price higher through buybacks? (2)
Available 26
Maximum 16

Part (d) – 1 mark for identifying & 1 mark for describing

 Use recycled paper for takeaway packaging. Avoid plastic containers/bags and (2)
other synthetic materials which are difficult & costly to recycle
 Make greater use of electronic media for marketing and less use of print & (2)
outdoor advertising which use paper and synthetic materials
 Donate leftover food and ingredients close to expiry date to those less fortunate (2)
 Separate waste into glass, paper, plastic and organic waste and dispose of responsibly (2)
 Donate spent cooking oil to manufacturers of biodiesel (2)
 Use LED lighting as these are more energy efficient (2)
 Install solar geysers to heat water for bathrooms and kitchen use (2)
 Minimize air travel which uses significant fuel and emits toxins into the atmosphere. (2)
 Rather arrange video conferencing meetings. Also, use public transport as much as
possible
 Procure from environmentally friendly suppliers (2)
 Monitor franchisees compliance with checklist of environmentally friendly practices (2)
 Limit red meat items on the menu – cattle are significant producers of methane gas (2)
 Source organic products from suppliers rather than those grown using fertilizers (2)
Available 24
Maximum 12

Part (e)
Executive chairman
 Chairman to provide leadership in devising business strategy & setting policies. An (2)
executive director cannot impartially set, implement and monitor success of
aforementioned as he is involved in this on a day to day basis
 Who will evaluate the performance of the executive chairman? (2)
 Sithole is the founder of Foodage and presumably remains a shareholder. Difficult for him (2)
to separate the interests of executives and shareholders as he is both. Blurring of
roles may result in conflicts of interests
 Sithole should rather be CEO given his holistic understanding of the group. These (2)
attributes do not necessarily make him a good chairperson. Chairman should be
independent and monitor the value add and performance of CEO and management
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Majority of directors are executives

 7 out of 8 directors are executives or previously executives. This aggravated by the
chairman being an executive too. Composition of board results in several potential
conflicts of interest between business needs and shareholder value enhancing
initiatives: (2)
o Spend money on share buybacks or commit this capital to organic growth? (1)
o Opening own retail outlets instead of supporting franchisee base (1)
o Opening Popinas wine bars in contradiction to the ethos of the business of
family friendly restaurants? (1)
o Being an ethical corporate citizen by embracing environmentally friendly ways of doing
business or maximizing profits? (1)
 Argument that it has not been possible to recruit suitably qualified non-executive
directors is a ‘cop out’. There are sufficiently talented individuals out there who could be (2)
effective non-executives with the appropriate induction, training and mentoring
Remuneration Committee
 3 and possibly 4 members are executives or previously executives meaning that the (2)
majority determine their own remuneration. This is a major conflict of interest.
 Shareholder vote at previous AGM (21% vote against remuneration structures) should (2)
clearly signal discontent of shareholders with current status quo re RemCo
 Share option scheme of 2006 resulted in R48m cost to shareholders which is material to (2)
annual profits. Scheme and RemCo needs to be questioned as profitability of group
has not been such to justify this type of incentive
 2006 scheme also had no downside for executives (1)
 Share buyback programme value destruction → no penalty to executives who oversaw (2)
this programme
 RemCo is a sub-committee of the board and can only make recommendations. Given the
lack of independent non-executives on the board, RemCo composition is a (2)
secondary problem which needs to be addressed.
Corporate governance at Foodage needs urgent attention to ensure that the chairman is (1)
independent, the board comprises mainly non-executives and remuneration policies are fair
Communication skills (2)
Available 30
Maximum 17
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QUESTION 24 SUGGESTED SOLUTION

ZAPPHIRE LIMITED
(Source: SAICA 2011 QE II Question 2 - adapted)

All the “Required” sections of this question are predominantly discussion based. It is important that you plan your
answer carefully and utilise the mark allocation to guide you regarding the length and level of detail of your
answers.
Part (a)
Discussion of factors to Critical evaluation of terms and conditions
be considered in AZN Proposal Hacienda Proposal Eurobond Proposal
evaluating a winning
proposal
Cost: Variable rate: JIBAR Fixed rate: 4.85% pa Fixed 5.65% pa not
• Prefer the lowest + 2.75% = 8.325% not directly comparable. directly comparable.
cost proposal, but pa currently not • Factor in the cost of • Factor in FEC
proposals are directly comparable. the call option (this cost of hedging
difficult to 1 • Factor in the cost will increase the 1 (ZAR:EUR) /
compare due to to fix the rate 1 NPC/IRR). likely change in
different terms. (this will increase • Account for timing / ZAR:EUR
• Calculate the NPC/IRR). interest on exchange rates
NPC/IRR for each 1 • Breach of debt 1 payments into 1 based on relative 1
proposal, making covenants has a DSRA account (this interest rates
adjustments to huge cost will increase the over 6 years (this
make penalty: + 5.25% NPC/IRR). will increase the
comparable. pa (8% - 2.75%). • Call option likely to NPC/IRR). 1
have a high 1 • A 6 year FEC
value/cost to may not be
Newco: available due to
o Exercise price is the long time
at the lowest 1 horizon / likely to
share price over be very 1
the past 12 expensive.
months. • Early settlement
o Zapphire price- could be punitive
earnings ratio is as the penalty is
6 (9.2/1.533) vs. 2.4% of the loan
8 – 12 for principal for each
industry. year or part
thereof that the
bond is
redeemed early.
Interest rate risk: • Variable rate • No interest rate risk, • No interest rate
• Prime rate may results in interest but if interest rates risk, but if interest
increase in rate risk, which in SA decrease the rates in SA
coming years / may be high if it fixed rate will be 1 decrease the 1
Newco will need is expected that 1 less attractive. fixed rate will be
to take a view on 1 rates will less attractive.
future interest rate increase, but
movements. • AZN gives option
(available 1
immediately) to
fix R350m of
R700m at an
additional cost.
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Forex risk: • N/A • N/A • Significant forex

• Lower risk is risk considering
preferred, the 6 year 1
especially given horizon.
recent volatility in • Possible
markets and 1 operational
future income in USD, 1
expectations in which may form a 1
this regard. partial natural
hedge
(USD:EUR vs.
ZAR: EUR)
Effect of restrictive Comparably strict 1 • No debt covenants Comparably very 1
covenants and covenants: or restrictions is a strict covenants:
conditions: • No repayment of very attractive 1 • No repayment of
• These may shareholder’s feature. shareholder’s
seriously affect 1 loan implies 1 • Call option: loan, no further
the running of the Zapphire has Hacienda may debt and no
company. R200m invested 1 acquire +/- 5% dividends means
• Preferably to be 1 for 4 years. (7.5m/150m) that Zapphire will 1
limited for a start • Keeping to shareholding in 1 unlikely reap any
–up company financial ratios Zapphire reducing benefit for 6
(Newco). could be very control of existing years.
limiting. shareholders.
Security required: • No less security • No less security • Additional
• Effect on Zapphire required than required than other security
preferably to be 1 other proposals, proposals, but requirement:
limited. but Zapphire is 1 Zapphire is shielded 1 cross-guarantee
shielded from from additional risk. from Zapphire.
additional risk. This is significant
given that
Zapphire is
directly exposed 1
should Newco be
unable to repay
the interest and
capital of the
bond. 1
• Cross-guarantee
will restrict 1
Zapphire’s ability
to borrow (will be
regarded as a
debt obligation),
but
• Zapphire
currently has no
long-term debt.
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Cash flow • Interest: greatest • Interest: least • Interest:

considerations: reprieve / reprieve / strain as intermediate
Matching of cash flexibility as 1 payable quarterly in 1 reprieve /
inflows and outflows: payable annually arrears. flexibility as 1
• A new business in arrears. • Capital: least payable semi-
faces many • Capital: reprieve reprieve / strain as annually in
uncertainties – / flexibility as 1 effectively arrears.
better to have a repayable in repayable monthly 1 • Capital: greatest
safety margin in 1 single payment in (due to effect of reprieve / 1
st
the 1 few years / 4 years’ time. DSRA payments). flexibility as
perform a cash • Capital 1 repayable in a
flow forecast. repayment: single payment in
• Asset(s) financial 6 years’ time
determine the discipline (additional 2
timing of cash 1 required / cash years to AZN).
inflows, therefore flow pressure in 1 • Bond redemption 1
the useful life and 4 years’ time. (EUR70m):
type of asset(s) • 4 years may be financial discipline
should dictate the shorter than the required /
term of asset- useful life of the extreme cash flow
based finance. asset placing pressure in 6
• Estimation of further pressure years’ time (effect
useful life of 1 on cash flows in of changes in
equipment: year 4. forex if not
Assuming hedged).
equipment is used
6 hours a day, 7
days a week, 52
weeks a year =
2 184 hours pa.
Therefore
FA2013: 10 000
hours / 2 184 =
4.6 years (mark
awarded for
calculation as long
as student states
assumption).
Other requirements • Long standing Eurobond listing:
and factors: relationship • Additional
between administration for 1
Zapphire & AZN 2 Newco.
implies greater • Credit agency 1
trust / room for ratings / reviews.
negotiation. • SARB 1
requirements to
be met.
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Additional information Additional information required (specific to proposal)

required (general)
• Are there any • What specific • Call option: approval • Similar, secured
other costs financial ratios required from JSE Eurobonds with
(advisory fees, does AZN expect 1 and/or 1 same redemption
legal fees, Newco to adhere shareholders? date: are yields /
underwriting fees) 1 to? • How is coupon on recent
associated with • Penalties for 1 Newco/Zapphire bond issues 1
any of the early settlement? going to cover its comparable to
options? 1 potential 5.65% pa (fixed)?
• What is the cost of counterparty • Will this proposal
registering a obligation? Will supply R700m? If
notarial bond? Newco hedge this ZAR:EUR
May be 1 by obtaining a increases before 1
significant. similar call option or 1 issue there will be
• How do costs and will Newco acquire a shortfall / will
terms compare to 5% of Zapphire to 1 bond be issued at
other recent cover the potential a premium or
asset-based exercise of the call discount?
finance obtained 1 option? • Option of having
by Zapphire? • DSRA account: will 1 Eurobonds 1
• Research into 1 Newco earn denominated in
expectations for interest? USD? Is this
mining industry 1 • Penalties for early option available,
over the next 4 – settlement / not especially 1
6 years: adhering to monthly considering
commodity price 1 DSRA payment possible USD
risk, risk of schedule? operational
government income (which will
intervention, etc. 1 give a natural
• Capital adequacy, hedge)?
liquidity ratios of • Impact of the
finance providers, financial crisis in
indicating their Europe on
ability to survive. demand for
• If fleet cost > Eurobonds / is the
R700m – which bond
proposals will underwritten?
allow for
additional
finance?
• Zapphire has
R675m in cash:
reason for not
using cash (even
partially)?
Available 70
Maximum 28
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Part (b)(i)&(ii)
Interest rate swap
• Newco will pay amount equivalent to fixed rate of a notional amount to AZN Bank (1)
• Newco will receive interest from AZN Bank equivalent to actual JIBAR calculated based (1)
on a notional amount
• If actual JIBAR is < fixed rate then Newco payments > receipts (1)
• If JIBAR rate> fixed rate then Newco will receive positive cash flow (1)
• Current interest rate is variable therefore Newco exposed to increasing interest rates (1)
for next 4 years of loan
• Swap effectively fixes interest rate for duration of agreed period providing certainty for (1)
Newco
• Newco will still have to pay 2.75% over & above fixed rate (1)
• To illustrate - if JIBAR increases to e.g. 7%: (1)
o Total of 9.75% (7% + 2.75%) vs.
o Swap total of 9,41% (6.66% + 2.75%) / 10,00% (7.25% + 2.75%) / 10,38% (7.63% +
2.75%)
• If JIBAR remains stable or declines, Newco will pay significantly higher effective (1)
interest than by not entering into swap
• Swap only hedges against interest rate exposure onR350m of R700m principal (1)
Interest rate cap
• If JIBAR < cap rate then Newco still benefits from lower rates (1)
• If JIBAR rises to above cap rate then Newco only pays cap rate (1)
• Cap provides certainty of a maximum interest rate (1)
• Premium paid upfront - sunk cost of hedging (1)
• Premium increases effective rate - if 2 year swap, JIBAR will need increase to (1)
>7.63% for Newco to be ‘in the money’
• Cap essentially an option (1)
• Newco cannot hedge against 2.75% only against JIBAR (1)
• Premium increases as strike rate decreases towards current JIBAR (1)
• To illustrate -if JIBAR increases to e.g. 8.0%: (1)
o Total of 10.75% (8%+2.75%) vs.
o Cap total of 10,38% (7.63% + 2.75%) / 10,88% (8.13% + 2.75%) / 11.38% (8.63% +
2.75%)
• Cap only hedges against interest rate exposure on R350m of R700m principal (1)
Factors to consider
Interest rates:
• Outlook (1)
• Historical trends (1)
• Recent movements (1)
Risk appetite of Newco:
• Eliminate interest rate risk (fix the rate) - enter into swap (1)
• Lower interest rate risk (cap rate at a maximum) - favour cap (1)
• Cap allows Newco to benefit from declining JIBAR (1)
Sensitivity analysis / scenario modelling required to assess impact of: (1)
• Potential JIBAR movements
• Timing of JIBAR movements
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Effective cost: (1)

• Cap premium payable upfront - significant cost
• If JIBAR decreases then cap more cost effective
• If JIBAR increases scenario modelling may determine cost effectiveness of swap vs cap
• If JIBAR stable then swap likely to be most costly
Duration: (1)
• Cap for 4 year period - protection over full term of loan
• Swap available for 2, 3 or 4 years - greater flexibility
Quoted rates versus current JIBAR (1)
• Swap rates higher than current JIBAR (1.09% (6.66% - 5.575%) to 2.06% (7.63% - 5.575%)
above)
• Cap strike rates much higher than current JIBAR (2.06% (7.63% - 5.575%) to 3.06%
(8.63% - 5.575%) above)
Quotes from other banks (1)
AZN probably applied thorough analysis - arbitrage opportunity unlikely. (1)
Available 4
Maximum 20

Part (c)
Overall: Hardrock and contract mining
Strategy:
• Proper strategic reason for entering contract mining, or merely the result of a possible
bargain price? (1)
• Effective geographical diversification from entering other African countries?
• Will probably offer ineffective business diversification (1)
o Analyst’s views that Zapphire is over-exposed to the mining sector may be (1)
exacerbated (1)
• Compile comprehensive business plan for acquisition, including forecast results for the (1)
next five years.
• Consider possible efficiencies / synergies between contract mining and existing (1)
business: opportunities to cross-sell, use of fleets across industries to take up excess
capacity, etc. (1)
• Hardrock fleet specialised in open cast mining, or easily adaptable to other targeted
mining operations?
Timing:
• Is this the proper time to enter contract mining given industry, economic expectations? (1)
• Core business has been under threat with negative outlook: wise to invest in a new
business? / Loss of management focus (1)
Key risks / threats / requirements:
• Risk of starting new business:
e.g. unknown market, variables, threats, critical success factors, unsecure revenue (1)
(1)
streams (1)
• Targeting existing Zapphire clients: impact of Newco’s teething problems on clients?
(1)
Does Zapphire have the required management expertise and resources: plant hire vs mining
contractor?
Hardrock legacy:
Employing management team responsible for Hardrock business failure – is this a wise
move? (Negative context.) Hardrock management team – will they be willing to join? (Positive (1)
context.) (1)
• Investigation of the reasons for Hardrock’s liquidation. (1)
• Differences in culture and salary levels: how will this impact Zapphire?
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Stock market reaction to acquisition? (Zapphire shares already undervalued.) (1)

Availability of alternative investment opportunities providing superior returns / diversification (1)
benefits?
Hardrock fleet
Results of comprehensive technical, legal and commercial due diligence investigations. (1)
Acquisition of Hardrock fleet: IRR >risk-adjusted specific WACC / positive NPV / Monte Carlo
(2)
analysis
Impact of key terms of finance raised to fund acquisition, e.g. debt covenants, cross
guarantees. (1)
Impact on Zapphire group:
• Effect on Zapphire group WACC? (1)
• Impact of acquisition on group’s future profits, gearing, balance sheet ratios.
• Materiality of the acquisition – R200m working capital investment plus R700m debt > (1)
Zapphire’s current NAV.
Impact of investment on existing dividend policy? May have to limit future dividend pay-outs
until Newco is financially stable? (1)
Ability to sell fleet in total or in part in the event that Newco is not successful – likely value to (1)
be realised?
Labour Relations Act requirements: (1)
Will Newco have to take over Hardrock employees?
Contract mining
Consider the market size / competitive landscape (1)
Specific to other African countries (Angola, DRC and Ghana):
• Country-specific risks to be considered: (1)
e.g. political risk, expropriation risk, corruption, bribes, security, risk of bad debts, difficulty
recovering debts , etc. (1)
• Results of thorough analysis of the industry there:
e.g. size of market, historic growth rates, key challenges, future prospects, current levels of
fixed investment, key success factors, major clients and suppliers. (1)
• May offer access to the fast-growing African market
• Skills shortage / infrastructure limitations (1)
• Foreign taxation levels, requirements, incentives?
• Exchange rate risks / benefits– income in USD, input cost currency? (1)
Part of the greater mining industry, with associated concerns:
• Impact of the dominance / negotiating power of mining groups? (1)
• Ease of compliance with mining regulations?
• Effect of commodity price risks / change in demand? (1)
Available 41
Maximum 20
Clear thinking and analysis in part 1
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Part (d)
Factors to be considered in determining charge-out rate / pricing policy
Newco to charge highest sustainable rate / Pricing should give adequate ROCI (1)
Impact of typical industry practices: (1)
• E.g. pricing, penalties and guarantees. (1)
• Plant hire vs mining contractor – different pricing considerations:
o Available time - few other pricing considerations, but consider machine (1)
breakage / down-time. (1)
o Productive time – several additional pricing considerations, incl. weather, (1)
interruptions, strikes. (1)
o Tons extracted – even more additional pricing considerations, incl. planning (1)
bottlenecks and operator efficiency. (1)
Consider differentiated pricing (e.g. Offer to charge per tonne extracted as opposed to
productive plant hours.) (1)
• Benefit: may price at a premium (1)
• Downside: may take on too many risks, which is dangerous for a new market entrant (1)
Consider differentiated service offering
(1)
• Possible in this market? May allow premium pricing. If not, long-term pricing becomes
(1)
more of an issue.
Consider the full cost of the service e.g. transport cost of fleet to Africa.(Only for costs not
(1)
already mentioned in the question.)
Specific issues to be considered in determining charge-out rate / pricing policy:
Hardrock pricing method- cost-plus pricing method (based on FA1013 example):
• Ignores other expenditure (employee cost, fuel, insurance, repairs and maintenance),
these should be considered (1)
• Arbitrary mark-up of 30% / mark-up seems to be grossly insufficient to recover
other expenditure and secure a reasonable profit (only R30,84 (133.64-102.8) per (1)
productive hour); careful consideration is required
• Plant cost per productive hour is the main cost driver and this basically equates to a
depreciation charge only (1)
• Plant cost per productive hour: new fleet vs fleet at FMV - very similar (R102,80 vs
R96,50). (1)
o Indicating that a reduced price may not be warranted only because the fleet is (1)
not new.
• Plant cost per productive hour: new or FMV vs acquisition price – large difference (1)
(R102,80/R96,50 vs R32,50).
o The issue is whether Newco should offer lower charge-out rates given acquisition (1)
discount? (1)
o Customers will know rumours and may ask for discounted prices. (1)
o Negative signalling effect of lower price: low quality, low productivity, old fleet (1)
• Estimate useful life of Hardrock fleet to indicate duration of the cost advantage.
o If the fleet life is, say, four years, this will influence its pricing strategy. If fleet (1)
life was one or two years, the cost advantage would be short lived and charge
rates should be more
Specific cost-considerations stable
related to the other African countries (Angola, DRC, Ghana):
• Other expenditure (employee cost, fuel, insurance, repairs and maintenance): priced in
(1)
USD?
• Invoicing in USD: consider the cost of hedging ZAR:USD on the USD difference between
(1)
income less expenditure
• Impact of skills shortage / infrastructure limitations / lack of suppliers / taxation /
(1)
bad debts on costs?
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Market conditions: SA vs Angola/DRC/Ghana – different opportunities may allow price (1)

discrimination strategy (e.g. market rates in new territories and discounted rates in SA).
Consider competitive pressures and competitors’ current pricing. (1)
New market entrant: consider penetration pricing to obtain market share (within allowances
of Competition Act). (1)
• Employing the existing Hardrock management team may enable Newco to charge realistic (1)
market rates.
• Prices charged to historical Hardrock customers may influence future pricing to the same (1)
customers by Newco.
Short term vs long term pricing: discounted rates in the beginning may make future increases
(1)
difficult.
The duration of customer contracts will impact on quoted rates – rates for a three-year
(1)
contract should be lower than for, say, a six-month contract.
Where a customer is the focus: Construction and contract mining may be offered to the same
customer, which may necessitate that the one service supplements the other. This may require a (1)
loss-leader pricing strategy.
Available 38
Maximum 11
Part (e)

Improper actions of Mr Williams

Williams is the executive chairman and major shareholder of Zapphire: (1)
• Chairman should be non-executive and independent. (1)
Offering sign-on bonuses to the former Hardrock management team on condition that they (1)
do not bid:
• Unfair business practice/ fraudulent /tantamount to paying a bribe. (1)
• Zapphire’s Board should provide ethical leadership and facilitate corporate citizenship. (1)
Socialising with the liquidators of Hardrock: (1)
• Should not take place - the parties have competing interests and it may be misconstrued
by the market should this behavior become public knowledge. (1)
Offer non-executive directorships to two of the liquidators of Hardrock: (1)
• May appear to be a financial inducement/ bribe for them to favour Zapphire’s bid for the
Hardrock fleet. (1)
Williams offered directorships to two key individuals unilaterally: (1)
• Directors are to be appointed through a formal process, assisted by a nomination
committee. (1)
Meeting with the CEO of BJL Civils and suggesting tender rigging: (1)
• This is a clear breach of the Competition Act / fraudulent behavior. (1)
• Zapphire should have risk and compliance procedures in place to ensure that
statutes and regulations are complied with and any non-adherence detected and resolved. (1)
Williams’ discussions with journalists:
• He is divulging confidential information to third parties – Williams and Zapphire should
(1)
have been bound by confidentiality agreements with Hardrock and their liquidators.
• Secondly, providing false information about the Hardrock fleet and business is (1)
dishonest and it could be published and affect the value realised by Hardrock liquidators.
Williams’s statement that Zapphire may pay introductory commissions for introductions to (1)
potential clients
• May be construed as paying bribes. (1)
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Overall behavior by Mr. Williams:

• Williams may be guilty of reckless trading in terms of Section 22 of Companies Act 71 of (1)
2008.
• Actions of Mr Williams do not comply with the requirements of the Code of Governance (1)
Before / during Hardrock strategy session
• Inviting former Hardrock management team to the think tank is not appropriate. They
may ‘repay’ the hospitality by disclosing confidential information about the Hardrock business (1)
to Zapphire.
• Directors travelled on same aircraft to Kruger Park think tank – this places group at
(1)
significant risk in the event of an accident.
• Extravagant spending at the think tank is not behavior becoming of directors. They are (1)
spending shareholders’ money and should be more circumspect than that.
Available 23
Maximum 16
Clarity of thought in part (e), not a laundry list of issues 1
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QUESTION 25 SUGGESTED SOLUTION

CATCON (PTY) LTD (Source: SAICA 2011 QE II Question 1- adapted)

Part (a)
2011
Profit before taxation 74
Add back non-cash items
Depreciation 32 (1)
Movement in provision 5 (1)
Foreign loan translation differences –25 (1)
Taxation paid [-21-13+3] (1m I/S tax, 1m B/S movement) –31 (2)
Working capital movements
Inventories –174 (1)
Depreciation movement through inventories
[(R25m/4.5m units)x0.8m units] –[(R20m/4.2)x0.7m units] 1 (2)
Trade receivables –54 (1)
Trade payables 172 (1)
Capital expenditure [-195-32+170] –57 (2)
Repayment of interest bearing debt [52-123(1m) +85-101(1m)+25(1m)] (3)
–62
Net increase in bank overdraft -119 (1)
Conclusion: Yes, AZN Bank is correct (1)
Maximum 12

Part (b)
2011 2010
Interest cover ratio 2,9 11,0 (1)
Debt-Equity ratio (including bank overdraft*) Alternatively calc gearing 59% 59% (1)
Alt:Debt-Equity ratio (excluding overdraft* is not correct for this question) 17% 30% (1)
Debt Ratio 61% 59% (1)
Alt:Total debt/Equity 159% 144% (1)
Interest cover ratio declining due to decrease in profitability (1)
Debt Equity ratio constant because foreign loan payments funded by Overdraft (1)
Alt: D:E (excl. overdraft) declining due to decrease in the long term loan (1)
Debt ratio stable due to creditors/overdraft funding asset increase (1)
Alt: Total debt/Equity increasing due to declining profits & overdraft/creditor (1)
Ratios at face value don’t indicate major gearing issue (1)
Foreign loan repayable within next 2yrs: frees up cash flow for other uses (1)
Major concern is declining profitability, esp. gross profit margin (1)
CatCon is not generating positive cash flow = major liquidity problem (1)
Overdraft can be revoked at any time: shouldn’t be overly reliant (2)
rd
Bankers have raised concerns re gearing (3 party confirmation) (2)
Note*: Bank overdraft should be included under the interest bearing debt as it is
used to finance more than just working capital as indicated by Ms Beezbubble
that “AZN Bank financed the repayments of the foreign loan, as CatCon is
not generating sufficient cash flows to service this themselves”

Conclusion: Consistent with analysis & appropriate (1)

Maximum 7
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Part (c) 2011 2010

Per unit R R
Revenue (5039 / 3 900 000) 1 330,00 1 (1)
COS per unit manufactured (3 812 + 1 726 + 25)/ 4 500 000 –1 236,23 –1 (1)
PGM costs –847,11 – (1)
Other manufacturing costs –383,56 – (1)
Depreciation –5,56 352,1
Inventory 11,46 4 (1)
Gross profit per unit sold incl. inventory 105,23 175, (1)
Alt: GP excl. inventory movements 93,77 152, (1)
Opening inventory cost per unit 1 198,57 1 (1)
Closing inventory cost per unit 1 266,25 1 (1)
(1)
Gross profit % 7,9% 13,6 (1)
Alt: Cost of sales as a % of revenue per unit (incl. inv. movements) 92,1% 86,4 (1)
% change in total revenue 16,1% (1)
% change in total COS 23,8% (1)
% change in total PGM costs 15,9% (1)
% Increase units sold 12,8% (1)
% change in per unit (1)
Revenue 2,9% (1)
PGM costs 8,2% (1)
Other manufacturing costs 9,0% (1)
Gross profit per unit sold –40,1% (1)
COS as a % of per unit revenue
Revenue 100,0% 100,0
PGM costs –63,7% – (1)
Other manufacturing costs –28,8% – (1)
Depreciation –0,4% – (1)
Change in inventory levels 0,8% 1,8 (1)
Gross profit % 7,9% 13,6 (1)
Cost of sales as a % of revenue per unit (total, excl. inv.) 92,9% 88,2% (1)

Strengthening of R against US $ 7,9% (1)

US $ terms: Revenue per unit 11,8% (1)
US$ increase: PGM costs p.u. manufactured (847/7 – 783/7,6) / 17,5% (1)
(783/7,6)
• Revenue levels will be lower due to strengthening rand. (1)
• COS in total increase off 23% > 16% increase in revenue in total = decrease in GP (1)
• CatCon unable to recover cost increases from customers: key reason for decrease in (1)
• PGM costs per unit increase with 8,2% (17,5% US$) yet revenue per unit only increased (1)
• PGM cost increases at least partly off-set by strengthening rand. (1)
• PGM quantities & mix consistent 2yrs: no production inefficiencies/ mix ‘variance’ (2)
• Other manufacturing costs are Rand-based: no impact of changing exchange rates (1)
• 9,0% increase in Other manufacturing costs above CPI (1)
• Increase in Other manuf costs may indicate rising labour (1m),electricity (1m). (2)
• Increase in inventory levels increased GP (fixed cost deferred to 2012). (2)
st (1)
• FIFO system: cheap inventory sold 1 , increased GP margin
• CatCon is operating below capacity: increase in COS / failure to recover overheads. (1)
Maximum 20
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Part (d) 1 mark identify risk, 1 mark discuss impact thereof

CatCon depends on global demand for vehicles– decline affects capacity utilisation &profit (2)
CatCon places reliance on one product: any negative economic event could bankrupt CC (2)
‘Acts of God’(earthquakes) / recall of customer vehicles may affect global production of (2)
Clients (Assemblers) significant negotiating power(note limited price increases could (2)
Competes against global manufacturers: rising labour costs, distance from European (2)
New market entrants: threat of competition (possibly lower cost) (2)
New technology e.g. hybrid vehicles affects demand for catalytic converters / makes (2)
Manufacturing advances (decrease in quantity of PGM/replace with other metals): become (2)
Environmental risk: any changes to laws etc which may affect demand for vehicles (2)
Public liability if converters do not operate as designed / allows harmful emissions (2)
Withdrawal of MIDP may discourage purchases. (2)
Exchange rate risk: PGM $ denominated (2)
Exchange rate risk: foreign loan (2)
CatCon is exposed to interest rate risk from the foreign loan. (2)
Declining gross profit margin may not cover local manufacturing costs. (2)
PGM input costs(large % of COS): PGMs are commodities / no control over ruling prices. (2)
Rising operational costs (labour, electricity): failure to recover through price increases (2)
Inflationary cost pressures would affect CatCon’s profitability. (2)
Failure to raise capital to reduce the overdraft: unable to trade due to insufficient funds. (2)
Liquidity risk: Non-repayment of OD may lead to liquidation. (2)
Industrial strikes / employee morale: suspended operations, lower productivity (2)
Any other valid point. (2)
Maximum 16

Part (e)
Equity value placed on CatCon R900m
Add foreign loan R137m (1)
Add bank overdraft R339m (1)
Enterprise value R1 376m (1)
PE (1)
PAT FY2011 R53m (1)
Implied PE multiple R900/ R53m 17,0 (1)
Average PAT 2010 & 2011 Or(1) R136,5m (1)
Implied PE multiple On WA: 8,3 6,6 (1)
EBIT (1)
EBIT FY2011 R113m (1)
Implied EBIT multiple R1 376m/ R113m 12,2 (1)
Average EBIT 2010 & 2011 Or(1) R226,5m (1)
Implied EBIT multiple On WA: 7,3 6,1 (1)
Average EBIT past 3 years Or weighted ave: R262,3m R336m (1)
Implied EBIT multiple On WA: 5,3 4,1 (1)
VALUATION
Based on PE ratio
2011 PAT or Average PAT over 2 or 3 years (as above)
Adjustment to (either PAT or : unlisted (1m)& specific (1m) (2)
Valuation using adjusted PE multiple (PAT x PE multiple)– 2011 (1m), average (2)
Based on EBIT
Valuation using adjusted EBIT multiple (EBIT x multiple) – 2011 (1m), average (2)
Less: foreign loan - R137 (1)
Less: overdraft - R339 (1)
Equity value R?m (1)
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Earnings multiple of comparable listed companies useful but:

• Based on average earnings or most recent reported earnings? (1)
• Have they been subject to revenue & profitability pressures faced by CatCon? (1)
EBIT multiple preferable to PEs do not adjust for capital structure (2)
Implied historic earnings multiples of offer higher than listed companies’ multiples (1)
However, average earnings multiples lower than listed companies’ multiples (1)
Any adjustments required to CatCon earnings? (forex, provisions, etc.) (1)
Profitability decreased past 3yrs: return to 2009 profit levels may mean Wohlstand offer too (1)
Forecast profitability FY2012 probably critical to assess reasonability of Wohlstand offer. (2)
CatCon doesn’t have many options – Wohlstand in strong position to negotiate value. (2)
CatCon’s current liquidity crisis to Wohlstand lowered offer price? (1)
How does Wohlstand valuation compare to Black Swan offer? (1)
FCF valuation needs to be done, more technically sound than earnings based (1)
Wohlstand offer not much higher than NAV of R807m (1)
Other reasonability checks: Value/revenue; Value/total assets (1)
Conclusion: appropriate based on analysis (1)
Maximum 14
Part (f) OPTION 1 OPTION 2
Black Swan Wohlstand
Split BS hybrid instrument into debt &equity portion (1)
Shareholding to be acquired 31,0%* 40% (1)
Dividend rights R31,5m p.a. None (1)
Implied Equity Valuation of CatCon (315m/[45m/145m R1 015m¹ R900m (1)
¹Convertible at option of s/h at any stage
Total interest-earning debt 30/6/2011 pre-capital raising R476m R476m
Debt post capital raising R161m R116m (1)
Debt-equity ratio (²Assumes pref shares regarded as 14,3%² 9,9% (2)
OPTION 1: BLACK SWAN (BS)
• Obligation to pay annual dividends to preference shareholders (1)
• Preference dividend rights are cumulative (1)
• Preference shareholders will rank ahead of ordinary shareholders in the event of liquidation. (1)
• Prefdiv yield 10% high: o/draft (9%), loan (7% US$). Equivalent pre-tax rate would be 13,9%. (2)
• BS’s investment = high-yielding non-redeemable debt instrument with a free option to
rd
convert to ordinary shares (can benefit from 3 party high valuation & sale of shares). (2)
• Higher implied valuation by BS should not be seen in isolation: only relevant if pref shares
are converted into ordinary shares; div rights impose an obligation on CatCon (should deduct). (1)
rd (2)
• Right to sell shares to 3 parties without pre-emptive rights: could be sold to competitor
OPTION 2: WOHLSTAND
• Wohlstand investment raises R45m extra capital: may or may not be advantageous. (1)
• Having a German-based shareholder may enhance credibility with European OEMs. (1)
• Both will lead to a dilution in BEE holding: W ohlstand immediately effect (pref only if convert) (1)
• Co Act: acquisition of 35% or more of voting securities triggers obligation to make offer to
acquire all co’s remaining securities: could impact Wohlstand given BBBEE shareholder (2)
BOTH
• Both = shareholding > 25%: strong veto right over major decisions (1)
• Management retains control if BS (51,03% post conversion), lose control if Wohlstand (44,4%) (2)
• Should investigate credibility& reputation of both BS & Wohlstand (1)
• CatCon has sufficient CF for ops before repaying debt: is turnaround in profit& CF expected
2012? If not, may require more funding than presently being raised and a turnaround plan. (2)
RECOMMENDATION: W ohlstand - higher amount of capital, less onerous dividend obligations. (2)
Maximum 18
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Part (g) 1 mark identify action, 1 mark discuss result of the action

• Increase selling price (GP% too low), if possible. (2)

• General cost control to reduce spending & increase cash flows & profit. (2)
• Pass PGM cost increases onto customers (2)
• Hedge commodity prices: set price paid for PGM, reduce losses from price fluctuations. (2)
• Find ways to limit Other manufacturing cost increases: cost cutting / outsourcing (2)
• Use LED lights to reduce electricity costs. (2)
• Explore ways to improve morale: higher productivity and innovation in the work place (2)
• Improve design of converters: use different mix of PGMs (2)
• Use spare capacity to manufacture another product and diversify their operations (2)
• Sell surplus assets, if any. (2)
• Sale and leaseback of PPE (2)
• Improve inventory management to reduce inventory-holding (e.g. use JIT) (2)
• Factor debtors to increase cash flows& redirect focus on production (2)
• Providing settlement discounts to improve CF. Operating profit margins may be (2)
• CatCon should raise equity from Wohlstand: increase cash flows to desired levels. (2)
Maximum 8
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QUESTION 26
SUGGESTED SOLUTION
SASSI STORES (PTY) LTD
(Source: SAICA 2010 QE II Question 2 -adapted)
Part (a)

“Rolling forecasts are a more effective management tool than annual budgets”

• Many companies elect to use both, annual budgets for a detailed annual review of costs etc. Rolling
forecasts are used as a complimentary tool to improve forecasting accuracy (2)
• Successful implementation of rolling forecasts requires the buy-in of management, without this,
rolling forecasts become a meaningless tool (2)

“Rolling forecasts generally involve companies preparing quarterly forecasts for the next 18 months and
these are updated as frequently as required”

• The forecasting period depends on the nature of companies business. A utility business (electricity
supplier) may have a longer planning horizon and forecast period could be significantly longer than
18 months (2)

“Rolling forecasts alleviate the need for companies to prepare annual budgets”

• Not necessarily, many companies elect to prepare annual budgets despite using rolling forecasts
(refer bullet point above) (2)

“Rolling forecasts encourage companies to realistically estimate what they should achieve…”

• The behavioural trait to force down targets by top management is not cured by rolling forecasts.
Management are still able to enforce targets (2)

“…variance analysis…is flawed…”

• There is merit in this argument as budgets assume that initial targets were realistic (2)
• Analysis of past results is important however, initial budgets should not necessarily be the
benchmark. It may be more appropriate to update budgets for changing circumstances but this is
difficult to do in practice given the level of detail in budgets (2)

“Rolling forecasts are less detail orientated than traditional budgets…”

• Annual budgets do take significant time and resource to prepare and are often unwieldy in updating
because of level of detail
 Rolling forecasts do have advantages over annual budgets given that they only focus on key drivers
in a business and are designed to be updated frequently (2)
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Part (b)

Arguments in favour of paying out surplus cash to shareholders

• Paying out surplus cash to shareholders would enable them to utilize cash for own purposes (may
have opportunities which provide higher return on investment) (1)
• If returns on cash is lower than the WACC then it is better to distribute cash to shareholders (1)
• Excess cash on balance sheet may render company a takeover target, thus dividend payment (1)
reduces this risk.
• The sustainability of working capital levels need to be investigated. If trade creditor days are not
sustainable then some degree of cash will be required in the business (1)

Gearing the Sassi Stores statement of financial position

• The gearing levels of other retailers need to be investigated – if retailers are not generally geared
there is usually a good reason for this. (1)
• Introducing a reasonable degree of leverage does enhance shareholder value due to the tax shield (1)
associated with interest bearing debt (1)
• Thus by introducing gearing (Kd) Sassi’s will lower its WACC (up to a certain point)
• Gearing will introduce/ increase financial risk (1)
• Sassi will need to meet debt covenants which may be restrictive ito dividends (1)
• Always consider what the effect of gearing will have on the target capital structure (1)

Arguments for retaining cash on the balance sheet

• If Sassi Stores starts a Credit Division then surplus cash may be required to fund this
• Having cash available for investment or to survive tough times may be prudent given the recent
global financial crisis (1)
• Sassi operates in the fashion industry which is higher risk than traditional retail. Having cash on
hand may assist in the event that the company has a poor trading season. (1)

Shareholder preference:

• Shareholders receive a return on their investment through capital growth and/or dividends. (1)
• Shareholders preference should be considered (consider the different shareholders i.e. the trust,
employees, etc.). (1)
• Sassi’s more traditional shareholders may believe that an entity’s earnings and growth potential
must be confirmed by its dividend pay-out (also known as the signalling effect). Thus by (1)
paying a dividend the share price may increase.
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Other:

• Always consider dividend tax cost re dividend (1)

• Effect on Sassi’s solvency and liquidity after paying out surplus cash should (1)
be considered
• If Sassi is able to identify feasible investments, retaining cash for growth (1)
purposes may lead to capital appreciation.
• When gearing is introduced interest-bearing debt normally exceeds cash as (1)
cash is normally only used to finance short term operating activities and debt is
used to finance long term and typically larger investments. Ms. Madiba’s
statement may therefore be unrealistic and an indication of an inappropriate
financing policy.

Part (c) Calculations 2012 2013 2014 2015

Account holders
Total number of account holders 63,000 99,000 108,600 113,400 (1)
Average number of account holders 31,500 81,000 103,800 111,000 (1)
Weighted average # of account holders 41,500 82,500 103,800 111,000
(1)
Annual increase in total number of account holders 57.1% 9.7% 4.4% (1)
Account holder analysis
(1)
Average account balance at year end per account holder R1 109 R1 607 R2 002 R2 269
(69 863’/ 63 000)
% increase in average balance per account holder (1)
(1 607- 1 109)/1 109 44.9% 24.6% 13.3% (1)
Average credit sales per weighted average number acc R2 800 R3 080 R3 132 R3 366 (1)
holders (116 200’/41 500) (1)
(1)
% change in average credit sales 10.0% 1.7% 7.5%
Average annual repayments per weighted average number R1 480 R2 525 R3 215 R3 738
acc holders (61 421’/ 41 500) (1)
% increase in annual repayments (2 525- 1 480)/1 480 70.6% 27.3% 16.3%
Gross receivables (2)
Increase in gross receivables (159 125 – 69 863)/ 69 863 127.8% 36.6% 18.4%
Increase in total credit sales to account holders 118.7% 27.9% 14.9%
(254 100- 116 200)/ 116 200
Annual change in total repayments (208 345 – 61 421 / 239.2% 60.2% 24.3%
61 421)

Gross receivables days (credit sales + charges) 209 219 234 241
69 863/( 116 200+ 4 980 +945)X365

(69 863/122 125 x 365)

Repayment as % of credit sales (61 421 / 116 200) 52,9% 82,0% 102,6% 111,0% (1)
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Revenue
Finance charges Nominal Annual 26.8% (1)
Compounded Monthly converted into annual interest rate
[12 P/YR; 24 Nominal; effective = 26.8%]
Finance charges/ave. gross receivables 26.2% 28.0% 27.8% 27.4% (1)
[2013: 32 050/(69 863 + 159 125)/2 )]
Increase in total revenue 188.4% 53.6% 21.4% (1)
- Increase in finance charge revenue 249.9% 63.3% 24.4% (½)
- Increase in monthly service charges 118.7% 31.5% 11.6% (½)
Annual increase in monthly service fee per account 10.0% 4.6% 4.4% (1)
Finance charges revenue/total revenue 60.7% 73.7% 78.3% 80.2% (½)
Monthly service fee revenue/total revenue 33.0% 25.0% 21.4% 19.7% (½)

Operating costs
Variable expenses/total revenue 34.4% 24.8% 21.4% 19.8% (1)

Annual change in variable costs 108.3% 32.5% 12.4% (1)

Variable costs/weighted # of account holders R125 R131 R138 R145

Annual change in fixed costs (employee costs) 6.0% 6.0% 6.0% (1)

Total costs/total revenue 167.8% 75.6% 49.8% 31.4% (1)

Other ratios & comments

Operating profit /Total revenue -67.8% 24.4% 50.2% 68.6% (1)

Effective tax rate 0% 32.5% 31.6% 29.5% (1)

Max 15
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Part (c) Comments

Account holders

• Weighted average number of account holders is higher than average number implying that more
accounts opened in the first part of the year in 2012 and 2013 (1)
• 63,000 new accounts in 2012 is significant, consider if there are sufficient resources and
infrastructure. (1)
• Increase in new accounts declines dramatically in 2014 and 2015 implying saturation. (1)
• Does business plan make any assumptions re loss of accounts or closing accounts? (1)
• Average account balance increase significantly in 2013 and 2014. Possibly as a result of general
recovery from the recession and increase in monthly income. (1)
• It is concerning that the average account balance in 2015 increased by 13.3%, which is higher
than credit sales growth of 7.5% and despite repayments exceeding credit sales (similar situation
in 2014). (1)
• Average account balances (gross receivables) increased by more than average credit sales
(credit sales). Is this due to charges and/or account holder monthly repayment assumptions? (1)
• The increase in average purchases per account holder is erratic – 10%  in 2013, 1,7%  in 2014
and 7,5%  in 2015. (1)
• Average repayments exceeds average credit sales in 2014 and 2015 – This seems unrealistic as
customers are repaying more than they are buying. Debtors are thus repaying previous debt which
indicates non-compliance with the debtors policy. (1)
• What monthly average repayment as a % of account balance has been assumed in forecasts?
Repayments must be lower than 15% policy given continual growth in average account balances.
• Is policy of minimum monthly repayment of 15% of account balance in line with competitors/
industry
• Given indebtedness of consumers in general, consider the feasibility of the new accounts.
Consider the reliability of industry research re potential number of account holders.
• Account limits should be based on more detailed affordability analysis than ‘10% rule’.
• Receivables days increasing gradually from 2012 to 2015, is this in line with credit guidelines and
policy

Revenue

• Finance charges/average receivables appears reasonable given annualized interest rate of

26,8%. (1)
• Monthly service fees make a significant contribution to profits as there appears to be no direct
costs associated with this (1)
• Total revenue growth is significantly higher than growth in debtors’ book. Reasons need to be
investigated. (1)
• Business plan should include incremental GP from credit sales
• Interest rate assumed to remain stable. Consideration should be given to changes in the prime
rate.
(1)
• Monthly service fee charges - how do these compare to competitors’ charges. (1)
• Why has monthly service increased by 10% in 2012 and then by only +/-4.4% thereafter (1)
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Operating costs

• Further detail required re provision for bad debts. Debtors ageing and repayment profile
assumptions need to be reviewed. Actual provision should be based on arrears and ageing of
book as opposed to a flat 10%. (2)

• Variable operating costs increases and % of revenue is not following a clear trend. What are
drivers of variable costs? Variable costs are possibly driven by number of account holders or
number of calls dealt with by the call centre./ Is outsourcing costs based on fixed monthly
payment or variable in relation to number of account holders? (1)

• Relationship between variable costs and weighted average number of account holders is more
understandable. Costs are relatively constant year on year, with inflationary increases. (1)

• Fixed costs increasing by 6% p.a., reasonable given the current inflationary outlook (1)

• Total costs declining as a % of revenue, possible indication of improved cost efficiencies. (1)

• Total costs decline significantly in 2015 due to assets being fully depreciated (1)

• IT cost estimates (R24m) could change/ Any further IT costs expected? Upgrades in future
years?
(1)
Other comments

• Effective tax rate exceeds 28% due to bad debt provision not being fully allowed by SARS (1)
• Benchmark operating margins against competitors.
• Include Deferred tax adjustment for temporary differences re provision for bad debts.
Maximum 15

Part (d) 2011 2012 2013 2014 2015

Initial investment -24,000 (1)
Operating profit -10 220 10 625 33 523 55 666 (1)
Add back depreciation –accounting 8 000 8 000 8 000 -
entry thus not cash (1)
Add back provision for bad debts 6 986 8 926 5 825 3 992
–accounting entry thus not cash (1)
Taxation - -3 455 -10 610 -16 425
Net movement in -69 863 -89 262 -58 247 -39 922 (1)
receivables Operating (2)
cash flows Terminal -24,000 -65,097 -65,166 -21,509 3,311
cash flow (1)
Net receivables 231 565 (1)
Any recovery of bad debt xxx (2)
provision xxx R 25 729’ (1)
Net asset value (retained XXX
profits) (1)
Net cash flows -24,000 -65,097 -65,166 -21,509 234 876

IRR 11.97%

Incremental GP should also be included

(1)
Maximum

Direction of cash inflow + or outflow – must be correct to earn marks

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Part (e) (i) Key business risks

• Initial investment in IT systems etc may be under-estimated. Risk is an overrun of expenditure

and unforeseen delays in setting up new division. (2)

• Sassi Stores may not have the expertise to establish and manage a credit business. Their core
expertise has been in retailing, providing credit to customers and collecting amounts outstanding
is a different business.
May lose focus of their core business. (2)

• Net investment in new division is significant in relation to current operations. Forecast cash flows
illustrate that a significant proportion of free cash flow will be reinvested into the new division. If
new division does not perform as forecast, this may place significant strain on the company’s
cash flows. (2)

• Sassi store’s successful investment in credit division (NPV and IRR) relies heavily on a large
terminal value as Cash flows are negative until 2014. (2)

• Sassi Stores may be placing undue pressure on itself to open the new division by 1 April 2011
and the board is still debating whether to establish the new division. The risk is that division and
related controls will not be implemented thoroughly, exposing the company to significant risk by
having inadequate systems and procedures. (2)

• There is a risk that Sassi Stores is over-estimating the extent to which customers will open
accounts. The current economic climate is such that consumers are under enormous debt
pressure and may be averse to extending this. The related risk is that Sassi Stores will establish
a divisional infrastructure that will cost more than revenue that can be generated. (2)

• Credit risk/ Bad debt risk may be understated. Sassi Stores may attract debt laden customers
who do not have the ability to repay amounts. Historical bad debt experience of other credit
retailers may not be an accurate forecast of future default given the economic crisis experienced
in RSA over the past 2 years. (2)

• New division’s revenue estimates may be ambitious. Interest rates of 24% given the 2010 prime
overdraft rate of 10% and annual service fees of R125 may not be attractive to potential
customers. (2)

• There is always a risk of customers fraudulently opening accounts by falsifying ID documentation

and proof of income. Sassi Stores may be exposing itself to the risk of large scale fraud or
internal collusion. (2)

• Forecast operating costs may be under-estimated, exposing Sassi Stores to lower financial
returns than anticipated. (2)
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• The forecast cash flows indicate that the new division will be cash negative until 2014. The
return on investment may indicate that Sassi Stores should rather invest in its core business or
acquiring a business that it understands and can unlock returns for shareholders. (2)

• Interest rate risk (higher rates making debt unaffordable, lower rates decreasing returns) (2)

• Actual revenues and costs may be different to forecasts – sensitivity analysis should be
performed (2)

• Risk of fraud or internal collusion (fictitious accounts etc) (2)

• Non-compliance/ Legislation risks (FICA, NCA etc) – risk of non-compliance and/or changes to
legislation (2)

• Standing data risk – unauthorized changes, failure to update regularly (2)

• Confidentiality of customer information – severe penalties if disclosed without permission (2)

• Outsourcing call centre (poor service, credibility, reliance on 3rd party ) (2)

• Liquidity risk – slow paying debtors forcing Sassi to borrow to fund debtors book (2)
Maximum 16
Part (e) (ii) Other key issues

The potential impact of providing credit sales on total merchandise sales

• If credit sales do not deplete existing cash sales then impact could be overwhelmingly positive,
increasing overall gross profit achieved by group. (1)

• If cash sales are to be eroded by credit sales then this impact needs to be considered in overall
financial impact on group.

• Other revenue stream opportunities such as life insurance, funeral cover, etc. (1)

Sassi will be investing a significant amount of its free cash flow in the project.

• Sassi currently has R80 million of cash available and is projected to have R170 million before
paying dividends at 31 March 2011. The Credit division will need R24 million initially plus R65
million in FY2012 and another R65 million in FY2013. (1)

• Should Sassi be investing such a material amount in a single project, which may or may not be
successful? (2)

• Are shareholders prepared to forego or reduce future dividends to fund the project? (1)

• Have all the key risks of the division been considered? These risks need to be weighed up
against potential returns and Sassi’s risk appetite
(1)
• The potential returns to be generated from the Credit division

• Credit sales could represent a material portion of overall sales (1)

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• Potential IRR of 11.97% is not a reasonable or attractive return, lower than 20% benchmark. (2)

• Credit division will start generating positive cash flow from FY2015, improving returns on
investment.
(1)
Overall impact on Sassi Stores financial results & position

• 2009 to 2011 sales are increasing but EBITDA/revenue margins are reducing. Credit division may
assist in reversing this trend. (1)

• Benchmark returns of 12% revenue growth and 10% EBITDA margin could be exceeded even
further if Credit division established. (1)

• Does Sassi have the expertise to manage a credit operation? Perhaps this is outside of its skills
and expertise and may distract focus from core operations? (2)

• It would be useful to benchmark against listed retailers which provide credit and those that don’t to
compare relative profitability and cash flows.

• Will Sassi be registered as a credit provider with relevant government bodies?

• Funding of debtors book through securitisation/factoring?

• Incremental gross profit from credit sales should be included in project analysis

• Should Sassi outsource entire credit division to a financial services company/bank?

• Consider the impact on Sassi’s credit rating

• Any alternative investment opportunities?

• Sassi brand & credibility – may lose customers through tight credit control

• Forecasts and potential returns benchmarked against competitors? Sensitivity analysis of

changing forecast assumptions

• Does the IRR exceed the cost of equity? Will shareholder value be created? This is unlikely as
the IRR is low.

• Consider the appropriateness of a 20% hurdle rate perhaps increasing it to compensate for
higher risk. (1)
Maximum 12
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QUESTION 27 SUGGESTED SOLUTION

BRAINZ (PTY) LTD

(Source: SAICA 2010 QE II Question 1 -adapted)
Part (a)

The “Required” should be broken down to understand what needs to be done i.e.

 The information in the scenario should be used to identify areas of non-compliance with King III.
 King III requires JSE listed entities to “Apply or Explain”.
 Reasons for such non-compliance should be provided; this would necessitate listing the requirements
of King III from which Brainz is deviating.

Area of non-compliance Reason (King III recommended practice)

Board of directors
The majority of directors are executives The majority of board should comprise non- (2)
executive directors

Non-executive directors are appointed The majority of non-executives should be (2)

by the Shareholders independent

Brainz has joint CEO’s The board should appoint “the CEO” (1 person)
(2)
Brainz only has an Audit Committee Board should delegate certain functions to well
structured committees and have at least Audit, Risk
and Nominations Committees (2)

Brainz board only meets twice annually Board should meet at least 4 times annually

Chairmen
Chairman of Brainz (Pty) Ltd appointed Chairman should be an independent non- (2)
by shareholders executive director

The chairmen of Brainz subsidiary Chairmen should be an independent non-

companies are executive directors executive directors (2)

Audit Committee
Audit Committee only has 2 members Should have at least 3 members (2)

Chairman of the board and Herd are the Chairman should not be a member of the Audit
members of the Audit Committee Committee nor should Chief Audit Executive.
Members should be independent non-executive
directors (2)
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Remuneration of directors
Non-executives participate in phantom Only executive directors & employees should
scheme participate in incentive schemes

Vesting period for scheme is 2 years Vesting period should not be < 3 years

Board considering re-pricing phantom There should be no re-pricing

scheme
Outgoing chairman paid a gratuity Non-executive fees should only comprise base
fee + meeting attendance fees

Internal Audit
Heard reports to the Chairman of the He should report to the Audit Committee (2)
Board

Internal Audit follows a compliance A risk based approach should be followed (2)
based approach

Other
Brainz Advisory sources work through May be construed to be fronting ito BEE Act, (2)
Umfolozi Brainz should comply with all laws etc
(Pty) Ltd
Acquisition of stake in Smile Inc. from Transaction may not have been at arm’s length, (2)
Brainz could be in contravention of SARB regulations
controlling shareholders
Available 34
Maximum 18

Part (b)

The marketing performance of Brainz should be compared to the benchmarked partners for
each of the categories provided in the scenario i.e. existing work, quotation success rate and
pipeline work. Possible reasons for deviations and the potential effect should be discussed.

Repeat work
Advisory’s repeat work % was higher than peers until 2010

Advisory’s repeat work % has been declining since 2008 (½)

Peers’ repeat work has been increasing steadily from 2006 to present (½)

The decline in Advisory’s ratio in 2010YTD is dramatic and concerning (1)

Repeat work is generally more profitable. (1)

Advisory’s declining repeat work % is concerning in this light as it may be contributing
to overall poor performance (1)
rd
Incentives (referral fees) may be encouraging 3 parties to seek new clients as
opposed to mining existing client base (2)

Advisory should investigate reasons for declining repeat work % and address trend (1)
urgently
Repeat work may have declined because of poor service or increasing competition (1)
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Quotation success rate

Advisory’s success rate % has historically been higher than peers
(½)
Advisory’s success rate has been declining since 2008 (½)

Peers’ ratios have been stable, increase slowing to present 22% (½)

Declining repeat work % may be contributing to lower success rate % (1)

Advisory’s increase charge rates may be resulting in them being price uncompetitive (1)

Has Advisory remained competitive in terms of their methodologies & thought leadership? (1)

Pipeline work
This ratio is an important capacity indicator eg. low ratio means potential spare capacity
(1)
Advisory’s ratio has been declining since 2008 (½)

Competitors ratios have also been declining since 2008 (½)

Advisory’s ratio has plummeted in 2010 from 78% to present 46% (½)

Advisory’s present ratio of 46% is significantly below peers (66%) (½)

Advisory may need to retrench staff if pipeline % does not improve in short term (1)

Current 46% ratio is also concerning because revenues are declining (double whammy) (1)

Overall comments
Advisory needs to investigate reasons for eroding competitive advantage since 2008
(1)
Using Umfolozi as a BEE front may be a reason for declining ratios – competitors may have (2)
strategic BEE partners

Perhaps offer Umfolozi a shareholding in lieu of 7.5% fee? (1)

Marketing costs as % of net revenue has increased from 5.1% (48 240/951 735) in (1)
FY2008 to 6.8% (48 650/716 750) in YTD2010.
This indicates that Advisory is increasingly reliant on outside parties to secure work (1)

Paying 2% fee on project presentation may not be effective, rather pay only for successful (1)
pitches?
Effectiveness of management needs to be questioned – ratios declining and no (1)
apparent corrective action to address this since 2008

Executive’s networking skills need to be questioned, not working that well anymore (1)

Reliance on IQ International methodologies needs to be questioned – perhaps their (1)

methodologies are outdated or no longer relevant?

Impact of global economic crisis on revenue? (1)

Advisory is barely breaking even – urgent action is required to increase revenue (1)
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Perhaps Advisory needs to change strategy? Start marketing department/advertise? (1)

Declining ratios may be due to loss of major client or completion of major project (2)

Available 33
Maximum 12

Part (c)

Since the “Required” is not specific regarding the category of ratios (i.e. it refers to the broad category of
financial performance), you would need to consider the best way in which you can present the financial
information provided in order to extract the most valuable commentary/conclusions i.e. costs as a % of
revenue, year on year movements, hours billed etc.

Revenue 2008 2009 2010

Change in gross revenue 24.4% -34.8%

Hours billed 558,333 595,238 339,354

2008: (1 005 000/1 800) 2009: (1 250 000/2 100) 2010: 814 450/2 400)

Change in hours billed

6.6% -43.0%
Annual change in charge out rates
16.7% 14.3%

Increase in charge out rates has been significant, driving revenue in FY2009 & causing (1)
Increase in charge out rates has been more than inflation and may be resulting in Advisory
being less competitive (2)
Hours billed plummeted in FY2010, need to establish reasons urgently, service levels
dropped/loss of major client? (1)

Repeat business with clients has been declining since 2008 (1)

Quotation success rate also declining (1)

Strategy of employing more highly qualified staff and increasing charge out rates has not
yielded results (1)
Advisory is trading close to breakeven levels (1)

Work in progress 2008 2009 2010

General provision/gross revenue 3.0% 3.0% 3.0%

Specific provision/gross revenue
(1 005 000 x 3% = 30 150) 2.3% 3.5% 9.0% (1)
(53 265 – 30150 = 23 115)
(23 115 / 1 005 000 = 2.3%)

Need to establish reason(s) for significant increase in specific provision in FY2010 (1)
Overall provision of 12% FY2010 is much more than general provision of 3%. Why? (1)
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Increasing work from new clients may explain increased provison given learning curve effect (2)

Employment costs 2008 2009 2010

Total employment costs/gross revenue 39.7% 37.3% 45.4%
(1)
Annual change in total employment costs 16.9% -20.8%
(1)
(1)
Annual change in average # of full-time employees Full 7.3% -4.4%
time employee costs/total employee costs Average
35.9% (1)
salary of permanent employees 36.5% 65.0%
(Full time employee costs/weighted average number of
R750k (1)
full time employees) R830k R1,226.7k

Strategy of shifting from mainly using contractors to permanent employees was ill (1)
conceived as
Advisory now has higher fixed costs (operating leverage) (1)
Employing more qualified (and more expensive) staff has not yielded positive results (1)

Average salary of full-time employees has risen dramatically probably due to employing
more qualified staff (1)

Despite the number of full-time employees declining in 2010 total salary bill has increased by
41.3% (1)
Employment costs represent the major expense item (1)

Marketing costs 2008 2009 2010

As % of gross revenue 4.8% 5.5% 6.0%
(1)
Annual change in marketing costs 42.5% -29.2%
(1)
Increasing
rd
marketing costs as % of revenue shows that Advisory becoming more dependent
on 3 parties for sourcing work (1)

Furthermore, Advisory must be sourcing majority of work from Umfolozi or it is paying 2%

for unsuccessful pitches (2)
Marketing efforts & strategy needs attention given the sharp revenue decline in FY2010 (1)

Royalties 2008 2009 2010

As % of gross revenue 13.4% 10.7% 15.7%

Annual change in royalties -0.5% -4.5%

Royalty expenses are fixed in US$ terms which may not be ideal in current scenario of (1)
decreasing revenues
Strengthening Rand has limited overall cost increase (1)
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Relationship with IQ needs to be re-examined as royalties represent a significant cost – is (2)

Advisory gaining access to leading edge methodologies and does this provide a competitive edge?
Other items in statements of comprehensive 2008 2009 2010
Annual change in office rental costs 13.0% 13.0% (1)

Annual change in admin. costs 10.4% 7.0% (1)

Interest cover 11.3 1.6 (1)

9.3
EBIT/Gross revenue or net revenue or PBT/gross 30.3% 4.8% (1)
25.9%
revenue

Office rental costs increasing at 13% which is higher than current inflation (1)
Annual increases in administration expenses have slowed to 7% in FY2010. However, with (1)
revenue decline of 35% Advisory needs to reduce fixed overheads (1)
Income from Learning increased which is pleasing (1)

Interest cover ratio was comfortable until FY2010, which is now a precarious 1.6 times (1)

Working capital
WIP days& trade receivables days have increased marginally from 2008 to 2010 however,
together move is significant 76 (47 +29) days to 101 ( 62+39) days (1)

Overall, working capital management has deteriorated which needs focus & attention (1)

Lower revenue levels have released working capital in FY2010 which is a positive (1)

Bank overdraft has declined primarily due to proceeds from sale of Whale (R35m) and
working capital release (1)

Overall comments
Advisory needs to urgently find ways to improve revenue performance
(1)
Fixed costs are significant (employment costs, royalties, admin expenses) and it may be
appropriate to reduce these/retrench staff to ensure business survival (1)

Available 55

Maxa 30

Part (d)

The “Required” deals with ROE and sustainability, therefore the following should be considered when planning
your answer:
 What are the components of ROE and given the nature of the “Learning” business what is the expected
impact on these components.
 What factors are expected to have an impact on the sustainability of a business of this nature.
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High ROE

ROE = Profit attributable to equity holders (1)

Shareholders’ funds

ROE (duPont) = Net profit after tax X Revenue X Total Assets

Revenue Total Assets Shareholders' Equity
Has limited fixed assets - hires venues (1)
Delegates likely to pay in advance for courses therefore limited trade receivables (1)
Venue hire costs & training material costs are variable in nature (1)
Has limited number of permanent employees, presenters contracted as & when needed (1)
Business sustainability
Continued access to course material NB (1)
Access to dynamic presenters is crucial (1)
High quality administration of courses & venues is NB to ensure leading service delivery (1)
Learning is a market leader, success breeds success (1)
Outsourcing of training material is a risk, what will happen post 2018? (1)
Advisory’s poor financial position may pose a risk – if Advisory discontinues trading or
supporting
Learning this could affect its market leadership and quality of training material (1)
Available 11
Maximum 7
Part (e)

Acquisition by Brainz of 40% interest in Smile Inc.

• Shareholders of Brainz held 90% interest in Smile therefore no independence or

objectivity in determining purchase price (1)
• Was US$30 (40% = US$12m) million valuation placed on Smile fair given that
the company was only established in January 2008 and had yet to report a profit? (1)
• Any contravention of SARB regulations through Adams & Smith family trusts
externalizing wealth? (1)
• Creditors of Brainz could have been prejudiced by company over-paying for Smile
stake
Brainz’ sale of Whale subject to profit warranties – could pressurize Smile to pay more for
services from Whale to ensure profit warranty targets met & balance of purchase price paid (2)

Brainz Services hosts Smile website – could be transfer pricing issues to externalize cash
to Smile situated in a tax haven (2)
Will pricing and service levels between Brainz Services& Smile be at arm’s length given
common shareholders (2)
Agiers Adams is Horatio’s son. Will board of Smile be able to make unfettered decisions or
will they be influenced by fact that companies have common shareholders & major
shareholder’s son is MD (2)
Valuation of Smile by Algiers Adams unlikely to be independent, could be an attempt
to boost valuation of Smile for financial reporting purposes (2)
Available 14
8
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Part (f)

Students are often comfortable with preparing a valuation but struggle with commenting and evaluating an
already prepared valuation. It is important to note that the same principles apply and you would need to analyse
each of the components of the valuation as well as all assumptions made and consider whether it is appropriate.

2011 2012 2013

Annual increase in no of members 329% 77% 38%

Advertising revenue/membership revenue 3.1% 5.2% 6.3%
Annual change in advertising revenue 200% 67%
Website hosting costs ($ 2x0.8x12x no. of members) 5 213 9 248 12 763
Royalties 4 000 4 000 4 000
Other expenses 17 889 35 607 51 039
Operating costs 27 102 48 855 67 802

Other expenses/total revenue 53% 59% 60%

Increase in other expenses 99% 43%
EBITDA/total revenue or Operating .costs/revenue 19.3% 19.6% 20.0%

Revenue forecasts
Forecasts assume that all members join on 1st day of financial year - unrealistic (1)
Monthly membership fees assumed to remain at US$10 – competitors may drive down pricing (1)
Assumptions regarding new members may be too optimistic (1)
Membership numbers may decline as members successfully find ‘matches’ (1)
What is size of industry& Smile’s assumed market share? (1)
What are barriers to entry & competitive risks? (1)
Advertising revenue assumptions need to benchmarked against industry norms (1)
Smile only commenced selling advertising in 2010, forecasts seem optimistic (1)
Operating cost forecasts
Assumption re ↓ in website hosting fees per member by 20% in FY2011 without agreement (1)
thereto by Services may not be appropriate
Assuming no increase in website hosting fees per member from October 2010 onwards may (1)
be unrealistic
Whale &Brainz are unlikely to agree to ↓ in annual royalties given the profit warranties (1)
arising on sale of business
Assuming no increase in annual royalties from October 2010 onwards may be unrealistic (1)
New owners of Whale may insist on fee increases given that companies no longer related (1)
Other expenses forecast to increase at higher rate than revenue. Why? (1)
Should costs be escalated for inflation? (1)
Overall financial forecasts
EBITDA of US$6.5m forecast in FY2011 from loss of US$17k is a significant turnaround, is this (1)
realistic
Is EBITDA/revenue margin of 20% realistic in comparison to competitors? (1)
Assumption that EBITDA=free cash flow realistic? What about working capital &capex?
• Working capital? (1)
• Capital expenditure (1)
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WACC
Cost of equity of 30% seems very high (1)
High beta assumed or high specific company risk/non-systematic risk premium in Smile’s
cost of Equity (1)
It is very difficult to maintain a consistent debt equity ratio into perpetuity (1)
18% cost of debt appears high in US$ terms (1)
Valuation approach
Is Algiers qualified & experienced to perform valuation? (1)
Algiers is not an independent party therefore valuation will be biased (1)
Forecast cash flows need to be for a longer period before determining continuing value (1)
Zero tax charge correctly included as Bahamas a tax haven (1)
Assumption of 5% increase in cash flows in perpetuity seems strange given high growth 2011 to (1)
2013
Are WACC and forecast cash flows consistent? Both real or nominal? (1)
Valuation result
The following were not taken into account in the valuation:
Cash balances added to value, (1)
Debt subtracted from value (1)
Discount for minority stake (1)
A sensitivity analysis should be performed (1)
US$90m derived is a significant increase on December 2009 valuation (US $12m)/US$3m
development cost (1)
Any similar listed companies to benchmark resultant valuation? EV/Revenue or EV/ number of
members (1)
Smile valuation may be overstated to boost Brainz’s balance sheet given the group’s
financial predicament (2)
Available 47
Maximum 20
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QUESTION 28 SUGGESTED SOLUTION

PALINDROME BRANDS (PTY) LTD

(Source: SAICA 2009 QE II Question 1- adapted)

The Required is very broad in that it states that ratios relating to the financial position and performance
should be calculated. You should therefore utilise the marks allocated and the financial information in the
scenario to guide you regarding which ratios you should calculate.

Part (a) Financial position & financial performance

ratios 2008 2009 % change
Revenue growth
(25 640 000 – 32 050 000 / 32 050 000) -20.0% (1)
Gross profit %
(9 615k / 32 050k) 30.0% (½)
(6 410k / 25 640k) 25.0% (½)
Admin. & distribution expenses
(3 805 935 – 4 006 250 / 4 006 250) -5.0% (1)
Interest cover
(4 797 500 + 811 250 / 811 250) 6.9 (½)
(1 244 065 + 945 000 / 945 000) 2.3 (½)
Effective interest rate
(811 250 / 4 990 000) 16.3% (½)
(945 000 / 3 899 539) 24.2% (½)
EBIT / Revenue
(4 797 500 + 811 250 / 32 050 000) 17.5% (½)
(1 244 065 + 945 000 / 25 640 000) 8.5% (½)
PAT / revenue
(3 454 200 / 32 050 000) 10.8% (½)
(877 526 / 25 640 000) 3.4% (½)
Change in PAT
(877 526 – 3 454 200 / 3 454 200) -74.6% (1)
Alternative: Change in EBIT
[(1 244 065 + 945 000) – (4 797 500 + 811 250) / (4 -61.0%
797 500+ 811 250)]
Effective tax rate
(1 343 300 / 4 797 500) 28.0% (½)
(366 539 / 1 244 065) 29.5% (½)
Inventory days
(7 375 890 / 22 435 000 x 365) 120 (½)
(6 585 616 / 19 230 000 x 365) 125 (½)
Trade receivables days
(3 951 370 / 32 050 000 x 365) 45 (½)
(3 512 329 / 25 640 000 x 365) 50 (½)
Trade payables days
(1 051 986 – 130 000 / 22 435 000 x 365) 15 (½)
(1 328 700 – 275 000 / 19 230 000 x 365) 20 (½)
Alternative: Including VAT
(1 051 986 / 22 435 000 x 365) 17
(1 328 700 / 19 230 000 x 365) 25
Interest bearing debt to equity
(4 990 000 / 4 771 974) 104.6% (½)
(3 899 539 / 5 649 500) 69.0% (½)
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ROE (½)

(3 454 200 / 4 771 974) 72.4%

(877 526 / 5 649 500) 15.5% (½)
Return on total assets
(3 454 200 / 12 226 768) 28.3% (½)
(877 526 / 11 079 562) 7.9% (½)
Alternative: RONA based EBIT
(4 797 500 + 811 250 / 12 226 768) 45.9%
(1 244 065 + 945 000 / 11 079 562) 19.8%
Return on Invested Capital
[3 454 200 + (811 250 x 72%)] / [850 000 +
11 327 260 – 7 454 794] 85.5% (½)
[877 526 + (945 000 x 72%)] / [905 000 + 10 097 945
– 5 430 062] 28.0% (½)
Return on Capital Employed
(4 797 500 + 811 250 / 4 771 974) 117.5% (½)
(1 244 065 + 945 000 / 5 649 500) 38.7% (½)
Current ratio
(11 327 260 / 7 454 794) 1.52:1 (½)
(10 097 945 / 5 430 062) 1.86:1 (½)
Quick ratio
(3 951 370 / 7 454 794) 0.53:1 (½)
(3 512 329 / 5 430 062) 0.65:1 (½)
Max 12

Part (b) Sustainable earnings:

Starting point FY2009 PAT R877 526
• FY2009 may not be reflective of sustainable profits due to effect of global
economic crisis on Zoosh and customer spending (2)
• Penalties & interest paid to SARS is a non-recurring item provided Zoosh can
resolve its cash flow crisis, and should be added back 65 000 (2)
• Bad debt expense should be added back as Zoosh has taken the policy
decision not to supply independent retailers in the future 350 000 (2)
• Rental expense in comprehensive income is higher than actual amounts paid
(deferred tax asset increasing). For the purposes of determining sustainable
earnings, actual rental paid should be used as this reflects economic reality of
escalations (76 617 – 49 508 / 28%) 96 818 (2)
• Exclude once-off retrenchment costs ? (1)
• Advertising expenses reduced, may be temporary. Include adjustment ? (1)
• The level of gearing of Zoosh may change in the future (overdraft has already
been reduced) hence, interest charge may decline ? (2)
• Tax effects of the above adjustments ? (1)
Max 8

Part (c) Differences in business practices & strategies: Identify and describe

• Palindrome imports from suppliers’ manufacturers; Zoosh imports from suppliers (2)
• Zoosh derives 40% of revenue from 1 supplier; Palindrome not overly reliant on any supplier
(2)
• Palindrome spends fixed % of revenue on advertising; Zoosh has no such policy (2)
• Zoosh focuses on footwear; Palindrome has a more diversified product range (2)
• Location of suppliers – Zoosh (USA & Europe); Palindrome (Asia) (2)
• Funding of business – Zoosh (overdraft); Palindrome (surplus cash) (2)
• Palindrome does not supply independents; Zoosh did until recently (2)
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• Employees – all shareholders in Palindrome & staff welfare is very important unlike Zoosh
(2)
• Palindrome declares dividends; Zoosh does not (2)
• Zoosh has to carry significant inventory; Palindrome’s inventory days are much lower (2)
Maximum 10

Part (d) – Key business risks: 1 mark for identifying, 1 mark for explaining

• Currency risk – adverse movements may erode margins, failure to hedge could lead to losses
(2)
• Liquidity risk – reducing overdraft and cash flow issues indicate potential going concern issues
(2)
• Overly reliant on 1 supplier for 40% of revenue (2)
• Short term funding of business – overdraft could be withdrawn on short notice (2)
• Current economic conditions could be protracted (2)
• Risk of further bad debts (2)
• Inventory levels high due to having to stock range of sizes – liquidity risk (2)
• Footwear is a fashion / luxury / branded item – high risk of redundant / slow moving stock
(2)
• Employee morale low after retrenchments – good employees may resign (2)
• 50% deposit paid to suppliers – risk of supplier liquidation or non-delivery (2)
• Risk of higher import duties eroding margins (2)
• Risk of SARS audit for failing to pay VAT when due – audit may reveal other non-compliance &
result in further penalties (2)
Maximum 10

This section would require you to include all cash flow movements not included in EBIT and
add back all non-cash items included in EBIT.

(e) Reconcile EBIT- > movement in cash for FYE2009 R

EBIT (1 244 065 + 945 000) 2 189 065

Finance cost -945 000
Profit before tax 1 244 065
Add back depreciation (850 000 + 230 000 – 905 000) 175 000 (2)
Taxation paid (1 412 808 + 366 539 – 201 823 + 76 617 - 49 508) -1 604 633 (2)
Inventories (6 585 616 – 7 375 890) 790 274 (1)
Trade receivables (3 512 329 – 3 951 370) 439 041 (1)
Trade payables and VAT (1 328 700 – 1 051 986) 276 714 (1)
Capex -230 000 (1)
Net movement in cash 1 090 461 (1)
Decrease in overdraft (3 899 539 – 4 990 000) 1 090 461 (1)
Maximum 8
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Part (f) – Sale and leaseback: 1 mark for identifying, 1 mark for explaining

Potential advantages

• Lease payments deductible (interest on loan to fund acquisition would not be deductible) (2)
• Raise higher amount from sale & leaseback than normal loan (2)
• 10 Year finance provides greater flexibility / breathing space to unlock acquisition benefits
(2)
• Yield to property inventors lower than current borrowing rates (9% vs. 10.5%) (2)
• Off balance sheet liability, will not affect debt ratios (2)
• No responsibility for maintenance & repairs (risks of ownership) (2)

Potential disadvantages

• CGT incurred from selling property (2)

• Hidden costs at end of lease (2)
• Locked into 10 year lease, difficult to move premises (2)
• Limited flexibility regarding early payment (locked into 10 year arrangement) (2)
• No participation in future growth of property (2)
• Higher fixed cost base which leads to higher breakeven revenue (2)
Maximum 8

Part (g)

Valuation approach and methodology

• Palindrome should use multiple methods to determine value of Zoosh (use to cross-check / as a
reasonability check) (1)
• Use earnings-based or FCF valuation to quantify intrinsic value of Zoosh / use these methods to
value (75%) majority shareholding / use these methods to determine value of operations /
quantify separately the value of debt, non-operating assets (1)
• Dividends-based methods inappropriate – Zoosh does not declare dividends (1)
• Even if not included in bid-price, quantify synergy value: cost synergies – consider benefit and
cost of achieving (e.g. saving in admin & distribution will only provide a benefit from year 2);
revenue synergies – normally very difficult to achieve. (1)
• Zoosh in financial difficulty therefore Palindrome should use this negotiating power / do not
include synergies in value of bid (1)
• The market sets the price for an asset so consider if there are other potential bidders (market
participants) for Zoosh. If there are and we consider to increase the bid above intrinsic value keep
in mind that we should be conservative as synergies are difficult to achieve and are mostly due
to Palindrome’s contribution (1)

Earnings based valuation

• May not be an appropriate method to use given the difficulty in determining sustainable
earnings (FY2009 profits may be abnormally low) (1)
• Possibly use average profits for the past 3 years (1)
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FCF valuation

• Conceptually the most appropriate method / use as main valuation method (1)
• Need to obtain & scrutinize forecast cash flows for reasonability (1)
• Zoosh unlisted therefore need to estimate beta based on similar listed companies (1)
• Sensitivity analysis is important – stress test FCF valuation (1)
• Future cash flows difficult to forecast given current economic conditions (1)
Maximum 7

Structuring of transaction
• Toot’s proposal that Palindrome advances a shareholder’s loan to Zoosh & he does not is
unacceptable (Toot is receiving proceeds from sale of shares & shareholders loan) (2)
• Palindrome acquiring a further 25% at fair value in 2016 is not in its best interests – it will pay for
enhancements brought to the business (2)

Changes to structure recommended:

• Acquire business as a going concern instead of shares (more tax efficient) (2)
• Acquire 100% interest, less administration & potential conflicts of interest (2)
• Provide collateral instead of advancing loan to Zoosh, more efficient use of capital (2)
• Toot / Zoosh to warrant FY2010 profits given uncertainty (2)
Maximum 6

For this section you would need to do the following:

 Calculate profit after tax of Zoosh in 2009 based on the provided assumptions
 Calculate the profit after tax of Palindrome in 2009 based on the provided assumptions
 Calculate the group profits (i.e. 2009 Palindrome profits + 75% of 2009 Zoosh profits)

The above calculations will then allow you to calculate the effect of the acquisition of Zoosh on
the Palindrome Brands group profit and ROE

Part (h)Pro forma effect on profits and ROE R’000 R’000

Effect on: Zoosh Group (75%)

Change in pro forma profits of Zoosh

FY2009 PAT 877.5 658.1
Non-recurring items (350k + 65k) 415.0 311.3 (1)
Annual cost savings 2 000.0 1 500.0 (1)
Costs to achieve savings -2 500.0 -1 875.0 (1)
Interest on shareholders’ loan (7 500k x 10.5%) -787.5 -590.6 (1)
Current finance charges avoided 945.0 708.7 (1)
Tax effect of above adjustments
(350k + 2 000k – 787.5k + 945k x 28%) -702.1 -526.6 (1)
247.9
Pro forma effect on group (247.9 x 75%) 185.9 (1)

Change in pro forma profits of Palindrome

PAT FY2009 36 800.0
Interest income – Zoosh loan 787.5 (1)
Finance charges on loan to fund acquisition (10.5% x 10 393.9) -1 091.4 (1)
• Total funding required (15 543.9 + 7 500) 23 043.9 (1)
• Own cash resources FY2008 -12 650.0 (1)
• Net borrowings 10 393.9
Tax effect (finance charges non-deductible) (787.5 x 28%) -220.5 (1)
Pro forma effect on group 36 275.6
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Net effect on Group pro-forma profits FY2009 (185.9 + 36 275.6) 36 461.5

ROE – actual (36 800k / 150 200k) 24.5% (1)

ROE – pro forma (36 461.5k / 150 200k) 24.3% (1)
Decrease in group profits (36 800k – 36 461.5k / 36 800k) 0.9% (1)
Maximum 12

Part (i) Unethical behavior

Palindrome

• No fringe benefit on employee perks – should include in remuneration & deduct PAYE (2)
• Collaboration with customers regarding pricing may be anti-competitive behaviour / against
Competition Act (2)

Ms Tenet

• Possible contravention of SARB regulations by holding shares in Palindrome through offshore

trust (2)
• Non-disclosure of interest in offshore trust (SA residents taxed on residency basis) (2)

Zoosh

• Failure to pay over VAT collected is in breach of VAT Act hence penalties (2)
Maximum 8
Part (j)bank overdraft

Advantages

• Facility amount flexible – don’t have to use full amount (2)

• Overdrafts often unsecured (2)

Disadvantages

• Overdraft can be revoked at short notice (2)

• Mismatch funding long term assets with short term funding (2)
• Generally interest rate higher on overdrafts than medium term loans (2)
• Banks monitor cash flows more closely than if medium term loan advanced (2)
Maximum 6