MAC3702 EXAM SOLUTION PACK

2020 - MAC3702

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This document contains suggested

solutions to the following past papers.
May/June 2017

October/November 2017

May/June 2018
MAC3702 Application of financial
October/November 2018
management techniques

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QUESTION – MAY 2017 (55 marks; 99 minutes)

Mike Sports Limited (“MSL”) is a Cape Town based football (soccer) kit manufacturer and supplier. The
company is listed on the Johannesburg Stock Exchange and it owns chain stores across the SADC region.
MSL also offers hundreds of people with franchise opportunities to enable them to operate their own
businesses.

Recently telecommunications companies have injected billions of rands into South African soccer by the
way of competitions, buying existing clubs and using local stars as faces of their marketing campaigns. This
has presented MSL and its peers with exciting opportunities to grow their bottom line, hence the recent
decision by the MSL Board to introduce a new soccer boot design - EISH 7 inspired by the great soccer
legend, Einstein Shabalala. The following information was sourced from the integrated annual report of
MSL.

Extract from the statement of financial position at 31 May 2016

Rand
Equity and Liabilities
Ordinary shares (80 cents each) 500 000
Retained income 720 000
Shareholders’ capital and reserves 1 220 000
15% Preference shares (R100 each) 120 000
Long term loan – Tebha Bank (16,67%) 680 000
Total equity and liabilities 2 020 000

Additional information
1. The expected operating profit, excluding profits from the sale of EISH 7 soccer boots, for the year
ending 31 May 2017 is as follows:

R Probability
1 600 000 20%
1 700 000 30%
1 800 000 40%
2 000 000 10%

2. Ordinary share dividends declared and paid in the previous five (5) years were as follows:

Year Dividend per share

2012 72 cents
2013 80 cents
2014 91 cents
2015 95 cents
2016 105 cents

The MSL Board intends to maintain the average growth in dividends.

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3. The market price for ordinary shares is currently R12 per share and that of preference shares is R96
per share. New issues will have no effect on these prices, although ordinary share issue costs will
be 4% per share issued.
4. MSL aims to maintain a debt: equity ratio of 1: 1 going forward (based on book values).
5. To manufacture the new EISH 7 soccer boot, MSL is planning to buy a new machine for R800 000
on 1 June 2016. The company will use this machine for 5 years in full production, and then scrap it
at R50 000.
6. The expected annual production quantities of this new soccer boot for which demand exists are
given below:

Quantity (pairs) Probability

8 000 30%
12 000 40%
15 000 20%
18 000 10%

The expected cost per pair:

Cost R
Direct material 465
Direct labour 200
Variable overhead 50

7. The budgeted cash fixed costs for the production of EISH 7 is R400 000 per annum and the selling
price is set at R800 per pair. No inflationary increases need to be considered.
8. The following options are available to finance the new initiative:
• New ordinary shares can be issued (retained earnings cannot be utilised).
• Up to 4 000 15% preference shares of R100 each can be issued.
• A loan from Sambo Bank of R200 000 at prime + 800 basis points.
• A top-up loan from Tebha Bank of R50 000 at the same rate as the existing loan, which is
considered to approximate the fair market interest rate.
The loans can only be taken at the total amounts as made available by the banks.

9. The South African Income Tax Act stipulates a company tax rate of 28% and a section 12C allowance
on new manufacturing machines of 20% per annum. The prime lending rate is currently 10,5% and
is expected to stay unchanged for the foreseeable future.

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REQUIRED

(a) Calculate the expected retained income for the year ending 31 May 2017, assuming both ordinary
and preference dividends are paid and there is no other movement in capital employed (ignore
financial impact of EISH 7).
[Round decimals to nearest whole number] (10)

(b) Calculate the market values of ordinary share capital and preference share capital before taking the
new investment into account.
(4)

(c) Determine how the new manufacturing machine should be financed, considering the funding
options available to MSL as well as the current capital structure on 31 May 2016 using book values.
(Calculations 6 marks; comments 2 marks) (8)

(d) Calculate the weighted average cost of capital of MSL based on book values after the financing of
the new project.
[Round rand amounts to the nearest cent and other numbers to the nearest two decimal places]
(10)

(e) Advise the MSL Board whether or not the new machine should be purchased, assuming a hurdle
rate of 19%. You can assume tax is payable in the same year as calculated and accrued.
[Round answers to the nearest rand] (13)

(f) Determine how long (in years) it will take MSL to recover its initial capital investment in the new
machine, using the discounted payback method. (5)

(g) List five (5) qualitative factors that should be taken into account by the Board of MSL before deciding
to buy the new machine. (5)
[55]

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MAC3702

MAY/JUNE 2017

SUGGESTED SOLUTION

QUESTION 1

a) Expected Operating Profit

1 600 000 x 20% = 320 000 Calculation of growth

1 700 000 x 30% = 510 000
1 800 000 x 40% = 720 000 PV = -72c
2 000 000 x 10% = 200 000 FV = 105c
n=4
EBIT 1 750 000 i = 9.89% ≈ 10%

Interest Expense No. of shares

- Loan (680 000 x 16.67%) (113 356)
R500 000 ÷ 0.8
Profit before Tax 1 636 644 625 000 shares

Taxation @ 28% (458 260)

Profit after Taxation 1 178 384

Dividends
- Ordinary
(625 000 x 1.05 x 1.10) (721 875)
- Prefs – Dividend
(120 000 x 0.15) (18 000)

Retained Profit 438 509

Retained Profit BOY 720 000
Retained Profit EOY 1 158 509

Market value of ordinary shares

625 000 x R12,00
R7 500 000

Market value of Preference shares

= 1 200 shares x R96
= R115 200

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PART C
Financing the new manufacturing machine:

Current capital structure Market Value

Ordinary shares R500 000
Retained income R720 000
Preference shares R120 000
Long term liabilities R680 000
Capital employed R2 020 000
New investment R800 000

Total capital structure after new investment R2 820 000

Capital structure Current New Capital

capital investment structure after new
structure investment

Equity R1 220 000 R190 000 R1 410 000

Preference shares
(*balancing figure) R120 000 * R360 000 R 480 000

Long-term loan – Tebha R680 000 R50 000 R730 000

Long-term loan - Sambo R0 R200 000 R200 000

Total R2 020 000 R800 000 R2 820 000

The new manufacturing machine must be financed through a fresh issue of ordinary shares (R190 000);
issue of preference shares (R360 000); top-up of the Tebha Bank loan (R50 000) and a loan from Sambo
Bank of R200 000.

Notes
Target capital structure (50: 50) – R1 410 000 debt and R1 410 000 equity. Long-term loans are utilized
first because of the tax break (cheaper than preference shares, therefore reducing WACC)
Max: 8 marks

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PART D
Weighted average cost of capital (after purchase of new machine)

Capital structure Book Portion of Cost of WACC

values capital capital
structure

Ordinary shares 1 410 000 0,50 20,07% 10,04%

Preference shares 480 000 0,17 15,63% 2,66%

Long-term loan – Tebha 730 000 0,26 12,00% 3,12%

Long-term loan – Sambo 200 000 0,07 13,32% 0,93%

Total 2 820 000 1/100% 16,75%

Ordinary shares
𝐷1
𝐾 = +g
𝑒 𝑃0−𝑓
𝐾 𝑐
=
+ 0,10
1,16

𝑒 12−0,48
Ke = 20,07%

fc = floating (issue) costs

D1 = R1,16 (calculated in part A)

g = 10% (calculated in part A)
P0 = R12
fc = R12 x 4% = R0,48

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Preference shares

𝐷1
𝐾 =
𝑝 𝑃0
15
𝐾 =
𝑝 96

Kp = 15,63%

Long-term loan – Tebha Bank

Kd1 = 16,67% x 0,72 = 12%

Long-term loan – Sambo Bank

Kd2 = (10,5%+8%) x 0,72 = 13,32%

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(e)

Expected sales and demand:

(8000 x 30%) + (12000 x 40%) + (15000 x 20%) + (18000 x 10%) = 12 000 units

Total Sales : 12 000 units x R800 9 600 000

Variable Costs : (465 + 200 + 50) x 12 000 8 580 000

1 020 000
Fixed costs 400 000
Net Cash Flow 620 000

Investment appraisal
0 1-4 5
Cost price (800 000)
Residual value 50 000
Working Capital - -
Net Cash Flow 620 000 620 000
Taxation _________ (128 800) (142 800)
(800 000) 491 200 527 200

NPV@19% = R716 996  Accept

Taxation 1–4 5

Net Cash Flow 620 000 620 000

Wear and Tear (160 000) (160 000)

Recoupment 50 000
- Selling Price 50 000
- Tax Base -

460 000 510 000

Taxation @ 28% 128 800 142 800

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(f)

Cash flow PV @19% Cumulative cf payback

Y1 491 200 412 773 412 773 1 year

Y2 491 200 346 868 759 641 2 years
Y3 491 200 291 485 1 051 126 40359/291485 0.14 years
2.14 years

(g)
• Will training be required.
• Reliability of estimates.
• Identification of buyer in 5 years.
• Change in technology.
• Available funding.
• Impact of funding on financial risk.
• Sustainability of demand.
• Change in costs.

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QUESTION (45 marks; 81 minutes)

Madlala (Pty) Ltd (“Madlala”) is one of South Africa’s leading gaming retailers and has an amazing range
of video games, consoles and accessories. With the opening of its first megastore at the Gateway Shopping
mall in December 2016, Madlala’s business now consists of six stores in four different provinces. The
company operates from leased premises and its investment in non-current assets includes intangible
assets, equipment and fittings. Lease restrictions have often hindered the company from creating a ‘fun
& play’ environment at its stores. Madlala (Pty) Ltd is currently not listed in any stock exchange.

Madlala is still enjoying the benefits of the successful launch of Playstation®4. However, recently the rand
has come under severe pressure against major world currencies and the management team is looking at
ways to protect the company against currency fluctuations. The company is also faced with the challenge
of a decrease in buying power of consumers, especially following rapid hikes in the lending rates.

The financial information for Madlala (Pty) Ltd for the past two financial periods is shown below.

Statement of comprehensive income for the year ended 30 April 2017

2017 2016
R R

Sales 2 400 000 2 180 000

Cost of sales (1 090 000) (980 000)
Gross profit 1 310 000 1 200 000
Marketing (133 000) (102 000)
Licensing and development (220 000) (218 000)
Administration (189 000) (175 000)
Depreciation (75 000) (65 000)
Profit before interest and tax 693 000 640 000
Interest expense (105 000) (88 000)
Interest income 27 000 5 000
Profit before tax 615 000 557 000
Taxation (191 000) (162 000)
Net profit 424 000 395 000

Dividends declared and paid (128 000) (107 000)

Retained earnings 296 000 288 000

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Summarised statement of financial position at 30 April 2017

2017 2016
R R
ASSETS
Non-current assets 1 030 000 980 000
Current assets Total 2 180 000 1 863 000
assets 3 210 000 2 843 000

EQUITY AND LIABILITIES

Ordinary share capital 100 000 100 000
Reserves 452 000 216 000
Non-current liabilities 1 424 000 1 270 000
Current liabilities 1 234 000 1 257 000
Total equity and liabilities 3 210 000 2 843 000

Business valuation

For the year ended 30 April 2017 the company recorded a net profit of R424 000 and free cash flows of
R258 267. The free cash flows for the 2016 financial year amounted to R240 603 and the increase in cash
flows is in line with expected future growth of the business. The company’s patents and distribution rights
though valued at R3 560 000 (net of tax) are currently recorded in the statement of financial position at
R506 000. Should the board of directors of Madlala decide to wind up the company, administration costs
are expected to be R160 000.

Working capital management

Due to increasing levels of bad debt, Madlala is considering a more aggressive working capital approach.
The company is therefore evaluating two credit policies, with the intention of implementing the most
profitable option of the two.

Current Option A Option B

Annual debtors’ collection costs R40 000 R50 000 R80 000
Bad debt losses (% of sales) 4% 2% 1%
Average collection period 2 months 1½ months 1 month

Additional information
• Weighted average cost of capital is 15%.
• Similar companies listed on AltX of the Johannesburg Stock Exchange have an average P/E ratio
of 11 times and earnings yield of 9,09%.
• Companies not listed on any stock exchange are estimated to trade at 8% below their fair
market values (marketability discount).
• The current applicable tax rate is 28%.

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REQUIRED

(a) Calculate the profitability ratios of Madlala (Pty) Ltd for the year ended 30 April 2017 and
where possible, provide reasons for changes from the previous financial year.
The following ratios are required:
i). Turnover growth (calculation 1 mark; comment 2 marks)
ii). Gross profit margin (calculation 2 marks; comment 1 mark)
iii). Effective tax rate (calculation 2 marks; comment 1 mark)
iv). EBITDA margin (calculation 2 marks; comment 1 mark)
v). Marketing expenses as % of revenue (calculation 1 mark; comment 1 mark)
vi). Net interest cover (calculation 3 marks; comment 1 mark)
vii). Dividend cover (calculation 2 marks; comment 1 mark)

[Round your answers to one decimal place] (21)

(b) Advise the management team of Madlala (Pty) Ltd which option they should choose as their
credit management policy. Show all supporting calculations. (12)

(c) Determine how much the owners of Madlala (Pty) Ltd should sell their shares to an independent
investor that is interested in buying 25% of the business. Use the price- earnings multiple
method. (6)

(d) Calculate the total value of Madlala (Pty) Ltd using the net asset value method, if the decision
is to wind up the company. (4)

(e) Calculate the total value of Madlala (Pty) Ltd using the free cash flow method. (2)
[45]

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QUESTION - MADLALA

2 400 000
i) Turnover growth = 2 180 000
−1

= 10.09%

≈ 10.1%

• Benefits of successful launch – people still attracted to product.

• Minor sales price increases would also contribute to the nominal growth rate
(which exceeds with inflation).

ii) Gross Profit Margin

2017 2016
1 310 000 1 200 000
2 400 000 2 180 000

54.6% 55.0%

Slight drop in GP, possibly as a result of higher input costs caused by the weakening rand.

Effective Tax rate

2017 2016
191 000 162 000
615 000 557 000
= 31.06% = 29.08%
≈ 31.1% ≈ 29.1%

Effective rate has increased, possibly due to non-deductible items.

EBITDA Margin 2017 2018

Profit before Interest and Tax 693 000 640 000
Depreciation 75 000 65 000
768 000 705 000
Sales ÷ 2 400 000 ÷ 2 180 000

32% 32.3%

The slight decrease was caused by the drop in GP% and a slight increase in expenses.

Marketing Expenses % 2017 2018

133 000 102 000
Possibly increased to 2 400 000 2 180 000
generate additional sales.
= 5,5% = 4,7%

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Net Interest cover

The interest income has
contributed to the improved 693 000 640 000
interest cover 78 000 83 000

8.9 times 7.7 times

iii)
Dividend Cover 2017 2016
424 000 395 000
128 000 107 000

3.3 times 3.7 times

Profits increased by 7.3%, where dividends increased by 19.6%, thereby causing the coverage
to deteriorate.

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(b)

Credit Sales R2 400 000 R2 400 000 R2 400 000

Ave collections 6 8 12
Ave o/s Balance R400 000 300 000 R200 000
Finance Costs @ 15% 60 000 45 000 30 000
Bad Debts 96 000 48 000 24 000
Collection Costs 40 000 50 000 50 000
Total Costs 196 000 143 000 134 000

 Option 2 is the most viable.

(c)

Valuation using earnings

Earnings per AFS 424 000

PE Multiple – see below 8
Value before owner level adjustments 3 392 000

Minority discount (say 20%) (678 400)

Owner level adjustments – given – marketability
discount @8% (271 360)
2 422 240

25% Interest 610 560

Adjusted PE multiple

PE of similar listed entity 11

Risk adjustments
- Presence in all provinces +
- Exchange rate pressure -
- Decrease in buying power -
- Weakness in debtors control -
- Any other valid point

Adjusted PE 8

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(d)

Non-Current Assets 4 084 000

- Given 1 030 000

- Market Value adjustment 3 054 000
• Patents (3 560 000 – 506 000)
Current Assets 2 180 000
Total Assets @ fair values 6 264 000
Current Liabilities (1 234 000)
Non-Current Liabilities (1 424 000
Net Asset Value 3 606 000
Less Costs (160 000)
3 446 000

e) FREE CASH FLOW

FCF1
Po =
WACC−g

258267 × 1.0734
=
0.15 − 0.0734

= 3 619 110

258 267
g= −1
240 603

= 7.34%

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MAC3702

OCTOBER 2017

QUESTION (50 marks: 90 minutes)

Bophelo of the Cross Limited (“Bophelo”) is a global supplier and manufacturer of branded and generic
pharmaceutical products as well as infant nutritionals and consumer healthcare products. Bophelo is
the second largest pharmaceutical group listed on the JSE and boasts of 10 manufacturing facilities on
five continents with a staff compliment of 40 000 people worldwide.

Bophelo’s research and development team has just successfully completed the testing of its new
antiretroviral (ARV) drug with improved safety profile, which can be used in smaller quantities and, as
a consequence, will result in fewer side effects. Although this is Bophelo’s initial entry to the ARV drug
market, the government being pressured by lobby groups has finally granted the group a license to
manufacture and sell this drug. The license is valid from 1 January 2018 until 31 December 2024.

Bophelo is highly geared and the group treasurer is concerned about how this new business
undertaking should be financed. The group requires R210 million to set up the ARV drug plant and
have it ready to start the manufacturing process at the beginning of the calendar year (2018). An
extract from the latest statement of financial position of Bophelo of the Cross Limited is provided
below:

EQUITY AND LIABILITIES Notes R’m

Ordinary share capital 1 304
Non-distributable reserves 1 300
Retained income 1 1 876
Preference share capital (50 cents each) 2 1 200
Long-term loan 3 800
Debentures 4 1 750
Total equity and liabilities 6 230

Notes:

1. 25% of ordinary shares were initially issued at R4 each and the remaining 75% was issued just four
years ago at R24 each. All these shares are now trading at R72,50 each. Retained earnings are
not available to finance the new asset. The recent dividend per share paid was R2,10. The market
return averages 15,25% and the market risk premium is estimated at 8,12% (beta is 0,9).

2. The preference shares will be redeemed in four years’ time at R2 per share. The group currently
pays a fixed cumulative dividend of R132 million. Similar shares yield approximately about 9,50%
in the market.

MAC3702
OCTOBER 2017
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3. The five-year term loan was issued at a post-tax interest rate of 8,10% three years ago. Interest
is paid annually while the capital is repaid at the end of the term. The going interest rate on loans
of this nature (before tax) is 10,25%.

4. Four million debentures were issued three years ago at a post-tax rate of 8,46%. These are
currently trading at R500 each.

5. The corporate taxation rate is 28%.

ARV drug plant

The group’s manufacturing site will be modified to accommodate the ARV drug machinery. An existing
machine will have to be disposed of at its tax value of R5 million at the start of 2018. This machine
was expected to generate after tax cash profits of R3,8 million per annum for the next two years. The
group is expected to pay site rehabilitation costs upfront of R15 million as the result of the new plant.
It has been estimated that the actual rehabilitation costs at the end of the project will be two-thirds
of the initial amount.

The plant will be depreciated in line with the group policy of 12,5% per annum and will be scrapped
for R35 million at the end of 2024. The group has budgeted cash sales of R84 million in 2018. The
Department of Health is embarking on an aggressive awareness campaign to curb the spread of
chronic diseases and as a result the sales value will shrink by 2% year on year. Bophelo maintains a
profit mark-up of 180% on cost. Additional site maintenance costs of R10 million per annum for the
first three years will be incurred and paid at the end of each year.

South African Revenue Services (SARS) allows capital allowance on similar plants over six years. The
group is required to pay any shortfall on rehabilitation costs (and is entitled to a refund in the event
the costs are less than the initial estimate). Rehabilitation costs are not deductible for income tax
purposes.

Funding options

The group treasury team has approached two major South African banks and they have each indicated
the willingness to finance the new plant. The following terms have been offered:

The Rand Bank

The bank will disburse R210 million to Bophelo to facilitate the purchase of the ARV drug plant. This
is a seven-year facility with the capital portion only repayable at the end of the loan term. The interest
will be paid annually in arrears at a fixed rate of 10,25%. The group will incur a service fee of R250 000
payable at the start of each year for the duration of the term.

Meditec Bank

Meditec Bank has offered to grant Bophelo the full R210 million as a loan at an annual interest rate of
10,25%. An upfront administration cost of R2 million is payable at the start of the loan term. The
capital portion of the loan will be repaid in five equal annual instalments at the end of each year. The
interest will be charged on outstanding balance and will be payable annually in arrears.

MAC3702
OCTOBER 2017
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REQUIRED:

a) Calculate the weighted average cost of capital of Bophelo of the Cross Limited.

[Round rand amounts to the nearest rand and all other numbers to the nearest three decimals]

(19)

b) Establish the net present value of the ARV drug plant.

[Round all numbers to the nearest two decimals. Workings should be rounded to the nearest R’m]
(12)

c) Advise the group treasurer whether the group should invest in the new ARV drug plant based on
part b) above, and provide qualitative factors (excluding those relating to the machine specifically)
they should consider before investing.
(5)

d) Given the two available loan facilities and assuming that the group has decided to go ahead with
the investment in the ARV drug plant, advise the group treasurer based on the net present cost
which bank loan should be preferred.

[Round all numbers to the nearest two decimals. Working should be rounded to the nearest R’m]
(14)

(50)

MAC3702
OCTOBER 2017
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OCTOBER 2017 – SOLUTION

QUESTION

a) Weighted Ave Cost of Capital

Market Value Weight Cost WACC

Equity 1 160 000 000 15.00% 14.438% 2.166%

Preference Shares 3 761 748 117 48.65% 9.5% 4.622%

Long-Term Loan 810 359 590 10.48% 7.38% 0.773%

Debentures 2 000 000 000 25.87% 7.40% 1.914%

7 732 107 707 100.00% 9.475%

 9.5%

Market Value of Equity

No. of Shares Issued x Share Price

= 16m x R72.50

= R1 160 000 000

No. of Shares in Issue

[0.25(𝑥) × 𝑅4] + [0.75(𝑥) × 𝑅24] = R304m

[1𝑥] + [18𝑥] = R304 m

𝑥 = 16m Shares

Cost of Equity (Ke) = 𝑹𝒇 + 𝜷 (𝑹𝒎 − 𝑹𝒇)

= 7.13% + 0.9 (15.25% - 7.13%)

= 14.438%

Market Premium (Ke) = 𝑹𝒎 − 𝑹𝒇

8.12% = 15.25% - 7.13%

Market Value of Preference Shares

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PMT = 132 000 000

FV = [R2 x 2 400 000 000]

i = 9.5

n = 4

PV = R3 761 748 117

Market Value of Long-Term Loan

PMT = 800 000 000 x 8.1%

= 64 800 000

FV = 800 000 000

i = 10.25 x 0.72

= 7.38

n =2

PV = 810 359 590

Market Value of Debentures

= 4 000 000 x R500

= R 2 000 000 000

𝑖(1 − 𝑇) = R1 750 000 000 X 8.46% = 148 050 000

4 000 000

Per Debenture = R37.0125

𝑲𝒅 𝑰(𝟏 − 𝑻)
=
𝑷𝒐

37.0125
=
500

= 7.4%
(b)

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Rmillions 0 1 2 3 4 5 6 7

Cost - New Plant (210.00)

Cash inflow - sale of plant 5.00
Rehabilitation costs (15.00) 5.00
Residual value 35.00

Net Cash Flow 44.00 42.92 41.86 50.82 49.81 48.81 47.84
Gross Profit - New plant 54.00 52.92 51.86 50.82 49.81 48.81 47.84
Site maintenance (10.00) (10.00) (10.00) - - - -

Opportunity cost (3.80) (3.80)

Taxation (2.52) (2.22) (1.92) (4.43) (4.15) (3.87) (23.20)

(220.00) 37.68 36.90 39.94 46.39 45.66 44.94 64.64

NPV @ CF CF CF CF CF CF CF CF

I = 9.5% NPV = -2.933m Therefore reject

Taxation 1 2 3 4 5 6 7

Net cash flow 44.00 42.92 41.86 50.82 49.81 48.81 47.84
Wear and Tear (35.00) (35.00) (35.00) (35.00) (35.00) (35.00)
Recoupment 35.00
Selling price 35.00
Tax base -
9.00 7.92 6.86 15.82 14.81 13.81 82.84

Taxation @28% 2.52 2.22 1.92 4.43 4.15 3.87 23.2

Gross profit - new plant

1 2 3 4 5 6 7

Sales 84.00 82.32 80.67 79.06 77.48 75.93 74.41

Profit

sales/2.8 x 1.8 54.00 52.92 51.86 50.82 49.81 48.81 47.84

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(c) The Investment should be rejected on the basis of the negative NPV

Other factors

• The Increasing costs of health care and the effect on the sustainability of the project
• What happens after 2024 when the licence expires
• Legal matters with respect negative effects of drugs
• The funding of the project
• The certainty of cash flows. How sure are we that the asset will sell for R35m in 5 years’
time?
• Is the mark-up on cost not unreasonable?

(d)

RAND BANK 0 1-6 7

Loan 210.00
Capital repayment (210.00)
Interest payment (22.00) (22.00)
Service fees (0.25) (0.25)

Tax benefit on interest and service

fees 6 6
209.75 (16.02) (225.77)

Effective after- tax cost CF CF CF

C0MPUTE IRR = 7.64%

Taxation 1-6 7

Interest (22.00) (22.00)

Service fees (0.25) (0.25)
(22.25) (22.25)

Tax benefit@28% 6.23 6.23

INTEREST

210 x 10.25% = 21.52

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MEDITEC 0 1 2 3 4 5

Loan 210.00
Admin fees (2.00)
Capital repayments (42.00) (42.00) (42.00) (42.00) (42.00)
Interest Payments (22) (17) (13) (9) (4)
Tax benefit on admin fees 0.56
Tax benefit on interest 6 5 4 2 1
208 (57) (54) (51) (48) (45)
Effective after- tax cost CF CF CF CF CF CF
C0MPUTE IRR = 7.52%

INTEREST 1 2 3 4 5

Opening balance 210.00 168.00 126.00 84.00 42.00

Capital
repayment (42.00) (42.00) (42.00) (42.00) (42.00)
Closing balance 168.00 126.00 84.00 42.00 -

Interest 21.525 17.22 12.915 8.61 4.305

The Meditech Loan is cheaper and should therefore be accepted.

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MAC3702

OCTOBER 2017

QUESTION 1 (50 marks: 90 minutes)

Multiple Choice Limited (“Multiple Choice”) is a JSE-listed video entertainment and internet company
with a strong presence in South Africa and across the African continent This leading multi-channel
pay-tv operator was founded in 1985 and has since then grown in leaps and bounds to become one
of South Africa’s favourite brands with more than five million subscribing South African households.
In addition to its digital satellite TV service, Multiple Choice is also South Africa’s largest internet
service provider. However, the company has been coming under a lot of pressure from the
government as it continues to lag behind on its economic transformation targets. Its recent public
spat with the government officials has put the company under immense pressure from its
shareholders to prioritise the transformation agenda.

Mvelaphansi Media (Pty) Limited (“Mvela”), a well-established 100% black owned and managed
private company was founded in 2007 by the former Minister of Communications Thoko Segoale.
Since its formation, Mvela has obtained Key contracts from provincial and local government
departments throughout the country with much higher margins than from its private sector clientele
(only 20% of Mvela’s business is generated from the private sector). In an effort to diversify its
business and alleviate the company from its financial woes following the liquidation of one of its
associates, Mvela’s managing director Judas Segoale has approached the Multiple choice board of
directors with an intention of buying 26% of Multiple Choice.

Mvela operates on cash-only basis and its abridged statement of profit and loss for the year ended 30
June 2017 is provided below. The profit for the year is after taking into account a once-off special tax
concession of R125 million received from the Swiss Federal Tax Administration. The directors of Mvela
are confident that the company will maintain its current income and expenses. Mvela business has a
required rate of return of 13%.

Mvelaphansi Medica (Pty) Limited

Statement of profit and loss for the year ended 30 June 2017

R’m
Turnover 23 452
Cost of Sales (13 485)
Gross Profit 9 967
Operating expenses (5 588)
Earnings before interest, tax, depreciation and amortisation 4 379
Depreciation and amortisation (394)
Earnings before interest and tax 3 985
Interest expense (620)
Profit before tax 3 365
Tax (875)
Profit for the year 2 490

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Multiple Choice has arranged a structure where by the existing shareholders of Multiple Choice will
sell 25% of their shareholding to Mvela. The market has speculated a great economic windfall for
Multiple Choice after this deal, as the South African Football Association (SAFA) is most likely to
partner with the Mvela sport channel division to broadcast SAFA’s football matches. The industry
average earnings yield remains at about 9,09% (Mvelaphansi media is also benchmarked against this
industry average). However, the deterioration of South Africa’s currency over the past year, coupled
with rising competition for content has increased the cost base of Multiple Choice.

Despite the trying economic conditions, Multiple Choice has managed to increase its customer base
by 6% mainly as a result of its flagship personal video recorder, the Dish Explorer that continues to be
a key differentiator in the market. Cost pressures from expanding the customer base, investment in
new technologies and international USA dollar-based content costs continue to hamper the
company’s efforts to contain its operating costs.

Due to recent sharp increase in the share price of Multiple Choice (directly at the back of the pending
deal), its board of directors unanimously agreed on the following terms of sale:

• The price per share will be the average share price for the second half of the 2017 financial
year of Multiple Choice Limited.
• A discount equivalent to the percentage decrease (from 2016 to 2017 financial year) in foreign
exchange losses account of Multiple Choice will be granted to Mvela
• Deal structuring costs of R4 million will be paid by Mvela for corporate advisory services.

Summarised financial statements of Multiple Choice for the past two financial years are presented
below:

Statement of comprehensive income of Multiple Choice Limited

Year ended Year ended

30 June 30 June
2017 2016
R’m R’m

Revenue 35 704 31 580

Cost of providing services and sale of goods (19 187) (16 646)
General selling and administration expenses (7 179) (6 117)
Operating profit 9 338 8 817
Foreign exchange losses (624) (641)
Interest received 153 144
Interest expenses (547) (443)
Profit before taxation 8 320 7 877
Taxation (2 318) (2 238)
Net profit for the year 6 002 5 639
Dividends – preference shares (155) (155)
Dividends – ordinary shares (1 998) (1 879)
Retained income for the year 3 849 3 605

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Year ended Year ended

30 June 30 June
2017 2016

Number of ordinary shares issued (million) 338 333

Number of preference shares issued (million) 80 80
Number of subscribers (000) 5 128 4 808
Share price – 1 July (cents) 16 478 15 353
Share price – 1 January (cents) 18 404 15 981
Share price – 30 June (cents) 18 604 16 478

Statement of financial position for Multiple Choice Limited

Year ended Year ended

30 June 30 June
2017 2016
R’m R’m
ASSETS
Non-current assets 12 788 12 360
Cash and Cash Equivalents 1 640 909
Current assets 9 175 7 828
Total assets 23 603 21 097
EQUITY AND LIABILITIES
Ordinary share capital 225 205
Retained income 7 834 6 351
8,45% non-redeemable preference shares 1 840 1 840
Term loan, long-term portion 3 350 3 120
Term loan, Short-term portion 1 350 1 443
Current liabilities 9 004 8 138
Total equity and liabilities 23 603 21 097

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REQUIRED:

a) Using closing balances and book values where applicable, calculate the 2016 and 2017 financial
year ratios of Multiple Choice Limited, and provide possible reasons for any movement

i) Dividend yield
ii) Earnings yield
iii) Return on assets
iv) Cash ratio
v) Gross profit margin
vi) Debt ratio
vii) Effective interest rate

(Calculate 16 marks, comment 7 marks) (23)

b) Calculate the existing capital structure of Multiple Choice Limited and comment on how the
business is financed.

(Calculation 3 marks, comment 2 marks) (5)

c) Using the Price/Earnings multiple method, establish the value of Mvelaphansi Media (Pty) Limited
as at 30 June 2017.
(8)

d) Perform a reasonableness check on part c) above by establishing the value of Mvelaphansi Media
(Pty) Limited at 30 June 2017 using the discounted cash flow method.
(4)

e) Determine how much it would cost Mvelaphansi Media (Pty) Limited to acquire the required stake
in Multiple Choice Limited.
(5)

f) Identify and discuss the risks that Multiple Choice is exposed to. (5)

[50]

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MAC3702

OCTOBER 2017 – SOLUTION

QUESTION 1

i)
2017 2016

Dividend yield = ∗ Dividend 5.91 5.64

Market Price 186.04 164.78

3.18% 3.42%

*Dividend/Share 1 998 1 879

338 333

5.91 5.64

The Dividend Yield has decreased. Although the Dividend per share has increased by 4.8%, the
Share Price has increased by 12.9%. This also is a result of the increase in the number of shares.

ii)
2017 2016

Earnings Yield = Earnings 17.76 16.93

Market Price 186.04 164.78

9.55% 10.27%

EPS = 6 002 5 639

338 333

17.76 16.93

Earnings Yield has decreased. The EPS has increased by a smaller extent that the Share Price.
This was caused by the increase in the number of shares.

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iii)
2017 2016

Return on Assets = EBIT (Op Profit) 9 338 8 817

Total Assets 23 603 21 097

39.56% 41.79%

This is an indication of the efficient use of Assets. This is mainly due to large increases in Cash
Balances and other Current Assets.

iv)
2017 2016

Cash Ratio = Cash & Cash Equivalents 1 640 909

Current Liabilities 1 350 + 9 004 1 443 + 8 138

0.16 : 1 0.09 : 1

Cash Ratio has improved. This is as a result of the almost doubling in Cash and Cash Equivalents.

v)
2017 2016

Gross Profit % = Gross Profit 16 517 14 934

Sales 35 704 31 580

46.3% 47.3%

Gross Profit = Sales 35 704 31 580

Less Cost of Sales (19 187) (16 646)

16 517 14 934

The GP% has decreased slightly. Possibly price increases could not be passed on to customers in
the short-term.

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vi)
2017 2016

Debt Ratio = Long − Term Debt 3 350 + 1 350 3 120 + 1 443

Total Assets 23 603 21 097

19.91% 21.63%

The Debt Ratio has declined, meaning that more of the Assets have been funded with Equity.

vii)
2017 2016

Effective Int rate – Total Interest Paid 547 443

on closing Balance = Total Long − Term debt 3 350 + 1 350 3 120 + 1 443

11.64% 9.71%

Effective rates have increased, an indication of increased risks and causing high interest rate
charges.

b) Existing Capital Structure - 2017

Share Capital 225

Retained Profits 7 834

Equity 8 059 55%

Preference Capital 1 840 13%

Loans 4 700 32%

14 599 100%

The company has a Debt to Equity Ratio of 45 : 55. More equity funding.

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c) Adjusted PE Multiple

Earnings Yield = 9.09%

 PE = 1⁄9.09%

= 11

 PE of similar listed company 11

Adjustments for specific risks

• Heavily reliant on government contracts _

• Associate company in liquidation (financial issues) _
• 100% Black-owned +
• Possible partnership with SAFA +
__
Fair PE 7

Earnings

Profit for the year 2 490

Tax Concession – once off (125)

2 365

Value = PE x Earnings

= 7 x 2 365

= R16 555

Value as above before 16 555

owner level adjustments

Marketability Discount (1 656)

(10%)
14 899

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d) Assuming Free Cash Flow

Profit for the year 2 490 Lack of information with respect to

Tax Concession – once off (125) working capital and Capital expenditure
2 365
Add. Long-Term Interest 620
Tax thereon [620 x 28%) (174)
2 817
Dep & Amortisation 394
3 205

FCF 3 205
Po = = = 24 654
WACC − g 0.13

e)

Share Price (18 404 + 18 604) ÷ 2

18 504 cents (R185.04)

Total Share Value 338m x R185.04

R62 543,52

Discount (2.65%) (1 658.72)

R60 884,80
Deal structuring (4 000,00)
Price payable 56 884,80

f)

Risks

New market entrance

High operating costs
High capital costs
Exchange rate fluctuations
Lack of transformation

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Question 1 (50 marks; 90 minutes) (MAY 2018)

Pick 2 Save Group (trading as “P2S”) is one of the major supermarkets listed on the Johannesburg Stock Exchange
and it boasts of more than 1 800 chain stores in five Southern African countries. Following the restructuring of
its business at the beginning of the current year, P2S has managed to reduce its workforce, and the company is
hopeful that in future this will result in improved trading profit margins. During the current year, P2S launched a
loyalty programme throughout its stores, and this has led to a significant increase in the number of customers.

Due to extreme heat conditions, particularly in the Western Cape, P2S has seen a sharp increase in its cost of
sales as the suppliers are pushing the costs onto the retailers. The retail sector in Southern Africa remains highly
competitive, and businesses always have to come up with innovative ways to stay ahead of the game. Despite
tough economic conditions anticipated, P2S continues to increase its retail footprint throughout the country.
Recently, the executive committee (“EXCO”) of P2S has approached you to evaluate the feasibility of constructing
additional stores (hypermarkets) for the company. There are three cities currently envisaged, namely Polokwane,
Nelson Mandela Bay and Mbombela. You have already furnished the EXCO with the following findings on
Polokwane and Nelson Mandela Bay:

Hypermarket Initial investment Internal rate of return NPVI

Polokwane R40 million 15,0% 1,23
Nelson Mandela Bay R35 million 16,8% 1,03

The following information relates to the Mbombela project:

The initial investment relates to the cost of construction to be incurred immediately (May 2018 - year 0). The
construction of a store usually takes twelve (12) months, after which it becomes operational. Because of its size,
the construction of the Mbombela P2S hypermarket (to cater for the Mpumalanga Province and Mozambican
markets) will cost 20% more than the average construction costs of Polokwane and Nelson Mandela Bay projects.
The company’s accounting policy on property, plant and equipment is to depreciate its buildings over 50 years.

The total sales in the first two years of operation will amount to R70 million (per annum). P2S will maintain the
group’s current trading profit margin as shown in the financial statements below. The sales will thereafter grow
at inflation + 60 basis points yearly (the future growth in profits is in line with the expected sales growth). Once in
operation P2S will donate a total sum of MT3,3 million (Mozambican Meticais) to charity organisations based in
Maputo.

The payment will be made in three equal annual instalments at the end of each financial year. The donations do
not form part of the company’s trading activities and are not tax deductible. The Mbombela project will require
working capital of R2 million, only for the year of construction. These funds will be reimbursed by P2S head office
at the end of the construction phase. The last year of evaluating the project is April 2023, when the continuing
value of the project will have to be established. P2S will use its current year’s effective tax rate to determine the
tax receivable or payable on the Mbombela project.

According to the company’s strategic guidelines, a project is only undertaken if its:

• Internal rate of return exceeds 12% and
• Net present value index is above 1,20

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The financial statements of Pick 2 Save Group are provided below:

STATEMENT OF COMPREHENSIVE INCOME FOR THE YEAR ENDED 30 APRIL 2018

2018 2017
Rm Rm
Sale of merchandise 130 028 113 694
Cost of sales (102 792) (90 180)
Gross profit 27 236 23 514
Other operating income 3 711 3 428
Salaries and wages (9 499) (8 507)
Other operating expenses (12 145) (10 374)
Trading profit before depreciation and amortisation 9 303 8 061
Depreciation and amortisation (2 025) (1 733)
Trading profit 7 278 6 328
Foreign exchange and other losses (109) (147)
Interest received 174 216
Finance costs (498) (415)
Profit before income tax 6 845 5 982
Income tax expense (1 998) (1 848)
Net profit for the year 4 847 4 134

Additional information:
2018 2017
Earnings per share (cents) 969,40 826,80
Dividend per share (cents) 387,76 344,50
Market capitalisation (Rm) 80 125 82 600
Number of stores 1 855 1 803
Number of employees 180 076 181 622

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STATEMENT OF FINANCIAL POSITION AT 30 APRIL 2018

2018 2017
Rm Rm

Non-current assets 20 086 18 035

Property, plant and equipment 16 908 15 374
Loans and receivables 694 725
Deferred income tax assets 599 469
Intangible assets 1 885 1 467

Current assets 28 181 25 885

Inventories 15 920 13 689
Investments (marketable securities) 2 416 2 103
Trade and other receivables 3 544 3 019
Cash and cash equivalents 6 301 7 074

Total assets 48 267 43 920

Equity and liabilities

Capital and reserves 21 403 19 160
Stated capital 3 920 3 920
Accumulated reserves 17 483 15 240

Non-current liabilities 6 516 6 227

Preference share capital 1 364 1 167
Interest-bearing debt (corporate bonds) 5 022 4 872
Provision 130 188

Current liabilities 20 348 18 533

Trade and other payables 19 555 17 435
Provision 219 138
Current income tax liabilities 574 960

Total equity and liabilities 48 267 43 920

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Additional information:

• The company has a target capital structure of 3: 0,5: 1 (Ordinary share capital: Preference share capital:
Corporate bonds). The cost of corporate bonds is JIBAR+2,05% and the cost of preference shares is 80% of
the prime lending rate. The target cost of equity is 12,212%.

• For evaluating the projects, the cash flows take place at the end of the financial year, unless stated
otherwise.

• The economic data is provided below:

Indicator 30 April
2018
Inflation rate - CPI (%) 5,25
Prime lending rate (%) 10,25
JIBAR (%) 7,00
Corporate tax rate (%) 28

• For the next five years, one South African Rand (R1) is forecasted to trade against the Mozambican Metical
as follows:

Date Annual Closing (spot)

average
May 2018 (actual) 4,082 4,082
30 April 2019 4,314 4,167
30 April 2020 4,050 4,505
30 April 2021 4,673 4,950
30 April 2022 5,005 5,181
30 April 2023 5,005 5,181

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REQUIRED

a) Describe two types of projects that are dealt with in capital budgeting and provide a business example
for each type.
(4)

b) Advise the executive committee of P2S whether it should accept any of the construction projects above,
using the capital budgeting techniques as per the company’s strategic guidelines.
(Calculations 16 marks; Comments 2 marks)
(18)

c) Considering the funding facilities currently used by P2S, discuss factors that the executive committee of
P2S will have to consider before deciding on the best financing option to fund its construction project/s.
(8)

d) Calculate the following ratios for the 2017 and 2018 financial years, using closing balances and book
values where applicable. Provide reasons for movements in the calculated ratios:
[Round the final answer to one decimal place. No marks will be awarded for simply stating whether there
was an increase or a decrease]
a. Dividend cover
b. P/E ratio
c. Average employee cost to company
d. Return on capital employed
e. Cash ratio
(Calculations 15 marks; Comments 5 marks)
(20)

[50]

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QUESTION 1

a) Independent projects: These are projects that are evaluated independent of each other, in other
words, they are not compared to one another. It is possible that both projects can be accepted if
the relevant criteria are met.

Example: Two vehicles are being evaluated for purchase, a courtesy bus for transporting staff and
a delivery truck. Clearly the purpose of both these vehicles are different and will not be compared
to one another.

Mutually exclusive projects: These are projects that will serve the same purpose and only one of
these can be selected.

Example: Two delivery trucks are being evaluated but only one is required

b) Investment appraisal

0 1 2 3 4 5
2019 2020 2021 2022 2023

Cost price (45 000 000)

Working capital (2 000 000) 2 000 000

Net cash profits 4 817 900 4 817 900 5 047 097 5 289 702
Taxation (1 143 635) (1 143 635) (1 210 538) (1 281 354)
Donation (244 173) (222 222) (212 314) -
(47 000 000) 2 000 000 3 430 092 3 452 043 3 624 245 4 008 348
Terminal value 91 243 793
(47 000 000) 2 000 000 3 430 092 3 452 043 3 624 245 95 252 141

CF CF CF CF CF CF
NPV @ 10.5% R20 426 615

IRR = 19.48% NPVI = 1.45

Only the Polokwane project meets both criteria, therefore accept

𝑵𝑵𝑵𝑵𝑵𝑵 + 𝑰𝑰𝑰𝑰𝑰𝑰𝑰𝑰𝑰𝑰𝑰𝑰𝑰𝑰𝑰𝑰𝑰𝑰𝑰𝑰
𝑵𝑵𝑵𝑵𝑵𝑵𝑵𝑵 =
𝑰𝑰𝑰𝑰𝑰𝑰𝑰𝑰𝑰𝑰𝑰𝑰𝑰𝑰𝑰𝑰𝑰𝑰𝑰𝑰

𝟐𝟐𝟎𝟎 𝟒𝟒𝟒𝟒𝟒𝟒 𝟔𝟔𝟔𝟔𝟔𝟔 + 𝟒𝟒𝟒𝟒 𝟎𝟎𝟎𝟎𝟎𝟎 𝟎𝟎𝟎𝟎𝟎𝟎

𝑵𝑵𝑵𝑵𝑵𝑵𝑵𝑵 =
𝟒𝟒𝟒𝟒 𝟎𝟎𝟎𝟎𝟎𝟎 𝟎𝟎𝟎𝟎𝟎𝟎

= 1,45

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𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪 𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷 𝟐𝟐𝟐𝟐𝟐𝟐𝟐𝟐

𝑻𝑻𝑻𝑻𝑻𝑻𝑻𝑻𝑻𝑻𝑻𝑻𝑻𝑻𝑻𝑻 𝑽𝑽𝑽𝑽𝑽𝑽𝑽𝑽𝑽𝑽 𝟐𝟐𝟐𝟐𝟐𝟐𝟐𝟐 =
𝑾𝑾𝑾𝑾𝑾𝑾𝑾𝑾 − 𝒈𝒈

𝟒𝟒 𝟎𝟎𝟎𝟎𝟎𝟎 𝟑𝟑𝟑𝟑𝟑𝟑 𝒙𝒙 𝟏𝟏. 𝟎𝟎𝟎𝟎𝟎𝟎𝟎𝟎

𝑻𝑻𝑬𝑬𝑬𝑬𝑬𝑬𝑬𝑬𝑬𝑬𝑬𝑬𝑬𝑬 𝑽𝑽𝑽𝑽𝑽𝑽𝑽𝑽𝑽𝑽 𝟐𝟐𝟐𝟐𝟐𝟐𝟐𝟐 =
𝟎𝟎. 𝟏𝟏𝟏𝟏𝟏𝟏𝟏𝟏 − 𝟎𝟎. 𝟎𝟎𝟎𝟎𝟎𝟎𝟎𝟎

= 𝐑𝐑 𝟗𝟗𝟗𝟗 𝟐𝟐𝟐𝟐𝟐𝟐 𝟕𝟕𝟕𝟕𝟕𝟕

2 3 4 5
2020 2021 2022 2023
Net profit and taxation
Growth (1.0585) (1.0585)
Sales 70 000 000 70 000 000 74 095 000 78 429 558

Trading profit margin 5.597% 5.597% 5.597% 5.597%

Trading profit 3 917 900 3 917 900 4 147 097 4 389 702

Depreciation 900 000 900 000 900 000 900 000

(45m/50)
Cash profits before tax 4 817 900 4 817 900 5 047 097 5 289 702

Effective rate
(1998/6845) 29.19% 29.19% 29.19% 29.19%

Taxation on trading
profit 1 143 635 1 143 635 1 120 538 1 281 354

7 278
𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇 𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝 = = 5.597%
130 028

1 998
𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸 𝑡𝑡𝑡𝑡𝑡𝑡 𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟 = = 29.19%
6 845

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Donation

3,3m Metical = 1.1m Meticals p.a.

2020 Y1 – 1 100 000 ÷ 4,505 = 244 173

2021 Y2 – 1 100 000 ÷ 4,950 = 222 222

2022 Y3 – 1 100 000 ÷ 5,181 = 212 314

Weighted Average Cost of Capital

Target Cost WACC

Equity 3,0 12,212% 36,636
Preference Capital 0,5 8,2% 4,1
Corporate Bonds 1,0 6,52% 6,52
4,5 47,256
÷ 4,5
10,5%

Cost of Preference Shares

10,25% x 80% = 8,2%

Cost of Corporate Bonds

(7% + 2,05%) x 0,72

= 6,52%

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c)
 Consider the current Weighted Average Cost of Capital (WACC) against the target.
 Management should consider the capacity available to raise either debt or equity to stay
within the range of the target WACC.
 Cost of various funding options must be considered when raising new funds, as these may not
be issued at the same coupon rates.
 Consider the movement in yield curves, these will affect market values.
 Consideration of additional financial risk and its impact on WACC.
 The shareholders perception of the additional risk and their required rate of return.
 Consider reducing dividends to fund capital projects.
 Management should utilise the cheapest form of funding.
 If new equity is issued, its impact on WACC must be considered.

d) Dividend Cover

2018 2017

969,40 826,80
387,76 344,50

2,5 times 2,4 times

• This ratio has improved.

• This means that the payout ratio has decreased.
• Net profit increased by a greater extent than the increase in dividend.

Price
P.E. Ratio =
Earnings
2018 2017

80 125 82 600
4 847 4 134

16,53 (16,5) 19,98 (20)

• The PE multiple has decreased.

• The share price played a significant role in this decline.
• Market capitalisation decreased (decrease in share price) indicating possible lower
confidence in future growth.

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10

Average Employee Cost to Company

2018 2017

Salaries & Wages 9 499 000 8 507 000

Number of Employees 180 076 181 622

R52,75 / Person R46,84 / Person

• The cost per employee has increased by 12,62%.

• This increase is in excess of inflation.
• This is significant as the wage bill increased despite a decrease in the number of employees.

Return on Capital Employed (Long-Term Funding)

EBIT 2018 2017

Capital Employed 7 278 6 328

27 789 25 199
26,2% 25,1%

Capital Employed
- Equity 21 403 19 160
- Preference shares 1 364 1 167
- Corporate Business 5 022 4 872
27 789 25 199

• An improvement in the ratio brought about by an increase in EBIT of 15%.

Cash & Equivalents

Cash Ratio =
Current Liabilities

2018 2017

2 416 + 6 301 2 103 + 7 074

20 348 18 533

0,43 : 1 0,50 : 1

• This ratio has worsened. Previously 50% of current liabilities could be covered by cash and
cash equivalents. This is down to 43%, increasing liquidity risk.
• The cash resources have declined while current liabilities have increased.

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Question (50 marks; 90 minutes) (MAY 2018)

High 5 Corporation (“High 5”) owns and operates retail stores that provide electronic audio-visual products and
appliances. The company has cemented its position in this market as a national chain focused on six main
categories: Television, audio products, appliances, computing, cellular and car audio. High 5 has strategically
positioned itself to save the consumer money mainly through sourcing the bulk of its products from major
electronics companies in Asia. In the past years, High 5 has been ranked ahead of its peers when it comes to the
quality of in-store and after-sales service. The surge of Asian immigrants who specialise in technology, with strong
business links to electronics companies around the world, has posed a serious threat to the business. The South
African consumers have not felt a severe impact of the depreciating Rand due to lending rates having remained
moderately low over the past few months. The credit terms offered by the company has also guaranteed that
consumers are able to meet their credit obligation, and as a result, the bad debt expense is negligible. High 5
grants its credit customers two (2) months to settle their accounts, and failure to comply with this credit policy
leads to penalty fees and interest charged to the customer account. Cash sales make one-fifth of total sales.

The company enters into CIF agreements (Cost, Insurance & Freight) with its suppliers, where the latter would be
responsible for all the costs incurred in the shipping of the merchandise to the Durban harbour (port of
destination). High 5 then uses its own transport fleet to move the inventory to the company’s depots situated in
Durban, Pretoria and Mangaung (carriage costs). High 5’s working capital policy is to pay its foreign suppliers
within a month from the time the merchandise is loaded on board the ship in the country of export. This is also
the average time that the suppliers expect to be paid. Local suppliers are seldom used and purchase costs from
these are negligible.

Owing to high value goods sold, among other things, High 5 immediately distributes most of its merchandise
directly to its stores in different metros and maintains low inventory levels at its depots. The sustainable success
of High 5 is predicated on its ability to manage its inventory levels through its robust inventory management
system, Fastel®. The company expects inventory to be on its shelves for a maximum of 20 days. Since the
introduction of the system, the company’s inventory turnover has significantly reduced the risk of obsolescence.

The management team is also evaluating its working capital strategy, especially around debtors and inventory
management, in an effort to bolster the company’s profitability. The plan is to reduce the average inventory
levels by 12,5%, leading to low inventory holding costs. Loss of profits due to stock- outs is expected to be R26
148. The company will reduce its number of weekly trips between its depots and the harbour, leading to a 10%
decrease in carriage costs. This saving relates to wages for the drivers who will be transferred to the packing
department. The low inventory levels will ensure that High 5 offers its customers the latest technology in the
market and this will lead to an increase in profits of R201 345 and increase in trade debtors of R244 000. Bad
debt expense ratio (based on current credit sales) is expected to be 0,28%.

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The financial controller has extracted the following accounts from the company’s accounting system at 30 April
2018 (the company’s financial year-end):

Account Notes Debit Credit

R 000 R 000

Sales 77 650
Interest income 1 010
Dividend income 2 342
Purchases 38 242
Carriage costs 1 208
Product marketing costs 1 777
Salaries & wages 8 773
Other operating costs 10 546
Property, plant & equipment 72 240
Investments 8 892
Cash and cash equivalents 4 608
Trade receivables 11 376
Income tax receivables 1 844
Accrued income 457
Inventory 01.05.2017 3 176
Inventory 30.04.2018 3 037
Ordinary share capital (64 cents each) 1 8 000
Share premium 1 2 000
Retained income 01.05.2017 26 313
Preference share capital (R2 each) 3 5 000
Dividends paid 2 9 175
Term loan - ENK 4 16 821
8,75% Debentures 5 22 000
Deferred tax 6 259
Trade payables 5 273
Accrued expense 1 727
Bank overdraft 956

Notes:

1. The company has a beta of 1,15 and the market risk premium is 6,5%. The yield on RSA bonds, considered
market risk-free, is 8,2%. Since the inception of High 5, there has been no movement in the share capital
of the company. The ordinary shares were initially issued at 80 cents each and are now trading at 800
cents on the JSE’s AltX.

2. During the year, the company declared and paid a dividend of 70 cents per ordinary share and 17 cents
per preference share.

3. These irredeemable preference shares were issued five years ago, and are currently trading at 200 basis
points below the prime lending rate.

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4. The term loan of R16,821 million received from Eerste Nasionale Korporasie (ENK) bears a fixed annual interest
of R1,5 million. The loan will be repaid on 25 April 2023, however, High 5 will pay a standard administration fee
of R500 000 on 25 April 2021. Borrowing the same amount of money under similar terms today would cost
High 5 an annual interest of R1,68 million.

5. The market value of the 8,75% debentures on 30 April 2018 was R20,25 million. The debentures were issued on
1 May 2015 and will be redeemed at a premium of 1% on 30 April 2023. There are no tax implications on the
premium amount.

Additional information:

• The prime lending rate is 10,25%.

• The corporate income tax rate is 28%.
• High 5’s stores opened daily during its financial year.
• Value added tax (VAT) must be ignored.

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REQUIRED

a) Calculate the weighted average cost of capital of High 5 Corporation at 30 April 2018.

[Round percentages to the nearest two decimal places]

(20)

b) Determine the cash conversion cycle of High 5 Corporation, and for each component: i).
Provide possible reasons for any deviations from the company policy, and
ii). Advise the management team on how it can be improved.

(Calculations 12 marks; Comments 6 marks)

(18)

c) Advise the management team of High 5 Corporation whether to implement the new working capital
strategy. Show all supporting calculations.
(7)

d) Describe the key business risks that High 5 Corporation faces and advise the management on how each
risk can be mitigated.
(5)

[50]

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SOLUTION

WACC

Market Value Proportion Cost WACC

Equity 100 000 000 70,43% 15,68% 11,04%
Pref. Capital 5 150 000 3,63% 8,25% 0,30%
Long-term Loan 16 578 507 11,68% 7,2% 0,84%
Debentures 20 250 000 14,26% 8,5% 1,21%
141 978 507 100,00% 13,39%

Market Value of Equity

No. of shares x Ex div Price

= 12 500 000 x R8

= R100 000 000

No. of shares

= R8 000 000 ÷ 0,64

= 12 500 000 shares

Cost of Equity

Ke = Rf + β (Rm − Rf)

= 8,2% + 1,15 (6,5%)

= 15,675% ≈ 15,68%

Market Value of Preference Shares

Po = Do�Kp Kp = 10,25% - 2%

0,17 = 8,25%
= 8,25%

= 2,06 / share x 2 500 000 shares (R5 000 000 / R2)

= R5 150 000

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Long-Term Loan

Book value of loan R16 821

Market related interest R1,68m

∴ Market return = 1,68 ÷ 16 821

= 10%

Interest and redemption Admin fees

Pmt = 1 500 000 x 0,72 FV = 500 000 X 0.72 = 360 000

= 1 080 000 i = 7.2

FV = 16 821 000 n =3

i = 7,2 PV = 292 226

n =5 TOTAL PV = R 16 578 507

PV = 16 286 281

Debentures

PV = -20 250 000

FV = 22 000 000 x 1,01

= 22 220 000

n =5

Pmt = 22 000 000 x 8,75% x 0,72

= 1 386 000

i = 8,48%

≈ 8,5%

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INFORMATION ANALYSIS [CALCULATIONS]

• Credit Sales = 4�5 x 77 650

= R62 120

• Cost of Sales

Opening Inventory 3 176

Purchases 38 242

Carriage 1 208

Closing Inventory (3 037)

39 589

Inventory Days 3 037

= × 365
39 589

= 28 days

• This is higher than management’s expectations of 20 days,

• Old Inventory likely still included in inventory levels.
• Put old items on sale.

Receivable days 11 376

= 62 120 × 365

= 66,8 days

• This is slightly over the 60 days allowed by the Company.

• Some of the bigger customers may be paying slower than required distorting the average days.
• Consider offering settlement discounts, even larger discounts for cash.

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Creditors days 5 273

= 38 242 × 365

= 50,3 days

• This seems to be completely contradictory to the 30 days terms as indicated. Possibly late shipment would
also delay payments.
• If this strategy works without compromising supply and relationships, then continue.

Cash Conversion Cycle

Actual Policy
Inventory days 28 days 20 days
Receivable days 66,8 days 60 days
Payables days (50,3 days) (30 days)
44,5 days 50 days

• Because of the delays in paying creditors, the working capital cycle is slightly better than the current policy.

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c) Evaluation of new working capital strategy

CURRENT PROPOSED DIFFERENCE

Inventory 3 037 000 2 658 000
Debtors 11 376 000 11 620 000
14 413 000 14 278 000
Savings 135 000

Opportunity cost R135 000 x 10.25% 13 838

saved
Additional profits 201 345
Bad debts R62 120 000 x .28% (173 936)
Carriage costs saved R 1 208 000 x 10% 120 800
Stock out costs (26 148)
135 899

d) Key risks and mitigation factors

RISKS MITIGATION
1 Currently only sources stock in Asia Start sourcing alternative suppliers
2 Asian immigrants’ new competitors Start sourcing new brands to give
customers alternatives
3 High level of bad debts Tighter measures required
4 Credit sales% to high Allow discounts for cash sales
5 Weakening Rand Use hedging techniques to reduce risk
6 Risk of obsolescence Regular sales to get rid of old stock

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MAC 3702
SUGGESTED SOLUTION
OCTOBER 2018 EXAM

a) When funding new projects, it is essential to consider the target debt equity ratio as this will
determine the capacity of the company to raise a particular form of funding without drastically
altering its capital structure and weighted average cost of capital.
Also note that when a company issues non-redeemable preference shares it can serve as equity
when analysing the capital structure.
Note that SA Clinic is a private company and does not have a tradeable market price.

PROPOSAL 1

Current
capital Target capital
structure structure Capacity
Book value
Equity 14 240 000 (1) 25 410 000 (3) 11 170 000
Debentures 3 560 000 (2) 10 890 000 (4) 7 330 000
17 800 000 36 300 000 18 500 000
New R12 500 000 x
project 18 500 000 1.48
36 300 000

1. R36 300 000 x 70%

2. R36 300 000 x 30%
3. R25 410 000 – R14 240 000
4. R10 890 000 – R3 560 000

No of ordinary
shares to be issues
Total value 11 170 000
Net price ÷ R3,86 (R4.05 – 4.78%)
2 893 782
Shares

No of debentures
Total value 7 330 000
Nominal value R70,00
104 714
Debentures

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PROPOSAL

No of Preference
shares to issued
Total value 11 170 000
Nominal value ÷ R100,00
111 700
preference
shares

No of debentures
Total value 7 330 000
Nominal value R70,00
104 714
Debentures

b) Weighted average cost of capital

Weighted average cost of capital

Value Weight Cost WACC
Equity 14 240 000 81,34% 11,94% 9,71%
Debt 3 267 330 18,66% 8,64% 1,61%
17 507 330 100,00% 11,32%

Cost of equity: In order to calculate the cost of equity we need the current market price. Since the
company is not listed, this information is unavailable. The R4,05 given in the question is not an
indication of fair value as this is a private company and the issue price could have been agreed upon
by the shareholders to raise the funds.

I have therefore used the current issue price of R3,25 as per the statement of financial position

Growth: The question states that growth will double going forward, therefore 3.5% x 2 = 7%.

𝐷1
𝐾𝑒 = +𝑔
𝑃0

0.15 𝑥 1.07
𝐾𝑒 = + 0.07
𝑅3.25

𝐾𝑒 = 11.94%

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Market value of debentures

1 2 3 4
2019 2020 2021 2022
Capital repayment (3 560 000)
Premium (1) (11 392)
Interest paid (300 000) (300 000) (300 000) (300 000)
Tax benefit on interest (2) 84 000 84 000 84 000 84 000
Tax benefit on premium (3) 3 190
(216 000) (216 000) (224 202) (3 776 000)
𝑃𝑉 @ 8.64%: − 216000𝑐𝑓, −216000𝑐𝑓, −224202𝑐𝑓, −3776000𝑐𝑓, 8.64𝑖 𝐶𝑜𝑚𝑝 𝑁𝑃𝑉
𝑵𝑷𝑽 = 𝑹𝟑 𝟐𝟔𝟕 𝟑𝟑𝟎
𝑲𝒅 = 𝟏𝟐% 𝒙 𝟎. 𝟕𝟐 = 𝟖. 𝟔𝟒%

1. R3 560 000 x 0.32%

2. R300 000 x 28%
3. R11 392 x 28%

c) Foreign exchange profit or loss

FEC rate at 1 December 2018 1,48

Spot rate at 1 January 2019 1,58
Gain (0,10)
Foreign amount 12 500 000
Gain (1 250 000)

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d) Risks and mitigating factors of implementation

RISKS MITIGATING FACTORS

1. Viability is not certain 1. Detailed research needs to be undertaken
including the preparation of a capital
budget
2. Operating skills and servicing of machines 2. Ensure that we sufficient skills to ensure
that machines are operated as intended
and also that servicing can be done locally
– send relevant people overseas for
training
3. Timing of implementation 3. Proper planning will ensure that delays are
kept to a minimum
4. Funding of project 4. Availability of funds – funding must be
secured ASAP as this will cause further
delays
5. Affordability of repayments and interest 5. Proper budgeting will help make better
financial decisions
6. Medical aid schemes not authorising 6. Hold meetings with medical aid schemes
treatment to ensure that that proper procedures are
followed to ensure that patients are able to
use the service without worrying about the
costs

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e) Ratio analysis

Change in other operating income

470
− 1 = −11.32%
530
No available information with respect this line item. Management needs to identify reasons for
the decrease. Given that this is a clinic, it may relate to sales of over-the-counter medication and
supplies.

EBITDA margin
𝑬𝑩𝑰𝑻𝑫𝑨
=
𝑹𝒆𝒗𝒆𝒏𝒖𝒆

2018 2017
1640 + 560(𝑑𝑒𝑝) 1380 + 420(𝑑𝑒𝑝)
= =
6600 5500
= 33.33% = 32.73%

• The margin increased very slightly

• This was caused by the fact that revenue increase by a higher rate than operating costs
• Revenue increased by 20% while operating costs increased only by 15.13%
• An indication either of cost control measures or that the clinic was able to pass on any cost
increases to patients

Effective tax rate

𝑻𝒂𝒙 𝒄𝒉𝒂𝒓𝒈𝒆
=
𝑷𝒓𝒐𝒇𝒊𝒕 𝒃𝒆𝒇𝒐𝒓𝒆 𝒕𝒂𝒙

2018 2017
334 307
= =
1260 1060
= 26.51% = 28.96%

• Effective rates differ from statutory rates as a result of permanent differences.

• In 2017 it seems we had items that were not deductible for tax purposes while in 2018 it
seems we had items of income that were not taxable

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Times interest earned (Interest cover)

The number of times interest is covered by EBIT

𝑬𝑩𝑰𝑻
=
𝑰𝒏𝒕𝒆𝒓𝒆𝒔𝒕 𝒑𝒂𝒊𝒅

NB: Interest received generally not a sustainable income item. Sometimes solutions net-off
the interest. This ratio is about financial risk and the ability to meet interest payments. I
therefore recommend not to net-off the interest received against the interest paid

2018 2017
1640 1380
= =
420 340
= 3.9 𝑡𝑖𝑚𝑒𝑠 = 4.06 𝑡𝑖𝑚𝑒𝑠

• Interest costs have increased for no logical reason as the non-current debt is the same as
2017 and the short-term borrowings have decreased.
• Notwithstanding this, EBIT has increased by R260 000 while the interest only by R40 000
which gives rise to the slight drop in the interest cover.

Capital gearing ratio

𝑳𝒐𝒏𝒈 − 𝒕𝒆𝒓𝒎 𝒊𝒏𝒕𝒆𝒓𝒆𝒔𝒕 𝒃𝒆𝒂𝒓𝒊𝒏𝒈 𝒅𝒆𝒃𝒕(𝑳𝑻𝑫)

=
𝑳𝑻𝑫 + 𝒆𝒒𝒖𝒊𝒕𝒚

2018 2017
3560 3560
= =
3560 + 14240 3560 + 13830
= 20% = 20.47%

• This ratio has improved slightly but as a result of decreased debt but rather an increase in
retained profits

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Dividend pay-out ratio

𝑫𝒊𝒗𝒊𝒅𝒆𝒏𝒅 𝒑𝒆𝒓 𝒔𝒉𝒂𝒓𝒆
=
𝑬𝒂𝒓𝒏𝒊𝒏𝒈𝒔 𝒑𝒆𝒓 𝒔𝒉𝒂𝒓𝒆

2018 2017
0.15 0.1449
= =
0.2692 0.2189
= 55.72% = 66.2%

2018 2017
𝑅926 000 𝑅753 000
𝑒𝑝𝑠 = 𝑒𝑝𝑠 =
3 440 000 3 440 000
= 0.2692 = 0.2189

Dividend 2017: Dividend growth is 3.5% therefore Div2018 is 3.5% bigger than Div2017
∴ R0.15 ÷ (1+3.5%) = R0.1449
𝑁𝑜 𝑜𝑓 𝑠ℎ𝑎𝑟𝑒𝑠 = 𝑅11 180 000 ÷ 𝑅3.25 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒 = 3 440 000 𝑠ℎ𝑎𝑟𝑒𝑠

• It is clear that the policy is not a stable % (ratio) of earnings

• The reason for the decline is that eps grew by 23% while dividends growth was at 3.5%.

Return on equity
𝑷𝒓𝒐𝒇𝒊𝒕 𝒂𝒇𝒕𝒆𝒓 𝒕𝒂𝒙
=
𝑬𝒒𝒖𝒊𝒕𝒚

2018 2017
𝑅926 000 𝑅753 000
= =
𝑅14 240 000 𝑅13 830 000
= 6.5% = 5.45%

• Equity remained fairly stable while earnings per share grew by 23%
• More of revenue was converted into profits.
• As mentioned earlier revenues increased at a better rate than costs.

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f) Free cash flow

Free cash flow

R
Profit before taxation 1 260 000
Add: Depreciation 560 000
Add: Long term interest 300 000
Less: interest received (1) (40 000)
2 080 000
Taxation (2) (406 800)
1 673 200
Working capital 225 000
Inventory (5000’ – 4550’) 450 000
Trade and other receivables (2050’- 1840’) (210 000)
Short-term borrowings (180’- 140’) (40 000)
Trade and other payables (45’- 20’) 25 000
1 898 200
Capital expenditure (3) (1 035 000)
863 200

1. Interest received is assumed to be earned from cash and cash equivalents. It has been left out of
the free cash flow as the actual cash balances will be added to the value.
2.
Taxation R
Taxation per SOCI 334 000
Add: Tax on interest paid 84 000
Less : tax on interest received (11 200)
406 800

3.
Capital expenditure R
Opening carry value 9 500 000
Depreciation (560 000)
Closing carry value (9 975 000)
(1 035 000)

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Value of operations

𝐹𝐶𝐹1
𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑜𝑝𝑒𝑟𝑎𝑡𝑖𝑜𝑛𝑠 =
𝑊𝑎𝑐𝑐 − 𝑔

𝑅863 200 𝑥 1.07

𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑜𝑝𝑒𝑟𝑎𝑡𝑖𝑜𝑛𝑠 =
11.32% − 7%

𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑜𝑝𝑒𝑟𝑎𝑡𝑖𝑜𝑛𝑠 = 𝑅21 380 185

Valuation

Value of operations 21 380 185

Add: Cash and cash equivalents 1 410 000
Less: Market value of debt (3 267 330)
Value before owner level adjustments 19 522 855
Less: Marketability discount say 20% (3 904 571)
Less: Minority discount say 15% (2 928 428)
12 689 856
26% thereof 3 299 362

Net asset value

Net asset value

Net equity 14 240 000
Fair value adjustment property (R3.8m – R2.0m) 1 800 000
16 040 000

The NAV is being compared to the FCF value before owner level adjustments.
The Difference in value is due the fact that NAV is based on historical results which excludes
potential growth, while the FCF method has been based on future sustainable cash flows with
growth built into the valuation

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10

g) Mobile units NPV

Mobile units appraisal

0 1 2 3 4 5
Cost price (4 500 000)
Residual value (1) 900 000
Net operating CF 593 000 555 680 1 731 121 1 689 188 1 644 739
Grant received (2) 1 215 000 1 215 000 2 430 000 2 430 000 2 430 000
Maintenance (3) (100 000) (106 000) (112 360) (119 102) (126 248)
Nurses salaries (4) (360 000) (381 600) (404 496) (428 766) (454 492)
Other (162 000) (171 720) (182 023) (192 945) (204 521)
(4 500 000) 593 000 555 680 1 731 121 1 689 188 2 544 739

𝑵𝑷𝑽@𝟏𝟓% = −𝑹𝟏𝟗𝟒 𝟗𝟓𝟎

−4500000𝑐𝑓, 593000𝑐𝑓, 555680𝑐𝑓, 1731121𝑐𝑓, 1689188𝑐𝑓, 2544739𝑐𝑓, 15𝑖 𝑐𝑜𝑚𝑝 𝑁𝑃𝑉

Calculations
1. R4 500 000 x 20%
2. 2 single payments then 3 double payments: 𝑥 + 𝑥 + 3(2𝑥) = 𝑅3 240 000𝑥 3𝑢𝑛𝑖𝑡𝑠
∴ 𝑥 = 𝑅1 215 000 𝑎𝑛𝑑 2𝑥 = 𝑅2 430 000
3. R25 000 x 4 quarters = R100 000, increase by 6% thereafter
4. R120 000 per nurse x 3 = R360 000, increase by 6% thereafter
5. R4 500 x 12 months x 3 units = R162 000, increase by 6% thereafter

h) The NPV is negative, therefore from a quantitative perspective the project should be rejected.
From a qualitative perspective
• To try and procure additional funding as this is a PBO
• The service is for the community and maybe to negotiate better prices on the mobile units
• Try to get some private funding as well

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11

i) Risks associated with running mobile clinics

• Mobile clinics run the risk of being removed/stolen and may require security
• The mobile units can be broken into during the night where supplies are stolen
• The costs of moving from area to area can be costly as the three units fulfil different
functions and must all move together.
• Damage to mobile units while in transit (Insurance)
• Government tends to delay payments. What if grants are not received timeously?
• Risk that the grant money is not utilised properly. The risk of fraud or corruption.

j) Effects and risks of HIV in the workplace

• People with HIV are singled out in the workplace and bear the risk of intimidation
• People with HIV are likely to fall ill, and this affects productivity
• Should a worker die of HIV, new workers need to be employed and trained. This comes at a
cost
• Companies, as part of their social responsibility, need to make regular testing available at
the work place at their own cost
• Should workers be working with sharp tools, etc there is a higher of contamination.

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MAC3702

MAY/JUNE 2019
SUGGESTED SOLUTION

QUESTION 1

a)

REPORT
TO:
FROM:
DATE:
SUBJECT:

Dear Sir/Madam

Following your request, we have performed a SWOT analysis of the company and present our findings
below.

Strengths

• The company has strict food guidelines. Products were tested negative for listeriosis.
• Owns its own abattoir so they can control slaughtering and storage process.
• They have good recruitment processes.
• There are good working conditions and management ensures that staff morale is high.
• They have skilled workers which ensures that food quality is not compromised
• Advertising digital campaign may strengthen its position in the market.
• The company strictly adheres to guidelines and legal requirements with respect to all the applicable
Acts.
• Workers are well compensated, and this ensures staff retention.

Weaknesses

• Too many policies and procedures and some policies may easily be compromised.
• Decision-making is complex and lengthy which does not facilitate quick action.
• Large footprint may prove difficult to control.
• Heavily dependent on key skilled personnel which puts the employee in a better bargaining
position with the company

Opportunities

• Potential acquisition creates new market opportunities.

• Advertising digital campaign may create an opportunity to gain bigger market share as the public
may see the company as being responsible and safety conscious.

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Threats

• Too many products may cause cross-contamination.

• Legislation implementation too numerous
• Risk of non-compliance is high
• Less people will buy processed meats as customers may paint the company with the same brush.
• Threats on cash-flow with respect to regular capital expenditure.
• Reputational damage of the industry could cause financial losses

Kindly contact us should you wish to discuss this further.

Yours faithfully

Never sign your own name in the exam CA(SA)

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b) Human Capital

Training spend

% increase =
5 800
−1
5 100

= 13,73%

Number of employees increase 602

= −1
582

= 3,43%

Average training spend per employee 2018 2017

5 800 000 5 100 000
602 582

R9 634,55 / person R8 762,89 / person

% increase in training spend per person =

9 634,55
−1
8 762,89

= 9,9%

The company has employed more people in 2018. The number of employees is up 3,43% from 582
people to 602 people.

The company in total has spent an additional 13,73% on training which translates to an average
increase of 9,9% per person.

Staff resignations have also declined from 11% in 2017 to 8% in 2018.

Clearly the company is making progress with respect to its human capital.

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Natural Capital

Electricity consumption =
15,5 mil
15,1 mil

= 2,65%

Kilowatt hrs consumption went up despite the implementation of energy efficient lighting. The
production facilities with respect to power usage by machines may be responsible for the increase.

Water consumption
Decrease % =
7 050
−1
9 100

= -22,53%

Water consumption has decreased by 22,53%. The medium pressure wash-down system is clearly
working, however, not yet at the 30% mark.

Greenhouse gas emission

Increase % =
24 569
23 874

= 2,91%

This is cause for concern. Management needs to implement measures to curb these Greenhouse gas
emissions, maybe by employing an environmental expert.

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c) WACC

Market Weight Cost WACC

value
Equity 3 216 m 74,13% 11,77% 8,73%
Preference shares 379,75 m 8,75% 9% 0,79%
Long-term loan 742,47 m 17,12% 7,56% 1,29%
4 338,22 m 100,00% 10,81%

Equity

Ke =
𝐷𝐷1
+g
𝑃𝑃0

(35m+45m)×1,0906
= 3 216
+ 0,0906

= 11,77%

Preference shares – No redemption date ∴ assume perpetuity

P0 =
D0 Loan = 1/11/2014 – 30/10/2019
Kp

=
105m ×0,3255 FV = 750m
9%
PMT = 750m x [10,25%-1.25%] x 0.72
= 379,75m i = (10,25 + 0,25 ) x 0.72
n = 1
PV = 742,47

𝐾𝐾𝐾𝐾 = 10.5 𝑥𝑥 0.72 = 7.56%

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d) Existing Capital Structure

• Equity (include non-redeemable preference shares) 3 595 750 000 82,88%

Debt 742 470 000 17,12%
4 338 220 000 100%

The company has low levels of debt which means low levels of financial risk. However, the company
must consider its target capital structure and its capacity to raise either debt or equity. Additional
debt will lower the weighted average cost of capital but will increase financial risk.

• Gross Profit Margin Gross Profit 1 250 − 603

= =
Sales 1 250

= 51,76%

Gross profit percentage can be improved by controlling input costs such as raw material, labour and
overhead cost. Also, improved sales levels above inflation will contribute towards a better gross
profit.

• Effective Tax Rate Taxation 86

= =
Profit before Taxation 397m − 110m

= 29,965%

This is probably attributable to expenditure that was not deductible for tax purposes. Better tax
planning may improve this ratio.

• Interest cover Profit before interest and tax 397m

= =
Interest 110m

= 3,61 times

Improved profitability and a reduction in interest bearing debt will lead to a better ratio.

• Dividend yield Dividend Paid 80m

= =
Market Price 3 216m

= 2,48%

Higher pay-out ratios will improve this ratio.

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• Price/sales multiple Price 3 216m

= =
Sales 1 250m

= 2,57 times

An improvement in the share price will have a positive impact on this ratio or lower sales. However
lower sales is not something a company would want.

• Operating costs
% of sales Operating Expenses ∗ 250
= =
Sales 1 250m

= 20%

*Operating Expenses

Gross profit [1 250m – 603m] 647

Profit before tax and interest (397)
250

More cost control, especially over fixed costs will have a positive effect on the ratio. Increased
revenue will also have a positive effect of improving this ratio.

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e)
Sustainable profits
2018 2017 2016
R’000 R’000 R’000
Profits before taxation 36 592 74 595 54 625
Restraint of trade 8 000 - -
Once of grant (1) (9 570)
GP on delayed sales(2) 14 118
58 710 65 025 54 625
Taxation @ 26,83% (15 752) (17 446) (14 656)
Profit after taxation 42 958 47 579 39 969
Weighted average x3 x2 x1
128 874 95 158 39 969

Sum 264 001

Weighted average (÷ 6) 44 000

(1) $725 000 x R13.20

(2) R30 000 000 ÷ 0.68 x 0.32 ( note that GP% is 32%)

PE Multiple
Similar listed company [1 ÷ 8.888%] 11,25
Specific risk adjustments
Size of company -
Opportunity with respect treatment of Listeriosis +
Reliance on key manager -
Poor performance -
Turnover expected to grow +
Estimated PE 9

Valuation R’000
Earnings 44 000
PE multiple 9
Value before owner level adjustments 396 000

Marketability discount 4% (15 840)

Control premium 10% 39 600
419 760

75% of value 314 820

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f)

Divisible projects
These projects are projects that can be broken down into smaller parts when undertaken. This is usually
important when sufficient capital may not be available to embark on the entire project all at once.
Projects Eishkom and Sediba can be done in stages, for example one plant at a time. However, the E-
learning platform will have to done in one go and is therefore not considered as divisible.

Independent projects
Projects are said to be independent when they are stand-alone and not compared to other projects
during the selection process. If the NPV is positive it will be accepted and if negative will be rejected. All
3 projects are for different purposes and are therefore independent of one another.

Mutually exclusive projects

Mutually exclusive projects are projects that are compared to one another and only one or the other can
be selected. The project with the highest NPV or highest IRR will be selected. All 3 of the projects are for
different purposes are therefore not compared to one another and are therefore not mutually exclusive.

Capital rationing
Capital rationing is the process of allocating limited capital to projects that will maximise, in
combination, shareholders wealth. In other words, a mix of independent projects where their combined
NPV’s maximise shareholder wealth, obviously within the constraints of the available capital. The NPV’s
of the 3 projects will need to be compared and the best combination selected with capital constraints.

g) Consequences of the Listeriosis outbreak

• Processed food manufacturers had to withdraw products from the shelves of supermarkets and the
like costing billions of rands with respect to loss of profits as well as incurring substantial costs to
dispose of the products

• Additional costs had to be incurred to ensure safety of products and no cross contamination of
products. This had had significant consequences for cash flows.

• Loss of lives have caused loss of productivity and capacity in the economy.

• Compensation to families have also put pressure on companies with respect to cash flows as well as
reputational damage.

• Additional compliance issues have come at a substantial cost

• All of the above factors have far reaching effects on the economy.

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