Download as pdf or txt
Download as pdf or txt
You are on page 1of 300

(iii) TOE408-W/1/2006-2007

ZAC408-H/1/2006-2007

INDEX

QUESTION REFERENCE T/L* PAGE

Question Solution
1 Skylite Helis (Pty) Ltd 1 125
2 Cushions Galore Ltd 3 127
3 Sucof (Pty) Ltd 5 129
4 Amakhya (Pty) Ltd 6 131
5 Plasto Ltd 8 133
6 Fashion (Pty) Ltd 10 136
7 Bester Builders 13 140
8 Goodies Ltd 15 143
9 NuCare Ltd 17 149
10 Distilt Ltd 19 151
11 Electro Motors Ltd 20 156
12 National Chemical Corp Ltd 23 161
13 Basson (Pty) Ltd 27 164
14 Space Age Ltd 28 169
15 Winegrowers Ltd 30 173
16 AA Manufacturing Ltd 32 177
17 Gempatch Ltd 34 180
18 Cycle Ltd 36 183
19 Foodcor Ltd 39 189
20 Techno 2020 Ltd 41 191
21 Flora Ltd 43 194
22 Almetals Ltd 45 198
23 Gauteng Transport Ltd 48 203
24 Fuelit Ltd 51 206
25 New Life Pharmaceuticals Ltd 53 210
(iv)

QUESTION REFERENCE PAGE


T/L* Question Solution
26 Retail Action Ltd 55 212
27 Creative Ltd 63 217
28 Ditech Ltd 64 220
29 Quickcon Ltd 67 224
30 Kwiktune Ltd 69 227
31 Viva Investment bank Ltd 71 229
32 Secure (Pty) Ltd 74 235
33 Security Systems (Pty) Ltd 76 237
34 Shop & Drop Ltd 78 239
35 Transport Holdings Ltd 82 241
36 SNA Retail Stores Group Ltd 85 246
37 SNA Retail Stores Group Ltd 85 251
38 Holdme Ltd 93 255
39 Professional Firm 96 258
40 Mega Mix Ltd 98 263
41 Peace-of-Mind Ltd 101 266
42 Outtel Ltd 105 268
43 FRA Ltd 108 272
44 Higro Ltd 110 275
45 Diamond Design Ltd 112 278
46 Chemical Partners 114 284
47 Steelco Ltd 120 291
48 John Doe Ltd 122 294

Note: All questions are SAICA sourced unless specifically indicated otherwise.
* Tutorial references can be completed by using the individual tutorial letters.
1 TOE408-W/1
ZAC408-H/1

QUESTION 1 35 marks

Officials of the Departments of Agriculture and Forestry travel extensively throughout South Africa. This
includes travelling to outlying and sometimes inaccessible areas.
In order to increase efficiency the directors general of the two departments decided to pool their
respective budget allocations for travelling and to change their transport policies with a view to placing
greater reliance on helicopters. It was further decided to outsource this service.
The contract was awarded to Skylite Helis (Pty) Ltd, a private air charter company. This contract
contained the following conditions:

• Skylite Helis (Pty) Ltd would provide helicopter services to the departments as and when required.
• Two different types of helicopters could be used depending on the circumstances, viz. a Macdonald
Douglas MD 500 and a Sikorsky 576C.
• The contract covers a period of one year commencing on 1 September 1998.
• The contract price is based on actual total cost per flying hour plus 15%.
• The two departments warranted minimum flying hours for the duration of the contract as set out
below:
MD 500 576C
Flying hours 1 200 900

Based on actual utilisation of the helicopters for the first six month period of the contract the management
of Skylite Helis (Pty) Ltd concluded that the warranted utilisation would not be achieved. Application was
therefore made to the Court to recover the resulting loss of income from the departments.

Legal counsel for the two departments concluded that they would probably lose the court case and
advised that an out-of-court settlement be negotiated.

The departments commissioned you to assist them in obtaining a reasonable settlement. On enquiry you
managed to obtain the following information from the departments and Skylite Helis (Pty) Ltd:

1. Budgeted direct cost figures used by Skylite Helis (Pty) Ltd to calculate a contract rate per flying
hour comprise the following:

MD 500 576C
R R
Direct costs
Fixed
Pilot salaries 180 000 180 000
Lease payments 186 000 540 000
Insurance 193 470 335 220
Variable
Fuel 147 888 136 512
Minor servicing 36 000 27 000
Lease payments - 432 000
2 TOE408-W/1
ZAC408-H/1

2. Budgeted indirect costs figures used by Skylite Helis (Pty) Ltd to calculate a contract rate per flying
hour comprise the following:
Fixed Variable
R R
Indirect costs
Maintenance 156 000 840 000
Hangar rent 108 000 -
Administration 660 000 -

Notes

• Maintenance and administration costs are allocated to each helicopter based on flying hours.
• Hanger rent is allocated equally to each helicopter.

3. The following flying hour statistics are available:


MD 500 576C
Actual flying hours for the first six months 299 204
Revised estimated total flying hours for the year 450 800

4. In the view of the pending court action and the sensitive stage of the negotiations, Skylite Helis (Pty)
Ltd is not prepared to provide you with actual cost figures for the first six months. You have
therefore assumed that:

• Actual costs for the first six months approximate budgeted costs; and
• Fixed costs are incurred evenly over the year.

5. The departments have indicated that they would be prepared to compensate Skylite Helis (Pty) Ltd
for the loss of income suffered over the first six months. However, due to cash flow constraints they
would prefer this recovery to be spread over the remaining six months and to be incorporated into a
revised contract price per flying hour.

REQUIRED

(a) Calculate the original contract price per flying hour for each helicopter and the anticipated profit
Skylite Helis (Pty) Ltd would have achieved in terms of the contract. (10)

(b) Calculate the recommended new rate per flying hour per helicopter for the remaining term of the
contract based on:

(i) a return of 15% on total costs incurred; and (12)


(ii) the initial anticipated profit Skylite Helis (Pty) Ltd would have achieved in terms of the contract

(c) Advise the departments which rates should be used for purposes of negotiating a settlement; and

(d) Discuss the appropriateness of the bases used to allocate indirect costs. (5)
3 TOE408-W/1
ZAC408-H/1

QUESTION 2 30 marks

This question consists of two parts which are independent of one another.

PART 1 20 marks

Cushions Galore Ltd is considering a package of proposals for design changes in one of a range of
decorative cushions. The proposals are as follows:

(a) Eliminate some of the decorative stitching from the cushions.

(b) Use cotton tassels instead of silk tassels on the cushions (four per cushion).

(c) Change the filling material used. It is proposed that scrap fabric left over from the cushion cover
be used instead of the synthetic material which is currently used.
The design change proposals have been considered by the management team and the following
information has been gathered:

(i) Cotton tassels will cost R300 per hundred whereas the existing silk tassels cost R500 per
hundred. The cotton tassels will fray more easily when being attached to the cushions leading
to a rejection rate of 10% of the quantity of tassels issued from stores as compared to 5% of
issues of silk tassels at present.

(ii) The synthetic filling material costs R900 per ton. One ton of filling is sufficient for 3 000
cushions.

(iii) Scrap fabric to be used as filling material will need to be cut into smaller pieces before use and
this will cost R1,50 per cushion. There is sufficient scrap fabric for the purpose.

(iv) The elimination of the decorative stitching is expected to reduce the appeal of the product, with
an estimated fall in sales by 15% from the current level. It is not felt that the change in tassels
or filling material will adversely affect sales volume. The elimination of the stitching will reduce
production costs by R2,30 per cushion.

(v) The current sales level of the decorative cushions is 30 000 units per annum. Apportioned
fixed costs per annum are R900 000. The net profit per cushion at the current sales level is R15.

REQUIRED

(a) Using the information given in the question, prepare an analysis which shows the estimated effect
on annual profit should all three proposals be implemented. (The proposals for cotton tassels
and the use of scrap fabric should be evaluated after the stitching elimination proposal has been
evaluated.); (9)

(b) Calculate the percentage reduction in sales resulting from the stitching elimination, at which the
implementation of all three design change proposals would result in the same total profit from the
cushions as that earned before the implementation of the changes in design; (6)

(c) Discuss what additional information should be obtained before a final decision is taken with regard
to the implementation of the proposals. (5)
4 TOE408-W/1
ZAC408-H/1

PART 2 10 marks

Outdoors Unlimited manufactures and sells exclusive wooden patio furniture. The furniture comes in sets
consisting of a table, chairs and an umbrella. The size of the table depends on the number of chairs,
which can be 4, 6, or 8. All the inventory is displayed in the stores as they do not have a warehouse. The
area of display required for each table size is as follows:

4 seater 9m2
6 seater 12m2
8 seater 15m2

They are thinking of opening another smaller store in a new waterfront development. The store area
available for display is 400m2. As they do not want to operate a warehouse, it is crucial that they stock
the right mixture of inventory on the floor. The estimated sales are based on the sales from their existing
store which has a display area of 500m2. They have approached you for advice as to which sets should
be carried on the floor.

The cost accountant has supplied you with the following information per set:

4 seater 6 seater 8 seater


Estimated sales per month 12 20 8
Selling price 2 500 4 000 7 000
Cost of wood 1 000 1 500 3 000
Labour 500 700 1 000
Fabric 200 250 300

Three sales people are to be employed at a salary of R3 000 per month each and commission of 10% of
the selling price of a set. The monthly rent of the store is R12 000 per month and insurance is R3 000 per
month.

REQUIRED

(d) Advise your client as to how many sets of each type should be carried in inventory; and (7)

(e) Estimate the net profit based on this sales mixture. (3)
(Unisa)
5 TOE408-W/1
ZAC408-H/1

QUESTION 3 40 marks

Sucof (Pty) Ltd, a manufacturing concern, is introducing a new product, Rica. To manufacture Rica the
company has to hire machinery at a cost of R300 000 per annum. This will enable them to manufacture
120 000 units per annum. The engineering department, however, reports that capacity can be further
increased by 40 000 units per annum for every additional machine which can be hired at R80 000 per
machine per annum. However, because of the lack of space it is not possible to increase production
beyond 180 000 units. The minimum rental period is for one year and the variable material cost is
estimated to be R3,00 per unit produced. There are no other fixed costs that can be specifically traced to
the product or are considered relevant.

The marketing department has estimated that maximum selling prices for a range of output from 100 000
units to 180 000 units are as follows:

Units sold: 100 000 120 000 140 000 160 000 180 000 180 000+
Selling price: R11,00 R10,00 R9,50 R9,00 R8,50 R7,50

REQUIRED

(a) resent relevant financial information to management for the pricing and output decision; (8)

(b) discuss the long-term and short-term implications and benefits based on a decision that a selling
price of R7,50 is assumed; (6)

(c) do a sensitivity analysis between the sales price of R9,50 and R9,00 and 140 000 and 160 000 units
sold; (6)

(d) discuss the difference between a price skimming policy and a penetration pricing policy; (5)

(e) define and illustrate the following:

• opportunity costs
• incremental cost
• target costing
• learning curve
• marginal costs (10)

(f) discuss why costs such as:

• labour
• electricity
• rent of factory

do not reflect in the deliberations. (5)

(UOFS - adapted)
6 TOE408-W/1
ZAC408-H/1

QUESTION 4 40 marks

Amakhya (Pty) Ltd owns a safari lodge in Limpopo. The lodge has luxurious accommodation facilities
catering for a maximum of 20 guests, and is renowned for its cuisine. The company focuses on providing
a unique African experience to tourists. Amakhya (Pty) Ltd has been offering photographic safaris and
hunting trips to tourists for a number of years. The majority of guests are from the USA and Germany, and
they often return to the lodge for subsequent safaris and hunting trips. The only business of Amakhya
(Pty) Ltd is the operation of the safari lodge.

The management team of Amakhya (Pty) Ltd has recently completed the operating budget of the
company for the financial year ending 31 December 2001. The key assumptions in the budget are
summarised below:

• The lodge will be open to guests for 350 days during the year and will operate at an average
occupancy level of 60%.

• Rates are to be $300 per night for photographic safari guests and $250 per night for hunting guests.
The accommodation rate includes all meals and drinks.

• Guests participating in the hunting trips will be charged per animal kill, and prices vary according to
animal species. The budget assumes that $4 000 per hunting trip of revenue will be generated from
this source. These trips last for five days and hunting parties will generally comprise four guests and
one professional game hunter. The meat from animals hunted is used for catering. The value of
consumable meat from each hunting trip is estimated to be R2 000, which is equal to the cost of
purchasing similar meat for catering purposes.

• It is estimated that 60% of guests will be visiting the lodge for the photographic safari outings and 40%
of the guests will be going on hunting trips.

• For purposes of the budget, the Rand:US $ exchange rate has been assumed to be 7,50:1 throughout
the period.

• The effective tax rate of the company is expected to remain at 30%.

• Operating costs of Amakhya (Pty) Ltd are forecast as follows:


R
Salaries and wages 1 890 000
Maintenance of buildings 347 000
Fuel 68 000
Operating costs of vehicles, excluding fuel 88 000
Food and drinks R120 per guest per day
Linen and laundry 295 000
Marketing and advertising 320 000
Electricity 310 000
Net interest expense 200 000
Other overheads 350 000

The cost of hiring professional hunters to accompany guests on hunting trips represents 20% of the
budgeted salaries and wages expense. Slaughter and meat processing expenses represent 10% of
other overhead expenditure.
7 TOE408-W/1
ZAC408-H/1

• Amakhya (Pty) Ltd relies on travel agents and inbound tour operators to attract guests to the safari
lodge. Management estimate that 80% of bookings in the 2001 financial year will be done via travel
agents and inbound tour operators, who charge a commission of 7,5% of the guest rate per night for
arranging such bookings.

• The company is budgeting R1 million in 2001 for the replacement of game resulting from natural
attrition. The replacement of game as a result of hunting activities is expected to cost R750 000 in the
2001 financial year.

• At the commencement of the 2001 financial year, Amakhya (Pty) Ltd had the following assets:

R
Land 15 000 000
Buildings 6 500 000
Vehicles 1 400 000
Game 10 000 000
Current assets 1 200 000

The company does not intend to acquire any further property and vehicles in the forthcoming financial
year. Working capital levels do not vary materially during the year. Amakhya (Pty) Ltd depreciates
buildings over 20 years and vehicles over five years.

The non-executive chairman of, and majority shareholder in Amakhya (Pty) Ltd, Mr Eco Green, has had a
change of heart regarding offering hunting trips to guests. He is of the opinion that hunting trips are
contrary to the spirit of eco-tourism and Amakhya (Pty) Ltd should not permit hunting except for necessary
culling as recommended by conservationists. Mr Green has requested that the following issues be
discussed at the next meeting of the board of directors of Amakhya (Pty) Ltd:

1. The potential impact of discontinuing hunting trips on the profitability of the company;
2. The company's return on total assets; and
3. The marketing and advertising strategy of the company. Mr Green proposes that the payment of
exorbitant commissions to travel agents and inbound tour operators be discontinued and that the
company embark on a strategy of obtaining bookings via internet travel portals, whose
commission rates are much lower.

REQUIRED

(a) Calculate the estimated return on total assets of Amakhya (Pty) Ltd in the 2001 financial year and
comment on whether this is a reasonable return for shareholders. (20)

(b) Calculate the impact of discontinuing hunting trips for guests on the budgeted profitability of
Amakhya (Pty) Ltd, assuming that occupancy levels remain at 60% as per the budget. (5)

(c) Indicate what other factors Amakhya (Pty) Ltd should consider in evaluating whether to
discontinue hunting trips. (5)

(d) Discuss the factors Amakhya (Pty) Ltd should consider prior to changing its strategy to one of
obtaining bookings via internet travel portals as opposed to obtaining bookings via travel agents
and inbound tour operators. (10)
8 TOE408-W/1
ZAC408-H/1

QUESTION 5 40 marks

Plasto Ltd is engaged in the production of plastic garden tools.

Budgeted overheads for the year are:

FACTORY
Administrative Moulding Finishing General
and overhead
distribution
Variable overhead R000 7 875 1 600 500 1 050
Fixed overhead R000 1 020 2 500 850 1 750
Budgeted activity
Machine hours (000) 800 600
Practical capacity
Machine hours (000) 1 200 800

• For the purposes of reallocation of general factory overhead it is agreed that the variable overheads
accrue in line with the machine hours worked in each department.
• General factory fixed overhead is to be reallocated on the basis of the practical machine hour capacity
of the two departments.
• It has been a longstanding company practice to establish selling prices by applying a mark-up on total
cost of between 20% and 30%.

New product

A possible price is sought for one new product which is in a final development stage. The total market for
this product is estimated at 200 000 units per annum. Market research indicates that the company could
expect to obtain and hold about 10% of the market. It is hoped the product will offer some improvement
over competitors’ products, which are currently marketed at between R140 and R150 each.

The product development department have determined that the direct material content is R9 per unit.
Each unit of the product will take two labour hours (four machine hours) in the moulding department and
three labour hours (three machine hours) in finishing. Hourly labour rates are R5,00 and R5,50
respectively.

Management estimates that the annual fixed costs which would be specifically incurred in relation to the
product are: supervision R20 000, depreciation of a recently acquired machine R120 000 and advertising
R27 000. It may be assumed that these costs are included in the budget given above. Given the state of
development of this new product, management does not consider it necessary to make revisions to the
budgeted activity levels given above, for any possible extra machine hours involved in its manufacture.
9 TOE408-W/1
ZAC408-H/1
Distribution

Plasto Ltd’s distribution fleet of four vehicles is quite old and requires replacement. The following
information has been gathered in respect of replacement vehicles:

Driven Petrol Diesel


Unit cost (R) 177 000 198 000
Consumption per 100km (l) 13 9
Average price per litre (R) R3,98 R3,63
Annual operational cost (%) 11 10

• Distance covered per annum per vehicle, 50 000 km.


• Operational cost covers insurance, maintenance and other day to day costs as a percentage of unit
costs.
• Estimated life expectancy, 5 years.

REQUIRED

(a) Prepare total cost and marginal cost information which may help with the pricing decision; (14)

(b) Comment on the cost information and suggest a price range which should be considered; (4)

(c) Calculate Plasto Ltd’s breakeven-point based on a 25% mark-up on full cost; (4)

(d) Discuss the issues to be considered for the distribution decision; and (10)

(e) List at least three other costing approaches and their possible advantages to Plasto Ltd. (8)

(Unisa)
10 TOE408-W/1
ZAC408-H/1

QUESTION 6 50 marks

Fashion (Pty) Ltd, a manufacturer of denim jeans and T-shirts, is based in Cape Town. The company
manufactures only its own brand of clothing, namely ‘Bundai’ jeans and T-shirts, which is sold to
independent clothing stores. The Bundai brand is positioned as a unisex premium brand targeting young
adults between the ages of 15 and 30. Garments are priced just below the levels commanded by
international brands of jeans and T-shirts, and independent clothing stores have supported this pricing
strategy. The company supplies approximately 200 independent clothing stores throughout South Africa,
none of which account for more than 5% of the turnover of Fashion (Pty) Ltd. Fashion (Pty) Ltd has not
historically sold products through major national clothing chains.

The standard manufacturing cost per garment for the current financial year of Fashion (Pty) Ltd ending on
30 September 2002 is summarised below:
Pair of T- shirt
jeans
Notes R R

Material cost 1 32,00 7,50


Labour cost 2 24,00 15,00
Variable manufacturing overheads 9,60 6,00
Fixed manufacturing overheads 3 6,40 4,00
72,00 32,50

Notes

1. Standard material cost is estimated on the basis of the expected usage of fabric and budgeted
purchase prices of fabric. Standards have closely approximated actual costs in the past. Costs are
averaged over the range of sizes and styles.

2. Standard labour costs are based on the expected time the machinists will spend on making a
garment, multiplied by hourly labour rates. Machinists on average take 48 minutes to make a pair
of jeans and 30 minutes to make a T-shirt. To improve production yields machinists specialise in
making either jeans or T-shirts, and they work a standard 40 hours per week.

Standard costs are based on normal production hours and it is assumed that machinists work
1 900 hours per annum after taking into account public holidays and sick leave. Budgeted labour
costs per machinist are an average of R30 per hour.

3. Budgeted fixed manufacturing overheads are estimated with care and allocated to product lines,
based on expected annual production hours. The budget of Fashion (Pty) Ltd for the current
financial year is based on the manufacture and sale of 118 750 pairs of jeans and 266 000 T-shirts.

The management accounts for the five-month period ended February 2002 indicate that the jeans
production line is operating at full capacity and the T-shirt production line is operating at less than
planned capacity. The company has experienced lower than expected T-shirt orders and
production volumes are expected to remain below budgeted levels for the remainder of the current
financial year. Machinists on the T-shirt production line are working normal hours, and could be
assigned to the jeans production line. However, the machinists who usually make T-shirts are only
able to manufacture on average one pair of jeans per hour.
11 TOE408-W/1
ZAC408-H/1
The average selling price for a pair of jeans was R120 for the first five months of the financial year,
and this is expected to remain stable. T-shirts have been sold at an average of R50 per item in this
financial year, but prices are expected to decline to R45 per T-shirt over the next couple of months.
Budgeted selling prices for the current financial year were R120 per pair of jeans and R52 per T-
shirt.

Fashion (Pty) Ltd manufactured and sold 47 500 pairs of jeans and 79 800 T-shirts in the five
months ended February 2002. The company is planning to produce and sell 71 250 pairs of jeans
over the remainder of the financial year, as was initially budgeted. In view of the lower demand for
T-shirts, it is estimated that only 119 700 T-shirts will be produced and sold in the remaining seven
months of the 2002 financial year.

The normal production hours for the remainder of the financial year are as follows:

March 19 920 hours July 19 680 hours


April 19 200 hours August 19 680 hours
May 19 920 hours September 18 720 hours
June 19 680 hours

Machinists are paid 1,5 times the normal rate for overtime worked. However, overtime per
employee is restricted to 80 hours per month.

Fashion (Pty) Ltd has been approached by a major clothing retail chain, GDF Stores, to fill an order
totaling 30 000 pairs of jeans to be delivered in equal parcels of 6 000 pairs per month. Production
for this order is required to commence on 1 April 2002.

GDF Stores has indicated that it will place further orders of around 7 500 pairs of jeans per month
commencing in October 2002 if the current order of 30 000 pairs successfully sells in its stores.
Management of Fashion (Pty) Ltd are excited about the prospect of doing regular business with
GDF Stores, given the potential impact on profitability, but they are uncertain about how to meet
the continuing increased product demand. Two possible options have been put forward:

1. The company should re-assign certain machinists from the T-shirt line to the jean line, and
offer employees on the jean line the opportunity to work overtime; or

2. The company should outsource some production to ‘cut, make and trim’ (CMT)
manufacturers. A CMT manufacturer, Style Ltd, has offered to manufacture jeans on
behalf of Fashion (Pty) Ltd subject to the latter supplying the fabric required for the
production of jeans as and when required. Style Ltd has quoted a ‘service’ charge of R50
per pair of jeans manufactured, payable in cash on delivery of jeans to the premises of
Fashion (Pty) Ltd. In terms of this arrangement Fashion (Pty) Ltd will be responsible for the
raw material costs, while all other costs will be for the account of Style Ltd.

You may ignore VAT in your calculations.


12 TOE408-W/1
ZAC408-H/1
REQUIRED

(a) Calculate the price per pair of jeans that Fashion (Pty) Ltd should charge GDF Stores for the order
of 30 000 pairs, assuming that Fashion (Pty) Ltd wishes to achieve a R55 contribution per pair of
jeans in respect of this order and decided to adopt option 1. (25)

(b) Discuss the basis adopted by Fashion (Pty) Ltd for the allocation of fixed manufacturing overheads
in the calculation of standard product costs and suggest improvements. (5)

(c) Assuming that Fashion (Pty) Ltd obtains regular orders for 7 500 pairs of jeans per month from
GDF Stores, discuss and evaluate the cost effectiveness of outsourcing the manufacturing of
jeans to Style Ltd. (7)

(d) List the factors to be considered prior to making the decision to outsource manufacturing to Style
Ltd. (8)

(e) Discuss the issues Fashion (Pty) Ltd should consider in evaluating whether it should supply
GDF Stores on a regular basis. (5)
13 TOE408-W/1
ZAC408-H/1

QUESTION 7 35 marks

Bester is a builder. His business will have spare capacity over the coming six months and he has been
investigating two projects.

Project A

Bester is tendering for a hospital extension contract. Normally he prices a contract by adding 100% to
direct costs to cover overheads and profit. He calculates direct costs as the actual cost of materials
valued on a first-in-first-out basis, plus the estimated wages of direct labour. For this contract he has
prepared more detailed information.

Four types of material will be used:

Quantity (units): Price per unit:


Material Needed for Already in Purchase price Current Current
contract stock of units in purchase resale
stock price price
(R) (R) (R)
Z 2 200 400 6,00 10,00 8,00
Y 300 300 30,00 34,00 28,00
X 900 600 48,00 35,00 27,00
W 400 800 15,00 18,00 11,00

Z and Y are in regular use. Neither X nor W is currently used. X has no foreseeable use in the business,
but W could be used on other jobs in place of material currently costing R16 per unit.

The contract will last for six months and requires two craftsmen, whose basic annual wage cost is
R32 000 each. To complete the contract in time it will also be necessary to pay them a bonus of R1 000
each. Without the contract they would be retained at their normal pay rates, doing work which will
otherwise be done by temporary workers engaged for the contract period at a total cost of R24 500.

Four casual labourers would also be employed specifically for the contract at a cost of R5 000 each.
The contract will require two types of equipment: general-purpose equipment already owned by Bester,
which will be retained at the end of the contract, and specialized equipment to be purchased second-
hand, which will be sold at the end of the contract.

The general-purpose equipment cost R43 000 two years ago and is being depreciated on a straight-line
basis over an eight-year life (with an estimated scrap value of R3 000). Equivalent new equipment can
be purchased currently at R52 000. The price for used comparable general-purpose equipment is

R30 000. The price for the relevant used specialized equipment amounts to R25 000, and it can probably
be sold at the end of the contract for R18 000.

The contract will require the use of a premises on which Bester has a five-year lease at a fixed rental of
R8 000 per year. If Bester does not get the contract the premises will probably remain empty. The
contract will also incur administrative expenses estimated at R7 000.
14 TOE408-W/1
ZAC408-H/1
Project B

If Bester does not get the contract he will buy a vacant plot for R40 000 and build an office block. Building
costs will depend on weather conditions:

Weather condition A B C

Probability 0,4 0,4 0,2


Building costs (excluding land) R80 000 R100 000 R120 000

Similarly the price obtained for the office block will depend on market conditions:

Market condition D E

Probability 0,7 0,3


Sales price (net of selling expenses) R150 000 R180 000

Bester does not have the resources to undertake both projects simultaneously.
The costs of his supervision time can be ignored.

REQUIRED

(a) Ignoring the possibility of undertaking project B, calculate:

(i) the price at which Bester would tender for the hospital extension contract if he used his
normal pricing method, and (5)

(ii) the tender price at which you consider Bester would neither gain nor lose by taking the
contract; (10)

(b) Explain, with supporting calculations, how the availability of project B should affect Bester's tender
for the hospital extension contract; (5)

(c) Discuss any other factors that Bester should take into account; (5)

(d) Discuss the merits and limitations of the pricing methods used above, and identify the
circumstances in which they might be appropriate. (10)

(CIMA - adapted)
15 TOE408-W/1
ZAC408-H/1

QUESTION 8 35 marks

Background

Goodies Limited operates a countrywide chain of shops, which sells clothing, food and household items.
In 1998 the company started to incur losses. The general consensus was that the company was losing
strategic direction. The business formula that had proved successful in the 1980's and 1990's was no
longer proving effective. A new Chief Executive Officer was appointed to turn the company around.

She implemented a three-pronged strategy:

• Remove levels in the hierarchy;


• Decentralise the organisation; and
• Focus on the core competencies of the business.

The core competencies were identified as essentially buying and selling, and from this analysis the
philosophy of outsourcing was developed. The argument supporting this is that the core activities have
to be world class and supporting activities should follow suit. As it is extremely difficult to achieve both
yourself (it requires different focuses), it was decided to outsource the non-core activities. E.g. distribution
was outsourced and had been reduced in size from 300 staff required to 5. Even though very high
standards were required (e.g. certain foods would have to be kept in a cold-chain and never be exposed
to temperatures exceeding 5oC from the time of packing to sale), this area had been outsourced
successfully.

Other activities followed this success, e.g. quality control and packaging.

Detail

The proviso for outsourcing is always that improvements be made in the specific area and that it should
not be implemented just for the sake of it.

In relation to Information and Communication Technology (ICT), the feeling of senior management was
that ICT was performing reasonably well in an operational sense, but not really delivering its full potential
to the business. Projects within the ICT department had been run on a relatively informal manner and
projects were tending to overrun budgets. During the previous year an investment of R1 million was
made in order to upgrade personal computer systems.

Goodies Ltd decided to investigate the possibility of outsourcing all ITC activities from 1/1/2002.

Investigation into the possible outsourcing of ICT

A shortlist of 4 possible vendors were compiled. These vendors each made a presentation to the
management of Goodies Ltd. Following this, IQ Data Ltd was selected as it was felt that this company
best understood the philosophy of Goodies Ltd, it had the resources and understood the future
development needs.
16 TOE408-W/1
ZAC408-H/1
Further negotiations with IQ Data were then entered into. Detailed requirements could be presented to IQ
Data as Goodies Ltd had already, during the previous 2 years, prepared a detailed listing of requirements.

Offer by IQ Data

A three year contract with a fixed price of R2 500 000 per year. IQ Data agreed to take on 8 of the 10 ICT
personnel, maintaining the terms of conditions they had with Goodies Ltd. (Average salary of ICT
personnel is R300 000 per staff member per year).

Additional information provided by the financial director and human resources manager

• Gerrit van der Merwe (one of the existing 10 ICT personnel) agreed on early retirement as he
wants to further his music career. If he does retire early, Goodies Ltd would have to pay an extra
R200 000 lump-sum into the pension fund.
• Another ICT personnel member can be retained by Goodies Ltd to help administer the planned
ICT outsourcing contract.
• The building housing the ICT department was on a 4 year lease (from 1/1/2001) and the company
was committed to an annual rental of R100 000 per year for that period. This building could be
sublet if ICT was outsourced, generating R40 000 in the second year, R80 000 in the third and
R100 000 in the fourth (final) year.
• The resale value of the computer equipment purchased in the previous year is R300 000.
• Annual overheads of the ICT department are R270 000 per year. 60% of the overhead varies with
staff members, the remaining 40% is a share of central overhead charges. Assume that this
amount would remain constant.
• All relevant personnel provisionally agreed to the planned changes.
• It is estimated that the value of money would depreciate by 10% per year.
• Average salary increases are estimated at 15% per year.
• A contract manager (new appointee) would have to be appointed by Goodies Ltd, with an
expected salary of R500 000 per year.
• It is assumed that tax be paid one year after the relevant income/expenditure flow. Assume that
the tax rate remains at 30% per annum.

You are a CA(SA) appointed as a consultant to Goodies Ltd.

REQUIRED

Compile a report in which you evaluate the outsourcing of ICT. Your report should include the following:

(a) An incremental costing analysis; (20)

(b) Discussion of other factors that need to be taken into account before a decision is made; (5)

(c) Recommendations with reasons; and (5)

(d) An executive summary. (5)

(Unisa)
17 TOE408-W/1
ZAC408-H/1

QUESTION 9 40 marks

You are the Financial Manager of NuCare Ltd, a retailer of bodycare products aimed at upper income
consumers. Product ranges include haircare products, soaps, fragrances, moisturisers, face creams and
bath oils. NuCare Ltd has 30 retail outlets. The products that the company sells have not been tested on
animals and it regards this as a competitive differentiating factor in the market place. NuCare Ltd
manufactures its range of soaps at its Cape Town factory, and the company's administration and central
warehouse facilities are also housed at these premises. All the soaps that the company manufactures are
distributed to its own retail outlets, while all other products sold by NuCare Ltd are imported from various
European suppliers.

The financial performance of the company for the year ended 30 September 2004 is summarised below:

ABRIDGED INCOME STATEMENT


Notes R000

Revenue 1 62 368
Cost of sales 2,3 40 157
Gross profit 22 211
Distribution costs 4 3 346
Other operating expenses 10 510
Operating profit 8 355
Net interest income 952
Profit before tax 9 307
Taxation 2 792
Profit after tax 6 515

Notes
1. NuCare Ltd had the following sales mix for the 2004 financial year:
R000

Soaps 15 500
Bath oils 13 720
Moisturisers and face creams 11 850
Haircare products 11 226
Fragrances 10 072
62 368
2. Cost of sales items:
R000
Cost of imported products
32 339
Cost of manufactured products 7 818
Material and labour 3 118
Variable overheads 1 563
Manufacturing fixed costs 2 537
Allocated fixed administrative expenses 600

40 157
18 TOE408-W/1
ZAC408-H/1

3. The manufacturing fixed costs, as reflected in note 2 above, are made up as follows:

R000
Manufacturing fixed costs
Operating lease expenses: Premises (allocated) 840
Depreciation of plant and machinery 650
Salaries 750
Other expenses 297
2 537

4. NuCare Ltd uses independent contractors to distribute products from the central warehouse to its retail
outlets. The following is the approximate floor space utilisation of the Cape Town premises:

%
Factory 60
Central warehouse 20
Administrative offices 20
100

5. NuCare Ltd sells soaps in packaged units of 200 grams, and during the 2004 financial year the
average retail price was R10,00 per unit.

The Chief Executive Officer of NuCare Ltd, Ms Helen Dandy, has approached you to assist in the
outsourcing of the company's manufacturing activities to a Cape Town-based contract manufacturer,
Cpac Ltd. Cpac Ltd has submitted a proposal for consideration by NuCare Ltd which has the following
salient features:

- Cpac Ltd will acquire the plant and machinery currently used to manufacture soap from Nucare
Ltd at net book value, on condition that NuCare Ltd enters into a five-year manufacturing contract
with Cpac Ltd;

- Cpac Ltd is to charge NuCare Ltd R5,00 (excluding VAT) per unit manufactured with effect from 1
January 2005, the proposed inception date of the agreement between the parties. Price
escalations will be based on a formula that will cover inflationary increases; and

- Costs of delivering the soaps to the central warehouse of NuCare Ltd will be carried by Cpac Ltd.
Cpac Ltd will furthermore purchase materials used for soap manufacture directly from approved
suppliers. Purchase quantities will be based on the rolling sales forecasts of NuCare Ltd.

REQUIRED

(a) Discuss the factors NuCare Ltd should consider prior to taking the strategic decision to outsource
its soap manufacturing activities. (20)
(b) Discuss the financial implications of outsourcing the soap manufacturing activities to Cpac Ltd.
Your answer should include a comparison between the current manufacturing cost per unit of
NuCare Ltd and the unit price proposed by Cpac Ltd. (10)
(c) List any additional issues which would require clarification and/or negotiation prior to finalising the
contract with Cpac Ltd. (10)
19 TOE408-W/1
ZAC408-H/1

QUESTION 10 35 marks

Distilt Ltd, a chemical company has a fixed contract to annually supply 3 600 tons of product A at R24 a
ton and 4 000 tons of product B at R14,50 per ton. The basic components for these products are
obtained from an initial joint distillation process. From this joint distillation a residue is produced which is
processed to yield 380 tons of by-product Z. By-product Z is sold locally at R5 per ton and the net income
is credited to the joint distillation process. Joint costs are allocated based on tonnage of output.

The budget for the year ending 30 June 2004 is based on the following data:
Separable costs
Joint Product A Product B By-product Z
process
Variable cost per ton of input (R) 5 11 2 1
Fixed costs for the year (R) 5 000 4 000 8 000 500
Evaporation loss in process (% of input) 6 10 20 5

After the budget was compiled, it was decided that an extensive five-week overhaul of the joint distillation
plant will be needed during the year. This will cost an additional R17 000 in repair costs and reduce all
production for the year by 10%. Supplies of the products can be imported to comply with the contract
obligations at a cost of R25 per ton for A and R15 per ton for B.

Experiments have also shown that plant operations can be changed during the year in that either:

(i) The joint distillation plant output of distillate for product A can increase by 200 tons with a
corresponding reduction in product B distillate. This change will increase the joint distillation
variable costs for that part of the operation by 2%; or
(ii) The residue of by-product Z can be mixed with distillate for products A and B in proportion to the
present output of these products. By intensifying the subsequent separate processing for products
A and B, acceptable quality can be obtained. The intensified operation will increase product A and
B’s separable fixed costs by 5% and increase the evaporation loss for each separate operation to
11% and 21% respectively.

REQUIRED

(a) Calculate on the basis of the original budget:

(i) the unit costs of final products A and B on a variable costing basis. (7)
(ii) the unit costs of final products A and B on an absorption costing basis. (5)
(iii) the total net profit for the year. (2)

(b) Based on the reduced production as a result of the overhaul, calculate the net profit for the year
attributable to product A, should the shortfall in production be made up by importing products. (8)

(c) Given the reduced production following the overhaul, advise management whether either of the
alternative production changes will improve the profitability and whether you would recommend
the use of either. (13)
(CIMA adapted)
20 TOE408-W/1
ZAC408-H/1

QUESTION 11 50 marks

You are the financial director of Electro Motors Ltd, which manufactures cooling motors for the local and
export market. The company was founded in 1972 and has, since then, established itself as a high
quality supplier to a number of large refrigerator manufacturers.

Current position

Since 1998 the company has experienced a continuous decline in the demand for its motors. Initially,
management was of the opinion that the depressed world economy was the main reason for the
reduced demand. The decline in demand has however continued and the profitability and cash flow of
Electro Motors Ltd are currently under severe pressure. The variance report for September 2004 is as
follows:

Material - Price 375 000 (U)


- Yield 173 000 (F)
Labour - Rate 120 000 (F)
- Efficiency 420 000 (F)
Variable overheads - Expenditure -
- Efficiency -
Manufacturing fixed cost - Expenditure 250 000 (U)
- Volume 1 233 000 (U)
Sales - Price 456 000 (F)
- Volume (value basis) 1 400 000 (U)
Administration fixed expenses - Above budget 429 500 (U)

Monthly standards:

Unit selling price R175


Material cost R70 per unit
Labour cost R24 per unit
Variable manufacturing cost R7 per unit
Manufacturing fixed cost R30 per unit
Administration fixed expenses R780 000
Non-manufacturing variable expenses
(sales commissions & distribution) R562 800
Normal capacity 80 000 units
Budgeted sales 46 900 units
Budgeted profit R720 800

Given the unsatisfactory state of affairs of Electro Motors Ltd, management has appointed external
consultants to advise them. The consultants have suggested two strategies to return the company to
profitability:

1. Reduce production costs through value engineering, as this will reduce selling prices and increase the
volume of sales of the existing range.
21 TOE408-W/1
ZAC408-H/1

Or

2. Design, develop, manufacture and sell a second range of motors, with an 18,5 kilowatt output,
for the heavy manufacturing sector.

Value engineering for sales growth

The consultants have compiled the following schedule in support of a value engineering exercise:

Primary functions Cost data Perceived Relative Assignment Value ratio


Of the unit per unit(1) market cost data target(4) target
value(2) per unit(3)
R % R R %
Power train
Switching gear 4,00 7 9,17 7,70 192
Cable 2,00 3 3,93 3,30 165
Drive train
Motor 51,00 45 58,95 49,50 97
Drive 12,00 9 11,79 9,90 83
Inner chamber 6,00 5 6,55 5,50 92
Safety
Motor hood 8,00 4 5,24 4,40 55
Internal cladding 10,00 8 10,48 8,80 88
Circuit breakers 15,00 11 14,41 12,10 80
Durability
External cladding 23,00 8 10,48 8,80 38
131,00 100% 131,00 110,00 84%

1. The cost data has been extracted from the records of Electro Motors Ltd.

2. The perceived market value has been determined by means of in-depth interviews in the
market place.

3. The relative cost data has been calculated using the percentage of the perceived market value
against the cost data.

4. The assignment target of R110 per unit has been determined as the target necessary to
ensure profitable sales volumes of 80 000 units a month.
22 TOE408-W/1
ZAC408-H/1
(ii) Adding a second range of motors

The following are requirements if a second range of 18,5 kilowatt motors is to be added:

1. The design, development, production and marketing of the motors.

2. An additional investment in advanced robotic manufacturing technology. The capital cost


is estimated at R30 million with an expected useful economic life of five years.

3. A significant portion of the existing idle manufacturing capacity will be used in the new
process.

Mr Kaplan, the marketing director, who attended the meeting with the external consultants, made
the following comment:

Value engineering appears to be nonsense and certainly this schedule is clearly


incomprehensible. I would suggest that, we commission forthwith a project team to use target
costing to develop the new range of motors.

REQUIRED

(a) Write a report to the board of directors of Electro Motors Ltd in which you analyse and comment
on the current financial performance of the company. (20)

(b) Draft a memorandum to Mr Kaplan in which you explain the concept of value engineering and
analyse the schedule compiled by the external consultants. (15)

(c) Discuss the nature and applicability of target costing principles for the development of a new range
of motors. (8)

(d) Discuss the advantages and disadvantages of the two options tabled by the external consultants.
(7)
23 TOE408-W/1
ZAC408-H/1

QUESTION 12 55 marks

You are the group financial accountant for the National Chemical Corporation Ltd. The company is listed
on the JSE Securities Exchange SA and is a subsidiary of International Chemical Corporation Inc, which
is based in the United States of America.

Your responsibilities include supervision of the accounting function at various branches, including the
Mealiebug Chemical Plant. The following has come to your attention in respect of the Mealiebug plant:

• The plant manufactures only one product, BugDed, a chemical used in crop spraying.

• BugDed is sold to wholesalers and farming co-operatives in 100 litre drums.

• Over the years, the plant has consistently maintained production of 15 000 drums per annum, although
this has recently increased to 1 500 drums per month.

In your opinion, the Mealiebug plant accountant is a meticulous individual, whose books and
reconciliations are always up to date. However, certain difficulties were encountered during the 2003
audit as the plant accountant is limited regarding his knowledge of the more intricate aspects of Generally
Accepted Accounting Practice. In particular, the auditors reported that he had not complied with AC 112,
The effects of changes in foreign exchange rates. Expense accruals and cut-off procedures concerning
accounts payable were also unsatisfactory.

The Mealiebug plant values inventories of raw materials (including the raw material content of finished
goods) at actual cost, determined on a first-in-first-out basis. A standard costing system is used for labour
and overheads, although the accounting for variances is reasonably simplistic.

The financial year end of the company was 29 February 2004 and you have decided to pre-empt any
audit problems this year by visiting the Mealiebug plant and conducting some audit checks yourself.

Whilst at the Mealiebug plant, you established the following:

1. Major inventories at 29 February 2004 consisted of the following:

• 130 000 litres of GCM (GeoCarbonMethylate - the main raw material used in the manufacture
of BugDed). This includes 100 000 litres in a customs warehouse;
• 1 500 empty drums; and
• 125 000 litres (1 250 drums) of completed BugDed.

2. The most recent shipment of GCM was received on 15 January 2004 per goods received note no.
36449.

• The shipment was for 200 000 litres at a cost of US $2,10 per litre.
• The invoice is payable on 15 May 2004.
24 TOE408-W/1
ZAC408-H/1

3. Ruling rates of exchange (one US $ to SA rand) R

• 15 January 2004 7,692

• 15 February 2004 8,696

As the rand began weakening against the dollar, the plant accountant decided
to enter into a forward exchange contract for settlement on 15 May 2004 at a
rate of $1 = R9,009

• 28 February 2004 9,091


Forward cover settlement on 15 May 2004 was available at a rate of
$1 = R9,346

4. The plant’s clearing agents submitted an invoice for R577 227 relating to goods received note no.
36449. This amount is made up as follows:
R
• Freight, insurance and clearing charges 156 000

• Duty at 10% on inventory released from custom warehouse 161 538

• VAT paid on stock released from custom warehouse 259 689

This invoice was paid in full on due date.

5. The plant accountant has passed the following entries to record the above transactions:

Dr Cr
R R
• Stock - raw materials 3 783 784
Creditors 3 783 784
Recording purchase of 200 000 litres of GCM at $2,10 per
litre, from International Chemical Corporation Inc.

• Stock - raw materials 317 538


VAT - Input tax 259 689
Creditors 577 227
Recording clearing agent’s invoice concerning above
shipment. See goods received note no. 36449.

6. The plant accountant has costed year end inventories as follows:


R
GCM
Import cost (R3 783 784 ÷ 200 000) 18,92
Freight, etc. (R156 000 ÷ 200 000) 0,78
Import duty (R161 538 ÷ 200 000) 0,81
Total cost per litre 20,51
25 TOE408-W/1
ZAC408-H/1

R
BugDed (100 litre drums)
50 litres GCM 1 025,50
50 litres other ingredients, reagents, etc 225,00
These are purchased locally and you believe the stated cost is
reasonably correct. 190,00
Drums
Per local supplier’s invoices, this was the contract price for the whole
year before taking into account the rebate
Labour
Budgeted cost (R3 150 000 ÷ 15 000 units) 210,00
Overheads
Budgeted cost (R1 620 000 ÷ 15 000 units) 108,00
Total cost per 100 litre drum 1 758,50

7. The final trial balance includes the following balances:

Dr Cr
R R

Cost of sales 25 575 000


Drum rebates 97 470
Labour variance 105 000
Overhead variance 4 000

In terms of the contract with the supplier, the plant is entitled to a rebate of 5% on the cost of all
drums purchased. The amount of R97 470 relates to the period of six months ended 31 August
2003, during which 9 000 drums were purchased. A further 8 000 drums were purchased during
the six months ended 28 February 2004.

8. The labour and overhead variances can be explained as follows:


Labour Overhead
variance variance
R R
A pay increase of 12% effective from 1 December 2003 100 000
Additional staff employed from 1 January 2004 102 000
Costs (depreciation, etc.) relating to new machinery brought
into use on 1 January 2004 42 000
Productivity increase in January and February 2004 from
1 250 drums per month to 1 500 (105 000) (54 000)
Minor variances which you propose to ignore 8 000 8 000
105 000 (4 000)
26 TOE408-W/1
ZAC408-H/1
REQUIRED

(a) Provide all adjusting journal entries that you consider necessary in connection with the information
provided. Show your workings for each adjustment and indicate whether the ledger account
balances being adjusted will be included in the income statement or the balance sheet.
(30)
(b) Compute the amount to be disclosed, in terms of AC 108, Inventories, in respect of the cost of
inventories expended for the year. (5)

(c) List the procedures you would execute in order to confirm the existence, ownership, valuation and
recording of the shipment of 200 000 litres of GCM received on 15 January 2004 and the related
year end accounts payable. (10)

(d) List the procedures you would execute in order to ensure that the year end expense accruals and
cut off, in respect of local accounts payable, are reasonably stated at 29 February 2004. (10)
27 TOE408-W/1
ZAC408-H/1

QUESTION 13 40 marks

Basson (Pty) Ltd produces a chemical called Mace-1, which is used for self-defence as well as for military
purposes. Analysis has shown that a 10 litre container of Mace-1 is made of 6 litres of Skunk-1 and 5
litres of Dung-2. For the year 2000, Dung-2 was predicted to cost R12,00 per litre and Skunk-1 was
expected to retail at R6,00 per litre.

The manufacture of Mace-1 involves heating Dung-2 and Skunk-1 to exactly 98 degrees Celsius and then
mixing the two together. As a result of the heating process, some input is lost due to evaporation.

The budget for 2000 estimated that sales and production volume would amount to 150 000 litres of Mace-
1. Due to a large military contract the sales and production volume was actually 206 000 litres. Basson
bought the necessary ingredients and produced Mace-1 to order. The risk of environmental damage
resulting from the storage of Mace-1 (and the related insurance costs) is too high for Basson to consider
any other policy. Because of the increase in expected sales volume in 2000 and beyond, the price of
Skunk-1 increased to R9,00 per litre. The price of Dung-2 decreased to R11,00 per litre. The effective
date of these increases/decreases was 1 January 2000.

The results for 2000 were interesting. Due to the increase in the price of Skunk-1, every effort was made
to reduce its spillage. This was achieved by utilising additional energy in the heating of Skunk-1. Less
care was devoted to Dung-2. The actual quantities used were: 123 826 litres of Dung-2 and 115 083
litres of Skunk-1.

The managing director of Basson was impressed with the results for the year. With sales increasing,
profits were higher than expected. Mace-1 sold for R32,00 per litre. Standard costs including materials,
labour and overheads amounted to R20,00 per litre. With selling and administrative costs (all fixed costs)
of R1 320 000, profit was estimated to be R480 000. Actual profits earned were R625 000. All sale
prices and expenses were as predicted with the exception of materials and the following variances:

- Labour rate variance (unfavourable) 6 000


- Variable manufacturing overhead spending variance (unfavourable) 203 767
- Total efficiency variance - variable (favourable) 103 000

A large bonus is planned to be paid to management and the managing director also plans to propose a
large dividend for shareholders at the next meeting of directors.
The previous management accountant died before completion of the management accounts and you are
appointed to supply management with the relevant information.

REQUIRED

Prepare a detailed report for presentation to the managing director, explaining the reasons why profits
were greater than expected in 2000. (40)
(CIMA - adapted)
28 TOE408-W/1
ZAC408-H/1

QUESTION 14 30 marks

You are the management accountant for SpaceAge Ltd. The company uses a standard costing basis to
calculate the cost of their product and to analyse variances.

Last night, a substantial portion of the administrative offices of SpaceAge was destroyed in a fire. The
panicky managing director, begs you to help him reconstruct the financial information as of March 2004.
He took a section of the variance analysis report of the standard costing system for this month home, with
him as he was concerned about the relatively high variances which were noted for March. He hopes that
you may be able to use this information to reconstruct an income statement, prior to the auditors arrival
for their annual audit.

You gather the following information from the management reports and the articles of association which
the auditors, Snoopers & Green, have kept at their offices:

• The company manufactures only one product, the Skywalker.

• Raw materials are recorded at their actual cost in the financial records of the company.

• Variable overheads serve as the basis for the allocation of productive labour hours to the Skywalker
products.

• An absorption costing system is used to account for fixed overheads. Fixed overheads are allocated
to finished products on the basis of machine hours. Fixed overhead variances, are however, not
analysed in detail, as management does not consider the information valuable.
Accordingly, the only difference that is calculated, is the difference between actual expenses and
the standard cost of production.

The production department has been able to advise you that 380 units were produced, completed and
transferred to the finished goods store during March. Further information gleaned from the production
department includes the following:

• There was no work-in-progress either at the beginning or end of the month, nor were there any
completed goods on hand at 1 March 2004.

• Two raw materials are mixed in order to produce the Skywalker. These two materials are called Io
and Europa. A FIFO system is used to account for the cost and movement of raw materials.

• Only one type of labour is used. Normal idle time is set at 10% of the hours clocked. The actual
productivity for March was 88% of the hours clocked. The total amount paid to labourers for this
month, including bonus payments, was R1 125 000.

• The variable manufacturing overheads allocated to products, amounted to R360 per productive
labour hour.
29 TOE408-W/1
ZAC408-H/1

According to last year’s financial statements, approved by the auditors, the standard cost and selling price
of one Skywalker is determined as follows:
R
Io (4 kilograms) 4 060
Europa (1 kilogram) 1 780
Direct labour (5 clocked hours) 2 610
Variable overheads (4,5 productive hours) 1 548
Fixed overheads (2 machine hours) 1 002
Total cost 11 000
Profit margin 4 000
Selling price 15 000

The following information and variances were noted in the report the managing director had taken home
with him:
R
Budgeted profit 1 576 000
Volume variance (124 000)
Budgeted profit at actual level of activity 1 452 000
Selling price variance 117 975
Adjusted profit before cost variances 1 569 975

Other specified variances are the following:

Labour efficiency variance 73 080 Favourable


Total fixed overhead variance 7 810 Favourable

The store manager was able to supply you with the raw material accounts for March based on the
inventory on hand and purchases for the month:

Io Europa
Units Rand value Units Rand value
Opening inventory 580 646 700 1 100 1 683 000
Purchases 1 760 1 900 800 1 350 2 227 500
Closing inventory 890 961 200 2 040 3 283 200

REQUIRED

(a) Calculate all the variances that could have been included in a management variance analysis
report. Remember that fixed overhead variances are not calculated in detail. (17)

(b) Compile the income statement for March 2004 in as much detail as possible. Show the cost of sales
calculation in detail. (4)

(c) Reconcile the actual profit with the budgeted profit; (3)

(d) Briefly explain the effect of activity based costing on the standard costing system; (3)

(e) Name at least three qualitative factors that SpaceAge Ltd should consider in following the
catastrophic events of this month. (3)
30 TOE408-W/1
ZAC408-H/1

QUESTION 15 35 marks

Winegrowers Limited manufactures a fertiliser product for the wine industry. A raw material mixture is
introduced at the commencement of the process, while labour and overheads are added equally during
the manufacturing process. There is a normal loss in the mass of the materials during the processing
which amounts to 10% of the input quantity. Wastage occurs at the beginning of the process. Standard
costs are calculated at a production output of 100 000 units and the budgeted sales for the year are
100 000 units. The standard mass of a unit of output is 2 kg.

Standard cost per unit R

Direct material (standard purchase price R4,50 per kg) 10,00


Direct labour at 0,5 standard hours per unit 1,00
Factory overheads - Variable 1,50
- Fixed 0,90
Manufacturing costs 13,40
Selling and distribution overheads (fixed) 0,60
Cost of sales 14,00
Profit margin 6,00
Selling price 20,00

All factory overheads vary with direct labour hours.

The management accountant died in a car hijacking before completion of the management accounts and
you have been appointed to supply management with the relevant information.

The following data and information are applicable to the year ended 31 December 2004:

1. Inventory 1 January 31 December

- Raw material (kg) 60 000 40 000


- Work-in-progress (units) 20% completed 10 000
40% completed 20 000
- Finished goods (units) 26 000 10 000

Inventories are valued at standard cost on the first-in first-out basis.

2. During the year 200 000 kg of raw material mixture was purchased while 220 000 kg was
transferred to work-in-progress. 86 000 units were completed and transferred.

3. Actual direct labour hours were 51 000 hours.

4. Actual expenses
R
- Raw material purchased at R4,49 per kg 898 000
- Factory overheads – Variable 147 000
- Fixed 92 500
- Selling and distribution overheads (fixed) 76 200

- Because of an IT crash the actual cost of direct labour must be calculated.


31 TOE408-W/1
ZAC408-H/1

5. Related variances as per provisional, incomplete management accounts

- Material price variance (favourable) 2 000


- Direct labour rate variance (unfavourable) 6 000
- Selling and distribution overheads variance (unfavourable) 15 000

REQUIRED

(a) Calculate the following variances:

(i) raw material usage variance


(ii) total efficiency variance
(iii) factory overhead expenditure variance
(iv) factory overhead capacity variance
(v) sales volume variance; (21)

(b) Draft a statement reconciling the actual profit of R534 300 with the budgeted profit of R600 000.
(8)

(c) Briefly explain the possible causes of the total efficiency variance (taking the other variances into
account) and list the steps which should be taken by management to prevent a future unfavourable
efficiency variance. (6)
32 TOE408-W/1
ZAC408-H/1

QUESTION 16 40 marks

You are the management accountant of AA Manufacturing Limited, a company which manufactures a
range of consumer products. The company has two large factories situated in the Gauteng area. The
first factory (Factory 1) manufactures three products in a labour intensive process. The second factory
(Factory 2) is more capital intensive and requires skilled workers to operate sophisticated manufacturing
equipment.

Information relevant to Factory 1 for the year 2002

Each of the three products manufactured in the factory passes through two stages: filling and packing.

Direct labour efficiency standards are set for each stage. The standards are based upon the number of
units expected to be manufactured per hour of direct labour.

Current standards are as follows:


Product 1 Product 2 Product 3
(units/hour) (units/hour) (units/hour)
Filling 32 75 62
Packing 23 25 23

Budgeted sales of the three products are:

Product 1 850 000 units


Product 2 1 500 000 units
Product 3 510 000 units

Production will be at the same level each month and will be sufficient to enable finished goods inventory
levels at the end of the year to be:

Product 1 200 000 units


Product 2 255 000 units
Product 3 70 000 units

Inventory at the beginning of the budget year is expected to be:

Product 1 100 000 units


Product 2 210 000 units
Product 3 105 000 units

After completion of the filling stage, 5% of the output of Products 1 and 3 is expected to be rejected and
thereafter destroyed. The cost of such rejects is treated as a normal loss.

A single direct labour hour rate is established for the factory as a whole. The total payroll cost of direct
labour personnel is included in the direct labour rate. Time spent by direct labour personnel are budgeted
to be divided as follows:
33 TOE408-W/1
ZAC408-H/1

% of total time
Direct work 80
Holidays (excluding public holidays) 7
Illness 3
Idle time 4
Cleaning 3
Training 3
100

All direct labour personnel are employed on a full-time basis to work a basic 35 hour, 5 day, week.
Overtime is to be budgeted at an average of 3 hours per employee per week. Overtime is paid at a
premium of 25% more than the basic hourly rate of R40 per hour. There are 250 possible working days
during the year. You are to assume that employees are paid for exactly 52 weeks in the year.

Information relevant at a recent Budget Committee meeting

One of the high-level executives serving on the Budget Committee raised a concern that the company is
not doing enough to deal with the potential risks relating to the HIV/AIDS (Acquired Immunodeficiency
Syndrome) issue.

Although the company is aware that a number of its workers are HIV-positive, no specific action plan has
been formulated to address the potential risks of HIV/AIDS.
The executive quoted the following excerpts from a recent article that appeared in a reputable
international magazine1 regarding the current state of affairs in South Africa:

• “AIDS makes most of South Africa’s other problems seem trivial ...”.
• “... the Minister of Health is of the opinion that 2,5 million people are HIV-positive and UNAIDS (the
United Nations’s AIDS unit) estimates the figure to be 4,2 million people - nearly a tenth of the
population. A study for ING Barings last year predicted 8 million infections by 2005".
• “Productivity will suffer ... especially in the final months of a workers life, and when his colleagues
take time off to attend his funeral ...”

Source
1
The Economist, February 24th 2001.

REQUIRED

(a) Assist the new manager of Factory 1 in the preparation of the labour budget by calculating the
following:

(i) The number of full-time direct employees required during the budget year. (12)
(ii) The direct labour rate. (4)
(iii) The direct labour cost of each product. (4)

(b) Prepare a report to the Budgeting Committee on the HIV/AIDS issue and its potential impact on AA
Manufacturing Ltd. Your report should deal with:

• General risks.
• Risks specific to Factory 1 and to Factory 2.
• How to manage these risks. (20)
34 TOE408-W/1
ZAC408-H/1

QUESTION 17 35 marks

Gempatch Ltd manufactures three products using the same plant and processes. The following is
relevant to the September 2000 production period:
Product
Jaspis Agate Sodalite

Volume 5 500 600 7 000


Material cost per unit R50 R160 R170
Direct labour per unit ½ hour 2 hours 1½ hour
Machine time per unit ¼ hour 1 hour 1½ hour
Labour cost per unit R30 R120 R90

The manufacturing overheads for the period can be analysed as follows:

R000
Machine activity 350
Set-up costs 44
Ordering costs 20
Material handling 75
Spare part administration 10
499

Currently the overheads are absorbed by the products based on machine hours at a rate of R40, which
gives the following overheads per product:

Jaspis R10
Agate R40
Sodalite R60

The company is at present considering a change to activity based costing. An investigation into the
manufacturing overheads activities for the period revealed the following:

Product
Total Jaspis Agate Sodalite

Number of set-ups 16 6 2 8
Number of orders 10 5 1 4
Number of material handlings 27 12 3 12
Number of spare parts 12 7 1 4
35 TOE408-W/1
ZAC408-H/1

REQUIRED

(a) Contrast the features of a business that will benefit from activity based costing (ABC) with those of a
business that will not. (4)

(b) Determine the overheads per product unit for Gempatch Ltd by using ABC and briefly comment on
the differences in the overheads per unit determined with the current system and the ABC system.
Your calculations must be rounded off to two decimals. (19)

(c) (i) Briefly explain the following two concepts:

• Life cycle costing (6)


• Target costing (4)

(ii) Briefly explain the role target costs play in life cycle costing. (2)
36 TOE408-W/1
ZAC408-H/1

QUESTION 18 45 marks

The management team of Cycle Ltd presented the following draft budget for the June 2001 financial year
to the managing director. The company manufactures and sells tricycles and small mountain bikes.

Tri- Moun-
cycles tain Total
bikes

Sales (units) 100 000 100 000 200 000


R000 R000 R000
Sales 30 000 60 000 90 000
Variable manufacturing cost 23 400 34 800 58 200
Commissions 600 1 200 1 800
Contribution margin 6 000 24 000 30 000
Direct fixed cost 9 000 12 000 21 000
Operating (loss)/profit (3 000) 12 000 9 000
Company common fixed costs 12 000
Net loss before interest and tax (3 000)

In view of the declining profitability over the past number of years, the projected loss for 2001 is cause for
concern. The managing director called an executive meeting with the production, marketing and financial
managers to discuss the problem.

There was strong disagreement over the feasibility of a number of potential solutions proposed. As
financial manager you were requested to evaluate the proposals and to report back. You made the
following notes during the meeting:

• Cycle Ltd has been a significant role player in the tricycle and small bike markets for a number of
years and has recorded good profits. However, given this year's expected loss after interest and tax
and the projections for next year, something will have to be done to save the company from demise.

• The company has been facing stiff competition in the tricycle market and the selling price should
possibly be dropped from R300 to R270 per unit. Projected unit sales are half what they were two
years ago; a drop in price of R30 per unit could lead to a doubling of the sales figure.

• Perhaps the tricycle line should be discontinued and a larger bike line added. (This had been
discussed on a previous occasion but not implemented because it would necessitate the acquisition
of new production equipment at a cost of approximately R12 million.)

• Many of the mountain bike customers had previously bought tricycles. They are thus buying the
brand name. If the tricycle line is discontinued, the company could face a 15% decline in mountain
bike sales.
37 TOE408-W/1
ZAC408-H/1

• Projected revenues and expenses for a new bike line are as follows:

R000

Sales 36 000
Variable cost 25 450
Contribution margin 10 550
Additional direct fixed cost (see note) 7 000
Operating profit 3 550

Additional direct fixed cost only include cash costs. They do not include depreciation on the new
equipment. The equipment would have a life of six years. The company's weighted average cost of
capital is estimated at 14%.

• In view of the high level of gearing, doubts have been expressed on whether it would be possible to
acquire adequate financing for the new project. The equipment used in the tricycle production
process has a useful life of six more years.

• A cost reduction strategy must be implemented using activity-based costing. For example, warranty
and repair costs comprise 30% of the direct fixed cost of the two lines; these costs are driven by the
number of defective bikes produced. Quality is a critical competitive factor. Over the past several
years the competitors' bikes have gained a reputation for being of a better quality than those of
Cycle Ltd.

• Data has been collected on the common fixed cost category except for the power activity. The
estimated demand the products place on each activity has been established. Power has traditionally
been treated as a fixed cost because the total amount paid is more or less the same from year to
year and a detailed analysis of the fixed and variable elements could not be prepared in time for the
meeting.

• Relevant data regarding common fixed cost is as follows:

Activity rate
Activity Cost driver Fixed rate Variable rate
R R
Purchasing Number of orders 75,00 -
Inspection Inspection hours 90,00 -
Dispatch Dispatch hours 96,00 30,00
Materials handling Number of moves 36,00 -
38 TOE408-W/1
ZAC408-H/1

The fixed rate is based on the following practical activity capacities:

Activity Capacity Whole unit


Purchasing 8 000 orders 2 000 orders
Inspection 10 000 inspection hours 2 000 hours
Dispatch 16 000 dispatch hours 1 600 hours
Materials handling 50 000 moves 5 000 moves

These resources represent those acquired or committed to in advance of usage and must be
acquired in batches of whole units.

• Product demands on activities at planned production levels


Moun-
Tri- tain
Cycles bikes

Purchasing 2 000 4 000


Inspection 3 000 4 800
Dispatch 4 000 8 000
Materials handling 15 000 25 000
Power (kilowatt hours) 46 000 90 000

The following analysis of actual power costs and kilowatt usage is available (power costs form part
of common fixed cost):
Kilo-
Month Power watt
costs hours
R used

July 276 000 12 000


August 330 000 15 000
September 240 000 10 000
October 222 000 9 000
November 204 000 8 000
December 222 000 9 000

REQUIRED

(a) Using breakeven analysis, determine production levels at which the company will achieve
breakeven (5)

(b) Analyse the profitability of the existing two product lines using activity-based costing.
Your analysis should include the impact of a potential closure of the tricycle line. (15)

(c) Calculate whether Cycle Ltd should invest in the new bike line. (5)

(d) Using the results of your analyses in parts (a), (b) and (c) discuss the alternative courses of
action that could be followed to improve profitability. (20)
39 TOE408-W/1
ZAC408-H/1

QUESTION 19 35 marks

Foodcor Ltd is a medium-size company producing a variety of consumer food and speciality products.
The financial year ends on 31 December. The current year’s (2000) projected income statement for the
olive oil product line is as follows:
R000 R000
Gross sales 30 000
Freight and settlement discounts 3 000
Net sales 27 000
Less manufacturing costs:
- Variable 13 500
- Fixed 4 100
- Depreciation 700
Total manufacturing costs 18 300
Gross profit 8 700
Less expenses:
- Marketing 4 000
- General and administrative 2 100
- Research and development 500
Total expenses 6 600
Profit before interest and tax 2 100

After a recent strategic planning session the Chief Executive Officer (CEO) indicated that he is setting the
following targets for next year’s (2001) performance:

• the % gross profit on net sales must at least be maintained;


• a 10% profit before interest and tax on gross sales; and
• a reduction of non-production overheads

Both the Marketing Director and the Production Director felt that the CEO’s objectives would be difficult to
achieve. However, after discussions with their staff, they came up with the following suggestions:

● Sales volumes
Foodcor’s current share of the olive oil market is 10% and the total olive oil market is expected to
increase by 5% for 2000. Foodcor’s current market share can be maintained by a marketing
expenditure of R4 200 000. It is felt that by increasing expenditure on advertising and sales
promotions the market share can be increased. For an additional expenditure of R1 225 000 the
market share can be raised by one percentage point until it reaches 12%. Further market
penetration can only be achieved by the 5 largest customers taking up the additional volumes.
They will only be prepared to do that if volume rebates equal to 10% of the incremental sales
values are granted to them. This strategy will only increase the market share until it reaches 15%.
Any further expenditure is unlikely to increase the market share beyond 15%.
40 TOE408-W/1
ZAC408-H/1

● Selling prices

The selling price was R6 per litre during 2000. The increase in the selling price is very dependent
on the increases in the variable cost of production. Foodcor will be able to pass on to their
customers 50% of the percentage point increase in the variable cost of production. Once a market
share of 15% has been achieved, Foodcor will become the dominant player in the market and it
can charge a premium of 5% on its price.

● Variable manufacturing cost

An increase of 6% per litre produced during 2001 is forecast.

● Fixed manufacturing cost

Fixed manufacturing cost consists of direct labour. It is estimated that the annual wage
negotiations will result in a general increase of 8%. The union is also insisting that R500 000 be
spent on basic adult education for its members.

● Capacity

The plant is currently operating at 80% capacity. (Sales = production) Once 100% capacity is
reached, an additional plant will have to be installed which will cost R25 million and add another 3
000 000 litres of capacity. Plant is depreciated on the straight-line basis over 10 years. Additional
labour cost of R200 000 will be needed to run the new plant.

● Freight and discount

The current rate of 10% of gross sales is expected to continue during 2001.

● General and administrative expenses

A management consultancy firm has been appointed to investigate the effectiveness of the non-
manufacturing overhead departments. Initial indications are that at least R200 000 can be saved.

● Research and development.

A 5% increase on the 2000 basis is required to meet divisional research targets.

REQUIRED

(a) Prepare a budgeted income statement for a 10%, 12% and 15% market share (19)

(b) Evaluate each plan in terms of the CEO’s objectives. (8)

(c) Comment on the management processes of Foodcor. (8)

(Unisa)
41 TOE408-W/1
ZAC408-H/1

QUESTION 20 35 marks

Techno 2020 Ltd is a company which focuses on the sale of information technology products and
services. It has three divisions which operate as autonomous business units. Details regarding these
divisions appear below. Techno 2020 Ltd has its head office in Johannesburg, which is responsible for
the setting of policies, strategies and performance targets for each division. The head office costs in the
2002 financial year are budgeted to be R12 million. It will be recovered from the operating divisions on
the basis of the budgeted turnover of each division.

1. Divisional performance targets

All three divisions are required to achieve a Return on Net Assets (RONA) of 20% per annum after
head office charges.
All divisions are required to achieve organic turnover growth of 10% per annum in real terms.

2. New developments

Techno 2020 Ltd is considering employing two senior information technology industry consultants.
Techno 2020 Ltd proposes paying each consultant R8 million to enter into employment contracts
with open month notice periods and two year restraint of trade agreements. The restraint to trade
will become effective on termination of employment. Techno 2020 Ltd proposes to capitalise the
initial R16 million and then write if off in equal annual amounts over eight years, being the expected
period of employment of each individual, followed by a two-year restraint period. Techno 2020 Ltd
has decided on the eight year expected employment period as this is the industry norm for the type
of individual that they are considering for the consultancy positions.

3. Operating divisions

3.1 Tech Training Division

Tech Training specialises in technical training for information technology specialists. It is an


authorised training partner of two major American software companies, one being a desktop
systems provider and the other an enterprise systems provider. In terms of the Techno
Training partnership agreement with the American companies it is entitled to confer
certificates of partnership agreements with the American companies it is entitled to confer
certificates of competence on its students, subject to the satisfactory completion of certain
course requirements. Tech Training operates from its own premises in Johannesburg, Cape
Town, Durban and Pretoria.

Tech Training employs 114 staff members of whom 22 are in support roles (e.g. marketing,
finance). The others are full-time lecturers.
42 TOE408-W/1
ZAC408-H/1

3.2 Tech Retail Division

Tech Retail was established in 1991 and is one of the original specialist information technology
retailers. The 32 Tech retail stores, spread countrywide, sell a comprehensive range of
software and a select range of hardware, consumables and peripherals. All sales are for cash.
All staff incentives are based on individual store performance. All products are purchased
centrally.

3.3 Tech Consulting Division

This division was established in January 1998 and provides professional consultancy services
specialising in enterprise system implementation, project management, e-commerce and
database management. Tech Consulting has offices in Johannesburg, Pretoria, Durban and
Cape Town and has 16 full-time employees. Tech Consulting contracts for the necessary
skills as and when consultants are needed for projects and pays these consultants a flat
weekly rate.

REQUIRED

(a) For each of the three operating divisions, list four critical success factors that are vital if each is to
perform at an optimal level. (12)

(b) List the advantages and disadvantages from Techno 2020 Ltd’s perspective, of recovering head
office costs from the operating divisions and comment on the method of head office cost allocation
used by Techno 2020. (5)

(c) Discuss the divisional performance targets and suggest ways in which each division could improve
performance. (10)

(d) Comment on Techno 2020 Ltd’s proposed accounting treatment of the upfront payments to the new
consultants. (8)
43 TOE408-W/1
ZAC408-H/1

QUESTION 21 30 marks

Flora Ltd has been operating in the flower business for several years by means of independent
divisions.

The manager of the divisions make decisions effecting income, expenses as well as decisions relating
to the purchase of new fixed assets. Financing are controlled centrally and Head office also act as
advisor on transfer prices.

The Managing director has organised a meeting between division managers where possible transfer-
price problems will be discussed and to find optimal solutions for them. You are the management
accountant and have been contacted by the managing director to provide advice to the division
managers.

The group is considering entering the European market with highveld-flowers. If so then one of the
divisions, the highveld-farm, will transfer flowers to the export division.

The following cost information is relevant for the cultivation of one dozen flowers (based on 100%
capacity):
R
Variable cultivation cost 2,70
Fixed overheads 6,00
Full cost 8,70

Further details:

● The maximum capacity of the farm under normal conditions is 100 000 dozen flowers;

● Fixed overheads include R180 000 allocated Head office charges, while the balance is incurred by
the farm. The overheads incurred by the farm could be viewed as semi-fixed as 80% of the cost is
incurred at a capacity level of 1-89% and 100% of the cost is incurred at a capacity of 90-100%;

● It is expected that a maximum of 70 000 dozen flowers would be sold locally in the coming year @
R20,00 per dozen. Packaging for local sales total R3,00 per dozen. No marketing costs would
have to be incurred as flowers are collected at the farm by a wholesaler;

● The export division expects a huge demand for highveld-flowers in Europe and estimates that a
maximum of 45 000 dozen flowers will be sold in the coming year. The average expected selling
price is R50,00 per dozen based on an exchange rate of R11:1GBP. If the flowers are exported
then the following additional costs would have to be incurred:

R
• Transport costs per dozen 10,00
• Packaging per dozen 12,00
• Fixed marketing costs (note 1) 850 000
44 TOE408-W/1
ZAC408-H/1
Note 1

If highveld-flowers are marketed in Europe, the following marketing costs would have to be incurred:

R
Rent of offices and storage space 100 000
Television advertisements 550 000
Initial market research 200 000
850 000
REQUIRED

(a) Indicate what the minimum price per dozen will be for the highveld-farm to transfer

• 15 000 dozen, or
• 45 000 dozen flowers, to the export division; (6)

(b) Indicate what the maximum price per dozen will be that the export division will be willing to pay for

• 15 000 dozen, or
• 45 000 dozen flowers; (8)

(c) Recommend and motivate whether Flora Ltd should market and sell highveld-flowers in Europe (to
a maximum of 45 000 dozen). (Support your answer with relevant calculations.); and (16)

(d) Recommend an alternative basis of calculating the transfer price if the European market is 70 000
dozen flowers with no local demand. (10)

(UP - adapted)
45 TOE408-W/1
ZAC408-H/1

QUESTION 22 50 marks

Almetals Ltd is considering the construction and operation of an aluminium smelter in Mozambique,
situated approximately 20 km from the Maputo harbour. An initial feasibility study has led to the
conclusion that this project has a “very good chance of being successful and profitable”.

In a post commissioning audit of a similar investment project for an aluminium smelter near Richards Bay,
the conclusion was that the Richards Bay project had proved to be very successful. There had been
significant savings in budgeted costs and it was completed three months ahead of schedule. The
Richards Bay smelter is currently operating at an increase of 7% above the originally estimated capacity.

The following excerpts from the Maputo project feasibility study are available:

1. Aluminium market and prices

Market analysts have forecast a significant increase in the per capita consumption of aluminium in
developing Asian economies such as China, India and South Korea.

World aluminium production has increased substantially over the past few years as a result of
improved efficiency, technological upgrades and the re-opening of idle capacity. Cost analysts
forecast that anticipated demand will continue to exceed supply. It is estimated that world
production capacity will have to increase by about 220 000 tons per year in order to satisfy future
demand.

An average LME (London Metal Exchange) price of US $1 800 per ton (in terms of December 1999
values) is forecast for the next ten years.

2. Capital cost and construction

Based on the experience gained on the Richards Bay smelter project (with some monitor
adjustments for the Maputo smelter), the capital cost of the Maputo smelter is estimated at US
$1 230 million. The cost will be evenly incurred over the two-year construction period.

Construction of the smelter, which will have a capacity of 340 000 tons per annum, is expected to
commence in January 2000 and will be undertaken by the same joint venture partners who were
responsible for the construction of the Richard Bay smelter.

3. Capacity

The smelter will be in operation by the beginning of 2002.


Capacity utilisation is planned as follows:

2002 40%
2003 60%
2004 and later 100%
46 TOE408-W/1
ZAC408-H/1
4. Operating costs

Operating costs comprise the following items (all amounts are constant 1999 prices):

• Alumina

Alumina will be imported from Australia at a landed cost of US $340 per ton. One ton of
alumina yields one ton of aluminium.

• Electricity

Electricity will be acquired from the Eskom network. Following initial discussions with Eskom
two lines will be provided for the plant. One line will run through Swaziland, while the other will
run north of Swaziland. either of the lines has the capacity to provide for the full electricity
requirements of the smelter. Electricity costs in 2002 are estimated at R8 000 000 and at
R10 951 200 in 2003.

• Salaries

Salaries will be paid in rand and are estimated at R5,2 million per year.

• Other raw materials

The costs are estimated at US $210 per ton of aluminium.

• Overheads

Overheads will amount to US $2,4 million per year.

5. Project financing

A decision has been taken to structure the project as a project financing transaction. The
investment will thus be housed in a separate entity, managed by Almetals Ltd.

The following financing structure has been proposed:

US$ million
Equity 440
Quasi-equity* 263
Debt 527
1 230

* Interest bearing convertible shareholders loans.


47 TOE408-W/1
ZAC408-H/1

6. Discount rate

For the purposes of the feasibility study the discount rate was based on the following information:

Cost of equity 14,5%


Cost of quasi-equity 13%
Cost of debt 10%

These rates represent United States dollar returns. The United States inflation rate is forecast at
3% and the interest rate differential between South African and the United States is expected to
amount to 8%.

7. Taxation

The Mozambique government has indicated that the project will have to pay a levy of 0,5% on
turnover as tax. No other taxation will be levied.

8. Terminal value

The terminal value of the project at the end of 2011 is estimated at US $200 million.

9. Exchange rate

The exchange rate of the rand to the US dollar has been assumed to be R6,20:US$1.

A portion of the equity stake has been made available to outside venture capital investors, and Almetals
Ltd has invited Equity Invest Ltd to make an investment. You have been retained as a financial advisor to
Equity Invest Ltd to assess the offer.

REQUIRED

(a) Discuss the possible risks related to this project and indicate how these risks could be managed or
hedged. (12)

(b) Evaluate the proposed financing structure. Your evaluation should include the factors that would
influence the maximum project debt/equity ratio that could be tolerated in the structure. (5)

(c) Advise Equity Invest Ltd whether you would recommend an equity exposure to the project. List any
additional information that you would deem necessary for purposes of your recommendation and
test the project’s sensitivity with respect to demand and the aluminium price. (33)
48 TOE408-W/1
ZAC408-H/1

QUESTION 23 30 marks

Gauteng Transport Ltd is a listed company of which the main business is the distribution of products
between the most important business centres in South Africa. The company became well known in the
transport industry over the past ten years.

The company’s vehicle fleet consists of 300 trucks and LDV’s which are currently utilized at 100% of their
capacity.

The marketing director is currently negotiating a contract with the Zimbabwe government for the
transportation of granite from Victoria Falls to the Cape Town harbour from where it will be shipped to
overseas countries. Environmental groups are currently applying pressure on the Zimbabwe government
not to mine the granite in the Victoria Falls region as this will upset the fauna and flora and have a
negative impact on the tourism and for this reason the company regards it as a high risk project.

The foreign exchange is, however, desperately needed by the Zimbabwe government to finance its
military activities in Angola, and it is therefore willing to issue guarantees to Gauteng Transport for the
contract amount over the three year period.

The following is a brief extract from the financial statements of Gauteng Transport for the past three
years:
Gauteng Transport Limited
Balance sheet as at 30 September

1997 1998 1999


R’000 R’000 R’000
ASSETS

Non-current assets: vehicles 4 000 5 000 6 500


Net working capital 1 160 2 318 4 456
5 160 7 318 10 956

EQUITY AND LIABILITIES 1997 1998 1999


R’000 R’000 R’000

Capital and reserves


Issued capital 1 000 1 000 1 000
Retained income 3 000 4 411 6 823
Shareholders’ interest 4 000 5 411 7 823
Non-current liabilities
Preference shares (12%) 400 400 400
Debentures (18%) 500 500 500
Long-term loans (20%) 200 927 2 193
Deferred tax 60 80 40
5 160 7 318 10 956
49 TOE408-W/1
ZAC408-H/1

Income statement for the year ended on 30 September

1997 1998 1999


R’000 R’000 R’000

Income 10 000 15 000 20 000


Less: Expenditure (6 680) (11 670) (14 360)
Operating expenditure 5 000 9 000 11 000
Administrative expenditure 1 000 1 500 2 000
Marketing expenditure 500 1 000 1 200
Finance charges 180 170 160
Profit before tax 3 320 3 330 5 640
Tax (35%) 1 162 1 166 1 974
Profit after tax 2 158 2 164 3 666
Proposed dividends
Preference dividends (48) (48) (48)
Ordinary dividends (703) (705) (1 206)

The details of the Zimbabwe contract are as follows:

Year 2000 2001 2002


R000 R000 R000

Net income 2 000 4 000 10 000


(excluding subcontractor costs)
Additional investment in working capital
on 1 October 1999 1 000
Starting date of contract 1 October 1999
Vehicles needed for contract 3 4 6

Additional information

• The ordinary share capital consists of 1 million ordinary shares of R1,00 each. The shares are
currently trading at 650c per share. Issue costs for new shares are 10%.

• The preference shares consist of 500 000 shares of 80c each. The current market value is 100c
per share and issue costs are estimated at 8%.

• The 5 000 R100 debentures are convertible to ordinary shares within one year in a ratio of 20
shares per one debenture.

• The long-term loans consist mainly of hire purchase agreements for the vehicles purchased.
Raising fees are approximately 2% of the amount financed.
50 TOE408-W/1
ZAC408-H/1

• The director responsible for logistics is worried about the safety of the vehicles to be used on the
Zimbabwe contract because of the increasing pressure applied on the Zimbabwe government by
organisations such as Green Peace. A large transportation business in Zimbabwe, Harare
Transport, is willing to transport the granite on a subcontractor basis at Z$36,00 per kilometre with
an annual escalation on 1 October equal to the inflation rate in Zimbabwe on that date. Each
vehicle will on average cover approximately 500 km per day for 240 days per year. The
subcontractor will use the same number of vehicles as Gauteng Transport would have used to
handle the contract. The following estimates were received from a prominent broking firm in
Johannesburg:

Date 1/10/1999 1/10/2000 1/10/2001

Z$ per R1,00 Z$6,00 Z$7,00 Z$8,00


Expected rate of inflation 39% 42%

You may assume that the exchange rates will remain constant during the year and will only change
on the abovementioned dates.

• The company evaluates projects using net present value techniques. Issue costs are ignored in
the calculation of the weighted average cost of capital. A weighted average issue cost is calculated
on the basis of the debt/equity ratio of the company and taken into consideration as a capital outflow
in the investment decision cashflows.

• The growth in earnings in 1999 is viewed as extraordinary by the directors. Approximately 80% of
the growth can be ascribed to new contracts entered into during 1999. A growth rate equal to 20%
of that experienced in 1999 is estimated for the 2000 year. (The new contract is included in these
estimates).

REQUIRED

(a) Calculate the weighted average cost of capital according to company policy; (18)

(b) Advise the marketing director on the acceptability of the Zimbabwe contract by using net present
value techniques. You may assume that the subcontractor will be used. (12)
Round off to nearest R1 000.
(Unisa)
51 TOE408-W/1
ZAC408-H/1

QUESTION 24 40 marks

Fuelit Ltd is an electricity supplier in the UK. The company has historically generated the majority of its
electricity using a coal fuelled power station, but as a result of the closure of many coal mines and
depleted coal resources, is now considering what type of new power station to invest in. The alternatives
are a gas fuelled power station, or a new type of efficient nuclear power station.

Both types of power station are expected to generate annual revenues at current prices of R6 000 million.
The expected operating life of both types of power station is 25 years.

Financial estimates
R million

Gas Nuclear

Building costs 6 000 33 000


Annual running costs (at current prices):
Labour costs 750 200
Gas purchase 5 000 -
Nuclear full purchases - 100
Sales and marketing expenses 400 400
Customer relations 50 200
Interest expense 510 3 300
Other cash outlays 50 250
Accounting depreciation 240 1 320

Other information

1. Whichever power station is selected, electricity generation is scheduled to commence in three years
time.

2. If gas is used most of the workers at the existing coal fired station can be transferred to the new
power station. After tax redundancy costs are expected to total 40 million in year four. If nuclear
power is selected fewer workers will be required and after tax redundancy costs will total R360
million, also in year four.

3. Both projects would be financed by Eurobond issues denominated in Euros. The gas powered
station would require a bond issue at 8,5% per year, the bond for the nuclear project would be at
10% reflecting the impact on financial gearing of a larger bond issue.

4. Costs of building the new power stations would be payable in two equal installments in one and two
years time.
52 TOE408-W/1
ZAC408-H/1
5. The existing coal fired power station would need to be demolished at a cost of R100 million in three
years time.

6. The company’s equity beta is expected to be 0,7 if the gas station is chosen and 1,4 if the nuclear
station is chosen. Gearing (debt to equity plus debt) is expected to be 35% with gas and 60% with
nuclear fuel.

7. The risk free rate is 4,5% per year and the market return is 14% per year. Inflation is currently 3%
per year in the UK and an average of 5% per year in the member countries of the Euro block in the
European Union.

8. Corporate tax is at the rate of 30% payable in the same year that the liability arises.

9. Tax allowable depreciation is at the rate of 10% per year on a straight line basis.

10. At the end of twenty-five years of operations the gas plant is expected to cost R250 million (after
tax) to demolish and clean up the site. Costs of decommissioning the nuclear plant are much less
certain, and could be anything between R5 000 million and R10 000 million (after tax) depending
upon what form of disposal is available for nuclear waste.

REQUIRED

(a) Estimate the expected NPV of EACH of an investment in an gas fuelled power station and
investment in a nuclear fuelled power station.
State clearly any assumptions that you make.

(NB: It is recommended that annuity tables are used wherever possible) (20)

(b) Discuss other information that might assist the decision process. (8)

(c) An external advisor has suggested that the discount rate for the costs of decommissioning the
nuclear power station should be adjusted because of their risk. Discuss whether or not this
discount rate should be increased or decreased. (4)

(d) Explain the significance of the existence of real options to the capital investment decision, and
briefly discuss examples of real options that might be significant in the power station decision
process. (8)
(ACCA - adapted)
53 TOE408-W/1
ZAC408-H/1

QUESTION 25 30 marks

New Life Pharmaceuticals Ltd have developed a new pharmaceutical product, dubbed the “millennium
capsule”, which they intend to market on a large scale.

Expected sales from the project in the first year of production and sale are as follows:

Probability Sales volume (units)

0,05 60 000
0,25 84 000
0,40 100 000
0,30 120 000

Once sales are established at a certain volume in the first year, they will grow by 20% in the second year,
10% in the third and remain constant thereafter up to the fifth year. The product is expected to have a
useful life of five years after which it will be replaced by a new superior product.
The following costs are associated with the “millennium capsule”.

Working capital will initially amount to R80 000. It will increase by 10% per annum during the first two
years of operation and remain constant thereafter.

Extensive research and development work (including market research) has already been carried out at a
cost of R3,5 million.

The necessary machinery will be purchased, using borrowed funds, at a cost of R500 000. The
machinery will qualify for a section 12C capital allowance of 20% on cost. Interest of 13% per annum will
be paid on the loan which is redeemable after six years. The machinery will have a resale value of
R100 000 at the end of the fifth year. The machinery will be installed in the west wing of the company’s
factory. This wing has been empty for the last four years. For fear of vandals, the wing is
guarded 24 hours a day at a cost of R30 000 per annum. This cost will be dispensed with should the wing
come into use.

Variable costs per unit

Labour R3,00
Materials R2,50
Other variable costs R2,00

To manufacture the product a manager will be transferred from another department (and not be replaced).
The manager currently earns R250 000 per annum. His salary will increase to R270 000 to compensate
him for the change that is anticipated in his work schedule. A supervisor will also be employed at a cost
of R70 000 per year.

The project’s share of general overheads each year will be R90 000. Of this amount, R40 000 represents
additional cash expenditure as a result of undertaking the project.
54 TOE408-W/1
ZAC408-H/1

The proposed selling price of the “millennium capsule” is R10 per unit. All sales and costs will take place
on a cash basis.

New Life Pharmaceuticals Ltd requires that cash flows from any project have a positive net present value
when discounted at the company’s weighted average cost of capital. It has been decided, however, that
there be an upward adjustment of 3 percentage points to the weighted average cost of capital when
evaluating this particular project, to compensate for the perceived high risk.

The company tax rate is 30% and you may assume that tax savings and/or payments occur in the same
year as the cash flows that give rise to them. Ignore STC and VAT.

The following is an extract from the balance sheet of New Life Pharmaceuticals Ltd at 30 June 2001:

Balance sheet at 30 June 2001

R000

Non-current assets (Net book value) 25 000


Current assets 8 000
Current liabilities (7 500)
25 500

Financed by:
Issued share capital (ordinary 50c shares) 10 000
Reserves 5 300
16% Debentures (irredeemable) 10 200
25 500

The current ex-dividend share price is 225 cents. Debt of similar risk and maturity (irredeemable) to that
in the balance sheet of New Life Pharmaceuticals Ltd is currently trading in the market at R125 per R100
nominal.

The dividend declared and paid for the year ended 30 June 2001 was 36 cents per share. The expected
growth in dividends in the foreseeable future is 5% per annum.

REQUIRED

(a) Based on market values, calculate the cost of capital to be used in evaluating the “millennium
capsule” project. (10)

(b) Determine whether or not the project should be undertaken. (20)


55 TOE408-W/1
ZAC408-H/1

QUESTION 26 95 marks

Retail Action Ltd (RAL) is listed on the JSE Securities Exchange SA and the group trades principally in
the clothing, furniture and vehicle sectors. The group also provides financial services to it’s customers
through a subsidiary company.

During 1999 the group suffered severe losses in its clothing and furniture chains and these operations
had to be restructured. The furniture chain and related finance company were subsequently sold.

The board of directors, at their last meeting, decided that RAL should return to their core activities.

The following decisions were taken:

• An investment of 10,1% held in a listed company in the property sector should be unbundled. RAL
holds 21 210 000 shares in the company, acquired at an average cost of R1,70. The current market
price is R5,15 per share.
• The IT-division of the group should be outsourced as soon as possible.
• RAL should proceed with a rights issue to bring debt to sustainable levels.
• Dividends should again be declared from the 2001 financial year.

The financial information relating to RAL is disclosed in the annexures hereto.

REQUIRED

(a) Financial performance

• Calculate the missing ratios for 2000;


• Comment on RAL’s performance in terms of:

Profitability
Productivity
Market returns
Debt;

• Discuss the impact of a profit warning on the company; (35)

(b) Dividend policy

• Discuss the policy over the five year period;


• Discuss the impact of a capitalisation share policy on the company;
• Indicate whether an unbundling by way of a dividend in specie can be considered as a
dividend policy or a replacement thereof. (8)

(c) EBITDA

• Calculate RAL’s EBITDA for 2000 and indicate when it is considered to be a useful
management tool; (5)
56 TOE408-W/1
ZAC408-H/1

(d) Growth

• Explain the terms:


Organic growth
Growth by acquisition; (4)

(e) Acquisition methods

Cash or shares are often used to effect acquisition of companies. Discuss their:
• Basic applications;
• Usability in terms of RAL’s current financial position; (5)

(f) Unbundling

RAL wishes to proceed with the unbundling of their investment in the listed property company.

• Determine the basis of the unbundling;


• Show the impact of the unbundling on RAL’s financial position for the year 2000;
• Prepare the journal entries to effect the unbundling; (6)

(g) Cost of capital

• Calculate RAL’s current cost of capital - RAL’s beta is 1,7 with a market premium of 5,5%;
• Indicate the effect of a rights issue on the cost of capital; (10)

(h) Rights issue

RAL’s board of directors proposes a rights issue of 200 000 000 shares at R1,20 each to raise
additional capital and decrease the debt further.

• List the issues to be considered;


• Prepare the journal entries to give effect to the rights issue; (7)

(i) Share buyback

• List the requirements to implement a share buyback scheme and indicate whether RAL
can implement, such a scheme;
• Discuss a share buyback scheme from (a) strategic perspective(s);
• Indicate the accounts affected by a share buyback and the subsequent cancelling of the
shares; (12)

(j) Outsourcing

• List the issues to be considered before RAL can outsource it’s IT-division. (3)

Note

Students should attempt to complete the above in 2½ hours, the equivalent of 100 marks in the
examination. (Unisa)
57 TOE408-W/1
ZAC408-H/1

APPENDIX I

RETAIL ACTION LTD

FIVE YEAR REVIEW

2000 1999 1998 1997 1996

Summarised income statement


(R000) 7 888 484 11 337 790 9 662 466 9 321 210 8 002 282
Turnover
Operating income 223 403 185 776 304 273 354 225 354 617
Operating interest paid 192 170 103 538 46 244 34 960 63 636
Debenture interest 33 090 40 962 47 339 51 182 52 032
(Loss)/income before taxation (1 857) 41 276 210 690 268 083 238 949
Taxation 16 673 107 281 37 991 77 401 76 068
(Loss)/income after taxation (18 530) (66 005) 172 699 190 682 162 881
Non-trading items - net (surplus)
/deficit (138 957) 203 342 34 269 - -
Attributable (loss)/earnings of
associates (12 531) 2 025 4 301 567 (594)
Outside shareholders’ interest 35 929 61 585 4 062 (3 349) (5 811)
Net income/(loss) attributable to
ordinary shareholders 71 967 (328 907) 138 669 187 900 156 476
Summarised balance sheet (R000)
Ordinary shareholders’ funds 416 308 306 162 641 268 576 768 981 185
Outside shareholders’ interest 21 196 379 654 127 194 13 075
30 743
Permanent capital 437 504 685 816 768 462 589 843 1 011 928
Other long-term funding 7 304 71 508 78 774 64 916 41 144
Interest bearing bank debt and
liability portion of convertible
debentures 731 729 1 623 549 583 667 348 671 383 622
Total funding 1 176 537 2 380 873 1 430 903 1 003 430 1 436 694

Intangible assets 8 500 25 419 13 730 - 513 112


Other non-current assets 793 678 916 337 858 518 381 132 293 418
Current assets 1 330 044 2 997 876 1 875 063 1 944 850 1 809 199
Current liabilities (955 685) (1 558 759) (1 316 (1 322 (1 179
406) 552) 035)
Total net assets 1 176 537 2 380 873 1 430 903 1 003 430 1 436 694
58 TOE408-W/1
ZAC408-H/1
APPENDIX II

DEFINITIONS
Acid-test ratio Current assets less inventory divided by total current liabilities. Total
current liabilities include current liabilities and short-term borrowings.
Asset turnover Turnover divided by total assets.
Assets per employee Total assets divided by the number of employees in service.
Current ratio Current assets divided by total current liabilities.
Debt equity ratio Interest bearing bank debt less cash as a percentage of permanent
(Including the impact of capital.
AC 125)
Debt equity ratio Interest bearing bank debt less cash as a percentage of permanent
(Excluding the impact of capital. Permanent capital includes the liability portion of convertible
AC 125) debentures.
Dividend cover Earnings per share divided by the dividend per share.
Dividend yield Dividends per ordinary share divided by the closing share price on the
JSE Securities Exchange SA
Earnings per share Net income attributable to ordinary shareholders divided by the
weighted average number of ordinary shares in issue.
Earnings yield Earnings per ordinary share divided by the closing share price on the
JSE Securities Exchange SA.
Headline earnings Includes all the trading profits and losses for the year but excludes the
earnings and taxation impact of discontinued operations, abnormal
closure costs, intangibles written off, and the profits/losses on disposal
of investments.
Interest cover Income before financing costs divided by financing costs.
Net asset value per share Ordinary shareholders’ funds divided by the number of ordinary shares
in issue.
Price earnings ratio The closing share price on the JSE Securities Exchange SA divided by
earnings per share
Return on ordinary share- Net income attributable to ordinary shareholders as a percentage of
holders’ funds average ordinary shareholders’ funds
Return on net assets Operating income as a percentage of average net tangible assets.
Turnover per employee Turnover divided by the number of employees in service.
Weighted average number The number of ordinary shares in issue at the beginning of the year
of shares in issue increased by shares issued during the year weighted on a time basis
for the period during which they have participated in the net income of
the group.
59 TOE408-W/1
ZAC408-H/1
APPENDIX III
RATIOS
FIVE YEAR REVIEW
Performance 2000 1999 1998 1997 1996

Profitability ratios
Return on ordinary shareholders’ funds (%) (69,43) 22,77 35,97 36,64
Return on net assets (%) 9,85 25,00 36,76 40,74
Operating income/turnover (%) 1,64 3,15 3,80 4,43

Per ordinary share


Number of shares in issue at year end (R000)
- weighted average 167 743 163 997 160 052 160 047 160 047
- fully diluted 221 049 248 814 242 547 241 743 241 502
Earnings - undiluted (cents) (200,6) 86,6 117,4 97,8
- fully diluted (100,5) 86,7 104,0 87,4
- fully diluted headline (26,9) 105,4 112,4 93,7
Dividends - interim (cents) - 14,0 18,0 16,0 12,5
- final - - 19,0 18,5 15,5
Net asset value (cents)
- undiluted 186,7 400,7 360,4 292,5
- diluted 202,7 364,1 352,4 312,4

Productivity ratios
Number of employees at year end 7 147 19 942 19 851 16 322 15 133
Turnover per employee (R000) 568,5 486,7 571,1 528,8
Assets per employee (R000) 197,6 138,4 142,5 138,9
Asset turnover (times) 2,88 3,52 4,01 3,06

Financial ratios
Debt equity ratio (including the impact of
AC 125) (%) 176,60 45,97 (10,76) (16,71)
Debt equity ratio (excluding the impact of
AC 125) (%) 139,16 36,03 (7,75) (13,51)
Interest cover (times)
- including convertible debenture interest 1,29 2,56 3,12 2,47
- excluding convertible debenture interest 1,79 6,58 10,13 5,57
Dividend cover (times) - 2,34 3,40 3,49
Current ratio 1,05 1,12 1,39 1,43
Acid-test ratio 0,59 0,54 0,65 0,65

Market performance
Traded prices per share
- closing (last sale) (cents) 122 550 1 300 1 400 1 425
- highest (cents) 500 1 775 1 600 2 125 1 800
- lowest (cents) 70 475 1 110 1 160 780
Volume of shares traded (000s) 97 020 23 228 16 298 8 030 8 211
Value of shares traded (Rm) 137,4 258,6 213,4 121,2 102,0
Volume traded as % of number in issue (%) 49,1 14,0 10,2 5,0 5,1
Market capitalisation (Rm) 910 2 081 2 241 2 281
Number of share in issue (000s) 197 724 165 450 160 058 160 047 160 047
Price earnings ratio (times) (2,7) 15,0 11,9 14,6
Dividend yield (%) 2,5 2,8 2,5 2,0
Earnings yield (%) (36,5) 6,7 8,4 6,9

The calculations above are based on the definitions stated.


60 TOE408-W/1
ZAC408-H/1
APPENDIX IV
BALANCE SHEET
2000 1999
R000 R000
Permanent capital 437 504 685 816
Stated capital 283 152 121 777
Equity portion of convertible debentures 47 256 150 067
Non-distributable reserves 92 547 54 336
(Accumulated deficit)/distributable reserves (6 647) (20 018)
Ordinary shareholders’ funds 416 308 306 162
Outside shareholders’ interest 21 196 379 654
Liability position of convertible debentures 122 135 184 542
Other long-term funding 7 304 71 508
Unearned insurance premium reserve 4 570 42 651
Life assurance fund 2 112 14 565
Deferred taxation 622 7 997
Holding company loan - 6 295
Interest bearing bank debt 609 594 1 439 007
Long-term borrowings 15 727 23 036
Short-term borrowings 593 867 1 295 449
Banking liabilities - 120 522
Total funding 1 176 537 2 380 873

Represented by:

Property, plant and equipment 132 663 302 447


Intangibles 8 500 25 419
Interest in subsidiary companies
Interest in associates & joint finance company 624 947 260 275
Investments 36 068 103 141
Banking advances - 250 474
Current assets 1 330 044 2 997 876
Inventory 677 757 1 326 420
Accounts receivable 597 388 1 229 365
Owing by joint finance company - 169 647
Taxation prepaid 713 44 603
Short-term investments and bank balance 54 186 227 841
Current liabilities 955 685 1 558 759
Accounts payable and provisions 949 918 1 500 148
Taxation payable 5 767 58 611
Total net assets 1 176 537 2 380 873
61 TOE408-W/1
ZAC408-H/1

APPENDIX V

RETAIL ACTION LTD: OTHER FINANCIAL INFORMATION

2000 1999
R000 R000
1. Turnover
Sales of goods 7 258 366 10 402 014
Service rendered 630 118 935 776
7 888 484 11 337 790

Continuing operations 7 197 967 6 916 132


Divested operations 690 517 4 421 658
7 888 484 11 337 790

2. Operating income
Continuing operations 144 714 149 166
Divested operations 108 689 36 610
223 403 185 776

3. Headline earnings
Net income/(loss) attributable to ordinary shareholders 71 967 (328 907)
Net non-trading items after taxation - net surplus/(deficit) 141 588 (204 362)
Net profit on sale of investments 667 273 18 316
Diminution in value of assets (328 894) (127 559)
Intangibles written off (167 720) (2 067)
Costs of restructure and closure (32 702) (92 032)
Net surplus/(deficit) before taxation 138 957 (203 342)
Taxation 2 631 (1 020)

Headline loss (69 621) (124 545)


4. Expenses taken into account:
Depreciation of property, plant and equipment 18 479 39 909
Amortisation of leasehold improvements 5 698 4 070
Amortisation of intangibles 180 475 4 045

5. Taxation
Statutory rate 30,0% 35,0%
Effective rate 12,1% (57,0%)
Estimated tax losses for use against future taxable income 446 709 330 153

6. Dividends
Cent per share
Interim 14,0 - 24 341
Final 0,0 - -
- 24 341
Dividends were paid by way of a capitalisation share issue.
62 TOE408-W/1
ZAC408-H/1

7. Stated capital Number of shares


2000 1999
(000) (000)
Authorised
Ordinary shares of no par value 350 000 350 000
Issued
At beginning of year 165 450 160 058
Capitalisation share award 1 445
Conversion of convertible debentures 32 274 3 947
At end of year 197 724 165 450
8. Convertible debentures
Equity portion 47 256 150 067
Non-distributable reserve - to cover future conversions 37 500 33 656
Liability portion of convertible debentures 122 135 184 542
206 891 368 265
41 378 142 stepped coupon compulsory convertible
debentures of 500 cents each, issued 1993
• Initial coupon rate 12,5% pa
• Current maximum rate 25,0% pa
• Basis 1:1 to ordinary shares
• Compulsory conversion date 2003
9. Interest bearing bank debt 2000 1999
% %
Rates payable on:
Long-term loans 18,5 18,5
Short-term loans 15,5 16,75
Bank/liabilities - 17,5
10. Property, plant and equipment R000 R000
Carried at market value
Insured value 625 000 571 000

11. Associated companies


Shares at cost 371 941 178 339
Attributable portion of profit 41 688 675
Debt 211 318 81 261
624 947 260 275

Market value of shares 221 641 181 441

12. Investments
Market value of shares 108 204 175 211
63 TOE408-W/1
ZAC408-H/1

QUESTION 27 30 marks

This question consists of two parts which are not related

PART A 15 marks

You are the financial manager of Creative Ltd, a national retailer of electronic appliances, which is listed
on the JSE Securities Exchange SA. The attributable earnings of Creative Ltd for the 11 months ended
31 October 1999 are 35% ahead of budget. Armani Boss CA(SA), the chief executive of Creative Ltd,
has requested you to make a material general provision against inventory to create a “reserve” for 2000,
as he is expecting tougher trading conditions in the 2000 financial year. He has requested you to create a
general inventory provision to cater for this eventuality which will enable Creative Ltd to report a steady
improvement in earnings in both the 1999 and 2000 financial years.

REQUIRED

(a) Discuss the ethical issues you should consider prior to complying with the request of the chief
executive of Creative Ltd to create a general provision against inventory. (10)

(b) Discuss generally whether it is in the interest of shareholders of listed companies such as Creative
Ltd to “smooth” earnings by creating excessive provisions. (5)

PART B 15 marks

You are the financial manager of Hibiscus Ltd, a listed company involved in the manufacture of
pharmaceutical and cosmetic products. The managing director of Hibiscus Ltd has asked you to advise
him regarding the recent amendments to the Companies Act in terms of which companies are permitted
to purchase their own shares.

REQUIRED

Draft a memorandum to the managing director of Hibiscus Ltd in which you -

(a) List the circumstances in which it may be appropriate for a company to purchase its own shares; (5)

(b) Briefly discuss the Companies Act requirements that a company should comply with in order to
purchase its own shares; and (5)

(c) List the issues the board of directors of Hibiscus Ltd should consider in evaluating whether to
recommend a purchase, by the company, of its own shares. (5)
64 TOE408-W/1
ZAC408-H/1

QUESTION 28 45 marks

Ditech Ltd is listed in the Information Technology (IT) sector of the JSE Securities Exchange South Africa.
The company commenced business as a retailer of computer equipment six years ago, and established an
outsourcing division during the 2000 financial year.

The Outsourcing Division enters into long-term contracts (typically between five and ten years) with small
and medium size corporate clients. In terms of the standard service level agreement between Ditech Ltd
and a client, Ditech Ltd –

• undertakes a comprehensive assessment of the systems needs (hardware as well as software) of


the client company;
• provides the necessary IT platform;
• undertakes to perform software upgrades as often as is appropriate;
• guarantees that all hardware will be replaced at least once every three years; and
• accepts responsibility for all routine servicing of the client company's computer network (this
includes the provision of consumables such as printer ink and paper up to specified maximum
quantities, after which clients are charged for any incremental usage).

The Outsourcing Division makes use of outside consultants in addition to its own professional staff to
perform its contractual duties. The division also employs a number of agents, responsible for sourcing
clients on a commission basis. Initial commission is earned when a new client is signed up, and in
addition there is an annual commission for the duration of the contract.

Amfurn Ltd, a national supplier of office furniture, was signed up as an outsourcing client by Ditech Ltd in
April 2001. In terms of the contract, Amfurn Ltd pays a monthly fee of R122 000 (excluding VAT) in return
for which Ditech Ltd supplies its equipment as well as providing the full range of services as set out above.
The monthly fee will increase at a fixed escalation rate of 8% per annum over the six-year period of the
contract. This transaction is considered to be typical of the business performed by the Outsourcing
Division of Ditech Ltd, both in terms of its nature and its size. The following worksheet summarises
aspects of the transaction with Amfurn Ltd from the point of view of Ditech Ltd:

DITECH LTD: TRANSACTION SCHEDULE

Client: Amfurn Ltd, Pinelands, Cape Town Ref: Q33NY


Type: Comprehensive Date: 1 April 2001
Period: Six years
Agent: F.B.Knight

1 Total value of transaction R8 784 000


R122 000 per month x 72 months
2 Margin on equipment Day 1: R2,2m x 30% = R660 000
Beginning of year 4: R3,5m x 30% = R1 050 000
65 TOE408-W/1
ZAC408-H/1

Budget
Year 1 2 3 4 5 6 Total
Cash in
Fee paid by client 1 464 000 1 581 120 1 707 610 1 844 218 1 991 756 2 151 096 10 739 800

Cash out
Equipment 2 200 000 100 000 110 000 3 500 000 133 100 146 410 6 189 510
Sales commission 439 200 79 056 85 380 92 211 99 588 107 555 902 990
Consulting fees 50 000 52 500 55 125 57 881 60 775 63 814 340 095
Printer ink 25 000 27 000 29 160 31 493 34 012 36 733 183 398
Paper 18 000 19 440 20 995 22 675 24 489 26 448 132 047
Other
consumables 10 000 10 800 11 664 12 597 13 605 14 693 73 359
Other costs 10 000 5 000 6 000 12 500 7 500 9 000 50 000

Allocated expenses
Professional fees / labour 150 000 30 000 33 000 120 000 39 930 43 923 416 853
Management time 100 000 40 000 44 000 48 400 53 240 58 564 344 204
(1 538 200) 1 217 324 1 312 286 (2 053 539) 1 525 517 1 643 956 2 107 344

During discussions with the financial director of Ditech Ltd, the following aspects came to your attention:

1. Since management believes that most of the work has been done when the initial client
assessment has been completed, they recognise 50% of the budgeted profit in the first year of
specific outsourcing contracts. For example, in the Amfurn Ltd transaction R1 053 672 (50% x
R2 107 344) was recognised in the 2001 financial year. The balance will be recognised evenly
over the remaining term of the contract.

2. The company further recognised a gross profit amounting to R660 000 on the supply of equipment
to Amfurn Ltd in April 2001. This profit was not credited to the Outsourcing Division but instead to
the Equipment Division of Ditech Ltd

3. During the financial year ended June 2001, Ditech Ltd decided to factor its debtors’ book. The
factoring house has recourse to Ditech Ltd in the event of debtors failing to pay amounts owing.

4. The net asset value of Ditech Ltd at 31 December 2001 was R10 per share.
66 TOE408-W/1
ZAC408-H/1

The following cash flow statements, from the annual reports of Ditech Ltd, are at your disposal:

2001 2000 1999


R’000 R’000 R’000

Net cash flows from operating activities (11 680) (7 325) 15 054
Cash generated by operations 60 875 44 381 36 995
Net increase in working capital (52 631) (37 456) (19 114)
Cash generated from operating activities 8 244 6 925 17 881
Finance costs (9 560) (5 002) (43)
Taxation paid (3 864) (4 248) (2 784)
Dividends paid (6 500) (5 000) 0
Net cash flows from investing activities (42 000) (29 880) (12 876)
Additions to fixed assets (16 400) (34 680) (12 876)
Proceeds from sale of fixed assets 0 4 800 0
Acquisitions (25 600) 0 0
Cash flows from financing activities 54 180 29 080 7 400
Increase in long-term liabilities 12 080 29 080 7 400
Proceeds from factoring of debtors 35 100 0 0
Net proceeds on issue of shares 7 000 0 0

(Decrease)/increase in cash and cash equivalents 500 (8 125) 9 578


Cash and cash equivalents at the beginning of the 3 965 12 090 2 512
year
Cash and cash equivalents at the end of the year 4 465 3 965 12 090

The latest information relating to a range of companies listed in the Information Technology sector
of the JSE Securities Exchange South Africa is summarised below:

Name Description of business Market Revenue Earnings


capitalisation
(R m) (R m) (R m)

Move-A-Box Distributor of computer hardware 275 1 625 55


Complan Network integrator 8 400 5 800 580
Out IT Outsourcing 500 667 50
Solutions Retailer 810 3 000 135
Ditech Retailer and outsourcing 315 750 45

REQUIRED

(a) Discuss the accounting treatment adopted by Ditech Ltd for the revenue and costs associated
with the Amfurn Ltd outsourcing contract. Discuss whether it complies with South African
statements of generally accepted accounting practice. (15)
(b) Critically evaluate and comment on the cash flows and gearing of Ditech Ltd for the financial
years ended 30 June 2000 and 2001. (15)
(c) Discuss, with reasons, whether the current market capitalisation of Ditech Ltd of R315 million is a
fair reflection of the value of the company. In your answer you should highlight risk factors that
may impact on the valuation of Ditech Ltd (15)
67 TOE408-W/1
ZAC408-H/1

QUESTION 29 40 marks

Quickcon Limited is engaged in various civil engineering activities, particularly railway, freeway and road
construction, earth works, tunneling, concrete structures, site investigations, engineering services, as well
as factory and warehouse construction.

During the past fifteen years the company’s growth has been rapid. Quickcon Limited has grown from a
civil engineering company with total assets of R5,5 million and turnover of R15 million to a major
contractor with its present size (based on total assets, it is one of the top fifty companies in South Africa)
and scale of operations. The firm’s growth can largely be attributed to three factors: the aggressive
efforts of its chairman and managing director, Julian Quickcon, the infrastructural development of the
country and the building boom which has occurred over the past fifteen years. The ordinary shares of
Quickcon Limited are currently actively traded on the JSE Securities Exchange SA at R8 per share.
Julian Quickcon and his family hold the controlling interest in Quickcon Limited.

The company is contemplating the expansion of its present business to the extent of R8 million. This
apparently excludes those assets which can be purchased with funds retained as a result of depreciation
charges.

The most recent share issues were in 1998 when 160 000 ordinary shares were issued to bring in about
R500 000 and in 2000 when 3 000 000 preference shares of R1 each were issued at par to provide
R3 000 000. All debt issues took place prior to 1998. In view of all the surrounding circumstances, it may
be possible to issue unsecured debentures at a rate of about 11,5% pa and redeemable preference
shares will command a preference dividend rate of about 10% pa.

EXHIBIT 1

QUICKCON LIMITED

ABBREVIATED BALANCE SHEET AS AT 30 JUNE 2000

Assets Rm

Non-current assets 23
Current assets 42
R 65
Equity and liabilities

Ordinary shareholders’ interest (1) 25


Redeemable preference share capital (2) 3
Share capital and reserves 28
Non-current liabilities
- Interest-bearing loan 7
Current liabilities 30
R 65
Notes

1. The issued share capital included in the ordinary shareholders interest comprises 4 960 000
ordinary shares of R0,50 each.
2. The 10% redeemable cumulative preference shares (par value R1) are redeemable at par in five
equal annual installments commencing 31 August 2004.
68 TOE408-W/1
ZAC408-H/1
EXHIBIT 2

Relevant details relating to the Income Statement of the company are as follows at 30 June: (in Rmillions)

2000 1999 1998

Turnover R 93 R 70 R 65
Income before interest and taxation 12 10 7
Interest paid 1 1 1
Net income before taxation 11 9 6
Taxation (30%) 3,3 2,7 1,8
Net income after taxation 7,7 6,3 4,2
Preference dividends 0,3 0 0
Profits attributable to ordinary shareholders R 7,4 R 6,3 R 4,2
Ordinary dividends paid R 1,8 R 1,6 R 1,4

EXHIBIT 3

Financial ratios for the building and construction sector of the JSE Securities Exchange SA

Current ratio 1,4 times


Average total asset turnover 1,3 times
Interest cover 4,5 times
Average inventory turnover 6,7 times
Average collection period 51,0 days
Debt ratio (excludes preference shares) 45%
Preference share capital/Total assets 1%
Return (earnings before interest and after taxation) on investment 8,3%
Return on equity 10,5%
Return (earnings before interest and after taxation) on sales 6,4%
Ordinary dividend cover 2,3 times

REQUIRED

As a member of Julian Quickcon’s management team, recommend a plan for financing the company’s
contemplated expansion. Consider the issue of debentures, preference shares, ordinary shares and the
retention of earnings. Present the factors to be taken into account in each case and ensure that selective
use is made of the data in the question to support the recommendation. Factors to consider are the
ratios, cost, risk, control, restrictions of future actions, effect on earnings per share and any other relevant
factors.
69 TOE408-W/1
ZAC408-H/1

QUESTION 30 35 marks

Kwiktune Ltd operates a chain of vehicle repair and fitment outlets in Gauteng. Some are company-
owned and some are operated under franchise. Minor repairs and fitment of tyres and exhausts are
undertaken. After initial rapid growth, this has now stabilised due to increased competition.

At a recent meeting between the directors and Kwiktune’s financial advisors, it was decided that the
company should expand to other regions. As the cash resources are limited, raising new finance are
inevitable. Two alternatives are being considered:

Alternative 1

A rights issue of 1 for 5 at R10 per share

Alternative 2

A floating rate loan of R50 million at an initial rate of 12% per annum. The loan would be for 8 years,
repayable on maturity and secured against the freehold land and buildings owned by Kwiktune Ltd.
Kwiktune’s bankers will grant the loan but insist that total debt to total debt plus equity should not be more
than 50% throughout the period.

Expansion

The expected initial operational changes are as follows:

• Turnover to increase by 10% per annum


• Direct costs, other than depreciation, will increase by 8% per annum as a result of a cost reduction
programme, including new supplier contracts
• Indirect costs should remain constant, due to internal restructuring
• Depreciation on existing assets at 30 September 2001 is forecast at R18 million for the year ending 30
September 2002 and R14 million for the year after that
• New assets of R50 million will be purchased in the year to 30 September 2002 and R40 million in the
year thereafter. Depreciation on these assets will be at 20% pa straight-line starting in the year of
purchase
• Additional inventory required of R20 million in the first year
• Tax payable at 30% pa in the year in which the liability arises
• Dividends are payable the year after they are declared. The current payout ratio will remain the same.

The summarised financial statements for the year ended 30 September 2001, are as follows:

Income Statement R000

Turnover 270 000


Direct costs (N1) 171 000
Indirect costs 40 000
Interest payable 5 000
Profit before tax 54 000
Taxation 16 200
Profit after tax 37 800
Dividends declared 22 680
70 TOE408-W/1
ZAC408-H/1
Balance sheet R000
Non-current assets 234 000
Current assets 94 500
Inventory 35 000
Debtors 49 000
Cash at bank 10 500

______
TOTAL ASSETS 328 500

R’000

Equity 212 820


Ordinary share capital (N2) 50 000
Distributable reserves 112 820
Revaluation reserve 50 000
Long term liabilities 50 000
10% Redeemable debentures - 2005
Current liabilities 65 680
Creditors 43 000
Shareholders for dividend 22 680
_______
TOTAL EQUITY AND LIABILITIES 328 500

N1 - Includes depreciation of R19 million


N2 - Shares of R2 each
N3 - Shares currently trade at R11,20 each

REQUIRED

(a) For both financing alternatives, prepare forecast

(i) Income Statement for the year to 30 September 2002; (6)


(ii) Balance Sheet at 30 September 2002; (7)
(iii) Cash flows for the year to 30 September 2002; (7)

Use a comparative format

(b) Evaluate the financing proposals; and (10)


(c) List other factors that should be considered. (5)
(ACCA - adapted)
71 TOE408-W/1
ZAC408-H/1

QUESTION 31 40 marks

You are an equity analyst at Viva Investment Bank Ltd, and have recently completed your training
contract at the bank. The head of the asset management division of Viva Investment Bank Ltd has
requested your assistance in evaluating Muzik.Co.Za.Ltd, a company listed in the Development Capital
sector of the JSE Securities Exchange SA.

Muzik.Co.Za.Ltd markets and sells music compact discs (CDs) via the internet. Muzik.Co.Za.Ltd was
established in January 1998 and commenced selling products in January 1999. The company sells music
CDs to its members only. This means that consumers cannot purchase music products from
Muzik.Co.Za.Ltd unless they join the company’s membership programme. Upon joining Muzik.Co.Za.Ltd’s
membership programme, new members are entitled to purchase three CDs for one cent each in terms of
the introductory offer to new members. Thereafter, members are contractually bound to purchase at least
one CD every quarter for a period of two years. After the initial two-year period, members may terminate
their membership by giving three months’ written notice.

Muzik.Co.Za.Ltd publishes an updated catalogue of available CDs on their website on a monthly basis.
Every month, there is a promotion of the “CD of the month” which is typically a new album issued by a
popular artist and sold at a discounted price to the members of Muzik.Co.Za.Ltd. Based on the high level
of sales generated by the “CD of the month” promotions, Muzik.Co.Za.Ltd is generally able to negotiate
favourable prices with suppliers. Members who do not order a CD in any given quarter are automatically
sent a copy of the latest “CD of the month” and billed accordingly.

Muzik.Co.Za.Ltd listed on the JSE Securities Exchange South Africa in June 1999 and raised R25 million
through an initial public offering of 25 million shares. There are currently 100 million Muzik.Co.Za.Ltd
shares in issue, which were issued as follows:

Date Description Number Issue price


(millions) (cents
per share)
1 January 1998 Issued to business founders and executive
directors 55 0,1
1 May 1999 Issued to promoters arranging listing 5 20,0
25 June 1999 Capital raised on listing 25 100,0
1 July 1999 Issued to vendors of CeeDeeCom Ltd 15 150,0
100

The entire share capital of CeeDeeCom Ltd, Muzik.Co.Za.Ltd’s major competitor at the time, was
acquired with effect from 1 July 1999. The purchase price was attributed to CeeDeeCom Ltd’s net asset
value of R500 000 and the balance to goodwill. Muzik.Co.Za.Ltd amortises goodwill on a straight-line
basis over ten years.

Muzik.Co.Za.Ltd has recently reported its group results for the financial year ended 31 December 2000.
Selected information included in the announcement of Muzik.Co.Za.Ltd’s consolidated financial results is
set out below:
72 TOE408-W/1
ZAC408-H/1

2000 1999
R000 R000
Revenue
CD sales 33 840 12 450
Advertising revenue 2 940 1 960
36 780 14 410
Cost of sales
Purchase cost of CDs (21 600) (7 500)
Gross profit 15 180 6 910
Operating expenses (11 890) (4 350)
EBITDA (earnings before interest, depreciation and amortisations) 3 290 2 560
Depreciation (3 500) (1 750)
Amortisation of goodwill (2 200) (1 100)
Amortisation: Member acquisition costs (6 420) (2 050)
Loss before interest (8 830) (2 340)
Interest received / (paid) 150 (670)
Attributable loss (8 680) (3 010)

The following information regarding the Muzik.Co.Za.Ltd’s trading performance is also available:

2000 1999

Number of members at year end 45 000 15 000


Unit sales
Introductory offers to new members 90 000 45 000
CD of the month 126 000 60 000
Other CD sales 144 000 45 000
360 000 150 000

Average selling price per CD (rand)


CD of the month 90 80
Other CD sales 100 90
Average purchase cost per CD (rand) 60 50

According to the company’s accounting policy, CD sales revenue in terms of the introductory offer to new
members is recognised at the average selling price of the “CD of the month”. The difference between
amounts received from new members availing themselves of the introductory offer and the amounts
recognised as revenue in the income statement is capitalised as “member acquisition costs” in the
balance sheet. Member acquisition costs are amortised over a two-year period on straight-line basis.

Advertising revenue is generated from the sale of advertising space on Muzik.Co.Za.Ltd’s website. The
company does not monitor direct costs associated with these sales activities and hence does not charge
such expenditure to “cost of sales”.

You received, via e-mail, the following extract from a report recently issued by Anna Liszt, a highly rated
researcher at a prominent stock broking house in Johannesburg:
73 TOE408-W/1
ZAC408-H/1

... Niche music retailer, Muzik.Co.Za.Ltd, reported a strong set of results for its year ended 31 December
2000. Revenue grew by 155% from the prior year and earnings before interest, depreciation and
amortisations (EBITDA) was up 29%. This reflects the company’s successful marketing efforts in building
a membership base.

The lower EBITDA growth in comparison to revenue growth is no cause for concern given the investment
in infrastructure and marketing expenditure to support future revenue growth.

We consider the price to revenue multiple to be the most appropriate yardstick upon which to value
internet based businesses. Muzik.Co.Za.Ltd is currently trading on a price to revenue multiple of 4,5
times, based on the current share price of 165 cents. This is conservative for high growth businesses
such as Muzik.Co.Za.Ltd, which are growing revenue at over 150% per annum. Our view is that
Muzik.Co.Za.Ltd is a strong buy up to 240 cents representing a price to revenue multiple of 6,5 times ...

REQUIRED

(a) Discuss the accounting treatment adopted by Muzik.Co.Za.Ltd for the introductory offer to new
members and whether this complies with South African statements of generally accepted
accounting practice. Your answer should address recognition of both revenue and expenditure. (8)

(b) Critically comment on the approach of Anna Liszt to valuing Muzik.Co.Za.Ltd on a price to revenue
multiple. (8)

(c) Prepare a report to the head of the asset management division of Viva Investment Bank Ltd, in
which you set out your views on

(i) the financial performance of Muzik.Co.Za.Ltd, (14)


(ii) the business model of Muzik.Co.Za.Ltd, and (6)
(iii) the methodology you would adopt in performing a valuation of Muzik.Co.Za.Ltd. (4)

Give reasons for your answers.


74 TOE408-W/1
ZAC408-H/1
QUESTION 32 30 marks

Secure (Pty) Ltd is a security company that has been in operation in the Gauteng and North-West
provinces for five years. The business consists of the following divisions:

• Manufacturing of security systems and fencing;


• Installation and erection of security systems and fencing; and
• A 24-hour radio linked reaction service.

Secure (Pty) Ltd was recently approached by one of its competitors, CrimeBust Ltd, with a view to
acquiring a controlling interest in Secure (Pty) Ltd at the end of March 2000. CrimeBust Ltd is active only
in KwaZulu-Natal and Mpumalanga. Business in these areas exhibited dramatic growth over the past year
and CrimeBust Ltd is now considering expanding into other provinces. The management of CrimeBust
Ltd considered organic growth, but decided rather to grow by acquisition.

In your capacity as the financial advisor to CrimeBust Ltd you have been approached to assist in the
negotiations to acquire a controlling interest in Secure (Pty) Ltd.

The financial director of Secure (Pty) Ltd provided you with the following working schedule:

BUDGET FOR THE YEAR ENDING 31 MARCH 2001

Manu- Instal- Reaction Head Total


facturing lation service office R000
R000 R000 R000 R000
Net profit/(loss) before taxation after taking 2 300 (200) (2 352) (152)
into account the following:
Interest paid - - - 820 820
Rent paid - - 260 - 260
Depreciation 4 000 800 210 400 5 410
Rent received - - - 132 132
Research and development costs 4 400 1 400 - - 5 800
Year-end market value of property, plant
and equipment 22 100 4 700 1 200 2 100 3 100
Net working capital at beginning of the year 2 050 810 20 19 2 899
Net working capital at end of the year 2 120 840 20 22 3 002

Manufacturing and installation

Secure (Pty) Ltd is planning to make a substantial investment in research and development during the
year ending 31 March 2001. For accounting purposes, such costs are written off in the year that they are
incurred, while the Receiver of Revenue will allow the cost to be written off over four years. It is expected
that the sales of systems and fencing of Secure (Pty) Ltd will increase dramatically as a result of this
research and development.

Fixed investment capital will be fully utilised by the end of March 2001. Depreciation and wear and tear
are calculated at 20% per year.
75 TOE408-W/1
ZAC408-H/1
Reaction service

The service has been in operation for three years. The directors are not concerned about the division,
despite the fact that the return of the division does not contribute significantly to the profit position of
Secure (Pty) Ltd. Stiff competition has been given as the primary reason for the division's under-
performance.

Secure (Pty) Ltd has found that the buyers of its systems and fencing prefer to be linked to other reaction
services (the systems of Secure (Pty) Ltd are generic enough to be linked to any reaction service).

No significant growth is expected for the reaction service division. No head office costs would be saved if
the reaction service division were closed.

Head office

Head office controls all the financing activities of the company.

The company owns the block of flats next to its offices, which comprises 50% of the market value of the
head office property, plant and equipment. All the rent received arises from this particular property.

Other information

As financial advisor to CrimeBust Ltd, some time ago you established the following after tax rates with a
view to performing a valuation of CrimeBust Ltd:

%
Earnings yield 15
Dividend yield 9
Cost of debt 12
Cost of equity 22
Cost of capital 20

Inflation is estimated at 7%.

REQUIRED

(a) Advise the management of CrimeBust Ltd regarding the most appropriate method you would use to
determine a purchase price for the interest in Secure (Pty) Ltd. Motivate your answer fully. (10)

(b) State, with reasons, the additional information you would require to enable you to determine a
purchase price for the interest in Secure (Pty) Ltd assuming that the interest is to be valued using
the free cash flow method. (20)
76 TOE408-W/1
ZAC408-H/1

QUESTION 33 35 marks

Background

Security Systems (Pty) Limited is a medium-sized private company which manufactures and sells
electronic gate openers. As a result of increasing security risks the company has been expanding to meet
the demands of the market. Many new competitors have recently entered the market and customers are
able to negotiate very favourable credit terms.

A concerned board of directors asked you, the Financial Director, to make recommendations for the new
financial year.

1. Sales and cost information

• Budgeted annual sales are R3 000 000 with an increase of R240 000 expected for the next
year if the present credit facility of one month is extended to two months. If the credit period is
extended to three months, sales will increase by 20% on R3 000 000. Credit terms are net of
invoice date.

• Bad debt is expected to be 2% of sales for a one month credit term, 3% for a two month credit
term and 6% for a three month credit term.

• A cash discount of 5% for payment within 15 days is offered to all customers. Approximately
20% of the customers take advantage of the early payment discount. All other customers make
use of the credit terms.

• The cost of goods sold averages 60% of the sales value. The company has negotiated a 60
days credit term with its suppliers.

• Cash operating and administration expenses are expected to be R420 000 per annum.

• Other cash expenses are expected to total R30 000.

• Opening balances on working capital accounts are:

- Overdraft R200 000


- Debtors R230 000
- Creditors R270 000

• Inventory levels will remain unchanged.

2. Financing

• The company currently pays interest on the overdraft at 15% per annum. Assume that interest
is payable annually in arrears.

• The company earns interest on a credit bank balance at 12% per annum. Assume that interest
is calculated annually in arrears.

• The company has an expected pre-tax return on investment of 20% per annum.

3. Tax may be ignored.


77 TOE408-W/1
ZAC408-H/1

REQUIRED

(a) Calculate

(i) debtors’ days for the current period; (2)

(ii) the estimated overdraft bank balance at the end of the period assuming the credit period is
increased to 2 months. (13)

(c) calculate whether the increased activity will be profitable if the credit period is extended to 3
months in view of the fact that the company is expecting a pre-tax return on investment of 20%.
The following additional information is available:

• The company sells its product for R3 000 per unit. The variable cost is R1 500 per unit.

• Fixed manufacturing costs total R300 000 for the year.

• Fixed manufacturing costs are likely to increase to R360 000 if the credit terms increase to
three months. (8)

(d) It has been established that the longer the credit terms are extended, the greater the risk of bad
debts. Given the extended credit terms and corresponding proportion of bad debts, advise the
Board which credit term they should use. (7)

(d) Briefly discuss methods which can be used to evaluate the creditworthiness of customers. (5)
78 TOE408-W/1
ZAC408-H/1

QUESTION 34 30 marks

You are the financial advisor of Shop & Drop Ltd, a company that assembles and distributes furniture and
appliances to the retail sector. Most products are sourced from the Far East in kit form and the company
has assembly and packaging operations in a number of locations in South Africa. The company is at a
crossroads in determining its future, as the market in which it operates is overtraded and maintaining a
profitable market share is very difficult. However, the directors are very pleased with the 100% increase in
earnings per share as reported in the annual financial statements for the year ended 31 December 1999.

The directors have scheduled a strategic planning session and have asked you to review the group
results over the past two years and provide your views on the company. You have received the following
extract of information from the latest annual report:

SHOP & DROP LTD

CASH FLOW STATEMENT FOR THE YEAR ENDED 31 DECEMBER 1999

18 months
ended
31 Decem-
1999 ber 1998
Notes R R
Cash flows from operating activities
Net profit before taxation 1 360 168 646 713
Adjustments for:
Depreciation of property, plant and equipment 100 837 145 470
Patents and trademarks written off 9 109 9 342
Interest and finance charges 1 331 559 1 493 214
Interest received - (3 296)
Profit on disposal of property, plant and equipment (23 369) (1 606)
Operating profit before working capital changes 2 778 304 2 289 837
Working capital changes (3 482 237) (1 959 650)
Increase in inventories (5 726 255) (3 500 708)
Increase in accounts receivable (4 354 544) (5 229 478)
Increase in accounts payable 6 598 562 6 770 536
79 TOE408-W/1
ZAC408-H/1
________ ________
Cash (absorbed by)/generated from operations (703 933) 330 187
Interest received - 3 296
Interest and finance charges (1 331 559) (1 493 214)
Dividends paid 2 - (186 000)
Taxation refunded/(paid) 3 18 822 (949 201)
Net cash outflow from operating activities (2 016 670) (2 294 932)

Cash flows from investing activities


Additions to property, plant and equipment 4 (249 328) (120 745)
Proceeds on sale of equipment 46 200 27 359
Net cash outflow from investing activities (203 128) (93 386)

Cash flows from financing activities


Proceeds from issue of share capital 40 000 45 000
Suspensive sale liabilities raised/(repaid) 12 657 (40 889)
Short-term borrowings - 750 000
Loan made (38 000) (42 500)
Net cash inflow from financing activities 14 657 711 611

Net decrease in cash and cash equivalents (2 205 141) (1 676 707)
Cash and cash equivalents at beginning of period (2 221 959) (545 252)
Cash and cash equivalents at end of period 5 (4 427 100) (2 221 959)

SHOP & DROP LTD

INCOME STATEMENT FOR THE YEAR ENDED 31 DECEMBER 1999


18 months
Notes ended
31
December
1999 1998
R R

Revenue 62 371 110 54 136 889

Operating profit 1 2 691 727 2 139 927


Interest and finance charges 1 331 559 1 493 214
Net profit before taxation 1 360 168 646 713
Income tax expense 702 640 323 784
Net profit for the year 657 528 322 929
Dividend proposed 159 500 -
Accumulated profits for the year 498 028 322 929
Accumulated profits brought forward 1 720 407 1 397 478
Accumulated profits at the end of the year 2 218 435 1 720 407

Earnings per share (cents) 4,14 2,07


80 TOE408-W/1
ZAC408-H/1

SHOP & DROP LTD

BALANCE SHEET AT 31 DECEMBER 1999

1999 1998
R R R R
ASSETS

Non-current assets
Property, plant and equipment 573 028 456 477
Loan 80 500 42 500
653 528 498 977
Current assets
Inventory 14 884 044 9 157 789
Accounts receivable 13 635 340 9 280 796
Cash on hand 19 225 2 764
28 538 609 18 441 349
Total assets 29 192 137 18 940 326

EQUITY AND LIABILITIES

Capital and reserves


Issued capital 1 549 066 1 509 066
Accumulated profits 2 218 435 1 720 407
3 767 501 3 229 473
Non-current liabilities
Suspensive sale liabilities 36 828 24 171
Deferred tax 167 631 198 017
204 459 222 188
Current liabilities
Accounts payable 16 609 845 10 011 283
Short-term borrowings 2 600 000 2 600 000
Tax 1 404 507 652 659
Bank overdraft 4 446 325 2 224 723
Shareholders for dividend 159 500 -
25 220 177 15 488 665
Total equity and liabilities 29 192 137 18 940 326
81 TOE408-W/1
ZAC408-H/1
The following extract of relevant notes was taken from the annual financial statements of Shop & Drop
Ltd:
1999 1998
R R
1. Operating profit is stated after
Income
Interest received - 3 296
Profit on disposal of property, plant and equipment 23 369 1 606
Expenditure
Administration fees 243 031 316 309
Auditors' remuneration 96 613 69 760
Depreciation of property, plant and equipment 100 837 145 570
Interest and finance charges 1 331 559 1 493 214
Leasing charges
Operating lease for premises 362 520 153 362
Operating lease for switchboard and office equipment 41 885 17 138
Patents and trademarks written off 9 109 9 342
Provision for doubtful debts 15 000 70 000

2. Dividend paid
Amount owing at the beginning of the year - 186 000
Amount charged per the income statement 159 500 -
Amount owing at the end of the year (159 500) -
- 186 000

3. Taxation refunded/(paid)
Amount owing at the beginning of the year (652 659) (940 780)
Amount charged per the income statement (733 026) (661 080)
Amount owing at the end of the year 1 404 507 652 659
18 822 (949 201)

4. Additions to property, plant and equipment


Motor vehicles 92 242 76 375
Office furniture and equipment 113 881 35 716
Patents and trademarks 14 205 8 654
Plant 29 000 -
249 328 120 745

5. Cash and cash equivalents


Cash and cash equivalents consist of cash on hand and bank
overdraft

Cash and cash equivalents included in the cash flow


statement comprise the following balance sheet amounts:
Cash on hand 19 225 2 764
Bank overdraft (4 446 325) (2 224 723)
Cash and cash equivalents (4 427 100) (2 221 959)

REQUIRED
(a) Critically analyse the generation and utilization of cash of Shop & Drop Ltd and discuss any areas
of concern. (15)
(b) Suggest remedial actions which the directors could take in order to improve the cash flow of Shop
& Drop Ltd. (15)
82 TOE408-W/1
ZAC408-H/1

QUESTION 35 60 marks

You are the financial manager of Transport Holdings Ltd, a company expanding rapidly both organically
and through acquisition. The company's business is operationally split into an automotive and a logistics
division. The automotive division is involved in truck rental, automotive dealerships and retailing of vehicle
parts and accessories on a national basis. The logistics division provides third-party distribution, fleet
management and warehousing services to its customer base.

Transport Holdings Ltd is considering further expansion through acquisition to increase its “product
basket” and achieve its goal of becoming the largest transport and distribution group in South Africa. The
financial director of Transport Holdings Ltd, Mr Able Baker CA(SA), has approached you to assist in the
acquisition of Glassy (Pty) Ltd. Discussions between the two entities are well advanced, with the chief
executives having agreed in principle to proceed with the takeover.

Glassy (Pty) Ltd is the leading glass fitment enterprise in South Africa, servicing both the automotive and
flat (window panes, etc.) glass sectors. The company operates through 125 fitment centres nationally and
10 mobile replacement units, which allows customers to have motor vehicle glass replaced at locations of
their choosing.

Glassy (Pty) Ltd has expanded rapidly over the past two years – opening 15 new fitment centres in the
1999 financial year and 10 new fitment centres in the 2000 financial year. The mobile replacement units
were introduced in the 2000 financial year. The cost of establishing these new fitment centres and
introducing the mobile replacement units has been funded primarily through bank borrowings. The capital
expenditure in this regard totaled R9,5 million in the 2000 financial year (1999: R5,6 million). The
increase in the number of fitment centres was in response to requests from major customers (insurance
companies) of Glassy (Pty) Ltd for improved national coverage, for the benefit and convenience of the
clients that they insure.

The financial performance of Glassy (Pty) Ltd for the financial years ended 30 June 1999 and 2000 is
summarised below:

ABRIDGED INCOME STATEMENTS 2000 1999

R000 R000
Revenue 172 991 145 429
Cost of sales 119 018 101 364
Gross profit 53 973 44 065
Operating costs 35 612 27 957
Depreciation 3 750 1 950
Net interest paid 2 087 1 250
Profit before tax 12 524 12 908
Income tax expense 3 482 3 950
Profit after tax 9 042 8 958
Dividend declared 3 000 3 000
Net profit for the year 6 042 5 958
83 TOE408-W/1
ZAC408-H/1

ABRIDGED BALANCE SHEETS AS AT 30 JUNE 2000 1999

R000 R000 R000 R000


ASSETS
Non-current assets 19 594 13 844
Property, plant and equipment 19 594 13 844

Current assets 46 872 37 132


Inventories 29 355 23 386
Trade and other receivables 17 517 13 746
Total assets 66 466 50 976

EQUITY AND LIABILITIES


Capital and reserves 28 361 28 361 22 319 22 319

Non-current liabilities 10 186 4 480


Long-term interest-bearing debt 10 186 4 480

Current liabilities 27 919 24 177


Trade and other payables 17 830 15 896
Taxation 2 745 3 341
Interest-bearing debt – short-term portion 3 487 1 020
Bank overdraft 857 920
Shareholders for dividend 3 000 3 000
Total equity and liabilities 66 466 50 976

Mr Able Baker is particularly excited by the prospect of acquiring Glassy (Pty) Ltd. He estimates that
annual cost savings of at least R6 million can be achieved by closing the head office of Glassy (Pty) Ltd,
the functions of which can be performed by Transport Holdings Ltd. In addition, Mr Baker foresees cross-
selling opportunities through co-operation between the existing retail network of the group and the glass
fitment centres. Potential exists in the medium term to rationalise the fitment centres of Glassy (Pty) Ltd
by incorporating them into the parts and accessories outlets of the automotive division.

Negotiations between the directors of Transport Holdings Ltd and Glassy (Pty) Ltd are about to
commence regarding the purchase price and detailed structuring of the acquisition. The current market
capitalisation of Transport Holdings Ltd on the JSE Securities Exchange SA is R540 million. The share
price has been stable at R10,80 over the past three months, which represents a price-earnings ratio of 12
(earnings per share of 90 cents was reported in the financial year ended 30 September 2000).

Mr Baker has requested your input to assist him and the board of directors of Transport Holdings Ltd in
establishing a fair purchase price for Glassy (Pty) Ltd. He has implied that you will be responsible for the
impending due diligence investigation and be given the opportunity to impress the board of Transport
Holdings Ltd with your valuation and structuring skills. In Mr Baker's opinion, a fair price for a 100%
interest in Glassy (Pty) Ltd is R48 600 000, which represents a price-earnings ratio of 5,4 based on the
average earnings over the past two years. Transport Holdings Ltd intends issuing shares at R10,80 to the
Glassy (Pty) Ltd vendors in settlement of the purchase price.
84 TOE408-W/1
ZAC408-H/1

Mr Baker has suggested that you purchase shares in Transport Holdings Ltd in anticipation of the
successful acquisition of Glassy (Pty) Ltd. He believes that the stock market will react favourably to the
acquisition announcement, particularly in view of the anticipated cost savings opportunities and the
reputation of Glassy (Pty) Ltd as the leader in the glass fitment industry. He hinted that his family trust
purchased Transport Holdings Ltd shares last week.

REQUIRED

(a) Discuss the ethical issues arising from the suggestion of Mr Baker that you should purchase shares
in Transport Holdings Ltd and his reference to his family trust’s recent share dealings. (10)

(b) Analyse and comment on the financial performance of Glassy (Pty) Ltd in the 1999 and 2000
financial years. (20)

(c) Indicate, with reasons, your preliminary opinion as to whether Transport Holdings Ltd should pursue
the acquisition of Glassy (Pty) Ltd. (10)

(d) Based on the valuation of Glassy (Pty) Ltd suggested by Mr Baker, discuss what impact the
acquisition of Glassy (Pty) Ltd may have on the earnings per share of Transport Holdings Ltd. (10)

(e) Give an outline of the key risk areas that should in your opinion form the focus of the due diligence
investigation of Glassy (Pty) Ltd. (10)
85 TOE408-W/1
ZAC408-H/1

QUESTION 36 40 marks

This question is based on the information set out in Appendix A, regarding the SNA Retail Stores Group
Ltd (“SNA”).

REQUIRED

(a) Critically analyse SNA’s operations for the three comparative trading periods; (8)

(b) Critically analyse the generation and utilisation of cash by SNA for the six months ended 30 June
2001; (14)

(c) Prepare the journal entry giving effect to the Pro-forma Balance Sheet at 30 June 2001; (8)

(d) Detail the remedial actions, which the directors can take to improve the cash flow of SNA. (8)

QUESTION 37 35 marks

This question is based on the information set out in Appendix A, regarding the SNA Retail Stores Group
(“SNA”).

REQUIRED

(a) Calculate the following for the six months ended 30 June 2001;

• Undiluted earnings per share


• Diluted headline earnings per share
• Interest cover
• Debt/equity ratio
• Undiluted net asset value per share
• Fully diluted net asset value per share; (6)

(b) Recommend, with the necessary motivation, a staff incentive scheme for:

• SNA Retail Holdings


• SNA Financial Services
• SNA Health Services; (12)

(c) Explain how value can be added to a rights issue; (2)

(d) Calculate SNA’s cost of capital based on the Pro-forma Balance Sheet at 30 June 2001. You may
assume that no conversion of debentures or preference shares will take place in the next five years;
(10)
(e) Discuss the continuance of the health-related division from a risk perspective; (5)

(Unisa)
86 TOE408-W/1
ZAC408-H/1

APPENDIX A

THE SNA RETAIL STORES GROUP LTD - LISTED ON THE JSE SECURITIES EXCHANGE

Mr SN Azzy, the CEO of the SNA Retail Stores Group, has announced the group’s interim results for the
half year ended 30 June 2001 during a press conference. Mr Azzy made the following clarifying points:

• Trading conditions in the clothing and electronics markets were weak and contributed to declining
profits.

• Trading in the travel and food industries were profitable and will remain the core business of the group,
as represented by SNA Retail Holdings.

• Continuing operations in the health-related industry, which are currently trading at a loss, are forecast
to become profitable within 24 months.

• Despite declining interest rates, finance costs remained a hugely negative factor.

• A guarantee issued in terms of the acquisition of the travel subsidiary has been fully provided for. In
terms of the guarantee, a cash settlement is due to the sellers as a result of the SNA Group’s share
price declining below guaranteed levels.

• The directors, in consultation with major shareholders - the Azzy family and the Group’s bankers - have
agreed to and propose the following actions:

o The disposal of a listed subsidiary in the clothing industry


o Settlement of debt
o Strengthening of the capital base

The above have been reflected in the Pro-forma balance sheet and statement of changes in
ordinary shareholders’ funds for 30 June 2001.

• The Group’s sponsoring brokers considered a fair issue price at 30 June 2001 to be 40 cents per
ordinary share.

• Preference shares trade at 11% per annum on a nominal value of R1.

• The Group’s beta has declined from 1,7 to 2,4 in the past six months.

• The market premium is considered to be 5% on the risk free rate of 10,5% per annum.

• The company has an assessed loss of R425 million.


87 TOE408-W/1
ZAC408-H/1

INTERIM REPORT FOR THE HALF YEAR ENDED 30 JUNE 2001 OF THE SNA RETAIL STORES
GROUP LTD

CONSOLIDATED INCOME STATEMENT

Unaudited Audited
Half year ended Year ended

Jun 2001 Jun 2000 Dec 2000


R000 R000 R000
Turnover
Continuing operations 4 612 740 4 001 596 8 079 401
Discontinued operations - 204 465 193 741
4 612 740 4 206 061 8 273 142

Operating income before interest 78 017 100 654 145 227


Continuing operations 78 017 97 077 141 430
Discontinued operations - 3 577 3 797

Net operating interest paid 46 442 50 556 65 940


Continuing operations 46 442 50 376 65 078
Discontinued operations - 180 862

Convertible debenture interest 9 384 11 571 23 143


Income before taxation and non-trading items 22 191 38 527 56 144
Continuing operations 22 191 35 130 53 209
Discontinued operations - 3 397 2 935

Non-trading items - net (deficit) / surplus (607 214) 106 (89 590)
Income before taxation (585 023) 38 633 (33 446)
Taxation (1 951) (4 733) (1 857)
(Loss)/income after taxation (586 974) 33 900 (35 303)
Associate companies - share of retained
income/(loss) 10 997 (30 745) (32 186)
(Loss)/income attributable to outside share-
holders of subsidiaries (551) 1 497 7 383
Net (loss)/income attributable to ordinary
Shareholders (575 426) 1 658 (74 872)
88 TOE408-W/1
ZAC408-H/1

Unaudited Audited
Half year ended Year ended

Jun 2001 Jun 2000 Dec 2000


R000 R000 R000

Determination of headline earnings:

Net (loss)/income attributable to ordinary


shareholders (575 426) 1 658 (74 872)
Net non-trading items after taxation
- net (deficit)/surplus: (604 904) 106 (89 590)
Net profit on sale of properties - - 2 736
Net profit on sale of investments 30 26 815 43 415
Impairment write down of assets (176 812) (23 347) (124 891)
Provision for Southern African losses - - (6 000)
Intangibles written off - (3 362) (1 206)
Provision for cancellation of property lease
contracts (757) - (3 634)
Provision for subsidiary guarantee (429 675) - -
Non-trading items before taxation (607 214) 100 (89 590)
Attributable to outside shareholders 2 310 - -

Headline earnings 29 478 1 552 14 718


89 TOE408-W/1
ZAC408-H/1
CONSOLIDATED BALANCE SHEET

Unaudited Pro-forma Audited


Jun 2001 Jun 2001 Dec 2000
R000 R000 R000
ASSETS
Non-current assets 949 709 621 419 1 045 875
Property, plant and equipment 160 539 160 539 155 933
Intangibles 4 826 4 826 5 132
Deferred taxation 207 525 207 525 205 849
Investments - listed 454 589 126 299 601 415
- unlisted 91 706 91 706 51 187
Bank balances held by insurance companies 30 524 30 524 26 359
Current assets 1 516 872 1 516 872 1 364 888
TOTAL ASSETS 2 466 581 2 138 291 2 410 763

EQUITY AND LIABILITIES


Capital and (deficit)/reserves (3 617) 421 348 564 878
Stated capital and (deficit)/reserves (88 622) 227 607 482 154
Equity portion of convertible debentures 47 189 22 232 47 189
Equity portion of convertible preference
shares 133 693
Ordinary shareholders’ (deficit)/funds (41 433) 383 532 529 343
Outside shareholders’ interest 37 816 37 816 35 535

Liability portion of convertible debentures 85 065 58 319 98 758


Liability portion of convertible preference
shares 16 307
Non-current liabilities 11 496 11 496 9 704
Unearned insurance premium reserve 8 344 8 344 7 234
Life assurance funds 3 152 3 152 2 470

Interest bearing debt 879 430 380 642 670 028


Long term borrowings 79 411 79 411 36 938
Short term borrowings 800 019 301 231 633 090

Current liabilities 1 494 207 1 250 179 1 067 395


TOTAL EQUITY AND LIABILITIES 2 466 581 2 138 291 2 410 763
90 TOE408-W/1
ZAC408-H/1

CONSOLIDATED STATEMENT OF CHANGES IN ORDINARY SHAREHOLDERS’ FUNDS


Unaudited Pro-forma Audited
Jun 2001 Jun 2001 Dec 2000
R000 R000 R000
Ordinary shareholders’ funds at the beginning
of the period 529 343 529 343 426 308
Movement in stated capital 162 746 066 1 090
Movement in equity portion of convertible
debentures - (24 957) (67)
Movement in equity portion of preference
shares - 133 693 -
Movement in non-distributable reserves 29 296 3 270 (5 318)
Movement in (accumulated deficit)/
distributable reserve (600 234) (1 003 883) 117 330
Net loss attributable to ordinary shareholders (575 426) (979 075) (74 872)
Change in accounting policy for deferred tax - - 191 865
Transfer (to)/from non-distributable reserves (24 808) (24 808) 337

Ordinary shareholders’ (deficit)/funds at the


end of the period (41 433) 383 532 529 343

SUMMARISED CONSOLIDATED CASH FLOW STATEMENT

Unaudited Audited
Jun 2001 Jun 2000 Dec 2000
R000 R000 R000
Cash (utilised by)/generated from operating
activities (43 677) 57 354 164 086
Interest paid (70 760) (73 637) (113 608)
Taxation paid (3 884) (4 804) (8 462)
Dividend paid to outside shareholder of
Subsidiary (86) (90) (107)
Net cash (outflow)/inflow from operating
activities (118 407) (21 177) 41 909
Cash (utilised by)/generated from investing
Activities (63 684) 15 084 (16 611)
Net cash (outflow)/inflow before financing
activities (182 091) (6 093) 25 298
Net increase/(decrease) in financing activities 209 565 11 321 (25 398)
Increase/(decrease) in cash resources 27 474 5 228 (100)
91 TOE408-W/1
ZAC408-H/1

SALIENT FEATURES
Unaudited Audited
Jun 2001 Jun 2000 Dec 2000
Income Statement
(Loss)/earnings per share (cents)
Undiluted - 8 (37,8)
Headline – diluted - 60 158
Ordinary shares in issue (000s)
Undiluted 198 735 197 824 198 522
Weighted average 198 735 197 818 198 069
Diluted 256 438 255 885 255 985
Dividends per share (cents) - - -
Convertible debentures in issue (000s) 41 268 41 278 41 268
Interest per convertible debenture (cents) 55,9 55,9 111,9
Interest cover (times) - 1,99 2,20
Depreciation (R’000) 8 044 10 825 29 389

Balance sheet
Net asset value per share (cents)
Undiluted - 305,4 267,3
Fully diluted - 281,7 254,4

Market value of listed investments (R’000) 409 665 533 475 481 391
Directors valuation of unlisted investments
(R’000) 91 706 51 816 51 187
Contingent liabilities (R’000) 5 229 8 162 4 309
Capital expenditure during the period (R’000) 15 471 44 810 51 639
Future capital commitments (R’000) 6 148 13 237 21 619
Share price (cents per share) 47 413 285
92 TOE408-W/1
ZAC408-H/1

SEGMENTAL ANALYSIS - CONTINUING OPERATIONS


SNA Retail Holdings
(R000) Jun 2001 Jun 2000 %
Turnover 4 479 495 3 876 220 15,6
Operating income/(loss) before interest 84 754 84 388 0,4
Interest paid/(received) 16 8 678 99,8
Income/(loss) before tax and non-trading items 84 738 75 710 11,9
Total assets 1 402 088 1 269 313 10,5
Total liabilities 1 103 686 996 882 10,7

SNA Financial Services


(R000) Jun 2001 Jun 2000 %
Turnover 28 825 15 363 87,6
Operating income/(loss) before interest 15 310 8 081 89,5
Interest paid/(received) (1 554) (2 114) (26,5)
Income/(loss) before tax and non-trading items 16 864 10 195 65,4
Total assets 82 696 54 972 50,4
Total liabilities 32 892 16 333 101,4

Total Group
(R000) Jun 2001 Jun 2000 %

Turnover 4 612 740 4 001 596 15,3


Operating income/(loss) before interest 78 017 97 077 (19,6)
Interest paid/(received) 55 826 61 947 9,9
Income/(loss) before tax and non-trading items 22 191 35 130 (36,8)
Total assets 2 466 581 2 182 240 13,0
Total liabilities 2 385 133 1 636 698 45,7
93 TOE408-W/1
ZAC408-H/1

QUESTION 38 45 marks

Holdme Ltd is a SA-based multinational company with subsidiaries in two countries. These subsidiaries,
which produce biscuits and clothing, are located in Botswana and Zimbabwe respectively. Holdme Ltd
also produces biscuits and clothing at its local factories. The company’s other activities focus on the
manufacture of electronic products.

Extract from the latest chairman’s report:

“I am delighted to report that we have once again had an excellent year, our profit before tax increasing
by 22%, and the ordinary share price increasing by 30%. All three major product areas showed a growth
in profitability, with a particularly strong performance in clothing manufacture. Our strong financial
position has allowed the company to successfully develop its operations in textiles, food processing and
electronics, and plans exist to double in turnover within five years in all areas of operation. The
management team has the skills to unlock full shareholder value and has every confidence in the future.’

Extracts from the company’s financial statements. Data are for full calendar years ending 31 December.
94 TOE408-W/1
ZAC408-H/1

Biscuits Clothing Group


SA Botswana SA Zimbabwe
(Rm) (Pula) (Rm) (Z$) (Rm)
2000 2001 2000 2001 2000 2001 2000 2001 2000 2001

Turnover 25 28 109 120 31 36 1 040 1 650 410 460

Operating
expenses 15 17 70 74 22 25 480 660 300 328
Net interest 1 1 4 5 - - 50 80 20 22
Profit before
tax 9 10 35 41 9 11 510 910 90 110
Taxation 2,7 3 10,5 12,3 2,7 3,3 204 364 27 33
Profit after
tax 6,3 7 24,5 28,7 6,3 7,7 306 546 63 77
Dividends 3 4 12 14 3 4 306 546 20 25
Retained 3,3 3 12,5 14,7 3,3 3,7 0 0 43 52

Fixed assets:
Tangible
assets (net) 34 39 80 95 33 38 950 950 320 380
Other in-
vestments - - - - - - - - 12 18
34 39 80 95 33 38 950 950 332 398

Stock 10 10 42 47 13 14 250 360 185 215


Debtors 8 8 15 18 14 16 280 400 75 80
Cash - - 1 1 - - 20 20 15 17

Current
liabilities:
Borrowings 4 4 8 10 - - 30 60 40 50
Other
creditors 13 14 17 19 12 14 280 360 95 112
Net current
assets 1 0 33 37 15 16 240 360 140 150

Term loans 8 8 60 60 - - 70 70 210 225


Net assets 27 31 53 72 48 54 1 120 1 240 262 323

Capital and
reserves:
Ordinary
shares 5 6 10 14 10 12 300 420 110 119
Reserves 22 25 43 58 38 42 820 820 152 204
27 31 53 72 48 54 1 120 1 240 262 323
95 TOE408-W/1
ZAC408-H/1
• Ordinary South African shares were issued at R1 par value.
• Holdme’s Ltd share price: End of 2000 End of 2001
690 cents 897 cents
• Holdme Ltd’s equity beta is 1,32 and the risk free rate is 11,5%.
• Comparative industry data:
Biscuits Clothing Electronics
Dividend yield 2,9% 4,3% 5,2%
P/E ratio 11 8 18
Gearing (total loans to equity) 0,85 0,65 0,43
2000 2001
Economic data:
JSE Top 40 share index (year-end) 6 712 8 963
Dividend yield of JSE Top 40 shares 4,5% 4,0%
Inflation:
SA 8% 6%
Botswana 2% 1%
Zimbabwe 75% 100%

Average exchange rates:

Pula/ZAR 0,833 0,667


Z$/ZAR 7 10

REQUIRED

Prepare a report which:

(a) analyses the financial condition of Holdme Ltd and, where appropriate, of its subsidiaries. The
analysis should include:

(i) an evaluation of the return, in terms of share price and dividends, that Holdme has provided to
its shareholders in the last calendar year.
(ii) determination of the expected P/E ratio of Holdme Ltd.
(iii) calculation of, and comment any on, relevant growth rates and financial ratios for the group and
for individual subsidiaries.

Highlight any aspects of the group’s or subsidiaries’ performance which might be of concern to an
external investor, and clearly state any assumptions that you have made.

(b) discuss the validity of ALL of the chairman’s comments. The discussion should include:

• commentary on the stated strategy of doubling turnover in all areas of operations within five
years.
• commentary on risks facing Holdme Ltd.

Approximately 25 marks are allocated for calculations and 20 marks for analysis/discussion.
(ACCA - adapted)
96 TOE408-W/1
ZAC408-H/1

QUESTION 39 40 marks

You are a senior consultant in the advisory services division of a professional firm. On 20 October 2000
the following awaited your attention:

TRANSACTION 1

Gloluck Ltd, a listed company with 220 000 000 shares of R1 each in issue, anticipates a profit after tax of
R264 million for the year ended 30 September 2000. The company favours a stable dividend cover of 4
times. In the past only a final cash dividend was paid. The board has recommended that a capitalisation
(scrip) option be utilized in addition to the cash dividend. This should be based on a 5% discount on the
current ruling price of R9,00 per share.

REQUIRED

(a) Describe the dividend process, accounting entries and the financial implications on the assumption
that 85% of the current shareholders will accept the capitalization offer; (9)

(b) Explain how fractions of shares resulting from the offer can be dealt with. (2)

TRANSACTION 2

Roberts Construction Limited is in a growth phase and has capital projects amounting to R37 650 000 in
the pipeline. The company has a target debt/equity ratio of 60% and follows a residual dividend
approach. For the current financial year, pre-tax profit of R41 300 000 is expected.

The effective tax rate of Roberts Construction is 28%.

REQUIRED

Determine the amount, if any, available for dividends. (3)

TRANSACTION 3

A client, Mr Jung-Tse, is upset because you have indicated that he should not invest in Petrochem Ltd.
His broker contends that Petrochem has achieved a return on equity of plus 35% for the last two years
running. You have extracted the following information:

2000 1999
R000 R000
Revenue 29 500 27 140
After-tax profit (920) 1 100
Total assets 10 170 12 240
Capital and reserves (2 230) 2 460
Interest bearing debt 8 150 2 860
Current liabilities 4 250 6 920

REQUIRED

Justify your recommendation by applying the du Pont analysis. (6)


97 TOE408-W/1
ZAC408-H/1
TRANSACTION 4

Teltex Ltd, a telecommunications company, has quietly acquired 17% of the shareholding of Celtec Ltd, a
rival listed company, on the open market. Teltex has published a notice in the national press that it
intends to make a hostile bid for Celtec, as the directors and management of Celtec have indicated their
unwillingness to commence with take-over talks.

REQUIRED

Inform the directors of Celtec Ltd of at least six options that they may exercise as a defense against the
hostile offer. (6)

TRANSACTION 5

Mower Limited is a manufacturer of lawn mowers and related equipment. The following information
relates to the capital structure currently in place at Mower Limited and the components’ related market
indicators.
R000
Ordinary shares @ R2 each 30 000 - current market value R4,80 per share
10% Preference shares @ R100 each 10 000 - market return 12,5%
Long-term debt @ 16% pa 20 000 - market yield 13,5%
Retained earnings and reserves 5 000
The long-term debt is not negotiable and cannot be restructured.
The current dividend per ordinary share is R0,35 and it is expected to grow by 6% per annum. The tax
rate is 30%.

REQUIRED

Calculate the weighted average cost of capital that Mower should use to evaluate capital projects. (6)

TRANSACTION 6

Fashion and Gosport announced:


• The sale of Topsport to Fashion for a cash consideration of R75m in respect of tangible assets of
R56m
• The R75m represents 31c per Gosport share
• The sale was effective for the six months ending 30 September 2000
• Topsport’s net loss for the six months ending 30 September 2000 was R2,612m
• The average investment rate for the six months ending 30 September 2000 was 9,25% per annum.
• Gosport has a large assessed loss.
• Before the transaction Topsport was a wholly owned subsidiary of Gosport.

REQUIRED

(a) Complete the following table showing the financial effect per Gosport share. (5)
Per Gosport ordinary share Before the After the % Increase
transaction transaction
(cent per share) (cent per share)
Earnings 3,5
Net asset value 80,0

(b) Explain the impact of the transaction on the Fashion and Gosport balance sheets. (3)
(Unisa)
98 TOE408-W/1
ZAC408-H/1

QUESTION 40 45 marks

This question consists of two parts that are related.

PART I

Mega Mix Ltd is a diversified industrial company listed on the JSE Securities Exchange (SA). It has a
number of divisions that are focused on segments of the forests products industry.

The Executive Committee (Exco) of Mega Mix Ltd recently decided to split the Timber Processing division
into two separate divisions, namely the Woodchip division and the Sawmilling division.

Mega Mix Ltd manages each of its divisions as stand alone entities with a target debt/equity ratio of 50%.
As the divisions are not separate legal entities, Mega Mix Ltd provides interest-free loans as equity and
interest-bearing loans as debt.

It has been agreed that the two new divisions would be restructured to ensure that they conform to the
target 50% debt/equity ratio on inception.

As the financial controller of Mega Mix Ltd, you have been requested to carry out the restructuring
exercise.

The following abridged financial information has been extracted from the trial balances of Mega Mix Ltd
and the new Woodchip and Sawmilling divisions on inception:

Woodchip Sawmilling Mega Mix


division division Ltd
R000 R000 R000
Group interest-free loan (49 700) (118 000)
Interdivisional loan from Woodchip (21 167)
Interest-free loan to Timber Processing 167 700
Interest-earning debt (153 000) 153 000
Fixed assets 25 800 70 600
Working capital 43 500 138 900
Interdivisional loan to Sawmilling 21 167

REQUIRED

Prepare the necessary adjusting journal entries for Mega Mix Ltd, the Sawmilling division and the
Woodchip division to effect the restructuring of the divisions. Narrations are required. (12)

PART II

In addition to the restructuring of the Mega Mix Ltd divisions, Exco has been considering a number of
incentive schemes for senior and middle management. The purpose is to encourage managers to act
and behave like owners with the ultimate aim of producing the best results for shareholders.

An extract from the minutes of the last Exco meeting reads as follows:
99 TOE408-W/1
ZAC408-H/1
“A scheme will be implemented which has the following objectives:

1. Alignment of management and shareholder interests to limit the extent of agency costs;
2. Provision of sufficient leverage to cause management to

• take unpopular decisions,


• take acceptable risks, and
• work tirelessly for the company;

3. Retention of the best of our people through the good years and the bad years;
4. Cost shareholders an appropriate amount given managerial success or failure; and
5. It must be easily understood and administered.”

To this end, Exco is considering the following four schemes:

1. Operating profit

Targets will be agreed annually with management at each division. Bonuses will be payable upon
the attainment of the agreed target and shall be increased on a sliding scale to a maximum of 20%
of annual salary should the division exceed its operating profit target by more than 20%.

2. Return On Net Assets (RONA)

Targeted RONA percentages will be agreed annually with individual divisional managers.
Bonuses will be payable upon the attainment of the target and shall be increased on a sliding
scale to a limit of 20% of annual salary should the division concerned exceed its RONA target by
more than 5%.

3. Share options

Initially the number of share options granted to each manager will be the equivalent of his/her
annual salary divided by the share price at the date of awarding the options. Options are
exercisable at the ruling share price at the date of awarding the options. In subsequent years the
number of options awarded to each manager shall be equal to 25% of his/her salary at that date,
divided by the ruling share price at the date of awarding the options.

Options shall be exercisable at the instance of the employee up to a maximum of –

• 20% at the end of year 2 following issuance;


• 20% at the end of year 3 following issuance; and
• 60% at the end of year 4 following issuance.

All options must be exercised or abandoned within eight years of being awarded.

4. Economic Value Added (EVA)

EVA targets shall be set for each division for the next five years. Bonus payments shall
commence annually on the attainment of a 4% growth in economic value over the previous year.
20% of EVA generated above target shall be allocated to management. In each year 33,3% of the
annual bonus shall be paid out and the balance (66,7%) taken to a bonus bank for payment in
equal parts over the next two years.
100 TOE408-W/1
ZAC408-H/1
Should a division generate negative EVA in any year, 20% of the value destruction shall be
apportioned to management and taken off their bonus bank. The accumulated balance in the
bonus bank is allowed to become negative.
Should an individual leave Mega Mix Ltd he/she shall only be paid the bonus due at the date of
departure and shall forego any surplus retained in the bonus bank.

REQUIRED

Critically evaluate each incentive scheme being considered by Exco and conclude with reasons whether
such scheme will be effective in meeting the objectives as set by Exco.

• Operating profit (7)

• Return On Net Assets (7)

• Share options (8)

• Economic Value Added (11)


101 TOE408-W/1
ZAC408-H/1

QUESTION 41 20 marks

You are the personal assistant to Ms June Privy, a non-executive director of Peace-of-Mind Ltd, a listed
company. Ms Privy represents Vigilance Ltd, an investment bank, which is the largest individual
shareholder of Peace-of-Mind Ltd. The agenda for the forthcoming meeting of the board of directors of
Peace-of-Mind Ltd is to consider, inter alia, the approval of the annual financial statements as well as the
repricing of options granted in terms of the Peace-of-Mind Share Option Scheme.

Ms Privy has requested you to assist her in preparing for the board meeting.

The following are extracts from the draft annual report of Peace-of-Mind Ltd, which have been included in
the packs sent out to board members:

DIRECTORS’ REPORT FOR THE YEAR ENDED 31 DECEMBER 2001

Options

On 1 January 2000, the shareholders of the company approved and adopted the Peace-of-Mind Share
Option Scheme. The purpose of this Scheme is to act as an incentive base to executive directors.

In terms of the Scheme, options to a total of 10% of the number of shares in issue may be granted to the
executive directors. Details of the options granted are as follows:

Executive director Number Grant date Strike price (cents)

S Gooding 300 000 2 January 2001 160


K Lombard 300 000 2 January 2001 160
S Nunn 277 000 2 January 2001 160
L Sizwe 300 000 1 January 2000 125
T Farrell 100 000 1 January 2000 125
1 277 000
102 TOE408-W/1
ZAC408-H/1

EXTRACT FROM BALANCE SHEET AT 31 DECEMBER

2001 2000
Notes R R
Share capital and premium 2 35 472 225 34 069 025

Loan to Share Trust 1,3 1 277 000 530 000

INCOME STATEMENT FOR THE YEAR ENDED 2001 2000


31 DECEMBER Notes R R

Net income before taxation and exceptional item 10 11 038 965 7 866 974
Exceptional item
Impairment of loan to Share Trust 3 747 130 -
Net income before taxation 10 291 835 7 866 974
Taxation 3 282 211 2 360 092
Net income 7 009 624 5 506 882

Earnings per share (basic) (cents) 12 30 24


Headline earnings per share (basic) (cents) 12 33 24
Dividends per share 7 6

NOTES TO THE ANNUAL FINANCIAL STATEMENTS

1. Accounting policies

Loan to Share Trust

The loan to the Share Trust is recognised as a long-term investment and interest income is
recognised in accordance with the terms of the loan. When there is an indicator of impairment, the
loan is considered for impairment and any diminution in value is recognised in earnings.

Dividends

The liability for dividends is recognised when the dividend is declared. However, dividends per
share are calculated on the basis of the directors’ recommended dividend in respect of profits
earned during that period.

2. Share capital and premium


2001 2000
R R
Issued: 23 648 150 (2000: 22 771 150) ordinary shares of
10 cents each 2 364 815 2 277 115
Share premium 33 107 410 31 791 910
35 472 225 34 069 025
103 TOE408-W/1
ZAC408-H/1

3. Loan to Share Trust


2001 2000
R R

Balance at beginning of the year 530 000 –


Shares issued to the Share Trust 1 403 200 500 000
Interest earned 114 930 50 000
Dividends received (24 000) (20 000)
Impairment of loan (747 130) –
1 277 000 530 000

10 Net income before taxation and exceptional item is stated after crediting:

Interest on loan to Share Trust 114 930 50 000

12 Earnings per share

Earnings 7 009 624 5 506 882


Add: Impairment of loan to Share Trust 747 130 -
Headline earnings 7 756 754 5 506 882

16 Employee benefits

The company established the Peace-of-Mind Share Option Scheme in January 2000. The
salient terms of the Scheme are as follows:

• A Share Trust was formed.


• The Remuneration Committee of the board of directors of Peace-of-Mind Ltd appoints the
trustees of the Share Trust.
• Each year, the Remuneration Committee recommends to the board of directors an
allocation of share options to the executive directors.
• The board of directors considers the recommendations of the Remuneration Committee
and, in terms of a board resolution, requests the trustees of the Share Trust to grant share
options to the executive directors.
• On the date that options are granted, the company issues an equivalent number of shares
to the Share Trust.
• These shares are issued to the Share Trust at the strike price of the options granted. The
strike price of the options is the average closing share price of the company’s ordinary
shares on the JSE Securities Exchange South Africa for the ten days prior to the date of
the board resolution authorising the granting of the options.
• The company advances a variable interest rate loan to the Share Trust to finance the
acquisition of such shares. The loan bears interest at 5% per annum below the prime
overdraft interest rate. Dividends received by the Share Trust in respect of shares held in
its own name are applied first to the settlement of the loan due by the Share Trust to the
company.
104 TOE408-W/1
ZAC408-H/1

• The terms of options granted to executive directors are as follows:

§ 40% of the options vest (i.e. may be exercised) three years after the date of the
board resolution that authorised the granting of the options;
§ The remaining 60% of the options vest four years after the date of the board
resolution that authorised the granting of the options; and
§ If a director leaves the employ of the company any non-vested options are forfeited
and are cancelled by the Share Trust.

SHARE PRICE PERFORMANCE

Share price at 31 December 2001: 100c


Share price at 31 December 2000: 165c

REQUIRED

(a) List and briefly explain the various issues that the board of directors should consider prior to taking a
decision to reprice employee share options. (12)

(b) List the audit procedures that should be performed by the external auditor in respect of the Peace-
of-Mind Share Option Scheme. (8)
105 TOE408-W/1
ZAC408-H/1

QUESTION 42 45 marks

Outtel Ltd, a South African company, imports components from Japan that it uses in the manufacture of a
wide range of high quality motherboards. The motherboards are then sold to customers in the United
States of America and Europe.

Extracts from the management accounts as at 30 September 2001 are as follows:

CAPITAL EMPLOYED Notes R million


Equity 1 000
Debt 1 700
1 700

EMPLOYMENT OF CAPITAL
Cash 30
Share portfolio 2 100
Working capital 500
Property, plant and equipment 1 070
1 700

Notes:
R million
1. Debt
The debt consists of the following:
Floating rate loan 220
- Interest is payable quarterly in arrears and is linked to the 90-day JIBAR
(Johannesburg Inter-Bank Acceptance Rate), + 2%.
- Repayment of capital will commence on 1 October 2002 in ten equal, annual
instalments.

8% Fixed rate loan 480


- Interest is payable quarterly in arrears. Capital is repayable in four annual
instalments of R120 million with the first payment due on 31 January 2002. ____
700

The debt is secured over property, plant and equipment with a net book value of R800 million.

2. Share portfolio

The portfolio consists of listed equity securities with a current market value of R100 million.
The portfolio is completely diversified and has managed to maintain a beta of 1.
The JSE allshare-index (ALSI) is currently at 10 000 points.

Other information

(a) Share portfolio

The share portfolio will be liquidated on 31 January 2002 to fund the first capital repayment due on
the fixed rate loan. Any shortfall will be funded from the cash surplus that is budgeted to remain at
R30 million for the next four months.
106 TOE408-W/1
ZAC408-H/1
Given the current volatile equity market conditions, Outtel Ltd is concerned that a fall in the equity
market may result in its inability to finance the first repayment on the fixed rate loan.
The centralised treasury is investigating the following four derivative instruments to hedge the
company’s share portfolio against this risk:

Instrument Expiry date ALSI strike Option premium


price

1 American put option on the ALSI 31 Jan 2002 9 700 R8 000 000
2 European put option on the ALSI 15 Feb 2002 9 800 R5 000 000
3 Future contract on the ALSI 31 Jan 2002 10 375 Nil
4 Forward contract on the ALSI 20 Jan 2002 10 500 Nil

The value per ALSI point is R10 000 for all the derivatives, i.e. the value of the derivative contracts
will increase or decrease by R10 000 for each one point movement in the ALSI. The nominal
value of each derivative contract is R100 million.

(b) Treasury operations

Outtel Ltd has a centralised treasury team of three traders, one of whom is also the treasurer. In
addition, several of the Outtel Ltd business units have their own treasuries and are not obliged to
use the centralised treasury. There is no routine interaction between the centralised treasury and
the business unit treasuries.

The directors of Outtel Ltd permit the centralised treasury traders to run an open daily position limit
of US $10 million. The centralised treasury trades a range of derivative instruments and maintains
a trading portfolio that is aligned to the business of Outtel Ltd. This activity is in addition to the
hedging activities undertaken by the centralised treasury. The centralised treasury is evaluated as
a profit centre.

The Group Financial Director of Outtel Ltd relies on the treasurer to inform him on treasury
activities on an ad hoc basis.

(c) Treasury review

The external auditors recently performed a treasury audit and highlighted several serious
concerns. The following is an extract from their report to management:

" … There is an almost complete lack of controls in the centralised treasury. The situation
is extremely serious and requires immediate attention. The following control breakdowns
were identified:

Event Description

1 Transaction On 1 September 2001 the centralised treasury was instructed to obtain


duplication forward cover for imports worth Y1 000 million (yen) for payment two
months later. The transaction was executed twice (by different traders),
resulting in an unhedged exposure.

2 Unhedged Outtel Ltd currently has an unmatched speculative derivative currency


exposure exposure of $20 million consisting of $12 million in the central treasury
and an additional $8 million in the business units (not reported to central
treasury). This amount exceeds the limit set as company policy.
107 TOE408-W/1
ZAC408-H/1

3 Ineffective At the end of the 2000 calendar year, the centralised treasury entered
hedge into a complex derivative structure, using bought and sold options to
hedge commodity risk. This hedge is not effective and has already
resulted in substantial losses for the year to date.

4 Counter- Outtel Ltd uses over-the-counter (OTC) instruments and deals mainly
party risk with small merchant banks. A total of 60% of its foreign exchange
contracts are with one such bank.

5 Regulatory Outtel Ltd has contravened the conditions of its foreign exchange control
contraven- approval. This could result in a fine being levied by the South African
tions Reserve Bank or even the withdrawal of the approval.

6 Bearer in- Bearer instruments are not controlled properly and could easily be
struments misappropriated.

7 Disregard On several occasions, traders ignored instructions from the treasurer,


of authority thus exposing the company to considerable risk.

8 Absence During the months of July and August 2001 the centralised treasury was
unstaffed for a day due to sickness, family issues and training
commitments.”

(d) Interest rate risk

Some commentators have expressed the view that local interest rates may increase in the short
term. The table below details the general market view of the expected 90-day forward JIBAR rates
for the indicated periods. Outtel Ltd is considering entering into a fixed-for-floating interest rate
swap to hedge against the interest rate risk on the floating rate loan of R220 million.

Expected 90-day JIBAR rates

2001/2 1 Dec. – 28 Feb. 1 Mar. – 31 May 1 June – 31 Aug. 1 Sep. – 30 Nov.


JIBAR rate 8% 9% 11% 12%

The market quote for a one-year fixed-for-floating interest rate swap is 10%.

REQUIRED

(a) List two advantages and two disadvantages for each of the derivative instruments proposed to
hedge the exposure on the share portfolio. (16)

(b) Calculate the final value of each of the four derivative strategies, on the assumption that the ALSI
remained at 9 750 points for the period 20 January 2002 to 15 February 2002. You may ignore
the time value of money. (8)

(c) Suggest two controls that Outtel Ltd should implement to address each of the control breakdowns
noted by the external auditors and indicate how these controls will mitigate the risks identified. (16)
Note: Do not duplicate the suggested control procedures, i.e. different controls should be
suggested for each risk.

(d) Discuss whether Outtel Ltd should enter into the proposed fixed-for-floating interest rate swap. (5)
108 TOE408-W/1
ZAC408-H/1

QUESTION 43 40 marks

You are an independent financial advisor to FRA Ltd, a manufacturer of packaging products for sale to
food and beverage manufacturers. FRA Ltd obtained a US $3,5 million loan from Case Bank, New York,
on 1 January 1997. The directors of FRA Ltd were of the opinion that the cost of the US dollar loan would
be cheaper than raising finance in the South African market. The loan was raised to finance the
expansion of a factory of FRA Ltd based in Roodepoort.

The salient terms of the loan from Case Bank are as follows:

• The loan bears interest at 11% per annum payable half yearly in arrears. The interest rate is fixed for
the duration of the loan and interest is calculated and paid on the outstanding balance at the end of
each six month period;

• • The loan is to be repaid in four equal annual instalments. The repayments commence on 1 January
1999; and

• • The loan is secured by a cession of FRA Ltd’s debtors book.

The financial director of FRA Ltd is concerned about the loan exposure of the company to Case Bank,
given the devaluation of the rand against the US dollar. FRA Ltd has historically been prepared to accept
a moderate degree of risk in financial transactions. The financial director is also concerned about the low
level of exports achieved by FRA Ltd. Currently exports represent 5% of total turnover. FRA Ltd has not
covered the foreign loan exposure through the use of forward exchange contracts or through any other
derivative instruments.

The following selected financial information has been extracted from the annual reports of FRA Ltd:

Years ended 31 December


BALANCE SHEET 1998 1997
R000 R000

Ordinary shareholders’ interest


Interest bearing liabilities
Long-term liabilities 20 267 18 455
Current portion of long-term liabilities
Bank and cash resources 15 750 17 150
5 250 -
3 514 2 784
INCOME STATEMENT

Revenue 61 765 51 470

Gross profit 16 429 13 691


Operating profit 4 304 5 920
Net interest paid 1 824 1 371
Profit after taxation 1 612 2 957
109 TOE408-W/1
ZAC408-H/1
Additional information

1. Exchange rate (SA rand to one USA $)


1998 1997
R R
Beginning of the year 4,90 4,60
Middle of the year 6,30 4,55
End of the year 6,00 4,90

2. Proposed loan from BE Bank

BE Bank, a leading South African Bank, has offered FRA Ltd a loan facility to replace the existing
loan of the company from Case Bank. The terms of the proposed loan from BE Bank are as
follows:

• • R15 million is to be advanced on 1 July 1999;

• • The loan is to bear interest at 1% below the prime overdraft rate (currently 24%);

• Interest is to be paid quarterly in arrears calculated on the capital balance outstanding at


the end of each quarter; and

• The loan is to be repaid in ten equal quarterly instalments which will commence on
1 October 1999.

REQUIRED

(a) Calculate the effective all inclusive annual borrowing cost (as a percentage) in rand terms of the
loan from Case Bank for the financial years ended 31 December 1997 and 1998. (8)

(b) Draft a report to the financial director of FRA Ltd in which you document your assessment of the
exposure of FRA Ltd to interest rate risk, currency risk and liquidity risk. Your report should detail
the following:

• Definitions of interest rate risk, currency risk and liquidity risk; (6)
• Your assessment, with reasons, of whether the exposure of FRA Ltd to the aforementioned
risks is low, moderate or high; and (11)
• Any suggestions you may have regarding how FRA Ltd can minimise its exposure to these
risks. 8)

(c) Discuss whether FRA Ltd should replace the loan from Case Bank with the proposed loan from BE
Bank. (7)
110 TOE408-W/1
ZAC408-H/1

QUESTION 44 40 marks

You are a management consultant at a large accounting firm. The board of directors of Higro Ltd are
currently considering the finalisation of the statements for the year ending 30 September 2001 and issues
related thereto. Higro Ltd is a listed company on the JSE Securities Exchange in the diversified industries
sector.

Relevant financial information

Earnings anticipated for the year R215 345 000


Shares in issue 195 768 500 shares
Historic dividend cover 6 times
Current share price R 9,00
Net asset value per share R14,00

The following 5 queries pertaining to Higro Ltd have been referred to you for your opinion.

Query 1

The sector dividend yield is 4,5%.

REQUIRED

What should be done to bring Higro Ltd in line with the sector dividend yield? (7)

Query 2

Share buybacks are currently very popular. Higro Ltd has adequate cash and finance facilities to
accommodate a general share buyback scheme.

REQUIRED

Discuss the consequences of implementing a general share buyback scheme. (5)

Query 3

3 Million share options have been issued to management at an average exercise price of R15 per share.

REQUIRED

Discuss the implications of cancelling the existing scheme and replacing it with a new scheme based on a
revised exercise price of R10,00 per share. (5)
111 TOE408-W/1
ZAC408-H/1

Query 4

Two companies have been identified as possible acquisition targets: SnP Ltd Multipac Ltd
Rm Rm
Balance Sheet
Non-current assets 25 110
Plant and equipment
Current assets 40 60
Inventory 5 40
Debtors 100 10
Cash
Current liabilities 80 60
Creditors

Income Statement
Turnover 620 200
Cost of sales 570 120
Marketing costs 12 3
Other expenses 28 42
Finance costs/(income) (10) 5

Growth
Average over last 5 year (%) 15 25

• SnP is a food retailing chain.


• Multipac is a manufacturing company in the packaging industry.

REQUIRED

(a) Assess the companies by looking at:

• Profitability
• Capital investment and
• Liquidity. (9)

(b) Value both companies with a possible acquisition in mind. (8)

Query 5

Higro Ltd’s bankers have offered the company a US$ 10 million loan facility at 6% per annum for a period
of three years. The current R/US$ exchange rate is R8,20 = US$1.

REQUIRED

List the issues to be considered. (6)


(Unisa)
112 TOE408-W/1
ZAC408-H/1
QUESTION 45 50 marks

DiamondDesign Ltd produces high quality rings, bracelets and other designer pieces which it has tradi-
tionally sold by mail order. Sales and profit growth were strong and consistent over the period 1990-1998.
Since 1998 the company has seen sales growth slow dramatically as a result of growing competition from
retailers on the World Wide Web (Internet).

Management consultants brought in by DiamondDesign Ltd estimate that rapid sales growth can be re-
established if the company invests in setting up its own website. The designs sold via the internet will
have a different brand name from those sold via mail order, in order to allow DiamondDesign to set
different, and possibly more competitive, prices for its websales.

Allowing for the current slowdown in the growth of mail order sales, and the introduction of the new
website, total sales are expected to increase in value by 30% per year for each of the next two years.
The website is expected to reduce total operating costs (excluding depreciation) to 82% of sales.

DiamondDesign Ltd’s balance sheet at the close of the last financial year is summarised below. Fixed
assets, including freehold land and buildings, are shown at historic cost, net of depreciation. The
debenture is redeemable in two years time, although early redemption without penalty is permissible.

BALANCE SHEET AS AT 30 NOVEMBER 2001


R000
Non-current assets 45 000
Freehold land and buildings 15 000
Machinery 30 000

Net current assets 6 000


Inventory 20 000
Debtors 5 000
Cash 5 000
Current assets 30 000
Current liabilities
Trade creditors (24 000)
_______
51 000

Issued ordinary share capital (par value 50 cents per share) 8 000
Retained income 31 000
Shareholders’ funds 39 000
10% Debenture 8 000
Bank loan (12%) 4 000
51 000

Additional information for DiamondDesign Ltd

• Operating profit for the year ended 30 November 2001 was 12,5% of sales of R120 million, after
deduction of depreciation of R5 million. The depreciation charge for the next two years is
expected to remain unchanged, and all depreciation provisions qualify for tax relief.
• Dividends are increased by 10% per year, and in the financial year ended 30 November 2001
dividends of R3,75 million were paid.
• Company tax is levied at 30%.
• The website became fully operational on 1 December 2001.
113 TOE408-W/1
ZAC408-H/1

• Interest charges are expected to remain unchanged over the next two years.
• The value of stock, debtors and trade creditors are expected to increase at the same rate as sales
over the next two years.
• The following information is also available regarding key financial indicators for DiamondDesign
Ltd’s major competitor:

Return on (long-term) capital employed 15%


Return on equity 12,8%
Operating profit margin 10%
Current ratio 1,25:1
Acid-test 1,1:1
Gearing (total debt/equity) 33%
Interest cover 6,0
Dividend cover 3,0

• At present DiamondDesign Ltd’s main market is Western Europe, and the company wishes to
expand into the North American market where there is strong demand for ‘collector’ items and high
priced specialist designs. DiamondDesign Ltd has been advised that the best way of establishing
a strong US sales base is to seek a joint venture or merger with a North American company. In
order to fund such a venture, the company is planning a 1 for 8 rights issue in March 2003. The
rights shares will be priced at a 25% discount on the share price current at the time of the issue.

REQUIRED

(a) Draft an income statement for the year ended 30 November 2001, and a forecast income
statement and balance sheet for the year ending 30 November 2002. (10)

(b) Discuss the performance and financial health of DiamondDesign Ltd in relation to that of its major
competitor, as at 30 November 2001. (12)

(c) In respect of the proposed expansion and rights issue:

(i) Calculate the market capitalisation of DiamondDesign Ltd and the price per share
immediately prior to the rights issue, assuming that the shares trade on a PE of 8 based on
the previous year’s earnings. (2)

(ii) Calculate the issue price of the rights shares, and the theoretical ex-rights price. (3)

(iii) Discuss under what circumstances DiamondDesign Ltd’s share price after the rights issue
may be higher than the theoretical ex-rights price. (3)

(iv) Critically comment upon the effect that the rights issue will have on the gearing of
Diamond-Design Ltd. (Detailed calculations are not required.) Your answer should pay
particular attention to the impact upon the return on equity. (6)

(d) Explain the potential benefits of interest rate swaps to DiamondDesign Ltd. (3)

(e) Discuss how foreign trade risk may be managed. (6)

(f) List other risk factors that the directors of DiamondDesign Ltd should consider and indicate
possible hedges. (5)
114 TOE408-W/1
ZAC408-H/1

QUESTION 46 75 marks

Chemical Partners, a large London based private equity fund, acquired a controlling interest in Atlas (Pty)
Ltd with effect from 1 October 2001, the start of the company's current financial year. The acquisition was
effected through a purchase of shares. Atlas (Pty) Ltd is a South African based company involved in
forest plantations and saw milling. Chemical Partners appointed a new Chief Executive Officer (CEO) and
Financial Director (FD) to the board of Atlas (Pty) Ltd to drive the re-engineering of the business and
implement a change in business strategy. The newly appointed CEO and FD have extensive international
experience in the forestry products industry and have recently drafted a business plan for the review and
approval of the board of directors and shareholders of Atlas (Pty) Ltd. Salient features of this business
plan are summarised below.

Forest plantations

Atlas (Pty) Ltd has 100 000 hectares of high quality forest plantations in South Africa, which are
comparable to the best in the world. The scientific management of these plantations together with
favourable climatic conditions have resulted in the company being a low cost timber producer by
international standards. The competitive advantage of Atlas (Pty) Ltd is reflected in recent statistics
published regarding the "cost of raw materials at saw-mill site" of various leading timber producing
countries as set out in the table below.

Atlas (Pty) Brazil Australia USA Canada


Ltd

Cost per cubic metre in US dollar 46 49 76 127 100

The forest plantations of the company are capable of supplying 75% of its raw material needs for the
forseeable future at its three saw-mills. The remainder of raw material needs is sourced from other South
African plantation owners.

Trees are generally felled 28 years after planting and scientific management of plantations results in
optimal utilisation of land, and systematic cultivation and harvesting of plantations. Felled trees are
debarked and unusable parts sawn off (resulting in what is commonly referred to as lumber) prior to
transportation to the company’s saw-mills.

Saw-mills

The three saw-mills of the company are situated close to its forest plantations. Lumber from its own forest
plantations as well as outside sources is processed into sawn wood (the finished product) at the saw-
mills. The customers of Atlas (Pty) Ltd use sawn wood for many different applications, such as the
production of furniture. Sawn wood is supplied in a variety of different sizes and shapes, according to
customer requirements.

The plant and machinery of the company is very old and inefficient, as is the case generally in the South
African timber industry, and the processes at the saw-mills are labour intensive. Throughput rates are low
by international standards with high levels of waste. In addition, the quality and range of sawn wood
produced is inferior to that of international competitors because of the nature and condition of the
company's existing plant and machinery.
115 TOE408-W/1
ZAC408-H/1

The table below illustrates the inability of the company to compete effectively in international markets:

Measurement Atlas (Pty) Industry averages


Ltd’s best saw- per saw-mill in:
mill
USA Australia
Annual production of sawn wood Cubic metres 155 000 310 000 220 000
Product range Number of items 40 350 415
Achieved selling price ex saw-mill US dollar per cubic
metre 110 216 231
Number of employees 550 80 150

Modernisation of saw-mills

It is proposed that Atlas (Pty) Ltd acquires and installs a combination of new and second hand plant and
machinery in order to improve the throughput and raw material recovery rates at the three saw-mills. In
addition, the modernised plant and machinery should increase the number of product lines and
significantly improve product quality. The plant and machinery will be imported from Europe and the USA.
The planned modernisation of the saw-mills is to occur on a piecemeal basis to minimise disruption to
ongoing production. Based on forecast exchange rates, the total capital expenditure is expected to
amount to R300 million. It will be spread over a two-year period commencing in April 2002.

The impact of the proposed investment in plant and machinery on the cost infrastructure and production
efficiency of the company is estimated to be significant, as is shown in the next table:

Total of company’s three


saw-mills
At present After modernisation
Annual production of sawn wood Cubic metres 420 000 680 000
Average selling price ex saw-mill Rand per cubic metre 807 975
Export sales Cubic metres 84 000 340 000

Existing markets

Atlas (Pty) Ltd is the market leader in sawn wood production in South Africa with an estimated market
share of 20%. It also has the broadest product range. The local market is very fragmented with a large
number of small saw-mills and no significant competitor for Atlas (Pty) Ltd. Local demand for sawn wood
has declined steadily over recent years, resulting in surplus capacity in the industry. As a result, selling
prices have also declined and conditions in the South African saw-milling industry (reducing demand and
downward pressure on selling prices of sawn wood) are not expected to improve in the medium term.

Proposed markets

The future strategy of Atlas (Pty) Ltd is to export as much as possible. The USA will be a particular target
market given its current shortfall in supply which resulted from the banning of logging in many areas of the
USA by the authorities. Timber retailers import significant volumes of sawn wood into the USA. The
company also envisages exporting to Western Europe and Japan. The ability of the company to compete
in international markets will depend on the pricing and on the quality and consistency of the product. It is
planned to export higher quality products to achieve best prices, and to supply the remainder of sawn
wood produced to the local market. Atlas (Pty) Ltd invoices foreign customers in US dollars.
116 TOE408-W/1
ZAC408-H/1

Employees

Senior management of Atlas (Pty) Ltd is assessed to be hard working and competent. However, there
are concerns that they may be unable to lead the process of change from a technical and a managerial
perspective.

The average length of employment at the company is 15 years. Employees are to be extensively retrained
over the next two years to enable them to operate the new plant and machinery, as well as to deal with
the change in marketing strategy. The modernisation of the saw-mills, with the concomitant more
mechanised production processes, is likely to result in 20% of the work force being made redundant.

Logistics and distribution

The anticipated increase in exports will require enhanced logistics facilities and systems. Offshore
customers require Atlas (Pty) Ltd to have the ability to track the progress of product shipments at all
stages of transit between the saw-mills and their premises. In addition, the company will need outsourced
warehouse facilities in the USA to store buffer stock for American customers.

Information systems

The company does not have an integrated accounting package for all operations. The saw-mills and
plantation office sites maintain their own accounting records and submit results to head office on a
monthly basis. Monthly consolidations are prepared manually.

The management information systems used at present are manually based and need significant
improvement.

The company will be required to –

• improve the communications infrastructure;


• implement an integrated accounting system; and
• introduce sophisticated management information systems to facilitate the availability of real-time
information and enable senior executives to manage the business effectively.

Financing

Atlas (Pty) Ltd is currently funded through shareholder funds (equity and non-interest-bearing loans). It is
proposed that the company fund the investment in plant and machinery using debt. The nature and
source of such interest-bearing borrowings is yet to be decided. Management is uncertain whether to
raise US dollar denominated loans from foreign banks or to source rand denominated loans from South
African banks. Local and foreign banks have indicated they are prepared to advance loans up to R300
million secured by plant and machinery, accounts receivable and the company's forest plantations.
117 TOE408-W/1
ZAC408-H/1

PROJECTED FINANCIAL INFORMATION


INCOME STATEMENTS
Actual Forecast
YEAR ENDING 30 SEPTEMBER 2001 2002 2003 2004 2005
R000 R000 R000 R000 R000

Export sales 68 205 112 597 202 170 351 000 493 000
Domestic sales 269 173 262 144 237 900 234 000 234 000
Gross sales 337 378 374 741 440 070 585 000 727 000
Logistics costs 52 968 65 580 85 814 131 625 163 575
Net sales 284 410 309 161 354 256 453 375 563 425
Raw materials 109 648 116 170 132 021 166 725 203 560
Gross profit 174 762 192 991 222 235 286 650 359 865
Employment costs 53 918 52 408 50 940 55 016 59 417
Redundancy costs 0 4 561 5 440 0 0
Other variable expenses 52 631 56 211 49 948 78 975 98 145
Fixed expenses 34 320 32 432 30 649 32 181 33 790
EBITDA 33 893 47 379 85 258 120 478 168 513
Depreciation 7 360 14 860 35 485 43 610 44 860
Net interest expense 201 8 136 28 737 34 098 33 207
Profit before tax 26 332 24 383 21 036 42 770 90 446
Income tax expense 9 431 8 711 7 496 15 319 32 313
Profit after tax 16 901 15 672 13 540 27 451 58 133

Actual Forecast
2001 2002 2003 2004 2005
R000 R000 R000 R000 R000
Notes on sales

Cubic metres
- Export sales 83 688 120 425 175 800 270 000 340 000
- Domestic sales 334 376 327 680 305 000 300 000 300 000
Average selling price in rand per cubic R R R R R
metre
- Export sales 815 935 1 150 1 300 1 450
- Domestic sales 805 800 780 780 780
118 TOE408-W/1
ZAC408-H/1

PROJECTED FINANCIAL INFORMATION BALANCE SHEETS


Actual Forecast
AT 30 SEPTEMBER 2001 2002 2003 2004 2005
R000 R000 R000 R000 R000
Assets
Non-current assets
Forestry plantation investments 422 830 426 172 429 672 433 972 440 172
Property, plant and equipment 59 404 165 860 279 920 292 980 255 020
482 234 592 032 709 592 726 952 695 192
Current assets 87 742 108 598 124 155 161 871 202 201
569 976 700 630 833 747 888 823 897 393
Equity and liabilities
Share capital and reserves 163 960 167 878 171 263 178 126 192 659
Non-interest-bearing shareholder 320 000 320 000 320 000 320 000 320 000
loans
Interest-bearing borrowings – total 0 116 234 234 942 252 173 222 212
Deferred taxation 39 450 40 050 41 230 42 360 43 015
Current liabilities 46 566 56 468 66 312 96 164 119 507
569 976 700 630 833 747 888 823 897 393
CASH FLOW STATEMENTS
YEAR ENDING 2001 2002 2003 2004 2005
30 SEPTEMBER R000 R000 R000 R000 R000

Cash generated from operations 28 424 49 604 72 965 104 595 152 952
Interest paid 201 8 136 28 737 34 098 33 207
Dividends paid 12 675 11 754 10 155 20 588 43 600
Normal tax paid 6 987 6 642 5 047 11 615 26 208
Secondary tax on companies paid 1 584 1 469 1 269 2 574 5 450
Net cash flow from operating
activities 6 977 21 603 27 757 35 720 44 487

Cash flows from investing activities


Purchase of plant and equipment 4 205 121 316 149 545 56 670 6 900
Forestry plantation investments 8 410 3 342 3 500 4 300 6 200

Cash flows from financing activities


Proceeds from interest-bearing
borrowings 0 120 000 140 000 40 000 0
Repayment of interest-bearing
Borrowings 0 3 766 21 292 22 769 29 961
Net increase/(decrease) in cash and
cash equivalents (5 638) 13 179 (6 580) (8 019) 1 426
Cash and cash equivalents at
beginning of year 8 655 3 017 16 196 9 616 1 597
Cash and cash equivalents at end
of year 3 017 16 196 9 616 1 597 3 023

REQUIRED
119 TOE408-W/1
ZAC408-H/1
(a) Assuming that Atlas (Pty) Ltd implements the proposed business plan, identify the risks facing the
company. (22)

(b) Analyse and comment on the following aspects of the financial projections in the business plan:

(i) The gearing of the company; (6)


(ii) The expected return on equity; (5)
(iii) Income statement performance; and (10)
(iv) Expected cash flows. (9)

(c) Advise the board of directors of Atlas (Pty) Ltd on whether it should approve the plans to
modernise the saw-mills of the company and focus on exports. Support your advice with detailed
reasons. (9)

(d) Discuss whether Atlas (Pty) Ltd should raise rand denominated debt from local banks or US dollar
denominated debt from foreign banks to fund the modernisation of the saw-mills. (8)

(e) Critically evaluate the proposal to pay dividends as set out in the business plan. (6)
120 TOE408-W/1
ZAC408-H/1

QUESTION 47 40 marks

You are the head of the internal audit department of Steelco Ltd, a company whose main business is the
operation of a smelting plant that produces steel from iron ore, which is then sold to other businesses.
The financial year end of the company is 31 March.

Background to the business

The company was founded a few years ago by the managing director, Mr Staal Burger, who is also the
majority shareholder, to exploit business opportunities arising from the popularity of steel furniture. Since
inception the company has experienced exceptional growth and it intends listing on the JSE Securities
Exchange South Africa within the next year. The company intends to develop the appropriate systems of
corporate governance prior to listing. Until recently the company had a very low gearing.

The compound annual growth in company earnings over the last three years has exceeded 20% per
annum and forecast earnings growth for the year ending 31 March 2002 is in excess of 30%. This is as a
result of the company securing some profitable contracts to supply a local manufacturer of quality steel
furniture.

In addition to earnings based management bonuses, share options are awarded annually to all senior
management, based on the extent to which profit targets have been exceeded.

During the current year Steelco Ltd acquired 100% of the shares in a company situated in Argentina. This
company manufactures steel products that are sold in its local markets. The purchase was financed by
means of a $3 million loan from a bank in the United States of America. The loan is repayable in five
equal instalments, commencing on 1 January 2002. The financial year end of this company is 30 June.

Steelco Ltd is also currently involved in litigation concerning the payment of royalties to a foreign company
for the use of a brand name. The claim against Steelco Ltd is that it has underpaid royalties and
inappropriately used the brand name on a lower quality product than was envisaged.

A fully computerised accounting system was installed two months ago. Certain problems are being
experienced with the new system, with the result that data have been lost and significant delays occurred
in data processing. A major advantage of the new system is that it is web-enabled, allowing the company
to advertise its products globally and to conduct business through the internet.

All manufacturing processes make use of a standard costing system. Management accounts, which are
used by management for planning and control purposes, are produced on a monthly basis.

System description for scrap metal

Scrap metal is produced as a by-product of the operations. Mr Jack Hammer was appointed to control
and manage the sale of scrap metal. The metal is sold on a weekly basis to a local merchant with whom
Mr Hammer had previously entered into a verbal agreement. The merchant collects all the scrap metal on
a weekly basis.
121 TOE408-W/1
ZAC408-H/1

No formal records of scrap metal are maintained as Mr Hammer is of the opinion that it is too time
consuming. Mr Hammer issues a clearing note to the merchant which allows him to leave the premises
without being troubled by the gate personnel. Mr Hammer invoices the merchant once a month and
payment is made to the debtors’ department of Steelco Ltd.

Capital expenditure

Capital expenditure requests are handled by the administration department. The required procedure is
that three quotes are obtained for all expenditure in excess of R500 000 and these are submitted to a
tender committee, which then awards the contract. Tenders in excess of R4 million must be approved by
the board of directors. A quorum for any directors’ meeting is that three of the five directors must be
present.

One of the contracts you have reviewed indicated that no alternative quotes had been obtained. In
addition, no documents could be produced to support the awarding of the contract. The R4,5 million
contract awarded to Big Builders (Pty) Ltd concerned the construction of a site office at the Durban plant.

You directed an enquiry to the financial director, who is a CA(SA), and he referred you to the minutes of
the directors’ meeting during which the contract was approved. The minutes reflect that the financial
director and two of the other directors were present. However, an accounting clerk has told you that Big
Builders (Pty) Ltd is controlled by the financial director’s wife, by virtue of the fact that she is the majority
shareholder in the company.

REQUIRED

(a) Discuss with reasons the main risks currently facing Steelco Ltd and the possible impact of these
risks on the operations of the company and make recommendations to management on possible
actions to address these risks. (20)

(b) Describe the weaknesses in the system of control over scrap metal and provide recommendations
to improve the controls over the production and disposal of scrap metal. (10)

(c) Comment on the adequacy of the procedures followed in awarding the contract to Big Builders
(Pty) Ltd and make recommendations to management regarding any corrective action that can be
taken. (10)
122 TOE408-W/1
ZAC408-H/1

QUESTION 48 45 marks

This question consists of two parts which are unrelated.

PART A

John Doe Ltd is a management company for a number of South African investment trusts. One of these
trusts, the United States New Economy Growth Fund (USNE Fund) aims to track the NASDAQ index in
the USA with a 90% correlation.

The Fund follows a high risk, high return investment strategy. The mandate of the Fund is to “take high
but calculated financial risks with the objective of achieving superior annual returns”. The Fund is highly
leveraged and completely offshore invested, with the exception of cash resources, which are
denominated in South African rand.

The following is the year-end balance sheet of the USNE Fund as at 30 September 2000:

R000
Capital employed
Equity 400
Variable rate loan 500
Ten-year zero coupon bond 100
1 000
Employment of capital
Share portfolio 960
Cash 40
1 000

Additional information

1. The loan, denominated in South African rand, is repayable on 1 October 2001 while interest is
payable quarterly in arrears. The interest rate on the loan is the floating three-month BA
(bankers’ acceptance) rate plus 2%.

2. The zero coupon bond is repayable on 30 December 2008 in South African rand.

3. Since inception the USNE Fund has achieved the following annual rand returns:

• 86% in the 1998 financial year;


• 95% in the 1999 financial year; and
• 111% in the 2000 financial year.

4. An external consultant has recently rated the liquidity risk of the USNE Fund as “high”. Per the
mandate, the Fund must maintain the liquidity risk at “medium”.

5. The portfolio manager of the USNE Fund has raised the following concerns with suggested
approaches on how to deal with them:

• Market risk: All John Doe Ltd research suggests that the NASDAQ is currently
overvalued and a downward correction is imminent. To hedge this risk, the portfolio
manager believes that the Fund should sell an option linked to the NASDAQ index.
123 TOE408-W/1
ZAC408-H/1

• Foreign exchange risk: An International Monetary Fund report claims that the South
African rand is 20% undervalued against the United States dollar ($). The portfolio
manager has decided not to hedge this risk as “the rand never strengthens”.
• Interest rate risk: All indications are that South African interest rates are moving up.
The table below contains the general market view as well as the internal view (of the
economics department of John Doe Ltd) on the expected three-month BA rate for the
indicated forward periods. The portfolio manager supports the internal view and therefore
wants to enter into a one-year fixed-for-floating interest rate swap for the variable rate loan.

Expected three-month BA rates for periods indicated:


01/10/2000 – 01/01/2001– 01/04/2001– 01/07/2001–
31/12/2000 31/03/2001 30/06/2001 30/09/2001
Market view 14% 15% 16% 17%
Internal view 14% 14,5% 15% 15,2%

The market quote at 1 October 2000 for a one-year fixed-for-floating interest rate swap is
15,5%.

REQUIRED

(a) Discuss with reasons whether or not you agree with the external consultant’s rating of the
liquidity risk of the Fund as “high”. (12)

(b) Comment on the appropriateness of the suggestion of the portfolio manager to “sell an option” to
hedge the market risk on the portfolio and, if necessary, recommend an alternative option
strategy. Assume that the option meets the definition of a financial instrument for accounting
purposes. (5)

(c) Evaluate the decision not to hedge the foreign exchange risk and provide practical suggestions
as to how this risk may be hedged. (13)

(d) Discuss the risks and limitations inherent in using derivatives as hedging instruments. (5)

PART B

You are a shareholder in Millenium Mines Ltd, a company which mines platinum in South Africa and
exports its products. The platinum is sold at the international platinum spot price, quoted in US dollars.
A daily business newspaper reported that Millenium Mines Ltd recently bought an option to hedge
against platinum price fluctuations.

REQUIRED

List the specific information that a shareholder should expect to be disclosed in the annual financial
statements of Millenium Mines Ltd regarding this option and comment on why the disclosure of this
information is meaningful to shareholders. (10)
124 TOE408-W/1
ZAC408-H/1

SUGGESTED SOLUTIONS
125 TOE408-W/1
ZAC408-H/1
QUESTION 1 - Suggested solution

(a) Calculation of contract price

Calculate the profit as if there were no default in any terms of the contract.

MD 500 576C Total


Budgeted flying hours 1 200 900 2 100 (½)
R R R

• Direct fixed costs 559 470 1 055 220 1 614 690 (1½)
Pilot salaries 180 000 180 000 360 000
Lease payments 186 000 540 000 726 000
Insurance 193 470 335 220 528 690

• Indirect fixed costs 520 286 403 714 924 000


Maintenance (on hours) 89 143 66 857 156 000
Hangar rent (equally) 54 000 54 000 108 000
Administration (on hours) 377 143 282 857 660 000 (1½)

• Total fixed costs 1 079 756 1 458 934 2 538 690

• Direct variable costs 183 888 595 512 779 400 (1½)
Fuel 147 888 136 512 284 400
Minor servicing 36 000 27 000 63 000
Lease payments - 432 000 432 000 (1½)
Maintenance (on hours) 480 000 360 000 840 000 (½)
• Total variable costs 663 888 955 512 1 619 400 (½)

• Variable cost rate per flying hour 554,24 1 061,68 (1)

Total costs 1 743 644 2 414 446 4 158 090 (1)


15% mark-up 261 546 362 167 623 713 (1)
Total revenue 2 005 190 2 776 613 4 781 803

Rate per flying hour 1 670,99 3 085,13 (1)


(10)
Costs are based on flying hours – determine the expected flying hours for the second six
months.

(b) MD 500 576C Total

Total revised budgeted hours for the year 450 800 1 250 (1)
Hours for the first six months 299 204 503 (1)
Hours for the second six months 151 596 747

Determine the total cost and calculate a 15% mark-up on it.


126 TOE408-W/1
ZAC408-H/1

MD 500 576C Total

R R R

(i) Rate based on return of 15% on total costs


• Total direct fixed costs per above 559 470 1 055 220 1 614 690 (1)
• Indirect fixed costs per above 520 286 403 714 924 000 (1)
• Variable costs per hour 553,24 1 061,68 (1)
• Total variable costs 248 958 849 344 1 098 302 (1)
• Total costs 1 328 714 2 308 278 3 636 992 (1)
• 15% mark-up 199 307 346 242 545 549 (2)
1 528 021 2 654 520 4 182 541
Less: Collected so far (rate per (a) times
hours for first 6 months) 499 626 629 367 1 128 993 (1)
• Balance recoverable over six months 1 028 395 2 025 153 3 053 548 (1)
• Rate (over hours for last six months) 6 810,56 3 397,91 (1)
(12)
(ii) Rate based on at least original expected
Profit R623 713. (1)
MD 500 576C Total

Total costs as above 1 328 714 2 308 278 3 636 992 (1)
Profits (effective 17,149% margin) 227 863 395 850 623 713 (1)
Total revenue 1 556 577 2 704 128 4 260 705
Less: Collected 499 626 629 367 1 128 993 (1)
Balance to be collected 1 056 951 2 074 761 3 131 712 (1)
Rate (over remaining flight hours) 6 999,68 3 481,14 (1)
(6)

(c) The departments should negotiate to pay the rates in (i) above. The calculations in (ii) can be used
to indicate the absolute maximum to be paid. (2)

(d) Allocation of indirect costs

The amount of maintenance expected on each helicopter is proportional to the time the aircraft is
operational and hence an allocation basis for variable maintenance costs based on flying hours is
reasonable. (1)

Fixed maintenance costs should probably be allocated in a similar way given that the maintenance
facilities are utilised by the aircraft in proportion to actual time and effort spent in servicing them,
which is determined by flying hours in turn. (1)

Equal allocation of hanger rent is done in a simplistic manner. A more sophisticated method could
arguably be the space taken up by each aircraft (i.e. in relation to size), or the time they spend on
the ground (this might be related inversely to flying hours). However, the amount involved is small
and errors in allocation are unlikely to have a significant distorting impact. (2)

It can be argued that admin service are consumed more intensely where the aircraft is flying rather
than standing in the hangar and thus flying hours may be appropriate, provided that the admin costs
are associated with these aircraft. (1)
(5)
127 TOE408-W/1
ZAC408-H/1

QUESTION 2 - Suggested solution

PART 1

(a) Fixed costs are not going to change, therefore the proposals are evaluated in terms of
contribution.

Contribution per unit - Fixed cost per unit (R30) = Net profit per unit (R15). (1)
Therefore contribution per unit = R45,00

Impact of stitching elimination

Loss of contribution from 15% sales reduction


(30 000 x 15% x R45,00) (202 500) (1)
Production cost reduction (25 500 x R2,30) 58 650 (1)
Net reduction (143 850)

The reduction in sales volume arising from the stitching elimination is also applied to the
evaluation of the proposals for the change in type of tassel and change in filling.

Use of cotton tassels

Tassels required for production = 102 000 (25 500 x 4) (1)


Cotton tassels required to allow for 10% input losses:
(102 000 / 0,90 x R3,00) (340 000) (1)
Silk tassels required to allow for 5% input losses:
(102 000 / 0,95 x R5,00) (536 842) (1)
Net saving in production costs 196 842

Use of scrap fabric for filling

Elimination of cost of synthetic filling (25 500 / 3 000 x R900) 7 650 (1)
Additional production cost of scrap fabric (25 500 x R1,50) (38 250) (1)
Net increase in cost from use of scrap fabric (30 600)

The overall net increase in annual net profit arising from the implementation of the three proposals
is R22 392 = (196 842 - 30 600 - 143 850). (1)

(b) Additional contribution from all three changes:

Determine the existing contribution per unit. Bring the effect of the changes in and determine a
new revised contribution per unit.

(58 650 + 196 842 - 30 600) / 25 500 R8,82 (3)


Existing contribution 45,00 (1)
Revised contribution per unit 53,82

Number of cushions required to give the same contribution as prior to the changes:
(R45,00 x 30 000) / R53,82 = 25 084 (1)
Therefore the reduction in sales that will still leave net profit unchanged:
= (30 000 - 25 084) / 30 000 (1)
= 16,4%
128 TOE408-W/1
ZAC408-H/1

(c) The following questions should be answered before a final decision is taken:

(i) How accurate is the estimate of demand? Demand is predicted to fall by 15% but the
answer to (b) indicates that if demand falls by more than 16,4%, profit will be lower if the
changes are implemented. (1)
(ii) Have all alternative courses of action been considered? For example, would a price
reduction, or advertising and a sales promotion, stimulate demand and profits? (1)
(iii) Will the change to using scrap fabric result in a loss of revenues from the sale of scrap? (1)
(iv) Will the elimination of stitching result in redundancy payments and possible industrial
action? (1)
(v) Consideration should be given to only using cotton tassels but not eliminating stitching and
using scrap fabric for filling. (1)
(vi) Any other valid point (1)
Max (5)

PART 2

Determine the contribution per set; fill the store starting with the set that yields the highest
contribution.

(d) Required space based on total estimated sales:


(12 x 9) + (20 x 12) + (8 x 15) = 468m2 (1)
Available space = 400m2
Therefore space are to be allocated per product with highest contribution per limiting factor.
4 seater 6 seater 8 seater
Estimated sales per month 12 20 8
Selling price 2 500 4 000 7 000
Cost of wood 1 000 1 500 3 000
Labour 500 700 1 000
Fabric 200 250 300
Commission 250 400 700
Contribution per set 550 1 150 2 000 (3)

Ranking 3 2 1 (1)
Allocated space (m2) 40 240 120 = 400m2 (1)
2
Allocated sales 4 20 8 = 396m (1)
(7)
2
( Ranking can also be done per m , with the same result.

R
(e) Contribution (4 x 550) + (20 x 1 150) + (8 x 2 000) 41 200 (1½)
Salaries of sales people (3 x 3 000) (9 000) (½)
Rent (12 000) (½)
Insurance (3 000) (½)
Net profit 17 200 (3)
(10)
129 TOE408-W/1
ZAC408-H/1

QUESTION 3 - Suggested solution

Calculate the contribution to common fixed cost. The option with the best contribution should be selected.

(a)
Selling price: R11,00 R10,00 R9,50 R9,00 R8,50 R7,50
Units sold: 100 000 120 000 140 000 160 000 180 000 180 000+
R R R R R R

Sales value 1 100 000 1 200 000 1 330 000 1 440 000 1 530 000 1 350 000 (2)
Less: Variable cost 300 000 360 000 420 000 480 000 540 000 540 000 (2)
Contribution 800 000 840 000 910 000 960 000 990 000 810 000
Less: Specific fixed (2)
cost 300 000 300 000 380 000 380 000 460 000 460 000
Contribution to
common fixed
costs 500 000 540 000 530 000 580 000 530 000 350 000

The selling of 160 000 units at R9,00 and the hire of an additional machine at R80 000 will
maximize short-term profits. (2)
(8)

(b) - The above decision maximizes short-term profits, a lower selling price may be chosen to
discourage competition and ensure that a larger share of the market can be obtained in the
future if facilities are expended. (2)
- If for example a selling price of R7,50 is adopted the company will be able to sell its maximum of
180 000 units, but the short-term profits will decline by R230 000 (R580 000 - R350 000). (2)
- The cost of adopting a lower than optimal price is R230 000 and this must be compared with the
expected longer term benefits of reduced competition and a larger share of the market. (2)
- The longer term availability of machinery should be considered. (1)
- The commitment to clients to supply for a longer period than 1 year or contractual obligations. (1)
- The relevant structure as par (a) remaining in place ie no change to labour or overheads in the
longer term. (1)
max (6)

(e) How many units must be sold at R9,00 to ensure that the profit is the same as that which is
obtainable at a selling price of R9,50?
@ R9,50
Contribution to common fixed cost R530 000 (1)
Specific fixed cost 380 000 (1)
R910 000
Sales price R9,00 (1)
Less: Variable cost 3,00 (1)
Contribution R6,00
Sales quantity 910 000/6,00 = 151 667 units (1)

The question is how confident is management that a reduction in selling price will lead to an
increase in sales from 140 000 to 151 667 units. (1)
(6)
130 TOE408-W/1
ZAC408-H/1

(f) Price-skimming policy


- An attempt to exploit those sections of the market and are relatively insensitive to price changes.
(1)
- High prices are charged to take advantage of the novelty appeal of a new product. Once the
market becomes saturated, the price can be reduced to attract the part of the market that has
not yet been exploited. (1)
- More appropriate when it is difficult for competitors to enter the market. (1)

Penetration pricing
- The concept of charging low prices critically, with the intention of gaining rapid acceptance of the
product. (1)
- The low prices discourage potential competitors from entering the market and enables a
company to establish a large share of the market. (1)
(5)

(e) (i) Opportunity costs:


The potential benefit that is lost when the selection of one course of action makes it
necessary to give up a competing course of action. Example: Price at 180 000 level (R8,50)
compared to 160 000 level (R9,00). (2)

(ii) Incremental cost:


The increase in cost between two alternatives or any cost that is present under one
alternative but is absent in whole or in part under another alternative in a decision-making
situation.
Example: Increase in specific fixed cost of R80 000 from 120 000 units to 160 000 units. (2)

(iii) Target costing


A target market price is determined, a desired profit margin is then deducted to determine the
target maximum allowable product cost. Example: A target price may be R7,50 per unit; from
this is deducted a target profit of say R2,50 which will leave a target cost of R5,00. (2)

(iii) Learning curve


The cost attached to a repetitive task performance will decrease as soon as experience in this
specific task performance increases. Example: None in the info given. This will however
relate specifically to labour and a particular learning rate. (2)

(v) Marginal cost


Represents the additional costs of one extra unit of output. Example: The cost of material of
R3 per unit. (2)
(10)
(f) Labour
Labour is not utilised fully. There are excess labourers that are currently idle or they can handle the
additional machine(s) with their processes. (2)

Electricity
Electricity consumption cannot be traced directly to the new machine. (1)

Rental
Fixed contract for space, part of which is not being utilised. (2)
(5)
131 TOE408-W/1
ZAC408-H/1
QUESTION 4 - Suggested solution

See this as an income statement and firstly determine profit after tax. Calculate the return on
average assets.

(a) Revenue

Guest nights available 7 000 (1)


Guest nights sold assuming 60% occupancy 4 200 (1)

R (1)
Accommodation Revenue: (1)
- Photographic safaris (4 200 x 60% x $300 x R7,50) 5 670 000
- Hunting trips (4 200 x 40% x $250 x R7,50) 3 150 000 (1)
(1)
No of hunting trips (70 or 84) (84 is used as illustration)
Revenue per hunting trips (4 000 x 7,5 = R30 000)
Revenue for hunting trip (R30 000 x 84) 2 520 000
11 340 000
Operating costs 7 301 200
1 890 000
Salaries & wages 35 000
Slaughter & meat processing 378 000
Cost of professional hunters 347 000
Maintenance 68 000
Fuel 88 000
Vehicle costs 504 000 (1)
Food & drink (168 000) (1)
Saving - meat 295 000
Linen & laundry 320 000
Marketing 310 000
Electricity 1 000 000 (1)
Game replace - attrition 750 000 (1)
Game replace - hunting 350 000
Other overheads 529 200 (2)
Commissions
Depreciation 325 000 (1)
- buildings 280 000 (1)
- vehicles
________

EBIT 4 038 800 (1)


Interest (200 000)
PBT 3 838 800 (1)
Taxation 1 151 640
Profit after tax 2 687 160
132 TOE408-W/1
ZAC408-H/1
Average Assets

Assumption 1 2 3 4
Land 15 000 000 15 000 000 15 000 000 15 000 000
Buildings 6 500 000 6 500 000 6 337 500 6 175 000
Vehicles 1 400 000 1 400 000 1 260 000 1 120 000
Game 11 750 000 10 000 000 10 000 000 10 000 000
Other assets 1 200 000 1 200 000 1 200 000 1 200 000
35 850 000 34 100 000 33 797 500 33 495 000 (2)
Return on assets
(must be before interest) 8,3%* (1)
___
(and after tax) (R4 038 800 x 70% ÷ R34 100 000) Maximum (16)

* Change according to the assumption adapt.

There is no indication of accumulated depreciation, a number of scenarios are therefore possible


based on the opening, closing or average balances used. Calculating and showing depreciation in the
income statement should impact on the balances used.

COMMENTS

• Return on assets low (1)


• Gearing is low (1)
• Possible capital growth (1)
• Comparison and other lodges (1)
• Reasonable return is eg Government bonds (1)
• Return increases if occupancy rises (1)
• Weakening rand will improve income (1)
• Refund relative to cost of capital (1)
• Any other valid point (1)
Maximum (4)
(20)
(b) No hunting

Loss of hunting revenue (2 520 000) (1)


Increase rate revenue (630 000 - 47 250) 582 750 (1)
Professional hunter salary 378 000 (1)
Slaughter & meat processing 35 000 (1)
Increased meat costs (168 000) (1)
Saving replacement of game 750 000 (1)
Net loss (942 250)
Maximum (5)
133 TOE408-W/1
ZAC408-H/1
(c) Other factors

• Hunting & photography complement - more guests.


• Compare occupancy with other lodges.
• Occupancy levels low - need more clients.
• Ability to fund losses if strategy change.
• Physical position relative to other lodges.
• Cost of culling animals.
• Eco publicity value.
• New opportunities ito photographic safari’s
• Any other value point.
1 each maximum (5)
(d) Internet bookings

• Advertising R320 000, commission R529 000 is 11% of turnover.


• Investigate cost of internet booking.
• Effectiveness of internet booking.
• Customer base in USA, Germany - portal over there.
• Portal must co-host/links with high traffic websites.
• Cost of Amakhaya website.
• Percentage of clients that return.
• Negotiate low commission with agents.
• Dual strategy, agents and internet, better.
• Portals may be controlled by agents.
• Time difference USA, online bookings good idea.
• Value of services rendered by agent.
• Security concerns with internet.
• Potential wider/smaller market.
• Any valid point.
1 each maximum (10)

QUESTION 5 – Suggested solution

Start by allocating the general factory costs to finishing and moulding. The next step is to calculate
machine hours: rate per hour.

(a) Moulding Finishing General


factory
R000 R000 R000

Variable overhead 1 600 500 1 050


Direct 600 450 (1 050) (1)
Reallocation on 1 400 hours 2 200 950
Machine hours 800 600
Rate per hour (R) 2,750 1,583 (2)

Fixed overhead 2 500 850 1 750


Direct 1 050 700 (1 750) (1)
Reallocation on 2 000 hours 3 550 1 550
Machine hours 800 600
Rate per hour (R) 4,438 2,583
134 TOE408-W/1
ZAC408-H/1
Product cost R
Total cost
Direct material 9,00
Direct labour (2 x 5 + 3 x 5,5) 26,50
Variable overhead (4 x 2,75 + 3 x 1,583) 15,75
Fixed overhead (4 x 4,438 + 3 x 2,583) 25,50
Manufacturing cost 76,75 (2)
Variable admin (7 875 ÷ 3 150 x 15,75) 39,38 (½)
Fixed admin (1 020 ÷ 5 100 x 25,50) 5,10 (½)
Total cost 121,23

Incremental fixed cost


Cost as above 121,23
Less: Fixed overhead (25,83) (½)
Add: Dedicated costs 8,35 (½)
(167 000 ÷ 200 000 x 10%) 103,75

Variable cost (121,23 - 5,10 - 25,50) 90,63 (½)

Pricing
Mark-up levels 20% 25% 30% (½)
Total cost R121,23
Mark-up 24,25 30,31 36,37 (2)
Price 145,48 151,54 157,60 (14)

(b) • Minimum recovery would be the variable cost of R90,63 - this makes no contribution to
overhead or profit. (1)
• Maximum calculated price of R157,60 is slightly higher than market - should be considered
against the product improvement. (1)
• Costs as given may decrease over time due to efficiency - lower price may be acceptable. (1)
• Price based on incremental recovery (R104,05 x 1,30 = R135,27) will undercut competition
and can be seen as a penetration pricing policy. (1)

• Considering all factors, a price between R145 and R150 will be very competitive. (1)
Maximum (4)

(c) Break-even at 25% mark-up


R
Sales price
Variable cost 151,54
Contribution 90,63 (1)
Contribution % 60,91 (½)
40,19
BEP 6 120 (½)
,4019
= R15,227m (1)
being dependant on

• machine hours utilized


• capacity levels utilized as given (½)
• average mark-up of 25% been all products (½)
(4)
135 TOE408-W/1
ZAC408-H/1
(d) On a differential basis:

Unit cost Ö Petrol + R21 000 (½)


Consumption Ö Diesel + 4 ℓ / 100km (½)
Fuel price Ö Diesel + 35c / ℓ (½)
Operational cost Ö Petrol (19 470 vs 19 800) (1)
Over the lifespan - 5 years
R
Petrol unit cost 21 000
Diesel 250 000 ÷ 100 x 9 x 0,35 (7 875)
Diesel 250 000 ÷ 100 x 4 x 3,98 (39 800)
Operational (19 470 - 19 800) x 5 1 650
Total advantage - diesel (25 025)

Total (4 vehicles) R100 100

Not taken account of:

• Future fuel price increases (1)


• Value of vehicle at end of period (1)

Taking into account

• Labour cost (1)


• Control aspects (1)
it may be worthwhile to investigate outsourcing of this activity or seeking alternative distribution
methods. (2)
Maximum (10)

(e) • Activity based accounting basing costs (1)


on activities and cost drivers, may (1)
change the cost profile of the products (and consequently the pricing) (1)
• Target costing using market prices (1)
(what consumers will pay as the starting point to determine target cost (after margin). (1)
May assist to drive down actual cost (1)
• Life-cycle costing all costs over (1)
the life of the product. Incorporates higher) up-front costs such as development (1)
and marketing, as well as manufacturing and closure costs. (1)
Maximum (8)
136 TOE408-W/1
ZAC408-H/1
QUESTION 6 - Suggested solution

Determine the contribution per hour for Jeans and T-shirts, and determine which contribution is the
highest.

Jeans T-shirts Total


Sales 14 250 000 13 832 000 28 082 000 (1)
Cost of sales
Material cost (3 800 000) (1 995 000) (5 795 000)
Labour (2 850 000) (3 990 000) (6 840 000)
Variable overheads (1 140 000) (1 596 000) (2 736 000)
Fixed overheads (760 000) (1 064 000) (1 824 000)
Profit 5 700 000 5 187 000 10 887 000 (1)

Contribution 6 460 000 6 251 000 12 711 000


Profit % 40,0% 37,5% 38,8% (1)
Contribution % 45,3% 45,2% 45,3% (1)
Budgeted hours 95 000 133 000 228 000 (1)
Number of machinists 50 70 120 (1)
Contribution per hour (R) 68 47 - (1)

Where possible, the manufacture of jeans should be pursued.

Allocate as much time as possible to Jean manufacturing.

Total
Normal manufacturing hours 136 800 (1)
Planned hours
• jeans (5/12) 57 000 (1)
• t-shirts (7/12) 79 800
Possible production in normal time
• jeans 71 250 (1)
• t-shirts 159 600
Planned production
• jeans 71 250 (1)
• t-shirts 119 700 (1)
Ö 75% of capacity
Available capacity (hours)
• further production of jeans (7 months) 19 950 (1)

Filling of 30 000 jean order


• t-shirt machinists @ 1 per hour (5 months)
• overtime production 14 250 (1)
15 750 (1)
30 000 (1)
∴ overtime jeans per months 3 150 (1)
137 TOE408-W/1
ZAC408-H/1
April has lowest capacity and consequently highest possible overtime.
Jeans = 19 200 x 7/12 x 0,25 = 2 800 (1)
∴ Overtime jeans 3 200 (1)
Total jeans 6 000

Overtime required 3 200 x 4/5 = 2 560 hours (1)


maximum permitted 4 000 (1)
∴ Monthly overtime acceptable (1)

Alternative

Machine capacity available

Total production hours for rest of year 136 800


Existing jeans production: 71 250 x 48/60 57 000
Existing t-shirt production: 119 700 x 30/60 59 850
Existing spare capacity 19 950

Available for GDF order 19 950 ÷ 7 = 2 850 h per month


T-shirt operators’ yield is 1 jean per hour
∴ jeans produced by T-shirt operators = 2 850
to be done in overtime (6 000 - 2 850) = 3 150

Number of jean operators to work overtime pm: 3 150 x 48/60/80 = 31,5

Existing jeans machinists 118 750 x 48/60 ÷1 900 = 50


∴ 50 > 32, only jean machinists to work overtime [9]

Cost estimate:

Additional cash outlay:


30 000 x material cost R32 = 960 000 (1)
Overtime of jean operators
3 150 x 5 x 48/60 x R30 x 1,5 = 567 000 (1)
(T-shirt operators already paid)
Variable manufacturing overheads = 288 000 (1)
1 815 000

Cost per unit (1 815/30) = R60,50 + contribution R55 = R115,50 selling price (2)
Maximum (25)

(b) • fixed overheads is not material: (R1 824 000/17 195 000) = 10,6%
• allocation of fixed overheads to product lines is a matter for debate.
• key determinant in allocating overheads is the nature of overheads.
• Fashion (Pty) Ltd is a labour intensive business.
• t-shirt production line has more machinists and hence should attract higher overhead
allocation.
• perhaps the allocation rate per pair of jeans needs to increase (hours higher than
anticipated).
• ABC will be an alternative useful approach.
• a fixed and variable costing approach may lead to sub-optimal decisions.
1 mark each, max (5)
138 TOE408-W/1
ZAC408-H/1

(c) Material cost R32


Style Ltd 50
Cost if outsourced R82 (1)

Assumptions:

(1) If GDF becomes a regular client, their product should bear the corresponding fixed
costs as well. (Bundai 118 750 p.a. vs 90 000 GDF)
(2) Available t-shirt operators retrained as jean-operators with 48/60 yield

Existing fixed costs:


jeans 118 750 x 6,40 760 000
t-shirts 266 000 x 4,00 1 064 000
1 824 000 (1)
or R152 000 p.m.

Average jeans production hours p.m. (118 750/12 + 7 500) x = 13 917 (1)
48/60
Alternative (71 250/7 + 7 500) = 17 679
Average t-shirts production hours p.m. (119 700/7) x 30/60 = 8 550
Total production hours per month 22 467 (1)

(alternative 26 229)

Cost per hour = 152 000/22 467


= 6,77 (1)
(alternative 5,80)

Cost per jean x 48/60 = 5,40 (Alternative R4,64)


Cost per ti-shirt x 30/60 = 3,39 (Alternative R2,90) (2)

Absorption cost

Material (7 500 x R32) = 240 000


Labour – t-shirt retrained as jean operators 2 850 x 60/48 x R24 = 85 000 (1)
2 850 x 60
Overtime (7 500 – ( 48 ) x 48/60 x R30 x 1,5 = 141 750
Fixed overhead (7 500 x R5,40) = 40 500 (Alt 34 800)
= 72 000
579 750 (Alt 574 050) (1)
• current standard cost per pair of R72,00 is likely to be higher (inflation) (1)
• t-shirt machinists are unlikely to produce enough to meet increased demand (1)
• existing machinists cannot be expected to work overtime every month given impact on
health and productivity (1)
• employment of more machinists vs drop in future demand (1)
• R82,00 per pair is 14% higher than current standard cost (1)
• R72,00 standard cost includes fixed overheads of R6,40 (may not be incurred if further
machinists are employed) (1)
• hidden costs need to be evaluated (interest/rejects) (1)
• any price higher than R82 will yield a contribution (1)
Maximum (7)
139 TOE408-W/1
ZAC408-H/1

(d) • quality of garments manufactured by CMT operators


• reputation and experience of CMT operators
• yields achieved (fabric used per garment)
• controls required to ensure quality and yields satisfactory
• ability to meet deadlines
• transport and handling costs
• cost of outsourcing entire manufacturing process as opposed to CMT
• co-ordination of buying of fabric and customer orders
• higher interest charges due to paying COD etc
• outsourcing of 7 500 pairs a month represents > 40% of current production; will become
very reliant one CMT operator
• other sources of supply if this CMT operator disappoints
• contract issues
• labour issues
• going concern issues
• competition may decrease
• use of own facilities/expansion or not
1 mark each, maximum (8)

(e) • use of own facilities/expansion or not


• reliance on 1 customer (GDF would represent 43% of business going forward)
• pricing of continuing orders
• payment terms
• support of Bundai brand as opposed to other brands
• reaction of Fashion’s traditional customer base
• ability to produce and/or outsource production to meet orders
• contract specifications
• continuous supply by suppliers
• pricing by GDF will impact on market 1 mark each, maximum (5)
(50)
140 TOE408-W/1
ZAC408-H/1
QUESTION 7 - Suggested solution

(a) (i) Contract price for contract A using Bester’s normal pricing method:

Materials: R
Z 400 x 6 2 400 (½)
1 800 x 10 18 000 (½)
Y 300 x 30 9 000 (½)
X 600 x 48 28 800 (½)
300 x 35 10 500 (½)
W 400 x 15 6 000 (½)
Labour:
Builders 2 x 6/12 x 32 000 32 000 (½)
2 x 1 000 2 000 (½)
Casual 4 x 5 000 20 000 (½)
128 700
100% mark-up 128 700 (½)
Contract price 257 400 (5)

(ii) Minimum price based on relevant costs:

Revise the theory on relevant cost before attempting this question.

Materials: R
Z 2 200 x 10 22 000 (1)
Y 300 x 34 10 200 (1)
X 600 x 27 (resale value) 16 200 (1)
300 x 35 10 500 (1)
W 400 x 16 6 400 (1)

Labour:
Temporary workers 24 500 (1)
Builders 2 x 1 000 2 000 (1)
Casual 4 x 5 000 20 000 (½)
141 TOE408-W/1
ZAC408-H/1

Equipment:
General purpose 2nd hand 30 000 (1)
[alternative: sunk = 0]
Specialized 25 000 - 18 000 7 000 (1)
Stand 0 (1)
Administrative expenses 7 000 (½)
Minimum contract price 155 800 Maximum (10)
Alternative 125 800

(b) Estimated profit Project B:

Estimated sales value: R


70% x 150 000 105 000 (½)
30% x 180 000 54 000 (½)
Estimated building costs:
40% x 80 000 (32 000) (½)
40% x 100 000 (40 000) (½)
20% x 120 000 (24 000) (½)
Building plot (40 000) (½)
Expected profit 23 000 (3)

Using expected profit as a measure of the alternative use of the capacity, the minimum price
using the relevant cost approach would be R178 800 (155 800 + 23 000). (1)
In other words, Bester would wish to ensure that the contract price is in excess of the profit
available from the alternative use of the facilities (opportunity cost), and this would depend on
his
assessment of the 'utility value' of project B. (1)
(5)

(c) • What are the expected weather conditions during the construction period? (1)
• Are there contractual penalties for not completing the intensive care unit on time? (1)
• Will the paying of bonuses set a precedent? (1)
• What are the labour law implications of letting the temporary workers go after six months?
(1)
• What is the possibility that the equipment will realise less than estimated in six months’
time? (1)
• The long-term effect of taking on the project should be considered. Will clients in future
expect to pay the lower relevant cost price (if that is used), instead of a full cost? (1)
• What are the long-term effects on the company’s business? Will this contract lead to
business being lost or perhaps to repeat business? (1)
142 TOE408-W/1
ZAC408-H/1

• What are the cash flow implications for Bester’s business and how can the necessary
funding be obtained? (1)
• What are the possibilities of renting/leasing the premises? (1)
• What marketing advantages are there to this project? It may be ‘socially commendable
and responsible to build a hospital extension and this could be used to improve Bester’s
public image. (1)
• Are temporary workers available? (1)
• Will the required materials be available and what is the lead time on these materials? (1)
• Any other valid point. (1)
Maximum (5)

(d) Distinction between relevant and cost plus principles. (1)

1. Relevant costs

1.1 The advantages of basing selling prices on relevant costs include:

(i) The alternative uses of resources are incorporated into the analysis. (1)

(ii) It distinguishes between relevant and irrelevant costs and indicates the incremental
cash flows incurred in manufacturing and selling a product. (1)

(iii) It provides the information to enable tenders to be made at more competitive prices.
(1)

1.2 The limitations include:

(i) It is a cost-based pricing method that ignores demand. (1)

(ii) It may provide an incentive to sell at low prices, resulting in total sales
revenue being insufficient to cover total fixed costs. (1)

(iii) There is difficulty in determining the opportunity cost of resources because


information on available opportunities may not be known. (1)

(iv) Where special contracts are negotiated that are in excess of relevant (incremental)
costs but less than full costs, there is a danger that customers will expect repeat
business at this selling price. Care must be taken to ensure that negotiating 'special
one-off' contracts does not affect the demand for other products. (2)

1.3 Appropriate applications include:

(i) Relevant cost pricing is more appropriate for 'one-off' pricing decisions. (1)

(ii) It is also appropriate in situations where a firm has unutilized capacity or can sell in
differentiated markets at different prices. (1)

(iii) Relevant cost pricing may also be appropriate where the policy is to sell certain
products as ‘loss leaders'. (1)
Maximum (5)
143 TOE408-W/1
ZAC408-H/1

2. Cost plus

2.1 The limitations of cost-plus pricing include:

(i) The main criticism against cost-plus pricing is that demand is ignored. It is
assumed that prices depend solely on costs (1)

(ii) Cost-plus pricing will also not shield the seller from making losses, if the sales
volume is less than that used to allocate fixed cost per unit. (1)

2.2 The advantages of using cost-plus pricing include:

(i) It is a relatively easy way to calculate selling prices, based on detailed cost
calculations. (1)
(ii) It may also help the firm predict the prices of competitors. (1)

2.3 Appropriate applications for cost-plus pricing include:

(i) Monopolistic suppliers usually can defend their prices based on this method. (1)
(ii) Benchmarking one firms price against another’s. (1)
Maximum (10)
(35)

QUESTION 8 - Suggested solution

Note to marker: information provided in a solid block should be taken into account during marking.

To: Management of Goodies Ltd


From: CA (SA)
Re: Outsourcing of ICT (confidential)

Executive summary

If executive summary is presented first in the answer, or if the student made a comment in his answer that
it should be presented first - allocate one mark.
(1)

Provisionally it is recommended that ICT activities be outsourced, as it would lead to a saving of


R751 393 over 3 years in terms of present value. (1)
This saving is, however, small compared to cashflows incurred for ICT in general. It is therefore crucial
that outsourcing should lead to improved service before a final decision is made. (1)

The ICT department is performing well, but is not providing optimum solutions for the business. Projects
are run on an informal basis and projects often overrun budgets. (1)
144 TOE408-W/1
ZAC408-H/1

The advantages of outsourcing IT

- Consistent with the strategy of outsourcing non-core activities; (1)


- Goodies Ltd has extensive experience in outsourcing (1)
- Detailed listing of IT requirements has already been compiled (1)
(3)
Maximum (1)
Potential problems:

- The ability of IQ data to deliver on the contract (on-par and in line with Service Level Agreement
(SLA)); (1)
- Effect on staff moral and motivation (specifically (ICT personnel); (1)
- Uncertainty of what would happen after the 3 years. (1)
3
Maximum (1)
(5)
1. Incremental costing analysis

Two alternative calculations are provided: max 20 marks

COST CALCULATION IF NO OUTSOURCING

Calculation 0 1 2 3 4

Personnel 10 x R300 000 (3 000 000) (3 000 000) (3 000 000) (1)
Salary increase R3million x 0,15 (450 000) (½)

(R3 million + R450 000) x (517 500) (½)


0,15
ICT overhead
(R3 million + R450 000 + (½)
R517 500) x 0,15
Rent (595 125)
ICT overheads R270 000 x 60% (Sunk) (1)
Taxation @
30% (162 000) (162 000) (162 000)
- - - - -
(3 612 000) (3 679 500) (3 757 125) - (1)

1 083 600 1 103 850 1 127 138

Taxable income/
(expenditure) (3 612 000) (3 679 500) (3 757
125)
(Outflow)/
Inflow (A) - (3 612 000) (2 595 900) (2 653 275) 1 127 138
145 TOE408-W/1
ZAC408-H/1
COSTS CALCULATION IF OUTSOURCING IS TO GO AHEAD

Calculation 0 1 2 3 4

Personnel R300 000 x 1 (300 000) (300 000) (300 000) (1)

Salary increase R300 000 x 0,15 (45 000) (½)


(R300 000 +
R45 000) x 0,15 (51 750) (½)
(R300 000 +
R45 000 +
R51 750) x 0,15 (59 513) (½)
New employee pay (500 000) (500 000) (500 000)

Pay increase R500 000 x 0,15 (75 000) (½)

(R500k + R75k) x 0,15 (86 250) (½)

(R500k + R75k (1)


+ R86 250) x
0,15 (99 188)
ICT overhead R270 000 x (1)
60% x 1/10 (16 200) (16 200) (16 200)
Or R270 000 x 60% x 0/10 =R0

Resale of computer
equipment 300 000
Rent (Sunk) - - - - -

Rent income (sublease) 40 000 80 000 100 000 - (1)

Pensionfund (200 000) (1)


Contribution
Contract payments (2 500 000) (2 500 000) (2 500 000) (1)

Subtotal 100 000 (3 396 200) (3 374 200) (3 374 901) - (1)
Taxation
(expenditure)
@ 30% 128 000 1 018 860 1 012 260 1 012 470
Above 100 000 (3 396 200) (3 374 200) (3 374 901)

Computer
equipment
Add back (300 000)
Scrapping Tax value
allowance = (R1m-R:m/3)
= R666667 (1)
Less 300 000
= R366667 (366 667) (1)
Pensionfund
Add back 200 000
Deduct R300 000 salary salaries x20%
(note 1)
(2)
Taxable income/ - (60 000)
(expenditure) (426 667) (3 396 200) (3 374 200) (3 374 901)

(Outflow)/Inflow (B) 100 000 (3 268 200) (2 355 340) (2 362 641) 1 012 470
146 TOE408-W/1
ZAC408-H/1

Calculation 0 1 2 3 4

Difference (B) - (A) 100 000 343 800 240 560 290 634 (114 668)

= Relevant (cost) / cost saving if outsourcing is to go ahead.

1. Alternative solution: incremental costing analysis


Relevant (cost)/cost saving if outsourcing is to go ahead
Calculation 0 1 2 3 4
Personnel 9 x R300 000 2 700 000 2 700 000 2 700 000 (2)

Salary increase R2 700 000 x 0,15


405 000 (1)
(R2 700k + R405k) x 0,15
465 750
(R2 700k + R405k + (1)
R465 750) x 0,15
535 613 (1)
New employee
Salary (500 000) (500 000) (500 000) (1)
Salary increase R500 000 x 0,15 (75 000) (½)

(R500k + R75k) x 0,15 (86 250) (½)

(R500k + R75k + R86


250) x 0,15 (99 188) (1)
ICT overheads R270 000 x 60%
x 9/10 145 800 145 800 145 800 (2)
or R270 000 x 60%
x 10/10 = R162 000
Re-sale computer 300 000 (1)
Equipment
Rent expense (sunk) - - - -

Rent income (sub-lease) 40 000 80 000 100 000 (1)

Pensionfund (1)
contribution (200 000)
Contract
Payments (2 500 000) (2 500 000) (2 500 000) (1)
147 TOE408-W/1
ZAC408-H/1

100 000 215 800 305 300 382 225 - (1)


Tax saving/
(expense) @
30% 128 000 (64 740) (91 590) (115 268) (2)
Above 100 000 215 800 305 300 384 225
Computer
equipment
Add back (300 000) (1)
Scrapping
allowance Tax value
= (R1m + R/m/3) (366 667) (1)
= R666667
less 300 000
= R366 667
200 000
R300 000 x 20%
Pensionfund (Note 1) (2)
Add back (60 000)
Deduct
Taxable income/(loss) (426 667) 215 800 305 300 384 225

Relevant (cost)/cost saving 100 000 343 800 240 560 290 635 (115 268)
(End of alternative solution)

Present value 1 1,1 1,21 1,33 1,46


Present value (÷ factor) 100 000 312 545 198 810 218 523 (78 951) (1)
Total 749 927 (1)
(22)
Maximum (20)

Note 1

Full R200 000 is deductible if agreement reached with SARS (if mentioned then allocate 2 marks)

2. Other factors to consider

• Uncertainty about contract price after 3 years. Should ideally negotiate further with
IQ Data - maybe for a fixed price. (1)
• If contract cannot be extended after 3 years, then Goodies Ltd would be heavily
exposed as most ICT personnel would have left. (1)
• As the quantitative saving is not very material (compared to total ICT expense), the
main consideration should be if there would actually be an improvement in service.
(2)
• Specific ways of measuring performance for the ICT department should be
established and then applied to IQ Data. Should preferably be incorporated into
SLA. The contract manager should then measure performance against this criteria.
(2)
• Taxation: the full R200 000 for pensionfund contribution could be deductible, but
only if this is negotiated with the SARS.
148 TOE408-W/1
ZAC408-H/1
• The following should be investigated further:

◦ The re-sale value of R300 000 for computer equipment on one-year old
computer equipment appears very low - maybe there is another buyer. (1)

◦ Assumption that 60% of ICT overhead is 100% variable on personnel


figures, may not be totally accurate as there is only going to be one (or zero
depending an assumption) remaining employee. (1)
(9)
Maximum (5)

3. Recommendation

Reasons why outsourcing is to be recommended:

• In the new economy outsourcing makes sense, as companies can then focus on its
core competencies. Earlier the purpose was to gain market share through
economies of scale. Today this makes less sense as product life cycles are a lot
shorter and because the focus shifted away from the product, towards service.

• Outsourcing is in line with the new strategy of Goodies Ltd and other areas were
already successfully outsourced. (1)

• Goodies Ltd’s management are of the opinion that own ICT department do not
provide full potential for the business and budgets are often overrun. (1)

• IT requirements are already fully documented and will ease the process of
compiling the SLA. (1)

• IT personnel may prefer change - better career opportunities. (1)

Reasons why not to be recommended:

• IT requirements are documented and changes could be made to own department


which could lead to improved service.

Recommendation

Goodies Ltd should outsource ICT on condition that a good contract manager should be
appointed and he/she should:

• Manage the risks of outsourcing (1)

• Monitor performance of IQ data by comparing performance with the criteria


contained in the SLA. (1)
(8)
Maximum (5)
(35)
149 TOE408-W/1
ZAC408-H/1

QUESTION 9 - Suggested solution

If you are unsure as to which points to raise use the principles of a SWOT analysis to start off.
Think of other advantages and disadvantages as well as points which relate to practical
arrangements. In a question of this nature to read each part/point of the information/story may
give you a clue as to which additional factors you can include.

(a) NuCare's 2004 profits can be analysed as follows:

R000's Soaps Other Total


products
Revenue 15 500 46 868 62 368
Cost of sales (7 818) (32 339) (40 157)
Gross profit 7 682 14 529 22 211

Sales mix 24,9% 75,1%


Gross profit % 49,6% 31,0% 35,6%
Contribution to total GP 34,6% 65,4%

- It follows that the company's manufacturing activities contribute significantly to the


bottom line. GP% on soap is significantly higher than other products – (this could be
due to the product range or as a result of NuCare maintaining manufacturing margin)
Either way, to interfere with the most profitable range is dangerous. (3)
- Outsourcing soap manufacturing could result in NuCare becoming dependant on Cpac
for product with reduced control over quality and lead times. (2)
- Outsourcing is done to reduce the cost of certain activities by allowing each party in the
value chain to focus/specialize on a particular activity: does the proposal achieve this i.e.
does NuCare intend to specialise in retail activities only? (3)
- The proposal fixes a cost structure for 5 years which introduces an element of cost
stability which must be absent from imported products (by definition). (2)
- Cape Town premises may no longer be suitable given the factory's space utilisation. (1)
- Investment in working capital may reduce after outsourcing (no inventory materials
required). (1)
- Some funds will become available from the sale of plant, what will be done with this,
given that NuCare is already in a net interest receiving position? (1)
- Outsourcing to Cpac may prove a strategic move. Perhaps other products should be
sourced locally - less risk of Rand devaluation? (1)
- Outsourcing will result in another party becoming aware of NuCare's soap "recipes". (1)
- Staff retrenchments required and impact on staff morale? (2)
- NuCare's ability to reduce fixed overheads given manufacturing's contribution to cover
these overheads? (2)
- Cpacs track record and financial standing. (2)
- Prospect of Cpac squeezing product margins over time? (1)
- Impact of outsourcing on NuCare's profits? (2)
- Other costs of discontinuing manufacturing division? (1)
- Manufacturing currently affords NuCare an insight into product manufacture and may
give them an edge in negotiations with material suppliers (always the veiled threat of
producing materials yourself)? (2)
- Cost of insourced soap purchase versus current cost. (2)
- Alternate contract manufacturers in SA other than Cpac? (2)
- Public liability risk given that another party manufactures the cosmetic product?
Mitigating factors? (2)
150 TOE408-W/1
ZAC408-H/1
- Scope to unlock economies of scale by outsourcing to larger manufacturer? Will Cpac
pass this on? (2)
- Asset flexibility depending on nature of contract. (1)
- Must not have ongoing labour negotiations. (1)
Maximum 20

(b) NuCare's direct current unit manufacturing cost.


2004
Number of units sold in 2004 1 550 000
R000's
Manufacturing costs 7 818
Therefore, cost per unit (R) 5,04 (2)

However, NuCare will continue to incur certain costs following outsourcing.

R000's
Lease of premises 840
Allocated overheads 600
1 440 (3)

NuCare may argue that they do not want to be worse off therefore Cpac's quote is in fact (1)
= (R1 440 000 number of units) + R5,00

This then is the total cost ie both fixed variable and

Mark ups Pre outsourcing Post outsourcing (2)


Soap 98,4% 100%?
Other products 44,9% ?

NuCare will be able to maintain high margins, and soap markup will remain higher than for other
products

Other aspects of Cpac's proposal

- acquisition of plant & machinery at NBV is unacceptable at face value. Equipment should
be transferred at market value. (1)
- price escalations need to be carefully considered. These should be subject to audit post (1)
agreement and be as transparent as possible. (1)
- 5 year contract is an extended period but understandable (1)
- What is the duration of the operating lease? (1)
Maximum (10)
151 TOE408-W/1
ZAC408-H/1

(c)

- minimum order levels per month and per annum (1)


- quality assurance procedures (1)
- penalties for underdelivery by Cpac (1)
- lead times (1)
- who carries inventory of finished product (1)
- restrictions on Cpac manufacturing soap for NuCare's competitors (1)
- responsibility for R&D (1)
- trade terms (payment terms, volume discounts, payment discounts…) (1)
- packaging criteria and related references to both companies (1)
- Cpac's disaster recovery planning and procedures (1)
- ability of NuCare to terminate contract in event of poor service etc (1)
- ability of NuCare to order less than contractual volumes because of market changes (1)
- protection of NuCare's intellectual property (soap formulas etc) (1)
- employment by Cpac of any of NuCare's production personnel and Labour Law (1)
implications/ procedures
- Competition Commission approval required. (1)
Maximum (10)

QUESTION 10 - Suggested solution

(a) Calculated required production input:

A B Z Joint
Final product from each process 3 600 4 000 380
Evaporation beyond seperation point (%) 10 20 5
Required output from joint process 4 000 5 000 400 9 400 (2)
Evaporation loss from joint process (%) 6
Required input for joint process 10 000 (½)

(i) Variable cost per unit:


R
Joint process variable cost 10 000 x R5 50 000 (½)
Less: Contribution from by-product:
• Sales 380 x R5 1 900 (½)
• Variable costs 400 x R1 400 1 500 (½)
Net joint variable costs 48 500
152 TOE408-W/1
ZAC408-H/1

Apportion net joint costs based on production output from joint process:

Product A Product B
R R
Joint costs R48 500 x 4 000 / 21 556 R48 500 x 5 000 / 26 944 (1)
9 000 9 000
Additional variable 4 000 x R11 44 000 5 000 x R2 10 000 (1)
Total variable 65 556 36 944
Variable cost per unit R65 556 / 3 600 1821 R36 944 / 4 000 9,24 (1)
(7)
(ii) Absorption cost per unit
R
Joint process fixed cost 5 000 (½)
Add: fixed costs from by-product 500 (½)
5 500

Apportion joint costs based on production output from joint process:

Product A Product B
R R
Joint costs R5 500 x 4 000 / 2 444 R5 500 x 5 000 / 3 056 (1)
9 000 9 000
Additional fixed 4 000 8 000 (½)
Total fixed costs 6 444 11 056
Fixed cost per unit R6 444 / 3 600 1,79 R11 056 / 4 000 2,76 (1)
Total variable 65 556 36 944 (½)
Total costs 72 000 48 000
Absorption cost per unit R72 000 / 3 600 20,00 R48 000 / 4 000 12,00 (1)
(5)
(iii) Total net profit for the year: R

Sales (3 600 x R24) + (4 000 x R14,50) 144 400 (1)


Absorption costs (72 000 + 48 000) 120 000 (1)
Net profit 24 400 (2)
153 TOE408-W/1
ZAC408-H/1

(b) Calculate revised output:


A B Z Joint
Final product from each process (budget) 3 600 4 000 380
Reduced output at 90% 3 240 3 600 342 (½)
Evaporation beyond split-off point (%) 10 20 5
Required output from joint process 3 600 4 500 360 8 460 (½)
Evaporation loss from joint process (%) 6
Required input to joint process 9 000 (½)

Calculate revised joint process costs: R

Variable cost 9 000 x R5 45 000 (½)


Fixed cost 5 000 (½)
Repair costs 17 000 (½)
Less: Net income from by-product:
• Sales 342 x R5 1 710
• Variable costs 360 x R1 (360) (½)
• Fixed costs (500) (850) (½)
Net joint process costs 66 150

Product A
R
Joint costs R66 150 x 3 600 / 8 100 29 400 (½)
Additional variable 3 600 x R11 39 600 (½)
Additional fixed 4 000 (½)
Total 73 000
Absorption cost per unit R73 000 / 3 240 22,53 (½)

Calculate tonnage to be imported:


A
Final product of process (budget) 3 600
Reduced output at 90% (b) above 3 240
Lost production to be imported 360 (½)
154 TOE408-W/1
ZAC408-H/1

Product A
R
Total costs per (b) above 73 000 (½)
Import costs 360 x R25 9 000 (½)
Revised total costs 82 000
Sales 3 600 x R24 86 400 (½)
Revised net profit 4 400 (8)

(c)(i) Revised output.


A B Z Joint
Required output from joint process 3 600 4 500 360 8 460
Reallocate output 200 (200) 0 (1)
Revised joint output 3 800 4 300 360 8 460
Evaporation loss (%) 10 20
Final product 3 420 3 440 (1)
Sales contract 3 600 4 000
Required imports 180 560 (1)

Differential costs: R
Additional joint variable costs 2% x 8 460 / 94% x 900 (½)
R5
Additional variable costs after separation point:
A 200 x R11 2 200 (½)
B 200 x R2 (400) 1 800 (½)
Savings on imports:
A (360 - 180) x R25 (4 500) (½)
B (400 - 560) x R15 2 400 (2 100) (½)
Net additional costs 600
Therefore, reject proposal (i). (½)
155 TOE408-W/1
ZAC408-H/1
(c)(ii) Allocate output of by-product Z to A and B in proportion to their output from the joint process.

A B Z
Required output from joint process 3 600 4 500 360
Reallocate output of Z 160 200 (360) (1)
Revised joint output 3 760 4 700 0
Evaporation loss (%) 11 21
Final product 3 346 3 713 (1)
Sales contract 3 600 4 000
Required imports 254 287 (1)

Differential costs: R

Increase in separable fixed costs: 5% x (4 000 + 8 000) 600 (½)


Additional variable costs after separation point:
A 160 x R11 1 760 (½)
B 200 x R2 400 2 160 (½)
Lost contribution from Z per (b) R1 710 - 360 1 350 (1)
Savings on imports:
A (360 – 254) x R25 (2 650) (½)
B (400 – 287) x R15 (1 695) (4 345) (½)
Net saving in costs (235)

Therefore, accept proposal ii). (½)


(13)
35
156 TOE408-W/1
ZAC408-H/1
QUESTION 11 - Suggested solution

Students should remember that a report like this can mostly be extracted from the information in the
question. Each point made directly relates to information in the question. Each point made directly
relates to information in the question that has been analysed.

To : Board of Directors of Electro Motors Ltd


From : Financial Director
Date : November 2004
Subject : Analysis of current results. (1)

Dear Sirs

At your request, I have reviewed the September results achieved by Electro Motors Ltd and thereon
comment as follows;

- The company incurred an operating loss of R654 200 for September, against a budgeted profit of
R720 800. (1)
- Reasons for failing to achieve the budgeted profit include;

1. Actual units sold were 17% below budget being 38 900 units (budget 46 900). (1)
2. Assuming all costs were kept in line with budget, the low level of achieved sales meant that
contribution fell by R352 000. (R1 711 600 ÷38 900 x 8 000). (1)
3. Against the fall in sales volumes prices achieved were R186,72 against a budgeted R175. (1)
4. The extra contribution attributable to the “above expected” sales price was some R456 000
(38 900 x [R186.72 – R175]). (1)
5. Production efficiencies achieved through a combination of more expensive materials and
significant gains re labour (both rates and efficiency) yielded a benefit of R793 500 above
budget. (1)
6. Sales and distribution costs were in line with budget at R12 per unit. (1)
7. As a result of meaningful extra production capacity (80 000 units vs actual of 38 900 units) a
fixed cost overhead element of R1 233 000 was not recovered in production. (1)
8. In addition, expenditure on fixed costs exceeded budget by some R250 000. (1)
9. Before taking into account Fixed Administration Expenses, Electro Motors Ltd still generated a
profit of R555 300. (1)
10. However, after Fixed Administration Expenses losses of R654 200 were incurred. __
Maximum (5)

From this analysis a number of issues require clarity;

1. To what extent is the market price elastic? At present the decision to charge an ‘extra’ R11,72 per
unit makes sense as this is greater than the lost contribution of R359 000, but the issue is will the
market cater greater for volumes than the achieved 38 900 per month? (2)

2. The excess plant capacity of ± 40 000 units per month will lead to non-absorbed production
variances of at least ([80 000 – 46 900] @ R30) = R993 000 per month. Clearly the company
needs to find a solution to this idle capacity. (2)
157 TOE408-W/1
ZAC408-H/1

3. The extent to which an entity can bear Fixed Administration Costs is always a function of turnover.
At Electro Motors Ltd, the turnover is below budget by [(R1 400 000) R456 000)] = R944 000 and
simultaneously the Administration overhead is R429 500 above budget. It is clear that head office
costs need to be reduced to reflect the size of the business or sales growth is urgently required.(2)
4. Given the current efficiencies and costs, the break-even point is 48 420 units. This is well above
the actual sales volumes of 38 900 units. (2)
Maximum (4)

In conclusion, the main concern is the fact that demand levels do not require the Administration and Fixed
Manufacturing capacity levels available in Electro Motors Ltd. The company must either reduce capacity
(if possible) with a reduction in fixed costs or demand must be created by improved marketing or a
change of strategy as suggested by the consultants. (1)

Should you have any queries please contact me.

FINANCIAL DIRECTOR

Workings: Financial Analysis

When provided with a list of variances a student is usually required to reconcile the
budgeted profit to the actual profit or to do a ‘portion’ of this reconciliation. A request to
analyse the performance is an instruction to compare the performance to some measure
which in this case is the budget. This standard set out will also assist in achieving a
systematic analysis.

Budgeted sales (46 900 x R175) 8 207 500 (½)


Less sales volume variance (1 400 000 / 175 = 8 000 units) (1 400 000) (½)
Actual sales 6 807 500
Standard cost of sales (R131 x 38 900 units) (5 095 900) (1)
Standard profit 1 711 600
Variances
Sales : price 456 000 (½)
Material : price (375 500) (½)
: yield 173 000 (½)
Labour : rate 120 000 (½)
: efficiency 420 000 793 500 (½)
Variable contribution 2 505 100
Less variable non-manufacturing
: sales and distribution (466 800) (½)
(R562 800 / 46 900) x 38 900
Contribution before Fixed expenses and fixed expenses variances 2 038 300
Less fixed expense variances
Fixed cost : expenditure (250 000)
: volume (1 233 000) (1 483 000) (1)
555 300
Less Fixed administration expenses (780 000) (½)
Less Fixed Administration ‘variance’ (429 500) (½)
Loss for the month (654 200)
158 TOE408-W/1
ZAC408-H/1
• Unit cost of sales = (R70+R24+R7+R30) = R131 (1)
• Contribution drop = (46 900 x [R175 – R70 – R24 – R7 – R30]) – (38 900 x [R175 –
R131]) = R352 000. (1)
• Achieved price per unit = (456 000 / 38 900) + R175 = R186,72 (1)
• Break even point = R654 200 / (R186,72 – 70 - 24 - 7) = 9 520 extra units
∴ total = 38 900 + 9 520 = 48 420 units. (1)

NB: Fixed overheads of R30 per unit have been excluded from the additional break even
units as they would have the impact of reducing the Fixed Cost Volume variance if
included. ___
Maximum (20)
(b)

To: Mr Kaplan
From: Financial Director
Subject: Value Engineering

• Value Engineering can be defined as;

 ○ The identification of the functional elements of a product. (1)


 ○ To determine the relative values of each element for the usage. (1)
○ To realize these values in the final design to the benefit of the customer. (1)

• The functions of the motors are those listed in column 1. ie power, drive safety, etc. (1)

• The observed market value is the importance the buying community attaches to each function.
In this case it was determined by interviews in the market place. (1)

• The relative cost data is the application of the existing total product cost in accordance with the
perceived value (as provided by buyers).

For example, from the schedule it can be seen that the switching gear currently costs R4 but if
the cost (as a % age of the total) accurately reflected buyer needs then it would cost R9,17.
This tells the company it is either very efficient or it is underspending on the switching gear. (2)

• The assigned target column uses the targeted end cost of R110 (which the consultants believe is
optimal) and then allocates this cost to each element in accordance with the % perceived market
value.

For example, the entire unit should be constructed for R110 and then, from a buyers perspective
up to R7,70 should be spent on the switching gear. (2)

• The value ratio target tells us that Electro could spend up to 192% of the current cost on the
switching gear in terms of customer preferences. (1)

• In evaluating the entire schedule Electro should;

 ○ Increase expenditure on the Power Train by up to


(R7,7 + R3,3 – R4 – R2) = R5 in order to provide the desired quality. (1)

○ Reduce expenditure on the Drive (motor, drive and inner chamber) by


(R51 + R12 + R6 – R49,50 – R9,9 – R5,5) = R4,10. (1)
159 TOE408-W/1
ZAC408-H/1

This could mean downgrading an “over-engineered” position or buying and


manufacturing more effectively (1)

○ Reduce expenditure on the Safety element by


(R8 + R10 + R15 – R4,4 – R8,8 – R12,1) = R7,70 (1)
This could mean downgrading an “over-engineered” position or buying and
manufacturing more effectively. (1)

○ Reduce expenditure on durability by


(R23 – R8,8) = R14,20. (1)
This could mean downgrading an “over-engineered” position or buying and
manufacturing more effectively. (1)

• The first area which should be tackled is durability, as:

○ with the current cost structure of R131 per unit, the perceived value is R10,48 as against an
actual spend of R23 ie it is chronically “over-engineered” in the eyes of the customer or
Electro is inefficiently overspending. (1)

○ In the target ratio, this presents the best opportunity to make a difference in the cost
structure. (1)

Conclusion

Value engineering is not a new concept and provided;

(a) the cost allocation from Electro is correct and


(b) the market testing was well done and
(c) the market is price sensitive,

It provides useful insight into developing a goal-orientated purpose product at reasonable price.
Maximum (15)

(c) Discuss the nature and applicability of Target Costing

The objective of target costing is to;

• identify the production cost of a proposed product


• so that when it is sold
• it generates the desired margins (2)

As such, target costing includes cross-functional involvement in the development of products (ie
finance for margins, production for costs, marketing for sales etc.) (1)

Target costing is used on new product development and therefore has applicability for Electro.

Target costing starts with determining what the market will bear and then requires research and
development, production, distribution etc. to meet these targets on a profitable basis. (1)
Target costing works best in an automated environment - as is proposed. (1)
Target costing is always used for long production runs - as is proposed. (1)
Target costing needs an environment where the price of input materials can be controlled (ie
arms length and not subject to volatile commodity pricing) which appears to be the case. (1)
160 TOE408-W/1
ZAC408-H/1

In conclusion the use of the concept appears sound and should have the impact of increasing
the probability of successfully developing and launching the new product range. (1)
Maximum (8)

(d) Discuss the advantages and disadvantages of the two options.

Development of a new range

Advantages Disadvantages

(i) Will use existing capacity and (i) Requires a capex investment of R30m.
reduce the non-absorbed overheads
every month.

(ii) Will provide extra revenue to off- (ii) No history of product development in
set the administration overheads. Electro.

(iii) Spreads the market risk beyond the (iii) Entirely new markets catered for.
white goods sector.

(iv) Is a closely related product. (iv) Technological risk in selecting the new
equipment.
(v) Builds on a good brand (quality). (v) Increases the effective volume sales risk
from fixed manufacturing capacity.

Increasing the existing market

Advantages Disadvantages

(i) Identical product range. (i) Whatever has been done to date has not
been successful.
(ii) Uses existing capacity.
(ii) Stripping the cost of the product by 16% or
(iii) Should use same marketing and (R21) will not be easy.
distribution channels.
(iii) Stripping the costs may compromise quality.

(iv) Could cause Electro to become dominant in


the market.
__
1 each max (7)
(50)
161 TOE408-W/1
ZAC408-H/1
QUESTION 12 - Suggested solution

(a) Adjusting journal entries


Debit Credit

Accounts payable (B/S) 553 144


Inventories - Raw materials (B/S) 359 544
Inventories - Finished Goods (B/S) 172 858
Cost of inventories sold (I/S) 20 742 (2)

Correcting of overstatement of purchase cost


The cost of the shipment of GCM should be recorded at the rate of exchange ruling at the
transaction date - $420 000 @ 7,692 = R3 230 640 and not the forward cover rate - $420 000 @
9,009 = R3 783 784

Difference of R553 144 apportioned as follows:


Inventories of raw materials: 130 000 litres out of 200 000 R359 544
Inventories of finished goods:
62 500 (125 000 ÷ 2) litres out of 200 000 R172 858
Cost of inventories sold: 7 500 litres out of 200 000 R 20 742 (4)
________________________________________________________________________________
Loss on foreign exchange (I/S) 587 580
Accounts payable (B/S) 587 580
Liabilities in foreign currency should be stated at the rate of exchange ruling at the accounting date
- $420 000 @ 9,091 = R3 818 220 adjusted from R3 230 640 as above. (2)
________________________________________________________________________________

Forward Exchange Contract (B/S) 141 540


Loss on foreign exchange (I/S) 141 540
The profit resulting from the difference between the FEC rate and the rate available, at the balance
sheet date, for a contract closing on the settlement date, needs to be recognised in the income
statement in the current period.
$420 000 @ FEC Rate of R9,009 = R3 783 780
$420 000 @ available FEC R9,346 = R3 925 320 (2)
_______________________________________________________________________________

Inventories - raw materials (B/S) 105 000


Inventories - Finished Goods (B/S) 50 469
Cost of inventories sold (I/S) 6 057
Accounts payable (B/S) 161 526 (2)

The importance duty to be paid on the 100 000 litres in the customs warehouse is a present obligation
arising from a past event (the purchase and import) and should be recognised as a liability.
R161 526 should be apportioned as follows:
Inventories of raw materials: 130 000 litres out of 200 000 (rounded-off) R105 000
Inventories of finished goods: 62 500 litres out of 200 000 R 50 469
Cost of inventories sold: 7 500 litres out of 200 000 R 6 057 (2)

Proof:
Value of import: R3 230 640
Duty @ 10%: R 323 064
Paid: R 161 538
Payable: R 161 526
162 TOE408-W/1
ZAC408-H/1

_________________________________________________________________________________

Drum rebate (I/S) 11 970


VAT - Output Tax (B/S) 11 970
(1)
The amount in the trial balance includes VAT on
9 000 Drums @ R190 = R1 710 000
5% rebate = R85 500 - plus 14% VAT = R97 470 (1)
__________________________________________________________________________________

Accounts receivable (B/S) 76 000


Drum rebate (I/S) 49 875
Inventories - Raw materials (B/S) 14 250
Inventories - Finished goods (B/S) 11 875
(2)
Rebate on 8 000 drums @ R190 = R1 520 000
The amount receivable is probable, measurable and relates
to a past event (the purchase of the drums) and should be re-
cognised in the current period.

5% = R76 000, apportioned as follows:


Inventories of raw materials: 1 500 out of 8 000 R14 250
Inventories of finished goods: 1 250 out of 8 000 R11 875
Cost of inventories sold: 5 250 (balance of 8 000) out of 8 000 R49 875 (2)
_________________________________________________________________________________

Inventories Finished Goods (B/S) 25 000


Labour variance (I/S) 25 000 (1)
There was a permanent change in the company’s cost
structure, due to a pay increase, and an increase in staff.
Similarly, normal capacity has increased. These changes in
cost structure should be taken into account in the cost of in-
ventories. Labour cost was R3 150 000 per annum based on
15 000 units.
This is R262 500 per month.
Monthly costs are now: 262 500
Plus wage increase of 12% 31 500
Plus additional staff 51 000
Total 345 000 (2)
Based on revised production of 1 500 units per month
Cost per units is R 230
an increase from R210, of R 20
R20 x 1 250 units R25 000 (2)
__________________________________________________________________________________
163 TOE408-W/1
ZAC408-H/1

Overhead variance (I/S) R5 000


Inventories Finished Goods (B/S) 5 000 (1)

There has been a permanent change in the company’s


cost structure owing to new equipment, whilst normal
capacity has also increased. These changes in cost structure
should be taken into account in the cost of inventories.
Overhead cost was R1 620 000 per annum based on 15 000
units.
This is R135 000 per month.
Monthly costs are now: 135 000
Plus new equipment 21 000
Total 156 000
Based on revised production of 1 500 units per month (2)
Cost per unit is R 104
a decrease, from R108, of R 4
R4 x 1 250 units R5 000 (2)
(30)

(b) Cost of inventories sold R

Per trial balance 25 575 000 (½)


Drum rebate (97 470) (½)
Labour variance 105 000 (½)
Overhead variance (4 000) (½)
Adjust import (20 742) (½)
Adjust import duty 6 057 (½)
VAT on drum rebate 11 970 (½)
Additional drum rebate (49 875) (½)
Labour variance (25 000) (½)
Overhead variance 5 000 (½)
Total R25 505 940 ___
(5)
164 TOE408-W/1
ZAC408-H/1
QUESTION 13 - Suggested solution

Analyse the required section:


• Detailed report [1]
• To the Managing Director [2]
• With reasons [3]
• As to why profits > than expected in 2000 [4]

Each section implies:

[1] Detailed report = calculations + discussion + conclusion + summary


[2] Letterhead:

To:
From:
Subject:

[3] Reasons – why did variances occur; address: variances calculated + those given
[4] Reconciliation between budgeted profit and actual profit.

Note that text included in a rectangular block does not form part of the suggested solution, but is for
information purposes.

CALCULATIONS

1. Standard cost of Mace-1


Calculation Mace-1
(1 litre)
R

Selling price- 32,00


Materials (9,60)
Dung-2 (5 litre x R12) ÷ 10 litre (6,00)
Skunk-1 (6 litre x R6) ÷ 10 litre (3,60)
Labour and overhead R20 - R6 - R3,60 (10,40)
Contribution margin 12,00 (2)

2. Budgeted profit
Calculation 150 000 206 000
litres litres
R R

Sales R32 x litres 4 800 000 6 592 000


Skunk-1 R3,60 x litres (540 000) (741 600)
Dung-2 R6,00 x litres (900 000) (1 236 000)
Labour and overhead R10,40 x litres (1 560 000) (2 142 400)
Fixed selling and admin costs (1 320 000) (1 320 000)
Profit 480 000 1 152 000 (2)

The 206 000 litres represents the “flexed” budgeted figures. It shows the budgeted profit for the
actual quantity sold.
165 TOE408-W/1
ZAC408-H/1

3. Actual profit
Calculation 206 000
litres
R

Sales R32 x 206 000 litres 6 592 000 (½)


Skunk-1 R9 x 115 083 litres (1 035 747) (½)
Dung-2 R11 x 123 826 litres (1 362 086) (½)
Labour and (R10,40 x 206 000 litres) + 6 000 + 203 767 - (1)
overheads 103 000 (2 249 167) (½)
Fixed overheads (1 320 000)
Actual profit 625 000

4. Difference in profit
Profit Diffe-
R rence
R
Original budget 480 000
Flexed budget adapted for actual amount sold 1 152 000 672 000
Actual 625 000 527 000
Original budget 480 000 145 000

5. Variances

5.1 Material variances

F - Favourable
U - Unfavourable

Material variances Skunk-1 Dung-2 Total Variance

Actual quantity x
actual price 1 035 747 1 362 086 2 397 833
Material price variance (345 249)U 123 826 F (221 423)U
Actual quantity x
standard price 690 4981 1 485 9122 2 176 410
Material mixture
variance 91 386 F (182 772)U (91 386)U
Input in standard mix 2 085 024
x standard price 781 8843 1 303 1404
Material yield variance (40 284) U (67 140)U 1 977 600 (107 424)U
Output x standard price 741 6005 1 236 0006
(420 233)U
1
115 083 litres x R6 = 690 498
(1)
2
123 826 litres x R12 = 1 485 912 (1)
3
(115 083 litres + 123 826 litres) x 6/11 x R6 = 781 884 (1)
4
(115 083 litres + 123 826 litres) x 5/11 x R12 = 1 303 140 (1)
5
206 000 litres x R3,60 = 741 600 (½)
6
206 000 litres x R6,00 = 1 236 000 (½)
166 TOE408-W/1
ZAC408-H/1

5.2 Sales variances

Sales volume variance Calculation Total Variance


Actual quantity sold x standard
contribution margin 206 000 x 12 2 472 000 (1)
Sales volume variance 672 000F
Standard quantity sold x standard
contribution margin income 150 000 x 12 1 800 000 (1)

ANSWER

To: Managing director


From: CA(SA)
Re: Results of operations for 2000 (1)

During the period actual profits of Basson exceeded original expectations by R145 000. (1)

Original budgeted figures can be reconciled to actual profit as follows:


R
Original budgeted profit 480 000
Sales volume variance 672 000 F (1)
Budgeted profit - flexed volume 1 152 000

Material variances

Skunk-1 price variance (345 249)U (1)


Dung-2 price variance 123 826 F (1)
Material price variance (221 423)U

Skunk-1 mix variance 91 386 F (1)


Dung-2 mix variance (182 772)U (1)
Material mix variance (91 386)U

Skunk-1 yield variance (40 284)U (1)


Dung-2 yield variance (67 140)U (1)
Material yield variance (107 424)U

Labour rate variance (6 000)U (1)


Variable overhead spending variance (203 767)U (1)
Total efficiency variance - variable 103 000 F (1)
Actual profit 625 000

Note that the difference between the original budgeted profit and the budgeted profit for the flexed
volume is always equal to the sales volume variance.
167 TOE408-W/1
ZAC408-H/1
The following favourable variances increased actual profit:
R
Sales volume variance 672 000
Dung-2 price variance 123 826
Skunk-1 mix variance 91 386
Total efficiency variance – variable 103 000

Sales volume variance

The profit would have been R1 152 000 with a sales volume of 206 000 litres, if no other variance had
occurred. (1)

Dung-2 price variance

There was a decrease in the cost of Dung-2 during the year from the original estimate of R12 per litre to
R11 per litre. (1)

Skunk-1 mix variance

The total usage variance for Skunk-1 is R51 102 favourable (741 600 - 690 498) and it is mentioned that
extra energy had been applied in the heating of Skunk-1 (and every effort was made to reduce
evaporation), it could be that these efforts paid off, hence providing a saving of R51 102. (1)

If the usage variance is, however, analysed in greater detail the following variances are ascertained:

Skunk-1 mix variance 91 386 F


Skunk-1 yield variance (40 284)U

This indicates that the increased energy applied to heat Skunk-1 paid off (it had less time to evaporate) as
less of Skunk-1 had to be input into the mix (hence the favourable mix variance). After this stage a further
loss occurred as the yield variance was unfavourable. (1)

Total efficiency variance

Input is probably based on machine-hours (as it is implied that the process is machine and not labour
intensive). (1)

This is probably due to the increased energy input (to heat Skunk-1), which may have reduced the total
machine hours (hence the favourable variance). (1)

The following unfavourable variances decreased the actual profit

Skunk-1 price variance 345 249


Dung-2 mix variance 182 772
Skunk-1 yield variance 40 284
Dung-2 yield variance 67 140
Labour rate variance 6 000
Variable overhead spending variance 203 767
168 TOE408-W/1
ZAC408-H/1

Skunk-1 price variance

There was an increase in the cost of Skunk-1 during the year from the original estimate of R6 to R9 per
litre.

Dung-2 mix and yield variance

Less effort and care was devoted to the production and consequential evaporation of Dung-2. The extra
energy used to heat Skunk-1 might have been taken away from Dung-2 (possibly more than usual was
spilled or evaporated or a move in heating elements, which could have caused it a take longer to heat and
cause more evaporation). (1)

Variable overhead spending variance

This might have been caused due to extra electricity costs used to heat Skunk-1. (Perhaps there are
peak KWh levels and if these are exceeded within a specified period the unit costs could have increased.)
(1)

Conclusion and summary

The major reason for the increase in profit is the unexpected increase in the volume. (1)

However, certain unexpected occurrences prevented Basson from reaching its true profit potential. I
would therefore deem it appropriate to carefully investigate the planned procedures for the use of raw
materials next year. (1)

While the price variance relating to how efficiently Basson used Skunk-1 and Dung-2 caused net income
to be about R200 000 (R91 386 + R107 424) less than would otherwise have been possible. (1)

The cause of the variable overhead expenditure increase would also have to be investigated. Perhaps a
cost- benefit analysis should be drawn up to investigate the link between additional electricity spending
and savings in evaporation. (1)

You might have to reconsider the dividend proposal as this might result in a change in expectations for
next year (depending on Bassons’s dividend policy) which could be dependant on future sale contracts.(1)

Please contact me at your convenience if you wish to discuss this report.

CA(SA)
169 TOE408-W/1
ZAC408-H/1
QUESTION 14 - Suggested solution

(a) Calculations:

• Actual number of units sold = R1 452 000/ R4 000 = 363 units (1)

• Raw material inputs:

Io: Units: 580 + 1 760 - 890 = 1 450 kg (½)


Rand: 646 700 + 1 900 800 - 961 200 = R1 586 300 (½)
Eur: Units: 1 100 + 1 350 - 2 040 = 410 kg (½)
Rand: 1 683 000 + 2 227 500 - 3 283 200 = R627 300 (½)
Total input: 1 450 kg + 410 kg = 1 860 kg

Total actual input in


standard mixture: Io: 1 860 x 4 / 5 = 1 488 kg (½)
Eur: 1 860 x 1 / 5 = 372 kg (½)

• Labour:

Clock hour tariff: R2 610 / 5 = R522 per clock hour (½)


Work hour tariff: R522 / 90% = R580 per work- (productive) hour (½)

Output at standard cost per unit = 380 units x R2 610 = R991 800 (½)
Actual work hours at standard tariff = R991 800 - R73 080 = R918 720 (½)

Number of work hours: R918 720 / R580 std w.h.t. = 1 584 hours (1)
Number of clock hours: 1 584 / 88% = 1 800 hours clocked (1)

• Variable overheads:
Hours actually worked = Labour hours worked productively
= 1 584 hours
Tariff paid = R360 (Given)
Standard tariff = R1 548 / 4,5 hours = R344 per hour (½)

• Number of units on hand at 31 March:


380 units completed - 363 units sold = 17 units in inventory (½)
170 TOE408-W/1
ZAC408-H/1
Variances:

Sales variances
Actual sales @ actual price (5 445 000 + 117 975) 5 562 975 (½)
PRICE VARIANCE Given 117 975
Actual sales @ standard price (363 x 15 000) 5 445 000 (½)

Actual sales @ standard profit Given 1 452 000


VOLUME VARIANCE Given (124 000)
Budgeted sales Given 1 576 000
Total sales variances (6 025)

Raw material variances


Io Europa Variance
Actual input @ actual price 1 586 300 627 300 (½)
(Calc above) (Calc above)
PRICE VARIANCE (12 050)
Actual input @ standard price 1 471 750 729 800 (1)
(1 450 x 4 060/4) (410 x 1 780)
MIXTURE VARIANCE (29 070)
Total actual input in standard 1 510 320 662 160 (1)
mixture @ standard price (1 488 x 1 015) (372 x 1 780)

QUANTITY VARIANCE 46 720


Output @ standard cost 1 542 800 676 400 (1)
(380 x 4 060) (380 x 1 780)
Total material variances Favourable 5 600

Labour variances

Actual clock hrs @ actual c.h.t. Given 1 125 000


TARIFF VARIANCE (185 400)
Actual clock hrs @ std c.h.t. (1 800 x 522) 939 600 (½)
IDLE TIME (20 880) (½)
Actual work hrs @ std w.h.t (991 800 - 73 080) 918 720
EFFICIENCY VARIANCE Given 73 080
Output @ standard cost per unit (380 x 2 610) - marks 991 800
given above
Total labour variances Unfavourable (133 200)

Variable overhead variances (allocated on productive hours)

Actual work hrs @ actual w.h.t. (1 584 x 360) 570 240 (½)
EXPENDITURE VARIANCE (25 344)
Actual work hrs @ std w.h.t. (1 584 x 344) 544 896 (½)
EFFICIENCY VARIANCE 43 344
Output at standard cost per unit (380 x 1 548) 588 240 (½)
Total variable overhead variances Favourable 18 000
171 TOE408-W/1
ZAC408-H/1

Fixed overhead variances (allocated on machine hours)

Actually paid (380 760 - 7 810) 372 950 (½)


TOTAL VARIANCE Given 7 810
Output at standard cost per unit (380 x 1 002) 380 760 (½)
Total fixed overhead variances Favourable 7 810
___
(17)

(b)
SPACEAGE LTD
INCOME STATEMENT FOR THE MONTH ENDED 31 MARCH 2004

R
Sales 5 562 975 (½)

Less: Cost of sales (4 094 790)


Materials (R1 586 300 + 627 300) 2 213 600 (1)
Labour 1 125 000 (½)
Variable overheads 570 240 (½)
Fixed overheads 372 950 (½)
Total production cost 4 281 790
Less: Closing inventory (17 x R11 000) (187 000) (1)
Gross profit 1 468 185
__
(4)

(c) Reconciliation of budgeted and actual profit

R
Budgeted profit 1 576 000
Volume variance (124 000)
Budgeted profit at actual activity level 1 452 000
Sales price variance 117 975
Adjusted profit before cost variances 1 569 975 (½)
Cost variances (See totals calculated above)
Materials 5 600 (½)
Labour (133 200) (½)
Variable overheads 18 000 (½)
Fixed overheads 7 810 (½)
Actual profit as per the income statement 1 468 185 (½)
__
(3)

(d) The effect of ABC on a standard costing system

• Traditional variance analysis will remain unchanged for unit level activities (volume related
activities) such as direct labour, direct materials and variable overheads that vary with output
(volume) or machine or direct labour hours. (1)
172 TOE408-W/1
ZAC408-H/1

• ABC therefore highlights the fact that a significant lag can occur between the acquisition of
direct labour sources (i.e. spending) being adjusted to reflect the changes in resource
consumption. (1)

• Thus ABC has therefore increased our understanding of the impact of variances on future
cash flows. (1)

• For non-volume based activities traditional overhead variance analysis based on direct
labour or machine hours needs to be modified to incorporate the different types of cost
drivers used by an ABC system. (1)

• By creating a greater number of cost pools, and using cost drivers that better reflect the
causes of resource consumption, ABC variance analysis provides more meaningful
information than traditional variance analysis. (1)

• It also becomes clear from the results of numerous studies undertaken, that the capacity
utilization and efficiency variances relating to activity fixed costs are not particularly useful for
short term cost management. (1)

• ABC therefore leads to the analysis of the above variances in a multi-period context to
identify recurring adverse capacity variances, so that excess capacity may be eliminated,
which should therefore result in cost savings. (1)
Maximum (3)

(e) Qualitative factors

• SpaceAge should consider the effect of the destroyed documentation on the auditors’ report,
and should attempt to obtain substantiating documentation where possible. The information
should be reconstructed in as much detail as possible. However, a qualified report may be
inevitable. (1)

• SpaceAge should definitely ensure that, in future, back-ups are made of all documentation
and computer programs, preferably at a different site than the administrative offices. A
separate store for back-up copies may be considered. (1)

• SpaceAge should find out whether there were any outstanding debt, and should attempt to
collect debtors and pay creditors, so that normal production and trade may ensue. The
required cash for trade must be obtained. (1)

• SpaceAge should purchase fire extinguishers, smoke detectors and fireproof safes and
should provide the necessary training for dealing with the above safety measures. (1)

• SpaceAge ought to investigate what the cause of the fire might have been, and should then
repair any errors or make any required improvements, and should also remember to claim
from insurance for the damage and losses suffered. (1)

• SpageAge should compile a contingency plan to explain how operation of the business will
take place until the crisis situation has been resolved and the information has been retrieved.
(1)
• Any other valid point.
Maximum (3)
(30)
173 TOE408-W/1
ZAC408-H/1

QUESTION 15 - Suggested solution

CALCULATIONS

1. Production for the year

1.1 Quantity schedule Units or Kilos

Opening WIP 10 000 20 000


Input 110 000 (220 000 ÷ 2) 220 000
To be accounted for 120 000 240 000 (2)

1.2 Equivalent production Notes Total Material Conversion


(units)

Opening WIP 1 10 0001 - 1 8 0001 (1)


Current 3 76 0003 76 0003 76 0003 (1)
Completed from current
production 2 86 0002 76 0004 84 0004
Normal loss 4 11 0005 - 5 - 5 (1)
Abnormal loss (balancing) 5 3 0007 3 0007 - 7 (1)
Closing WIP 6 20 0006 20 0006 8 0006 (1)
Units 120 0008 99 0008 92 0008
or
Equivalent production (kg)
All figures in 1.2 multiplied by two 240 0008 198 0008 184 0008

Notes (not part of answer, for information purposes only)

1. Opening WIP completed in current period: conversion


= 10 000 x 0,8 (80% must still be completed)
= 8 000
2. In the question it is mentioned that 86 000 units have been completed and transferred
3. 86 000 - 10 000 = 76 000 total, material and conversion
4. 110 000 input x 10% = 11 000. Material’s normal loss is equal to zero as it is already
incorporated into the standard cost.
5. Balancing figure. Material equals the total figure as it is not incorporated into standard
cost and as spillage (is assumed to) occur at the beginning of the process. Conversion
equals zero as it occurs progressively throughout the process. Due to the assumption that
spillage occurs at the beginning of the process no conversion units could spill.
Material could also equal zero as the “good” output would then be shown as the subtotal
(96 000 instead of 99 000). (Also see the calculation for the material usage variance).
6. Closing WIP = 20 000. 40% is completed in the current period, thus conversion units
equal = 20 000 x 0,4 = 8 000.
Material is added at the beginning and i.e. 20 000 x 100% = 20 000 is completed in the
current period.
1-8
Figures have been calculated in the sequence indicated by the numbers next to them.]
174 TOE408-W/1
ZAC408-H/1

(a) (i) Raw material usage variance

Variance

3 000 (abnormal loss units) x R10,00 = R30 000 (U) (2)


or
6 000 (abnormal loss kg) ÷ 2 x R10,00 = R30 000 (U) (2)

or
Calculation Total Variance

Actual input 220 000 kg x R4,5 990 000 (1)


Material usage variance 30 000(U)
Good output x standard price (99 000 - 3 000)
x R10,00 960 000 (1)

(ii) Total efficiency variance (labour and overhead)

(Standard hours allowed - actual hours) x standard rate per hour for labour and overheads

∴ {(92 000 x 0,5) - 51 000} x R6,801

or {(184 000kg ÷ 2 x 0,5) - 51 000} x R6,801

= R34 000(U) (2)


1
R1,00 + R1,50 + R0,90
0,5 = R6,80 (2)
or

Calculation Total Variance

Input x standard price R1,00 + R1,50 + R0,9


51 000 hours x ( 0,5 ) 346 000 (1)

Total efficiency variance 34 000(U)


Good output x standard
price 92 000 units x (1,00 + 1,50 + 0,90) 312 800 (1)

(iii) Factory overhead expenditure variance

Fixed overhead Calculation

Actual expense 92 500 (1)


Fixed overhead expenditure 2 500(U)
Budgeted expense R0,9 x 100 000 units 90 000 (1)

Variable overhead

Actual expense 147 000 (1)


Variable overhead expenditure 6 000(F)
Budgeted expense
175 TOE408-W/1
ZAC408-H/1

Calculation Total Variance

R1,5
Actual hours x standard rate 51 000 hours x ( 0,5 ) 153 000 (1)

(iv) Factory overhead capacity variance

Budget 90 000 (1)


Overhead capacity 1 800(F)
R0,9
Input x standard rate 51 000 hours x ( 0,5 ) 91 800 (1)

(v) Sales volume (quantity) variance

Standard profit per unit = R20 - R14 = R6 (1)


Units sold
Opening stock (finished goods) + production
(transferred) - sales = Closing stock

∴ 26 000 + 86 000 - x = 10 000


∴ x = 102 000 units sold (1)

Calculation Total Variance

Actual quantity sold x standard


profit per unit 102 000 x R6 612 000 (1)
Sales volume variance 12 000(F)
Budgeted quantity sold x standard
profit per unit 100 000 x R6 600 000 (1)
21

(b) To: General Manager


From: Management Accountant

The final management accounts for December 2004 show a profit of only R534 300 as compared
to the budgeted profit of R600 000. The drop in profits is accounted for as follows:
176 TOE408-W/1
ZAC408-H/1
R R

Budgeted profit 600 000


Add: Favourable variances
Variable overhead expenditure 2 000 (1)
Factory overhead capacity 1 800 (1)
Material price 6 000 (1)
Sales volume 12 000 21 800
621 800
Deduct: Unfavourable variances
Raw material usage 30 000 (1)
Direct labour rate 6 000 (1)
Fixed overhead expenditure 2 500 (1)
Total efficiency 34 000 (1)
Selling and distribution overhead 15 000 (1)
87 500
Actual profit R534 300
or
Actual profit
Less: Favourable variances
Plus: Unfavourable variances __
= budgeted profit (8)

(c) (i) Possible causes for the total efficiency variance

• Too high a standard. (1)


• Inefficient control over the manufacturing activities. It took the factory personnel 5 000
hours more than the standard to manufacture the 92 000 units.
It is highly unlikely that the above was due to the employment of unskilled (or lower
skilled) labourers as the labour rate variance is unfavourable (thus probably more
expensive labourers). (1)
• Material of a possible lower quantity was purchased (the material price variance is
favourable), which could have caused the abnormal spill. Labourers did spend time on
manufacturing, but some of the time was lost it was spend on the production of abnormally
spilled fertiliser which reduced efficiency. (1)
• The IT breakdown (if the production process is controlled by computer to a certain extent)
(1)
• Any other valid point. (1)
Maximum (3)

(ii) Steps to be taken to prevent a future unfavourable efficiency variance

• Review the standard if necessary. (1)


• Better control and supervision. (1)
• Review the policy for the purchase of material. Perform a cost-benefit analysis and
ascertain whether a lower quality material is beneficial. Fix quality standards and identify
acceptable suppliers. (1)
• Update and implement an IT disaster recovery plan to limit the negative effects to a
minimum. (1)
• Any other valid point. (1)
Maximum (3)
35
177 TOE408-W/1
ZAC408-H/1
QUESTION 16 - Suggested solution

(a)(i) Calculate number of units to be produced

Product 1 Product 2 Product 3


Sales 850 000 1 500 000 510 000 (1)
Closing inventory 200 000 255 000 70 000 (1)
Opening inventory (100 000) (210 000) (105 000) (1)
Production units packed 950 000 1 545 000 475 000
Normal spillage (production x
5/95) 50 000 - 25 000 (1)
Production units filled 1 000 000 1 545 000 500 000 (1)
(production 100/95)

Calculate total labour hours per employee per year

Hours per week = 35 + 3


= 38 hours (1)

Working weeks = 250 days ÷ 5 days per week


= 50 working weeks (1)

Total labour hours per employee per year

= 38 x 50
= 1 900 hours (1)
Max (2)

Calculate direct labour hours

Product 1 Product 2 Product 3


Filling units (A) 1 000 000 1 545 000 500 000
Number per hour (B) 32 75 62
Hours (A/B) 31 250 20 600 8 065 (2)

Packing units (A) 950 000 1 545 000 475 000


Number per hour (B) (B) 23 25 23 (2)
Hours (A/B) 41 304 61 800 20 652

Total direct labour hours = 183 671 hours (31 250 + 20 600 + 8 065 + 41 304 + 61 800 + 20 652)
(1)

Calculate total labour hours

= 183 671 / 0,8


= 229 589 hours (1)
178 TOE408-W/1
ZAC408-H/1

Calculate number of employees

= 229 589 / 1 900


= 120,84
= 121 (1)
Maximum (12)

(ii) Calculate total payroll costs

Basic: (121 x 35 hours x 52 weeks x R40) 8 808 800 (2)


Overtime: (121 x 3 hours x 50 weeks x R50) 907 500 (2)
Total payroll cost 9 716 300

For overtime we use 50 weeks as employees can only be paid overtime for working weeks

Calculate direct labour rate

= Total payroll costs ÷ total direct labour hours


= R9 716 300 ÷ 183 671
= R52,90 (1)
Maximum (4)
(iii) Direct labour cost of each product

Product 1 Product 2 Product 3


Filling
Production units (final) 950 000 1 545 000 475 000 (1)
Total direct labour cost
31 250 x R52,90 1 653 125 (½)
20 600 x R52,90 1 089 740 (½)
8 065 x R52,90 R426 639 (½)
Per unit R1,74 R0,70 R0,90

Packing
Total direct labour cost
41 304 x R52,90 2 184 982 (½)
61 800 x R52,90 3 269 220 (½)
20 652 x R52,90 1 092 491 (½)
Per unit R2,30 R2,12 R2,3000
R4,04 R2,83 R3,20 (1)

__
Maximum (4)
179 TOE408-W/1
ZAC408-H/1

(b) To: Budgeting Committee


From: Management accountant
Re: HIV/AIDS issues and potential impact for AA Manufacturing Ltd (confidential) (1)

General risks

• Productivity will decrease, resulting in increased direct labour cost per hour. (1)
• There might not be enough personnel for a full production shift. (1)
• Increased portion of total time will probably be taken up by sick and idle time - again increase
in direct labour cost per hour. (1)
• More leave taken at the same time (eg. in the case of a colleague’s funeral, especially if it is
held in some distant rural area). (1)
• Other workers could be infected by HIV positive workers, resulting in a claim against the
company, if it is as a result of a work-related injury or incident. (1)
• Cost of the average set of risk benefits (employment benefits e.g. death benefit, spouse’s and
disability pensions, and medical aid scheme costs (if applicable)) will increase dramatically.(1)
• General risk of market decreasing in size due to a reduction in South Africa’s GDP in future
(due to HIV/AIDS and a specific risk of reduction in market size depending on the HIV
prevalence within its specific market). (1)

Risk specific to Factory 1

• No risks above and beyond the general risks as process is labour-intensive, making use of
unskilled workers which are relatively easy to replace. (1)

Risk specific to Factory 2

• This process requires specialised labour to operate sophisticated machinery - this type of
labour is expensive and scarce and could be difficult to replace. (1)

Any other relevant risk. (1)

Manage risks

• Develop a policy on HIV/AIDS. This policy should set out the legal obligations and provide a
framework for how management and employees will be expected to deal with AIDS-related
issues. (2)
• Consult a specialist on Labour Law in setting up the policy (HIV/AIDS is a sensitive issue). (1)
• Implement an AIDS training programme. It should be designed to prevent infection (possibly
provide free condoms). (1)
• Perform a KAP (Knowledge, Attitudes and Practices) study on the HIV/AIDS issue. (1)
• Perform on analysis on the possible effect of HIV/AIDS on the average set of employee
benefits and consider if changes need to be made. (1)
• Cross-training (especially for Factory 2 workers). (1)
• Standards should possibly be adjusted to account for changes in % of time spent on activities
(probably an increase in sick and training time). (1)
• Standards should possibly be adjusted to account for the change in budgeted labour rate per
hour as average overtime hours would probably increase (if more employees are sick then
more employees would have to work overtime). (1)
• Encourage workers to go for voluntary HIV tests at clinics/hospitals. (1)
180 TOE408-W/1
ZAC408-H/1

Note that the Employment Equity Act bans HIV/AIDS tests by the employer, subject to special
authorisation by the Labour Court (according to a recent ruling). (1)

• Implement (and widely publicize) a policy that all open wounds and bleeding should
immediately be bandaged (give someone this responsibility and training). (2)
• Perform cost-benefit analyses:

○ For Factory 1: would it be better to change the process to a more capital intensive
process (less labour-intensive), but consider labour issues. (1)
○ For Factory 2: possibility to decrease labour even further, e.g. computer-operated
machinery. (1)

• If employees have external pension funds and are HIV-positive, recommend that they change
the investment choice (if possible) to manage the exit risk better. (1)

Note that at current it is probably still not cost-effective to provide free anti-retroviral drugs to HIV-
positive employees, as the cost is roughly USD 10 000 per person per year. Future developments
do, however, need to be taken into account. (1)

• Other relevant and practical points. (1)


(18)
Maximum (11)
Total (40)

QUESTION 17 - Suggested solution

(a) The main characteristics for the successful application of ABC are as follows:

• A highly competitive market (½)


• A diversity of products, processes and customers (½)
• Significant overheads not easily assigned to individual products (½)
• Demands on overhead resources placed by individual products or customers that are not
proportional to volume of production (½)

Businesses which would not benefit from ABC include the following:

• Single product companies (½)


• Monopolistic companies (½)
• Any organisation the bulk of whose costs are direct material and direct labour (1)
(4)
181 TOE408-W/1
ZAC408-H/1
(b) Activity based overhead per product
Product
Jaspis Agate Sodalite
R/u R/u R/u

Machining 7,01 28,06 42,08


350 000 350 000 350 000
( 12 475(i) x 0,25 ) ( 12 475 x 1 ) ( 12 475 x 1,5 ) (1½)
Set-up costs 3,00 9,17 3,14
44 000 44 000 44 000
[( 16 x 6 )/5 500 ] [( 16 x 2 ) /600] [( 16 x 8 ) /7 000]
(3)
Order costs 1,82 3,33 1,14
20 000 20 000 20 000
[( 10 x 5 )/ 5 500 ] [( 10 x 1 ) /600 ] [( 10 x 4 ) / 7 000]
(3)
Material
6,06 13,89 4,76
handling
75 000 75 000 75 000
[( 27 x 12 )/5 500] [( 27 x 3 ) /600] [( 27 x 12 ) /7 000]
(3)
Parts 1,06 1,39 0,48
10 000 10 800 10 000
[( 12 x 7 ) / 5 500] [( 12 x 1 ) / 600 ] [( 12 x 4 ) /7 000]
(3)

Overhead per unit 18,95 55,84 51,60


Current system 10,00 40,00 60,00

(i) Total machine hours


(5 500 x 0,25) + (600 x 1) + (7 000 x 1,5) = 12 475 (½)
(14)

• The present system is based on the assumption that all overhead expenditure is volume-related,
measured in terms of machine hours. However, the overheads for the supporting activities
supplied in the question are unlikely to be related to machine hours. Instead, they are related to
the factors that influence the spending on support activities (ie cost drivers). The ABC-system
traces costs to products based on the quantity (cost drivers) of activities consumed. (2)

• Product Sodalite is the high volume product, and thus the present volume-based system traces a
large share of overheads to this product. (1)

• In contrast, the ABC-system recognizes that product Sodalite consumes overheads according to
activity consumption, and traces a lower amount of overheads to this product. (1)
182 TOE408-W/1
ZAC408-H/1

• The overall effect is that, with the present system Sodalite is overcosted and the remaining
products are undercosted. This could lead to problems in decision making - inter alia with pricing.
(1)
(5)
(19)
(c) • Life-cycle costing

•• The term life-cycle costing is used to describe a system that tracks and accumulates the actual
costs and revenues attributable to each product from inception to abandonment. (1)

•• The profitability of any given product can therefore be determined at the end of its economic
life. (½)

•• Most accounting systems merely report on a periodic basis, and product profits are not
monitored over their lifecycles. (½)

•• In contrast, product life-cycle costing reporting involves tracing costs and revenues on a
product-by-product basis over several calendar periods throughout their entire life cycle. Cost
and revenues can be analysed by time periods, but the emphasis is on cost and revenue
accumulation over the entire life cycle of each product. (1)

•• The main purpose of life cycle costing is to provide feedback information regarding the
enterprises’s success or failure with the development of new products. (½)

•• In today’s competitive environment companies can no longer rely on many years of stable high
demand when a new product is being introduced. (½)

•• A product’s useful life in the marketplace is constantly being threatened by new versions
incorporating the latest design features. (½)

•• In an advanced manufacturing environment a large fraction of costs is committed prior to


production commencing. (½)

•• Abovementioned factors have created the need for life-cycle reporting and “post-completion
product audits” based on approaches similar to those used after completion of a capital
investment. (1)
(6)

• Target costing

•• Target costing is driven by external market factors. A target market price is determined by
marketing management prior to designing and introducing a new product. (1)

•• This target price is set at a level that will permit the company to achieve a desired market share
and sales volume. (½)

•• A desired profit margin is then deducted to determine the target maximum allowable product
cost.
(½)
•• Product costs are computed based on design specifications and compared with the target cost.
(½)
183 TOE408-W/1
ZAC408-H/1

•• If the projected product cost is above the target cost then product designers focus on modifying
the design of the product so that it becomes cheaper to produce. (½)

•• Manufacturing engineers also focus on methods of improving production efficiency so that the
target cost can be achieved over a period of roughly 12 - 24 months. (1)
(4)

(ii) • Target costing has its greatest impact at the design stage because a large percentage of a
product’s life cycle costs are determined by decisions made early in its life cycle. (½)

• However, target costing can also be applied to cost reduction exercises for all products
throughout their entire life cycle. (½)

• Hence, the target cost computed at the beginning of the life cycle does not remain the final
focus. (½)

• Over the life of the product the target cost must be continuously reviewed and reduced as part
of a continuous improvement process. (½)
(2)
(12)
35

QUESTION 18 - Suggested solution

(a) Unit contribution

Tricycle (T) = 6 000 ÷ 100 = R 60 pu (1)


Mountain Bike (MB) = 24 000 ÷ 100 = R240 pu (1)

Current position

T segment = 9 000 000 ÷ 60 = 150 000 units (1)


MB segment = 12 000 000 ÷ 240 = 50 000 units (1)
Company = 33 000 000 ÷ (0,5 x 60 + 0,5 x 240) = 220 000 units
(ie 110 000 units each; a 10% increase)
(5)

The ratio of 50:50 indicated by the unit sales in the draft budget.

Alternatives

The current loss of R3m should be recovered from one of the products or by changing the mix. This
can be illustrated by the following scenarios:
184 TOE408-W/1
ZAC408-H/1

T MB
Scenario 1 100% 0%
Resulting breakeven (9m - 3 m + 3m)/60 (12m + 12m)/240
production = 150 000 = 100 000
units units
∴ 50% increase no change
Scenario 2 0% 100%
Resulting breakeven (9m - 3 m)/60 = 100 000 (12m + 12m + 3m)/240
production units = 112 500 units
no change ∴ 12,5% increase
Scenario 3 50% 50%
Resulting breakeven (9 m - 3 m + 1,5m)/60 (12m + 12m + 1,5m)/240
production = 125 000 units = 106 250 units
∴ 25% increase ∴ 6,25% increase

• A whole range of possibilities thus exist that will satisfy the breakeven conundrum.

• The company may thus also decide to manufacture only one of the products.

(b)
No data regarding direct fixed expenses is provided. The analysis can therefore only cover
common fixed expenses. Capacities are not fully utilised, therefore the savings in common fixed
costs will drive the decision.

Analyse current production mix using activity based costing.

Unused
capacity
Unused to be
Activity Capacity Usage capacity eliminated Saving

Purchasing 8 000 6 000 2 000 2 000 150 000


Inspection 10 000 7 800 2 200 2 000 180 000
Despatch 16 000 12 000 4 000 3 200 307 200
Material
handling 50 000 40 000 10 000 10 000 360 000
Fixed cost savings by eliminating unutilised capacity 997 200 (2)

The above is based on the assumption that a batch of whole units in respect of the inspection and
despatch processes can be split over the two lines. Should this not be the case, ie each line
‘contracts’ the process when required, the following usage and savings will be applicable:
185 TOE408-W/1
ZAC408-H/1

Unused
capacity
Unused to be
Activity Capacity Usage capacity eliminated Saving

Purchasing 8 000 6 000 2 000 2 000 150 000


Inspection 10 000 10 000 - - -
Despatch 16 000 12 800 3 200 3 200 307 200
Material
handling 50 000 40 000 10 000 10 000 360 000
817 200 (2)

Total power costs can be analysed into fixed and variable components as follows by using the high-
low approach.

Variable cost:

276 000 – 240 000


12 000 – 10 000 = R18 per Kwu (1)

Fixed cost:

276 000 - (12 000 x 18) = 60 000 (1)

Activity utilisation assuming Tricycle line is dropped, including a 15% reduction in mountain bike
production.

Unused
capacity
Unused to be
Activity Capacity Usage capacity eliminated Saving

Purchasing 8 000 3 400 4 600 4 000 300 000


Inspection 10 000 4 080 5 920 4 000 360 000
Despatch 16 000 6 800 9 200 8 000 768 000
Material handling
50 000 21 250 28 750 25 000 900 000
Cost savings 2 328 000 (2)
Variable cost savings - despatch (4 000 + 8 000 x 15%) x 30 156 000 (1)
Savings in variable power costs (46 000 + 90 000 x 15%) x 18 1 071 000 (1)
Total savings 3 555 000
Savings associated with normal capacity optimisation (refer above) 997 200
Incremental savings with closing the Tricycle line 2 557 800 (½)
186 TOE408-W/1
ZAC408-H/1

Activity utilisation assuming Tricycle line is dropped, without a 15% reduction in mountain bike
production.
Unused
capacity
Unused to be
Activity Capacity Usage capacity eliminated Saving

Purchasing 8 000 4 000 4 000 4 000 300 000


Inspection 10 000 4 800 5 200 4 000 360 000
Despatch 16 000 8 000 8 000 8 000 768 000
Material
handling 50 000 25 000 25 000 25 000 900 000
Cost savings 2 328 000 (2)
Variable cost savings - despatch 4 000 x 30 120 000 (1)
Savings in variable power costs 46 000 x 18 828 000 (1)
Total savings 3 276 000
Savings associated with normal capacity optimisation 997 200
Incremental savings with closing the Tricycle line 2 278 800 (½)
(15)

(c) On a breakeven analysis basis the new segment would be profitable: R3,55m profit less
depreciation of R2,0m (R12m/6) results in a R1,55m contribution to common fixed costs and profits.

A project evaluation of this nature should make use of discounted cash flow techniques:

Year
Year 0 1 to 6
Initial cost (R12 000 000) (½)
Cash profits before tax R 3 550 000
Taxation (30%) 1 065 000 (½)
Depreciation tax saving 600 000 (½)
R 3 085 000 (½)
Net cash flow (R12 000 000) R11 997 565 (1)
Factor 1,0 3,889
Net present value at 14%: (R2 435)

The NPV of the project is negative and as a result it should not be undertaken. (1)

The NPV is, however, only marginally negative and small changes in the estimated values of the
various numbers could result in a positive NPV. (1)
Maximum (5)

(d) • Current planned production losses amount to R3m.

Alternative sales and production strategies arising from breakeven analysis

• The high contribution margin per unit for mountain bikes (4 times higher than for Tricycles)
means that the shortfall will be made up most quickly by increasing the production of mountain
bikes. Placing reliance on Tricycles to make good the shortfall requires a far greater
proportionate increase in sales in that area. (2)
187 TOE408-W/1
ZAC408-H/1

• Information in the question indicates that a reduction of R30 in the sales price of Tricycles
could double sales. This halves contribution per unit to R30. Such a decision would result in
the same level of segment result (200 000 units @ R30 = R6m contribution). It thus seems
unlikely that the loss of contribution arising from sales price reduction in Tricycles will be
adequately offset by increases in volumes. (2)

• No information has been provided on the price sensitivity of Mountain bikes. However, given
the higher contribution percentage of sales price (40% for mountain bikes; 20% for tricycles)
allows greater scope for sales increases induced by sales price reductions, provided that
demand is sufficiently price sensitive. (2)

• Assuming the Tricycle line is dropped and a 15% decline in mountain bike volumes is
suffered, revised contribution amounts to 100 000 @ 85% @ R240 = R20,4m resulting in a
net loss after common fixed costs of R12m. Information needs to be obtained on whether a
more than 50% reduction in total production volumes does not give rise to savings in common
fixed costs (production might operate in a lower “relevant range”). (2)

• The introduction of a new range of bikes at anticipated production levels would not result in
overall breakeven. After accounting for depreciation under direct fixed expenses, only
R1,55m is added to net income. (1)

• The impact of the introduction of a new product line on e.g. the sales level of mountain bikes
has not been assessed. If this step leads to an increase in mountain bike sales, it could more
than offset the negative impact on dropping the Tricycle line. The additional marketing costs
arising from the new line also reduce the potential benefit of this strategy. (1)

Comments arising on assessment of new production line

There may also be other factors that need to be considered:

• Opening of new markets and accessing of new customers with potential ripple impact on sales
of other products. (1)

• Updated (newer) production technologies may make the company more flexible in the future;
or could have a positive impact on quality with consequent savings on wastage/warranty
claims. (1)

• Given the NPV profile of the project, it might be possible to obtain suitable financing in spite of
current gearing levels. (1)

The net closure costs/salvage of the Tricycle line (that might be considered) might be able to reduce
some of the existing debt/reduce the new financing costs. (1)

With a marginal NPV result it is imperative that more detailed analysis is performed on the date
used in the analysis. Furthermore a detailed qualitative analysis should be undertaken to consider
unquantifiable variables. (1)

Comments arising on ABC analysis

• The elimination of excess fixed cost capacity, without any changes in product mix or volumes
implies that costs could be reduced by another R997 000; with a net planned loss of about
R2m. (1)
188 TOE408-W/1
ZAC408-H/1

• It was previously estimated that the elimination of the Tricycle line together with the
associated expected 15% drop in Mountain bike production levels would result in a planned
operating loss of R12m. Based on the ABC analysis, additional savings in common fixed
costs would reduce by R3,7m including the capacity optimisation savings above. The revised
loss is thus R8,3m. (2)

• The analysis of spare capacity in common fixed costs indicates that a doubling of volumes of
Tricycles would actually increase losses: both the inspection as well as despatch activities do
not have adequate spare capacity to absorb a doubling of volumes. Furthermore the variable
elements in despatch and power costs would also add to common fixed costs. (1)

• If it is possible to eliminate the Tricycle range without losing small mountain bike sales,
together with capacity optimisation, breakeven will be achieved. (1)

• The impact of a large mountain bike range on common fixed costs needs to be assessed.
This new range, or increased sales levels by the small mountain bike range (at large unit
contributions) could return the company to profitability. Avenues of increasing mountain bike
sales should be investigated such as:

• Focus on quality (1)

• Changes in marketing strategy (1)

• Price sensitivity of product (1)

• It should be noted that based on current capacity, elimination of the Tricycle range leaves
adequate common fixed cost capacity to double mountain bike production (with some increases
due to the variable nature of elements of “common fixed costs” such as despatch and power).
(1)

• Given comments on quality management: there should be a strong focus on quality


management: (1)

• Building a continuous improvement culture (1)

• Improved quality will reduce high product specific fixed costs (warranty costs) (1)

• Improved quality could lead to higher sales without having to reduce prices (1)

• Analysis of common fixed costs has shown that opportunity exists for cost savings; product
specific fixed costs should also be analysed similarly into activities to assess the potential for
further savings. (1)
Maximum (20)
189 TOE408-W/1
ZAC408-H/1

QUESTION 19 - Suggested solution

This budget is driven by the market share (litres sold), variable costs and sales prices where some
dependency exists.

(a)
2000 2001
Market share 10% 10% 12% 15%
Litres 5 000 000 1) 5 250 000 6 300 000 7 875 000 (1)
Selling price: Rand per litre 600 618 618 648,9 (1)
Variable cost per litre 2700 2862 2862 286,2 (1)

R’000 R’000 R’000 R’000

Gross sales 30 000 32 445 38 934 51 101 (1)


Freight and settlement 3 000 3 245 3 893 5 110 (1)
discounts
Volume rebates 1 217 2)
Net sales 27 000 29 201 35 041 44 774

Less: Manufacturing costs: 18 300 20 654 26 359 30 866


- Variable 13 500 15 026 18 031 22 538 (1)
- Fixed 4 100 4 928 5 128 5 128 (1)
- Depreciation 700 700 3 200 3 200 3)

Gross profit 8 700 8 547 8 682 13 908

Less: Expenses: 6 600 6 625 9 075 9 075


- Marketing 4 000 4 200 6 650 6 650 4)
- General and administrative 2 100 1 900 1 900 1 900 (1)
- Research and development 500 525 525 525 (1)

Profit before interest and tax 2 100 1 922 (393) 4833


(½ ) (½ ) (½ )

Gross profit % on net sales 32% 29% 25% 31% (1)


Profit before interest and tax on 7% 6% -1% 9% (1)
gross sales

Workings:

1. R30 000 000 / R6 per litre = 5 000 000 litres (½)


5 000 000 litres = 10% market share
total market = 50 000 000 litres (1)
total market next year = 50 000 000 x 1,05 = 52 500 000 litres (½)
Foodcor’s 10% share = 5 250 000 litres (1)
1% increment in market share = 525 000 litres

2. Gross sales increase = 51 101 - 38 934 = 12 167


volume rebate of 10% = 12 167 x 10% = 1 217 (1)
190 TOE408-W/1
ZAC408-H/1
3. new plant depreciation = 25 000 000 x 10% = 2 500 000
total depreciation = 700 000 + 2 500 000 = 3 200 000 (1)

4.
market expenditure to maintain 10% share 4 200 000 (½)
increase to 11% 1 225 000 (½)
increase to 12% 1 225 000 (½)
6 650 000

(b)

The plan that maintains 10% market share is not acceptable as it results in a reduction in the
GP% as well as the PBIT% mainly as a result of: (1)
• The variable costs being increased by 6%, however only 3% could be added to the (1)
selling price
• The fixed wage costs being increased by 8% as well as the additional spending on (1)
training
• The plan that increases the market share to 12% is even more detrimental as GP% is
now only 25% and the PBIT% is negative. This can mainly be attributable to: (1)
• The addition of the new capacity increasing the fixed costs by a further R200 000 and
the R3 200 000 depreciation which is not covered by the increased sales (1)
• Additional marketing expenditure being incurred to penetrate the market but at these
volumes not yet being covered (1)
The 15% market share plan is the one that should be recommended as it is the one that
fits the CEO’s objectives the best. This is the result of: (1)
• The increase in the sales volume and price which now offsets the increased fixed
production and marketing costs (1)
(8)
(c)
• Before the budget process starts a strategic planning session is held to determine the
strategic direction of the company (1)
• Flowing from the strategic session, the CEO sets short term objectives (targets) which is
aligned with the long term direction of the company (1)
• Once the targets are set, a bottoms-up approach is followed in that the operating units
are given the opportunity to give input into how they can achieve the targets, that
encourages buy-in into the final plan (2)
• The targets are difficult but achievable, thereby it achieves its motivational role for the
operating units (1)
• In terms of balancing the scorecard, money is spent on education of employees as well
as on research and development (2)
• Non-production overheads are not just accepted and escalated for budgeting purposes,
but are subject to review and analysis (1)
(8)
191 TOE408-W/1
ZAC408-H/1
QUESTION 20 - Suggested solution

The entire question relies on discussion and argument. Several of the issues listed are common to
different practical scenarios and consequently this question may be used as a study document.

(a) Tech Training

• Quality of USA software programmes on which training is based


• Demand for / market penetration of these programmes in South Africa
• Quality of lecturing staff
• Quality of lecturing materials
• Access to “corporate” business
• WIP and debtors management
• Number of students attending courses
• Utilisation of premises given the investment in “bricks and mortar” (ie need to run as many
courses as possible)

Tech Retail

• Venue siting is vital


• Pricing is key in a competitive market
• Inventory management:
- avoiding obsolescence
- turning over cash
• Knowledgeable, friendly staff
• Underlying retail info systems to manage the Tech retail business
• Access to superior product range
• Business branding
• Buying and merchandising

Tech Consulting

• Calibre of consultants (up to date)


• Reputation / success
• Marketing network
• WIP and debtors management
• Areas of specialisation would need to be those for which a demand exists
• Research base, in terms of methodologies
• Charge out rates
• Diversified client base
1 each sub max (4)
(12)
33(b) Advantage

• Products / service pricing is based on all costs therefore absolute margins are protected (1)
• Operating Divisions have to generate income after all appropriate cost (1)

Disadvantages

• Too much time can be spent arguing over the quantum of or method of allocation (1)
• The Operating Divisions cannot control Head Office expenditure (1)
192 TOE408-W/1
ZAC408-H/1

Comment on the method of head office cost allocation:

• It is simple to calculate which avoids time wasting etc


• It may be flawed in that it assumes:

(a) There is an equal relationship between turnover and margin amongst the three
divisions i.e. they all have the same capacity to assume cost
(b) The services consumed by each division from the head office are a function of
turnover. (1)

• The allocation method runs contrary to the growth targets on turnover i.e. uneven turnover
growth between the divisions could lead to “extra” overhead burden. (1)
Maximum (5)
(c)
Profit after tax
Return on net assets = Net assets (1)

which is a combination of
Profit after tax Turnover
Return on sales = Turnover x (Asset Turnover) = Net assets (1)

So movement in:

(a) turnover and/or (1)


(b) profit and/or (1)
(c) assets will have an impact (1)

Real turnover growth of 10% p.a.

Real turnover will be a function of the pricing increase impact in each division. (1)
e.g. retailing may have an average selling price increase of 15% (because of the rand) and
therefore would need to achieve 25% growth in turnover. (1)

Both targets in combination

In effect Techno 2020 has put in place a reasonably effective combination of targets as
market share / market growth (turnover target) and margin maintenance and asset
utilisation (RONA) are being monitored.

One can question the RONA impact for consulting which is not asset intensive. Perhaps
an income per employee is more relevant. The Training division is likely to be capital
intensive given the investment in premises - it may be more difficult for this division to
achieve RONA target. (1)
193 TOE408-W/1
ZAC408-H/1
Ways to improve performance

Tech Training Division

• Increase class sizes while paying the same lecturer / venue cost
• Sell of premises (i.e. reduce assets) and lease space
• Outsource / incentivise the body of lecturers thereby eliminating a degree of fixed cost
• Have the Tech Consulting Division “on sell” training for a finders fee, of say, 5%.
• Lease premises as eg. conference facilities when not in use for training.
1 each max (2)
Tech Consulting

• Have Tech Consulting “on sell” hardware and software solutions in consulting
• Have clients “up front” a percentage of fees for projects
• Pay consultants a flat percentage of billings
• Negotiate “at risk” fees eg as % cost savings/improved efficiencies
1 each max (2)

Tech Retailing

• Obtain consignment stock from suppliers


• Optimise inter branch stock transfers to reduce inventory
• As pricing is almost a given in this market, look for some kind of relationship management
process similar to Voyager miles or Clicks Cards.
• Arrange for product suppliers to pay for advertising of special promotions.
1 each max (2)
Maximum (10)
(d)
• What Techno 202 Ltd is proposing is what is happening in practice (1)
• Clearly the proposal to write-off the up-front money is not prudent (1)
• However, the matching argument is what is being used i.e. 6 years expected benefit from
work and 2 years restraint if trade gives 8 years advantage (1)
• The 2 year restraint period will clearly have a different income impact in that Techno 2020
Ltd will not be generating income from the consultants but shall be limiting the impact of
competition (1)
• The six year period of expected employment is questionable as normal salary agreements
are being signed. However, if statistically Techno 2020 Ltd can show that consultants of
the profile being considered will normally stay in employment for six years then they have a
valid argument (2)
• In the event of either or both the consultants leaving before the expiry of the 6 years period
then the capitalised balance available for this “missing” period will have to be written off
(1)
• Full disclosure would need to be made of the “deferred’ asset. (1)
(8)
194 TOE408-W/1
ZAC408-H/1
QUESTION 21 - Suggested solution

Note that the information included in a rectangular block do not form part of the suggested solution and
should serve for information purposes only.

(a) Minimum price per dozen to be asked by the highveld farm

What principle should be applied to obtain this price?


The minimum price would equal the incremental cost (marginal cost per unit) plus
opportunity cost (if applicable).

What is the difference between marginal and incremental cost?

Why should above-mentioned principle be applied?


As the highveld farm would at least want to recover their cost (remember incremental cost
is the additional cost incurred and could include fixed cost). Opportunity cost should be
considered when there is limited capacity causing a loss in contribution earned from local
sales.

Calculate incremental cost and loss contribution

Incremental cost Notes / calculation 15 000 dozen


R
Variable cost 2.70 x 15 000 40 500 (½)
Fixed cost (Still below 90 000 [0.9x100 000]) - (½)
Lost contribution
(None, as 70 000 dozen could still be sold locally) - (½)
40 500
Per dozen (40 500 / 15 000) 2,70 (½)

Calculation technique

It is recommended that you first calculate totals and then from the total figure calculate a
price per unit

Incremental cost Notes / calculation 45 000 dozen


R
Variable cost 2,70 x 45 000 121 500 (½)
Fixed cost (Total production is now above 90 000
dozen [70 000 + 45 000 = 115 000 dozen])
I.e. 15 000 dozen over the capacity and also
exceeding the 90 000 dozen barrier
195 TOE408-W/1
ZAC408-H/1
R
Fixed cost
Total (6,00 x 100 000) 600 000 (½)
Head office (180 000) (½)
Highveld farm 420 000
x 0,8 336 000 (1)
Difference 84 000
84 000
Lost contribution (15 000 x (20 - 2,70 - 3,00)) 214 500 (1)
420 000
Per dozen (420 000 / 45 000) 9,33 (½)
(6)

(b) Maximum price per dozen that export division will pay

What principle should be applied in obtaining this price?


The price that would ensure that the export division earn a minimum of profit (R0,01)
should be calculated.
First calculate what the profit should be with no transfer cost.

Calculate profit with no transfer cost

Note / calculation 15 000 dozen 45 000 dozen


R R

Selling price R50 x units 750 000 250 000 (2)


Variable cost (10+12) x units (330 000) (990 000) (2)
Fixed cost The full amount has been used in the (850 000) (850 000) (1)
calculation, but R200 000 market
research and R550 000 TV ads would
probably be once-off or would be
incurred mainly in the beginning. (1)
Principle
All costs that a business incurs would
have to be recovered in the long term.
Initial costs, as above, can also be
recovered in later years. As the
view for this question is of a short-term
nature the full R850 000 has been used.

Note / calculation 15 000 dozen 45 000 dozen


R R

Examination technique
Write down your assumption and the
reason for making it. ________ _______
Profit / (loss) [Maximum transfer price] (430 000) 410 000 (1)
Per dozen - 9,11 (1)

Conclusion

It is not probable that flowers would be transferred as the maximum price that would be paid is
below the minimum price. (8)
196 TOE408-W/1
ZAC408-H/1

(c) Should highveld flowers be marketed and sold in Europe?

What principle should be applied?


Calculate if the entire group would make more profit with the exports than without.

How?
Calculate if the incremental (extra) income is more than the incremental (extra) cost for exports.

What quantities for export should be used in our calculations?


Increments in units that would change the cost structure in every case.
I.e:
1 - 19 999: Because a maximum of (70 000 + 19 999) 89 999 dozen would then be
manufactured, implying that the highveld farm’s overheads would still lie
in the 80% bracket.
20 000 - 30 000: Because a maximum of (70 000 + 30 000) 100 000 dozen would then be
manufactured, representing the full production capacity. I.e. still no
limited capacity.
30 001 - 45 000: The remaining capacity up to maximum.

Incremental income v. incremental cost

Note / calculation 1-19 999 20 000 30 001


- 30 000 - 45 000
(19 999 max) (30 000 max) (45 000 max)
R R R
Incremental income
Contribution (50 - 10 - 12 - 2.70)
x maximum units 505 975 758 975 1 138 500 (3)
Incremental cost
Fixed cost (850 000) (850 000) (850 000) (1½)
Incremental
Fixed cost (calculated in 1) - (84 000) (84 000) (1)
Lost contribution (calculated in 1) - - (214 500) (1)
Net marginal cost (344 025) (175 025) (10 000) (1½)

Motivation

Out of the calculation above it appears as if, in quantitative terms, it is not worthwhile exporting highveld
flowers. (1)

The following factors also have to be considered:

• Marketing costs include once-off cost (ex. market research) and cost that would probably be lower
in future (ex. TV ads). It could be short-sighted to turn down the project based on the quantitative
figures alone as these figures could be much lower in future periods; (2)

• The R/GBP exchange rate is uncertain. It is, however, probable that the GBP would improve still
in future, which could turn the net marginal cost into an -income (especially for 30 001 - 45 000
units); (2)

• The European market could be expanded; (1)


197 TOE408-W/1
ZAC408-H/1

• Production could be increased if additional land is acquired. (If capacity increases then the lost
contribution decreases.); (1)

• Production returns in not fixed and could differ depending the weather, pests, insects, etc.; (1)

• Competition and its influence; (1)

• Export incentive schemes; (1)

• Depending on the method used to measure management’s performance (probably ROE or EVA
for a investment-centre), it could result in a negative attitude in management. (1)
Maximum (16)

(d) Alternative basis for calculating transfer prices with no local demand

With no local demand, it is improper for the highveld-farm to be considered an investment centre.
It would be better to treat it as a cost centre so that its profit goals would not be detrimental to the
group as a whole. The main consideration should be control over costs. (3)

If the highveld farm is viewed as a cost centre:

• All costs incurred in an efficient manner should be recovered; (1)

• A standard cost per dozen should be calculated and used as basis for the transfer price; and
(1)

• In calculating the standard cost, distinction should be made between fixed and variable cost.
Fixed cost should preferably be recovered once a year as a single charge and variable cost
should be recovered per dozen transferred. (3)

If the highveld farm is viewed as an investment centre (not likely):

Same as above, but a portion of the profit of the export division should be transferred to the farm;
and (1)
Negotiations should serve as the basis for determining the transfer price (with input from head
office). (1)
(10)
198 TOE408-W/1
ZAC408-H/1
QUESTION 22 - Suggested solution

(a)

The layout used for the identification of the risks and their management/hedging is quite common to QE
solutions and students should endeavour to use it where possible. The key word is the emboldened
“and”.

The most important risks involved are: Hedging/management


Risk strategy
Completion risk: (Technical/financial)
Technical: Although this risk may be relevant, the Could be achieved by security
following should be take into account: (completion) arrangement with
• Construction of a similar smelter was done construction company
recently;
• No new technology is being introduced.
• The same construction team will be responsible
for the Maputo-smelter (the Richards Bay smelter was
completed early).
From a technical point of view there seems to be a low
risk of non-completion:

Financial Risk of cost overruns not being financed - Ensure arrangement whereby “cost
therefore non-completion. overruns” finance is guaranteed by
Project is similar to Richards Bay smelter, therefore the sponsors/equity holders/other obligators
cost estimates should be trusted.
Economic risk:
Operating cost structure: Anticipated returns will not be Future/forwards for raw materials;
achieved due to errors in forecasting operating costs and Management of cost with well
raw materials, costs. Risk should be low due to the developed budgeting process and
experience on the Richards Bay smelter. control

Income risk (aluminium price/tonnage) Price risk: There Forward selling or futures based
is a risk that the expected price of US$1 800 price will not hedging strategies
be maintained.

Demand risk: This risk seems very low (demand forecast Forward selling or futures based
to increase by 220 000 tons per annum). Changes in hedging strategies
demand patterns or commissioning of capacity at higher
than forecast rates give rise to this risk.

Interest rate risk: Rate that interest rate fluctuations will Interest rate hedging strategies such as
cause unexpected increased interest costs leading to caps, swaps, forward rate agreements.
reduced profitability or even default.
Currency risk: Relevant when income/cost streams are Forwards/futures/swaps
denominated in different currencies. Though this is true,
income is generated in a strong currency (US$) while
some costs are paid in a weaker currency (Rands). This
risk seems to be low.
199 TOE408-W/1
ZAC408-H/1
Technological risk: Risk that technologies used at the Losses could be curtailed through
smelter become obsolete with smelters of more hedging strategies using futures.
advanced technologies being constructed. This risk is
difficult to determine but should not cause major
problems unless the new technologies are so
revolutionary that they saturate the market, crowding out
less efficient operators.

Political risk: Involves the possibility of political Political insurance


authorities interfering with the project (expropriation, Involvement of World
unfair taxes, restrictions on transfer of free cash, unfair Bank
legislation, war). Securities by Mozambique government
In the case of this project this risk seems medium to high. Securities by SADC and SA
Risk on one country (Swaziland) reduced due to dual government
power supply.

1 each max (12)


(b) Evaluation of financing package:

Factors influencing the maximum debt/equity ratio:

• The expected profitability and operating risk of the project. High profitability and low operating
risk will allow for a higher maximum feasible debt/equity ratio (ability of project to finance
interest); (1)
• Adequacy of the project’s security arrangements. The more secure the project’s security
arrangements the lower the risk, the higher the maximum debt/equity ratio; (1)
• The creditworthiness of the parties obligated under such arrangements. The more creditworthy
the obligators the higher the maximum debt/equity ratio; (1)
• Availability of equity or debt. (1)

General evaluation

Structure proposed:

Equity 440/1230 35,8%


Quasi-equity 283/1230 21,4%
Debt 537/1230 42,8% (2)

Though the project may seem highly geared, the operating and economic risk seems low(due to
experience gained on Richards Bay smelter and assuming proper risk management done). (1)

No information on the quasi-equity is available. More information is required to be able to assess


the impact of the terms of this form of financing on the overall financing risk and hence the
appropriateness of the structure. (1)

More information is required about factors listed on determination of debt/equity ratio -


However, the structure seems acceptable. (1)
Maximum (5)
200 TOE408-W/1
ZAC408-H/1

(c) Advice to Equity Invest Ltd

To: Board of Directors


Subject: Equity exposure to Maputo-smelter

The following factors will influence my advice:

(i) NPV of the project;


(ii) Risks involved (sensitivity analysis);
(iii) Additional information. (1)

Conclusion

An annuity approach is indicated by information point 3: full capacity is reached. Thereafter the
terminal year should be disclosed separately.

(i) NPV of the project

1. Assumptions: • cash flows at end of each year


• rates quoted are nominal
$ NPV: $000 (1)

1999 2000 2001 2002 2003 2004- 2011


2010
Year 0 1 2 3 4 5 - 11 12

Capital (615 000) (615 000) (1)

Income 1 244 800 367 200 612 000 612 000 (1)

Raw material 1 (74 800) (112 200) (187 000) (187 000) (1)

Overheads (2 400) (2 400) (2 400) (2 400) (1)

Tax levy (1 224) (1 836) (3 060) (3 060) (1)

Terminal value 200 000 (½)

(615 000) (615 000) 166 376 250 764 419 540 619 540 (½)

NPV = US$ 940 392 000 - 10 121 000 (note 3)


= US$ 930 271 000 @
(1)
Note 1

Capacity Income Raw materials


2002 - 136 000 x 1 800 = 244 800 x (210 + 340) = 74 800
2003 - 204 000 x 1 800 = 267 200 x 550 = 112 200
2004 - 340 000 x 18000 = 612 000 x 550 = 187 000
(2)
201 TOE408-W/1
ZAC408-H/1
Note 2

Cost of capital

Cost Weighting
14,5% 35,8% 5,19
13% 21,4% 2,78
10% 42,8% 4,28
12,25% (2)

Cash flows are real therefore discount rate must be converted to real, using the Fisher formula:

(1 + real) = (1 + nominal)/(1 + i)
(1 + real = (1 + 0,1225)/(1 + 0,03)
real rate = 8,9%
= 9% (1)

Note 3

Rand NPV
2002 2003 2004 – 2011
Electricity - fixed 2 098 2 098 2 098
- variable 5 902 8 854 14 756
Salaries 5 200 5 200 5 200
13 200 16 152 22 054 (2)

NPV = R62 748 000 convert @ spot of R6,20 = US$ 10 121 000

Electricity

R10 951 200 - 204 000


R 8 000 000 - 136 000
R 2 951 200 - 68 000
2 951 200
@ 68 000 = R43,40/ton (2)
@ Fixed R8m - (43,4 x 136 000) = R2 097 600 (1)
@ 43,4/6,20 = US$7/ton

Rand discount rate

(1 + R Rate) = (1 + $ rate)(1 + 1)
@ (1 + R Rate) = (1 + 0,09) (1 + 0,08)
@ R Rate = (17,72%
= 18% (1)
202 TOE408-W/1
ZAC408-H/1
(ii) Sensitivity analysis

The critical issue is to determine the capacity/price levels at which the project is no longer
economically viable; i.e. determine breakeven points. (1)

Contribution: 1 800 - 550 - 7 - (0,005 x 1 800) = 1 234 (1)

Fixed costs and NPV to be recovered


Breakeven occurs where the contribution (on a discounted basis) is adequate to recover the
capital
outlay of the project, fixed costs, net of the terminal value. (1)

Initial outlay: 615 000 000* (0,917 + 0,842) = 1 081 785 000
Terminal value: 200 000 000* 0,356 - 71 200 000
Fixed costs: (2 096 000 + 5 200 000)/6,2 + 2 400 000) *5,4016 = 19 322 000
Total net present (fixed) cost 1 029 907 000 (1)

Net present value 930 271


Total contribution (PV) 1 960 178 000 (1)

Breakeven capacity

1 029 907 000


Breakeven = 1 960 178 000 * 340 000 = 178 641  179 000 (1)

Slight rounding differences to be expected given decimal point rounding of discounting factors

340 000 - 179 000


@ 340 000 = 47,4% safety margin (1)

Breakeven aluminium price:

1 029 907 000


Breakeven contribution per unit: = 1 960 178 000 * 1 234 = 648,4 (1)

648,4 + 557
Breakeven price = 1,000 - 0,005 = 1 211,5 (1)

Alternative calculation (long form)

1 029 907 000 = 136 000* (0,995y - 557)* 0,772 + 204 000 (0,995y - 557)* 0,708
+ 340 000 (0,995y - 557) x 3,921

= 104 992* (0,995y - 557) + 144 432* (0,995y - 557)


+ 1 333 140* (0,995y - 557)

= 104 467(y) - 58 480 544 + 143 710(y) - 80 448 624


+ 1 326 474(y) - 742 558 980

= 1 574 651(y) - 881 528 148

y = 1 213,9 (small rounding errors accepted due to rounding in discount factors)


203 TOE408-W/1
ZAC408-H/1
1 800,0 - 1 211,5
@ 1 800,0 = 33% safety margin

(iii) Additional information

• other parties involved; (1)


• other investment opportunities available to Equity Invest; (1)
• risk hedging/management implemented/planned; (1)
• assumptions underlying the estimates; (1)
• who will manage the projects’ operations; (1)
• what dividend policy (distribution of free cash flow) will be adopted; (1)
• is the debt/quasi-equity already in place. (1)

(iv) Conclusion

• Given a very high US$ NPV of US$ 930 million the project seem very attractive for investment.
(1)
• The project relatively high safety margin’s relative to capacity and price built in. (1)
• The finance package proposed is appropriate - given a relatively cash rich project. (1)
• A similar project was proven successful (Richards Bay smelter). (1)
• Political risk is high (what management techniques will be used to reduce this risk?) (1)

Assuming the political risk being managed successfully I would advise the board to take a medium
sized equity exposure to the project. Depending on the funds available a 20% equity exposure will
be acceptable. (2)
max (35)

QUESTION 23 - Suggested solution

In performing a WACC exercise, structured approach will yield additional marks → do the cost
calculations, market values and weighting individually.

(a) Weighted average cost of capital

• Cost of equity

Ke = D1 + g
Po

g: Dividends stayed constant from 1997 to 1998.


Dividends grew with 71% from 1998 to 1999. (1)

As the dividend cover stayed constant for the past 3 years, we can assume that the growth
in dividends in the 2000 year will be the equal to that of the earnings. (1)
Growth will thus be: 71% x 20% = 14% (1)

D1 : Do = 705 / (1 000 + 100) = 64c per share (1)

D1 = 64c x 1,14 = 72,96 c (1)


204 TOE408-W/1
ZAC408-H/1

Note: The dilution in earnings because of the conversion of the debentures is already taken
into account in the calculation above.

Po: 650c (given)

Ke = 72,96 + 0,14
650c
= 25% (2)

Total market value: 1 000 000 shares @ 650c = R6 500 000 (1)

• Cost of preference shares

Preference dividend = 80c x 12% = 11,2c per share


Market value = 100c (given)

Cost: 11,2 / 100 = 11,2% (2)

Total market value: 500 000 x 100c = R500 000 (1)

• Cost of debentures

Since the debentures are convertible into ordinary shares and we are quite certain that the
debenture holders will convert, it can already be viewed as part of equity.
(650c x 20 = R130 versus R100 debenture) (1)

• Cost of long-term loans

Interest rate: 20%


After tax : 13% (1)
Value: R2 193 000 (1)

• Weighted average cost of capital

Component Market value Percentage Cost WACC


R000 % % %

Ordinary shares 6 500


Debentures 650
Equity 7 150 73 25,0 18,25
Preference shares 500 5 11,2 0,56
Longterm loans 2 193 22 13,0 2,86
9 843 100 21,67
(4)
(18)

Weight should indicate 100% or 1; use costs as calculated previously and extend.
205 TOE408-W/1
ZAC408-H/1
(b) Investment decision

Year 0 1 2 3
R000 R000 R000 R000

Current assets (1 000) 1 000 (1)


Issue cost (cal 1) (87)
Income after tax 1 300 2 600 6 500
Subcontractors costs (cal 2) ______ (1 404) (2 231) (4 156)
(1 087) (104) 369 3 344
Factor @ 21,67% 1,00 0,82 0,68 0,56
(1 087) (85) 251 1 873
Net present value 952

Workings

1. Weighted average issue cost

Ratio Issue cost Weighted


average

Equity 73% 10% 7,3%


Preference shares 5% 8% 0,4%
Long-term loans 22% 2% 0,4%
8,1%
say 8% (3)
Investment needed R1 000 = 92%
Issue cost R1 000 x 8/92 = R87 (1)

The issue cost is treated as an upfront cash flow item.

2. Subcontractors costs

Years 2000 2001 2002


Average km per day 500 500 500
Working days per
year 240 240 240
Total km per year 360 000 480 000 720 000 (3)
Cost per km
Z$ 36,00 50,04 71,06
(36 x 1,39) (50,04 x 1,42)
Exchange rate
per R1,00 Z$6 Z$7 Z$8
Randvalue R6,00 R7,15 R8,88

Total cost (R000) 2 160 3 432 6 394 (3)


After tax (65%) 1 404 2 231 4 156

Conclusion

The contract must be accepted as the net present value is positive. (1)
(12)
(30)
206 TOE408-W/1
ZAC408-H/1

QUESTION 24 - Suggested solution

The period indicated is long term, one should consequently attempt to identify annuity cash flows. Capital
outlays occur in years 1-4 and 28. Revenue and associated costs from years 4-28, with a change in year
14. The approach followed is geared to mnimis3e the number of calculations.

(a) Fuelit

Financial evaluation of the alternative power stations.

Gas fuelled power station


Cash flows at
current prices
(R million)
Year 4-13 14-28
(annual) (annual)

Revenue 800 800

Labour 75 75
Fuel purchases 500 500
Sales and marketing 40 40
Customer relations 5 5
Other 5 5 (3)
Tax allowable depreciation 60 - (1)
685 625
Taxable 115 175
Taxation (30%) 34,5 52,5 (1)
80,5 122,5
Add back depreciation 60 -
140,5 122,5
Present value at 6% 140,5 x 7,360 x 0,84 (end of year 3)
= 868,6 (1)
122,5 x 9,712 x 0,469 (end of year 13)
= 558,0 (1)

Other cash flows (R million)


Year 1 2 3 4 28
Redundancy 4
Capital outlays 300 300
Decommissioning costs ____ ____ 10 ___ 25 (2)
300 300 10 4 25
Discount rate (6%) 0,943 0,890 0,840 0,792 0,196 (0,417 x 0,469)
Present values 282,9 267,0 8,40 3,17 4,9 (1)

Expected net present value: 868,6 + 558,0 - (282,9 + 267,0 + 8,40 + 3,17 + 4,9)
= R860,23 million
207 TOE408-W/1
ZAC408-H/1
Notes

• The interest cost is included in the discount rate.

• Decommissioning is assumed to have the same risk as the rest of the project.

• Discount rates

Gas: Cost of equity using CAPM is 4,5% + (14% - 4,5%) 0,7 = 11,15% (1)

WACC = 11,15% x 0,65 + 8,5% (1 - 0,3) x 0,35 = 9,33% (1)

However, this is the nominal cost of capital which includes inflation. The cash flow projections
exclude inflation and must be discounted at a real cost of capital.

1,0933/1,03 = 1,061 (1)

6% will be used as the real discount rate.

Nuclear: Cost of equity using CAPM is 4,5% + (14% - 4,5%) 1,4 = 17,8% (1)

WACC = 17,8 x 0,40 + 10%(1 - 0,3) x 0,60 = 11,32% (1)

The real cost of capital is 1,1132/1,03 = 1,081 (1)

8% will be used as the real discount rate. (1)

Nuclear fuelled power station


Cash flows at
current prices
(R million)
Year 4-13 14-28
(annual) (annual)

Revenue 800 800

Labour 20 20
Fuel purchases 10 10
Sales and marketing 40 40
Customer relations 20 20
Other 25 25 (3)
Tax allowable depreciation 330 - (1)
445 115
Taxable 355 685
Taxation (30%) 106,5 205,5 (1)
248,5 479,5
Add back depreciation 330 -
578,5 479,5

Present value at 8% 578,5 x 6,71 x 0,794


= 3,082 (1)
479,5 x 8,559 x 0,368 (1)
= 1,510,3
208 TOE408-W/1
ZAC408-H/1
Other cash flows (R million)
Year 1 2 3 4 28
Redundancy 36
Capital outlays 1,650 1,650
Decommissioning costs 10 1,000 (2)
1,650 1,650 10 36 1,000
Discount rate (8%) 0,926 0,890 0,794 0,735 0,116
Present values 1,527,9 1,414 7,94 26,5 116
(1)

Expected net present value: 3 082 + 1 510,2 - (1 527,9 + 1 414 + 7,94 + 26,5 + 116)
= R1 500 million

Notes

• If decommissioning costs R500 million the expected NPV is R1 558 million.


• For the purpose of selecting between alternatives the demolition costs in three years’ time could
be ignored.
• On financial grounds the nuclear alternative is expected to produce the higher NPV. (1)
Maximum (20)

(b) Information that might assist the decision process includes:

The issues listed below are common to most capital project evaluations.

• How accurate are the projected cash flows? Are the various revenues and costs likely to be
subject to the same price level changes? (2)

• Is the risk of the project correctly measured by the beta estimates? (1)

• What is the chance of significant changes in tax rates or tax allowable depreciation? (1)

• How accurate is the estimate of the working life of the power stations? What happens if
technology changes? (1)

• Is the technology well tested, especially for the nuclear alternative? (1)

Sensitivity and/or simulation analysis to investigate outcomes under different assumptions is


strongly recommended.

• What will be the impact of the alternative levels of gearing on other activities of the company and
on the company’s share price? (1)

• What real options might exist with the alternative projects? (1)

• How significant are non-financial factors? In the light of the nuclear accidents in Russia and
Japan how safe is the nuclear alternative? How environmentally or politically acceptable would
this alternative be? Even if the nuclear alternative is the better choice financially, this might be
outweighed by non-financial considerations. (2)
Maximum (8)
209 TOE408-W/1
ZAC408-H/1

(c) The external advisor has suggested adjusting the discount rate as the decommissioning costs are
not know with any certainty. As these cash flows are relatively risky, an adjustment to the discount
rate might be justified. The decommissioning costs are cash outflows. In order to reflect the
higher risk the discount rate of these cash flows should be reduced to result in a higher negative
present value.

(d) Capital investment decisions are often based upon the present value of expected future cash
flows, discounted at a rate that reflects the risk of the project. However, this ignores any actions
that can be taken after the project has commenced to alter the cash flows, or any future
opportunities that might arise as a direct result of having undertaken the project. Opportunities to
respond to changing future circumstances are known as options. When such options relate to
capital investments they are commonly known as real options. The existence of real options can
significantly add to the value of an investment. If investments are judged only on their expected
NPV, and the value embedded in the options is ignored, then an incorrect investment decision
might result. Unfortunately the valuation of real options is extremely difficult. (4)

In the context of the power station investment a number of options might exist including:

• The option to abandon the project. This is likely to be easier and more valuable with the gas
project than the nuclear project because of the lower cost, and much fewer
decommissioning problems of the gas project. (2)

• The option to expand production. This is also likely to be more valuable with the gas project
as much lower investment is required in new plant to expand. (1)

• The option to adjust the nature of production, for example the fuel used. This is far easier
for the gas project which could probably switch to oil or other fuels at a much lower cost than
the nuclear project. (2)

• The option to take advantage of new technology. Once again there is likely to be more
flexibility in the gas project. (1)

In conclusion there are likely to be more valuable real options associated with the gas fuelled
power station project. __
Maximum (8)
210 TOE408-W/1
ZAC408-H/1
QUESTION 25 - Suggested solution

(a) Market values

Ordinary shares 2,25 x 10 000 000 = R45 000 000


0,5 (1)

Debentures 125 x 10 200 000 = R12 750 000 (1)


100

Component costs of capital

Ordinary shares: 36 (1,05) + 0,05 = 21,8% (2½)


225

Debentures: 16 (1 – 0,3) = 8,96% (2)


125

Note the following with regard to the calculation of a company’s weighted average cost of capital:
‰ It is always better to use market values if we have them.
‰ Remember that share premium, retained income and other reserves should not be included in the
calculation of WACC when using the market value of ordinary share capital. These are already
included.
‰ Cost of debentures – the 16% is a coupon rate, which simply means this debenture will render an
interest payment of R16 p.a., based on the debenture’s nominal value of R100. The cost of the
debenture is a function of the annual payment (R16) and its market value (R125). The effect of
taxation should also be considered.
‰ Many companies nowadays opt for a discount rate higher than their calculated cost of capital. This
is a way to deal with unexpected risk.

Weightings and WACC


Market value Weight Cost Weighted cost
R000 %
Ordinary shares 45 000 0,779 21,80 16,982
Debentures 12 750 0,221 8,96 1,980
57 750 18,962 (3)
∴ WACC = 19%
Cost of capital to be used = 19 + 3
= 22% (½)
(10)
(b) Year 1 expected value of sales
Sales volume Probability Expected value

60 000 0,05 3 000


84 000 0,25 21 000
100 000 0,40 40 000
120 000 0,30 36 000
100 000 (2)
211 TOE408-W/1
ZAC408-H/1
Year 1 2 3 4 5
Sales volume 100 000 120 000 132 000 132 000 132 000
R
Unit contribution
Sales 10,00
Variable costs (3+2,50+2) 7,50
R2,50 (1)
After tax contribution R2,50 x 0,7 = R1,75 (½)

Year 0 1 2 3 4 5
R000 R000 R000 R000 R000 R000
Machinery (500) 70 (2)
Wear and tear allowance 30 30 30 30 30 (1½)
Working capital (80) (8) (8,8) 96,8 (2)
Security savings 21 21 21 21 21 (1)
Managers salary (14) (14) (14) (14) (14) (2)
Supervisor (49) (49) (49) (49) (49) (1)
Overheads (28) (28) (28) (28) (28) (1½)
Contribution 175 210 231 231 231 (2½)
(580) 127 161,2 191 191 3 578
Discount factor at 22% 1 0,8197 0,6719 0,5507 0,4514 3 700 (½)
Present value (580) 104,1 108,3 105,2 86,2 132,4
Net present value = R(43 800) (½)
* - R3,5m treated as sunk cost (½)
- Interest payments disregarded (½)

‰ We can assume a cash inflow at the end of the project as a result of the working capital initially
invested which are now no longer required – R96,8 million.
‰ The tax saved because of the wear and tear allowance represents an inflow of cash.
‰ The resale value of the machinery is fully taxable (Sec 8(4)(a) recoupment) as the asset has a
tax value of zero.
‰ Research and development costs have already been incurred. It is a sunk cost and should not
influence the decision to invest.
‰ Only R20 000 of the manager’s total salary of R270 000 is relevant. He would have received
the balance anyway.

CONCLUSION

The project gives a negative net present value when its cash flows are discounted at 22% and as such
fails the criteria set by the company. It should not be undertaken. (1)
(20)
(30)
212 TOE408-W/1
ZAC408-H/1
QUESTION 26 - Suggested solution

This is not a typical exam question, which usually tends to be shorter. However, it is a very useful
question to revise important aspects of financial management such as ratio analysis, dividend
policy, cost of capital and acquisitions.

(a)
Return on ordinary shareholders funds 19,92% (1)
RONA 12,68% (1)
Operating income/turnover 2,83% (1)
Earnings - undiluted 42,9c (1)
- fully diluted 48,6c (1)
- fully diluted (headline) (15,4c) (1)
Net asset value - undiluted 248,2c (1)
- diluted 254,7c (1)
Turnover per employee (R000) 1 103,7 (1)
Assets per employee (R000) 197,6 (1)
Asset turnover (times) 3,7 (1)
Debt equity (incl AC 125) 126,95 (1)
Debt equity (excl AC 125) 99,24 (1)
Interest cover (incl debenture interest) 0,99 times (1)
Interest cover (excl debenture interest) 1,16 times (1)
Dividend cover - (1)
Current ratio 0,86 (1)
Acid – test ratio 0,42 (1)
Price – earnings ratio (times) 2,8 (1)
Dividend yield - (1)
Earnings yield 36,2% (1)

If you are uncertain of any ratio, first recalculate the ratios provided as part of the question
until you are certain. Then apply the same formula to the unknown ratios.

Profitability

• Return on shareholders’ funds and RONA stable for 95/96, declined for 97/98 and turned in 2000.
(1)
• Operating income, although the same trend, remained positive throughout the period. (1)

• Disconcerting that a large part of the operating income can be ascribed to discontinued operations.
(1)

Productivity

• Employees increased when the poor years 98/98 were experienced. (1)

• Drastic drop in employees due to restructuring. (1)

• Measurements should cover areas of operation ie vehicles and clothing. Trends may become a lot
more clear. (1)

• Existing measurements incorporate inflation, the impact of which unknown. (1)


213 TOE408-W/1
ZAC408-H/1
Market returns

• No dividends paid. (1)

• Earnings yield like a yo-yo. (1)

• P/E ratio substantial drop due to share price reflecting the company’s performance. (1)

• Share volume sharply up in 2000, may indicate institutions getting rid of their shares. (1)

• Above will impact negatively on RAL’s ability to raise finance. (1)

Debt

• Debt equity ratio turned around from 1996 to 2000. Capital has been eroded by losses, whilst debt
has doubled to keep RAL going. (1)

• This reflects in the interest paid over the period, even though interest rates dropped sharply. (1)

• The debenture interest is currently at a fixed rate of 25%, interest trends were predicted incorrectly.
(1)
Profit warning

Profit warning will depress share price immediately. Moral issue ito disclosure. The warning is issued to
prohibit insider trading and soften the impact of poor results when these are announced. (2)
Maximum (35)

(b) Dividend policy

• Cover dropped from ± 6 (96/97) to 4 in 1998. (1)

• Interim declared in 99 although already in loss situation (1)

• No dividend in 2000. (1)

To declare a dividend (even in capital form) would be reckless considering the current financial
position. (1)

Capitalisation shares

• Usually linked to a cash option. (1)

• Issued at a discount to current share price. (1)

• Used in times of (expected) growth in share prices. (1)

Given the current uncertainty, using this approach will not be feasible. (1)

Div in specie

• Any form, cash or paper, may be considered a dividend and should be disclosed as such. (2)
Maximum (8)
214 TOE408-W/1
ZAC408-H/1
(c) EBITDA

Operating income 223 403 (1)


Depreciation 18 479 (1)
Amortisation 180 475 (1)
422 357

• Indicator of cash generated in the business, this should be confirmed with the cash flow
statement. (1)

• Used by business which experience huge accounting write-offs (ex mining/technology) to


focus on their cash ‘profit’. (1)

• Cash creation valuable to assist risk assessment and valuation. (1)


Maximum (5)

(d) Organic growth

Growth internally generated, typified by high dividend cover and profit retained. (2)

Growth by acquisition

Acquiring companies in a grow phase or in a growth industry. Purchase price often settled with
paper (shares) and synergy creation a stated objective. (2)
(4)

(e) Based applications

Cash - should be available internally or through facilities. (1)


- price negotiated may be influenced if seller requires cash. (1)

Shares - share exchange approach based on the relative value per share and NAV or PER
of companies. (1)
- often used when growth in share price the focus and cash not available. (1)

RAL has no cash resources and the share price is quite low. Neither of these seem an option. (1)
(5)

(f) Current share issued 197 724 000


Shares held 21 210 000

∴ Will receive 0,1073 for every 1 held [per 100 shares 10,7] (2)

Impact

• Other non-current assets will decrease by R36,057 million. (1)

• Capital will decrease by a similar amount. Dividend in specie will presumably be used. (1)

Dr Dividend paid 36 057 000


Cr Investment in propr co 36 057 000 (1)
215 TOE408-W/1
ZAC408-H/1

Notes:

• Not desirable in terms of strategy as the investment can be sold for R109m, which will relieve
some of the funding pressure. (1)

• Current decision unlocks value for shareholders and not RAL. (1)

• Not an unbundling exercise, as this takes place in a group situation where subsidiaries are
unbundled. (1)
Maximum (6)

(g) Cost of equity = Rf + (Rm - Rf)


= 12 + 1,7 x 5,5
= 21,35% (2)

Assuming government stock currently trading at 12% pa.

Cost of debt ranges from 15,5% on short=term to 25% on debentures. The effective cost is taken
as 15,5% as:

• debentures will most likely be converted into shares. (1)

• huge tax loss indicates no tax advantage for the foreseeable future. (1)

Equity: Current shares 197 724


To be converted 41 378
239 102 (1)

∴ Market value at 1,22 R291 704 32,3%


Debt 609 594 67,7%
R901 298 (2)

• Long-term funding items can be ignored as not material. (1)

• Depending on the approach regarding debentures, the above ratio’s will change. One can
argue that for the next 3 years conversion will be unlikely and therefor use as debt. (1)

Cost of capital = 21,35 x ,323 + 15,5 x ,677


= 17,39% (1)
A rights issue will:

• increase share capital (high return) and (1)

• decrease debt (cash used to repay). (1)

As a consequence, the cost of capital will increase. (1)


Maximum (10)
216 TOE408-W/1
ZAC408-H/1
(h) Issues

• Current share price R1,22. Issue price at R1,20 no great incentive to shareholders. (1)
• Underwriters will have to be obtained (at a cost of up to 5%). (1)
• Controlling shareholders may have to take up more shares - control implications. (1)
• Road-show to sell the rights issue to shareholders, particularly institutions (shareholder profile
must be considered). (1)
• Authorised share capital will have to be increased. (1)
• Necessary approvals acquired. (1)
• Market conditions re rights issues considered. (1)
• Motivation spelled out. (1)

Entries
Dr Bank 240m
Cr Share capital 240m
[Note: Cost to be taken account of] (1)
Maximum (7)
(i) Requirements

• Ability to pay debt not impaired. (1)


• Assets fairly valued exceed liabilities. (1)
• Issued capital adequate. (1)
• Working capital sufficient. (1)

RAL can not be considered to fulfil all of the requirements. As they do not have cash, they will have
to loan money which will not be sensical. (1)

Strategic issue

• Cancel shares. (1)


• Keep them, often in a subsidiary. Reasons for this could be to: (1)

block a take-over. (1)


effect a take-over (cost of acquisition assumed to be lower than price of share at time of
transaction). (1)
start/increase holding in a share incentive scheme. (1)
realise the potential loss in such a scheme. (1)
effect a management buy-out by obtaining a strategic block of shares. (1)
stabilize the share price. (1)

Accounts

Dr Share capital
Share premium (if applicable)
Reserves
Cr Bank (2)
Maximum (12)

(j) • Staff treatment (take-on liabilities). (1)


• Contract stipulations: period, cost etc. (1)
• Services to be rendered. (1)
• Strategic dependence. (1)
Maximum (3)
217 TOE408-W/1
ZAC408-H/1

QUESTION 27 - Suggested solution

(a) Discussion of ethical issues

- AC 000 does that reliability is a qualitative characteristic of financial statements. Reliability


requires the exercise of prudence. “However, the exercise of prudence does not allow, for
example, the creation of hidden reserves or excessive provisions, the deliberate
understatement of assets or income, or the deliberate overstatement of liabilities or expenses,
because the financial statements would not be neutral and, therefore, not have the quality of
reliability.”
(1)
- AC 108 does not permit the raising of general provisions against inventory. (1)
- Therefore, the request of the chief executive appears to be contrary to professional
accounting standards.
- Section 20 of the Code of Professional Conduct notes that “members owe a duty of loyalty to
their employer as well as to their profession and there may be times when the two are in
conflict. An employee’s normal priority should be to support his organisation’s legitimate and
ethical objectives and the rules and procedures drawn in support of them. However, an
employee cannot legitimately be required to -

(a) break the law;


(b) breach the rules and standards of the profession;
(c) lie to or mislead (including by keeping silent) those acting as auditors to the employer; or
(d) put their name to or otherwise be associated with a statement which materially
misrepresents the facts. (2)

- Compliance with the chief executive’s request may therefore be contrary to the Code because
it is a breach of the profession’s standards, may materially misrepresent the facts and may
require or lead to misleading of auditors.

- Section 3 of the Code notes “a member should be and appear to be free of any influence,
interest or relationship, whether direct or indirect which might be regarded, whatever it actual
effect, as being incompatible with integrity and objectivity. It should be noted that an honest
difference of opinion between a member and another party is not in itself an ethical issue. It is
recognised, however, that there can be particular factors which occur when the responsibilities
of a member may conflict with internal external demands of one type or another. Hence: (1)

(a) There may be the danger of pressure from an overbearing supervisor, manager, director
or partner.
(b) A member may be asked to act contrary to technical and/or professional standards.
(c) A question of divided loyalty as between the member’s superior and the required
professional standards of conduct could occur.
(d) Conflict could arise when false, misrepresenting, or misleading statements or
information is released or published which may be to the advantage of the employer or
client and which may or may not benefit the member as a result of such publication.” (2)
218 TOE408-W/1
ZAC408-H/1

- Since the chief executive’s request raises a number of the issues in the previous paragraph,
the financial manager should review the conflict problem with his immediate superior (possibly
a financial director). The Code notes that “if the problem is not resolved with the immediate
superior and the member determines to go to the next higher managerial level, the immediate
superior should be notified of the decision. If it appears that the superior is involved in the
problem (which is the case in respect of the chief executive in this question), the member
should raise the issue with the next higher level of management. When the immediate
superior is the Chief Executive Officer, the next higher reviewing level may be the executive
Committee, Board of Directors, Non-Executive Directors or shareholders.”

The financial manager should consider reviewing the chief executive’s request with one of
these groups, or possibly with the Audit Committee. (2)

- Compliance with the chief executive’s request may require the financial manager to make
similar requests of the employee under the financial manager’s supervision. In this regard the
financial manger should recognise that “a member may be held responsible for a breach o, or
failure to comply with, this Code on the part of all ;persons who are under hi supervision.”
(Section 1). The financial manger may also wish to bring this consideration to the attention of
the chief executive, who is a CA. (1)

- The financial manger, in dealing with people under his or her supervision, is required to ‘give
due weight for the need to them to develop and hold their own judgment in accounting matters
and should deal with differences of opinion in a professional way.” This will be particularly
applicable if certain people under his or her supervision note objections to the raising of the
general provision. (This same consideration applies to the chief executive in his dealings with
the financial manager.) (1)
1 each, max (10)

(b) The primary problem with smoothing of earnings is that it obscures facts that investors ought to
know, and may therefore frustrate their ability to value the business.

This is particularly egregious in circumstances where a company is under-performing and earnings


management (i.e. the release of provisions) obscures the true extent of any deterioration.

Earnings management imposes opportunity costs, such as:

- Management time to select appropriate techniques


- Management time to talk to analysts and modify exceptions
- Time to defend actions before auditors.

From a shareholder perspective, this time may be more appropriately spent on the management of
operations.

The motivation for earnings management may include executive compensation packages which are
linked to share performance. Analysts expect consistent earnings and penalise companies which do
not provide such earnings. Management may therefore manage earnings in order to obtain
favourable analysis and improved share prices for investors and themselves.

The smoothing of earnings, particularly where is becomes part of a businesses culture, may assist in
the concealment of accounting frauds. This is clearly to the investors disadvantage.
219 TOE408-W/1
ZAC408-H/1

Excess provision is a particularly egregious earnings management technique, since the practice is
currently not disclosed, even as an accounting policy. __
1 each max (5)
PART A

This is an example of a discussion-type question. You can expect a significant portion of total marks in
an exam to be discussion-type questions. These questions test your understanding of the topic
examined.
To answer this question properly, the student would have to use the following sources:
‰ GAAP – AC 000, AC 108 et al;
‰ Code of Professional Conduct;
‰ Understanding of Corporate Governance issues;
‰ General business knowledge;
‰ Own working experience;
‰ The question itself – often problems stated in the question will earn you marks if highlighted as
part of your answer.
Students are therefore encouraged to read widely, and to use sources such as the text book, knowledge
of other subjects, own working experience and general business knowledge to ensure a complete
answer.
Note:
‰ The answer is in ‘bullet’ format – this facilitates marking;
‰ There are more bullets than marks available – this will enhance the candidate’s chances of
passing this question.

PART B

MEMORANDUM

TO: Managing Director


FROM: Financial Manager
RE: Share buybacks
DATE: December 99

The Companies Act was recently amended to allow companies to purchase their own shares. This
memorandum outlines circumstances in which this may be appropriate, the relevant Companies act
requirements regarding buybacks and issues to consider in deciding to embark upon share repurchase.

The question specifically asks for a memorandum – a candidate ignoring this request is certain to forfeit
a mark or two.
Note that the answer is in bullet form, and that the headings stand out. An answer which is easy to
navigate will earn more marks than one where the marker has to struggle to understand what the
candidate is trying to communicate.

Circumstances in which it may be appropriate for a company to purchase its own shares

- To avert a hostile takeover.


- Where a company has cash in excess of its requirements for the foreseeable future (next 3 years).
It may be appropriate in these circumstances to pay out surplus liquid funds to shareholders. This
in turn should improve the company’s return on equity ratio.
- The repurchase of shares of departing employees where this is not feasible given the Employee
Share Trust’s liquidation position.
220 TOE408-W/1
ZAC408-H/1

- In situations where a company’s share price is trading at a discount to net asset value, the return of
capital to shareholders would compensate for the poor share rating.
- To facilitate the purchase of an unlisted company’s shares for example, where a minority
shareholder wishes to sell his shares and the other shareholders do not have sufficient resources to
purchase these shares.
1 each, max (5)
Companies Act requirements

- Articles of association must permit share buybacks.


- General or specific authority required from shareholders in terms of a special resolution.
- Solvency requirement (assets, fairly valued, must exceed liabilities after buyback).
- Liquidity requirement (company must be able to pay its debts in the ordinary course of business).
- Issue circular to shareholders.
- Offer to purchase shares from all shareholders pro rata to existing shareholdings. __
1 each, max (5)
Issues to consider

- STC implications.
- Pricing of share purchase (relative to ruling price and NAV).
- Premium write-off (CRRF, reserves, share premium).
- Hibiscus’ future cash flow requirements e.g. capex, dividends, acquisitions.
- Directors’ personal liability in the event of solvency and liquidity requirements not being met.
- Other mechanisms to return funds to shareholders (dividends, reduction of capital).
- Impact on EPS and NAV of share repurchases. __
1 each, max (5)

QUESTION 28 - Suggested solution

Note the following important aspects of correct exam technique:


‰ Clear headings – the marker finds it easy to identify the different main parts of the answer;
‰ Bullets – one valid item or mark per bullet;
The total number of bullets are more than the number of marks available – you cannot assume that
every single point you make will earn you a mark.

(a) Revenue - service

Amount measured reliably? (1)


Yes, Ditech can measure the amount reliably. (1)
Probability of future economic benefits? (1)
• Yes, there is a probability of future economic benefits (1)
• However, Amfurn credit risk should be evaluated (1)
• Risk of Amfurn cancelling contract? (1)
Stage of completion measured reliably? (1)
• Any valid point and discussion (2)
221 TOE408-W/1
ZAC408-H/1

Costs incurred & costs to complete measured reliably? (1)


• New division: no track record of estimating costs over 6 years (1)
• Difficult to forecast equipment costs OR IT changes quickly (1)
• Sales commission and people costs should be reasonably accurate (1)
• Other costs immaterial (1)
• Debatable whether management time should be allocated (1)
Other considerations
• Need to discount profits at a suitable rate/Should take into account the time
value of money (1)
• Cash negative in year 1 of Amfurn contract (1)
• Profit from contract uncertain given potential variability of costs (1)
• AC111 requires all 4 conditions to be met (1)
Conclusion
• 1 mark for conclusion, 1 mark if conclusion is correct (2)
• e.g. Recognising 50% of expected profit in 2001 too aggressive, or
• Alternate treatment may be to recognise revenue based on costs incurred as %
of expected total cost, or
• Use % of completion method.
Revenue from sales
• Revenue should be recognised as and when supply occurs OR
• Revenue should be recognised as part of the service contract (2)
Costs
• 2 marks if accounting for cost is discussed (2)
• e.g. Record as and when costs are incurred, or
• Matching of costs and revenue
___
Maximum (15)

(b) Cash flows

• Retail and Outsourcing divisions have different cash flow profiles and need to be
analysed separately (2)
• Cash generated by operations has increased over the past 2 years (28% CAGR)
presumably due to Outsourcing division (1)
• Discussion of the increased investment in working capital:
e.g. Increase in stock could be due to obsolescence and
The increase in working capital is worrying (2)
• Accrual of “outsourcing profits” which are yet to convert into cash as per Amfurn
contract may be a reason for higher working capital (2)
• Increasing financing costs indicates higher levels of debt (1)
• Interest cover ratio (6,11) appears reasonable (1)
• However, cash generated in 2001 is unable to cover interest expense (2)
222 TOE408-W/1
ZAC408-H/1
• Reason for taxation paid declining in 2001? (1)
• Dividends paid yet debt levels increasing? Policy questionable (2)
• Net cash flows from operations negative over the past 2 years! (1)
• Reasons for capex needs to be established. Is retail division expanding?
Outsourcing division would presumably not be capital intensive. (2)
• Ownership of assets over to clients as profit is recognised (1)
• Long term debt was used to finance capex (1)
• What acquisition was made? Should have been funded by shareholders and not
through increased borrowings (2)
• If not for the factoring of debtors and the shares issue, the cash shortage would
have been R41 600’. (1)
• The entity is now in a net borrowing position. (1)
• Debtors are factored with recourse – this could lead to an even worse cash flow
position in future if debtors don’t settle their accounts (1)

Gearing (1)

• Debt levels have increased significantly, probably > R50 m


• Lenders may be concerned re gearing levels and limiting advances (1)
• Limited borrowing in 1999 given low interest charge. Increased gearing mainly in
2000 and 2001 to fund capex and working capital (2)
• Factoring is expensive and such borrowing is often indicative that conventional
sources of finance have been exhausted. (2)
• Ditech may be expanding too quickly (Outsourcing and acquisitions) given poor
cash flow generation or Overtrading (2)
• Capital structure needs assessment, gearing too high? (1)
• Liquidity risk is high (1)
• Is Ditech still a going concern? (1)
Maximum 15
(c) Valuation

Note that we are not required to do a valuation, simply to comment on the current
market value of the company. We do this by comparing the company’s P/E ratio to that
of similar companies.
(1)
• Ditech’s PE currently 7 (315/45)
• Comparative PE ratios:
" Move a Box (5,0)
" Complan (14,5)
" Out IT (10,0)
" Solutions (6,0) (2)
• Calculation of separate revenue multiples (1)
• Network integrators and outsourcing companies appear to have higher PE ratios
OR Retailers appear to have lower PE ratios (2)
223 TOE408-W/1
ZAC408-H/1
• Ditech’s rating may be lower than Out IT due to its retailing interests (1)
• Ditech’s revenue recognition policy may be a major factor in the market valuing
the company. Earnings may be lower than R45 m! (2)
• Complan and Out IT larger businesses than Ditech and this could affect relative
rating (2)
• Ditech’s lack of focus could also affect rating (1)
• Ditech’s rapid expansion could also affect rating (1)
• Ditech’s earnings/revenue appear reasonable compared to other retailers and
outsourcing companies:
○ Calculations (2)
○ Comment (1)

• Valuation of Ditech on a DCF basis could be difficult given negative cash flows (1)

Risks

• Rapid diversification (outsourcing and acquisition) (1)


• High gearing (cash interest cover negative, funding through debt) (2)
• Outsourcing model and profits uncertain given early stage of development of this
business (1)
• Factoring indicates liquidity issues (2)
• Current IT industry slowdown or Ditech trades in a very competitive market (1)
• Management’s ability to deal with acquisition and growth (2)
• Poor cash flow situation (1)
• Poor working capital management/Increase in working capital (1)
• Debtors factored with recourse – potential liability (1)

Conclusion
• Any reasonable conclusion re value (1)
(15)
45
224 TOE408-W/1
ZAC408-H/1
QUESTION 29 - Suggested solution

NOTE:

1. Framework for analysis

The question requires four possibilities to be considered: ordinary shares, preference shares,
debentures, retained earnings. In respect of the first three sources, each of the following should be
considered:

• cost
• risk
• control
• restrictions on future actions
• effect on EPS
• other relevant factors such as cash flow implications

2. Background to analysis

2.1 Ratios Quickcon Sector

Current ratio 1,4 times 1,4 times


Average total assets turnover 1,4 times 1,3 times
Interest cover* (profit before interest and taxes) 12 times 4,5 times
Average inventory turnover 6,7 times
Average collection period 51,0 Days
Debt ratio (debt excludes prefs)* 11,25% 45%
Preference share capital/total assets* 4,6% 1%
Return (EBIAT) on investment* 13,38% 8,3%
Return on equity 34,8% 10,5%
Return (EBIAT) on sales 9,4% 6,4%
Ordinary dividend cover* 4 times 2,3 times
Earnings per share* (price per share/PE ratio) R1,55
Earnings yield (NP after tax/total equity) 30,8%
Dividend yield (Dividend/price) 4,5%
(12)
2.2 Limitations

The limitations of industry averages should be borne in mind by the decision-maker, as


well as possible distortion owing to the use of year-end amounts where as averages are
used in the sector ratios. Notwithstanding these limitations, useful background for the
analysis can be provided.
225 TOE408-W/1
ZAC408-H/1

2.3 Risk

2.3.1 The financial risk of the company, as indicated by the debt ratio, appears
inordinately low at 11,25% as against an industry average of 45%;

2.3.2 The importance of a proper balance between financial risk and business risk should
be stressed; with its fluctuating fortunes and cyclical behaviour of earnings, the level
of business risk in the construction industry is relatively high. This reinforces the
prima facie acceptability of a relatively low debt ratio. (2)

2.3.3 The low level of industry risk could be countered to some extent by the strength of
Quickcon and its management. The success of the company is indicated by its
strong growth into one of the top 50 companies. Management strength is hinted (2)
at in the case. This is supported by the strong ROI. relative to the industry (to an
extent, further supported by asset turnover and return on sales). (1)
Thus, for this company, the debt ratio could be regarded as acceptable. This is
supported by the apparent acceptability of the company’s shares on the JSE. (1)
(8)

3. Debentures

Note that we can generally use the following three headings when discussing financing options:
‰ Cost
‰ Risk
‰ Control

3.1 Cost: Effective after tax cost is 70% x 11,5% = 8,05%. This is the lowest of the
four possibilities and provides scope for maintaining leverage. (1)

3.2 Risk: Financial risk is increased; the debt ratio would rise to 20,55% (15 / 73). (1)
Interest cover would fall from 12x to about 7x, still above industry average
and supporting a high interest charge. (1)
While the relatively low debt ratio has been supported up to this point (see
above) careful consideration should be given to the attitude of shareholders
to this (1)
increase; there could be an unfavourable effect on the share price; the issue
itself may not be well received. (1)

3.3 Control: Not affected in any way. An advantage assuming that Quickcon wishes to
retain control. (1)

3.4 Restrictions: Possible restrictive provision in the debenture trust deed (minimum
current ratio; dividend payments). (1)
226 TOE408-W/1
ZAC408-H/1

3.5 Other factors:

• Possible drain on cash flow on redemption; depends on refinancing possibilities. (1)

• Advantages of fixed cost and repayment under present inflationary conditions. (1)

• “Locked into” this rate should interest rates ease. (1)


(10)

4. Redeemable preference shares

4.1 Cost: Effective after tax cost is 10% ± ; no tax deductions applicable to company
(before tax cost 10/70 = 14,28%). (1)

4.2 Risk: Although obligations relating to the payment of preference dividends are not as
onerous as in the case of debenture interest, they must be met eventually, and
there is an obligation to redeem the shares. (2)

The preference shares/total assets ratio would move to 15% which is very much
out of line with the industry which is 1% (presently 4,6%). It is doubtful that this
per se would affect the risk assessment. (1)

4.3 Control: Not directly affected. Where preference dividends are in arrear, however,
preference shareholders are entitled to vote; this could threaten control if there
is dissatisfaction with management. (2)

4.4 Other factors:

• Possible drain on cash flow on redemption; depends on refinancing possibilities. (1)


(7)

5. Ordinary shares

5.1 Cost: This is the most expensive of the possible sources. A rough estimation of the
cost of equity using the Gordon growth model gives a cost of 25% +. The effect
of issue costs and reduction of issue price for right issues are relevant. (1)

5.2 Risk: There is a reduction in financial risk. Assuming that the present debt ratio is
acceptable, a share issue would provide a good base for future debt issues. (1)

5.3 Control: There is a threat to control; seriousness of which depends on the extent of
Quickcon’s holding. Any attempt to retain control would require a substantial
injection of cash which may not be available. (1)

5.4 EPS: Significant deduction in EPS occurs. (1)


14
227 TOE408-W/1
ZAC408-H/1

6. Retained earnings

6.1 Cost: Not quite as expensive as ordinary shares, as there are no issue costs
involved.

6.2 Risk: The retention of funds reduces financial risk and provides a base for the
issue of debt in future. (1)

6.3 Control: Clearly, no threat to control. (1)

6.4 Dividend policy:

The retention level is high: 4,17 dividend cover as against an industry average of 2,3.
Existing shareholders appear to find this satisfactory, however; probably on account
of the high growth rate. It is doubtful, however, that the company could push this
further, e.g. to a zero payout. In any event, a continuation of the existing policy with
earnings, at the 2000 level, would provide R4,3 million so that only R3,8 million need
be raised via the methods examined above. This assumes that 2001 retained
earnings have not been earmarked for other projects.
(5)
Maximum 40

QUESTION 30 - Suggested solution

(a)(i) Income statement


Shares Loan
Rm Rm
Turnover (270 x 1,1) 297 000 297 000 (1)
Direct costs excl depr (171 - 19) x 1,08 (164,160) (164 160) (1)
Depreciation (18 + 10) (28 000) (28 000) (½)
Indirect costs (40 000) (40 000) (½)
Interest payable (5 000) (11 000) (½)
Profit before tax 59 840 53 840 (½)
Tax (17 952) (16 152)
Profit after tax 41 888 37 688 (1)
Dividend (cover 60%) 25 133 22 613
16 775 15 075
228 TOE408-W/1
ZAC408-H/1

(ii) Balance sheet Shares Loan


Rm Rm
Non-current assets (234 + 50 - 28) 256 000 256 000 (1)
Current assets 143 460 137 460
Inventory (35 + 20) 55 000 55 000 (½)
Debtors (49 x 1,1) 53 900 53 900 (1)
Cash (balancing figure) 34 560 28 560 (1)
_______
TOTAL ASSETS 399 460 393 460

EQUITY 279 575 227 895


Ordinary share cap 60 000 50 000 (1)
Share premium 40 000 0
Distributable (112,8 + 41,9 - 25,1) 129 575 127 895 (½)
Revaluation reserve 50 000 50 000 (1)
Long-term liabilities 50 000 100 000 (1)
Current liabilities 69 885 65 565
Creditors (43 + 17,9 - 16,2) 44 752 42 952 (1)
Shareholders for div 25 133 22 613 (1)
_______ ______
TOTAL EQUITY AND LIABILITIES 399 460 393 460 __
Maximum (7)
(iii) Cash flows

From operating activities 48 960 42 960


Cash generated from operations 92 840 92 840 (1)
Finance costs (5 000) (11 000) (1)
Taxation paid (16 200) (16 200) (1)
Dividends paid (prior year (22 680) (22 680) (1)

From investing activities (74 900) (74 900) (1)


Plant and equipment purchased (50 000) (50 000)
Increase in stock (20 000) (20 000)
Increase in debtors (4 900) (4 900)

Proceeds from share issue 50 000 (1)


Long-term liabilities 50 000 (1)

Reconciliation of cash
Increase 24 060 18 060
Beginning of period 10 500 10 500 (1)
34 560 28 560 (1)
Maximum (7)
Reconciliation of cash
Net increase
Beginning of period (2001) (1)
End of period (2002) (1)
Maximum (7)
229 TOE408-W/1
ZAC408-H/1
(b) Rights issue
• Decrease earnings per share (1)
• Decrease dividends per share (1)
• Dilute share price (1)
• Gearing more towards equity (1)
• Cost of capital will increase (re capital) (1)
• Shareholding may change as a consequence of following rights (1)
• Capital profit incentive to shareholders (1)

Loan
• No impact on shares/shareholding (1)
• Interest payable increases, cover slightly lower (1)
• Gearing more positive, within bankers requirement (2)
• Cost of capital will decrease as result of tax effective cost (1)
• Matching of asset and liability structured better (1)
• Security given for loan (1)
Maximum (10)
(c) • Market growth forecast (1)
• Competition in other regions (1)
• Management back-up available (1)
• Capital for investment of R40m in 2003 from internal resources? (1)
• Forecast returns on new investments - assumptions realistic (1)
• High dividend payout - can be changed to fund new investment (2)
• Overdraft facilities available (1)
• Economy: impact on vehicle sales and repairs. (1)
Maximum (5)

QUESTION 31 - Suggested solution

(a)

Muzik.Co.Za.Ltd currently recognises the unamortised portion of “member acquisition costs” as an


intangible asset in the balance sheet. AC 129 – Intangible Assets defines an intangible asset as “an
identifiable non-monetary asset without physical substance held for use in the production or
supply of goods or services, for rental to others, or for administrative purposes.” (AC 129.08)

An intangible asset should be recognised if, and only if:

(a) it is probable that the future economic benefits that are attributable to the asset will
flow to the enterprise, and
(b) the cost of the asset can be measured reliably.

“An enterprise may have a portfolio of customers or a market share, and may expect that, due to its
efforts in building customer relationships and loyalty, the customers will continue to trade with the
enterprise. However, in the absence of legal rights to protect, or other ways to control, the
relationships with customers or the loyalty of the customers to the enterprise, the enterprise usually
has insufficient control over the economic benefits from customer relationships and loyalty to consider
that such items (portfolio of customers, market shares, customer relationships, customer loyalty) meet
the definition of intangible assets.” (AC 129.17)
230 TOE408-W/1
ZAC408-H/1

In this case the key factor is therefor the determination of whether the legal contract which binds
Muzik.Co.Za’s customers to purchase one CD per quarter for two years is enforceable in practice. If
so, the customer base meets the definition of an intangible asset because it is identifiable,
Muzik.Co.Za has control of it in terms of a legal agreement, and it is likely to result in future
economic benefits in the form of future CD sales.

An intangible asset should initially be measured at cost (AC 129.23) and should subsequently be
amortised over it useful life. (AC 129.80)

The cost of each customer in the customer base is the cost of the 3 CD’s used to “acquire” the
customer, i.e. (3 X R50 in 1999 and 3 X R60 in 2000), not the “selling price” of the CD’s, which is
effectively what Muzik.Co.Za is currently using to initially measure the intangible asset; i.e. the journal
entry should be:

Dr Cr
R R
Customer base (intangible asset) 180
Inventories 180

And not the current:

Customer base 270


Revenue 270

Cost of sales 180


Inventories 180

Because the customer base gives rise to economic benefits in the form of CD sales over a two year
period, the intangible asset should be amortised over a two year period, as is currently done by
Muzik.Co.Za.

If there is an indicator of impairment, Muzik.Co.Za should assess the intangible asset for impairment
in terms of AC 128.

AC 111 – Revenue defines revenue as “the gross inflows of economic benefits during the period
arising in the course of the ordinary activities of an enterprise when those inflows result in
increases in equity, other than increases relating to contributions from equity participants.”
(AC 111.09)

Revenue should be measured at the “fair value of the consideration received or receivable.”
(AC 111.11)

The fair value of the amount received for the introductory CD’s is 1 cent each. In view of the
insignificant amount of this revenue, this amount could be recognised as revenue or as a reduction in
the cost of the intangible asset.
Maximum (8)
231 TOE408-W/1
ZAC408-H/1
(b)

Internet companies are difficult to value for various reasons -

• usually incur losses or small profits in first few years of existence


• revenue growth rate is often exponential
• business models are new and untested. Many internet businesses fail

Price to revenue valuation approach to valuing Muzik.Co.Za is flawed:

• revenue is growing at more than 100% p.a. Do you adjust multiple every year, therefore ongoing
escalations in value of business?
• uniqueness of Muzik.Co.Za is not taken into account
• how does one factor in specific risks re business model of Muzik.Co.Za?
• business failure risk? This needs some consideration
• fails to address fundamentals underlying business and key value drivers
• revenue recognition for new subscribers is blatant manipulation. It follows that disclosed revenue
cannot be used as basis of valuing company.
• ignores any future returns to shareholders whether this be dividends or other cash flows.

Price to revenue multiple is one benchmark and should not be used as a basis for valuing a business!
__
1 each, Maximum (8)
(c)

Viva Investment Bank Ltd


Head of the asset management division

Report on Muzik.Co.Za
Calculation 2000 1999
R000 R000
Revenue as currently disclosed:
- introductory offers 1 8 100 3 600
- CD of the month 2 11 340 4 800
- other CD sales 3 14 400 4 050
- advertising revenue 2 940 1 960
36 780 14 410

Unit sales
- introductory offers 4 25% 30%
- CD of the month 5 35% 40%
- other CD sales 6 40% 30%
100% 100%
232 TOE408-W/1
ZAC408-H/1

Membership estimates
- beginning of year 15 000 0
- new members 7 30 000 15 000
- churn 0* 0*
- end of year 45 000 15 000

- average during the year (assuming even growth) 8 30 000 7 500 (1)
* Members sign up for two years!
Average CD sales to members
- introductory offers 9 3,0 3,0 0%
- total other sales (based on closing membership) 10 6,0 7,0 -14%
- total other sales (based on average membership) 9,0 14,0 -36%
- CD of the month 11 4,2 8,0 -48%
- other CD sales 12 4,8 6,0 -20%
(1)
RESTATED INCOME STATEMENT
Revenue
- introductory offers 1 0
- CD of the month 13 11 340 4 800
- other CD sales 14 14 400 4 050
- Advertising revenue 2 940 1 960
28 681 10 810 (1)
Cost of sales 15 16 200 5 250
Gross profit 12 481 5 560
Operating costs 11 890 4 350
EBITDA 591 1 210 (1)
Depreciation 3 500 1 750
Amortisation of goodwill 2 200 1 100
Amortisation of member acquisition cost 16 3 825 1 125
EBIT (8 934) (2 765)
Interest received / (paid) 150 (670)
Attributable loss (8 784) (3 435) (1)
233 TOE408-W/1
ZAC408-H/1

Ratio’s
Revenue growth 17 165,3% (1)
GP% 18 43,5% 51,4% (1)
GP% excluding advertising revenue 19 48,5% 62,8% (1)
Advertising revenue as % of total 20 10,3% 18,1% (1)
Breakeven revenue 21 49 211 16 186 (1)
Breakeven revenue (ignoring depreciation and goodwill) 22 27 323 8 457 (1)

Membership increase 23 200% (1)


Gross revenue per average member 24 956 1 441 (1)
Operating costs per average member 396 580 (1)
25
EBITDA per average member 26 20 161 (1)

2000 1999

1. 90 000 x 90 45 000 x 80
2. 126 000 x 90 60 000 x 80
3. 144 000 x 100 45 000 x 90
4. 90 000 ÷ 360 000 45 000 ÷ 150 000
5. 126 000 ÷ 360 000 60 000 ÷ 150 000
6. 144 000 ÷ 360 000 45 000 ÷ 150 000
7. 45 000 – 15 000 15 000 – 0
8. 15 000 (opening) + 30 000/2 15 000/2
9. 90 000 ÷ 30 000 45 000 ÷ 15 000
10. (126 000 + 144 000) ÷ 45 000 (60 000 + 45 000) ÷ 15 000
11. 126 000 ÷ 30 000 60 000 ÷ 7 500
12. 144 000 ÷ 30 000 45 000 ÷ 7 500
13. 126 000 x 90 60 000 x 80
14. 144 000 x 100 45 000 x 90
15. (126 000 + 144 000) x 60 (60 000 + 45 000) x 50
16. (90 000 x 60)/2 + 1 125 45 000 x 50 ÷ 2
17. (28 681 ÷ 10 810) – 1 n/a
18. 12 481 ÷ 28 681 5 560 ÷ 10 810
19. 12 481 ÷ (28 681 – 2 940) 5 560 ÷ (10 810 – 1 960)
20. 2 940 ÷ 28 681 1 960 ÷ 10 810
21. (11 890 + 3 500 + 2 200 + 3 825) ÷ (4 350 + 1 750 + 1 100 + 1 125) ÷ 51.4%
22. 43,5% 4 350 ÷ 51,4%
23. 11 890 ÷ 43,5% n/a
24. (45 000 ÷ 15 000) – 1 10 810 ÷ 7,5’
25. 28 681 ÷ 30’ 4 350 ÷ 7,5’
26. 11 890 ÷ 30’ 1 210 ÷ 7,5’
591 ÷ 30’
234 TOE408-W/1
ZAC408-H/1
Comments on financial performance:

• Membership increase has been impressive, resulting in 165% revenue growth.


• Revenue recognition policy re new members is nonsense.
• Figures restated per above decline in GP% of concern, particularly in relation to increase in cost of
infrastructure.
• Breakeven revenue has grown from 1999 to R49 million (versus current turnover of R29 million).
• Cash flows are improving given positive interest in 2000, probably due to IPO in 1999. However,
the concern is whether the cash resources are sufficient to fund continued losses.
• Other sales per member show a significant decline, indicating that the new members have a lower
propensity to buy, or that demand from existing members has reached saturation.
• Sales of CD of the month show the biggest decline; this puts to question the attractiveness of this
option. Particularly bearing in mind that CD of the month is cheaper.
• The reduction in per member EBITDA arises in the main out of lower gross revenue per member,
due to lower sales per member. Increased cost efficiencies inadequate to cover the decline.
Reduced sales revenues per member are a significant concern.
• Revenue mix indicates reducing contributions from advertising revenue.
• Unless problems above are addressed, profitability is critically dependent on growth in
membership. ___
1 each maximum (14)
Commentary on Business Model

• Muzik.Co.Za has obviously been a huge success given the 45 000 members in 2 years.
• The strategy of “forcing” members to buy 1 CD a quarter and restricting sales to members only has
to be questioned. The sustainability of this model whereby members are lured into the fold by
giving 3 CD’s in return for a minimum sales to such of 8 CD’s over 2 years seems ridiculous.
Assuming members buy CD’s over 2 years, avail themselves of the free introductory offer, an
average selling price and cost price per CD of R90 and R53,64 respectively, Muzik.Co.Za makes
R130 per customer over a 2 year period.
• Profitability is a function of membership retention (the longer members stay beyond 2 years, the
bigger the incremental profits); but data shows a declining purchase capacity by members. Further
structure of contracts incentivises members to terminate contracts after two years and rejoin to get
freebies. This aspect of the business model puts an inherent cap on profitability.
• Other CD sales (non CD of the month) shows best performance in comparison. Hence it seems
members use membership for normal electronic shopping rather than being attracted by the CD of
the month (i.e. what do they look for: the convenience of on-line shopping or the unique product
offering of Muzik). It seems it is the former; hence Muzik is vulnerable to new entrants - one would
question the loyalty of members due to being able to have access to CD of the month.
• The business model is flawed unless Muzik is aiming to generate more revenue from advertising/
membership database.
• The churn rate re members is untested - it may transpire that members purely joined to obtain
freebies and that they will cancel and rejoin after 2 years.
• How does the average CD sales to members of 9 compare to industry norms? __
Maximum (6)
235 TOE408-W/1
ZAC408-H/1
Commentary on valuation methodology

• Cannot use PE basis since the company is incurring losses


• Also, are there any similar listed entities to benchmark against?
• NAV unlikely to be of any relevance
• DCF seems the only feasible way to value business
• However, given the high growth and uncertainty re future performance can one use a “vanilla” DCF
approach?
• seems likely that a DCF with option pricing methodology/probability theory may be appropriate.
__
Maximum (4)

QUESTION 32 - Suggested solution

(a) The valuation is that of a majority/controlling interest in Secure (Pty) Ltd. (1)

The following valuation methods can therefore be considered:

• Net asset value


• Earnings yield/price-earnings
• Free cash flow (1)

When answering a question like this, also briefly refer to the methods NOT to be used, such
as the dividend yield method. Briefly mention dividend yield as a method and state why it
would not be appropriate to use this method.

Net asset value method essentially values the interest on the basis of accounting net asset
value. Accounting valuation does not purport to value underlying assets on the basis of
economic value. It is also not suitable to value internally generated intangibles such as
goodwill and brand value. Generally accounting values, particularly when done on the basis of
amortised historical cost gives rise to conservative values for assets and tends to undervalue
the business. At best this method can be used as a reasonability check. (3)

The earnings yield method is in practice often used in the valuation of majority stakes. This
method does not rely on cash flows and to the extent that earnings do not necessarily measure
the generation of economic value, the valuation is likely to be inaccurate. Estimates and
judgemental factors can have a significant impact on the quantity and timing of earnings
without there being any fundamental change in the underlying value generated by the
business. (2)

Given the prevalence of use of this method in practice it may be necessary to justify the ultimate
valuation arrived at using this method; or to use this method as a reasonability check. (1)

Conceptually the most appropriate valuation technique is one that measures the use and return
of economic resources (cash), adjusting for the timing of the cash flows over time. Hence the
most appropriate method would be the free cash flow valuation technique. This technique
values the economic value of the business. The value must be reduced by a fair value of
236 TOE408-W/1
ZAC408-H/1
liabilities (face value adjusted where liabilities are subject to interest rates that differ from market
rates). (2)

Separate assets - i.e. assets that do not form an integral part of the business (such as the block
of flats) - where there might be a readily available market value should be valued on a market
value basis. (1)
Maximum (10)

(b) Discount rate

• What is an appropriate cost of capital of the acquiror. (1)


• What is cost of debt of the acquiror. (1)
• What is an appropriate long term capital structure for the acquiror. (1)
• What is the relative riskiness of the target relative to the acquiror; i.e. should there be a
risk premium or discount applied to the cost of capital based on the risks inherent in the
new business. (2)
• What is the risk of merger related difficulties in realising potential cash flows (morale, I
incompatibility of cultures). (2)

Free cash flows

• Investment in fixed assets to maintain operating capacity. (1)


• Investment in fixed assets to accommodate growth (e.g. as a result of R&D). (1)
• Working capital requirements. (1)
• Impact of R&D on future revenues. (1)
• Future R&D expenditure requirements. (1)
• Anticipated margins and changes therein. (1)
• Future plans/strategy regarding the loss-making reaction unit. (1)
• What are cash flows associated with the block of flats (or is this a separate asset with a
ready market value). (1)
• Costs associated with restraining existing owners. (1)
• Do current results factor in a reasonable cost of employment of existing owners. (1)
• Interest rates of existing borrowings to determine fair value. (1)
• Are there any tax assets or contingent liabilities to be adjusted for (assessed losses, STC
credits, outstanding penalties, etc). (2)
• Stiff competition giving rise to losses in reaction unit - what is the impact of this competition
on future revenue growth and margins. (1)

Are there incremental costs/synergies that can be extracted as a result of the merger (e.g. head
office cost savings; use of R&D results within the wider business of the acquiror). While these
are not strictly part of the value of the target, they represent important considerations in
determining the degree of a premium that might be offered. (2)
(20)

Note that in both parts of this question the marks add up to more than the required marks.
Always be conservative and attempt to provide more than what is required. This will earn you
more marks in an exam.
237 TOE408-W/1
ZAC408-H/1
QUESTION 33 - Suggested solution

(a)(i) Debtors days R

Annual sales 3 000 000


Debtors 230 000
230 000 x 365
∴ Debtor days = 3 000 000

= 27,98 days

(ii) Forecast overdraft balance

Gross profit 40% of R3 240 000 1 296 000 (1)


Cash discounts 20% of 5% of R3 240 000 (32 400) (1)
Operating and administration expenses (420 000) (1)
Other expenses (30 000) (1)
Increased debtors (284 849) (3)
- 1 month R 230 000
- 2 months
100% x R3 240 000 x 61/365 R(541 479)
20% x R3 240 000 x 15/365 R 26 630
Bad debts 3% of R3 240 000 (97 200) (1)
Increased creditors 60/365 x 60% of
R3 240 000 = R319 561 - R270 000 49 561 (3)
Operational cash flow 481 112
Opening balance (200 000) (1)
281 112
Interest 12% of R281 112 33 733 (1)
Closing balance 314 845

(13)

(b) Income 1 Month 3 Month


Credit term Credit term
R R

Sales 3 000 000 3 600 000


Variable costs (Including discount and
bad debts)[(1 500 x 1 000) + (2% x
3 000 000) + (20% x 5% x 3 000 000)] 1 590 000 2 052 000 (1)
Contribution 1 410 000 1 548 000
Fixed manufacturing costs 300 000 360 000 (1)
Net income 1 110 000 1 188 000

Increase in net income R 78 000 (1)


238 TOE408-W/1
ZAC408-H/1
600 000
Fixed (60 000) [360 - 300]
Variable (300 000) [(1 000 - 1 200) x 1 500]
Discount (6 000) (36 - 30)
Bad debts (156 000) (216 - 60)

Average investment in debtors

Units 1 000 1 200


Contribution per unit 1 500 1 500
Fixed costs 300 000 360 000
Discount and bad debts 90 000 252 000
Total cost 1 890 000 2 412 000
Months 12 4 (2)

Investment in debtors 157 500 603 000


∴ Increase 445 500 (1)

Return required on additional investment

20% x R445 500 = 89 100 (1)

Additional net income R 78 000


Return on investment required (89 100)
Shortfall R (11 100) (2)
(8)

(c) 1 Month 2 Month 3 Month


Credit term Credit term Credit term
R R R

Investment in debtors 1 890 000 2 049 600 2 412 000


Increase - 159 600 362 400
@ 20% return - 31 920 72 480 (1)
Profit 1 110 000 1 190 400 1 188 000
Profit available 1 110 000 1 158 480 1 115 520 (1)
Bad debts
2% x R3 000 000 60 000
3% x R3 240 000 97 200
6% x R3 600 000 216 000 (1)
1 050 000 1 061 280 899 520

The consideration of the effect of bad debts on the profitability, arising from the increase in
credit facilities, is most revealing. Although the company has a very reasonable contribution
rate the influence of bad debts on the profitability outweighs this as bad debt losses cover not
only the profit element in sales but also constitute a complete loss of costs and profits. (1)
It would not be profitable to extend the credit period to either two months or three months. (1)
Consideration must also be given to the nature of the debtors concerned as well as to any
additional costs to be incurred due to increased activities of debt collection. The factorising of
debtors may also be a possibility. (2)
(7)
239 TOE408-W/1
ZAC408-H/1

(d) A number of approaches can be used to assess the creditworthiness of the individual
customer:

• New customers should give two good references, including one from the bank, before
being granted credit. (1)
• Credit ratings should be checked using credit agencies. (1)
• For large value customers, a file should be maintained of any available financial
information, including an analysis of the company’s annual report and accounts. Relevant
press comments are also useful and provide up-to-date information on current
performance. (1)
• Staff should visit the potential customer to get a first hand impression of the company and
its prospects. (1)
• The customer’s willingness to meet credit obligations (Character). (1)
• The customer’s ability to meet credit obligations out of operating cash flows (Capacity).(1)
• The customer’s financial reserves (Capital). (1)
• A pledged asset in the case of default. (Collateral) (1)
• General economic conditions in the customer’s line of business (Conditions). (1)
(1 mark per point maximum) (5)
Total 35

QUESTION 34 - Suggested solution

(a) Overall

This company is operating in a very difficult and competitive industry.

Understanding of financial results

• Profitability for the two periods has shown good growth with EPS increasing by 100% this year
• Working capital has also grown quickly, but both current and quick ratios weakened this year
• Interest expense is high compared to profitability, interest cover is about 2x
• More reliance is being placed on overdraft for funding the company
• Taxes that will arise on profits have not yet been paid
• Dividends are proposed which will put pressure on the cash flows
• The debt: equity ratio is poor, with high creditor and bank borrowings
• Overdraft borrowings are short-term in nature and expense

Business environment

• This is a highly traded sector, with many competitors


• There is a low brand loyalty, products are easily substituted
• Prices are based on consumer demand
• Retailers who sell the product will be expecting discounts and are traditionally slow payers
• There is a forex exposure as most of the product is imported
• The value of inventory on hand will need to be checked due to rapid obsolescence
• Margins will therefore be under pressure
240 TOE408-W/1
ZAC408-H/1
Impact on cash flows of Shop & Drop

The company appears to be running out of cash, due to:

• growing too quickly


• inadequate shareholders’ funds to meet growing working capital requirements
• growing dependence on bank overdraft

Additional pressure is being created by:

• declaring of dividends
• taxation on profits declared still needs to be paid
• increase in inventory levels of concern, as must move this type of inventory quickly
• resultant increase in creditors as they wait for inventory to turn
1 each, max (15)

(b) 1. Working capital strategies

• Debtors - Offer incentives eg settlement discounts


- Enforce terms of credit
- Charge interest on overdue balances
- Factor debtors book - release cash
• Inventory - Obtain consignment stock from manufacturer
- JIT strategy to manage inventory levels
- Link with other suppliers, eg sharing of shipping costs
- Tighten ordering/purchasing options
- Consider lead time taken from Far East supplier

• Creditors - Ask for extended terms


- Even terms with finance (< than O/D) vs early settlement terms

2. Balance sheet structure

• Increase permanent capital to reduce short-term funding


- Debt: convert to debentures that are convertible to equity
- Equity
• Gearing is currently way out of line
- Convert long-term loan
• Structured finance - possibly make use of any tax base available
• Sale and leaseback of any assets? Make as many costs operating/variable rather
than fixed

3. Trading opportunities

• Possible confusion as to who/what is current market (undertake some market


research)
- Establish who buys product and what do they buy
• Minimise tax through structured finance with deductible interest
• Understand primary cost drivers
241 TOE408-W/1
ZAC408-H/1
4. Other

• Establish alliances with product distributors


• Eliminate certain product lines that are slow moving/unprofitable
• Focus on fewer products/narrow range - become best in market
• Sell off certain brands to release potential capital

5. Management

• Establish budgets and a 3 - 5 year plan that optimises the balance between profit
and cash
• Source alternative products that complement existing products which are cheaper
• Outsource the assembly and/or distribution of products currently being assembled
• Consider the need to outsource other operations of the business
1 each, max (15)

QUESTION 35 - Suggested solution

(a) Ethical issues

- The key ethical issue arising in this question is Able Baker's insider trading. This is a
serious offence, and is in contravention of the Companies Act and JSE regulations. It
makes no difference to the ethics involved that he is using his family trust as the vehicle to
acquire the shares. (2)
- You are faced with two problems in dealing with this issue. Firstly, you owe your
company a duty of confidentiality and may not disclose the fact that Able Baker has
committed insider trading unless one of three exceptions apply:
- Disclosure is authorised;
- Disclosure is required by law e.g. you are subpoenaed to give evidence; and
- There is a professional duty or right to disclose e.g. in responding to an
- The second matter relates to a conflict of loyalties. You owe your employer a duty of
loyalty. (4)
However, your employer cannot legitimately require you to break the law, or breach the
standards or rules of your profession.
- If you are unable to resolve your ethical differences with your fellow CA employer, (1)
who in terms of the Code of Professional Conduct is bound to assist you to comply with
the Code, you would need to follow the steps in dealing with matters of conflict of interest
set out in the Code. These include reviewing the matter with your immediate superior, or
even approaching the Chairman of the board of directors if the matter remains unresolved,
obtaining advice from the Institute, or, as a last resort after exhausting all the levels of
internal review, you may have no option but to resign, and state the reasons for your
resignation in your letter, which should be addressed to an appropriate person in the
company. (3)
(10)
242 TOE408-W/1
ZAC408-H/1
(b) Analysis and comment of financial performance

2000 1999
Turnover
- % increase 19,0%
- average turnover per outlet (R000's) 1 281 1 385
- % change in outlet turnover -7,5%

Questions arising:
- What impact did the mobile units have on existing outlets?
- When did new outlets actually open and what are the actual stats per outlet?

Observations:
- Turnover increased by 19% in 2000 however, the number of outlets (including mobile
units) increased by 29%.

Gross Profit 2000 1999


- GP % 31,2% 30,3%
- Per outlet (R000's) 400 420

Observations:
- Gross profit % has improved in the 2000 financial year which is encouraging.

Questions arising:
- Why has GP per outlet decreased in real terms?
- What is the profitability of new mobile units? Is this business model working?

Operating costs 2000 1999


- Annual increase 27,4%
- Per outlet (R000's) 264 266

Observations:
- Operating costs have increased at higher rate than revenue growth! Perhaps this
is temporary given new outlets which opened in 2000.
- Operating costs per outlet has decreased in real terms from prior year.

Depreciation 2000 1999


- Depreciation charge/year end plant & equipment 19,1% 14,1%

Observations:
- Capital expenditure of R9,5 million incurred in 2000 (1999:R5,6 million). It
follows that depreciation charge will be higher - eg assume 20% p.a.
amortisation = additional R1,9 million p.a.

Interest 2000 1999


- Interest/average debt 19,9%
- Interest cover 7,0 11,3
243 TOE408-W/1
ZAC408-H/1
Observations:
- Interest expense has increased by R0,8 million in 2000 which is expected given the
increase in borrowings of R8,1 million
- Interest cover ratios are acceptable

Profitability ratio's 2000 1999


- PBIT/turnover 8,4% 9,7%
- EBITDA/turnover 10,6% 11,1%
- ROE 35,7% 40,1%
- Return on total assets 13,6% 17,6%

Observations:

- Profitability relatively stable however, new outlets opened will have adversely
affected ratio's given lag between opening and trading optimally

- ROE ratio's are outstanding. Suggests that capital structure is sound (use debt to
fund expansion, pay dividends despite no cash resources?)
Taxation 2000 1999
Tax charge excluding STC 3,107 3,575
Effective tax rate 24,8% 27,7%

Observations/questions:
- Effective tax rate is much lower than statutory rate - why?
- No deferred tax is provided - why?

Working capital ratio's 2000 1999


- Stock days 90 84
- Debtors days 37 34
- Creditors days 55 57

Net investment in working capital (R000's) 29 042 21 236


Questions/observations:
- % of turnover which is cash versus terms to calculate the correct debtors days
ratio's.
- Monthly balances to calculate "truer" working capital ratio's
- Investment in inventory may suggest that glass is imported or that working
capital management could improve
- Net investment in working capital has increased by R7,8 million in 2000 or
36,8%. This must be of concern to Glassy SA

Gearing 2000 1999


Debt equity ratio 51,2% 28,8%

Observations:
- Gearing ratio's appear high however, given the dividend and funding policies this may
be deliberate to achieve acceptable profitability ratios and leverage. Interest cover
ratio's suggest that business is not overgeared.
- Future expansion may be constrained by access to capital and borrowings. This could
adversely impact on revenue and profit growth over next two/three years.
244 TOE408-W/1
ZAC408-H/1

Cash flow 2000


Operating profit 18 361
Interest expense -2 087
Dividends paid -3 000
Taxation paid -4 078
Net movement in working capital -7 806
Cash flow from operating activities 1 390

Investing activities:
Capital expenditure -9 500
-8 110
Net increase in borrowings 8 110

Max 4 per sub-area (20)

Observations:
- Glassy SA is a retail orientated business and cash flows should be positive. The
above analysis suggests that cash flows are poor although the extent of investment
in working capital may be a direct result of new outlets being opened. Historical cash
flows need to be analysed to establish cash flow generation ability of Glassy SA. (2)
- Funding of dividends out of borrowings should be questioned! (1)
Maximum (20)
(c) Preliminary opinion whether to pursue acquisition of Glassy (Pty) Ltd

Business rationale for takeover:


- Acquisition of national leader in glass fitment would complement existing
motor dealerships and retail outlets (spares & accessories). Servicing the
automotive after market through parts outlets and glass fitment outlets.
- Would result in expansion of customer base - insurance claim market and flat
glass (insurance & household market).
- Cross selling opportunities should realise given the potential to house parts,
dealerships and fitment centres in same physical location or through
referrals.
- It may transpire that customers will find it convenient to visit one location for
repairs and glass fitment.

Post acquisition benefits:


- Cost savings should be realised through closure of Glassy SA's head office
- Rationalisation of outlets should reduce operational costs common
warehousing and distribution infrastructure?
- Glassy SA would have access to group expertise in distribution and logistics
- Financial muscle of larger group may be beneficial - buying power, access to
capital.
- Group marketing efforts may be more efficient and cost effective

Glassy SA business - it appears to be a good business:


- Market leader, established business
- Stable financial performance
245 TOE408-W/1
ZAC408-H/1
Preliminary conclusion:
- It makes sense for Transport Holdings to pursue acquisition for reasons
stated above provided terms of acquisition are attractive:
- Pricing should be not be more than 60% of Transport Holdings PE given
unlisted status and difference in size and diversity of businesses
- Suitable warranties

- Glassy SA should contribute to group profits - will represent 17% of group __


profits based on 2000 results. (10)
1 each, max

(d) Impact on EPS of Transport Holdings Ltd

Increase in number of issued shares:


- Currently 50 million shares in issue
- Issue to vendors of 4,5 million shares
- Issue date to be finalised in due course, dilution only effective from effective date of
acquisition.

Impact on earnings:
- No forecast profitability provided therefore have to consider historical impact
- Transport Holdings earnings in 2000 was R45 million
- Glassy SA would have boosted earnings by R9 million
- Cost savings of R6 million p.a. however, retrenchment & closure costs may nullify this
benefit in 2001
- Amortisation of goodwill?
- Goodwill to amount to R20,2 million
- Amortisation over 10 years = R2 million p.a.

Likely impact will be positive given the differential PE's however, impact in 2001 likely to be
minimal given goodwill amortisation and Glassy SA head office closure costs
Impact in 2002 onwards should be positive
- based on 2000 profitability say 10% increase
- goodwill amortisation is not tax deductible and may cancel cost savings benefits
__
1 each, maximum (10)
(e) Key risk areas

- Business model employed


- Are fitment centres sustainable going forward or is trend towards mobile units?
Any change in product delivery will have enormous impact on Glassy SA given
number of outlets
- Remaining duration of property leases
- International trends in this regard

- Fitment centres & mobile units


- Turnover trends per outlet
- Profitability trends per outlet
- Investigate risk of closure of outlets in future due to poor trading performance
and reliance on select number of outlets for profits
246 TOE408-W/1
ZAC408-H/1
- Industry analysis
- Growth in sales of new vehicles and the after market
- Competition in market
- International trends
- Industry structure analysis

- Warranties
- Product warranties and ability to pass on risk to suppliers
- Public liability claims?

- Working capital
- Analysis of financial performance revealed that investment very high
- Analyse historical trends and terms of trade (customers & suppliers)

- Supply sources
- Any obsolete inventory/ bad debts?
- Sources of supply
- Local or imported?
- Alternate sources of supply and financial well being of suppliers
- Impact of continued devaluation of Rand?
- Any historical supply problems?
- Availability of glass/delivery lead times?

- Customer base
- Reliance on limited number of customers (insurers)
- Nature of relationship (kick backs etc)
- Fickleness of major customers - overly price sensitive?
- Customers reaction to takeover?

- Reliability of historical financial data


- Auditors and audit process
- Historical audit issues
- Systems and controls in place (although going forward this is less relevant)
1 each maximum (10)

QUESTION 36 - Suggested solution

Note on approach

A question containing masses of data, normally leads to information-overload.

To deal with such a situation it is recommended that you do the following:


• First read through required section a couple of times;
• Read through the information once; and
• Then use only the relevant information for each required-section.
247 TOE408-W/1
ZAC408-H/1

(a) Critically analyse SNA’s operations for the three comparative trading periods

First dissect the required sentence, in order to determine exactly what is required.
Critically analyse:
Implies: Calculate ratios AND discuss
SNA:
Total group
Operations:
Continuing, discontinued or both? (Due to few marks we focus only on continuing
operations.)
Operations – where to find the info?
Consolidated income statement + segmental analysis + cash flow (only from
operations)
Comparative trading periods:
Compare apples to apples, thus:
Six months ended: Jun 2001, Dec 2000 & Jun 2000

Calculations (consolidated income statement)

Continuing operations Six months Six months Six months


ended: ended: ended:
Jun 2001 Dec 2000 Jun 2000
(R’000) (R’000) (R’000)

Turnover (Rm) – A 4 612,7 4 077,8 4 001,6 (1)


(8 079,4 – 4 001,6) 4 077,8

Growth % 13,1 1,9 - (1)

Operating income before interest 78,0 44,3 97,1 (1)


(Rm) – B

% income to turnover (%) 1,7 1,1 2,4 (2)


B / A x 100

Income before tax 22,2 18,1 35,1 (1)


Interest cover 78,0 44,3 97,1
46,4 14,7 50,4
=1,7 times =3,0 times =1,9 times (2)
Cash flow – operating activities
Net cash from
operating activities (118 407) 63 086 (21 177) (1)
Maximum (5)

Comments

Based on calculations

• Turnover increased for every period, showing a more significant increase for the 6 months
ended June 2001. (1)
248 TOE408-W/1
ZAC408-H/1

• Turnover-growth, operating income before interest and percentage income to turnover


showed a dip for the 6 months ended Dec 2000, compared to previous six months, but
improved for the 6 months ended Jun 2001. (1)
• Interest cover was the best for the six months ended Dec 2000, largely as the interest
expense was the lowest for this period. Too much interest is being paid, especially for the 6
months ended June 2001. (1)
• Operating activities consumed cash for the first (Jun 2000 period) and third period (Jun
2001), which is concerning. Interest paid also placed a burden on cash flow. (1)

Consolidated income statement

Net income turned to a considerable loss for the half-year ended June 2001, due to a large
write-down for non-trading items (specifically write down of assets and provisions). (1)

Segmental analysis

• Financial Services are doing well – good growth in turnover and operating income, but it is
only a small segment of the group. (1)
• SNA Retail Holdings (travel and food industries) is profitable; the other segments appear to
be unprofitable. (1)
Maximum (5)
Total (10)

(b) Critical analysis of the generation and utilisation of cash for the six months ended
30 June 2001

First dissect the required sentence, in order to determine exactly what is required.

Critically analyse:
Calculate ratios AND discuss
Generation and utilisation of cash – where to find the info?
Summarised consolidated cash flow statement + follow figures through to source
but remember number of marks are few). Prepare a schedule detailing the generation
nd utilisation of cash, as the cash flow statement does not include detail.
Period
Only last 6 months
249 TOE408-W/1
ZAC408-H/1

The funds can be further analysed for the following major elements:

Generated Utilised Net


R’000 R’000 R’000 R’000
Operating activities
Operating profit
Income before interest 78 017 (1)
Depreciation 8 044 (1)
Provisions
(429 675 + 757) 430 432 (1)

This represents a bonus mark if included. This question was compiled from actual published
financial information and as the company is a financial-services company, provisions were
included separately. Provisions were therefore already added-back in the income before
interest figure and should not be added back again. This bonus mark is allocated as the student
could have included this, as he/she had no way of knowing this.
_____
86 061 If figure included (1)
Current assets
1 516 872 (B/S Jun 2001)
- 1 364 888 (B/S Dec2000) 151 984 (1)
Current liabilities
1 494 207 (B/S Jun 2001)
- 429 675 (provision) (1)
- 757 (provision) (1)
- 1 067 395 (B/S Dec 2000) (1)
3620
Interest paid 70 760 (1)
Tax paid 3 884 (1)
Dividends paid 86
Other (balance) 18 626 (1)
Cash outflow from operating activities (118 407)

Investing activities
Used for investments 63 684 (1)
Cash outflow from investing activities (63 684)

Financing activities
Long term loans 42 473
(79 411 - 36 938) (1)
Short term loans 166 929
(800 019 - 633 090) (1)
Other (balance) 163
Cash inflow from financing
activities 209 565
27 474 __
Maximum (9)
250 TOE408-W/1
ZAC408-H/1
Comments

• Operating profit was positive, but barely covered the interest paid. (1)
• Current assets increased considerably and utilised a lot of cash. (1)
• The increase in current assets and its usage of cash should be questioned, given the
position of the group. (1)
• Current liabilities (excluding non-cash items) did not increase much and as a result did
not help finance the increase in current assets. (1)
• Investments utilised cash, and was probably financed mainly with the increase in long-
term liabilities. Roughly one third was then financed using short-term financing, which is
not healthy. (The timing of expected inflows and outflows of cash should match.) (2)
• Short-term loans increased significantly in order to generate the needed cash and
mainly in order to finance the increase in current assets. (1)
Maximum: (5)
Total: (14)

(c) Dt Short term loan 498 788 (1)


Current liabilities 244 028 (1)
Loss attributable to ordinary shares 403 649 (1)
Convertible debentures 51 703 (1)
Ct Convertible preference shares 150 000 (1)
Ordinary shareholders 719 878 (1)
Investment listed co’s 328 290 (1)
Dt/Cr Bank - (1)
8

Journal entry for:


• Sale of investment
• Settlement of debt by way of cash/preference
shares/ordinary shares
• Issue of new shares
• Repayment of debentures / conversion to ordinary shares

Movement of cash can be shown through the bank account

(d) Remedial actions, which could be taken by the directors

• Reduce current assets, focusing on:

o Keep inventory levels low, avoid obsolete stock


o Lower debtors – consider:

ƒ Applying a more stringent credit policy


ƒ Applying a more stringent collection policy
ƒ Consider (better) cash discounts (but consider cost)

• Restructure the business – follow through on the proposed sale of the subsidiary (the
clothing industry is not doing well)

• Reduce capital spending


251 TOE408-W/1
ZAC408-H/1

• Reduce expansion of new shops

• Implement personnel motivational schemes

• Reduce debt (this will decrease pressure on cash flow – no/less compulsory interest
payments)

• Strengthen capital base (but consider cost of equity vs. debt)

• Perform a rights issue

o Suggested value per share 40c

• Convert debt to equity

• Issue preference shares (as indicated in pro forma B/S)

1 each, maximum: (8)

QUESTION 37 - Suggested solution

(575 426 000)


(a) Undiluted EPS = 198 735 000

= (289,5) cps (loss per share) (1)

29 478 000 + 9 384 000


Diluted HEPS = 256 438 000

= 15,2 cps (1)

78 017 78 017
Interest cover = 46 442 + 9 384 ALTERNATIVE 70 760

= 1,40 times = (1)


1,1 times
879 430
Debt / equity = (3 617) + 85 065
= 10,8:1 or
> 100% (1)
Note that convertible debentures are included under equity, as it would
soon be.
252 TOE408-W/1
ZAC408-H/1

(41 433 000) (3 617)


Undiluted NAV = 198 735 000 ALTERNATIVE 198 735

= (20,9) cps = (1,8) (1)


cps
 (2) cps

(41 433) + 85 065 + 9 384


Fully diluted NAV = 256 438

= 20,7 cps (1)


(6)

(b) Recommended staff motivation schemes

1. SNA Retail Holdings

Recommended method Motivation


• Sales managers (not Commission would provide incentive. Not
responsible for credit policy) responsible for credit policy also,
should earn commission on sales. (1) otherwise sales would be made to
doubtful debtors. (1)
• Store managers (which couldn’t ROI would maximise the return
make investments, also not generated for investment given, but if
creditors policy, but who can they could make investments, they could
manage stock and debtors manipulate the investment base. (1)
policy) – Return on investment
(ROI), (1)
• Store managers (which couldn’t ROI would maximise the return
make investments, also not generated for investment given, but if
creditors policy, but who can they could make investments, they could
manage stock and debtors manipulate the investment base. (1)
policy) – Return on investment (1)
(ROI),
or return linked to a measure Would maximise the return generated for
e.g. floor space (1) a certain measure (1)
• Management (who could choose RI and EVA compare actual returns to
business sites and creditors required returns. (1)
policy) – Residual income (RI)
or Economic Value Added
(EVA). (1)
253 TOE408-W/1
ZAC408-H/1
2. SNA Financial Services

Recommended method Motivation


• Brokers: commission on new Commission would provide incentive.
products sold initially + yearly if Penalty system to ensure that broker
product still in existence keeps client happy. (1)
(penalise if client stops –
depending on years) (1)
• Managers – RI or EVA – but RI and EVA compare actual returns to
linked to risk evaluation of required returns. Risk adjustment and
clients. (1) RAPM ensures that a manager is not
• Risk-adjusted return on capital rewarded now for taking unnecessary
(RAROC), Sharpe ratio, risks, which could nullify return achieved
Treynor measure, or other risk later on when debtors go bad (managers
adjusted performance normally do not pay back their bonuses) (2)
measure- (1)
ment (RAPM).

3. SNA Health Services

Recommended method Motivation


• Brokers: commission on new Same as for SNA Financial Services
products sold initially + yearly if
product still in existence
(penalise if client stops –
depending on years). (1)
• Managers – RI or EVA. (1) Same as for SNA Retail Holdings

___
Maximum (12)

(c) How to add value to a rights issue

• The price should be incentive to take up the issue, ie lower than current price. (2)
• The option to purchase more shares in future can be linked to a additional right (1)
Maximum (2)
(d) Calculation of the cost of capital

1. Ordinary shares

Cost: Ke = Kf +  (Rm - Rf)


= 10,5 + 2,4(5)
= 22,5% (2)

2. Preference shares

Cost : 11% - given (1)

Value: R1 each, R150m (16 703 000+ 133 693 000) (1)
254 TOE408-W/1
ZAC408-H/1
3. Convertible debentures

Cost: 9 384 / (R47 189 + 85 505 + 47 189 + 98 758) / 2) x 2 (2)

Convertible debenture interest / average book value

= 13,47%
= 13,5%

Value: Book value R80,551m (1)

4. Interest bearing debt

Cost: (70 760 - 9 384) / (879 430 + 670 028) / 2 (2)

Interest paid / average interest bearing debt

= 15,84%

Value: Book value R380,6 m (1)

Cots of capital

V C Weight Average
Ordinary cap 227,6 (1) 0,225 0,271 ,061
Pref cap 150,0 0,110 0,179 ,012
Debentures 80,5 0,135 0,096 ,013
Debt 380,6 0,158 0,454 ,072
838,7 1,000 ,158
(1) (1)
WACC 15,8%
Maximum (10)
Note

Tax not taken account of, as the company will not pay tax for a number of years; the effective
cost is therefore the interest cost. (1)
255 TOE408-W/1
ZAC408-H/1
Alternative

V C Weight Average
Ordinary cap 800,0(2) 0,225 0 ,567 0,128
Pref cap 150,0 0,110 0,106 0,012
Debentures 80,5 0,135 0,057 0,008
Debt 380,6 0,158 0,270 0,043
1 411,1 1,000 0,191
(1) (2)

WACC 19,1%
Maximum (10)
(e) Continuance of the health-related division

Risk factors:
• Currently loss-making (increase risk) (1)
• How correct is 24 month forecast (if too optimistic – increase risk) (1)
• Medical inflation high (increase risk) (1)
• Overcrowded market (a lot of medical aid schemes) (increase risk) (1)
• State cannot provide health-care (decrease risk) (1)
• State can prescribe procedures (increase risk) (1)
• Those that can afford, privatise (if in upper-market - decrease risk) (1)
• HIV will grow market (decrease risk) (1)
• HIV could change future, make estimate more complex (increase risk)
• Flight of intellectual capital (staff) (increase risk) (1)

Should it continue?
• It is a high risk sector, but could also provide high return if well managed (1)
• It is not a current core business, but can link to the financial services-division (1)
• Due to current difficulties and it not being a core business, selling should be
considered, else trade with care (1)
Maximum (5)

QUESTION 38 - Suggested solution

Report format

(a) Analysis of the company

• Refer to the analysis for detailed information. (1)

• Clothing companies performed best. (1)

• Electronics section in decline, but biscuits fairly stable. (1)

• Zimbabwe operations negative growth taking inflation into account. (1)


256 TOE408-W/1
ZAC408-H/1

• Impact of Zimbabwe on rand values not as severe as the exchange rate does not reflect the
inflation difference. (1)

• Botswana showed a high growth in Rand terms due to strengthening of the pula. (1)

• Sales in terms of asset low, are the assets used effectively? (1)

• Current ratios very high, due to: (1)

high stock levels (1)

debtors outstanding for many days, especially in South Africa.

• Gearing reasonable - although clothing companies very low. (1)

• Dividend yields lower than comparative industries. (1)

• P/E ratio high, taking into account the electronics section. (1)

• All dividends declared by subsidiaries do not flow through the group. (1)

• Additional share capital raised during the year. (1)

• No retention of profit in Zimbabwe to cater for growth - taking money out due to inflation. (1)

• Growth lower than for top 40 companies - this is to be expected as Holdme does not fall into
this category. (1)

(b) Chairmans statement

• Chairman correct in his statements, does not per se imply an excellent year. (1)

• No major improvement in profit before tax ratios. (1)

• Increase in share price lower than market growth, although assessment in terms of P/E very
reasonable (refer clothing industry 8 and biscuits 11). (2)

Strategic goals

• Focus on doubling turnover may be a problem. (1)

• This will not ensure financial viability. (1)

• Shareholder value must be defined: share price growth plus dividends, EVA or another
measurement standard. (1)

• Company may be too diversified - does electronics fit in with food and clothing. (1)
Maximum (20)
257 TOE408-W/1
ZAC408-H/1
Analysis

Group
Rand Inflation
Value Adj
Growth rates (%)
Sales 12 6 (1)
Profit after tax 22 15 (1)
Dividend 25 22 (1)
Share price 30 22 (1)
Top 40 index 34 26 (1)

2001 2000
Earnings per share 64,7 57,3 (1)
P/E ratio 14 12 (1)
Dividend cover 3,0 3,2 (1)
Dividend yield 2,3% 2,6% (1)

Subsidiaries in Rand terms


Botswana Zimbabwe
2001 2000 2001 2000
Turnover 180 131 165 148 (1)
Profit after tax 43,1 29,4 54,6 43,6 (1)
Dividends 21 14,4 54,6 43,6 (1)

Electronics
2001 2000
Turnover 51 75 (1)
Profit after tax (35,4) (22,6) (1)
Note: Dividends declared by subsidiaries
exceed group dividends (1)

Product
Biscuits
Growth rates (%) Local Botswana
RV IA PV IA RV
Sales 12 6 10 9 37 (2)
Profit after tax 11 5 17 16 47 (2)

Clothing
Growth rates (%) Local Zimbabwe
RV IA ZV IA RV
Sales 16 10 59 (20) 12 (2)
Profit after tax 22 15 78 (11) 25 (2)
258 TOE408-W/1
ZAC408-H/1
Balance sheet
Biscuits Clothing
Group Local Bots Local Zim
2001 2000 2001 2001 2001 2001
Sales/Total assets 0,65 0,68 0,49 0,74 0,53 0,95 (2)
PBT/Total assets (%) 15,5 14,8 17,5 25,5 16,2 52,6 (2)
PBT/Sales (%) 23,9 22,0 35,7 34,2 30,6 55,1 (2)
Current ratio 1,92 2,04 1,0 2,27 2,14 1,86 (2)
Sales/Stock 2,14 2,22 2,80 2,55 2,57 4,58 (2)
Debtors days 63 67 104 55 162 88 (2)
Gearing 0,85 0,85 0,39 0,97 0 0,10 (2)

Expected return

Return on top 40: (8 963 - 6 712)/6 712 + 4%


= 37,5% (1)

CAPM = 11,5 + 1,32 (37,5 - 11,5)


= 45,8% (1)

Delivered = 30% + 2,3%


= 32,3% (1)

Gap/shortfall = 13,5% (1)


Maximum (25)

QUESTION 39 - Suggested solution

TRANSACTION 1

1(a) Financial implications

Earnings per share 264m ÷ 220m


= 120 cps (½)

Cover
∴ Dividend per share = 30 cps (½)

Acceptance level 85%


∴ Scrip shares to be issued
= (220 000 000 x R0,30) x 85% ÷ (9,00 x 95%) (1)
= 56 100 000 ÷ 8,55
= 6 561 404 shares (1)

Process

• Declaration date, offer choice (½)


259 TOE408-W/1
ZAC408-H/1
220 m x R0,30 = R66m

Dt Dividend payable 66 000 000


Cr Provision for dividend 66 000 000 (1)

• Last date to register (½)

Record shareholders and their choice (½)


Determine acceptance: require specific cash instruction (½)

• Date of payment (½)

Issue cheques and share certificates (1)

Dt Provision for dividend 9 900 000


Cr Bank 9 900 000 (1)
(15% x R66m)
Dt Provision for dividend 56 100 000
Cr Share account 6 561 404
Cr Share premium account 49 538 596 (2)
Maximum (9)

Mistakes made by students in answering the question:

Dividend process
Few students knew the process steps: from declaration, approval, acceptance, and effect to
eventual payment/issue of certificates

Accounting entries
Accounting entries were a mess and a vast number of students treated the dividend payment as a
dividend received and the issue of shares as a decrease in capital.

Financial implications
This focussed on the dividend to be paid and its flow into the capitalisation offer. The following
errors were made:

• incorrect profit base used


• share capital was substituted for profit
• incorrect discount was applied

(b) Sell all fractions and pay cash to relevant shareholders (1)

Structure the scrip offer so that no fractions come about i.e. a minimum shareholding is required
to qualify for the offer. (1)
(2)
260 TOE408-W/1
ZAC408-H/1

Mistakes made by students in answering the question:

Fractions

Students did not make practical recommendations, these included:

• cancel fractions
• keep a register of fractions
• write fractions off against profit/share premium

General

Students spent unnecessary time dealing with the ramifications of STC, which was not
required.

TRANSACTION 2
R R

Projects to be funded 37 650 000 (1)


Equity required 100/160 23 531 250 (1)
Earnings before tax 41 300 000
Tax 28% 11 564 000
Earnings available 29 736 000 (1)
Maximum available for dividend 6 204 750
(3)

TRANSACTION 3

ROE = Return on equity


NPAT = Net profit after tax
S = Sales
NA = Net assets
E = Equity
NPAT S NA
1999 ROE = S x NA x E
1 100 27 140 5 320
= 27 140 x (12 240 – 6 920) x 2 460
= 0,04 x 5,10 x 2,16
= 0,447 or 44,7% (2)
[With full decimals 45,2%]

(920) 29 500 5 920


2000 ROE = 29 500 x 5 920 x (2 230)
= (0,03) x 4,98 x (2,65)
= 0,41 or 41% (2)
[With full decimals 41,25%]
261 TOE408-W/1
ZAC408-H/1
The return for 2000, shown as positive, is misleading as the company made a loss for the year and
now has negative capital. It requires a capital injection and should be avoided. (2)
(6)

Comment
It was quite possible to obtain good marks without an application of the du Pont-model by merely
considering and discussing the financials given. The catch was that by applying du Pont, the
negatives resulted in a positive answer, which was clearly not viable.

TRANSACTION 4

•Attempt to use friendly means to persuade the bidder to drop the offer (e.g. an invitation to join
the board). (1)
• Urge shareholders to refuse the offer by pointing out its downside or criticising the payment
terms. (1)
• Endeavour to increase the market value of the Celtec’s shares to make them more expensive
to Teltex by for instance disclosing favourable information. (1)
• Eliminate surplus cash, or increase borrowings, acquire another business, pay a special
dividend or commit to a major new project.* (1)
• Sell an asset to generate surplus cash for the above purposes.* (1)
• Persuade another company, whom management prefers to Teltex (a white knight) to make a
higher counter offer. (1)
• Make a counter offer to take over the Teltex (the so-called pac-man defense). (1)
• Issue options/shares/convertible securities to friendly parties.* (1)
• Consider a defensive merger or takeover.* (1)
• Consider “scorched earth” strategies such as heavy salary increases for employees.* (1)
• Management could make a counter offer via a leveraged buyout. (1)
* The strategies marked with an asterisk may only be implemented with the approval of the existing
shareholders. __
Maximum (6)

TRANSACTION 5

MV Weight Cost Weighted


Average

Ordinary shares 72 000 0,72 13,73 9,89 (1)


Preference shares 8 000 0,08 12,50 1,00 (1)
Long-term debt 20 000 0,20 9,45 1,89 (1)
100 000 1,00 12,78

Workings

1. Ordinary shares MV = 30 000 ÷ 2 x 4,8


= R72 000 (½)

2. Preference shares MV = 10 000 ÷ 0,125 x 0,10 = R 8 000 (½)

D1
3. Ordinary shares cost = P + g
262 TOE408-W/1
ZAC408-H/1
0,35 x 1,06
= 4,80 + 0,06
= 0,0773 + 0,06
= 13,73% (1½)

4. Long-term loan cost = 13,5 x 0,70


= 9,45% (½)
(6)

TRANSACTION 6

(a) Workings

R75m ÷ 0,31 = 241 935 000 shares (½)

Earnings R’m
∴ Current profit (x 0,035) = 8,468 (½)
Adjustment for loss 2,612 (½)
Adjustment for interest 9,25
(R75m x 100 x ½) 3,469 (½)
14,549

Other
Per share (R14,549 000÷ 241 935 000) 6,0c (½)
Increase (6c - 3,5c) ÷ 3,5c 71% (½)

Asset value
R’m
Current value (241 935 000 x R0,80) 193,548 (½)
Net increase (+R75m - R56m) 19,000 (½)
212,548 (½)

Other
New value per share R212 548 000 ÷ 241 935 000) 87,85c (½)
Increase (88c – 80c) ÷ 80c 10% (½)
(5)
∴ Completed table

Per Gosport Before the trans- After the trans- %


ordinary share action: cent per action: cent per share increase
share

Earnings 3,80 6,0 71


Net asset value 80,00 88,0 10

(b) Impact on Fashion

• Cash decreases by R75m and assets increase by R56m (1)


• Intangible assets (goodwill) of R19m created (1)
263 TOE408-W/1
ZAC408-H/1
Impact on Gosport

• Assets increase with a net R19 m (1)


• Debt/equity ratio may change by utilizing the cash (1)
Maximum (3)

QUESTION 40 - Suggested solution

Part I

Target debt/equity ratio Woodchip Sawmilling Mega Mix

Fixed assets 25 800 70 600


Net current assets 43 500 138 900
69 300 209 500 (2)

Interest free loan (49 700) (118 000) 167 700


Interest bearing loan 0 (153 000) 153 000
Interdivisional loan 21 167 (21 167)
Therefore, accumulated (profit)/loss (40 767) 82 667 320 700 (2)

Interdivisional loan restructured, transferred to interest free loan. Restated balance


sheets therefore:
Woodchip Sawmilling Mega Mix

Fixed assets 25 800 70 600


Net current assets 43 500 138 900
69 300 209 500
Accumulated profits/(losses) 40 767 (82 667)
Interest free loan 28 533 139 167 167 700
Interest bearing loan 0 153 000 153 000
69 300 209 500 320 700 (2)
Equity = accumulated profits/losses + interest free loan

Allocation of interest free and interest bearing loans to based on net assets:

Net assets 69 300 209 500

Divided into:
Debt 23 100 69 833 (2)
Equity 46 200 139 667 92 933 (2)
69 300 209 500
Equity further divided into:
Accumulated profits/(losses) 40 767 (82 667)
Interest free loan, therefore 5 433 222 334 227 767 (2)
46 200 139 667 320 700
264 TOE408-W/1
ZAC408-H/1
Journal entries required to effect re-gearing:

Accounting records of Woodchip:


Dr Cr
Group interest free loan 21 167
Interdivisional loan 21 167 (1)
Group interest free loan 23 100
Interest bearing loan 23 100 (1)

Accounting records of Sawmilling:


Dr Cr
Interdivisional loan 21 167
Group interest free loan 21 167 (1)
Interest bearing debt 83 167
Group interest free loan 83 167 (1)
Accounting records of Mega Mix Ltd

Interest free loan to Woodchip and Sawmilling divisions 60 067


Interest bearing loan 60 067 (1)
Maximum (12)
Part II

Operating Profit

• System is easy to understand and management’s targets are clear. (1)


• Key issue is whether management will be able to influence budgeted profit (could set
themselves easy targets or be demotivated by unrealistic targets). (1)
• Setting targets annually is also problematic as it induces negotiation between divisions
and head office. (1)
• Major problem with the scheme is its simplistic focus on profit targets. There is no
cognisance of assets controlled or cash utilised by divisions. Hence, the scheme
encourages divergence between management and shareholder aspirations (2)
• Ignores the cost of capital. (1)
• Encourages short-term decision making to achieve annual budget instead of long-term
wealth creation for both management and shareholders. (1)
• Cap on bonus amounts appears unfairly weighted in favour of the company. The
quantum of basic salaries becomes a critical issue to all managers since the more they
earn, the higher the potential bonus. There is no incentive to over achieve – managers
may slack off once targets are reached. (2)

Potential effectiveness of scheme: (1)

• High level of agency costs given management’s focus on short term profits versus
shareholders’ objective of long term wealth creation/increase in company value.
• Insufficient leverage to take unpopular decisions and risks given limited upside in (1)
bonuses.
• Good people are likely to leave. (1)
• Scheme’s major advantage is that it is easy to understand and implement. (1)
Conclusion – inappropriate scheme. (1)
Maximum (7)
265 TOE408-W/1
ZAC408-H/1
RONA

• Forces managers to focus on asset utilisation.


• Interest is taken into account in calculation of returns generated.
• Encourages short-term behavior, managers may be loath to embark on long-term capital
investment projects.
• The value of assets under management’s control becomes a major issue. Divisions with
fully depreciated assets are better placed to achieve RONA targets.
• Annual targets are problematic. Managers may write off assets and create provisions to
benefit their subsequent year’s performance.
• Cap on bonus payments discourages management from significantly exceeding targets.
• Quantum of basic salaries is a matter of extreme importance. Managers will strive to
obtain high basic salaries instead of generating superior returns for shareholders.
• Does not take into account the company’s cost of capital.
• Ignores absolute value – refers only to targets.

Potential effectiveness of scheme:

• As with Operating Profit scheme, encourages short-term behavior instead of long-term


enhancement of shareholder value.
• Only advantage over Operating Profit scheme is the focus on balance sheet in addition
to profits.
1 each, maximum: (7)
SHARE OPTIONS

• Upfront award penalises the rising stars in the organisation.


• Salaries are of critical importance to managers – encourages high fixed employment
costs.
• There is no link between “bonus” to individuals and divisions performance.
• Tax consequences of options are severe.
• Share price performance is beyond the control of managers and they may be
penalised in event of bearish equity markets.
• The timing of granting of options is critical. Managers are favoured if upon receipt of
options the share price is depressed (more options).
• Managers may become obsessed with share price movements – encourages action
to boost share price.
• Provide employees with a sense of ownership.
• Promotes long service from employees who wait to exercise options.
• May encourage under performing employees to stay and overachievers to seek
greener pastures given length of time before reaping rewards.

Potential effectiveness of scheme:

• Certainly aligns shareholder and managers interests assuming an efficient equity


market.
• Major downfall is the absence of performance targets.
Conclusion: Inappropriate scheme on its own but may be an affective scheme in conjunction
with a performance based scheme.
1 each, maximum: (8)
266 TOE408-W/1
ZAC408-H/1

EVA

• Aligns shareholder and management interests by incorporating holistic measures and


targets.
• Incorporates cost of capital.
• Unlimited upside for managers in achieving bonuses whilst not penalising
shareholders
• 20% pool debatable, however, managers have less at risk than shareholders.
• Bonus bank encourages longer term view by managers – may act as golden
handcuffs.
• 5 year EVA targets means no annual negotiations.
• Encourages management to reduce cost of capital and ensure business is
appropriately capitalised.
• 4% annual growth in EVA means that management is incentivised to recover,
following a bad year.
• Complicated scheme in administering and defining parameters.
• Fluctuating macro-economic factors may adversely impact on EVA in the short term –
varying cost of capital.
Potential effectiveness of scheme:

• Forces managers to take decisive action in disposing of non-productive assets.


• Potential effectiveness could be influenced by the 4% target - is 4% an appropriate
target given SA’s inflation and interest rates?
• Conclusion: Most appropriate scheme.
1 each, maximum: (11)

QUESTION 41 - Suggested solution

(a) Issues to consider

This question was very poorly answered in the QE exams and a similar question in the near
future seems likely, especially as the disclosure requirements & GAAP regulations relating to
share options recently changed.

The question originally included two questions relating to the accounting treatment of share
options as well, but this was omitted here due to the changes in the GAAP requirements. The
general information and audit procedures are, however, still considered relevant today.

The question needs to be approached with a fair amount of logic and practical knowledge of
the topic. It would be in a student’s best interest to keep up to date with new articles and
discussions published by SAICA in the ‘Accountancy SA’.

• Share options are supposed to align managers’ interests with those of shareholders.
Since shareholders’ lose when the share price falls, it may be inappropriate to
completely insulate management from the effects of the fall. (2)
• It may be argued that repricing rewards management for poor share price
performance. (1)
267 TOE408-W/1
ZAC408-H/1

• Shareholders may be doubly disadvantaged by a decision to reprice executive share


options:
1. the value of the shareholders’ investment has declined as a result of the decline in
the share price and (1)
2. future earnings attributable to the shareholders are likely to be diluted by the
issuance of price (at the money) options. (1)

• In order to enhance governance and to reduce perceptions of the board unduly


favouring the executive directors, the board should consider whether the repricing
decision should be put to the shareholders for approval. (1)
• Repricing could possibly result in management owning options with a similar fair value
to those which are cancelled, rather than owning the same number of options. This
causes management to suffer some loss, but still to have the incentive of an at-the-
money option. (1)
• The board should consider what the appropriate exercise price should be for reprice
options, that is, should the options be exercisable at the current market price or should
they still be somewhat out of the money so that the executives bear some of the loss
associated with the share price decline. (1)
• The board should consider whether all of the executives should participate in a
repricing programme. If a particular executive has performed excellently or poorly, it
may be appropriate to take that into account in terms of the number and exercise price
of reprice options awarded to that person. (2)
• If employee share options are deep out of the money, the motivational aspects and
remuneration aspects of the option no longer exist and staff may leave if the options
are not repriced. (1)
• Listed companies should provide complete disclosure of the terms of the share option
scheme, including proposed revised terms. (1)
• Listed companies should consider the cause of the decline in Peace-of-Mind’s share
price. It is likely to be more appropriate to reprice options when the decline is the
result of a general decline in the market or the sector and Peace-of-Mind has
outperformed the relevant market or sector than when the decline is a result of specific
actions and decisions of management. (2)
• The board of directors should consider the possible negative publicity which may arise
from a decision to reprice options and the additional impact that such publicity may
have on the share price. (1)
Maximum (12)

(b) Audit procedures

It is fairly easy to combine management accounting and auditing questions. Use your
general knowledge of audit techniques to answer this question successfully. Take time to
consider the given information and use this information in your solution.

• Read the share option scheme rules and agree the disclosed terms to the rules. (1)
• Read the share option trust deed and agree the disclosed terms to the rules. (1)
• Agree the loan to the share purchase trust and to the share option trust trial balance. (1)
• Inspect the board resolutions recommending the allocation of share options and agree
the terms to the rules and to the amount of the loan. (1)
• Inspect the resolution of the trustees of the share option trust authorising the issue of
share options and agree the terms to the rules and to the amount of the loan. (1)
268 TOE408-W/1
ZAC408-H/1

• Recalculate the amount of interest expense in accordance with the rules of the share
option scheme. (1)
• Inspect the shareholders’ register to verify the number of shares held by the trust. (1)
• Agree the year-end share price to the published price at year end and recalculate the
impairment of the loan to the share option trust. (1)
• Inspect the statutory documentation associated with the issue of shares to the trust
during the period. (1)
Maximum (8)

QUESTION 42 - Suggested solution

(a) Advantages/disadvantages

This is a fairly easy question and a proper theoretical knowledge of hedging instruments,
especially definitions, advantages and disadvantages, should enable a student to do well.
Remember that American options = close any time,
and European options = close on expiry.
Know the difference between a put option: the right to sell, and a call option: the right to
buy, as well as between a future contract: formal, exchange traded standardised instrument,
and a forward contract: an over-the-counter instrument.

Advantages

1. American put option Disadvantages

1. Can exercise the option any 1. Immediate cash outflow to pay premium
point up to 31 January 2002, will put pressure on the liquidity of Outtel
i.e. can time the market for Ltd. (1)
best exercise date. (1) 2. Most expensive of the 4 instruments
(upfront). (1)
2. Retain upside potential while 3. Only hedges downside risk below 9 700
hedging the downside potential points, ie still unhedged for first '300 basis
below the strike price (inherent points' (R3 000 000). (1) (4)
in options). (1)

2. European put option

1. Retain upside potential while 1. Can only exercise option on expiry date
hedging the downside potential (15 Feb 2002) which is post the debt
below the strike price repayment date, i.e. may cause interim
(inherent in options). (1) funding problems. (1)
2. Cheaper than the American 2. Immediate cash outflow to pay premium
option. (1) will put pressure on the liquidity of Outtel
Ltd. (1)
3. Only hedges downside risk below 9 800
points, ie still unhedged for first '200 basis
points' (R2 000 000). (1) (4)
269 TOE408-W/1
ZAC408-H/1
3. Futures contract

1. No upfront cash outflow. (1) 1. Sacrificed upside potential to hedge


2. Complete certainty about downside risk. (1)
liquidation value, i.e. 100% 2. Daily mark-to-market which may require (4)
hedge. (1) cash outflows and put pressure on the
3. Formal, exchange traded liquidity of Outtel Ltd. (1)
instrument, i.e. settlement
guaranteed by the clearing-
house. (1)

4. Forward contract

1. Better priced than future, i.e. 1. As an over-the-counter instrument,


strike price of 10 500 com- exposed to counterparty (credit)
pared to 10 375 for future risk, i.e. counterparty may default.
contract. (1) (1)
2. No upfront cash outflow. (1) 2. Sacrificed upside potential to hedge
3. Complete certainty about downside risk. (1) (4)
liquidation value, i.e. 100% (16)
hedge. (1)

(b) Liquidation value

Instrument Liquidation value Net value


R
American option Will not exercise option , i.e. 9 750*R10 000-R8m
premium 89 500 000
(2)
European option Will exercise option, i.e. 9 800*R10 000-R5m
premium 93 000 000
(2)
Future Effective liquidation at 10 375 points 103 750 000
(2)
Forward Effective liquidation at 10 500 points 105 000 000
(2)
(8)
(c) Control sheet

Auditing often focuses on addressing specific risks. Managerial Finance wishes to


improve shareholder wealth by maximising cash inflow or minimizing risks. The two topics
are therefore frequently linked, and risk identification is a popular QE topic. It is important
to work through integrated questions and to consider the inter-relatedness of various
topics in order to prepare effectively for these questions.
270 TOE408-W/1
ZAC408-H/1

Concern Control Impact

1. Transaction Segregation of duties in front office, Transactions can only be executed


duplication i.e. dealers allocated to specific by specific treasury desk/dealer to
desk only, eg FX, money market, prevent duplications. (1)
capital markets, etc.

Clear responsibilities / mandates All similar transactions to be


approved for all treasury staff. executed by same person to prevent
duplications. (1)

2. Unhedged All business units must be obliged to A consolidated view of risk for entire
exposure report financial risk exposures to the company is essential to ensure net
central treasury (even if they decide exposure is within the Board's limits.
not to hedge). (1)
Institute a formal middle office A middle office will have monitored
function to monitor risks. the net exposure to the company
against limits. (1)

3. Ineffective Only authorised / approved deriva- Limiting the use of complex


hedge tive instruments may be used. derivatives will prevent unanti-
cipated exposures. (1)

All derivative structures to be Independent review of all complex


approved by treasury middle office structures will prevent unanticipated
and/or financial director. exposures. (1)

4. Counter- Authorised counterparties and limits. This will prevent Outtel Ltd being
party risk exposed to banks with low
creditworthiness. (1)

Guidelines for use of OTC Once counterparty limits are


instruments versus formal reached, exchange traded
instruments. (OTC is exposed to derivatives should be used to
counterparty risk, while formal is prevent further credit risk. (1)
guaranteed by the clearinghouse
of the exchange.)

5. Regulatory All treasury staff should be trained Once treasury staff is know-
contra- on regulatory compliance. ledgeable of regulatory issues, non-
vention compliance should disappear. (1)

A compliance officer should be A compliance officer can ensure on


appointed to monitor compliance. an ongoing basis that all regulatory
requirements are being met.

All treasury accounting policies Approved accounting policies will


should be reviewed and approved ensure the correct accounting
by the external auditors and then treatment is followed. (1)
followed.
271 TOE408-W/1
ZAC408-H/1

6. Bearer in- All bearer instruments should be Bearer instruments are like cash
struments controlled as ‘cash’, i.e. extensive and controls similar to cash controls (1)
control procedures put in place. will prevent theft.

Bearer instruments should prefer- Banks have sophisticated systems


ably be kept in safe keeping by a to control bearer instruments and is
reputable bank. used by most market participants. (1)

7. Disregard Disciplinary procedures should be Strict disciplinary procedures should


of autho- drafted and approved. All staff serve to encourage staff to act
rity should be trained. within their mandate and
instructions. (1)

Staff disobeying instructions, should Strict action against violations will


receive formal warnings, i.e. strict enforce compliance.
action should be taken against (1)
anyone deliberately disregarding
authority.

8. Absence Formal contingency plans should be Proper contingency planning will


created and tested to ensure all prevent or limit system failure and
important eventualities can be dealt treasury downtime. (1)
with.

Treasury trading hours should be The treasury should be available


defined and strictly enforced, i.e. the during the entire trading day to deal
treasury desks should be manned with any unexpected market moves. (1)
during this period.

A back-up trading location should be This will ensure that the treasury
secured, eg access to a bank’s can operate even in the event of (1)
trading desk or a friendly corporate. physical or system disasters.
Maximum (1)
(16)

) (d) Interest rate swap


)
) A detailed knowledge and practical experience of hedging instruments will only be tested
in part 2 of the QE exam. A relatively theoretical discussion of swaps should have
awarded students a pass mark on this section of the question.

Should the forecast forward JIBAR rates materialise, the average floating rate on a
nominal basis for the period will be 10% [(8%+9%+11%+12%)/4]. (1)

This equals the interest rate that can be locked in by entering into the fixed-for-floating
rate swap. (1)
272 TOE408-W/1
ZAC408-H/1
However under the 90-day JIBAR, rates start off lower and increase over time. Due to the
time value of money, the effective interest rate on the floating rate loan will therefore be (1)
lower than the one-year fixed-for-floating rate swap.

Therefore, under the assumption that the forecast 90-day JIBAR rates materialise, it will (1)
be cheaper not to enter into the one-year fixed-for-floating rate swap agreement.
However, this is only a market forecast of expected future rates. Should interest rates go
up faster than forecast, the effective floating interest rate will quickly exceed the one-year (1)
fixed-for-floating rate swap.

Outtel Ltd should make two decisions:

1. Is it prepared to carry the interest rate risk on a floating rate loan? If not, enter into (1)
the one-year fixed-for-floating rate swap.
2. Does it agree with the market forecast of interest rates? If not and the company (1)
believes rates will rise faster, enter into the one-year fixed-for-floating swap. (5)
Maximum

QUESTION 43 - Suggested solution

(a) Borrowing cost

The effective all inclusive annual borrowing cost must be calculated based on the cost
incurred in Rand terms and include:
• interest (semi-annual) and
• the increase in the loan amount due to the devaluation of the Rand.

1997 R

Initial loan amount @ R4,60 16 100 000

Interest
- January to June 1997 ($3,5m x 11% x 4,55 x 6/12) 875 875 (1)
- July to December 1997 (÷ 4,55 x 4,90) 943 250 (1)
Devaluation (increased loan amount)(16,1m ÷ 4,60 x 4,90) 1 050 000 (1)
2 869 125

Therefore, effective annual interest rate (2 869 125/16 100 000) 17,82% (1)

1998 R

Opening loan balance (16 100 000 + 1 050 000) 17 150 000

Interest
- January to June 1998 ($3,5m x 11% x 6,30 x 6/12) 1 212 750 (1)
- July to December 1998 (÷ 6,30 x 6,00) 1 155 000 (1)
Devaluation ($3,5m x 6,00 - R17,150m) 3 850 000 (1)
6 217 750

Effective annual interest rate 36,26% (1)


(8)
273 TOE408-W/1
ZAC408-H/1
(b) Assessment of exposure

Exam technique (presentation) is very important to answer any question well! Here your
answer should have been prepared in report format to obtain three easy marks.

Report format (3)

Definition of risks

• Interest rate risk is the risk that the value of a financial instrument will fluctuate due to the
changes in market interest rates. (1)

• Currency risk is the risk that the value of a financial instrument will fluctuate due to
changes in foreign exchange rates. (1)

• Liquidity risk is the risk that the company cannot meet its financial obligations when they
fall due. (1)
(3)

Assessment of exposure

Assessment of FRA Ltd’s exposure to interest rate risk: low/none

• The interest on the loan from Case Bank is fixed for the duration of the loan hence there

is no exposure to interest rate risk. (1)

• In addition, the company has no other interest bearing debt. (1)

Assessment of exposure to currency risk : high

• FRA Ltd is highly exposed to currency risk evidenced by the loss on translation of the
Case loan. (1)

•• 1997 R1,05 million loss


•• 1998 R3,85 million loss

• The Rand depreciated against the US$ by 6,5% in 1997 and 22,4% in 1998. (1)

• The effect of future adverse currency movements can be illustrated as follows:

Devaluation of Rand against $ in 1999 Loss incurred by FRA Ltd


(R’000)
10% (R6,60) 2,100 ([R6,60 – R6,00] * $3,5m)
20% (R7,20) 4,200 ([R7,20 – R6,00] * $3,5m)
30% (R7,80) 6,300 ([R7,80 – R6,00] * $3,5m) (2)

• FRA Ltd’s exposure to currency risk is high particularly given 1998 profit before interest
of R4,3 million. It follows that FRA Ltd may incur losses in 1999 given the interest
burden and potential foreign currency translation losses. (2)
274 TOE408-W/1
ZAC408-H/1
Assessment of exposure to liquidity risk : moderate

• Gearing levels (interest bearing debt to equity ratio)

•• 1997 92,9% (17 150 / 18 455)


•• 1998 103,6% (21 000 / 20 267) (1)

• Interest cover ratios

•• 1997 4,3 times


•• 1998 2,4 times (1)

• FRA Ltd’s ability to repay foreign loan is dependent on the company generating sufficient
cash flow and/or raising further debt or equity. Net borrowings of R17,5 million (R21m –
R3,5 m cash) needs to be repaid over the next 3 years. (1)

• Given the 1998 financial results, namely:

•• increase in cash resources of R0,7 million;


•• profit after tax of R1,6 million; and
•• the nature of FRA Ltd’s business i.e. manufacturing (not usually cash generative if
high capex), it would appear unlikely that FRA Ltd will generate sufficient cash to
repay the Case loan. (2)

• FRA Ltd’s exposure to liquidity risk is assessed to be moderate for the abovementioned
reasons. (1)

• FRA Ltd has used long-term finance to fund expansion which also reduces the risk. (1)
Maximum (11)
Suggestions to minimise risks

Suggestions to minimise currency risk

• Obtain forward cover on interest payments and loan repayments. (1)


• Attempt to increase export turnover. (1)
• Consider replacing foreign debt with local loans. (1)
• Repay part of foreign loan utilising current cash resources of R3,5 million. (1)
• Consider swapping Case loan with South African corporates which have significant
export businesses. (1)

Suggestions to minimise liquidity risk

• Consider recapitalising the business through an equity injection or selling off surplus
assets. (1)
• Consider replacing Case loan with local debt. (1)
• Examine asset base i.e. consider sale and leaseback of land and buildings (longer term
finance). (1)
(8)
275 TOE408-W/1
ZAC408-H/1
(c) Replacement of foreign loan

Compare the two options taking FRA Ltd’s specific circumstances into account. Think of the
spread of payments, term, cost of each and the risks that the two options expose the company
to.

• Comparison of terms:
Case Bank BE Bank

Term remaining from 01/07/1999 30 months 33 months (1)


Interest rate 11% fixed 23% variable (1)
Security Cession of debtors ? (1)

• Given FRA Ltd’s limited export business (R3,1 million turnover in 1998; R0,8 million in
gross profit), it is advisable to limit currency risk. (1)

• The effective all-inclusive interest cost of the Case loan was higher than local borrowings
in 1998, another reason to convert to local borrowings. (1)

• It may be argued that the Rand has strengthened against the $ in the last 6 months and
hence retain the foreign loan. (1)

• Recommendation, however, is to replace the Case loan with a loan from BE Bank given
FRA Ltd’s stated policy of accepting a moderate risk profile. (1)
(7)

QUESTION 44 - Suggested solution

This is an excellent question that tests a wide variety of topics, is on par with the level required by
SAICA for QE1 and awards the student an opportunity to achieve marks for both theory and
practical implications. The principles addressed here must be clearly understood.

Query 1

The question clearly leads you to calculate what dividend needs to be paid to achieve the sector
yield. The number of marks allocated to the question indicates that more information is required,
and therefore it would also be appropriate to calculate Higro’s current yield and to give advice (as
requested) as to how the change may be effected.

EPS = 215,345 ÷ 195,7685 = 110 cps (1)


Historic cover (6) ∴ dps = 18,3 cps (1)
Price = 900 cps
∴ Yield = 2% (1)
4,5% yield requires 40,5 cps (1)
∴ cover of 110/40,5 = 2,7 times (2)
∴ decrease historical cover (1)
276 TOE408-W/1
ZAC408-H/1
Alternatives could be to

lower share price or (1)


achieve higher earnings, (1)
but these options are not under such direct control as dividend cover. (1)
Maximum (7)

Query 2

Here you need to consider the practical implications of a company buying its own shares, i.e.
• what will happen to the number of issued shares? (it is reduced);
• how does this affect key indicators (such as EPS and market price);
• how will payment be made (less cash; changed NAV);
• what becomes of the shares? (Company Act implications of treasury stock).

Consequences:
• cash reduced (1)
• share price stabilized (1)
• net asset value will change (less cash, but also less shares) (1)

Shares bought back, can be

cancelled (1)
EPS ↑ (½)
Dividend ↑ per (assuming total R dividend remains the same) (½)
Share price ↑ (company value unchanged, less shares in issue) (1)

held

lesser impact on price (although treasury stock may not vote or receive dividends) (1)
Maximum (5)
Query 3

Consider whether management would be incentivised by the current share scheme, whether the
new scheme would be more favourable and how “regular’ shareholders are likely to react to a
proposed change.

• Scheme price R15, current price R9; negative impact for management. (1)
• If pure option scheme, options will be lapsed (not exercised) as no value (exercise price exceeds
market price). (1)
• If shares issued to scheme with an associated loan and management refuses to exercise options,
value of loan will have to be written down (impaired) (1)
with a consequent loss in the income statement of R180m ([R15 – R9] x 3m). (1)
• Replacement of existing scheme with new scheme at R10, may raise ethical issues (1)
regarding favouritism of management versus treatment of other shareholders. (1)
• Shareholder approval of the new scheme should be obtained before implementation. (1)
Maximum (5)
277 TOE408-W/1
ZAC408-H/1
Query 4

The question, although at first sight apparently complex, is in fact a straight forward ratio analysis and
a valuation question.

For profitability calculations, for instance, work with the limited information given. Ratios such as the
gross and net profit percentages, return on total assets, total asset turnover and so forth may have
been calculated. Although a limited number of options is given in the solution, all valid ratios were in
fact marked in the exams.

For the valuation a number of techniques could be applied, including the net asset value method, the
earnings yield model and an adapted free cash flow model (assuming a certain cost of capital). This
abbreviated way of testing valuation principles is very popular for examinations and also very useful in
a practical scenario.

(a) Profitability SnP Multipac


Gross profit Rm 50 80
Gross profit % (50/620) 8,1 (80/200) 40,0 (1)
Net profit Rm 20 30
Net profit % (20/620) 3,2 (30/200) 15,0 (1)
Growth % 15,0 25,0 (1)
Return on total assets % (20/170) 11,8 (30/220) 13,6 (1)

Capital investment

Net asset value (equity) Rm 90 160 (1)


Plant and equipment 25 110 (1)
Investment type Working capital Non-current
Assets (1)

Liquidity
Cash held Rm 100 10 (1)
Current ratio (145:80) 1,8 (110:60) 1,8 (1)
Sales type Cash Credit (1)
Interest cover Interest earning Low interest
paid (1)
Maximum (9)
(b) Valuation

Net asset value Rm 90 160 (1)

Net profit Rm 20 30 (1)


Depreciation (+) (25/5) 5 (110/5) 22 (1)
Cash generated 25 52 (1)
278 TOE408-W/1
ZAC408-H/1

Cash valuation (assume any


cost of capital):
20 30 25 52
90, 160 @ say 0,225 0,188 111 227 (1)

Profit valuation
(minimum = profit x 3) 60 90 (1)
Profit valuation
(@ Higro P/E 8) 160 240 (2)
Average 110 165 (1)
(8)

Query 5

Consider all the implications of an overseas loan, such as cost, inflation, currency risk and appropriate
use of the loan, in your answer. A good theoretical background will stand you in good stead here.

• Period is long @ deterioration of currency (currency risk). (1)


• Interest of 6% lower than local rates. (1)
• Effective rate with currency weakening may be higher. (1)
• Interest differential in future. (1)
• Hedging of currency (cost, availability). (1)
• Cash flows required/available to pay loan and interest. (2)
• What are the uses for the loan? (1)
• Is there possibility of USA take-over to act as hedge? (1)
Maximum (6)

QUESTION 45 - Suggested solution

(a) INCOME STATEMENT FOR THE YEAR ENDED 30 NOVEMBER 2001

Calculation Rm
Sales 120,0
Cost of sales (105,0)
Operating profit (R120m x 0,125) 15,0 (1)
Interest paid (R8 000’ x 0,1 + R4 000’ x 0,12) (1,28) (½)
Pre-tax profit 13,72
Taxation (R13,72m x 0,3) (4,12) (½)
Profits attributable to ordinary 9,6
shareholders (Given) (3,75) (½)
Dividends 5,85
Retained earnings
279 TOE408-W/1
ZAC408-H/1
INCOME STATEMENT FOR THE YEAR ENDING 30 NOVEMBER 2002

Calculation Rm
Sales (R120m x 1,30) 156,0 (½)
Cost of sales (R156m x 0,82 + R5m) (132,92) (1)
Operating profit 23,08
Interest paid (Unchanged) (1,28) (½)
Pre-tax profit 21,80
Taxation (R21,80 x 0,3) (6,54) (½)
Profits attributable to ordinary shareholders 15,26
Dividends (R3,75m x 1,1) (4,13) (½)
Retained earnings 11,13

BALANCE SHEET AS AT 30 NOVEMBER 2002

Calculation Rm
Non-current assets (R45m - R5m) 40 (½)
Net current assets 22,13 (½)
Inventory (R20m x 1,3) 26,00 (½)
Debtors (R5m x 1,3) 6,50 (½)
Cash (Balancing figure) 20,83 (½)
Current assets 53,33
Current liabilities
Trade creditors (R24m x 1,3) (31,2) (½)

_____
62,13

Issued ordinary share capital 8,0 (½)


Retained income (R31m + R11,13m) 42,13 (1)
Shareholders’ funds 50,13
Debentures (10%) 8,0
Bank loan (12%) 4,0
62,13 ___
(10)

(b) Performance and financial health

For all ratio analysis questions, it is important to use similar ratios to enable meaningful
comparisons to be made. Comparisons may be made to previous years’ information, budgets,
norms, competitors and industry averages.
In this question you therefore had to calculate ratios for DiamondDesign that could be compared
to its major competitor. Most of the information and calculations were given, making this a fairly
easy question to answer, the only ‘catch’ being that the 2001 year’s information had to be used,
and not the 2002 forecast.
Always ensure that you understand what the ratios mean, as the discussion thereof is quite
frequently more important than the calculations!
280 TOE408-W/1
ZAC408-H/1

The table below compares DiamondDesign Ltd’s ratios with those of its major competitor:

Competitor DiamondDesign
Ltd
Return on (long-term) capital employed 15% 15/51 = 29% (1)
Return on equity 12,8% 9,6/39 = 24,6% (1)
Operating profit margin 10% 12,5% (given)
Current ratio 1,25:1 30/24 = 1,25:1 (1)
Acid test 1,1:1 10/24 = 0,4:1 (1)
Gearing (total debt/equity) 33% 12/39 = 31% (1)
Interest cover 6,0 15/1,28 = 11,7 (1)
Dividend cover 3,0 9,6/3,75 = 2,56 (1)

• DiamondDesign Ltd’s profitability, in terms of ROCE, ROE and the operating profit margin
compares very favourably with that of its major competitor. The ROCE might be inflated by the
use of a historic cost base, insofar as assets have never been revalued, but although a
revaluation might depress ROCE, the company appears attractive compared to its peers.

• The net profit margin of 12,5% is above that of the major competitor, suggesting a cost
advantage either in production, distribution or administration. Alternatively, it may be that
DiamondDesign Ltd operates in a market niche with a strong brand name, and is able to charge
premium prices. (2)

• The greatest differential lies in the return on equity, which is almost twice that of the competitor.
This seems to be a consequence of the higher operating profit margin, because even with the
financial gearing for DiamondDesign Ltd almost matching that of the competitor, there is still a
high level of interest cover. (1)

• Set against the apparently strong profitability is DiamondDesign Ltd’s current poor level of
liquidity. The acid-test ratio is well below that of the competitor, but in moving to internet selling,
liquidity should improve, as one would expect the cash collection to coincide with orders and so
cash balances to be consequently larger. (1)

• The forecast balance sheet for 30 November 2002 which shows a cash balance of over R20
million compared with just R5 million the preceding year, is indicative of increased liquidity. (1)

• Re-calculating the acid test ratio for November 2002, it works out at 0,88:1. This ratio is close to
that of the major competitor, and suggest that the financial year ending November 2002 is a
critical one for improving the liquidity of DiamondDesign Ltd. (1)

• Present borrowings are all long-term. The debenture is due for repayment within the next two
years, but this is unlikely to put a strain on liquidity since the growth in sales should generate
cash, and there is currently no demand for cash for capital investment purposes. The balance
sheet for the year ended 30 November 2002 indicates that there is more than sufficient cash to
redeem the debenture after just one year. (2)

• Gearing is almost equal to that of the competitor, but DiamondDesign Ltd retains a relatively high
level of interest cover, which suggests that there is scope for additional borrowing if required.
Maximum (12)
281 TOE408-W/1
ZAC408-H/1
(c) Expansion and rights issue

The rights issue is planned for 2003, and therefore the 2002 forecast must be used to calculate
the market capitalisation (number of shares x share price or value of the company) and price
per share. Prior to the rights issue there will not yet be any dilution of the eps or market price
ps.

(i) Earnings for year ending 30 November 2002: R15,26m


PE ratio: 8
Market capitalisation = 8 x 15,26 = R122,08 million (1)
There are currently 16 million shares in issue, so this gives a price per share of
R122,08/16 = R7,63 per share. (1)
(2)

(ii) Issue 2 million shares on a 1 for 8 basis. (1)


Already in issue 16 million, therefore total shares in issue post rights equals 18 million.
Issue price per share = 0,75 (R7,63) = R5,72 per share (1)
This means the sum raised by the issue is R11,45 million.
Theoretical ex-rights price is therefore:

R122,08 + R11,45 million/18 million = R7,42 (1)


Maximum (3)

(iii) The share price might be higher than the theoretical ex-rights price for a number of
reasons including:

- an increase in the company’s forecast earnings if the new website proves particularly
successful at generating sales; (1)
- a high positive NPV for the investment; (1)
- a rise in the projected ROCE in response to a successful joint venture agreement
with a US company; (1)
- a general rise in the stock market, or shares in this sector. (1)
Maximum (3)
(iv) Effect on gearing:

For a discussion on gearing, bear the following in mind:


• Gearing refers to the amount of debt introduced into the capital structure of a
company.
• Gearing normally helps to increase return on equity as
- debt is cheaper than equity because
* the cost of debt is tax deductible
* debt is often secured over the assets of the company
* specific payment dates are set for interest and capital repayments
* in case of liquidation, debt is satisfied (if possible) before any payments
are made to shareholders.
- more financing enables a company to grow or expand more quickly than if
only equity (own funds) were used.
• Gearing therefore helps to reduce a company’s cost of capital, at least up to a
critical point, where the introduction of more debt increases the financial risk of the
company to such an extent that the suppliers of capital insist on higher
compensation.
282 TOE408-W/1
ZAC408-H/1
• Gearing increases the financial risk (ie the risk of non-payment) of a company.

Now consider for this question, how an increase in equity, because of the rights issue,
will affect the capital structure and cost of capital of the company.

• The rights issue will clearly work to reduce the gearing of DiamondDesign Ltd to very
low levels. The sum raised by the issue is almost equal to the current level of total
debt. This may seem to be a good thing insofar as it appears to reduce the risk to
shareholders, but it will also serve to slow down the rate of growth of returns to
equity which are likely to accompany business expansion. (2)

• The cost of debt is generally accepted as being lower than the cost of equity, and so
the weighted cost of capital of a moderately geared company tends to be below that
of a low geared company. After the rights issue, the level of gearing in
DiamondDesign Ltd will be very low, so that by introducing a reasonable level of
new borrowing, it may be possible to reduce the cost of capital. The forecast
balance sheet suggests that there is scope to do this, particularly as the company
currently has no short term borrowing at all.

• The lower cost of capital which would result from increased gearing would then
serve to increase the profit attributable to shareholders, thereby increasing the
return on equity. It may be that the managers of DiamondDesign Ltd are very risk
averse, and it is for this reason that they have opted for low financial gearing. Even
so, they should note that gearing can work to the benefit of shareholders in a
company such as Diamond Design Ltd, where interest cover is high, and sales and
profits are rising.
(2)
Maximum (6)
(d) Benefits

• Ability to obtain finance at a lower rate than would be possible by borrowing directly. (1)

• Opportunity to effectively restructure the capital profile without physically redeeming debt.

• Long-term hedging against interest rate movements (roll-over facility). (1)

• Ability to access a type of finance which may otherwise not be possible due to: (1)

lack of track record (1)


low credit rating. (1)
Maximum (3)

(e) The management of risk associated with foreign trade will depend upon the nature of the risk:

• Commercial risk is risk that the client will not pay or will only pay after the due date. It
may be managed by: (1)

Credit screening prior to the contract being signed. This might include formal credit
evaluation through a credit agency, use of information from trade associations,
government databases, bank references or trace references. (2)
283 TOE408-W/1
ZAC408-H/1
The terms of sale. Some terms of sale involve much less risk than others. Most
secure (but not common) is cash in advance. Others, in order of increasing risk
include cash on delivery, documentary letter of credit, bills of exchange and an open
account. (2)

The method of payment. The quicker and more secure the method of payment, the
lower the risk. Extremes range from secure electronic funds transfer to sending a
cheque in the post. (1)

Insurance against non-payment or late payment. (The Credit Guarantee


scheme.) (1)

• Physical risk, the risk of damage or theft in transit is best managed through insurance
cover.
(1)
• Political risk is risk of non-payment or late payment as a result of the actions of a foreign
government, eg through the introduction of exchange controls, tariffs or quotas. (1)

• Cultural risk is risk associated with different cultures, ways of doing business, attitude to
religion, colours, gender etc. In order to reduce such risk thorough research of the local
market, culture and business practices should be undertaken prior to trading. (2)
Maximum (6)

(f) Other risk factors and possible hedges include:

As mentioned in previous questions, risk identification is a favourite topic for QE and other
exam questions.

Think logically, consider normal business and financial risks, and read through the given
information carefully. The risks are mostly already mentioned there – just use what is given.

The following common risk factors may always be considered, and then applied to the
question, if appropriate:

• Limited capital • Industry specifics


• Limited resources - Growing/declining market
- Capacity - Competition
- Materials - International markets
- Skilled labour - Government action
- Hours available • General economic indicators
- Management experience • Financial results
• Union action - Past results
• Company specifics - Qualified audit reports
- Age - Growth
- Location - Losses
- Nature of business - Debt/equity ratios
284 TOE408-W/1
ZAC408-H/1
• Commodities risk - change in raw material prices (gold, platinum, diamonds) will impact on
pricing (1)
 denominate prices in foreign currency. (1)
• Theft of valuable stock (1)
 security arrangements (premises, mail). (1)
• Skilled staff leaving (1)
 Incentives to stay (bonus, travel) (1)
• Products not moving (1)
 Fashion research, shows, design on order, branding (2)
• Economic downturn (1)
 Marketing investment value (1)
Maximum (5)

QUESTION 46 - Suggested solution

This question, at 75 marks, may seem daunting at first. However, when broken down into its
subsections, it actually becomes quite manageable and the single case study may in fact be less
time-consuming than two shorter questions. It is, however, very important to read the question (what
is ‘required’) before the case study, to know what to look out for, and a planned and organised
approach to this question is absolutely essential.

(a) Risk identification

Risk identification is an important part of a financial manager’s task. Please refer to part (f) of
the previous question for a detail discussion of possible risks to consider. Please use the
information given in the question – there is no need to thumbsuck the possible risk factors!

Business strategy
- Major changes in strategy have its own risks. The investment in modernisation of
saw mills (R300 million) represents a major risk of destruction of shareholder
value if it does not result in the expected benefits. (2)
- Change in marketing focus from local sales to offshore represents a fundamental
shift. Related risks are numerous, however, key risk is the inability to
effectively penetrate new market. (2)
- Local market is declining, therefore, if export sales do not materialise, Atlas
could be in serious trouble. (2)
- The company operates in a commodity industry that is globally competitive.
Product pricing is highly sensitive to external forces. By changing marketing
focus and investing in modernisation programme, the company is compounding
these risks. (2)
Maximum (6)
Plant & machinery
- Risk of selecting inappropriate technology or investing in equipment that will be
made technologically redundant in the next 5 years. (1)
- Plant & machinery will probably be imported and hence, risk of Rand
devaluation. (1)
- Implementation risks (machinery does not work as planned, retraining operators,
disruptions to existing operations, underestimating time to implement, etc). (2)
- Ongoing maintenance and servicing of new equipment (access to appropriate
technicians? sourcing parts?) (1)
285 TOE408-W/1
ZAC408-H/1
- Current plant and machinery delivers wood that is inferior in comparison to that
of international competitors. (1)

Marketing focus
- Penetrating offshore markets from SA base is notoriously difficult. (1)
- Risk of selecting inappropriate resellers/sales channel partners in US. US
represent 50 different states that are in effect, 50 different markets. (1)
- Loss of local sales due to focus on offshore markets. (1)
- Not understanding US market and susceptibility to vagaries of this market. What
are future drivers of demand for sawn wood in the US? (2)
- Increased investment in working capital due to longer delivery times,
warehousing of buffer stocks, and so forth. (1)
- Increased risk of bad debts due to dealing with new customers in new territories. (1)

Logistics
- New systems required (Cost thereof? Management of supply chain). (2)
- Risk of increasing shipping costs. (1)

People issues
- Ability of existing senior management and employees to cope with change and
new processes/technology. (2)
- Impact on morale due to planned retrenchments? (1)
- Ability of company to retrain existing employees? (1)
- New CEO and FD create stress amongst management and employees. Coupled
with changing strategies creates uncertainty and affects productivity. (2)
- Risk of loss of key people? (1)
- Risk of strike action following announcement of retrenchments. (1)
- The company is currently labour intensive and therefore very vulnerable
to union action. (1)

Raw materials
- Access to lumber going forward is critical. The company has a major competitive
advantage by owning its own plantations (low cost by world standards). Growing
production may place strain on reserves and sourcing of quality lumber
(including 25% from other growers) is a key risk. (3)
- Large-scale forest fires could have a devastating impact on business given
higher volumes and export focus. (1)
- What impact will environmental issues have on the company? (1)
- Trees are only felled after 28 years. This is a very long term investment, and
costs are only recovered when related products are sold. (1)

IT, MIS and accounting systems


- Inappropriate systems for future. Investment in new systems represents a risk in
itself. (1)
- Commerce security risks relating to suppliers wanting to access supply chain
and requiring real time info. (2)
286 TOE408-W/1
ZAC408-H/1

Gearing/financial risks
- Strategy is to produce in a soft currency and sell in a hard currency – if rand
strengthens everything changes. (3)
- Could be argued that gearing is not high however, asset cover ratio's (excluding
plantations) may indicate greatly increased risk. (1)
- Financial projections are estimates! Should forecasts not be achieved there
could be a major risk of debt default. (2)
Maximum (16)

(b) Financial projections

Gearing 2001 2002 2003 2004 2005


Interest bearing debt 0 116 234 234 942 252 173 222 212
Shareholders' funds 483 960 487 878 491 263 498 126 512 659
Debt to equity ratio 0% 24% 48% 51% 43% (1)

Debt to equity ratio appears reasonable rising to a maximum of 51% in 2004. The (1)
treatment of shareholder loans is critical to this ratio, and banks will want some comfort
on the repayment terms of the loan. (2)

EBIT (EBITDA –
Depreciation) 26 533 32 519 49 773 76 868 123 653
Interest paid 201 8 136 28 737 34 098 33 207
Interest cover ratio N/A 4,0 1,7 2,3 3,7 (2)

Interest cover ratio appears less favourable over time, worsening to 1,7 times in 2003.
Consider the treatment of redundancy costs – adding it back may improve the
ratio slightly. (1)
Banks may be concerned over this ratio particularly in 2003 and 2004. Given the higher
level of depreciation, the cash interest cover ratio may be more appropriate. (1)

Cash flow from


operations 28 424 49 604 72 965 104 595 152 951
Interest paid 201 8 136 28 737 34 098 33 207
Cash interest cover N/A 6,1 2,5 3,1 4,6 (3)

Ratio appears reasonable. Banks may insist on no dividends being paid to


improve cash flows or permit deferred repayments of capital? (1)
Maximum (6)

Return on equity 2001 2002 2003 2004 2005


Profit after tax 16 901 15 672 13 540 27 451 58 133
Shareholders' funds 483 960 487 878 491 263 498 126 512 659
ROE 3,5% 3,2% 2,8% 5,5% 11,3% (2)

Average shareholders' funds 485 919 489 570 494 694 505 392
Adjusted ROE 3,2% 2,8% 5,5% 11,5% (3)
287 TOE408-W/1
ZAC408-H/1
ROE % in 2001 is low by any standard. Increase to 11,5% in 2005 represents a
significant increase, however, the company's risk profile is significantly higher given the (2)
capex programme and focus on global markets.

Major contributor to poor ROE ratios are forest plantation investments which are funded
by shareholders. Removal of this asset from balance sheet would significantly improve
ratios, however, leave Atlas at a strategic disadvantage in terms of access to raw (2)
materials.
Treatment of redundancy costs? Should cost of changing strategy be included in profit (1)
after tax? (5)
Maximum
Income statement performance
When Income Statements are used to judge the performance of a company, it is
appropriate to calculate the growth or decline on a year-to-year basis. Significant
trends will thus come to light.

2001 2002 2003 2004 2005


Increase in Rand value of
export sales 65% 80% 74% 40%
Change in Rand value of
domestic sales -3% -10% -2% 0%
Increase in Rand value of
total sales 11% 17% 33% 24%
Increase in sales volume (units) 7% 7% 19% 12%
Exports/total sales (R) 20% 30% 46% 60% 68%

- Export sales increase in line with plan and as a % of sales (R) increase to more
than 60% due to higher prices achieved. (1)
- Average sales price per cubic metre for exports seems reasonable given
devaluation of Rand and higher grade product being exported. In fact, export
sales prices seem too conservative. (1)
- Local sales decrease in volume terms in line with deteriorating market
conditions. Sales prices are also under pressure. (1)
- Sales volume increases are in line with increased production. (1)

2001 2002 2003 2004 2005


Logistics costs/gross sales 16% 18% 20% 23% 23% (1)

Logistical costs increase significantly, due to increased exports.

2001 2002 2003 2004 2005


Gross profit % (Gross profit/
Sales) 52% 51% 50% 49% 50% (1)
- GP % seems high for a commodity business. Should the ratio be based on net
sales or gross sales? (1)
- Raw materials start at 33% of Gross Sales and fall by 1% per annum to 28% in
2005. (1)
GP ratio decreases over time due to higher logistics costs and limited/no gains in
raw material usage ratios. (1)

(1)
288 TOE408-W/1
ZAC408-H/1
Increase in employment costs -3% -3% 8% 8%

- Retrenchments planned in 2002 and 2003 (20% of workforce?) gives a 11% (8% (2)
annual increase +3%) gain.
- Increase in labour costs seems reasonable.
EBITDA/Gross sales 10,0% 12,6% 19,4% 20,6% 23,2% (2)
EBIT/Gross sales 7,9% 8,7% 11,3% 13,1% 17,0% (1)
- Above ratios indicate a significant improvement in efficiency in the business.
Interest expense and depreciation increase in line with capex & increased borrowings. (1)
Maximum (10)

Cash flows 2001 2002 2003 2004 2005

EBITDA 33 893 47 379 85 258 120 478 168 513


Change in working capital ? -10 954 -5 713 -7 864 -16 987
Add back change in cash
position -5 638 13 179 -6 580 -8 019 1 426 (2)
Cash generated from opera-
tions 28 424 49 604 72 965 104 595 152 952 (1)

Increases in net working capital investment due to sales growth and export activities. (1)

Annual increase in cash generated from


operations 75% 47% 43% 46% (1)

- these increases are due to greater production and sales volumes.


- increased cash flow is required to fund repayment of debt and for investment in
capacity.

Gross sales 337 378 374 741 440 070 585 000 727 000
Net working capital exclu-
ding cash 38 159 35 934 48 227 64 110 79 671

Gross sales/net working capital 8,8 10,4 9,1 9,1 9,1


(2)
- Investment in working capital is increasing. This makes sense given sales growth
and longer lead times in global markets and buffer stocks. If anything, it may be
too light!
(2)
Capital expenditure funded using medium term debt.
(2)
The net cash position is still positive even after paying dividends!
Maximum (1)
(9)
289 TOE408-W/1
ZAC408-H/1
(c) Should modernisation be approved?

Arguments for investment


- Current predicament of supplying declining local market and not being able to
compete in international markets requires immediate strategic attention. The
company has to do something to improve its positioning and take advantage of its
competitive edge of having access to low cost, high quality plantations. (2)
- New CEO and FD have extensive international experience and should be
supported in their endeavours. (2)
- Increasing export sales will place Atlas in a strong position locally and globally. (1)
- Financial projections in the business plan seem conservative, and the capex can
easily be funded. (2)
- Investment is worth the risk given the potential enhancement in shareholder value
and current predicament of business. (2)

Arguments against investment


- Changing focus to penetrate offshore markets is very risky and "easier said than
done". Plan may be overly ambitious. (2)
- Financial risk associated with plan is extremely high. Perhaps the company should
consider selling off plantations to fund some of the expansion. (1)
- Atlas operates in a commodity industry where selling prices are dictated by forces
beyond its control. Plan does not take this into consideration. (2)
- ROE after change in focus and modernisation is still too low. Reason is the large
investment in plantations and capital structure of balance sheet. (2)
- Cannot approve the plan until sensitivity analysis is done and independent
consultants are engaged to review plan. The company is planning to invest R300
million! (1)
- Asset turnover is low, meaning that returns are generated in prices/margins in a
commodity business = high risk! (3)
Any recommendation accepted provided this is supported by valid arguments. (1)
Maximum (9)

(d) Local vs foreign debt

The question doesn’t specifically give any exchange rate or forecasts of the movement in the
exchange rate.

However, currently the selling price in US$ per m3 for the best saw-mill is $110, and the average
price for the company’s three saw-mills is R807 per m3 . This gives an approximate exchange
rate of $1 = R7,34.

Furthermore, future clients in international markets will be invoiced in dollar. The rise in selling
prices in Rand predicted (from R815 to R1 450) therefore indicates that the Rand will devaluate
against the US dollar.

To be conservative, the future exchange rate is therefore predicted to change from 9 to 12 over
the next four years.
290 TOE408-W/1
ZAC408-H/1
- Proposed capex = R300 million, around US$ 41 million (R300/7,3) currently.
Plant is to be imported. (1)
- Volume of export sales? R000 US $000 Exchange rate?

2002 112 597 12 511 9,00


2003 202 170 20 217 10,00
2004 351 000 31 909 11,00
2005 493 000 41 083 12,00 (2)

- Are export sales of sufficient volume to cover the risk of US$ denominated loans?
Could it be a natural hedge? (2)
- Raising loans in Rands versus US$ should cost the same given the devaluation of
the Rand over time. Argument is that the Rand devalues by the inflation
differential to the US? (1)
- SA is an emerging market and risk of Rand devaluation due to negative sentiment
against such economies is a huge risk. (1)
- Forward cover costs are significant. (1)
- Offshore bank’s covenant terms may be harsher than that of SA banks given the
former's view on value of forest plantations and land tenure issues. (2)
- Export sales are only plans at present – are there signed orders? If export sales
do not materialise then Atlas will have significant risk. (1)
Maximum (8)

(e) Proposal to pay dividends

- Dividend policy proposed is to pay 75% of after tax profits as dividends (1)
- Wisdom of paying dividends where the company's gearing increases significantly
should be questioned . (1)
- It would be preferable to reduce gearing as opposed to paying dividends. (1)
- The tax efficiency of paying STC on dividends should be considered. Perhaps
shareholder loans need to be repaid instead. (1)
- Need to investigate the most tax efficient way of distributing "income" to London
based controlling shareholder. Double tax agreements, withholding tax on
dividends? Interest versus dividends? (2)
(6)
291 TOE408-W/1
ZAC408-H/1
QUESTION 47 - Suggested solution

(a) Risks

Use the information given in the case study – the risks are all already mentioned there. You
need to list these risks and consider logical ways of mitigating them.

Main risks Possible impact Action


BUSINESS
The company’s product is a Losses may be suffered if Prices may be fixed with future
commodity. Sales prices selling prices change, contracts.
are often determined by leading to redundancies or
external forces. even closure.
The company is planning to Level of interest in this type Seek advice as to market
list. A risk exists regarding of business may influence perception of this type of business
the actual quality of assets reporting of assets and and evaluate likely success of
and profits. profits. listing.
Conversion of owner/ Management do not have Review strength of board of
Managed entrepreneurial the depth of expertise to directors, acknowledge deficien-
business to listed public handle change and shift in cies and recruit appropriate
company requirements directors/ management
FINANCIAL
High growth has been Low profits would not Build forecasts of profits based on
experienced – can it be support interest in listing. product life cycle evaluation for
continued / is the 30% years after listing.
prediction truly attainable?
Management view of profits Profit disclosed to date has Perform due diligence on profit
may be influenced by the been overstated. quality and impact of incentive
basis of bonus and share schemes.
option calculations.
The company may have Gearing of the company This may be a reason for listing.
liquidity and currency and currency exposure will Plan to hedge $ exposure. Build
exposures arising from the affect risk profile negatively. cash flow forecasts.
$ loan and repayment
terms.
Royalty agreement pay- Accounting estimates as per Quantify as best as possible.
ments could be AC 130 may affect financial
understated. statements.
LEGAL
Impact of existing litigation Going concern problem may Clear resolution action plan.
on continuing access to arise. Check impact of lack of access to
right to use patent. patents.
Compliance with Compa- Will inhibit listing process. Penalties could damage
nies Act, given process for reputation and potential auditor
entering into contracts. qualifications may exist.
292 TOE408-W/1
ZAC408-H/1
GOVERNANCE
Company does not yet Listing will be difficult and Consult with external auditors and
have an appropriate shareholders’ perceptions set up an appropriate system
system of corporate may be damaged. asap.
governance.
Timing of reporting and S293 – year-end of Change Argentinean company
differing year ends of subsidiaries should be the year-end.
Steelco Ltd to its same as the holding
Argentinean subsidiary. company.
Attitude to Corporate Perception of management Introduce improved standards and
Governance given example style will negatively affect rectify current projects. Disclose
of building contract the listing. directors’ interests in contracts.
problems
Management approach to Control consciousness: Attend to deficiencies in control
internal controls, evidenced potential impact on profita- environment.
in scrap metal (verbal bility.
agreements, no formal
records, clearing note).
INFORMATION SYSTEMS
The stability of the new
computer system and the Data conversion problems, Post implementation review,
quality of financial infor- misstatements of results, follow up financial audit, and
mation reported. training of staff on the provide training plan.
system, loss of revenue
from inability to conduct
busi-ness.
Internet link may create Inappropriate and unautho- Review security standards.
security exposure. rised access to confidential
data.
Will production and supply Inability to sustain growth to Clear business plan for focus on
logistics support access to business. selected markets. Development of
global markets? personnel to be able to effectively
respond and match production
planning.
Security and reliability of Quality and reliability of Introduce adequate IT strategy
the new IT system. reporting information. and processes.
OPERATIONAL
Language and other issues Foreign operation could Develop clear strategy for
related to management of distract local business, management of Argentinean
foreign operation. produce poor profitability, subsidiary.
drain SA company.

__
1 mark for each of the above-mentioned Maximum (20)
293 TOE408-W/1
ZAC408-H/1
(b)

Weaknesses Recommendations
Segregation of duties is lacking as Jack Hammer should record scrap produced and sign,
Hammer is in total control of contracting, authorising the volumes.
accounting and selling the scrap metal.
No records are kept of scrap metal Introduce daily measures of scrap generated as a
produced and on hand. production report.
No control exists over scrap metal Volumes/weight confirmed by Hammer to be
leaving the premises, as goods are not agreed to weigh bridge on leaving. Security to
independently checked against review and agree.
supporting documentation.
No delivery notes stating quantities and Introduce weight/volume-based delivery notes.
weight sold are issued.
No procedures appear to exist for Invoicing to be completed by accounts office.
following up on outstanding invoices.
No management control or review over Management reporting to include scrap targets and
scrap metal. monitor daily/weekly/monthly.
The contract with the scrap merchant Directors to review new contracts annually and to
has not been authorised by confirm existing contracts.
management.
No budgetary information is prepared to Introduce management reporting on scrap
monitor scrap volumes produced, percentages related to production. Has a direct
especially as tin has a high value. profit impact.

__
1 mark for each of the above-mentioned Maximum (10)
(c)

Adequacy of procedures Action


COMPANIES ACT
The contract may not be valid as the director Directors to pass additional resolution
should have declared his interest in the contract acknowledging interest and approving contract.
– s234.
This declaration should have been minuted – Record in minutes of directors’ meeting.
s240.
The declaration should have been recorded in Register of directors’ interests in contracts to be
the register of directors’ interests in contracts – prepared and reviewed at each meeting.
s239.
The financial director may not have been Excuse himself from meeting where the contract
entitled to vote at the meeting depending on the is discussed.
Articles of Association.
A quorum, in terms of common law, is defined Directors need to pass a resolution
as a quorum without a self interest – the acknowledging interest and approving contract.
directors’ meeting was not valid, and the
awarding of the contract is ultra vires (but not
void) – s36.
294 TOE408-W/1
ZAC408-H/1
CODE OF CONDUCT
As a CA(SA) the financial director has to comply Bring this to the attention of the financial
with the Code of Professional Conduct. director.
According to the Code a member must appear Possible censure by board of directors.
to be free of any relationship which might Depending on the disciplinary action to be
obstruct their ability to be objective. taken, they could report to SAICA.
The financial director’s actions could be seen as Bring to the attention of managing director.
potentially bringing the profession into disrepute. Depending on the disciplinary action to be
taken, they could report to SAICA.
CORPORATE GOVERNANCE
Directors have a duty of loyalty towards their
company and must therefore avoid conflicts of
interest.
King Code of Corporate Governance Code does not apply to unlisted companies, but
recommends that the directors act at all times in will affect listing process.
the best interest of the company.
The financial director did not disclose his Censure of financial director.
interest in the contract. He could be seen to
have misled the other directors.

__
1 mark for each of the above-mentioned Maximum (10)

QUESTION 48 - Suggested solution

PART A

(a) Liquidity risk

Liquidity risk refers to the risk of not being able to satisfy liabilities as they become due. This
includes both capital and interest payments. To discuss the liquidity risk of the fund it would
therefore be sensible to prepare a small cash flow projection to see whether or not the
company may indeed be exposed to the possibility of not being able to meet its commitments.
As the cash flow projection is for internal use, the internal view of interest rates was used.

A simple cash flow projection highlights the significant liquidity shortfall that is awaiting
the trust to service and shortly repay its debt. The fund only has enough cash to cover (1)
the next 6 months’ interest. (1)

Cash flows (Rm) 31 Dec 31 March 30 June 30 Sep


2000 2001 2001 2001

Interest (internal view) (W1) -20 -20,6 -21,3 -21,5 (2)


Capital repayment -500,0 (½)
Cash available 40,0 20,0 -0,6 -21,9 (½)
Liquidity surplus/(shortfall) 20,0 -0,6 -21,9 -543,4 (1)

W1. 500 (variable rate loan) x (14 + 2%) x 3/12


295 TOE408-W/1
ZAC408-H/1
The liquid funds are unlikely to increase dramatically from dividends:
• dividend payout ratios are extremely low and have been declining over the last
few years (1)
• most of the companies on the NASDAQ are high growth companies and retain
most of their earnings to finance growth (ie no dividends). (1)

(Note: Some may comment that the fund will also have an inflow from new investors,
ie positive cash flows. The information does not clarify whether this is a close-ended (1)
or open-ended investment trust. The problem with these cash flows are that they’re
unpredictable, unstable and closely linked to sentiment – the fund cannot rely on it to
meet its cash flows). (1)

Theoretically, all the shares in the portfolio are highly liquid (they are listed if they
appear in the NASDAQ index and listed shares are normally quite liquid) and can
therefore be sold quickly to obtain cash. The reality however is: (1)

• the fund may be forced to liquidate shares at a time when the market is at a (1)
short term low (ie the fund will realise losses);
• liquidating shares may destroy the 90% correlation that the fund is
required to maintain; (1)
• the NASDAQ is not as liquid as the Dow Jones, etc. due to the nature of the
companies listed on it and it is also more volatile. There is actually a
small risk that the fund may not be able to liquidate an adequate number of
shares quickly enough. (1)
Maximum (12)

(b) A written/sold option alone cannot be used as an effective hedge, as it has an


unlimited downside component. (It can only be used as a partial hedge or as part of a (1)
combined derivative structure that achieves the desired hedge position.) (1)

Two types of written/sold options exist, neither of which achieves a hedged position (1)
with limited downside as required:
• Sell a call option (1)
• Sell a put option (1)

The correct approach to hedge the downside is to buy a put option: (1)
• The downside is limited to the premium paid for the option, while most of the (1)
upside is retained (the only portion given away is the premium paid). (1)
Maximum (5)
296 TOE408-W/1
ZAC408-H/1

(c) Foreign exchange risk

To answer this question, consider the following:


• Is the fund exposed to exchange rate risk?
→ Yes, as all of its assets are listed in USD
→ Its liabilities are Rand denominated
→ A change in the exchange rate may significantly affect earnings and
asset values
→ It currently has no hedging
• Do you think hedging is required?
→ Probably, as an exchange rate change may significantly change the
asset values of the Fund.
• What kind of hedging is appropriate?
→ try to eliminate the risk that the Rand may strengthen
→ try to do so as cheaply as possible
→ keep in mind the company’s “high risk, high return” philosophy.

Assessing the risk:

• The fund has a large currency risk exposure as all its assets are denominated in USD
and all its funds in ZAR . (1)

• The research report about the ZAR being undervalued highlights the risk that if the
ZAR strengthens against the USD in the future, the fund will suffer large currency
losses. (1)

• Some may say that this risk is small as the ZAR never strengthens. This is a (1)
subjective opinion and not based on any fundamental risk analysis. (1)
297 TOE408-W/1
ZAC408-H/1

What can the USNE fund do to reduce its currency risk?

• A number of derivative instruments can be used. The question is what is most (1)
appropriate for the risk profile of the fund. It is a high risk fund and a large portion its
high returns reported during the last 3 years were probably due to FX profits from the
devaluation of the rand. (1)
• The selected derivative should therefore reduce or limit the downside while retaining (1)
some upside potential (otherwise the fund may not meet its high return objectives). (1)
• Instruments such as (long term) FX futures and forwards as well as forward exchange
contracts are therefore not appropriate. They give away both the upside and the
downside, in exchange for price certainty. (1)
• The fund can also replace its ZAR loans with dollar denominated loans, ie (1)
eliminate FX risk completely. This has the same problem as discussed above –
eliminates the opportunity of the fund to benefit from depreciation in the rand. (1)
• The solution is therefore an FX option (buy a put option on the USD – the right to sell
USD at a fixed exchange rate for ZAR, even if the rand strengthens). This is the same
as a call option on the ZAR (the right to buy ZAR at a fixed exchange rate for USD). (1)
• The problem is that options have an upfront cash outflow in the form of the premium (1)
that will reduce the return and worsen the cash flow situation. (1)
• The fund can eliminate/reduce the option cost by simultaneously buying put options on
the ZAR and selling call options with a higher strike price. They therefore ‘buy’ (1)
downside insurance by giving a way a portion of, but not all, the upside potential. (1)
Maximum (13)

(d) • Cash outflows: Certain derivatives such as options require upfront cash flows (the pre-
premium) that may not be available. (1)
• No perfect hedge: The derivative seldom achieves a perfect hedge, eg the portfolio is
compiled to track the NASDAQ 90%, while a NASDAQ option will track it 100%. The
10% difference can still equate to a material unhedged exposure. (1)
• Not the same maturity: Derivatives are often not available for the same period as the
underlying position (typically only available for shorter periods). This requires deriva-
tives to be continuously rolled. This creates liquidity risk in that bid-ask spreads may
open on the expiry date making the roll-over more expensive. (2)

• Market liquidity: A lack of market liquidity may prevent the trust from liquidating the
derivative position when an expected risk or threat has abated. (1)
• Credit risk: Over-the-counter derivatives carry the same credit risk as the issuer
(writer, counterparty). If the counterparty fails the derivative has no value (even though
it may have a market value). Exchange traded derivatives are guaranteed by the
exchange clearinghouse. (2)
Maximum (5)
298 TOE408-W/1
ZAC408-H/1

PART B

Type of information Rationale

This clarifies the type of hedge that was put in


1. Is it a put or a call option? (1) place: (1)
• A put option gives Millenium the right to sell
platinum at a certain price (eg should the
international platinum price fall). (1)
• A call option gives Millenium the right to buy
platinum at a certain price (eg to buy- in
platinum to meet future commitments if own
production is too low). (1)

2. Is it an OTC (over the counter) or a A formal option (traded on a formal ex-change,


formal option? (1) eg SAFEX) is typically guaranteed by the
exchange, ie fairly low credit risk. The credit risk
of an OTC option depends on the counterparty. (2)

3. If it is an OTC option, who is the The counterparty determines the credit risk of
counterparty? (1) the option. It is of no value if the option is in the
money on expiry date and yet the counterparty
defaults. (1)

4. What was the upfront cash premium The upfront premium is typically sizeable and
that was paid to buy the option? (1) represents a cash outflow to the company, ie it
(Is there a daily mark-to-market and has cash flow implications. (1)
settlement process?) The same applies if there’s a daily settlement
involved.

5. In what currency is the option is If the option is not denominated in US dollar, the
denominated? (1) company is still exposed to currency risk. (1)

6. What is the current market value of the The market value indicates whether the option is
option? (1) currently in the money or out, ie to date has the
hedge created or lost value? (1)
Some indication of how it changes with a The delta indicates how effective and complete
change in the international platinum price the option is, ie does it cover 100% of price
of platinum (the delta of the option). (1) movements, more or less? (1)

7. The hedging strategy of the company.(1) Knowing this enables shareholders to evaluate
the potential upside and downside of the (1)
company:
• Which risks are/are not hedged?
• What type of hedging instruments are used
(optional vs non-optional). ___
Maximum (10)

You might also like