Professional Documents
Culture Documents
Blue BK Manc PDF
Blue BK Manc PDF
ZAC408-H/1/2006-2007
INDEX
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)
Note: All questions are SAICA sourced unless specifically indicated otherwise.
* Tutorial references can be completed by using the individual tutorial letters.
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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
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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.
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:
(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)
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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:
(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)
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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:
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)
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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)
• opportunity costs
• incremental cost
• target costing
• learning curve
• marginal costs (10)
• labour
• electricity
• rent of factory
(UOFS - adapted)
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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 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.
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• 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)
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QUESTION 5 40 marks
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.
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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:
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)
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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
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.
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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:
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.
(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)
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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.
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.
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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
Similarly the price obtained for the office block will depend on market conditions:
Market condition D E
Bester does not have the resources to undertake both projects simultaneously.
The costs of his supervision time can be ignored.
REQUIRED
(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)
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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.
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.
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.
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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.
REQUIRED
Compile a report in which you evaluate the outsourcing of ICT. Your report should include the following:
(b) Discussion of other factors that need to be taken into account before a decision is made; (5)
(Unisa)
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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:
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
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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)
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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
(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)
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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:
Monthly standards:
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
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Or
2. Design, develop, manufacture and sell a second range of motors, with an 18,5 kilowatt output,
for the heavy manufacturing sector.
The consultants have compiled the following schedule in support of a value engineering exercise:
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.
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(ii) Adding a second range of motors
The following are requirements if a second range of 18,5 kilowatt motors is to be added:
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:
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)
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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.
• 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.
• 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.
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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
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
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.
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
Dr Cr
R R
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.
(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)
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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:
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)
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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:
• 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.
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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
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)
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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.
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:
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.
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
REQUIRED
(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)
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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.
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.
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:
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:
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% 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.
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)
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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
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
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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)
(ii) Briefly explain the role target costs play in life cycle costing. (2)
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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
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.
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• 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.
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 -
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These resources represent those acquired or committed to in advance of usage and must be
acquired in batches of whole units.
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
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)
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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:
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%.
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● 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.
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.
The current rate of 10% of gross sales is expected to continue during 2001.
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.
REQUIRED
(a) Prepare a budgeted income statement for a 10%, 12% and 15% market share (19)
(Unisa)
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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.
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
Tech Training employs 114 staff members of whom 22 are in support roles (e.g. marketing,
finance). The others are full-time lecturers.
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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.
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)
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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
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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)
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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:
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.
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
2002 40%
2003 60%
2004 and later 100%
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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 $340 per ton. One ton of
alumina yields one ton of aluminium.
• Electricity
Electricity will be acquired from the Eskom network. Following initial discussions with Eskom
two lines will be provided for the plant. One line will run through Swaziland, while the other will
run north of Swaziland. either of the lines has the capacity to provide for the full electricity
requirements of the smelter. Electricity costs in 2002 are estimated at R8 000 000 and at
R10 951 200 in 2003.
• Salaries
Salaries will be paid in rand and are estimated at R5,2 million per year.
• Overheads
5. Project financing
A decision has been taken to structure the project as a project financing transaction. The
investment will thus be housed in a separate entity, managed by Almetals Ltd.
US$ million
Equity 440
Quasi-equity* 263
Debt 527
1 230
6. Discount rate
For the purposes of the feasibility study the discount rate was based on the following information:
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)
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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
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.
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• 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:
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)
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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
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.
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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)
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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:
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.
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.
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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:
R000
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)
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.
• 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.
REQUIRED
Profitability
Productivity
Market returns
Debt;
(c) EBITDA
• Calculate RAL’s EBITDA for 2000 and indicate when it is considered to be a useful
management tool; (5)
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(d) Growth
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.
• 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)
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 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)
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APPENDIX I
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.
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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
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
Represented by:
APPENDIX V
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
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)
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.
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12. Investments
Market value of shares 108 204 175 211
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QUESTION 27 30 marks
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
(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)
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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 –
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:
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.
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The following cash flow statements, from the annual reports of Ditech Ltd, are at your disposal:
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
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:
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)
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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
Assets Rm
Non-current assets 23
Current assets 42
R 65
Equity and liabilities
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.
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EXHIBIT 2
Relevant details relating to the Income Statement of the company are as follows at 30 June: (in Rmillions)
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
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.
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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
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 summarised financial statements for the year ended 30 September 2001, are as follows:
______
TOTAL ASSETS 328 500
R’000
REQUIRED
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:
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:
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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
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:
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... 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
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:
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:
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.
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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
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
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)
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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.
• 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.
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.
REQUIRED
(a) Calculate
(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 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)
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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:
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
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________ ________
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)
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)
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
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)
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)
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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:
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
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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.
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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)
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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;
(b) Recommend, with the necessary motivation, a staff incentive scheme for:
(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)
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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:
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.
• 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.
INTERIM REPORT FOR THE HALF YEAR ENDED 30 JUNE 2001 OF THE SNA RETAIL STORES
GROUP LTD
Unaudited Audited
Half year ended Year ended
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)
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Unaudited Audited
Half year ended Year ended
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)
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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
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Total Group
(R000) Jun 2001 Jun 2000 %
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.
“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.
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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
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
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
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• 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%
REQUIRED
(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)
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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.
REQUIRED
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
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
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)
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QUESTION 40 45 marks
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:
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:
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“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
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.”
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%.
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.
All options must be exercised or abandoned within eight years of being awarded.
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.
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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.
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:
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:
2001 2000
Notes R R
Share capital and premium 2 35 472 225 34 069 025
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
1. Accounting policies
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.
10 Net income before taxation and exceptional item is stated after crediting:
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:
§ 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.
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)
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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.
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.
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
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.
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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:
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.
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.
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
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.
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.”
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.
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)
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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 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:
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:
• • The loan is to bear interest at 1% below the prime overdraft rate (currently 24%);
• 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)
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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.
The following 5 queries pertaining to Higro Ltd have been referred to you for your opinion.
Query 1
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
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)
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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
REQUIRED
• Profitability
• Capital investment and
• Liquidity. (9)
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
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.
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
• 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.
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• 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:
• 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)
(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)
(f) List other risk factors that the directors of DiamondDesign Ltd should consider and indicate
possible hedges. (5)
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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.
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.
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The table below illustrates the inability of the company to compete effectively in international markets:
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:
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.
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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.
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.
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.
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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
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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
REQUIRED
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(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:
(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)
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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.
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.
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.
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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)
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QUESTION 48 45 marks
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:
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.
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• 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.
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)
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SUGGESTED SOLUTIONS
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QUESTION 1 - Suggested solution
Calculate the profit as if there were no default in any terms of the contract.
• 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
• 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)
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
R R R
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)
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)
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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
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.
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)
Determine the existing contribution per unit. Bring the effect of the changes in and determine a
new revised contribution per unit.
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%
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(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.
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)
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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)
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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)
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)
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QUESTION 4 - Suggested solution
See this as an income statement and firstly determine profit after tax. Calculate the return on
average assets.
(a) Revenue
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
________
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)
COMMENTS
Start by allocating the general factory costs to finishing and moulding. The next step is to calculate
machine hours: rate per hour.
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)
Determine the contribution per hour for Jeans and T-shirts, and determine which contribution is the
highest.
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)
Alternative
Cost estimate:
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)
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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
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)
Absorption cost
(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)
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
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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
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
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• 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)
1. Relevant costs
(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)
(ii) It may provide an incentive to sell at low prices, resulting in total sales
revenue being insufficient to cover total fixed costs. (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)
(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)
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2. Cost plus
(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)
(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)
(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)
Note to marker: information provided in a solid block should be taken into account during marking.
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)
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
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- 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
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)
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
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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)
Resale of computer
equipment 300 000
Rent (Sunk) - - - - -
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
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Calculation 0 1 2 3 4
Difference (B) - (A) 100 000 343 800 240 560 290 634 (114 668)
Pensionfund (1)
contribution (200 000)
Contract
Payments (2 500 000) (2 500 000) (2 500 000) (1)
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Relevant (cost)/cost saving 100 000 343 800 240 560 290 635 (115 268)
(End of alternative solution)
Note 1
Full R200 000 is deductible if agreement reached with SARS (if mentioned then allocate 2 marks)
• 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.
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• 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)
3. Recommendation
• 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)
Recommendation
Goodies Ltd should outsource ICT on condition that a good contract manager should be
appointed and he/she should:
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.
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
NuCare will be able to maintain high margins, and soap markup will remain higher than for other
products
- 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
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(c)
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)
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
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
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)
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)
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
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(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
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.
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)
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)
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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)
FINANCIAL DIRECTOR
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.
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
• 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)
○ 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
It provides useful insight into developing a goal-orientated purpose product at reasonable price.
Maximum (15)
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
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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)
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.
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.
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
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_________________________________________________________________________________
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
2. Budgeted profit
Calculation 150 000 206 000
litres litres
R R
The 206 000 litres represents the “flexed” budgeted figures. It shows the budgeted profit for the
actual quantity sold.
165 TOE408-W/1
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3. Actual profit
Calculation 206 000
litres
R
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
F - Favourable
U - Unfavourable
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
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ANSWER
During the period actual profits of Basson exceeded original expectations by R145 000. (1)
Material variances
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.
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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
The profit would have been R1 152 000 with a sales volume of 206 000 litres, if no other variance had
occurred. (1)
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)
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:
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)
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)
There was an increase in the cost of Skunk-1 during the year from the original estimate of R6 to R9 per
litre.
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)
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)
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)
CA(SA)
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QUESTION 14 - Suggested solution
(a) Calculations:
• Actual number of units sold = R1 452 000/ R4 000 = 363 units (1)
• Labour:
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)
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)
Labour variances
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
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(b)
SPACEAGE LTD
INCOME STATEMENT FOR THE MONTH ENDED 31 MARCH 2004
R
Sales 5 562 975 (½)
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)
• 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)
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• 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)
• 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)
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CALCULATIONS
Variance
or
Calculation Total Variance
(Standard hours allowed - actual hours) x standard rate per hour for labour and overheads
Variable overhead
R1,5
Actual hours x standard rate 51 000 hours x ( 0,5 ) 153 000 (1)
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:
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R R
= 38 x 50
= 1 900 hours (1)
Max (2)
Total direct labour hours = 183 671 hours (31 250 + 20 600 + 8 065 + 41 304 + 61 800 + 20 652)
(1)
For overtime we use 50 weeks as employees can only be paid overtime for working weeks
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)
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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)
• 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)
• This process requires specialised labour to operate sophisticated machinery - this type of
labour is expensive and scarce and could be difficult to replace. (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)
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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)
(a) The main characteristics for the successful application of ABC are as follows:
Businesses which would not benefit from ABC include the following:
• 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)
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• 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)
•• 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)
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•• 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
Current position
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:
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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.
Unused
capacity
Unused to be
Activity Capacity Usage capacity eliminated Saving
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:
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Unused
capacity
Unused to be
Activity Capacity Usage capacity eliminated Saving
Total power costs can be analysed into fixed and variable components as follows by using the high-
low approach.
Variable cost:
Fixed cost:
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
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
(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)
• 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)
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• 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)
• 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)
• 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)
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• 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:
• 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)
• 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)
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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)
Workings:
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)
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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.
Tech Retail
Tech Consulting
• 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)
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(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:
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)
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)
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Ways to improve performance
• 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
Note that the information included in a rectangular block do not form part of the suggested solution and
should serve for information purposes only.
Calculation technique
It is recommended that you first calculate totals and then from the total figure calculate a
price per unit
(b) Maximum price per dozen that export division will pay
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)
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How?
Calculate if the incremental (extra) income is more than the incremental (extra) cost for exports.
Motivation
Out of the calculation above it appears as if, in quantitative terms, it is not worthwhile exporting highveld
flowers. (1)
• 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)
• 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)
• 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)
• 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)
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)
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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”.
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.
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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.
• 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:
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)
Conclusion
An annuity approach is indicated by information point 3: full capacity is reached. Thereafter the
terminal year should be disclosed separately.
Income 1 244 800 367 200 612 000 612 000 (1)
Raw material 1 (74 800) (112 200) (187 000) (187 000) (1)
(615 000) (615 000) 166 376 250 764 419 540 619 540 (½)
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
(1 + R Rate) = (1 + $ rate)(1 + 1)
@ (1 + R Rate) = (1 + 0,09) (1 + 0,08)
@ R Rate = (17,72%
= 18% (1)
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(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)
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)
Breakeven capacity
Slight rounding differences to be expected given decimal point rounding of discounting factors
648,4 + 557
Breakeven price = 1,000 - 0,005 = 1 211,5 (1)
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
(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)
In performing a WACC exercise, structured approach will yield additional marks → do the cost
calculations, market values and weighting individually.
• Cost of equity
Ke = D1 + g
Po
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)
Note: The dilution in earnings because of the conversion of the debentures is already taken
into account in the calculation above.
Ke = 72,96 + 0,14
650c
= 25% (2)
Total market value: 1 000 000 shares @ 650c = R6 500 000 (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)
Weight should indicate 100% or 1; use costs as calculated previously and extend.
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(b) Investment decision
Year 0 1 2 3
R000 R000 R000 R000
Workings
2. Subcontractors costs
Conclusion
The contract must be accepted as the net present value is positive. (1)
(12)
(30)
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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
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)
Expected net present value: 868,6 + 558,0 - (282,9 + 267,0 + 8,40 + 3,17 + 4,9)
= R860,23 million
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Notes
• 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)
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.
Nuclear: Cost of equity using CAPM is 4,5% + (14% - 4,5%) 1,4 = 17,8% (1)
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
Expected net present value: 3 082 + 1 510,2 - (1 527,9 + 1 414 + 7,94 + 26,5 + 116)
= R1 500 million
Notes
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)
• 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)
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(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)
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QUESTION 25 - Suggested solution
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.
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)
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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)
• Measurements should cover areas of operation ie vehicles and clothing. Trends may become a lot
more clear. (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)
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)
To declare a dividend (even in capital form) would be reckless considering the current financial
position. (1)
Capitalisation shares
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)
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(c) EBITDA
• Indicator of cash generated in the business, this should be confirmed with the cash flow
statement. (1)
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)
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)
∴ Will receive 0,1073 for every 1 held [per 100 shares 10,7] (2)
Impact
• Capital will decrease by a similar amount. Dividend in specie will presumably be used. (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)
Cost of debt ranges from 15,5% on short=term to 25% on debentures. The effective cost is taken
as 15,5% as:
• huge tax loss indicates no tax advantage for the foreseeable future. (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)
• 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
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
Accounts
Dr Share capital
Share premium (if applicable)
Reserves
Cr Bank (2)
Maximum (12)
- 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)
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- 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.
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.
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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
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
- 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
- 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)
• 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)
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• 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)
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)
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• 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
Conclusion
• Any reasonable conclusion re value (1)
(15)
45
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QUESTION 29 - Suggested solution
NOTE:
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
2.3 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)
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• Advantages of fixed cost and repayment under present inflationary conditions. (1)
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)
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)
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)
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
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)
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(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)
(a)
(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)
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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
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)
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(b)
• 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)
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%
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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)
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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)
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’
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Comments on financial performance:
• 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)
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Commentary on valuation methodology
(a) The valuation is that of a majority/controlling interest in Secure (Pty) Ltd. (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
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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)
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.
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QUESTION 33 - Suggested solution
= 27,98 days
(13)
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)
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(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
(a) Overall
• 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
• 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)
3. Trading opportunities
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)
- 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)
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(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%.
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?
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.
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.
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?
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.
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Investing activities:
Capital expenditure -9 500
-8 110
Net increase in borrowings 8 110
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
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
- 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?
Note on approach
(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
Comments
Based on calculations
• Turnover increased for every period, showing a more significant increase for the 6 months
ended June 2001. (1)
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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
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The funds can be further analysed for the following major elements:
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)
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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)
• Restructure the business – follow through on the proposed sale of the subsidiary (the
clothing industry is not doing well)
• Reduce debt (this will decrease pressure on cash flow – no/less compulsory interest
payments)
78 017 78 017
Interest cover = 46 442 + 9 384 ALTERNATIVE 70 760
___
Maximum (12)
• 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
2. Preference shares
Value: R1 each, R150m (16 703 000+ 133 693 000) (1)
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3. Convertible debentures
= 13,47%
= 13,5%
= 15,84%
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)
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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)
Report format
• 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)
• P/E ratio high, taking into account the electronics section. (1)
• All dividends declared by subsidiaries do not flow through the group. (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)
• Chairman correct in his statements, does not per se imply an excellent year. (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
• 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)
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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)
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)
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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
TRANSACTION 1
Cover
∴ Dividend per share = 30 cps (½)
Process
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:
(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)
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Fractions
• 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
TRANSACTION 3
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
Workings
D1
3. Ordinary shares cost = P + g
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0,35 x 1,06
= 4,80 + 0,06
= 0,0773 + 0,06
= 13,73% (1½)
TRANSACTION 6
(a) Workings
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
Part I
Allocation of interest free and interest bearing loans to based on net assets:
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
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Journal entries required to effect re-gearing:
Operating Profit
• 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)
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RONA
EVA
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)
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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)
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• 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)
(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. 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)
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)
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3. Futures contract
4. Forward contract
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)
4. Counter- Authorised counterparties and limits. This will prevent Outtel Ltd being
party risk exposed to banks with low
creditworthiness. (1)
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)
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.
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)
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)
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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.
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
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
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 ($3,5m x 6,00 - R17,150m) 3 850 000 (1)
6 217 750
Exam technique (presentation) is very important to answer any question well! Here your
answer should have been prepared in report format to obtain three easy marks.
Definition of risks
• Interest rate risk is the risk that the value of a financial instrument will fluctuate due to the
changes in market interest rates. (1)
• Currency risk is the risk that the value of a financial instrument will fluctuate due to
changes in foreign exchange rates. (1)
• Liquidity risk is the risk that the company cannot meet its financial obligations when they
fall due. (1)
(3)
Assessment of exposure
• The interest on the loan from Case Bank is fixed for the duration of the loan hence there
• FRA Ltd is highly exposed to currency risk evidenced by the loss on translation of the
Case loan. (1)
• The Rand depreciated against the US$ by 6,5% in 1997 and 22,4% in 1998. (1)
• 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)
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Assessment of exposure to liquidity risk : moderate
• 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)
• 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
• 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)
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(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
• 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)
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.
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)
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)
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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.
Capital investment
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
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.
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
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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
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
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!
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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)
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(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.
(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:
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.
• Ability to access a type of finance which may otherwise not be possible due to: (1)
(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)
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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)
• 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)
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:
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.
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)
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- 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)
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)
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)
Average shareholders' funds 485 919 489 570 494 694 505 392
Adjusted ROE 3,2% 2,8% 5,5% 11,5% (3)
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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.
- 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)
(1)
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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)
Increases in net working capital investment due to sales growth and export activities. (1)
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
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 $1 = R7,34.
Furthermore, future clients in international markets will be invoiced in dollar. The rise in selling
prices in Rand predicted (from R815 to R1 450) therefore indicates that the Rand will devaluate
against the US dollar.
To be conservative, the future exchange rate is therefore predicted to change from 9 to 12 over
the next four years.
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- Proposed capex = R300 million, around US$ 41 million (R300/7,3) currently.
Plant is to be imported. (1)
- Volume of export sales? R000 US $000 Exchange rate?
- Are export sales of sufficient volume to cover the risk of US$ 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)
- 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)
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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.
__
1 mark for each of the above-mentioned Maximum (20)
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(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)
__
1 mark for each of the above-mentioned Maximum (10)
PART A
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)
(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)
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)
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• 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)
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• 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)
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PART B
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)