SCENARIO

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The Technology Partnership (Pty) Ltd (“TTP”) is an information technology (IT)

company that specialises in the assembly, sale, installation and maintenance of
computers, computer networks and related technologies. TTP is 80% owned by
Mlugisi Masina, an IT engineer, who founded TTP over 25 years ago. The remaining
20% is held by senior management.

TTP’s primary clients are large companies and government departments who choose
to outsource their IT management to a 3rd party. When a company or government
department requires a new IT system, TTP will submit a tender to supply them with
the computers and various components they require. They will also assist in
designing the appropriate system, setting up the computers, installing the necessary
network infrastructure and providing on going IT maintenance and support services.
They have many well establish clients and have developed good relationships and
important contacts in government and business in South Africa.

Mlugisi and his management team have built TTP into one of the most successful
black owned and managed technology companies in South Africa, where they have a
25-year long track record. Mlugisi’s deep technical knowledge of IT, hands on
approach in working with clients, commitment to the highest service and product
standards at reasonable prices has earned TTP an excellent reputation in a very
competitive industry.

However, despite TTP’s excellent industry standing, South Africa faces significant
economic challenges at present which have negatively impact on TTP. The economy
is growing at a low rate and many companies are not willing to make further
investments without the prospect of higher growth rates. TTP’s clients are turning to
cutting costs as they are unable to grow revenue. This pressure has also resulted in
many of TTP clients struggling to pay TTP on time.

© Milpark Education Management Accounting & Finance MACF01-OS Exam 2019 Page 3 of 14
Issue 1 - Potential sale of TTP

Mlugisi was recently approach by Global Solutions Limited, a large technology

company based in India. Global Solutions is interested in buying 100% of TTP’s
shares as a way of entering the South Africa market. Global Solution’s management
believe that South Africa is a very attractive investment opportunity for several
reasons:

• Despite the negative situation in South Africa at present, they believe that the
South African economy is likely to turn around and that there may be a
significant increase in business over the next few years.
• Even if the economy doesn’t turn around quickly, the huge skills shortages in
South Africa mean that many businesses and government lack the necessary
IT skills themselves to remain competitive, and they will have to rely on
outsourced providers such as TTP and Global Solutions.
• The negativity about the South African economy is pushing share prices down
so they hope this will create an opportunity to buy an established South
African company cheaply.

Your role
After more than 25 years in the industry Mlugisi is interested in selling his business
and retiring. Global Solutions has hired you as a local South African CA(SA) and
management consultant to assist them in evaluating TTP as a potential company to
acquire. You have obtained the following information, as well as a copy of an email
from Mlugisi in which he attached a free cash flow valuation he has performed along
with extracts from the most recent financial statements.

Comparative market information

There are two listed companies with public information that are similar to TTP and
could be used for comparison purposes. These are:

1. Global Solution itself. Global Solutions is a very similar business TTP but is
listed in India where it trades in the market on a PE multiple of 15. It is
significantly larger and more stable in terms of earnings than TTP, and is
globally diversified with operation in over 25 countries, although it does not
yet have a presence in South Africa or Africa.

2. Cloud South Africa Limited is listed on the JSE’s Altx. Cloud South Africa, is
significantly smaller than TTP and are a more recent entrant into the market,
but they have grown very rapidly over the last few years. In order to fund
their expansion, they have raised debt, and have significantly more debt than

© Milpark Education Management Accounting & Finance MACF01-OS Exam 2019 Page 4 of 14
 TTP. Cloud South Africa has very few government clients compared to TTP,
but they operate several retail stores selling direct to customers in shopping
malls around the country which TTP does not. Like TTP they are struggling
with a tough economic environment in South Africa. Their share price is
currently R58.60 per share with earnings per share of 432c for the year
ending 30 September 2019.

Additional information about TTP

• TTP has a target debt:equity ratio of 1.
• TTP has weighted average cost of capital of 15% and a cost of equity of 18%.
• Inflation is 5%

Mlugisi’s valuation
Mlugisi has sent the following email to Global Solutions:

To: The directors of the Global Solutions Limited

From: Mlugisi Masina, founder, The Technology Partnership

Below I have attached a free cash flow valuation of TTP that I have prepared, as
well as some additional notes to clarify the assumptions and calculations I have
made. I have also included extracts from TPP’s latest financial statements.

Attachment 1 – Free cash flow valuation of TPP with notes.

Attachment 2 – Extracts from TPP’s statement of financial position.
Attachment 3 – Extracts from TPP’s statement of financial performance.

I think you will agree I have made conservative estimates and the valuation is fair
and reasonable.

If we agree, I would propose a price of R942 million for 100% of TPP’s shares.
Once we reach agreement, I will approach my senior management team, who are
20% shareholders in TPP, with the offer. Until such time as we agree on a price
please keep this information confidential.

Kind regards,
Mlugisi Masina

© Milpark Education Management Accounting & Finance MACF01-OS Exam 2019 Page 5 of 14
Attachment 1: free cash flow valuation of TPP with notes

Here is the free cash flow I have performed, along with some additional notes. I have
worked carefully through a leading financial management textbook to ensure the
technical accuracy and I believe my calculations comply in all regards with IFRS.

Note 30 Sept 2019 30 Sept 2020 30 Sept 2021

Sales revenue 1 110 000 000 115 500 000 121 275 000
Consulting services 1 240 000 000 252 000 000 264 600 000
Rental income 2 1 000 000 1 000 000 1 000 000
Dividend income 2 4 000 000 4 000 000 4 000 000
Cost of sales 3 -92 000 000 -95 680 000 -99 507 200
Operating expenses 3 -185 000 000 -192 400 000 -200 096 000
Finance costs 4 -41 565 000 -41 565 000 -41 565 000
Taxation 5 10 201 800 -11 999 400 -13 917 904
Add back interest tax shields 6 11 638 200 11 638 200 11 638 200
Net investment in inventory 7 -7 650 000 -8 032 500 -8 434 125
Investment in capital assets 8 N/A N/A N/A
Dividends paid 9 -5 246 640 -6 892 260 -7 798 594
Net cash flows 10 45 378 360 27 569 040 31 194 377
CF0 CF1 CF2

Value of explicit period 11 288 770 234

Value of terminal period 12 92 938 869
Total = value of operations 195 831 365

Values of operational assets 13 426 786 560

PPE 250 000 000
Current assets 176 786 560

Liabilities 14 226 858 000

Long term debt 219 208 000
Trade payables 7 650 000

Enterprise value 14 942 414 794

Notes to the valuation

1. Growth in sales and consulting service. I have used the most recent figures
from the financial statements at 30 September 2019 as a starting point for
the first year.

© Milpark Education Management Accounting & Finance MACF01-OS Exam 2019 Page 6 of 14
 Due to the tough economic conditions, I expect sales and consulting services
to grow by inflation of 5% in 2020 and 2021.

Thereafter I think we can all agree that the economic conditions will improve,
and I feel that a growth rate of inflation plus 8% will be achieved. I have
therefore used a total growth rate of 13% (5% inflation + 8% company
growth) in determining the terminal value.

2. Dividend and rental income. These are dividends from listed shares and rental
income from properties that the directors of TTP decided to buy as
investments using TTP’s excess cash. I have been prudent in assuming
dividends and rental income from these investments will not increase in the
next 2 years due to the economic environment.

3. Cost of sales and operating expenses. As the economic conditions worsen

over the next 3 years, I believe TTP will be able to put pressure on suppliers if
they want to keep our business, and that cost of sales and operating
expenses will only grow by 4% per year.

4. Finance costs. These relate to interest paid on the long-term bank loan that is
part of TTP’s permanent capital structure.

5. Tax is estimated as the sum of the above cash flows x 28%.

6. Interest tax shields. These are the tax deductions allowed on interest
expenses. I have estimated these to be (finance costs) x 28%.

7. Net investment in inventory. I have calculated this as inventory closing

balance less trade payables. I have shown my calculation below.

30 Sept 2019 30 Sept 2020 30 Sept 2021

Inventory 15 300 000 16 065 000 16 868 250
Trade payables -7 650 000 -8 032 500 -8 434 125
Net investment in inventory 7 650 000 8 032 500 8 434 125

It makes sense to deduct the trade payables as investing in inventory is a

cash outflow, but where TTP uses trade creditors no cash has actually flowed
hence I use the net amount. I have estimated the closing inventory balance
based on our historic experience of the levels of inventory needed to support
operations in the next period.

© Milpark Education Management Accounting & Finance MACF01-OS Exam 2019 Page 7 of 14
8. Investment in capital assets. I have deliberately left this out as I have
included depreciation in the operating expenses as this must surely equal our
cash outflows on capital assets over time. Including the amount spent on
capital assets here would thus be double counting.

9. These are the dividends that are paid to shareholders. I and my senior
management all draw lower salaries but are compensated with a dividend at
the end of the year if the company has done well. Without this dividend we
would need to incur R5 million extra costs as part of our salaries expense.

10. The balance of cash left is the free cash flow available for the firm to invest in
future growth to increase the value of the firm. These must be discounted to
determine the value of the firm.

11. The present value of the explicit period is the present value of the 3 cash
flows discounted at the WACC. The inputs into my calculator are:
CF0 = R45 378 360; CF1=R27 569 040; CF2=R31 194 377CF0;
i=WACC=15%, calculate NPV = R288 770 234.

12. The present value of the terminal period is calculated using the terminal
growth formula for equity: (cash flow of final period) x (1 + g) / ke. =
R31 194 377 x (1 + 13%) / 18% = R92 938 869.

13. The assets that make up the business operations i.e. the PPE and current
assets, need to be valued and included in the value of the company.

14. Enterprise value (EV) is the value of the company as a whole. So, EV = Value
of Debt + Value of equity. In this case, in this case EV = liability of
R226 858 000 and equity equal to the value of the operations of
R195 831 365 + value of the operational assets + R426 786 560. This gives
the total value for 100% of the shares to be paid by Global Solutions.

© Milpark Education Management Accounting & Finance MACF01-OS Exam 2019 Page 8 of 14
Attachment 2: Extracts from TPP’s statement of financial position.

30 Sept 2018 30 Sept 2019

Non-current assets
Property, plant & equipment 215 000 000 250 000 000
Investment property 32 300 000 33 500 000
Investment in listed shares 78 400 000 80 000 000

Current Assets
Inventory 14 500 000 15 300 000
Trade receivables 84 500 000 161 000 000
Cash 18 000 000 486 560

Total assets 442 700 000 540 286 560

Equity and liabilities

Equity
Share capital 125 000 125 000
Share premium 3 500 000 3 500 000
Retained earnings 212 594 000 233 580 560

Total equity 216 219 000 237 205 560

Non-current liabilities
Long term loan 171 023 000 219 208 000

Current liabilities
Trade payables 7 235 000 7 650 000
Overdraft 12 000 000 38 000 000
Current portion of long-term debt 36 223 000 38 223 000

Total liabilities 226 481 000 303 081 000

Note: Investments in property and listed investments are measured at fair value.

© Milpark Education Management Accounting & Finance MACF01-OS Exam 2019 Page 9 of 14
Attachment 3: Extracts from TPP’s statement of financial performance.

30 Sept 2018 30 Sept 2019

Sales revenue 114 500 000 110 000 000

Cost of sales -86 800 000 -92 000 000
Gross profit 27 700 000 18 000 000
Other income and expenses
Consulting services income 228 570 000 240 000 000
Rental income 970 000 1 000 000
Dividend income 3 920 000 4 000 000
Operating expenses -174 500 000 -185 000 000
Operating profit 86 660 000 78 000 000
Finance costs -30 250 000 -41 565 000
Taxation -15 794 800 -10 201 800
Net profit 40 615 200 26 233 200

© Milpark Education Management Accounting & Finance MACF01-OS Exam 2019 Page 10 of 14
Issue 2 – Establishing a new division

TTP is considering establishing a new division that will provide energy management
services to existing and new customers. The new division will consult to owners of
commercial property and industrial plants on how to reduce energy costs as well as
design and install energy management systems (EMS) for them to use to reduce
energy costs. An EMS is a building automation system which controls all electronic
equipment (lights, heaters, phones etc) in order to make more efficient use of
energy.

Mlugisi believes that energy management services represent a new growth

opportunity for TTP. Problems with Eskom in South Africa has resulted in significant
increases in the cost of electricity and the depressed economic situation has caused
an increased focus on cost management. On top of this there is growing global
concern over climate change and energy management is becoming increasingly
important to big business and government.

Pilot Project
TTP has no prior experience in the area of energy management and has decided to
assess the feasibility of the new division by conducting a pilot project with CRE
Africa (Pty) Ltd, one of TTP’s clients. CRE Africa is one of the largest commercial
property services company in South Africa and was already looking to begin
implementing EMS in the various properties which it manages. The reason that CRE
Africa has proposed that TTP implement the EMS is because TTP is already very
familiar with CRE Africa’s IT system, which the EMS must integrate into. CRE Africa
has suggested that TTP designs and implements an EMS in one of their older
buildings – 899 Northgate Road, Johannesburg as the pilot project. The pilot project
is expected to take three months before installation is complete.

Project fees
As neither CRE Africa nor TTP have any experience in this field, both parties are
unsure of the cost savings that could be achieved as a result of installing the EMS.
As a result, CRE Africa has suggested that the fee TTP charges should be based on
the cost reductions that CRE Africa achieves. If the project is accepted, TTP has
agreed to a fee of 50% of the cost saving achieved by CRE Africa in the 12-month
period following the project’s successful implementation. CRE Africa believes that the
cost saving that they will achieve would be approximately 30% of the current energy
costs. This is quite high relative to industry norms but CRE Africa believes the 30%
is achievable as Building 899 is a very old building. CRE Africa’s energy costs for the
previous 12-month period amounted to R4.4 million.

© Milpark Education Management Accounting & Finance MACF01-OS Exam 2019 Page 11 of 14
This is a once off pricing structure for the pilot project. In future as TTP gains
experience and better understanding of EMS installation project, they will charge
customers on a different basis.

Resource requirements
TTP has already performed a preliminary system design and based on this, has
drafted the following resource requirements for the project:

Materials Units Note

HVAC controllers 65 1
Programmable HVAC controllers 2 1
LED lightbulbs 420 2
Low voltage lighting controllers 6 3
Lighting control panels 12 4
Routers 5 5

Labour Hours
Senior consultant 350 6
Design Labour 100 7
Programming Labour 650 8
Installation Labour - Network technician 800 9
Installation Labour - Junior consultant 600 9

Overheads
Depreciation on equipment 210 10

1. The HVAC controllers will be purchased specifically for this contract at a price
of R900 each. The two programmable controllers were also purchased
specifically for this project 12 days ago at a cost of R1 200 each as it was
necessary to purchase these controllers in order to assist with the initial
design. These controllers cannot be used on any future EMS project as the
warranty for these controllers has already been licensed to CRE Africa.

2. The energy efficient lightbulbs can be purchased from several lighting

retailers. A few of the lighting retailers have given TTP a free sample of the
energy efficient bulb that they stock.

a. Retailer #1 supplied TTP with 2 sample bulbs. This retailer sells these
bulbs at R36 per bulb and is willing to offer a bulk discount of 15% on
all orders over R1 000;

© Milpark Education Management Accounting & Finance MACF01-OS Exam 2019 Page 12 of 14
 b. Retailer #2 supplied TTP with 1 sample bulb. This retailer sells the
bulbs at R32 per bulb; and
c. Retailer #3 supplied TTP with 4 sample bulbs. This retailer sells these
bulbs at R35 per bulb with a 5% discount available for cash purchases.

As far as TTP is concerned, all the bulbs received are identical.

3. TTP have 4 low voltage lighting controllers on hand which they purchased two
weeks ago to install in their own building. These lighting controllers were
purchased at a price of R2 000 per controller. The current purchase price of
these controllers is now R2 200.

4. The lighting control panels would have to be purchased specifically for this
contract at a cost of R3 500 per panel.

5. Routers are used in every computer network that TTP installs for their
customers. Routers can be purchased from the regular supplier at a cost of
R650 per router. Routers supplied to TTP customers are charged at cost plus
a 25% mark-up. TTP has 27 routers in stock, which were purchased at a price
of R640 each.

6. Senior consultants are paid R37 500 per month and are expected to work 200
hours per month, as well as any overtime required. Senior consultants are
not paid for any overtime worked.

7. The 100 design labour hours above include the 35 hours worked last month
on the initial design that has been presented to CRE Africa. The designer is a
permanent, salaried employee who is paid R40 000 per month and is
expected to work 200 hours per month. If the project was accepted, the
design work on the EMS system would have to be completed this month to
make the deadline. The designer is paid at time and a half for any overtime
worked. The designer already has 160 hours of work for other clients that
must also be completed this month.

8. TTP’s programmers work on a contract basis. Programmers are paid R120 per
hour and can work up to 300 programming hours per month.

The software for the EMS system must be written within the next three
months. There is only one programmer that TTP can use for the pilot project,
but she is currently working on a second project for TTP which also must be
completed within the next three months and requires the same programmer.

© Milpark Education Management Accounting & Finance MACF01-OS Exam 2019 Page 13 of 14
 TTP’s client contracting to the second project has one of their own
programmers working alongside TTP’s programmer to learn. Now that the
work on that second project has begun the client could release up to 80 hours
of the TTP programmers time over the 3 months.

It was initially agreed that the existing job would require 320 hours of
programming time in total for the next three months and TTP would charge
this client R360 per hour of the programmer’s time. However, if less time
was worked on the second project, then TTP will only be able to bill the client
for hours actually worked by their programmer.

9. Network Technicians and Junior consultants, both salaried employees, are

used to install new networks from scratch, as well as effect repairs to existing
networks. Both the technicians and the junior consultants are working at
capacity and this situation is likely to remain for the foreseeable future. Each
new installation and each repair job require the following labour hours:

Junior
Technician
Consultant
New installation 100 hours 50 hours
Repair 30 hours 25 hours

The contribution earned by TTP on a new installation and on a repair is

R20 000 and R10 000 respectively.

10. Depreciation on installation equipment is not calculated on the basis of

number of years of useful life, but rather on the estimated total number of
operating hours.

© Milpark Education Management Accounting & Finance MACF01-OS Exam 2019 Page 14 of 14
REQUIRED ONLY

Marks

Sub-total Total

Related to Issue 1 – Potential sale of TTP

a. Using ratio analysis to assist you, evaluate and comment 20

on TPP’s financial performance and position as at, and for
the year ended 30 September 2019 (attachment 2 & 3).

Marking notes:
1. Marks are available both for calculations and insightful
comments. There are significantly more ratios to
calculate and discussion points available than are
needed to earn 20 marks, so manage your time
carefully and limit yourself to key issues.
2. You may need to calculate comparative year ratios to
be able to provide meaningful interpretations.

b. Identify and discuss key concerns you have about 18

Mlugisi’s valuation of TPP (attachment 1). You should
comment on the assumptions and the technical soundness
of his valuation.

Marking notes:
1. You can assume the numerical accuracy of the given
numbers is correct, and do not need to re-cast or
check calculations.
2. Marks are awarded for clearly identifying an issue (1
mark) and potential further discussion marks for
example for explaining why the approach is incorrect,
the correct approach, what Mlugisi should have
considered but hasn’t.
3. There are significantly more issues and discussion
points available than are needed to earn 18 marks, so
manage your time carefully and limit yourself to key
issues.

c. Perform a valuation of TPP using the PE (price earnings) 12

multiple approach.

© Milpark Education Management Accounting & Finance MACF01-OS Exam 2019 Page 2 of 3
d. Discuss any further issues Global Solutions should 8
consider before making an offer to purchase TPP.

Related to Issue 2 – Establishing a new division

e. Using relevant costing, calculate the financial impact for 28

TTP of accepting the pilot project. Identify items that do
not have a financial impact and give reasons.

f. Irrespective of your actual answer assume the result from 4

(e) above is a net benefit of R190 000. Using CVP (cost-
volume-profit) principles determine the percentage
energy efficiency savings required to breakeven.

g. What key issues should TTP consider in deciding whether 10

to accept the pilot project.

TOTAL MARKS 100

© Milpark Education Management Accounting & Finance MACF01-OS Exam 2019 Page 3 of 3