Corporate Financial Management 221 University of the Western Cape 2023

CORPORATE FINANCIAL MANAGEMENT

(CFM 221)
2023

221 Valuations)
MODULE 4 (part 2 of Basic
Discounted Cash Flow Valuations

Contents:

Module information
1. Required readings Chapter 6 Correia
2. Module objectives
3. Pre-lecture questions
4. Questions for the week
5. Notes and illustrative examples

Worked example (Paintworks (Pty) Ltd (no forecasted figures given)

Questions
 DCF 1 Dynamic (forecasted figures given, debentures re financed)
 DCF 2 Fruity Ltd (solution in the notes)
 DCF 3 FCB Beverages (similar to DCF 1)
 DCF 4 Zucchero Ltd (Tutorial August 2020)
 Macaroon Holdings Tutorial 16 September 2022
 Trooper Foods Term Test 29 August 2014
 Ajax Foods Term Test 30 September 2022 (see folder “old tests”)
 Hammer and Sickle Test 19 September 2020
 Summary difference between worked example and DCF 1

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Module information

1. Required readings

Chapter 6 Financial Management 7th edition (Correia, Flynn, Uliana & Wormald)
Pages 6-21 to 6 –24.

2. Module objectives

As we work through the module you should focus understanding:

1. How to employ the free cash flow method to value the firm
2. How to employ the free cash flow method to value the ordinary equity of the firm

3. Pre-lecture questions

1. What is the basic principle regarding the value of anything (future cash flows discounted at a
certain required rate of return)?
2. How does the basic principle tie in with the free cash flow method (operational cash flows are
discounted at weighted average cost of capital (wacc) … wacc represents/reflects the risks of the
operational cash flows best)?

Discounted Cash flow Valuations

In Part 1 of this module we introduced the fact that DCF valuations can be used to value the ordinary
equity of the company by:

1) Discounting Operating cash flows @ the Weighted Average Cost of Capital (WACC) in order to
establish the Present Value of Operations (A) to which,
2) The Present Value of non-operating Assets (B) is added in order to establish the value of the firm as
a whole (C) and then
3) The Present Value of Debt and Preference Shares (D) is deducted in order to establish the Present
Value of ordinary equity (E)

This method considers the investment in assets, WC and the capital structure to find a cash flow which is
available to all stakeholders. Very sound model to use although the cash flow projections can be
subjective. WACC incorporates the risk/growth in the operating cash flows.

More than calculating earnings available for ordinary shareholders, as with the dividend growth model.

This calculation can be laid out as follows (refer next page):

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LAYOUT OF A DCF VALUATION

Explicit 1st year of

A) PRESENT VALUE OF OPERATIONS period perpetuity

Yr 0 Yr 1 Yr2 Yr3

Cash operating profit (no depreciation) xxx xxx xxx

Taxation paid (xxx) (xxx) (xxx)

Increase in net working capital (xxx) (xxx) (xxx)

Capital expenditure (xxx) (xxx) (xxx)

Free cash flows (FCF) from operations 103 221 362

Valuing the Perpetuity

Present value of explicit period xxx CF3
TV2 =
Present value of terminal value xxx (WACC – g)
PV (2 years) WACC - g
Present value of operations xxx

B) PRESENT VALUE OF NON-OPERATING ASSETS

Surplus cash xxx

Equity investments xxx

Property xxx

Present value of non-operating assets xxx

C) VALUE OF THE FIRM (A+B) xxx (value before financing costs)

D) PV OF DEBT xxx

Preference shares xxx

Debentures xxx

Bank loans xxx

(xxx)

E) VALUE OF EQUITY (C-D) xxx

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DCF VALUATIONS – SOME PRINCIPLES

Operating and Non-operating activities should be valued separately

Why?:

Operating and non-operating cash flows have different risk profiles therefore different discount rates apply.

Notice that the value of the firm is made up of two parts:

PV of operations Free Cash Flows (FCF) from operations are discounted at the WACC (i.e.
Weighted Average Cost of Capital, which is the weighted average cos of debt
and equity. The detail regarding the calculation of WACC will be discussed in a
later module called Cost of Capital). The WACC primarily reflects the
operating risk of the company. Investment in working capital and capital
expenditure is included because it is needed for growth and expansion of the
operating activities.

+ PV of non-operating activities and assets/investments. The market value for each investment or
non-operating asset is determined by discounting the cash flow from that
investment at the risk appropriate rate for that investment (different from
the operational cash flows).

= PV of Firm

To calculate the value of ordinary equity, the PV of debt and PV of preference shares are deducted from
the value of the firm.

In order to compare the value per share to the share price, outside shareholders’ interest should be
deducted (at market value), as the number of shares in issue relate to the shareholders in the parent
company (which minorities are not!)

Operating Profit

The future operating cash flows are discounted at WACC (which primarily reflects operating risk) – so make
sure that there are NO non-operating cash flows (or tax thereon) included in operating profit! Also make
sure that there are no non-cash items in cash operating profit, and that any cash operating income and
expenses not reflected on the income statement are included.

Non-operating cash flows reflected in the Statement of Comprehensive income to exclude: (1 – 5)

1. Dividends received
2. Interest Income
3. Investment Income

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4. Rental Income (value building separately under non - operating activities as shown in Part 1 of this
module, by discounting the cash flow (Rental income – rates) at the risk appropriate rate for that type
of property (NOT WACC!) net of growth in rentals (i.e., escalation). ({rental-rates}*1+growth/{Kp-
growth})
5. Financing cash flows should NOT be taken into account to determine FCF to the firm. These are interest
(and the tax deduction thereon) and repayment of debt. These are taken into account later when the
PV of debt is subtracted from the value of the firm to determine the value of ordinary equity. (Refer to
unseen 20 September 2021 for tax and interest calculation)

Non- cash flows reflected in the Statement of Comprehensive income to exclude:

6. Depreciation and amortisation

7. Impairment gains and losses
8. Unrealised profits
9. Profits and losses on sale of assets (The actual cash flow is the proceeds on sale and this would be
taken into account - not the accounting profit)
10. Any other non-cash flow items that you are aware of from Financial Accounting

Non-operating cash flows NOT reflected in the Statement of Comprehensive income to include:

11. Capitalised expenses – make sure that the cash flow is reflected IN THE YEAR it occurs. No deferral, no
amortization. Make sure the tax on this is taken into account in accordance with tax rules.

Issues as regards using historic info to estimate the future operating cash flows:

Historic information ((earnings) can only be used to the extent they represent sustainable, future earnings.
Issues to consider:

 Volatile historic earnings stream

 Once off / abnormal items

The key question that you are trying to answer here is:

Is the current year’s result a reasonable basis from which to forecast the company’s future cash flows?
Remember that sales revenue drives everything else related to operations – expenses, tax, the level of
investment in net working capital (NWC) and fixed assets (PPE)*, and so one needs to consider whether
the existing relationship between costs and revenue, and assets (NWC and PPE) and revenue will continue
into the future, or if something needs to be corrected before forecasting future cash flows.

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*by this we mean that a 10% increase in revenue will necessitate a 10% increase in costs and a 10%
increase in net working capital and PPE.

Technical matters
Refer to note 1 of
Growth worked example
solution
Where both growth is expected as a result of more than 1 variable (e.g. growth in prices (including, but not
limited to inflation) as well as growth in volumes, remember that the total growth rate is compounded –
not merely an addition of the two rates. Use the Fisher model (introduced in the TVM Module): Nominal
rate = (1 + r)(1+infl) -1
e.g., inflation 4%, growth 8%: {(1+0.04)*(1+0.08)}-1 (refer to Paintworks/worked example)

Tax Paid

The main principle regarding tax paid is that we want to deduct the CASH TAX PAID relating to the
OPERATING CASH FLOWS. (i.e., excluding the tax effects of anything that relates to non-operating
investment or debt, as the tax on these will be taken into account when we value these things individually).
This means that we need to determine the Income tax expense for the year as per the Income Tax Act, and
+/- the change in the SARS liability. This method is used when you are given projected Balance Sheets
(refer to DCF 1 in the notes). If there is no projected figures given (refer to worked example in the notes),
you should use (EBITDA – W&T)*tax rate.

This can be calculated by means of T-account as follows (refer to DCF 1):

SARS liability
OB
TAX PAID
Income Tax expense

CB

Refer to note 2 of
This can be calculated by means of T-account as follows: worked example
solution
(EBITDA* – W&T) x 28% (refer to worked example)

*After excluding all non-operating income, abnormal items, non-cash items and expenses from EBITDA

Change In Net Working Capital

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The net increase (or decrease) in Working Capital is deducted from (or added to) the Free Cash Flows of
the company, as this represents cash which is not available (or free) to be taken out of the company and
returned to providers of capital. The level of investment in working capital is driven by revenue, and
therefore the growth in the net working capital balances should be in line with the growth in revenue. The
change in NWC is calculated by deducting opening balances from closing balances.

This most commonly comprises changes in:

Refer to note 3 of
 Inventory worked example
 Accounts receivable solution
 Accounts payable
 Operating cash (assume all cash balances are surplus cash, unless specific info provided as to
operating cash requirements)
 SARS TAX liability (if tax expense rather than cash tax paid included in tax line item above)

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CAPEX

This is represented as cash flows to maintain and expand a company’s non-current asset base.

This amount is frequently given, or can calculated in terms of a T-acc

NBV .
OB Depreciation Refer to note 4 of
CAPEX CB worked example
solution
If no CAPEX (purchase of assets) is given assume CAPEX = Depreciation, and state your assumption. This
would be the case in the situation of no growth, and no inflation.

Terminal value

PV of the perpetuity at T0 is for the perpetuity beginning at T1 .

PV Perpetuity0 OR (TV0) = FCF1 FCF0 (1+g) Refer to note 5 of

WACC – g or WACC - g worked example
solution

Be very, very careful not to double count or leave out the first year of the perpetuity. Also remember that if
the perpetuity begins in yr 5 (or FCF 4 x 1(+g) ), then the PV of the perpetuity is returned at year 4, and
must only be discounted by 4 years to get it back to T 0. Then make sure that the cash flows for year 1 – 4
(inclusive) have all been discounted to T0.

Non-operating Assets should be added to the value of operations at market value, in order to determine the
value of the firm.

These should be valued by taking the cash flow that streams from the asset, and discounting this at the
appropriate risk related discount rate (Not WACC, WACC only for the operations part)
Equity Investments:
Refer to note 6 of
worked example
The value can of equity investments can be determined by various
solution
methods and may either be:
1. Given in the question
2. Calculated as the market value times the number of shares invested (100 shares and the
market price per share is R10, then 100*R10)

3. Calculated using the GGM = PV0 = D (1+g)

Ke –g
4. Calculated using the Price Earnings valuation method (If P/E ratio is 10 and maintainable
earnings are R100 000, then the value is 10*R100 000)
5. Calculated as: Market to Book ratio x Net Asset Valuation (refer to Proxy example in Cost of
Capital module)
6. Calculated using DCF (Although highly unlikely that a DCF will be tested within a DCF
question.)

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Property:
Refer to note 7 of
The value of property is calculated as: worked example
PV0 = (Rentals – Rates) *(1 + growth) solution
K prop – growth

Where K prop is the required return on similar properties.

Surplus cash (Balance Sheet amount is already at PV)

Refer to note 8 of
worked example
solution

The present value of debt and preference shares should be deducted from the value of operations at
market value, in order to determine the value of equity (TVM principles applied)

Debt is valued by discounting the appropriate cash flows by the appropriate cost of debt (this would be
different for different types of debt, secured, unsecured, debentures which are redeemable, convertible, or
neither etc.) Debentures that are redeemed (including any premium/discount) should be valued using pre-
tax cash flows and cost of debt, in order to avoid the S24J complication. The valuation of debt instruments
has been discussed in Part 1 of this module.
Floating rate/variable rate debt: should already be at market value on the balance sheet, as there
shouldn’t be a difference between actual and market rate, as the rate that applies to variable rate debt
automatically changes as the market changes.

Refer to note 9 of
worked example
solution

Fixed rate instruments: these may well have to be valued.

Preference shares should also be deducted where the purpose of the valuation is to value ordinary
equity.

Refer to note 10
of worked example
solution

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DISCOUNTED CASH FLOW METHOD TO PLACE A VALUE ON EQUITY AND/OR A COMPANY

Discussion of the differences between Worked example 1 and DCF1

Working example info for last three years were given (2012 is now)

DCF1 info for the next three years were given (20x1 is now)

It is important to note which year is NOW to do the correct discounting for the PV

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Worked example:

No projections are given for the next three years, so tax, working capital changes and Capex must be calculated on
the projected growth (of percentages) on the operating profit/sales

The growth in sales is combined – please note! (inflation and growth)

Depreciation is added back to find the operating profit (R125 000) and the Wear and Tear is used to calculate the tax
paid.

Note that abnormal items must be taken OUT if we want to find the maintainable cash operating profit!!!!

Decrease in working capital is an INFLOW

Balances (opening and closing balances) in working capital is given in terms of the sales projections.

You must use these balances in a T account to calculate the CHANGE in WC!!!!

SARS balance is included (R1) in current liabilities as we do not use these balances in the Tax calculation. (refer to
DCF1 where we do the tax paid with a T-account and exclude the SARS balance from working capital)

The tax calculation (NB is must be cash out/inflows) is the (operating profit less W and T)*28%

You cannot do the T account because you do not have the opening and closing balances for the next few years. (you
have this in DCF1)

If the T-account is used to calculate the tax paid, then the SARS liability (balances) is taken OUT from current
assets/liabilities because you are using it in the T-account (see DCF1 where the SARS liability is NOT included in the
working capital changes)

The CAPEX calculation is done on the R150 000 times the growth each year. You cannot do a T-account to calculate
the change as we do not have the balances on the assets for the future years.

The T account will use the opening/closing balances and the depreciation, to be able to find the investment in assets.
(see DCF1)

The long-term loan is issued at a variable rate: this means that Market value and book value will be the same.

The short-term part of the loan term loan must NOT be included in the Working capital calculations.

If cash is not operational, it must be taken out from working capital and it should be showed under “PV of non-
operating assets”

DCF1
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The calculation of depreciation (to add back in cash operating profit) is difficult, you must use the T-account for
CAPEX. (CAPEX amount is given, opening and closing balances are given, there for the balancing figure is the
depreciation)

Remember that each time you can start to find your operating profit from either (i) Profit before tax or (ii) profit
attributable to shareholders…..IT DEPENDS WHERE YOU START AS TO WHAT FIGURES YOU WILL ADD BACK OR
EXCLUDE OR INCLUDE.

Growth is stable after 20x4….do the PV in year 20x4 given the cash flows in year 5 being stable.

T account is used to calculate the tax paid (balance sheets given for the next three years)

T account is used to calculate the changes in Working capital (balance sheets given for the next three years)
Remember to ignore the SARS balances as this was used already in the tax calculations. All the cash is operational
and should stay in the working capital calculation.

The debenture interest is difficult. Remember to use the nominal value of R125m to calculate the interest payment
and it should be discounted at market rate (14%)

Note that the debentures are re-financed with a bank overdraft.

The growth to apply for the equity investment is 6%. Please see that you can calculate the growth.

This equity investment is not part of operations and valued separately.

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Discounted Cash Flow – Worked Example

Paintworks (Pty) Ltd manufactures a range of paint suitable for industrial, commercial and residential
purposes. Residential paint is sold both through hardware stores and similar retail outlets and to
developers of residential complexes, while commercial and industrial paints are sold directly to
construction companies for use in commercial and industrial developments.

Paintworks has experienced some difficultly in generating adequate cash flows since 2009, and the
shareholders of Paintworks are considering selling their entire shareholding to a French Paint manufacturer
who wishes to enter the South African market. As a result, it is necessary to value the ordinary equity of
Paintworks in order to determine the value of the ordinary equity.

Extracts from the detailed income statement and Statement of Financial Position for the year ended 30
June for the last three years, together with some additional information, have been provided in order to
provide basis for the valuation to be performed.

Extracts from the detailed income statement for the last 3 years:

Notes 2010 2011 2012

R000's R000's R000's

Revenue 884 928 969

Sales 1 850 893 946
Dividends received 2 3 3 5
Rental income 3 30 32 17
Interest earned 1 - 1
Cost of Sales 4 - 592 - 649 - 649
Gross Profit 292 278 320
Operating and administration expenses 5 - 194 - 204 - 271
Operating Profit 97 74 48
Finance charges 6 - 40 - 40 - 40
Net Profit 57 34 8
Taxation - 16 - 10 - 2
Net Profit after Tax 41 25 6

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Extracts from the Statement of Financial Position at 30 June 2012:

(Values shown in R’000)

Notes 2012

Non-current Assets
PPE 7 1,500
Rental Property 3 100
Equity Investment 8 50

Current Assets
Accounts Receivable 9 240
Inventory 9 300
Cash 9 50
Loans to employees 9 10

Equity
Ordinary shares 1
Retained earnings
Preference shares 10 35

Non-current liabilities
Long term loan 11 330

Current liabilities
Current portion of long term loan 12 70
Accounts payable 12 108
Provisions 12 20
SARS 12 1

Notes:

1. Two factors determine the company’s growth in revenue, price inflation and volume growth. The
company expects price inflation to be at 4% for the next 3 years and thereafter return to the SA
government’s targeted CPI figure of 6%. The company expects volume growth of 10%, 20% and 15% in
2013, 2014 and 2015 respectively due to recovery from the recession and renewed vigour in the
construction industry. Growth in perpetuity is expected to be in line with inflation expectations.

2. Dividends received relates to Paintworks investment in Capitec Bank Holdings (Refer note 8)

3. Rental income. At the start of the 2012 Financial year Paintworks sold one of their rental properties at
book value, in order to assist with a cash flow problem that developed at the beginning of the financial
year, when a large debtor unexpectedly went into liquidation (refer note 5). Municipal rates paid on
rental properties included in operating expenses amounted to R 2 500, R 2 650 and R 2 000 in 2010,
2011 and 2012 respectively. The directors are of the opinion that appropriate risk-related discount rate
for commercial property of this nature is 10% before tax. Rental escalations have been contractually
agreed at 6%.

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4. Cost of sales was 67% of revenue in 2010 and 2012, which reflects historic ratios. In 2011 cost of sales
increased to 70% of revenue due to extended striking of workers and poor control over operations.
Neither are expected to occur again to the same magnitude and cost of sales should continue to be
67% in the future.

5. Depreciation included in cost of sales and operating expenses amounted to R125, 000 in 2012. Wear
and tear is R150 000 and will remain unchanged for the next 3 years. Also included in operating and
administration expenses is a bad debt written off R 100 000. This amount relates to one large debtor
that went into liquidation. The amount is abnormal and similar write-offs are not expected to occur
again in the future.

6. Finance charges related to Interest on the Long-term loan from FNB bank.

7. PPE consists of the machinery and equipment used in the company’s operations. The investment in
CAPEX was R 150 000 for 2012. This amount is expected to grow in line with the company’s growth in
revenue, price inflation and volume growth as per Note 1. above.

8. The Equity investment relates to an investment in Capitec Bank Holdings of 250 shares. Capitec Bank
shares are trading at R220 per share as at 30 June 2012.

9. The level of current assets (excluding loans to employees) is expected to be at 40% of Sales for the
foreseeable future. The company has a policy of extending loans to employees as deserving
circumstances arise (i.e., the extent of loans granted is not related to operations, nor is it driven by
revenue). The cash balance of R 50 000 is considered to be surplus cash.

10. Preference shares consist of 10 000 8% cumulative redeemable preference shares issued at R3.50.
These preference shares are redeemable in 5 years’ time at premium of 5%. The required rate of return
is 12%.

11. The long-term loan was issued at variable rate of prime + 1%. It is repayable in equal annual instalment
from 2013 onwards, over 7 years.

12. Current liabilities excluding the short-term portion of the long-term loan (i.e., Accounts Payable,
Provisions and the liability to SARS) is expected to be at 10% of Sales for the foreseeable future. You
may assume the WACC to be 12%
DCF 1 (35 marks; 63 minutes)

Dynamic Ltd is company quoted on the JSE. The directors of the company hold 58% of the issued share
capital between them and they have asked you to value the business.

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The directors of Dynamic Ltd are currently negotiating the sale of a substantial portion of their
shareholding to MNA, an overseas company in the same industry. The directors would like your opinion on
the value of Dynamic Ltd.

Balance sheet at end February

Current Forecast
20x1 20x2 20x3 20x4
R Mil. R Mil. R Mil. R Mil.
Capital Employed:
Issued share capital 800 800 800 800
Reserves 325 215 260 273
Prefence shares 400 445 488 514
Debentures 100 100 100 0
1625 1560 1648 1587

Employment of Capital
Fixed Assets 1180 1100 1190 1160
Investments 80 80 80 80

Current Assets
Inventory 320 350 390 370
Accounts Receivable 360 370 380 490
Cash 5 4 0 -125

Current Liabilities
Accounts Payable -280 -310 -340 -320
Receiver of Revenue -40 -34 -52 -68
1625 1560 1648 1587

Extracts from Income Statements - Year ended February

Current Forecast
20x1 20x2 20x3 20x4
R Mil. R Mil. R Mil. R Mil.
Profit before tax 188 161 248 376
Taxation -78 -50 -86 -125
Profit after tax 110 111 162 251
Dividend from Investments 15 16 17 18
Preference dividends -64 -64 -64 -64
Profit attributable to ordinary
shareholders before dividends 61 63 115 205

Receiver of revenue= SARS

Forecast= SARS NOT INCLUDED IN THE WORKING CAPITAL BUT IF THERE IS NO FORECAST SARS IS
INCLUDED IN THE WORKING CAPITAL.

Only deduct interest on debenture (long term loan) if interest is on bank overdraft ignore

You are given the following additional information:

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1. Management has estimated that the following Fixed Assets will be purchased over the next 3 years

20x2 R50 million

20x3 R170 million
20x4 R160 million

No assets are expected to be sold over the same period

2. The preference shares are non-redeemable

3. The debentures were issued 5 years ago at a discount of 20% of par value. Annual interest is 12%
based on the par value per debenture. The debentures are redeemable on 1 March 20x3 at par.
The company will need to replace the maturing debt with long-term debt in due course.
The book value in the balance sheet is = to the discounted value. Have to find the par value by
reversing
4. The investment of 80 million represents a 10% holding in a company that operates in a similar
industry. Management is of the opinion that an appropriate return is 18%. Minority =dividend
growth model

5. Corporate income tax is 28%

The WACC is 17%
Company growth from 20x5 is estimated at 8% per annum perpetuity valued in 20x4

Current Market related debenture rate 14%

Current Market related Preference share return 12%
Cuurent Market related Overdraft rate 16%

6. Wear and Tear approximates Depreciation and cash is not regarded as surplus.

You are required to:

Value the shares held by the directors of Dynamic Ltd using the Free Cash Flow method. Include your
workings and any assumptions you have made in arriving at your valuation.

(Questions in MAF, 4th ed, Vigario Adapted)

DCF 2 (CFM 221 Final Exam 2012 Adapted) (30 marks, 54 minutes)

Fruity Ltd is a company listed on the JSE. Fruity Ltd is a manufacturer of a variety of fruit juices and is the
industry leader in this segment of the local beverage market. Mr Liqui, the CEO of Fruity Ltd, has
approached you to assist in negotiations for the sale of a 40% equity interest to Fizzy Ltd.
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Mr Liqui requires you to value the business of Fruity Ltd. Although Mr. Brutal the CFO, has already
performed a discounted cash flow valuation (Refer Appendix A), the directors intend to use your valuation
instead for the purpose of their negotiations, as there was has been numerous questions lately with regard
to the credibility of the work performed by Mr. Brutal.

In order to assist you, Mr Liqui has provided you with extracts from the projected Statement of
Comprehensive Income and Statement of Financial Position for the next 3 years together with extracts
from the draft Statement of Comprehensive Income and Statement of Financial Position for the year ended
29 February 2012.

Extracts from Statement of Comprehensive Income

2012 2013 2014 2015

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Current
year Projected

Notes R'000 R'000 R'000 R'000

Gross profit 186 000 193 000 189 000 194 000

Depreciation -22 500 -25 000 -25 600 -34 600

Other expenses -29 000 -31 000 -34 000 -25 000

Abnormal bad debts 1 0 -6 000 0 0

Rental income 2 17 000 18 000 19 000 20 000

Dividends received 3 5 000 6 000 7 200 8 640

Profit before interest 156 500 155 000 155 600 163 040

Interest 4 -13 000 -9 000 -5 000 0

Profit before taxation 143 500 146 000 150 600 163 040

Taxation -43 050 -43 800 -45 180 -48 912

Profit after taxation 100 450 102 200 105 420 114 128

Extracts from Statement of Financial Position

2012 2013 2014 2015

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Current Projected

Note
s R'000 R'000 R'000 R'000

ASSETS

Non-current assets

Property, plant and equipment 121 000 99 000 78 000 88 000

Rental property 2 100 000 100 000 100 000 100 000

Investment in Distell Group Ltd 3 95 000 95 000 95 000 95 000

316 000 294 000 273 000 283 000

Current assets

Inventory 34 000 39 000 43 000 48 000

Accounts Receivable 44 000 4 000 53 000 58 000

Cash 200 330 470

78 200 88 250 96 330 106 470

394 200 382 250 369 330 389 470

EQUITY AND LIABILITIES

Shareholders' equity 208 600 236 750 266 830 282 170

Long-term loan 4 48 000 0 0 0

Preference shares 5 50 000 50 000 50 000 50 000

306 600 286 750 316 830 332 170

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Current liabilities

Accounts payable 38 000 42 000 46 000 50 000

Provisions 2 000 2 500 2 700 2 600

SARS 3 600 3 000 3 800 4 700

Short-term portion of long-term

loan 4 44 000 48 000 0 0

87 600 95 500 52 500 57 300

Total equity and liabilities 394 200 382 250 369 330 389 470

Notes:

13. The abnormal bad debt in the 2013 projected Statement of Comprehensive Income relates to a debtor
who is expected to go into liquidation during the 2013 year, similar write-offs are not expected to occur
again in the future.

14. Rental income relates to revenue from the letting of the rental property. Municipal rates paid on rental
properties included in other expenses amounted to R 2 000 000 in 2012. The directors are of the
opinion that appropriate risk-related discount rate for commercial property of this nature is 10% before
tax. Rental escalations have been contractually agreed at 6%.

15. Dividends received relates to Fruity Ltd.’s investment of 200 000 shares in Distell Group Ltd, which was
purchased in 2009 for R 475 per share. The growth in dividends received from Distell Group Ltd is
expected to be 20%. Management considers appropriate rate of return for all investments to be 22%,
but for the investment in Distell Group Ltd a rate of return of 25% is deemed more appropriate.

16. Finance charges relates to interest on the long term loan from Standard bank. The loan was originally
issued on 1 March 2009 for an amount of R 200 000 000 payable at a fixed interest rate of 10%, at
which time prime was 10% (Fruity is normally able to borrow at the prime rate). The loan is repayable
by means of 5 equal annual installments which commenced on 28 February 2010. The prime rate at 29
February 2012 in South Africa is 8.5%. As at 29 February 2012 Fruity has not defaulted on any
payments. The present value of the loan at the 29 February 2012 based on the prime rate of 8.5% is R
93 443 000.
21
Corporate Financial Management 221 University of the Western Cape 2023

17. Preference shares consist of 1 000 000 10% non- redeemable preference shares issued at R50. The
market related rate of return is 9%.

Additional information

 Corporate income tax rate 28%

 Weighted Average Cost of Capital: Fruity Ltd 12%

 Weighted Average Cost of Capital: Fizzy Ltd 14%
 Wear and tear allowances approximates Depreciation
 Cash balances are regarded as being surplus

 The growth in cash flows from 2016 onwards will be 5% and is expected to be sustainable into the
foreseeable future. The working capital days and asset turnover ratio that exists at the end of 2015
is considered to be sustainable into the future. (I.e. The relationship between the closing working
capital balance and revenue will remain constant in percentage terms into the future. Similarly, the
closing net book value of property, plant and equipment will remain constant as percentage of
revenue into the future.)

Discounted Cash Flow Valuation performed by Mr Brutal

Mr. Brutal, has performed a discounted cash flow valuation of Fruity Ltd and this is presented in Appendix
A.

Based on this valuation of the company he is recommending that R455.3 million is a fair value for a 40%
equity stake in Fruity Ltd.

22
Corporate Financial Management 221 University of the Western Cape 2023

Appendix A: DCF valuation performed by Mr Brutal

2012 2013 2014 2015

Rm Rm Rm Rm
Cash flows from operations

Profit before tax 146 150.6 163.0

Add back dividends received 6 7.2 8.6
Cash operating profit 152 157.8 171.7

Taxation paid (Cash operating profit x 28%) -42.6 -44.2 -48.1

Change in Net working capital (W1) -6 -4 -6
Capital expenditure (W2) -3 -4.6 -44.6

Free Cash Flows from operations 100.4 105.0 73.0

C1 C2 C3
PV of explicit period 218.2 88.1 80.8 49.3
PV 2015 = 73.0 x 1.05
14% - 5%
PV of terminal value 581.8 C4 = 851.8

PV OF OPERATIONS 800.0

PV OF NON-OPERATING ASSETS 480.2

Investment in Distell Group Ltd (W3) 300
Rental Property (W4) 180.2

VALUE OF THE FIRM 1,280.2

PV OF DEBT -92
PV OF PREFERENCE SHARES -50
VALUE OF EQUITY 1,138.2

X 40% 455.3

Calculator workings
C1: N = 1, FV = 106.9, I/YR = 14%, P/YR = 1
C2: N = 2, FV = 108.6, I/YR = 14%, P/YR = 1
C3: N = 3, FV = 73.0, I/YR = 14%, P/YR = 1
C4: N = 4, FV = 851.8, I/YR = 14%, P/YR = 1
Corporate Financial Management 221 University of the Western Cape 2023

Appendix A continued

2012 2013 2014 2015

Rm Rm Rm Rm

W1: Change in net working capital

Accounts receivable and inventory 78 88 96 106
Accounts payable -38 -42 -46 -50
Closing balance - net working capital 40 46 50 56
Opening balance -40 -46 -50
Increase (Decrease) in net working capital 6 4 6

W2: Capital expenditure

Closing balance (PPE ) 121 99 78 88

Opening balance (PPE ) -121 -99 -78
Change in NBV (PPE ) -22 -21 10
Depreciation 25 25.6 34.6
Capex 3 4.6 44.6

W3: Investment in Distell Group Ltd Rm

Current Dividend R5

g= 20%

ke = 22%

P0 = 5 000 000 x 120% = R 300

22% - 20%

W4: Rental Property Rm

Current rental income R 17

10
Cost of property %

Escalation 6%
Corporate Financial Management 221 University of the Western Cape 2023

PV = 17 00 000 x 106% = R 180.2

10%

REQUIRED:

Review the valuation performed by Mr Brutal and identify and comment on any
shortcomings which may exist. These shortcomings may include any aspects (including
forecasts) of the valuation that you believe have either been performed erroneously or
inadequately, as well as any other matters that should be considered in relation to the
adequacy and/or reliability of the valuation. (You may assume that all casts (additions,
subtractions, etc.) are correct and other mathematical functions are in accordance with
workings provided.)

Each shortcoming should be supported by a brief explanation or appropriate calculation

(you do not need to correctly re-perform any aspect of the valuation). (27 marks)

Effective and efficient communication (3 marks)

Corporate Financial Management 221 University of the Western Cape 2023

Suggested Solution to Question DCF 2

Part A

Marks

CASH OPERATING PROFIT

Interest expense is included in operating profit – should have been reversed as it does not
represent operating cash flows. Further – debt will be separately valued and deducted (i.e.
interest cost has been double counted).

Dividends received should have been deducted in determining cash operating profit and not
added back (i.e. have been double counted). 2
Cash operating profit includes depreciation. Depreciation should be added back as it is a non-
cash flow item.

Rental income and related rates is included in operating profit – should have been reversed as
it does not represent operating cash flows. Further – Rental property will be separately valued 2
under non-operating assets and added (i.e. rental income has been double counted).

TAXATION

Tax has been calculated after adding back deprecation, but without taking wear and into
2
account.

WORKING CAPITAL and CAPEX

The change in working capital for the perpetuity has been calculated incorrectly by taking
change in working capital nd CAPEX for 2015 and multiplying by the growth rate. The change in
working capital for the perpetuity should have been calculated by multiplying the closing
3
balance for 2015 by 1 + the growth rate. This would have determined the closing balance for
2016 from which the closing balance for 2015 should have been deducted to determine the
change in working capital and capex for the first year of the perpetuity.

Further, provisions and the SARS balance have been completely ignored in the valuation, these
should have been included with working caital as they are operating in nature.
Corporate Financial Management 221 University of the Western Cape 2023

PERPETUITY

The numerator reflects the cash flow in 2015 multiplied by the growth rate. This is incorrect as 2
calculating the cash flow in perpetuity by merely multiplying up the FCF from 2015 assumes
that all cash flows in 2015 are sustainable into the future. This is not true of the cash flow
relating to changes in working capital and capex (given the explicit relationship between the
asset balance and sales), which is now overstated in perpetuity.
3

WACC

The FCF was discounted at the WACC rate for Fizzy Ltd, instead of Fruity Ltd, this is incorrect as
we valuing the equity of Fruity Ltd, and the appropriate discount rate would be the risk
appropriate rate for Fruity Ltd, which is 12% and not 14%.

DISTELL SHARES
2
Dividend stream appears to have been valued at Ke of Fruity Ltd – the growth rate and Ke for
1
Distell should have been applied

PROPERTY

Rental Property has valued without taking municipal rates into account. The denominator for
the growth in perpetuity formula is also incorrect as growth was not deducted from the
required return of property.

2
CASH

Surplus cash should have been included as a non-operating asset, and it’s balance added to the
value of the firm.

2
PREFERENCE SHARES

Preference shares – the book value of preferences shares has been deducted, however as
coupon rate of the preference shares is 10% and the required rate of return is 9%, the book
value of preferences therefore does not represent the market value. Thus the value of equity
will be misstated.
Corporate Financial Management 221 University of the Western Cape 2023

LONG-TERM DEBT 2

The book value of debt has been deducted, however as the loan was issued at a fixed rate,
which currently differs from the market rate for the company, which is the prime rate, the
value of the loan must therefore be adjusted to the market rate. Thus, the value of equity will
be misstated.

Total available 35

Total required 27

Marking note:
Corporate Financial Management 221 University of the Western Cape 2023

In addition to the 35 marks above there are a further 2 marks allocated to NOT adjusting for
the abnormal debt.

DCF 3 (Test 2: CFM 2012 Adapted) (50 MARKS, 90 MINUTES)

FCB Beverages Ltd is in the business of manufacturing and selling non-alcoholic beverages.
Its two major brands are Virgin Rum and Virgin Brandy. FCB is quoted on the JSE. The
directors of the company hold 58% of the issued share capital between them and are
currently negotiating the sale their shareholding to Xavier Incorporated, an overseas
company in the same industry. The directors would like your opinion on the value of FCB
Beverages Ltd and they have asked you to determine the value of their 58% equity stake.

The financial director of FCB Beverages Ltd, Mr Satardien, has provided you with the
following financial information for the current year and the forecast information for the
next three years, which you have been instructed to rely on, even though you have some
doubts about the appropriateness of certain of the assumptions. The financial director has
also performed certain calculations to assist you in your valuation of FCB Beverages Ltd
(Refer to Appendix A).

Extracts from the Statement of Financial Position at 28 February

Current Forecast

2012 2013 2014 2015

R Mil. R Mil. R Mil. R Mil.

ASSETS

Non-current assets

Property, plant and equipment 1180 1100 1190 1160

Available-for-sale investments 80 80 80 80

Current assets

Inventory 320 350 390 370

Accounts Receivable 360 370 380 490

Cash 5 4 6 8

Total assets 1945 1904 2046 2108

Corporate Financial Management 221 University of the Western Cape 2023

EQUITY AND LIABILITIES

Equity

Issued share capital 900 900 900 900

Reserves 194 168 306 420

Non-current liabilities

Long-term loan 91 48 0 0

Preference shares 400 400 400 400

Current Liabilities

Accounts Payable 280 310 340 320

Short term portion of Long-term loan 40 44 48 0

Receiver of Revenue 40 34 52 68

1945 1904 2046 2108

Corporate Financial Management 221 University of the Western Cape 2023

Extracts from Detailed Income Statements - Year ended 28 February

Current Forecast

2012 2013 2014 2015

R Mil. R Mil. R Mil. R Mil.

Gross Profit 305 304 337 571

Finance costs -17 -13 -9 -5

Depreciation -100 -130 -80 -190

Profit before tax 188 161 248 376

Taxation -53 -45 -69 -105

Profit after tax 135 116 179 271

Dividend from Investments 15 16 17 18

Preference dividends -64 -64 -64 -64

Profit attributable to ordinary shareholders

before dividends
86 68 132 225

You are given the following additional information:

7. Mr Sataardien has assumed that the following Fixed Assets will be purchased over the
next 3 years

2013 R50 million

2014 R170 million
2015 R160 million

He has also assumed that no assets will be sold over the same period

8. The preference shares are non-redeemable. The market related preference share return
at 29 February 2012 is 12%
Corporate Financial Management 221 University of the Western Cape 2023

9. Finance charges relates to interest on the long-term loan from Investec Bank. The loan
was originally issued on 1 March 2010 for an amount of R 200 million, payable at a fixed
interest rate of 10%, at which time the prime rate was 10% (FCB Beverages Ltd is
normally able to borrow at the prime rate). The loan is repayable in 5 equal annual
instalments which commenced on 28 February 2011. The prime rate at 29 February
2012 is 9%. As at 29 February 2012, FCB Beverages Ltd has not defaulted on any
payments. The present value of the loan at 9% on 29 February 2012 is R 133 550 000.

10. The investment of R80 million represents a 10% holding in a company that operates in a
similar industry. Mr Satardien has assumed that an appropriate return is 16% and that
the growth rate for this investment is 8%.

11. Mr Sataardien has also assumed the following:

The corporate income tax rate is 28%.
FCB Beverages’s WACC is 17%
Company growth after 2015 is estimated to be 10% per annum indefinitely.

12. Wear and tear approximate depreciation.

13. Mr Satardien has assumed that cash balances are surplus to operating requirements.
Corporate Financial Management 221 University of the Western Cape 2023

Appendix A

Change in net working capital

20x1 20x2 20x3 20x4

R Mil R Mil R Mil R Mil

Current assets

Inventory 320 350 390 370

Accounts receivable 360 370 380 490

Current liabilities

Accounts payable -280 -310 -340 -320

Closing balance of net working

capital 400 410 430 540

Opening balance -400 -410 -430

Change in net working capital 10 20 110

REQUIRED

1) Value the shares held by the directors of FCB Beverages Ltd using the Free Cash Flow
method at 29 February 2012. Include your workings and any assumptions you have
made in arriving at your valuation.

You may assume that the calculations performed by the financial director in Appendix A
are correct and may be used where you deem it appropriate. (38 marks)

2) Identify the likely errors (or assumptions that are unlikely to be correct) in the
information provided to you by the financial director (2 marks per error / assumption).

(8 marks)
Corporate Financial Management 221 University of the Western Cape 2023

Zucchero Tutorial 28 August 2020 35 marks; 63 minutes

Zucchero Ltd is company listed in the Packaging and Printing Sector of the Johannesburg
Stock Exchange. Zucchero Ltd manufactures cardboard boxes and is one of the top
performers in this segment of the market.

You have been approached to assist in preliminary negotiations for the sale of 30% equity
interest in Zucchero Ltd to Blackhawk Ltd. The shares are currently held by the directors of
Zucchero Ltd and you have been provided with extracts of the latest Balance sheet and
Income Statement for the year just ended.
Current and Forecast Balance Sheets for Zucchero Ltd
for the year ended 31 August

Current
19x1
R '000
Capital Employed:
Issued shares 1000
Non-Distributable reserves 2000
Distributable reserves 2200
Preference shares 2000
Debentures 3000
Deferred Taxati on 340
10540

Employment of Capital
Fixed Assets 7960
Investments 2000
Inventory and Accounts Receivable 2000
Accounts payable -600
Receiver of Revenue -320
Short-term borrowings -500
10540

Income Statements for Zucchero Ltd for the year ending

31 August
Current
19x1
R '000
Gross Profi t 7940
Depreciati on -500
Expenses -5580
Profi t before interest 1860
Debenture interest -780
Other interest -120
Profi t before taxati on 960
Taxati on -320
Profi t aft er taxati on 640
Dividend income 600
Preference shares dividend -340
Ordinary shares dividend -400
Retained income 500
Corporate Financial Management 221 University of the Western Cape 2023

You are given the following additional information:

1. The investment of R 2 000 000 represents an 8% holding of a private company

similar to Zucchero Ltd. The shareholders’ required return is 22%

2. The preference shares are redeemable at 10% discount in 4 years’ time. Similar
preference shares carry a required return of 15%.

3. The debentures are non-redeemable

4. You may assume the following for the purposes of your value of Zucchero Ltd.

Corporate income tax rate 28%

WACC 15%

Cash flows are expected to grow at

10% for the next 2 years and at 7% from 19X4 onwards

Current debenture rate 30%

The closing balance of net working capital is expected to grow in line with cash flows.

The investment in CAPEX at 31 August 19x1 is R1.5m and is expected to grow in line
with cash flows.

Wear and tear is R750 000 at 31 August 19x1 and is expected to grow in line with
cash flows.

You are required to:

Value the 30% shareholding of Zucchero Ltd as requested by the directors using the free
cash flow method. Include your workings and any assumptions you make in your answer.

(Questions in MAF, 4th ed, Vigario Adapted)