MAC3702

MAY/JUNE 2020
UNIVERSITY EXAMINATIONS

May/June 2020

MAC3702

APPLICATION OF FINANCIAL MANAGEMENT TECHNIQUES

100 marks
3 hours
30 minutes additional time for uploading

THIS PAPER CONSISTS OF EIGHT (8) PAGES.

INSTRUCTIONS:

Please remember to complete the Honesty Declaration.

Follow these steps to submit your take-home answer file.

1. Access myUnisa at https://my.unisa.ac.za/portal and login using your student number and
myUnisa password.
2. Click on the “myAdmin” tab in the top navigation.
3. In the “Assessments” submenu, click on the “Assessment Info” tool in the drop-down
list.
 Locate the section for UNISA summative assessments at the bottom of the list.
 Find the corresponding portfolio number for your module.
 Click on the Submit link in the Action column and follow the steps described below.
Load the answer file from your PC to myUnisa:
 Click on the Browse button next to File Name.
 In the Choose File dialog box, select the file you want to upload, and then click OK.
 Select the correct file format from the File Format drop-down list. Only PDF formatted
files are allowed to be uploaded.
 Click on the Continue button. If you do not click Continue, no submission action will
take place.
 The link for upload will close at exactly 18:30pm.

PLEASE NOTE:

1. The paper consists of ONE (1) question.

2. All sub section parts (a) to (g) must be answered and clearly indicated.
3. All calculations must be shown.

4. PROPOSED TIME-TABLE: (Avoid deviating from this as far as possible.)

Question Subject Marks Time

number (minutes)
Capital budgeting, Weighted average cost of capital, Working
1 100 180
Capital Management, Ratios and Discussion.
100 180

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Question 1 (100 marks; 3 hours)

Eddy Fashion Holdings (“EFH”) is South Africa’s oldest and biggest retailer by assets and is
listed on the Johannesburg Stock Exchange. In the recent years the company has struggled
to deliver impressive results as it faces serious competition from both local and international
retailers. The company’s share price was trading at 4 598 cents on 01 October 2018, at the
start of the financial year, but had lost about 52% of its value by the end of September 2019
as it recorded a net loss of R109 million. With no dividend declared at the end of the year, this
loss brought the company’s net asset value down to R1 269 billion. EFH’s significant
shareholders include the Public Investment Corporation (22%), Rembrandt Group (19%) and
African Rainbow Capital (15%). Only 50% of the company’s authorised shares remains
unissued.

The company has approached the Industrial Development Company (IDC) for a possible
capital injection into the business of up to R8 850 million in order to pay off its interest-bearing
debt, increase working capital levels, and embark on a new expansion programme. EFH
requires R600 million for its ARISE & DREAM project (see Part A below); R8 billion to repay
its long-term debts (see Part B); and R250 million (see Part C) to manage liquidity for the next
few months. IDC has proposed that EFH issues new EFH ordinary shares in return for the
capital injection into EFH business.

Part A – ARISE & DREAM Project

EFH will be embarking on a new comprehensive business model that is aimed not only at
revenue generation, but also at the empowerment of upcoming and aspiring young designers.

The EFH procurement team has already identified four of South Africa’s top young designers
to be part of the new clothing range called “ARISE & DREAM”. The designers will
conceptualise and design the clothes which will then be sent to EFH’s trusted local
manufacturers to manufacture the required quantities for all its 350 participating stores. Once
major alterations and renovations have been completed at these stores, ARISE & DREAM
clothing range will be sold for a period of five years (ending December 2025) before the range
becomes out of fashion. It is estimated that afterwards the company will be able to find
substitute products to sell utilising space previously occupied by ARISE & DREAM clothing
range. Each store is expected to generate an average trading profit of R65 000 per annum on
the extra space going forward (after taking into account future wear and tear allowances). This
trading profit will increase at 4,80% per annum.

The final four top young designers, with their designs showcased below, are: Nkhensani Nkosi,
Amanda Laird, Mzukisi Mbane and Jacques van der Watt.

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TOP 4 YOUNG DESIGNERS:

Style For All, by Nkhensani Nkosi Cherry, by Amanda Laird

Imprint, by Mzukisi Mbane Lace and frills, by Jacques van der Watt

1. Capital expenditure
The first two years (2020 & 2021) will be for the construction phase, however, ARISE &
DREAM sections at all participating stores will be operational at the end of the first year.
Full capacity will only be reached at the end of 2023. At the start of the project EFH will
spend R245 million on alterations and renovations and another R245 million will only be
spent a year later (these qualify for 5% wear and tear allowance). The balance of the
project amount will be spent between store fittings and working capital (see note 3 below).
Working capital will be equivalent to 50% of the store fittings costs. Store fittings will also
be purchased at the beginning of the project and are subject to a capital allowance of 20%.
Wear and tear as well as capital allowance are only deductible once the stores are opened
and operational (pro rata applies).

2. Working capital
The working capital will only be required once the ARISE & DREAM sections at all
participating stores are operational. 60% of the total working capital requirement will be
provided for in the first year of opening the stores, with the balance being provided in the
following year. Only 90 cents in a Rand of the invested working capital will be recovered
at the end of the project.

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3. Sales
The young designers have signed a five-year agreement to design the clothing range to
be sold at the 350 participating stores. The range entails men’s, women’s, kids’, footwear
and accessories for every occasion. The expected number of units to be sold by each
designer per annum are given below, with the starting average price per item. The ARISE
& DREAM clothing line is priced at a mark-up of 50% on cost (manufacturing).
Manufacturing costs include designers’ fees paid to the four young designers.

Number of units expected to be sold and unit price:

Expected annual % of capacity (Quantity)
Number of
Design Average price
units per 2021 2022 2023 2024 2025
per unit 2
store1
Cherry 2 000 R200
Lace and frills 2 000 R150
55% 90% 100% 100% 100%
Imprint 2 000 R150
Style For All 2 000 R100

1
This is at full capacity per store per year. There is a demand, spread evenly throughout the year for all the
products manufactured each year. All four clothing labels will be available at all participating stores.
2
This average price per unit is the price at the start of the construction phase. The selling price will increase
by 6% per annum.

4. Operating/trading costs
Expected operating costs will amount to a total of R30 million per annum for all the
participating stores (excluding marketing costs). These operating costs will be incurred at
the same time the revenue is realised. The company will also be embarking on a 3D
marketing campaign for its new clothing range. The 3D marketing will display the new
clothing range using a 3D clothing visualisation technology at various shopping centres
where the participating stores are located. Payment for related marketing costs, made in
advance, will be R2 million in the first year of launching the clothing range but will reduce
by 20% (based on the initial marketing cost) in each following year. Excluded from the
amounts above is an annual depreciation charge of 10% on buildings and 25% on
equipment and fittings. Depreciation is only accounted for once the asset has been brought
into use.

5. Salaries
The company will have to contract a digital marketing manager and Sethu Ndamase with
eight years’ experience in the advertising industry has already been identified. Sethu
Ndamase will likely start at the beginning of 2020 in order to familiarise herself with the
business. The job requires her to manage, develop and expand the marketing department
with current marketing technology models and tools. She will be responsible for:

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 Creating efficient, effective advertising strategies in digital spaces to promote the

new clothing range.
 Focus on increasing sales and brand loyalty by holding events or campaigns to
increase awareness and surveys.

No interview has been conducted with her yet but her expected salary package for the
2020 financial year will be R982 377 with an expected increase of 8% per annum and
included in this amount are the following:

 Annual contribution to the retirement fund of R100 000, and

 Once-off reallocation cost of R38 000 and a sign-on bonus of R100 000 (these
amounts will be paid at the start of the contract).

Sethu Ndamase was referred to EFH by one of the reputable recruitment agencies, and
the agency will be paid R120 000 for their work in identifying the suitable candidates for
this job. This payment will be effected at the beginning of 2020.

Part B – REPAYMENT OF DEBT

EFH has the following interest- and dividend-bearing facilities at 30 September 2019:

Preference share capital: The three million preference shares were issued three years ago
at a nominal cost of R605 per share, which bear a fixed dividend yield of prime+20bps. Similar
shares are estimated to be trading at R581 each. The redemption date of all these shares is
29 September 2025.

Debentures: 10-year term debentures for R3 144 million were also issued around the same
time as the preference shares above. The finance costs (net of tax) on these debentures
amount to R249 million per annum. The premium and the annual administration costs are
waived, but there is a once-off administration fee of R15 million payable on 30 September
2025. Debentures structured in this manner incur interest at prime lending rate.

Long-term loan: A loan of R871,5 million was obtained on 2 October 2018 and its capital is
repaid in three equal annual instalments. The fixed 11% interest is also paid on the last day
of each financial year. Similar loans bear an interest rate of about 9,75%.

Subordinated debt: EFH also obtained an unsecured subordinated debt from African
Rainbow Capital for R2 010 million on 10 October 2015 at an equivalent interest rate of
prime+2. Similar subordinated debt facilities are estimated to yield an interest at prime lending
rate.

Short-term loan: The loan for R450 million was obtained from CreditSis Bank at prime lending
rate and is repayable on 28 February 2020. The loan was taken out to settle unexpected legal
costs after the company was embroiled in a price-fixing scandal. The company was forced to
take out this loan due to low cash reserves at the time. The cash position of the company has
since improved as EFH closed the year with more than R300 million of cash and cash
equivalents and a zero balance on its bank overdraft facility.

The interest expense on this loan for the year ending 30 September 2019 was R26 million.
Similar loans and overdraft facilities are generally priced around prime+1.

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Part C – WORKING CAPITAL MANAGEMENT

EFH’s debt levels have been on the rise in recent years due to a number of internal and
external factors which have unfolded over the years. One of the major internal factors cited is
poor liquidity management processes. The company has often flout the budgeting/forecasting
processes and as a result finds itself having to use expensive debt to fund any deficits in its
working capital. However, since the IDC bailout application the management team has
implemented more stringent controls around the working capital of the company.

The statement of financial position on 30 September 2019 had net current assets of
approximately R2 billion and is made up of the following:

* Net current assets Rm

Inventory (6 132 000 items of clothing) 1 533
Trade and other receivables 3 752
Trade and other payables 3 432
Income tax liabilities 299
Cash and cash equivalents 341
Other current assets 102
* The net current assets exclude the interest-bearing liabilities given in Part B above.

Cash sales average 25% of total sales and each month’s credit sales are invoiced on the last
day of the month. Credit sales are also collected as follows:
o 60% within 7 days after the invoice date;
o 28% by the end of the month after sales.
o 9% by the end of the second month after sales; and
o 3% is uncollectible.

Half of the monthly purchases the company makes, is paid for in the month of purchase and
the remainder in the following month. The number of items of clothing (units) in each month’s
closing inventory equals 120% of the next month’s units of sales. EFH maintains an average
product mark-up of 33% on selling price. The company also expects in the foreseeable future
to maintain the existing average cost price per unit (as indicated in net current assets above).

The actual and budgeted sales of EFH are given below:

Month Units
September 2019 (Actual) 5 253 000
* October 2019 (Actual) 5 110 000
November 2019 (Budgeted) 5 876 500
December 2019 (Budgeted) 6 054 000
January 2020 (Budgeted) 5 270 000
February 2020 (Budgeted) 5 538 600
* Actual units purchased during October 2019 totalled 6 029 800.

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Part D – ADDITIONAL INFORMATION

 EFH undertakes projects that have an internal rate of return of at least 20%.
 As at 30 September 2019, EFH had 840 million authorised ordinary shares.
 The South African corporate income tax is rate 28%.
 Prime lending rate is 10,25% and the cost of equity is 15,2%.

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REQUIRED

a) By calculating the internal rate of return, determine whether EFH should undertake the
ARISE & DREAM project. [You can scale your workings down by Rm]
(27)

b) Using market values at 30 September 2019, calculate the weighted average cost of
capital (WACC).
(18)

c) Draw up a purchases (production) budget in units for EFH for the months of November,
December 2019 and January 2020.
(10)

d) Calculate budgeted cash receipts and payments for the months of November, December
2019 and January 2020.
[Focus only on the sales and costs associated with the purchase of inventory]
(15)

e) Calculate the following ratios for EFH for the year ended 30 September 2019; and provide
practical ways the ratios can be improved (use market values where possible):
 Interest-bearing debt equity ratio (net)
 Current ratio
 Return on equity
 Price/book ratio
 Cash interest cover
(Calculations – 5 marks; comments – 12 marks)
(17)

f) Determine the number of shares to be issued by EFH to the Industrial Development

Company if the parties agree to the terms of the bailout (also calculate the new
shareholding by the major shareholders after the deal).
[Assume for the purpose of this deal each EFH share is priced at premium of 10% above
its current share price]
(8)

g) Discuss the factors that should have been considered before deciding on obtaining the
funds from the Industrial Development Company. No calculations are required.
(5)

TOTAL: 100 MARKS

UNISA 2020

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