MANAGERIAL ACCOUNTING & FINANCE II

(ACC4020W)

SOURCES OF FINANCE

READINGS: Chapter 13 – Sources of Finance

CONTENTS:

Exam technique notes on practical application

Tutorials and solutions

TUTORIAL SOLUTIONS INCLUDED FOR REVISION PURPOSES

13.12, 13.14, 13.15 (These are only provided for those who want to reinforce prior concepts)

CLASS EXAMPLE

Aquazania (e) and (f)

SEEN TUTORIALS AT THE APPROPRIATE STANDARD

Cloth Group Ltd

Thorn Limited (to be handed in)
 Factors influencing the selection of appropriate source of finance:
Comparison of debt and equity
FEATURES

Flexibility: Ability to raise finance in response to new investment opportunities

Risk: Ability to meet repayment obligations and consequences thereof

Maturity / life of instrument (matching maturities of assets and debt)

Income: Volatility of the income stream

Control: Dilution in control (75%, 50%, 35%, 20%-30% effective control)

Timing: General economic factors, Stock Market, Interest rates

Other: COST!
Equity: value given vs value received, dilutive effect on shareholders’ return.
Issue costs.

Pref’s/Debt: Rate thereof and tax (pg12)

Sale and lease back – expensive for appreciating assets
Short term > Long term

Tax: CGT, Income tax, STC

Loan used to purchase shares – Interest not deductible (Consider
purchasing assets, not shares)
Assessed loss (value of interest tax deduction reduced)
Consider prefs or s41-s47 (transfer of assets between group
companies)

Opportunity costs

SIGNALLING CONTENT
- of issuing equity (incl rights offer)
 CONSIDERATIONS when evaluating finance alternatives:

EARNINGS: VOLATILITY & QUALITY EQUITY

Kind of product/service Current ownership & how it will change

Industry Control (consider ord equity, outstanding
Contract basis (Volatile & WC commitments) options, pref’s in arrears)
Forex Exposure to takeover
Operating leverage Value of equity holding
Fixed expense commitments (e.g. leases, capital EPS and profit share
intensive?) Current returns (attractive or not?)
New Business (uncertainty and initially low/no Covenants
profit) high payout ratio limits growth, residual
Taxable income/loss (A.L. debt more costly) theory of dividends
Quality – to what extent earnings translates into restricts decision making
cash Expertise (finance, marketing/exposure, industry,
corp gov, etc)
Shareholders loans
Ability to extract capital quickly
Does not affect control
“guaranteed” return (interest ranks before
dividends)

DEBT ASSETS

Debt (/Equity) ratio (interest bearing or not?) Non-current

Interest Cover (watch out for changes at Y/E)
Loan covenants
existing and new,
often 3x, 4x interest cover required
restrictions on disposal of assets, new
acquisition, and raising new finance
side step securing asset with pre-emptive right
agreement
Credit ratings (esp Corporate bonds and
debentures, rating agency requirements)
Repayment terms and maturity profile (new and
existing debt), vs life of assets
Sureties
Usually given by shareholders/directors
Lose benefit of limited liability and potential
loss to the provider of the surety exceeds the
capital invested in the business
Potential for security:
Property
Plant and machinery (general or specialised,
ability to sell)
Already given as security?
Any undervalued (revalue and use as security for
a mortgage, or sale and lease back)
Investments: non-core to business
D/T asset: assessed loss? (would reduce value of
interest tax shield)
Current
Bank – surplus cash (2% guide)
Asset securitisation (high quality debtors?)
Working capital management ideas?
Term of Finance Type Life

Long Term Ordinary Share Capital Permanent

Debentures 10-20
Mortgage loans 5 – 25
Lease Backs 10 - 20

Medium Term Redeemable Pref’s 5 – 10

Leasing 3 – 10

Suspensive sale 3 – 10

Term Loans 3–7

Short Term Overdraft 12 months

Acceptances: Local 90 – 120 days

Acceptances: Foreign 180 days

Debtor Factoring 12 Months

TUTORIAL SOLUTIONS – FOR REVISION OF CONCEPTS

13-12
a Why is the maximum subscription price R15.00? Gastrak

The maximum subscription price is R15.00 because at subscription prices higher than R15.00,
there would be no value in the right. If the subscription price was set at say R16.00, then investors
would simply purchase shares in the market for R15.00 and the right would have no value unless
the time to excercising the right was set at a long time in the future. The rights issue would not be
successful and the company would not be able to raise the required funding via the rights issue.

b What is the problem with setting a subscription price close to the current listed price?

If the subscription price is set at a price very close to the listed price, then there is a risk that due to
general or specific market movements, the price of the share could fall below the subscription price
and place the whole issue at risk as investors will not take up their rights as the shares are trading
at lower levels in the market and they would rather purchase the shares directly in the market.

c Number of shares to be issued

Funding from rights issue 200,000,000
Subscription price 12.00
Number of shares to be issued 16,666,667

d Ex-rights price
Number of shares to be issued 16,666,667 a
Total no. of shares prior to rights issue 400,000,000 b
Number of shares to 1 right 24.0000 b/a

No. of shares
Ex-rights price Share price
per right
Value of shares prior to rights issue 15.00 24.000 360.00
Subscription price 12.00
372.00
No. of shares held after the rights issue 25.00
Estimated ex-rights price 14.88
Alternatively, we can determine the ex-rights price as follows;
Share price No. of shares Total Value
Value of shares prior to rights issue 15.00 400,000,000 6,000,000,000
Financing from rights issue 200,000,000
Total value 6,200,000,000 c
Prior to issue Rights issue
Total no. of shares after the rights issue 400,000,000 16,666,667 416,666,667 d
Estimated ex-rights price 14.88 c/d
e Value of Right
Estimated ex-rights price 14.88
Subscription price 12.00
Value of Right 2.88
f Why should a shareholder sell his rights if unable to take up rights?
If a shareholder sells her rights then the net wealth will not have changed. If a shareholder does not
sell the rights, then as the share price is expected to fall to R14.88, the shareholder will suffer a
dilution in value as the value of the right falls to zero after expiry date. An example will show this
scenario. Assume a shareholder currently owns 100 000 shares.
Market value of current holding 100,000 15.00 1,500,000
Expected value of shares after the rights issue 100,000 14.88 1,488,000
Value of rights 7 4,166.67 2.88 12,000
1,500,000
If the shareholder does not sell her rights, the value of the rights will expire.
The value of the holding will be only 1,488,000
13-14

Is the company able to borrow rather than issue equity?

What is the current debt ratio of Dripli, what is the current interest cover and can the company raise additional debt?
What is the interest rate?

If the company raises finance through an issue of shares, then this will double the issued share capital.
Currently in issue: 1000 000 shares
To raise R3000 000 @ R3 each: 1000 000 shares
Therefore if outsiders take up all these shares, Ann's holding will drop from 70% to 35% and so she will lose control.

Is R3.00 a fair price in relation to a valuation of the company?

Can Ann take up some of the issue or will any of the existing holders take up some of the new shares? A private
placement normally occurs with the institutions but as this is a small company, the placement might be with an
individual investor. Whilst institutions will generally not interfere with operations if the company is being managed
properly, the same may not hold true of individual investors.

What is the loyalty to Ann and to the company of Bonz and of the other key personnel?

Ann must consider the impact on control and the critical points she should watch are 75% (special resolution) and
50% (ordinary resolution) and effective control, hence the concern about loyalties and new holders holding
substantial blocks of shares.

8
13-15

a) The crucial considerations regarding the choice of loan or equity capital for Mr A revolve around two
fundamental factors, namely the cash flow forecasts and the nature of the assets to be employed.

If the forecast of earnings and the cash flows is erratic perhaps with an initial period of financial deficits, then equity
capital would be most desirable from Mr A's point of view. Under such circumstances, his capital suppliers would be
prepared to take the risk of little or no initial return, or a highly variable return, on their investment, in the
expectation that they would ultimately secure a return sufficiently high to compensate for the risks, which they have
undertaken. Under these circumstances, suppliers of debt capital would be likely to express reservations regarding
the security of interest payments. Also, from A's point of view, financial deficits or highly irregular patterns of
earnings will make his business vulnerable to defaulting on the payment of fixed interest charges. This could
jeopardise the continued operations of the business.

On the other hand, if the cash flow forecast is one of modest, but regular earnings, it is highly likely that loan capital
would best suit his purposes. Under such circumstances he would be able to meet his interest obligations as they
fall due. This would remove the possible threat of creditors' liquidation, if earnings were extremely volatile. Also, if
the expected returns are modest, it is unlikely that he would attract risk capital in any event. On the basis of the
limited information available regarding the product's characteristics and the extent of existing (or potential)
competition, it seems that equity capital is the most likely option perhaps combined with a limited amount of loan
capital.

If the assets employed were highly specialised, with little prospect of recovering the initial outlay in the event of the
failure of the business, they would be unlikely to provide adequate security for a supplier of loan capital. On the
other hand, Mr A might nevertheless obtain equity capital under such circumstances, although suppliers of this form
of finance would seek a higher return to compensate for the higher risk involved.

b) There are a number of possible sources of finance, which are available to Mr A. Bearing in mind the fact that
he has no track record of success as he is just starting, some obvious routes, such as the JSE will be effectively closed
to him. Possible sources of finance include Business Partners, Khula Enterprise Finance and small private equity funds
as well as the banks. However, the banks will often require security.

c) An important consideration is the personal skills of Mr A. If he has the necessary skills to organise the
production and marketing of his product, his interest in raising debt or equity will be purely in terms of finance.
However, if he has limited managerial capabilities or experience, it would be useful to select a capital supplier who
would complement his skills in product innovation. One possibility would be a joint venture, with the other party
supplying distribution, financial and/or administrative skills. On the other hand, if Mr A has the necessary managerial
skills, he might wish to retain control of his business by opting for loan capital and maintaining an arm's length
relationship with his capital supplier. However, the considerations which determine the appropriateness of a
particular form of finance to Mr A, or the suitability of Mr A's business to a capital supplier would be those
considerations set out in answer to part a) of this question.

In the biotech sector, there are small companies that make important discoveries but do not have the ability to
finance the next stage of development or trials. Such companies also do not have the ability to undertake the
distribution of a drug arising from such discoveries. In practice, small companies will either enter into joint ventures
with the major pharmaceutical companies once the discovery is technically viable or the major company will buy out
the shareholders of the small biotech company.

9
CLASS EXAMPLE – AQUAZANIA (SAICA 2015) 100 MARKS

Aquazania Tanks (Pty) Ltd (‘Aquazania’) is a manufacturer of water storage tanks for use in farming,
industrial and residential applications. The water storage tanks are used to collect rainwater for
irrigating small crop fields or gardens and providing drinking water for livestock and also for use in
sanitation by commercial and industrial customers. Water has become a scarce resource globally and
there is increasing focus on conserving this precious resource. The demand for Aquazania’s products
has grown dramatically in recent times as more and more companies and households embrace water
conservation practices.

Aquazania manufactures a limited range of vertical water storage tanks made from polyethylene, a
type of plastic. These tanks are used above the ground to collect rainwater directly or from rooftops.

The company previously used to manufacture tanks ranging in size from 250 litres to 15 000 litres. In
2008 Aquazania discontinued the manufacture of tanks that are smaller than 5 000 litres in size, as
the company found that manufacturing too wide a product range was not cost efficient. The company
still sells smaller water storage tanks but these are procured from outsourced suppliers.

Aquazania currently manufactures the following three products only:

Product reference Storage capacity

WS5 5 000 litres
WS10 10 000 litres
WS15 15 000 litres

Aquazania uses a manufacturing process called rotational moulding to produce water storage tanks.
The manufacturing process essentially involves three steps:
• The polyethylene powder (‘powder’) is loaded into a mould which is then transferred into a
large oven, where it is slowly rotated. The heat and rotational movement, both of which are
controlled by computers, result in the powder melting into the shape of the mould.
• The mould is then cooled by removing the heat while continuing to rotate the mould inside the
oven.
• The hollow plastic tank is later removed from the mould and various components (e.g. pipe
fittings and water level indicators) are attached to the tank.

1 Forecasts for the 2016 financial year

The company’s manufacturing plant and equipment are nearing the end of their useful lives and sales
volumes are being constrained by production capacity.

10
The financial manager of Aquazania has produced the following production and sales forecast,
together with relevant notes, for the financial year ending 29 February 2016 (‘FY2016’) for review by
the board of directors:

Aquazania
Forecast for 12 months ending 29 February 2016
Notes WS5 WS10 WS15 Total
Units to be produced and sold 3 500 7 500 3 000 14 000
Expected selling price per unit R5 500 R10 500 R16 000

Manufacturing forecasts
Machine hours per unit 1,2 1,6 1,8
Total machine hours 1.1 4 200 12 000 5 400 21 600

Direct labour hours per unit 6,0 10,0 10,0

Total direct labour hours 1.2 21 000 75 000 30 000 126 000

Powder per unit (kg) 80,0 180,0 300,0

Direct production costs

Direct labour cost per hour R95,00 R95,00 R95,00
Powder cost per kilogram 1.3 R20,25 R20,25 R20,25
Component cost per unit R325,00 R390,00 R450,00

R per R per R per

R
unit unit unit
Production overheads
Total variable production overheads
1.4 5 184 000
Allocation of variable production
overheads based on machine hours
288 384 432
Fixed production overheads 11 680 000
Surplus direct labour costs 1.2 505 400
Depreciation of machinery 480 000
Other 1.5 10 694 600
Allocation of fixed production
overheads based on total revenue
440 840 1 280

Gross profit margin

Selling price 5 500 10 500 16 000
Powder cost (1 620) (3 645) (6 075)
Direct labour (570) (950) (950)
Components (325) (390) (450)
Variable production overheads (288) (384) (432)
Fixed production overheads (440) (840) (1 280)
Gross profit per unit 2 257 4 291 6 813

Gross profit percentage 41,0% 40,9% 42,6%

11
 Aquazania
Forecast for 12 months ending 29 February 2016 (cont.)
WS5 WS10 WS15 Total
Notes
R
Manufacturing profit summary
Revenue 146 000 000
Powder cost (51 232 500)
Direct labour (11 970 000)
Components (5 412 500)
Variable production overheads (5 184 000)
Fixed production overheads (11 680 000)
Gross profit 60 521 000

Notes

1.1 The theoretical annual capacity is 24 000 machine hours. However, planned maintenance and
an annual three-week production shut-down result in a maximum production capacity of
plant and equipment over the 12-month period ending 29 February 2016 of 21 600
machine hours.
1.2 Available direct labour hours per annum are currently 131 320 hours. The surplus direct labour
hours (5 320 hours) are not allocated directly to units produced but rather included in fixed
production overheads.
1.3 Polyethylene prices tend to track changes in the prevailing crude oil price, which is denominated
in USD. Prices also vary depending on the global demand versus the supply of polyethylene.
1.4 Variable production overheads comprise mainly electricity, water and consumables used in the
manufacturing process. Aquazania has historically allocated variable production overheads
based on machine hours. These are regarded as the most appropriate indicator of electricity,
water and consumables usage in the manufacturing process.
1.5 Other fixed production overheads comprise mainly indirect salaries, wages and rental costs.

2 FY2017 to FY2021 forecasts using new manufacturing equipment

Aquazania is considering investing in new manufacturing equipment. If they do invest, the equipment
will be installed and operational by 1 March 2016. The existing equipment will be scrapped if the new
equipment is acquired and management does not expect to receive any value for the existing
equipment. The estimated cost of the new equipment is R50 million. This will include the cost of new
moulds and industrial design services. The expected economic and useful life of the new equipment
is 285 000 machine hours and it will have no residual value at the end of its useful life.

12
The estimated production and sales for the year ending 28 February 2017, using the new equipment,
are summarised in the table below:

Aquazania
Forecast for 12 months ending 28 February 2017
Notes WS5 WS10 WS15 Total
Units to be produced and sold 2.1 3 500 8 250 3 000 14 750
Expected selling price per unit 2.2, 2.8 R5 940 R11 760 R17 280

Manufacturing forecasts
Machine hours per unit 1,2 1,5 1,6
Total machine hours 2.3 4 200 12 375 4 800 21 375

Direct labour hours per unit 6,0 9,0 9,0

Total direct labour hours 2.4 21 000 74 250 27 000 122 250

Notes

2.1 The demand for WS5 and WS15 products is expected to remain at FY2016 levels for the
foreseeable future. However, the demand for WS10 is increasing and Aquazania estimates that
it can manufacture and sell the following units per annum of this product:

FY2017 FY2018 FY2019 FY2020 FY2021

Annual number of WS10
units to be manufactured
and sold 8 250 9 000 9 750 10 500 11 250

2.2 The selling price increase for WS5 and WS15 is targeted to be 8% per annum for the forecast
period (FY2017 to FY2021).
2.3 The annual production capacity of the new equipment is 36 000 machine hours per annum,
after taking into account scheduled maintenance downtime and annual holidays.
2.4 Aquazania has not required labourers to work overtime in recent years due to production
capacity constraints. Should overtime be necessary, existing labourers would be able to work a
maximum of 25% more hours annually, provided they are paid 150% of normal hourly rates for
overtime worked. There are no plans to retrench any workers for the foreseeable future.
2.5 Powder usage for each product is expected to remain the same as in FY2016 throughout the
forecast period. Component costs of each product are expected to increase by 6,0% per annum
from FY2017 to FY2021.
2.6 Fixed production overheads, excluding depreciation and surplus direct labour, are expected to
increase by 7% per annum over the forecast period. The current infrastructure is sufficient to
cater for expected growth over the forecast period.
2.7 Sales and marketing expenditure has historically been 2,5% of revenue and this is expected to
continue in the future.

13
2.8 The following information relates to WS10 for the forecast period:

Aquazania
Forecast for FY2017 to FY2021
FY2017 FY2018 FY2019 FY2020 FY2021
R R R R R
Selling price per unit of
WS10 11 760,00 12 700,80 13 716,80 14 814,10 16 000,00
Powder cost per
kilogram 22,68 24,50 26,50 28,50 30,80
Direct labour cost per
hour 104,50 112,80 121,90 131,60 142,10
Component cost per
unit of WS10 413,40 438,20 464,50 492,30 521,90
Variable production
overheads per
machine hour 259,20 279,90 302,30 326,50 352,60

The selling price of WS10 is to be increased by 12% in FY2017, in view of planned design
enhancements to the product and the expected increased demand.

3 Analysis of investing in new equipment

The board of directors has requested an incremental net present value analysis of investing in the new
equipment versus retaining the status quo to confirm whether the investment is economically viable.

The requested analysis is to be performed based on the following assumptions:

• A pre-tax weighted average cost of capital of 15% is used for Aquazania;
• The taxation and working capital consequences are ignored;
• The analysis is based on a five-year period commencing on 1 March 2016;
• All cash flows occur at the beginning or end of the year, whichever is appropriate; and
• The forecast machine hours and direct labour hours per unit manufactured in FY2017 remain
constant throughout the next four years.

3.1 Status quo

Aquazania could operate the existing equipment for the period FY2017 to FY2021 provided it spends
an extra R1 million annually on repairs and maintenance. If Aquazania were to pursue this option, the
planned production and sales quantities for FY2016 would have to be maintained (i.e. no volume
growth would be possible) throughout this period and it would service its existing customer base only.
The selling price increases of WS10 over the period FY2017 to FY2021 would be 6,0% per annum if this
option is pursued.

Given the production constraints currently being experienced, maintaining the status quo would allow
competitors the opportunity to increase their market share, particularly with regard to the WS10
product.

4 Allocation of fixed production overheads

The board of directors of Aquazania has questioned whether the allocation of fixed production
overheads using relative revenue values of products sold is appropriate. It would appear that this
favours products with a lower revenue value, which may be inaccurate. The board has requested that
an analysis be performed to determine whether allocating fixed

14
production overheads based on direct labour hours or machine hours would provide a better
reflection of the absorption of fixed overheads during the manufacturing process.

5 Funding of new manufacturing equipment

Aquazania currently has R10 million surplus cash available to invest in the new equipment. It will need
to raise the balance required, amounting to R40 million, from external sources. The company has
received two proposals to fund the planned capital expenditure.

5.1 Ziggy Commercial Bank (‘Ziggy’)

Ziggy is Aquazania’s commercial banker and has offered to advance a R40 million loan to the company
on the following terms and conditions:
• The loan will be advanced on 29 February 2016 and will be repayable in five equal annual
repayments, with the first instalment due on 28 February 2017;
• The loan will bear interest at a fixed rate of 10,0% per annum; and
• The loan will be secured by a cession and pledge of Aquazania’s trade receivables and a notarial
general bond over inventories.

5.2 ADF Infrastructure Fund (‘ADF’)

ADF has offered to subscribe for preference shares to be issued by Aquazania. The preference shares
will be created and issued on the following terms and conditions:
• 40 000 preference shares will be issued at no par value for a total subscription price of R40 million
on 29 February 2016;
• The preference shareholders will have no voting rights;
• The preference shareholders will be entitled to receive annual dividends in arrears, equivalent to
7% of the total subscription price and it will be cumulative; and
• The preference shares will be redeemable at a premium of 10% on the total subscription price on
28 February 2021 or convertible into 5% of the total ordinary shares in issue of Aquazania at the
time, at the election of Aquazania.

15
INITIAL TEST OF COMPETENCE

JANUARY 2015

PROFESSIONAL PAPER 4

This question consists of two parts. Answer each part in a separate answer book.

Marks
QUESTION 1, PART II – REQUIRED Sub-
total Total
(e) Discuss each of the two finance proposals available to Aquazania to fund the
acquisition of the new equipment and recommend which of these should be
pursued by the company. Include any further issues that may need to be
clarified with regard to each proposal. 11

Communication skills – logical argument 1 12

(f) Identify and describe the key business risks that Aquazania faces for
the foreseeable future, assuming that the company invests in the new
manufacturing equipment. 16

Communication skills – clarity of expression 1 17

Total for part II 29
CLOTH GROUP (SEEN) 50 marks

Cloth Group Ltd (‘Cloth Group’) is a clothing retailer with 55 stores throughout South Africa. These
stores, which focus on fashion clothing, are situated in suburban shopping malls and their target
market is 25 to 45 year-old females and males. Approximately 75% of sales are on credit and
customers are granted 30 days’ interest-free credit from the date of the statement. If payments are
not made within this period, customers have to pay interest on the outstanding balance, calculated
from the date of purchase, at the prime overdraft lending rate (currently 15,5% per annum) plus 4%.
Customers are required to settle the full amount owing on a purchase within six months.

Cloth Group is listed on the JSE Securities Exchange. The company has performed well over the past
two years, reporting revenue of R412 million for the year ended 31 January 2009 (2008:
R357 million) and achieving a gross profit margin of 42% for the 2009 financial year (2008: 41%).

Cloth Group purchases clothing from foreign and local suppliers. Suppliers are selected based on the
quality of merchandise supplied, pricing and reliability. The majority of foreign suppliers are based
in Europe and invoice Cloth Group in euro (€).

The audited statement of financial position of Cloth Group at 31 January 2009, together with
comparative figures, is set out below:

CLOTH GROUP LTD

STATEMENT OF FINANCIAL POSITION AT 31 JANUARY
2009 2008
R’000 R’000
ASSETS
Non-current assets
Property, plant and equipment 102 280 89 180

Current assets 198 050 169 800

Inventories 49 800 43 340
Trade receivables 129 600 110 180
Cash and cash equivalents 18 650 16 280

TOTAL ASSETS 300 330 258 980

EQUITY AND LIABILITIES

Share capital 15 000 15 000
Retained earnings 192 875 153 000
Total equity 207 875 168 000

Current liabilities 92 455 90 980

Current borrowings (bank overdraft) 29 050 42 090
Trade and other payables 34 080 27 100
Shareholders for dividends 11 250 9 750
Taxation payable 18 075 12 040

TOTAL EQUITY AND LIABILITIES 300 330 258 980

Raising of medium-term finance

The Treasury Division of Cloth Group has been tasked with raising finance of between R100 million
and R125 million. Cloth Group requires the funding to grow its trade receivables and consequently
revenue. The Treasury Division has received various formal proposals and has short-listed the
following two proposals:

1 Euro denominated bond

Total nominal value €9 600 000

Coupon (fixed) 6,9%
Issue date 31 March 2009
Maturity date 31 March 2012

Interest coupon on the bond is payable annually in arrears. The total nominal value is
repayable in full on the maturity date.

2 Syndicated loan

Principal amount R120 000 000

Nominal interest rate 3 month JIBAR plus 2,5%
Loan advance date 31 March 2009
Term 3 years
Upfront issuance cost 2% of the principal amount

Interest on the loan is to be calculated and paid quarterly in arrears. The current Johannesburg
Interbank Agreed Rate (JIBAR) is 12,5%. The principal amount is to be repaid in three equal
annual instalments, with the first repayment due on 31 March 2010. The upfront issuance cost
is to be paid by Cloth Group on the loan advance date, or the company can elect to receive
98% of the principal amount on the advance date.

Cloth Group’s policy is to hedge all foreign currency exposure. Their commercial bankers have quoted
the following spot and forward exchange contract rates:

Current spot rate €1 : R12,50

12 months forward to 31 March 2010 €1 : R13,75
24 months forward to 31 March 2011 €1 : R15,10
36 months forward to 31 March 2012 €1 : R16,60

Capital structure

Cloth Group has historically funded its growth out of its own cash flows and through short- term
borrowings, mainly in the form of bank overdrafts. The Chief Executive Officer of Cloth Group has
asked the Financial Director to determine what impact the raising of medium-term finance will have
on the weighted average cost of capital (WACC) of Cloth Group.
Information that may be relevant in determining Cloth Group’s WACC is set out in the table below:

Cloth Group
Number of shares in issue 15 000 000
Current share price R24,60
Beta co-efficient 0.90
Effective normal income tax rate 28%
Dividend per share declared on 31 January 2009 75c

Other information
Current yield of the R204 RSA government bond, maturity
date 21 December 2018 9,0%
Current yield of the R153 RSA government bond, maturity
date 31 August 2010 9,4%
Premium for market risk 8,0%

REQUIRED

Marks

(a) Calculate and determine which debt instrument (euro denominated bond or
the syndicated loan) will be the most cost effective way for Cloth Group Ltd to
raise medium-term finance. 15
Ignore all tax implications.

(b) Identify and describe the key factors that Cloth Group Ltd should
consider in evaluating which debt instrument to issue. 6

(c) Calculate, with reasons, the weighted average cost of capital (WACC) of Cloth
Group Ltd at 31 March 2009, assuming that the company elects to issue the
euro denominated bond. 12

(d) Assuming that Cloth Group Ltd elected to enter into the syndicated loan
agreement, discuss the key factors and issues that Cloth Group Ltd should
consider in evaluating whether to change from a floating interest rate to a fixed
interest rate. 5

(e) Briefly describe the concept of asset-backed securitisation and indicate what
benefits, if any, could accrue to Cloth Group Ltd from securitising its trade
receivables. 5

(f) Identify the key procedures that Cloth Group Ltd should follow in
assessing the creditworthiness of new customers. 4

Presentation marks: Arrangement and layout, clarity of explanation, logical

argument and language usage. 3

A table of present value factors for various interest and/or discount rates for varying periods and a
table of various nominal interest rates paid quarterly in arrears together with the equivalent effective
annual interest rates are provided on the next page.
FUTURE VALUE AND PRESENT VALUE TABLES: CLOTH GROUP

Present value tables

Present value interest factors for R1,00 discounted at various rates for varying periods
Interest rate
Period
10,00% 11,00% 12,00% 13,00% 14,00% 15,00% 16,00% 17,00% 18,00%
1 0,909 0,901 0,893 0,885 0,877 0,870 0,862 0,855 0,847
2 0,826 0,812 0,797 0,783 0,769 0,756 0,743 0,731 0,718
3 0,751 0,731 0,712 0,693 0,675 0,658 0,641 0,624 0,609
4 0,683 0,659 0,636 0,613 0,592 0,572 0,552 0,534 0,516
5 0,621 0,593 0,567 0,543 0,519 0,497 0,476 0,456 0,437
6 0,564 0,535 0,507 0,480 0,456 0,432 0,410 0,390 0,370
7 0,513 0,482 0,452 0,425 0,400 0,376 0,354 0,333 0,314
8 0,467 0,434 0,404 0,376 0,351 0,327 0,305 0,285 0,266
9 0,424 0,391 0,361 0,333 0,308 0,284 0,263 0,243 0,225
10 0,386 0,352 0,322 0,295 0,270 0,247 0,227 0,208 0,191

Interest rates

Nominal interest rate Equivalent effective

paid quarterly in arrears annual interest rate
10,00% 10,38%
11,00% 11,46%
12,00% 12,55%
13,00% 13,65%
14,00% 14,75%
15,00% 15,87%
16,00% 16,99%
17,00% 18,11%
18,00% 19,25%
19,00% 20,40%
20,00% 21,55%
THORN – PGDA FINAL EXAM 2016 (23 MARKS: 30 MINUTES)

Thorn Limited (Thorn) is a JSE listed company that develops, acquires and manages independent schools
in South Africa. It has grown rapidly and has seen a dramatic rise in its share price. The management
of Thorn believes that there are many growth opportunities on offer and are keen to continue to grow
rapidly.

One option for growth is to build schools as part of the development of residential areas. Thorn has
partnered with property developers and the arrangement appears to be a win-win. Families like
buying properties close to good schools and then Thorn has high demand for the school as soon as it
opens. These opportunities are dependent on the level of property development and Thorn is keen
to explore another growth option in case property development slows down.

Another option for growth that has worked well is to acquire other private schools. Most of these
deals have been small (involving no more than 3 or 4 schools) but a large deal has now presented
itself. Sparks Limited (Sparks) is another JSE listed company that has remained fairly stagnant over
the past few years. Investors have grown frustrated with the Sparks management team that appears
to be slow to realise the potential in the education market. Thorn has been approached by a large
shareholder in Sparks that believes that a deal might be beneficial to both parties. The shareholders
believes that there could be both revenue and cost cutting synergies available if the companies
became one.

The following table provides a high level overview of these two companies:

Thorn Sparks
P/E ratio 199 29
Revenue R1bn R1.9bn
Market capitalisation R12.5bn R5.2bn
Number of students 29 000 41 000

Thorn management is keen to pursue this deal and has instructed its bankers to arrange finance for an
offer. The bankers believe that the best possible source of finance would be debt, because it is lower
than the cost of equity. Thorn management however are keen to get another opinion and have
approached an independent consultant to offer advice on the matter. There are now two options on
the table and these are presented below:

Debt finance option

- Fund the entire purchase with debt.
- Security will be provided. This will be all the school properties that Thorn owns.
- Debt covenants will be set at a maximum debt/equity ratio of 60%.
- The repayment terms are JIBAR (currently at 6.125%) + 3% variable rate with annual
payments of both capital and interest over 10 years.
Hybrid finance option
- Issue equity to fund 50% of the purchase price and raise debt to fund the other 50% of the
purchase price.
- The Sparks shareholders will initially have the choice between these options. This could
mean that some shareholders receive their payment 100% in shares whilst another
shareholder might prefer 100% cash. If there is uneven demand, shareholders will receive
a blend of the two but weighted towards what they would prefer to receive.
- The debt repayment terms are 10.5% fixed rate with annual payments of both capital and
interest over 5 years.
Thorn specialises in primary schools whilst Sparks predominantly operates high schools and tertiary
education establishments. Sparks also has a lot of experience with incorporating technology in the
classroom and has signed a long-term contract with the Department of Education to roll out tablets to
all the students that receive financial aid.

Sparks does not own any of its schools but has signed leases. This has allowed the company to maintain
low gearing as it has not needed debt to purchase properties. The terms of the lease are generally long-
term but some are soon up for renewal within the next two years. Sparks is on good terms with its lessors
and believes that these negotiations will be a success.

Thorn management know that this deal will the largest they have ever attempted. They do however
believe that this could be the perfect time due to the recent weak share price performance of Sparks as
well as the great growth opportunities that exist in the SA education market. They also believe that this
deal could help shift attention away from some recent bad newspaper coverage. Thorn has recently
grabbed newspaper headlines due to an incident of racism at one of its schools. The headmaster
segregated students according to race and this has led to a national outcry. Thorn management has
apologised and has clearly stated that this was not in accordance with company policy. There has been
damage to the Thorn brand however and many parents are upset that this incident occurred.

Some Thorn shareholders are also starting to ask questions about the Thorn dividend policy. Thorn has
never paid a dividend and believes that all earnings should be retained and invested in the growth
opportunities that exist.

REQUIRED
(a) Critically analyse the two suggested finance arrangements for the deal. You should 12
offer a recommendation to Thorn Ltd.

Communication skills – layout and structure 1

(b) What revenue and cost synergies would you expect from such a deal 5

Communication skills – clarity of expression 1

(c) Critically analyse the current dividend policy of Thorn. 4