Management Professional Competence

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Multi Subject Assessments – Winter 2019

A.1 Perfect Building & Plumbing Supplies Ltd (PBPS)

(a) Divisional performance analysis

(i) Revenue
The Building Division has increased sales by 6.4% whilst the Plumbing Division has
lagged behind with a sales growth of 5.9%. Both divisions have failed to meet the
10% revenue growth target for 20X9 which the directors are likely to find
disappointing. As both divisional managers believe sale volume growth has exceeded
10%, this suggests both divisions have discounted to achieve target sales volumes
without meeting the revenue target. This points to price competition in the
marketplace.

(ii) Gross margin

The gross margin for the Building Division has held steady (24.5% to 24.6% in 20X9),
suggesting that cost management initiatives have offset increased discounting.

The gross margin for the Plumbing Division has fallen from 30.5% to 28.7%. It is
possible that inventory write downs have contributed to this as the Plumbing
Division carries a very wide product range which the division has been tasked with
reducing.

Whilst the Plumbing Division has achieved lower margin compared to the last year,
the gap between the two divisions is reducing.

(iii) Operating costs and operating profit

Operating costs at both divisions have increased and exceeded revenue growth at
7.2% for the Building division and 7.8% for the Plumbing division.

At the Building Division, this increase has been offset by the increase in sales as the
operating profit margin is unchanged 2.7%.

However, there has been a significant fall in operating margin from 3.9% to 1.6% at
the Plumbing Division, suggesting further cost control measures are required. If costs
continue to rise, then it is likely that the Plumbing Division will become loss-making.

Working capital
(i) Inventory
At the Building Division, inventory days have decreased from 56 to 44 days which is a
divisional achievement.

At the Plumbing Division, inventory remains high at 75 days; a fall of two days from
77 days. This suggests that efforts to reduce the product range have only been
marginally successful, which highlights a risk that inventory may be overstated if any
of it is obsolete or has deteriorated.

(ii) Receivables
Receivables days at the Building Division have only slightly decreased from 63 to 62
days, which fails to meet the 10% reduction target.

Receivables days at the Plumbing Division have increased from 47 to 49 days despite
the 10% reduction target. This has contributed to a weaker cash position at the
Plumbing Division and suggests there could be an issue with credit control at the
Plumbing Division.

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(iii) Payables
Whilst payable days at both divisions have improved marginally (Building Division:
95 to 89 days; Plumbing Division: 119 to 107 days), this improvement doesn't go as
far as the board required. Only the Building Division has marginally met the 90-day
target.

The level of payables at the Plumbing Division is a particular concern, suggesting that
the division is regularly exceeding agreed credit terms with its suppliers.

(iv) Return on capital employed (ROCE)

The Building Division has improved its ROCE from 7.8% to 8.5%, which is due to its
growth and cost management. The Plumbing Division has seen a significant fall from
13.3% to 5.8% as it appears to be struggling to maintain pricing levels and pass on
rising costs to its customers.

In summary
Both divisions have missed their revenue targets. The board need to understand if this is
internally related due to its product offer and promotional activity, or whether it is
indicative of market sector trends and the activities of its competitors. Therefore, the
following recommendations are suggested:
 A full external market analysis, and internal product and promotion review is advised
to determine actions which could improve PBPS's growth and target profit levels.
This is particularly urgent for the Plumbing Division which has underperformed
significantly and is facing the risk of liquidity problems if these trends continue.
 Both divisions should look to make efficiencies in their cost bases. This could include
a divestment of underperforming sites in the case of the Plumbing Division. Cost
efficiencies in the warehousing and distribution network would help to support and
could be achieved by implementing a better logistics management system.
 A full aged receivables recoverability analysis should be performed, particularly at
the Plumbing Division where receivables remain high in spite of the target to reduce
receivable days by 10%.
 A review of payables is also required as these are excessive at Plumbing Division and
could be damaging goodwill in the supply chain. It may be that the volume of
suppliers (over 25,000) is simply too large to manage effectively. Therefore, an
initiative to reduce the number of suppliers to a smaller number of key suppliers
would help to improve procurement efficiency and manage the level of outstanding
payables.
 The board of PBPS is advised to address the fall in ROCE at the Plumbing Division by
downsizing its plumbing operations through the closure of underperforming stores.

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 Management Professional Competence
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Appendix 1 – Divisional performance analysis

Divisional performance Building Division Plumbing Division

20X9 20X8 Change 20X9 20X8 Change
Rs. in million (%) Rs. in million (%)
Revenue 8,565.3 8,048.0 6.4 6,171.5 5,828.8 5.9
Cost of sales (6,459.4) (6,076.7) 6.3 (4,397.4) (4,051.3) 8.5
Gross profit 2,105.9 1,971.3 1,774.1 1,777.5
Operating costs (1,878.1) (1,751.2) 7.2 (1,673.9) (1,552.8) 7.8
Operating profit 227.8 220.1 100.2 224.7

Ratio analysis
Gross profit margin 24.6% 24.5% 28.7% 30.5%
(gross profit / revenue)
Operating profit margin 2.7% 2.7% 1.6% 3.9%
(operating profit / revenue)
Inventory days 44 56 75 77
(inventory / cost of sales 
365)
Trade receivable days 62 63 49 47
(receivables / revenue  365)
Trade payable days 89 95 107 119
(payables / cost of sales  365)
Return on capital employed 8.6% 7.8% 5.9% 13.3%
(Operating profit / TALCL)

(b) Moving to a single e-commerce platform and the e-marketing opportunities it would create
(i) E-commerce platform
Operating different e-commerce platforms across different business units involves
unnecessary duplication of systems maintenance, and consequently a larger than
desired support function. Moving to a single platform should bring about a reduction
in support activities and associated costs.

Since the products offered by each division are likely to be complementary, for
example between plumbing and building supplies, it is reasonable to expect some
level of cross-selling. It is therefore undesirable to operate independent platforms. If a
common platform is used by both divisions, then PBPS should be more likely to
realise cross-selling opportunities.

One of the strategic developments PBPS is exploring is with regard to customer

orders being delivered directly from the supplier. For this to work, the link between
the end customer and the supplier needs to be robust and efficient, and it would not
be realistic to expect suppliers to deal with numerous disparate platforms. As a result,
the move to a single e-commerce platform could be seen as a first step on the road to
direct supplier delivery.

Inventory information could be shared amongst business units, allowing them to fulfil
customer orders from stores within other business units. Not only would this speed
up fulfilment, improving the customer experience, but it would also allow PBPS to
better track the items it has in stock, reducing the investment in working capital.

Where changes are required, for example, updating system security or information
relating to new product lines, it will likely be faster and more efficient for these
changes to be made to a single platform, avoiding the need for excessive systems
down time. It also reduces the risk of human error when the updating takes place.

(ii) E-marketing opportunities

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Data mining
The new e-commerce site will give PBPS access to a unified data set, enabling it to
undertake data mining to gain meaningful insight of current customer purchasing
trends. This will improve inventory ordering to match current consumer demands
and ensure there is sufficient range and quantity.

Targeting promotions for specific groups of customers

As an extension of the recommendations, customer data can be analysed to
understand the promotions that would be most suitable for them. For example, a
customer who has been inactive for a long period, may be attracted back with a
generous discount voucher, although such a voucher would not be necessary for a
customer who is already a regular purchaser.

Individual customer offers

Customer buying history can be analysed in detail so that suitable products can be
promoted for each user. This is more effective than promoting a generic set of
products that may not be of interest to the consumer.

Improved customer feedback and customer survey engagement

A personalised marketing approach encourages dialogue between PBPS and the
customer. For example, a customer who has purchased a new bathroom suite could
be sent a link to a blog or video that suggests handy hints for installing the products.
Customers are more likely to provide feedback if it is easy to submit electronically.
The more the customer engages with the e-commerce platform, the more likely they
are to share their thoughts.

This is particularly popular with regard to feedback on their purchases. Such

feedback is especially popular with other customers, as it is seen as less biased than
marketing information, written by the retailer. Furthermore, it creates even more
data for PBPS to analyse, which in turn, can inform the range of products it stocks and
the ones it promotes to specific customers.

(c) Using benchmarking at PBPS to improve product integrity and staff turnover

(i) Product integrity

Product integrity is a key CSR aim for PBPS. It is likely to be more relevant for PBPS to
adopt industry-wide best practice in this area, and PBPS may find information on
competitors easily available. Specific areas of competitive benchmarking could
include information on product recalls and customer complaints compared to other
providers.

Although PBPS is currently unaware of any specific product integrity issues, this may
be due to a failure to identify issues rather than an absence of issues. PBPS needs to
have confidence in its processes to avoid any impact on customers in respect of
product integrity.

It is crucial that PBPS adopts, and is seen to adopt, best practice to provide assurance
to customers and regulators. This is particularly important for PBPS, as it has such a
diverse supplier base, with many of its suppliers having entered its supply chain via
acquisitions. This may mean that those suppliers have not been subject to the same
rigorous audit process that PBPS is likely to apply when accepting a new supplier in
its own right.

It would be impractical to audit all suppliers in a timely fashion, and therefore, PBPS
should use benchmarking to create a common set of criteria to issue to each supplier,

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 Management Professional Competence
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ahead of a more rigorous audit programme.

(ii) Staff turnover
Staff turnover needs to be addressed because experienced and knowledgeable staff
contribute directly to the customer experience, and this is a critical success factor for
PBPS.

Benchmarking between PBPS and similar large retail or other industry operations,
may well assist in developing training programmes for customer facing staff.
Benchmarking recognises that even though a company may operate in a different
industry, concepts such as customer service are transferable and good lessons can be
learned and applied by PBPS.

PBPS may find it challenging to gather sufficient customer service data from external
organisations to conduct an effective benchmarking exercise. Such data would be a
source of competitive advantage and therefore is normally closely protected.

Benchmarking will also enable PBPS to identify factors or initiatives which are
successfully used by other organisations to retain staff and minimise the impact of
staff turnover, and implement similar initiatives which are relevant to the nature of
PBPS's operations.

(d) Product development

(i) The following financial analysis, based on director assumptions, suggests there is
additional profit to be earned if similar margins can be generated, however, there are
reservations which are discussed below:

Expected net profit margin

Year 1 2 3 4 5 Total
------------------------- Rs. in million -------------------------
Revenue
(20% p.a. growth) 40.0 48.0 57.6 69.1 82.9 297.6
(199.5
COS (balancing)
(26.8) (32.2) (38.6) (46.3) (55.6) )
Gross profit (33.0%) 13.2 15.8 19.0 22.8 27.3 98.1
R&D (8) (8)
Training (4) (1) (1) (1) (1) (8)
Refit costs (1.2) (1.2) (1.2) (1.2) (1.2) (6)
Lost margin
(Rs. 8m  26.4%) (2.1) (2.1) (2.1) (2.1) (2.1) (10.5)
Total expected profit (2.1) 11.5 14.7 18.5 23.0 65.6

Net margin (5%) 24% 26% 27% 28% 22%

Working
 Gross profit margin = 3,888 / 14,736.8 = 26.4%
 Expected new product profit margin = 26.4%  1.25 = 32.91% say 33%

Reservations
 Year 1 sales are highly speculative due to the innovative nature of the products, so
despite what the marketing director has said, the sales figure is far from certain. It
also seems likely that the project will need a further, perhaps yearly, injection of
R&D expenditure due to the highly technical nature of the industry.
 The five-year analysis shows sales continuing to grow at a rapid rate (20% p.a.).
However, high-tech products are likely to have a finite life cycle, so it seems
debatable whether the products could sustain this rate of growth over the entire

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five-year period.
 The profit margins use the 20X9 gross margin for PBPS overall, but the margin
varies between building and plumbing products. Product specific gross margins
should be used when the nature of the new ecological products are clearer.
 The profit margin is forecast to remain constant over the entire lifecycle, which is
unlikely, particularly as margins will probably reduce over time due to the high-
tech nature of the products. For example, they would lose their cutting-edge
position in the market if competitors introduced similar products or new
innovations of their own that were superior.
 There is also no mention of any marketing spend, yet this seems like an oversight
as it would be essential for a new product launch.
 The loss of floor space, and ultimately some product ranges, may have a
detrimental impact on customer satisfaction and long-term supplier agreements.
The opportunity cost of lost sales seems too general. A separate analysis would
need to be undertaken to determine which ranges to cut, and therefore provide
more detailed analysis than is available here. Furthermore, since sales of the new
range are forecast to grow, it seems probable that PBPS would wish to devote
more floor space to the new range in future periods, increasing the opportunity
cost of lost sales and requiring further refit costs.

(ii) Suitability, acceptability and feasibility analysis

Suitability: developing a new product is consistent with PBPS's aim to sell and
"continuously improve the breadth and quality of product range". It also relates well to
being responsive 'to changing customer needs' and its aim to 'minimise environmental
damage'.

The option is also suitable in that it responds to market opportunities presented by recent
government initiatives and corresponding high levels of demand.

Acceptability: the market for sustainable eco-friendly products at the forefront of the
industry is likely to be less price sensitive, as demonstrated by the higher than average
gross margins. This higher gross margin will also be acceptable to stakeholders in general
and shareholders in particular.

However, the project involves a significant amount of risk. Demand is highly dependent on
the government's policy to offer tax incentives for environmentally friendly products. It is
also highly exposed to other technological advances which might wipe out PBPS's
competitive advantage. There is also a risk that suppliers will attempt to take advantage
of their increased power, since the supply chain for the new products would become
inevitably far more concentrated.

Feasibility: PBPS appears to have identified a small number of potential suppliers within
its supply chain, but it is unclear whether they have the technical and financial capability
to develop the required products. Furthermore, since the launch of these products is likely
to be extremely time-sensitive, it may not be feasible to get them to market on time from a
standing start.

Although alternative external suppliers have been identified, they lack the production
capacity to meet PBPS's requirements. PBPS may consider a joint venture, an acquisition,
or some form of licence agreement, but there is no information on whether these options
would be feasible.
Recommendation:

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The potential returns suggest that the proposal has merit and should be analysed further
with new product development discussions held with potential suppliers. Additionally,
further due diligence on the projected revenues and costs should be undertaken to ensure
projected returns are not overstated.

Whilst there is concern regarding reliance on one supplier, it is likely that other
competitors will enter this market to meet increasing customer demand, if PBPS fail to
do so.

(e) Code of Conduct

Introduction
A Code of Conduct clarifies the ethical values required to meet the expectations of
stakeholders in any relationship – for PBPS, the Code of Conduct relates specifically to its
relationship with its suppliers. The anonymous letter demonstrates the need for such a
code: given that PBPS deals with over 25,000 suppliers, so the scale of the potential issue
is considerable; getting it right will be a major challenge for the PBPS Board.
Given the risk of further cases of bribery and fraud across suppliers, it is apparent that
although PBPS has its own corporate responsibility aims, they are either insufficient or
invisible to suppliers. As such, the first issue is producing a Code that is both fit for
purpose and transparent for all to see, while the second issue relates to its enforcement.
Fitness for purpose and transparency
To work properly, the Code should clarify exactly what is and is not acceptable conduct
between PBPS and its suppliers. This may need to take into account the possibility that in
some jurisdictions, some forms of bribery could be seen as part of normal business
behaviour. It is important for PBPS to adhere to ethical standards and to clarify that
regardless of any social norms, it sees any payment of bribes as unacceptable.
The scope of business activities that could be affected by bribery and fraud need to be
clarified in the Code (for example, policies on gifts, hospitality and entertaining corporate
clients) but it can be difficult to make the language in a Code of Conduct clear enough to
explain what is and is not allowed, but not so specific to allow either side to benefit from
loopholes.
Examples of ethical codes already in existence could be adapted to PBPS's best practice,
but these may be difficult to obtain, especially in this industry. PBPS could consider the use
of a qualified third party to draft the PBPS Code of Conduct, but aside from the cost
involved, this may hinder its acceptance as a personal agreement between PBPS and its
suppliers.
Enforceable
Once produced, the PBPS Code of Conduct will need to be recognised signed by all 25,000
suppliers, agreeing that it is in everyone's best interests to stick to. Administratively, this
will be a challenge for PBPS to undertake. Where a supplier refuses to sign up to the Code
of Conduct, then unless the supplier is business critical, dealings with that supplier should
cease, and an alternative supplier found.
To ensure that the PBPS Supplier Code of Conduct works in practice, there would need to
be a highly visible demonstration of compliance from all levels of the company (both from
PBPS and its suppliers) requiring significant communication of the terms of the Code as
well as demonstrable examples of the consequences of both compliance and non-
compliance ('carrots and sticks').
The consequences of any non-compliance by suppliers would need to be considered (for
example, in terms of the supply contract being terminated and possible penalties, such as
prosecution). These consequences need to be seen to be acted upon for the new Code of

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Conduct to be considered effective.

A.2 (a) There are essentially three approaches FCW could take to expand into Myanmar:
(1) internal (organic) growth, (2) acquisition, or (3) some form of strategic partnership
or alliance.

(i) Internal (organic) growth

This method involves acquiring a site(s) in Myanmar and building a factory from a
zero base, then employing people and growing the business internally.
FCW can execute this strategy at their own pace, and however they so wish, could
develop the new business within existing FCW systems and processes, and manage
culture from the start. In addition, they would not have to pay a 'control premium' for
purchasing an established business.
However, this method is likely to be too slow to achieve the required strategic and
financial short-term goals.
Also, in this case, FCW may not have a full understanding of Myanmar's language,
culture, regulations and business practices. There is therefore a chance that they will
make mistakes as they develop their new business.

(ii) Acquisition
This method will involve acquiring established business(es) in Myanmar.
These would naturally be local businesses, hence they will have already proven
themselves, and will have naturally developed within the Myanmar culture, language
and regulations. They may already be established names locally which will help
establish early success. This method of expansion is likely to be relatively quick.
However, this is a relatively expensive method – a control premium would have to be
paid along with potentially significant transaction costs.

There could also be integration issues as established systems and culture will
probably need to be revised as the new acquisition becomes a part of the FCW group.
In addition, it may be difficult to find established businesses that are available for sale
that suit FCW's needs exactly.

(iii) Strategic partnership

This could be in the form of a joint-venture (in which a separate legal entity would be
set up in partnership with a local business) or some other form of strategic alliance
such as licensing or franchising.

This would have the advantage of sharing the risk and cost with a partner with
hopefully complimentary skills.

However, rewards would also have to be shared and there is a risk that the
relationship with the strategic partner is less than perfect as they may have different
values and priorities than FCW. There is a danger, for example, that they could in fact
damage relationships with established customers rather than improve them, which
was the aim.

Recommendation
Given that FCW has little experience with Myanmar's language, culture and business
regulations, I would recommend that FCW identifies potential acquisitions and work with
them in strategic partnerships initially to ensure they are a strategic fit with our
organisation. In due course, they could then be acquired. This will ensure full control of the
local operation in the medium to long term. Although FCW has no experience of acquiring

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businesses in Myanmar, professional advisers could be used to assist.

(b) (i) Ks
T0 T1 T2 T3 T4
Operating cash flows (plus inflation) 33.00 36.30 39.93 43.92
(30  (33  1.12) (33  1.13) (33  1.14)
1.1)

Tax (W-1) (4.19) (8.23) (9.22) (10.30)

Initial cost (50.00)
Scrap 24.60
Net cash flow (50.00) 28.81 28.07 30.71 58.22

Forecast exchange rate (W-2) 9.50 9.679 9.862 10.048 10.238

Net cash flow Rs. (5.26) 2.98 2.85 3.06 5.69
Discount rate @ WACC 18.75% (W-3) 1.000 0.842 0.709 0.597 0.503
PV Rs. (5.26) 2.51 2.02 1.83 2.86

NPV = Rs. in million 3.96

Workings
1 Taxation T0 T1 T2 T3 T4
-------------------- Rs. in million --------------------
Cost 50
Capital allowances
Initial (12.5)
Annual allowance (3.75)
(3.75) (3.38) (3.04) (2.73)
Tax written down value 50.00 33.75 30.37 27.33 24.60

Corporation tax
Operating inflows 33.00 36.30 39.93 43.92
Less: initial allowance (from above) (12.50)
Less: annual allowance (from above) (3.75) (3.38) (3.04) (2.73)
Taxable profits 16.75 32.92 36.89 41.19

Corporation tax at 25% 4.19 8.23 9.22 10.30

2 Forecast exchange rates

Myanmar inflation (MYR) 8%
Pakistan inflation (PKR) 6%
Exchange rate
[opening rate × (1 + MYR rate/1 +
PKR rate)] i.e. 9.50  (1.08 / 1.06) =
9.679 9.50 9.679 9.862 10.048 10.238

W-3: Weighted average cost of capital

Cost of finance Market value Cost  MV
Source
% -------- Rs. in million --------
Equity (W-3.1) 27.60 125 34.5
Bank loan (W-3.2) 5.68 40 2.272
Bonds (W-3.3) 7.43 51.6 3.834
Total 216.6 40.606

WACC = 40.606 / 216.6 = 18.75%

W-3.1: Equity
Cost = [Do(1 + g) / Po] + g = [20(1.1) / 125] + 0.1 = 27.600%
Market value = price  number of shares = 125  1,000,000 = 125 million

W-3.2: Bank loan

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Cost = I% (1 – t) = 8% (1 – 0.29) = 5.6800%

Value = 40,000,000

W-3.3: Irredeemable bonds

Cost = I(1 – t) / Po = 900 / (8,600)  (1 – 0.29) 7.43%
Ex Int value = Cum Int value – interest = 9,500 – 900 = 8,600
Value = 8,600 / 10,000  60,000,000 = 51,600,000

Additional relevant considerations

Following considerations are assumed while computing NPV of this project:
 purchasing power parity applies to predict exchange rates
 the current WACC can be used for this appraisal (same business risk)
 capital structure doesn't change

(ii) The traditional view of capital structure suggests that there is as an optimum balance
to strike between debt and equity. Some debt reduces the weighted average cost of
capital as debt is relatively cheap and interest is tax-deductible. However, if gearing is
excessive then financial distress causes the cost of debt, the cost of equity and the
weighted-average cost of capital to increase.

There are various practical considerations as well, such as:

Financing through debt

 The availability of debt finance – it may make sense to finance the expansion
using a Myanmar loan, but FCW may struggle to obtain this themselves as they
are unlikely to have an established credit rating in Myanmar.
 Matching issues – the expansion is likely to be permanent and it makes sense to
match the term of the finance with the term of the investment. This lends itself
more towards equity, or possibly, irredeemable debt.
 Quality of security – much of the investment is likely to be spent on land. The
quality of the security will be a key factor for lenders to consider when setting
an interest rate for any debt finance.

Financing through equity

Issue cost, control dilution and compliance of regulations should be considered.

Recommendation
If we assume that the industry average gearing level is approximately optimal at
50%, we could use this as target gearing level for FCW. By market values, FCW's
gearing level is currently (91.6m / 216.6m) 43%. This would suggest financing the
expansion initially using debt. If the expansion is large enough, such that this would
push gearing higher than 50%, then a mixture of debt and equity could be used.

(iii) Remitting quarterly dividends presents a transaction risk for FCW – the exchange rate
could move from quarter to quarter, affecting the rupee value of the dividend.

One of the key advantages of this transaction is that the timing and size of the
dividend is within the control of FCW. A simple solution could be to simply wait until
the exchange rate is relatively favourable and remit at that point.

However, assuming remittances are to be regular, there are several options available

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to FCW:
 Forward contract – given the amount and timing of the payment are likely to be
known with some accuracy, a forward contract could be used, as it is tailored to
suit the needs of the particular transaction. It is also easy to arrange. The only
downside is that timing is inflexible and the rate may not be particularly
attractive.
 Money market hedge – FCW could synthesise a forward contract by borrowing
money today in Myanmar, re-patriating funds today and repaying the Myanmar
loan with the dividend. This will be awkward to arrange, albeit a better rate than
a forward contract might achieve if FCW has spare cash to use as opposed to
needing to borrow initially.
 Futures and options – these are a possibility but futures are not a perfect hedge,
and options are expensive.

Recommendation
Given that timing and the amount of foreign currency cash flows should be known
with reasonable certainty, forward contracts are a simple and practical approach to
hedging the transaction risk presented by the remittance dividends.

A.3 (a) Valuation summary

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Equity value Per share

Valuation method
Rs. in million Rs.
Asset-based (W-1) 849 849
P/E-based (W-2) 2,800 2,800
Dividend valuation model (W-3) 3,710 3,710
Discounted cash flows (W-4) 3,446 3,446

Commentary

(i) Asset-based valuation

Despite including an estimate for calculated intangible value, this method is not likely
to be relevant for a service-based start-up as it has low tangible net assets, and the
intangible value is very subjective. It is a useful starting point as the seller would not
accept less than the assets-based value, but it is nothing more than that in this case.

(ii) P/E based

This approach requires adjustments to a proxy P/E ratio. The adjustments may be
relatively arbitrary in size. In addition, the proxy company may not be comparable to
the target company. For this reason, this is an indicative value only.

(iii) Dividend valuation model

This valuation is best suited to a minority stake. A premium is likely to be required to
be paid to secure a majority stake.

(iv) Discounted cash flow valuation

This valuation assumes the industry growth rate going forward. As SGIL is a new
start-up business with historically much higher growth than this, this valuation is
probably underestimated quite significantly. A growth rate of 30%, for example,
produces a value of Rs. 5,427 per share (see W-5).

(v) Bidding strategy

The asset-based approach should be discounted immediately for the reasons given
above. The bidding strategy should be to start at the P/E-based valuation, say Rs.
2,800 per share, with scope to increase this up to around Rs. 5,000 per share if the
board feel the future growth rate is likely to be significantly higher than the industry
average.

Workings
W-1: Asset-based value
SGIL is a service business, hence the vast majority of its assets are intangible and not
part of the balance sheet. However, a Calculated Intangible Value (CIV) valuation
could be used, as follows.
Industry ROCE: 50%
SGIL PAT: 200
Expected SGIL return: 55.5 (SGIL Equity + LT debt)  industry
ROCE = (51 + 60)  50%
Actual SGIL return: 200
Premium return due to intangibles: 144.5 Actual – expected return = 200 – 55.5

SGIL cost of equity 18.1% = Rf + β (Rm – Rf) = 2 + 2.3 (9 – 2) = 18.1

Return into perpetuity (Rs. in million) 798 = return / Ke = 144.5 / 0.181

Book value of equity: 51

Calculated intangible value: 798
Total asset value: 849
W-2: Price to earnings ratio-based valuation

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Industry P/E ratio: 7

Double: 14 to reflect higher than average growth
Latest earnings: 200
Valuation (Rs. in million) 2,800 (P/E ratio  earnings = 14  200)

W-3: Dividend valuation model

Value = Do (1 + g) / (Ke – g) = 100 (1 + 0.15) / (0.181 – 0.15) = Rs. 3,710 million
Do = 100 Latest dividend
g = 15% Sector growth rate used as SGIL is only a start-up so historical
dividends unreliable basis
Ke = 18.1% (W-1) above

W-4: Discounted cash flow valuation at 15% annual growth

Assumed growth rate: 15% Assuming industry average, SGIL is higher than this:
T1 T2 T3 T4
Profit after tax 230.0 264.5 304.2 349.8
Terminal value (349.8  15) 5,247
Total cash flow 230 265 304 5,597

Discount rate 18.1% 0.8467 0.7170 0.6071 0.5140

Present value 195 190 185 2,877
Total present value 3,446

W-5: Discounted cash flow valuation at 30% annual growth

Assumed growth rate: 30% Assuming industry average, SGIL is higher than this:
T1 T2 T3 T4
Profit after tax 260.0 338.0 439.4 571.2
Terminal value (571.2  15) 8,568
Total cash flow 260 338 439 9,140

Discount rate 18.1% 0.8467 0.7170 0.6071 0.5140

Present value 220 242 267 4,698
Total present value 5,427

(b) To: The Board of KCL

From: Advisor
Briefing paper: Tax consequences of acquisition
Date: 03 December 2019

Presently, it is not clear that KCL would acquire 100% share in SGIL or provide some
shares to the owner of SGIL who is keen to stay involved in growing the business. Both
scenarios have different tax implications under the Income Tax Ordinance 2001, discussed
below:
 If KCL acquires 100% of the ordinary shares in SGIL, it can be taxed as a single fiscal
unit, subject to providing an irrevocable option for group taxation, and complying with
such corporate governance requirements and group regulations, as may be specified by
SECP from time to time. In such a case, any losses made by either entity, would be
automatically offset against the profit made by other entities. Further, any income
derived by KCL on account of a dividend from SGIL, will be exempt from tax, subject to
the condition that the tax return of the group has been filed for the tax year.
 If KCL acquires an ordinary shareholding of between 55% to 100%, the tax benefits
will only be limited to an adjustment of losses to the extent of holding percentage.

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It is important to note that in both cases, KCL would not be able to use pre-acquisition
brought forward tax losses of SGIL.

Conclusion
On the basis of the above information, it is obvious that KCL would not be able to obtain
any group tax benefits in the case it acquires less than 100% of the ordinary shares of
SGIL, as none of the companies are expected to incur a loss in the future. However, in the
case of a 100% shareholding, it may be beneficial for KCL to avoid inter-company dividend
taxation. Further, submission of a tax return as a fiscal unit would also reduce the
administrative burden for the group. However, Tariq Saigal’s interest in participating
would also need to be considered.

(c) Integration risks

There are several integration risks associated with this acquisition, including:

(i) Loss of key personnel: much of the value of the acquisition of SGIL is tied up in the
continuing input of the current owner, Tariq Sahu. There is a significant risk that
upon realising his investment, he may lose motivation or even leave.

(ii) Due diligence failure: detailed due diligence should be undertaken before the
acquisition progresses any further. However, due diligence processes are less than
perfect – they are generally based on publicly available information and limited
information provided by the seller. There is always a risk that some significant issues
are either underestimated or unnoticed. This could ultimately lead to the acquisition
being overvalued. For example, there is a risk that the knowledge and technology
exploited by Tariq Sahu becomes superseded by a competitor, seriously damaging
the value of SGIL.

(iii) Systems’ integration: there are technical product synergies between KCL and SGIL –
one provides data analytics and the other provides a cloud-based storage solution.
Therefore, they will need to be integrated post-acquisition, as will many other
systems and processes. This will add to the cost and is often a less than perfect
process, meaning that sometimes synergies are not realised to the extent that were
originally anticipated.

(iv) Culture clash: although both companies operate in an arguably similar sector, they
may well have different cultures. For example, KCL is a listed company that have
adapted to the pressures of being listed on the stock exchange. On the other hand,
SGIL has to date, been an owner-managed business with the associated freedom that
entails. It may prove difficult to curtail this freedom, as SGIL is brought into a listed
company environment.

Change management program

Key elements of a change management program should include:

(i) Maintaining the engagement of key staff – particular focus needs to be the retention
of key personnel. For example, this could be done with the payment of a loyalty
bonus, such that if key staff are still in position in three years' time, they will receive
additional remuneration.

(ii) Participation – systems and processes integration should be a participative and

collaborative process wherever possible to ensure that each side learns from the
other, and that ownership of the resulting systems is improved.

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(iii) Clarity of direction – staff and management need to be clear on the future role SGIL
and its employees are to have. This will improve a sense of security and direction.
This should be communicated face-to-face, as quickly as possible.

(iv) Market message – SGIL has been growing successfully since its launch. Customers
need to be assured that the quality of service they have been receiving will be
maintained and enhanced.

(v) Target synergies – specific targets should be set for the attainment of synergies in a
timely manner post acquisition, and individuals should be given responsibility for
those targets. This will ensure a motivated focus on adding value.

(vi) Respect – the current systems and processes within SGIL have clearly worked well so
far given their history of growth. This should be borne in mind in the post-
acquisition integration processthat existing SGIL processes shouldn't be changed or
discarded just for the sake of it – there is probably much more that KCL can learn
from them.

(vii) Cross-fertilisation – soon after acquisition, some promotions should be made

between SGIL and KCL, and vice versa to help the cultures merge.

(THE END)

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