TERM 2 FINANCIAL MANAGEMENT LECTURE EXAMPLE …

CTA2020 Management Accounting (MAC4861/2)

© Endunamoo CTA Support Course 2020 Term 2 Lecture Example Solutions - 1

TERM 2 FINANCIAL MANAGEMENT LECTURE EXAMPLE SOLUTIONS

FINANCIAL ANALYSIS

LE1: Financial, social and environmental analysis

(a) Analysis of financial information / performance 2018 2017 Marks

Revenue growth 12,00% ½

- Sales volume 6,67% ½

Selling price per unit 5 775 5 500 1

- Price increase 5,00% ½

Cost of sales 55,00% 52,05% 1

Cost of sales growth 6,00% ½

Gross profit margin (%) 45,00% 47,95% 1

GP growth 19,33% ½

Employee costs 22,00% 20,00% 1

Employee costs growth 23,20% ½

Depreciation as % revenue 5,13% 5,00% 1

Depreciation growth 15,00% ½

Marketing expense as % revenue 9,00% 8,00% 1

Marketing expense growth 26,00% ½

Other expense as % revenue 3,00% 3,00% 1

Other expense growth 12,00% ½

Operating margin 8,81% 9,00% 1

Operating income growth 9,67% ½

Net profit margin 6,35% 6,57% 1

Profit after tax growth 8,16% ½

Effective tax rate 28,00% 27,00% 1

Available marks 15½

Maximum marks 10



Interpretation of the financial information / analysis Marks

• The revenue improved by 12% during the year and this growth is above the inflation rate

of 6% per annum and therefore Mxit experienced real growth over the period.

(Note: real growth represents growth in sales volume)

1

• The sales price improvement of 5% is, however, below the inflation rate and this could

be attributable to the competitiveness of the industry in which Mxit operates. 1

• However, the real growth experienced by Mxit of 6,67% is below the market growth of

9% and this highlights that Mxit lost market share during the period.

(Note: If a company’s sales volume growth is below that of the overall market, it means that a portion

of its growth has been taken away by its competitors)

1

• Cost of sales grew in line with inflation, which could highlight that costs have been well

managed. 1

• The lower growth in cost of sales in relation to revenue could be attributable to the fact

that the majority of the costs in cost of sales are fixed in nature. 1

• The employee costs grew at a rate higher than revenue / inflation as a result of the

unexpected increase in wages due to strike. 1

• Depreciation grew at higher rate than revenue because of the higher depreciation

expense on the new manufacturing equipment acquired during the period. 1

• The growth is marketing expenses of 26% appears too excessive and might need to

be investigated further. 1

• However, the increase in the marketing expense could have been due to the response to

the declining market share. 1

• The growth in other operating expenses could be attributable to increased number of

bursaries awarded by the company. 1

• However, the growth in other operating expenses might have been mitigated by the

decline in donations. 1

• The operating margin and net profit margin slightly declined during the period which

could highlight that costs have not been well managed during the period or as a result

of the increase in the employee costs and depreciation costs.

1

• The tax rate in 28% is in line with the corporate income tax rate. However, in 2018, it

was below the corporate income tax rate and this might need to be investigated. 1

• Overall, the performance of Mxit during the year was satisfactory given the revenue

performance and the profit growth during the year. 1

Available marks 14

Communication skills – logical argument 1

Maximum marks 10



(b) Analysis of social and environmental analysis Marks

Electricity consumption (112 million / 108 million - 1) 3,70% ½

- Manufacturing operations (98,5 million / 100 million - 1) (1,50%) ½

- Administration (13,5 million / 8 million - 1) 68,75% ½

Carbon emissions (550 000 / 600 000 - 1) (8,33%) ½

Number of bursaries awarded (150 / 120 -1) 25,00% 1

Donations (1,30% - 1,08%) 0,22% 1

Available marks 4

Maximum marks 3

Interpretation of the social and environment analysis Marks

Electricity consumption

• The electricity consumption increased during the current year which is indicative of

negative environmental performance.

• The increase was attributable to the administration operations of the company and this

might need to be investigated in order for Mxit to strive for improvement.

• The decrease in electricity consumption in the manufacturing operations might have been

as a result of the upgrade of the manufacturing equipment to more energy efficient

equipment.

1

1

1

Carbon emissions

• The carbon emissions decreased during the current year which indicates improved

environmental performance.

• The decrease in carbon emissions might have been as a result of the upgrade of the

manufacturing equipment to more energy efficient equipment.

1

1

Number of bursaries awarded

• The number of bursaries awarded increased during the current year which indicates

improved social performance.

• This is likely to increase the public image of the company within the local communities.

1

1

Donations

• The value of donations decreased during the current year which indicates a negative

social performance.

• This is likely to negatively impact the public image of the company within the local

communities.

1

1

Conclusion

• Overall, it appears that there are noteworthy improvements in the social and

environmental performance of Mxit.

1

Available marks 10


Maximum marks 7



LE2: Working capital and investor ratios

Part a) YFL Competitor

2017 2016 Change 2017 2016 Change

Inventory days 110 116 (5.17%) 98 109 (10.09%)

Debtors days 61 78 (21.79%) 53 63 (15.87%)

Payables days 66 78 (15.38%) 71 92 (22.83%)

Cash conversion cycles 105 116 (9.48%) 80 80 0%

Note to marks:

• Calculation of a ratio (1)

• Calculate the change / movement in ratio (½)

Commentary Marks

Inventory days

• Inventory days indicate the number of days it takes YFL to turn its inventory from

manufacture/purchase to sale 1

• YFL’s inventory days have improved from prior year (1) as it has decreased thereby

resulting in decreased holding and finance costs. (1) 2

• While YFL’s inventory days have improved, the industry has still performed better than

YFL (1) in terms of both inventory days and the decrease thereof (10.09%vs.5.17%).

(1)

2

• Inventory days reduced due to inventory increasing at a lower rate (36%) than the

increase in cost of sales (45%). 1

Accounts receivable days

• Accounts receivable days indicates the time it takes for debtors to pay their accounts. 1

• YFL’s accounts receivable days have improved from prior year (1) as it has decreased

thereby resulting in a decrease in the cost to finance the debtors as well as a

decreased risk of default (1)

2

• The above could be as a result of stricter credit terms. 1

• The accounts receivable increased with only 7.5% while sales increased with 37%. 1

• YFL’s competitor has performed better with lower accounts receivable days in both

2017 and 2016 1

• However, YFL has experienced a better improvement rate than its competitor (21.79%

vs.15.87%) 1

• The drastic improvement in YFL’s accounts receivable days could be attributed to the

restructuring of their debtor’s department. 1

Accounts payable days

• Accounts payable days indicate the time taken to pay creditors. 1

• YFL’s accounts payable days have decreased from prior year and while this is usually

regarded as negative (1) it does seem to be in line with that of its competitor whose

days have also decreased. (1)

2

• Furthermore, the competitors accounts payable days seem to be decreasing at a

faster rate than that of YFL (22.82% vs.15.38%) bringing their days more in line with

that of YFL

2

• This could indicate that YFL’s accounts payable days may be reasonable. 1



Commentary Marks

• Accounts payable increased with 24% compared to cost of sales increase of 45%. 1

Accounts payable days

• The cash conversion cycle indicates the time taken for cash to circulate through

business operating activities until converted to cash again. 1

• YFL’s cash conversion cycle has improved form the prior year. 1

• While YFL has achieved an improvement (9.48%), their competitor is still performing

much better 1

• YFL should therefore further decrease their inventory days and their accounts

receivable days to bring it more in line with that of its competitors. 1

Available marks 30

Maximum marks 21


Part b) Marks

2017 2016

Dividend yield

2017: 42,20 / 2 000

2016: 24,80 / 1 543

2,11% 1,61% 1

The dividend yield ratio indicates the return investors derive on their investment. 1

When assessing the acceptability of a company’s dividend yield, the following needs to be

considered: 2

• The preference of the company’s shareholders i.e. do they prefer dividends or

capital growth 1

• The performance of competitors/industry averages 1

YFL’s dividend yield has increased from prior year as a result of the large increase in

dividends (70%). 1

This could be attributed to a lower increase in the share price (30%) as opposed to increase

in dividends. 2

The dividend yield of YFL is low compared to similar companies within the industry. 1

The reason for this could be that YFL is pursuing an aggressive growth strategy as

evidenced by the large number of acquisitions (1) and the capital expenditure incurred and

planned to be incurred (1)

2

Available marks 9

Maximum marks 7



VALUATION

LE1: Earnings yield valuation

Step 1: Determining the appropriate earnings Gross revenue 19 500 000

Administration costs (14 40 000)

Profit before tax 5 100 000

Taxation (1 428 000)

Profit after tax 3 672 000

Step 2: Determining the appropriate earnings yield multiple Average earnings yield multiple 8%

Adjustment in respect of: - Size: Cape Town wine estate is relatively smaller (3 000 m2 vs 5 000 m2) (negative) +

- Location / Quality: Cape Town wine estate has quality grapes (positive) -

- Age: Cape Town office block is relatively old (negative) +

- Harvest / Yields: Cape Town wine estate has lower yields (negative) +

Adjusted earnings yield multiple 12%

Step 3: Determining the value of interest in the estate Valuation of the Cape Town wine estate (3 672 000 / 12%) 30 600 000

Marketability discount (wine estate is unlisted) (3 060 000 x 5%) (1 530 000)

Controlling premium (majority interest in being valued) (30 600 000 x 15%) 4 590 000

Valuation of 100% interest in the estate 33 600 000

Valuation of CA Ltd's 75% interest in the estate (33 600 000 x 75%) 25 245 000

LE2: P/E multiple valuation

(a) Discuss the factors that the management of CA Ltd need to consider before acquiring MBL

Established brand: MBL has been in existence for 20 years and it is likely that it has established a loyal

customer base over this period.

Overreliance of key personnel: Over the past 20 years, the business was run by the couple and

therefore there might a risk that the customer loyalty might be lost when they retire.

Overreliance on a single customer: The government contributes a significant portion of MBL’s revenue

and loss of such customer could threaten the continuity of the business.

Overreliance on government: Government is known as a slow payer and delays in payment could

result in liquidity problems for the company.

Potential tax liability: The couple have previously included personal expenditures in the financials of

the business and there is a risk that there might be potential tax liability arising from these expenditures.

Other mergers and acquisition considerations,

• Funding of the transactions and impact on the debt/equity of the acquirer and combined entity;

• Control premium to be paid and expected synergetic benefits; and

• Management culture clashes.



(b) VVL’s earnings multiple

Historic earnings multiple = MPS / EPS = 15 / 2

Earnings per share = 30 000 000 / 15 000 000 = 2 7,5x

Forecast earnings multiple (7,5x / 1,25)

Alternative:

FY2019 earnings: 1,25 x 30 000 000 = 37 500 000

P/E (2019): 225 000 000 / 37 500 000 6,0x

(c) Minimum value of the equity interest in MBL

Step 1: Estimating the maintainable earnings FY2016 FY2017 FY2018

Profit after tax 2 268 478 3 173 455 3 000 000

BEE transaction expense

The cost is likely to be a once-off expense. It is unlikely that the

entity would engage into transactions of this nature on a regular

basis

420 000

No tax impact because BEE expense is non-deductible -

Adjustment of salaries to market (1 350 000 – 800 000)

The maintainable earnings need to reflect the true cost of

operating the entity and as a result the market related salary

should be considered (454 545) (500 000) (550 000)

Tax on additional salary 127 273 140 000 154 000

Personal expenses

The maintainable earnings need to reflect the true cost of

operating the entity and as a result the cost of the owner's

personal expenses should not be included

180 000

No tax impact because expenditure is non-deductible -

Dividend income

Investment in Kyalami Motors has a different risk profile to MBL

and therefore the property would be valued separately.

(120 000)

No tax impact because dividends are exempt -

Restructuring costs

Add back as it benefits the entity for more than a single period

Amortisation of costs over benefit period (540 000 / 5)

540 000

(108 000) (108 000) (108 000)

Adjusted profit after tax 2 373 206 2 705 455 2 976 000

Growth in earnings 14,0% 10,0%

Comment: Declining trend but unclear whether it will stabilise or

decline further, therefore use the weighted average earnings to

determine maintainable earnings

Maintainable earnings

FY2016: 1 x 2 373 206 = 2 373 206

+ FY2017: 2 x 2 705 455 = 5 410 910

+ FY2018: 3 x 2 976 000 = 8 928 000 16 712 116

Maintainable earnings [16 712 111 / (1 + 2 + 3)] 2 785 353



Step 2: Determining the appropriate P/E multiple

VVL’s multiple

(Historic multiple to be used as historical financial information of MBL is used) 7,5x

Adjustments in respect of:

• Size in terms of net profit, MBL is 10x smaller than VVL (R3m versus R30 million) -

• BEE status, MBL has a higher / favourable status relative to VVL +

• MBL does not have television broadcasting operations which have higher margins -

Adjusted multiple 6,6x

Step 3: Determining the value of CA Ltd’s interest in MBL

Value of equity based on P/E (6,6 x 2 785 353) 18 383 330

Add surplus cash 250 000

Add value of investment in Kyalami Motors [120 000 x 1,05 / (11% - 5%)] 2 100 000

Total equity value of MBL 20 733 330

Marketability discount (MBL is unlisted) (20 733 330 x 7%) (1 451 333)

Controlling premium (majority interest in being valued) (20 733 330 x 12%) 2 488 000

Valuation of 100% interest in MBL 21 769 996

Valuation of CA Ltd's 75% interest in MBL (21 769 996 x 80%) 17 415 997



LE3: Net asset valuation

Alternative 1 Rands

Shareholders' equity (2 000 000 + 7 000 000) 9 000 000

Manufacturing building

Market valuation adjustment (15 000 000 – 4 950 000) 10 050 000

Tax on the market value

- Recoupment [(9 000 000 – 4 950 000) x 28%)] (1 134 000)

- Capital gain [(15 000 000 – 9 000 000) x 80% x 28%] (1 344 000)

Debtor bankruptcy

- Bad debt adjustment (400 000 - 120 000) (280 000)

- Tax adjustment on the bad debts 78 400

Debt termination costs (5% x 1 050 000) (52 500)

Retrenchment and liquidation costs, net tax (1 570 000 x 72%) (1 130 400)

Net asset valuation 15 187 500


Alternative 2 Rands

Property 15 000 000

Tax on the disposal - Recoupment [(9 000 000 – 4 950 000) x 28%)] (1 134 000)

- Capital gain [(15 000 000 – 9 000 000) x 80% x 28%] (1 344 000)

Broadcasting equipment 4 000 000

Cash 250 000

Debtors 850 000

Bad debt adjustment (400 000 – 120 000) (280 000)

Tax adjustment on the bad debts 78 400

Long-term loans (1 050 000)

Debt termination costs (52 500)

Retrenchment and liquidation costs, net tax (1 570 000 x 72%) (1 130 400)

Net asset valuation 15 187 500




LE2: Company valuations

(a) Free cash flow valuation 2019 2020 2021

Operating cash flows, net tax (C2) 22 792 25 062 27 045

Investment in working capital (C3) (4 740) (3 632) (3 196)

Investment in capital expenditure (C4) (14 376) (13 225) (13 093)

Free cash flows 3 676 8 205 10 755

Terminal value (C5) 169 326

Total free cash flows 3 676 8 205 180 082

Discount factors @14,86% 0,8706 0,7580 0,6599

Discounted free cash flows 3 201 6 219 118 840

Value of operations 128 260

Surplus cash (C3) 22 530

Market value of investments (C6) 11 200

Market value of debt (C7) (24 945)

137 045

Marketability discount (6%) (6% x 137 045) (8 223)

Value of 100% equity in Cleaners 128 822

Value of 80% shareholding (128 822 x 80%) 103 058

Workings for free cash flows

C1: Operating income 2018 2019 2020 2021

Total revenue 115 000 132 250 145 475 157 113

Dividends income

2019: 600 x 1,12 = 672

2020: 672 x 1,12 = 753

2021: 753 x 1,12 = 843 (600) (672) (753) (843)

Revenue from sale of goods 114 400 131 578 144 722 156 270

Operating expenses (102 494) (112 743) (121 763)

Operating income 29 084 31 979 34 507

Operating margin 22,1% 22,1% 22,1%

C2: Operating cash flows 2018 2019 2020 2021

Operating income 29 084 31 979 34 507

Depreciation (6 613) (7 274) (7 856)

Taxable operating income 22 471 24 705 26 651

Taxation at 28% (6 292) (6 918) (7 462)

Depreciation - non cash flows 6 613 7 274 7 856

Operating cash flows, net tax 22 792 25 062 27 045



Alternative method 2018 2019 2020 2021

Profit after tax 15 556 17 244 18 736

Net interest expense 1 800 1 800 1 800

Tax on net interest expense (504) (504) (504)

Depreciation - non cash flows 6 613 7 274 7 856

Tax shields on depreciation - - -

Dividends income (672) (753) (843)

Dividends are exempt from tax - - -

Operating cash flows, net tax 22 793 25 062 27 045

C3: Working capital requirements 2018 2019 2020 2021

Accounts receivable 51 720 59 479 65 426 70 659

Inventory 37 375 42 981 47 279 51 062

Accounts payable (57 500) (66 125) (72 738) (78 557)

Net working capital 31 595 36 335 39 967 43 164

Investment in working capital 4 740 3 632 3 196

% of operating revenue 3,6% 2,5% 2,0%

Accounts receivable days 147 147 147 147

Inventory days 119 119 119 119

Accounts payable days (183) (183) (183) (183)

Cash conversion cycle 83 83 83 83

C4: Capital expenditure requirements 2018 2019 2020 2021

Opening balance (a) 51 750 59 513 65 464

Depreciation (b) 6 613 7 274 7 856

Closing balance (c) 59 513 65 464 70 701

Investment in capex (c) + (b) - (a) 14 376 13 225 13 093

% of operating revenue 10,9% 9,1% 8,4%

C5: Terminal value

Sustainable growth rate (g) 8%

WACC - Cleaners Ltd

This cost of capital will reflect the risk inherent in cash flows of the division 14,86%

FCF2021 10 755

Terminal value = FCF2021 x (1 + g) / (WACC - g) = 10 755 x (1,08) / (14,86% - 8%) 169 326



C6: Market value of investments

Sustainable growth rate (g) 12,00%

Cost of equity of Shampoo 18,00%

Annual dividends (D2018A) 600

Fair value = D2018 x (1 + g) / (Ke - g) 11 200

C7: Market value of debt

FV (R2 250 x 10 x 125%) 28 125

PMT (10% x R2 250 x 10 x 72%) 1 620

N 5

I (12% x 72%) 8,64%

Market value of debt 24 945

Reasonability check for the discounted free cash flow valuation

MVIC/EBITDA valuation Maintainable EBITDA [(115 000 – 600 (Dividends) – 92 000] 22 400

Trailing EV/EBITDA multiple of Water Ltd 6,5x

Adjustments in respect of:

• Smaller size -

• Market leadership -

Any reasonable P/E 6,0x

Enterprise value (22 400 x 6) 134 400

Market value of debt (24 945)

Equity value of Cleaners 110 330

Marketability discount (Cleaners is unlisted) (6%) (6 620)

Controlling premium (80% shareholding is under consideration) (15%) 16 550

Value of 100% equity 120 260

Value of 80% equity 96 208



MERGERS AND ACQUISITION

LE1: Determining the merger price

Amount (R)

Minimum value of SA Ltd’s equity 450 000 000

Minimum bid value for 75% equity interest (450 000 000 x 75%) 337 500 000

Minimum value 450 000 000

Building {3 800 000 – [(3 800 000 - 500 000) x 80% x 28%]} 3 060 800

Transaction costs (100 000)

Saved salary of retrenched employees

[(120 000 x 1,06 / (15% - 6%)) x 1 100 x 16% x 72%] 179 097 600

Retrenchment costs (64 800 x 1 100 x 16%) (11 404 800)

Relocation costs (1 100 x 84% x 545 x 72%) (362 578)

Fair value of SA Ltd’s equity 620 291 022

Fair value transaction value for 75% equity interest (620 291 022 x 75%) 465 218 267

Fair value of SA Ltd’s equity 620 291 022

Transaction costs (175 000 – 100 000) (75 000)

Marketing costs [(PV=?; PMT = 15 000 000; i = 15%; N = 3) x 72%] 24 658 831

Maximum value of SA Ltd’s equity 644 874 853

Maximum bid value for 75% equity interest (644 874 853 x 75%) 483 656 140

LE2: Share exchange ratio

a) Based on EPS (0,75 / 1,50) 0,500

Number of CA Ltd shares to be issued 450 000

b) Based on market price (2 / 3) 0,667

Number of CA Ltd shares to be issued 600 000

2. Market price premium

Share exchange ratio 0,700

Number of CA Ltd shares to be issued (900 000 x 0,7) 630,000

Market price of CA Ltd share 3

Total market value of issued shares 1 890 000

Market value of SA Ltd shares 1 800 000

Market premium 90 000

Market premium (%) (90 000 / 1 800 000) 5%



LE2: Financing a transaction

Part a) Determine the number of shares after the acquisition Purchase consideration 69 090 000

CA Ltd's share price (210 000 000 / 10 000 000) 21

Total number of SA Ltd shares to issue 3 290 000

Existing number of shares 10 000 000

Total number of shares post acquisition 13 290 000

Determine the post-combination earnings SA Ltd's forecast earnings 16 560 000

CA Ltd's forecast earnings 33 000 000

Merger synergies 880 000

Total earnings for the combined entity 50 440 000

Determine the new earnings per share (50 440 000 / 13 290 000) 3,80

Evaluation of the merger Current earnings per share for - CA Ltd (30 000 000 / 10 000 000) 3,00

Forecast year earnings per share - CA Ltd (33 000 000 / 10 000 000) 3,30

Expected growth in earnings per share (3,30 / 3,00 - 1) 10%

Forecast year earnings per share - combined entity 3,80

Expected growth in earnings per share (3,80 / 3,00 - 1) 27%

Conclusion

With the merger, CA Ltd would not have met its target earnings per share growth

However, the combined entity would achieve an earnings per share growth of 27% and will achieve the

targeted earnings per growth of 15%.

Therefore, it is advisable that the board of directors of CA Ltd approve of the transaction



Part b)

If funded by issue of ordinary shares Earnings per share (see above) 3,80

Debt to equity ratio Total earnings of the combined entity (see above) 50 440 000

Expected price-earnings per share (given) 6,50

Expected market value post the combination 327 860 000

Total debt of the combined entity 123 300 000

CA Ltd 94 500 000

SA Ltd 28 800 000

Debt to equity ratio (123 300 000 / 327 860 000) 37,6%

If funded by cash Earnings per share Total earnings of the combined entity (see above) 50 440 000

Less lost interest income (30 000 000 x 8% x 72%) (1 728 000)

Less interest expense [(69 090 000 - 30 000 000) x 12%] (4 690 800)

Total earnings of the combined entity 44 021 200

Existing number of shares 10 000 000

Earnings per share (44 021 200 / 10 000 000) 4,40

Debt to equity ratio -

Total earnings of the combined entity (see above) 44 021 200

Expected price-earnings per share (given) 6,50

Expected market value post the combination 286 137 800

Total debt of the combined entity 162 390 000

CA Ltd 94 500 000

SA Ltd 28 800 000

New debt 39 090 000

Debt to equity ratio (162 390 000 / 294 249 800) 56,8%

Evaluation

Earnings per share

• The earnings per share growth will exceed the target growth of 12% p.a. regardless of how the

transaction is funded

• However, the impact of using the entity's cash resources is much more significant because no new

ordinary shares were issued in acquiring the new company



Part b)

• The earnings per share is 20% (4,53 / 3,80 - 1) higher when the transaction is cash funded versus

when it is equity funded

• It therefore appears attractive to fund the acquisition through the entity's cash resources

Debt to equity ratio

• Current debt to equity ratio (94 500 000 / 210 000 000) = 45%

• Prior to the acquisition, CA Ltd was operating within its targeted to equity ratio

• This meant that its financial risks were at acceptable levels (or low)

• The debt to equity ratio when the transaction is cash funded increases to 48,4% and further

deteriorates the entity's solvency

• This will result in increased financial risk for the combined entity

• This is further worsened by the fact that interest on debt used to fund the purchase of equity is non-

deductible for tax purposes (it can be argued differently if the provisions of the Tax Act are carefully

considered)

• Upon acquisition, CA Ltd was operating at a debt to equity ratio of 50% and this contributed to the

deterioration of the financial position of the combined entity

• The cost of funding for the combined entity is likely to significantly grow

• However, when the transaction is funded by equity, additional equity is raised, and this improves the

entity's solvency by reducing the debt to equity ratio to 37,6%

TERM 2 FINANCIAL MANAGEMENT LECTURE EXAMPLE …

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