Tutorial letter 102/0/2020 - Unisa · The parts of this tutorial letter are described below: ... PART 2 – FUNCTION OF FINANCIAL MANAGEMENT ... Supplementary literature/additional

MAC4862/102/0/2020 NMA4862/102/0/2020 ZMA4862/102/0/2020

Tutorial letter 102/0/2020 APPLIED MANAGEMENT ACCOUNTING

Year module Department of Financial Intelligence IMPORTANT INFORMATION This tutorial letter contains important information about your module

MAC4862 NMA4862 ZMA4862

2 MAC4862/102

APPLIED MANAGEMENT ACCOUNTING

TUTORIAL LETTER 102 / 2020

TABLE OF CONTENTS PAGE

MODULE PURPOSE 4

INTRODUCTION AND OVERVIEW 4

PART 1 – STRATEGY, RISK MANAGEMENT AND FINANCING

8

LEARNING UNIT 1 STRATEGY AND GOVERNANCE 9

LEARNING UNIT 1.1 STRATEGY AND GOVERNANCE

LEARNING UNIT 1.2 PUBLIC SECTOR

11

16

LEARNING UNIT 2 RISK MANAGEMENT 29

LEARNING UNIT 2.1 RISK MANAGEMENT 30

LEARNING UNIT 3 COST OF CAPITAL AND CAPITAL INVESTMENT

APPRAISAL

32

LEARNING UNIT 3.1 WEIGHTED AVERAGE COST OF CAPITAL

LEARNING UNIT 3.2 CAPITAL INVESTMENT APPRAISAL – ISSUES IN

INVESTMENT APPRAISAL

LEARNING UNIT 3.3 FOREIGN INVESTMENT

LEARNING UNIT 3.4 SCENARIO ANALYSIS AND MONTE CARLO SIMULATION

34

35

37

44

LEARNING UNIT 4 SOURCES AND FORMS OF FINANCE 47

LEARNING UNIT 4.1 SOURCES AND FORMS OF FINANCE AND THE

FINANCING DECION

LEARNING UNIT 4.2 SOURCES AND FORMS OF FOREIGN FINANCE

LEARNING UNIT 4.3 QUANTITATIVE ANALYSIS OF FOREIGN FINANCE,

BASED ON DISCOUNTED CASH FLOW

49

51

53

LEARNING UNIT 5 DIVIDEND DECISION 60

LEARNING UNIT 5.1 DIVIDEND DECISION 61

LEARNING UNIT 6 MANAGEMENT OF WORKING CAPITAL 63

LEARNING UNIT 6.1 MANAGEMENT OF WORKING CAPITAL 64

LEARNING UNIT 7 TREASURY FUNCTION 66

LEARNING UNIT 7.1 THE TREASURY FUNCTION 67

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TABLE OF CONTENTS (CONTINUED) PAGE

PART 2 – FUNCTION OF FINANCIAL MANAGEMENT

69

LEARNING UNIT 8 ANALYSIS AND INTERPRETATION OF FINANCIAL AND

NON-FINANCIAL INFORMATION

70

LEARNING UNIT 8.1 ANALYSIS AND INTERPRETATION OF FINANCIAL AND


71

LEARNING UNIT 9 BUSINESSES IN DIFFICULTY 73

LEARNING UNIT 9.1 BUSINESSES IN DIFFICULTY 74

LEARNING UNIT 10 VALUATIONS 75

LEARNING UNIT 10.1 VALUATIONS 77

PART 3 – MERGERS AND ACQUISITIONS AND BUSINESS PLANS

79

LEARNING UNIT 11 MERGERS AND ACQUISITIONS 80

LEARNING UNIT 11.1 VALUATION FOR PURPOSES OF M&As: SYNERGIES 82

LEARNING UNIT 11.2 OTHER CONSIDERATIONS 87

LEARNING UNIT 12 BUSINESS PLANS AND FINANCIAL PROPOSALS 93

LEARNING UNIT 12.1 BUSINESS PLANS AND FINANCIAL PROPOSALS 95

INTEGRATED SELF-ASSESSMENT

INTEGRATED QUESTION 1

INTEGRATED QUESTION 2

96

96

96

TEST 1 (2019) – MAC4862/NMA4862/ZMA4862 97

TEST 1 (2019) – SUGGESTED SOLUTION 99

TEST 2 (2019) – MAC4862/NMA4862/ZMA4862 103

TEST 2 (2019) – SUGGESTED SOLUTION

106

TEST 1 (2019) – MAC4861/NMA4861/ZMA4861 114


TEST 2 (2019) – MAC4861/NMA4861/ZMA4861 120


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MODULE PURPOSE

INTRODUCTION AND OVERVIEW

The purpose of this tutorial letter is to provide students with tutorial matter relating to Strategy, Risk Management, and Financial Management topics. This tutorial letter will build upon your prior knowledge and introduce a few new concepts relating to strategy, risk and financing; the function of financial management; and also within mergers and acquisitions, and business plans. PRE-REQUISITES The parts and learning units in this tutorial letter build, to a large extent, upon prior knowledge obtained in your undergraduate Management Accounting studies and in the post-graduate Advanced Management Accounting module. It is therefore assumed that you have achieved the necessary prior learning. STRUCTURE OF THIS TUTORIAL LETTER This tutorial letter is structured as three distinct parts, each containing a number of learning units. A learning unit is the main study area within a part, and each learning unit is further divided into sub learning units. You will find the outcomes, which you are required to achieve for each learning unit at the beginning of each learning unit. Self-assessment activities are provided at the end of each learning unit so that you can assess whether you have mastered the learning outcomes. The parts of this tutorial letter are described below: PART 1 – STRATEGY, RISK MANAGEMENT AND FINANCING (containing learning units 1-7) PART 2 – FUNCTION OF FINANCIAL MANAGEMENT (containing learning units 8–10) PART 3 – MERGERS AND ACQUISITIONS, AND BUSINESS PLANS (containing learning units 11-12)

This module is intended for students who are studying towards a Certificate in the Theory of Accounting (CTA), a prerequisite for the professional qualification of Chartered Accountant (SA) (registered with SAICA). This module is therefore designed to help you develop the prerequisite competencies relating to Management Decision Making and Control; as well as Strategy, Risk Management, and Financial Management.

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CONTENT – THIS MODULE The diagram below contains a schematic presentation of the content of this module.

MAC4862 Applied Management Accounting

Tutorial letter 101

Tutorial Letter 102

Planning and general

Strategy, Risk, Management,

Financial Management

Management decision

making and control

Prior exams, questions and

revision

Tutorial Letter 104

Tutorial Letter 103

Part 1 Part 2 Part 3

Tutorial letters in

the 3-series (3**)

Learning units

1. Strategy and governance 2. Risk management 3. Cost of capital and capital

investment appraisal 4. Sources and forms of finance 5. Dividend decision 6. Management of working

capital 7. Treasury function

Learning units

8. Analysis and interpretation of financial and non-financial information

9. Businesses in difficulty

10. Valuations

Learning units

11. Mergers and acquisitions

12. Business plans and financial proposals

TEST 1 TEST 2

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STUDY MATERIAL AND RESOURCES Prescribed study material The prescribed textbooks for this module are:

• Drury, C. Management and Cost Accounting (including Student’s Manual), 10th edition.

• Skae, FO. Managerial Finance. 8th Edition. LexisNexis: Johannesburg. myUnisa resources Please make use of myUnisa (https://my.unisa.ac.za) as it contains further resources to help you master this module. The following resources are available on myUnisa (made available at appropriate times during the year):

• your tutorial letters for this module

• tutorial letters of Advanced Management Accounting (MAC/NMA/ZMA4861) for this year

• tests and suggested solutions

• additional questions

• e-learning initiatives

• announcements containing information/updates relating to this module Important note: This tutorial letter makes principle reference to the textbook Managerial Finance, 8th Edition, and Tutorial Letters 102 Advanced Management Accounting (MAC/NMA/ZMA4861). Supplementary literature/additional reading You can use the bibliography at the end of each learning unit for additional reading for purposes of self-enrichment. General information and CTA news For general information and CTA news please refer to the CTA Support Page. The CTA support page can be accessed from our CAS website landing page. The short URL for this page is: www.unisa.ac.za/cas/cta TESTS The learning units assessed by Test 1 will cover predominately (but not exclusively) the content of Part 1 (learning units 1–7); and Test 2 the content of Parts 2 and 3 (learning units 8–12). It is important to realise that the examination papers of this module will integrate between the various learning units and disciplines. In preparation for the exam, you can therefore also expect some level of integration in the tests.

https://my.unisa.ac.za/

http://www.unisa.ac.za/cas/cta

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STUDY PROGRAMME A study programme has been published in Tutorial Letter CASALL301. Please utilise this to plan you studies. We recommend that you allocate your time according to the following approximate allocation:

Part

Learning unit no.

Learning unit

1 1 Strategy and governance 4% 2 Risk management 4% 3 Cost of capital and capital investment appraisal 12% 4 Sources and forms of finance 9% 5 Dividend decision 4% 6 Management of working capital 6% 7 Treasury function 6%

2 8 Analysis and interpretation of financial and non-financial information 10% 9 Businesses in difficulty 7% 10 Valuations 11%

3 11 Mergers and acquisitions 8% 12 Business plans and financial proposals 8%

Integrated self-assessment 11%

Total 100%

Note If you struggle with any of the learning units we strongly recommend that you allocate additional time above and beyond the total 90 hours indicated. CONCLUSION We trust that the preceding sections will assist you in approaching your studies (linked to this tutorial letter) in a methodical manner and with a greater level of understanding. We hope you enjoy this part of your studies! Regards, Your Applied Management Accounting lecturers

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PART 1: STRATEGY, RISK MANAGEMENT AND FINANCING

PURPOSE

The purpose of Part 1 is to reinforce and enhance your existing competencies related to strategy, risk management and financing. Its purpose is further to assist you in applying your knowledge to a scenario on an integrated basis. The specific competencies referred to above relate to the development and evaluation of an entity’s ability to make decisions and maximise its performance (including governance, strategies, policies and resources). The competencies further relate to the management of financial assets and the treasury function.

The purpose of the numerous activities and self-assessment activities included in this part is also to enhance your pervasive qualities and skills – the professional qualities and skills that Chartered Accountants are expected to bring to all tasks. These professional qualities include ethical behaviour and professionalism, personal attributes, and professional skills.

The diagram below contains a schematic presentation of the content of this part as well as later parts.


Learning units

1. Strategy and governance 2. Risk management 3. Cost of capital and

capital investment appraisal

4. Sources and forms of finance

5. Dividend decision 6. Management of working


Learning units



10. Valuations

Learning units



Tutorial Letter 102

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LEARNING UNIT 1 – STRATEGY AND GOVERNANCE

LEARNING OUTCOMES After studying this learning unit, you should be able to further apply your knowledge and skills achieved through your prior learning (see below) to a scenario, on an integrated basis. In addition, after studying this learning unit, you should: 1. Be aware of and understand the public sector, including the applicable legal system and legal

framework.

PRIOR LEARNING ASSUMED In your undergraduate and Advanced Management Accounting studies you have already mastered the learning outcomes indicated below. If you want to refresh your knowledge, please refer to your undergraduate material, prescribed textbook and MAC4861 Tutorial Letter 102/2020 (available under ‘additional resources’ on myUnisa). For your convenience we also provide textbook references.

Learning outcome

Managerial Finance,

8th edition

• Demonstrate sound knowledge of the concepts of mandate and business model in the context of an organisation.

• Critically review the appropriateness of an entity’s mission, vision, strategies and strategic plan.

• Critically reflect upon the internal and external influences on an entity’s strategy development.

• Evaluate an entity’s ability to manage organisational performance in accordance with its strategies.

• Assess the alignment of management decisions with the entity’s vision, mission, values and mandates.

• Understand and evaluate the business model of the entity in the context of the entity’s vision, mission, values, mandate and overall objective.

• Utilise analytical tools to assess the feasibility of strategies formulated.

• Discuss and critically review the strategic alignment of the financial function.

• Evaluate relevant structural and governance issues, including sustainability issues and integrated reporting matters.

• Understand what the International Integrated Reporting Framework entails and its reference to the various capitals within the organisation (financial, manufactured, intellectual, human, social and human relationships and natural).

• Chapter 1 and 2

• MAC4861 TL102

INTRODUCTION For an entity to be successful, it has to be guided by an overarching corporate strategy. In this regard, the financial function could also add more value through a process of strategic alignment. In dealing with the ‘bigger picture’, it is also important to realise that a firm functions within a greater context and therefore has to consider other stakeholders by means of appropriate corporate governance. The content of this learning unit is intended to enhance your knowledge of corporate strategy.

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THIS LEARNING UNIT CONSISTS OF THE FOLLOWING SUB LEARNING UNITS: LEARNING UNITS TITLE LEARNING UNIT 1.1 STRATEGY AND GOVERNANCE LEARNING UNIT 1.2 PUBLIC SECTOR

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LEARNING UNIT 1.1 - STRATEGY AND GOVERNANCE

1. Introduction

Author, Dale Littler points out that corporate strategy should address the fundamentals, ‘namely, the “what,” “why,” “how,” and “when” of the organization’ (2011: no page number). In addition, when contemplating the ‘bigger picture’, it is important to temper ambitions by means of appropriate corporate governance. This learning unit is based on selected sections of the following chapter in your prescribed textbook (Managerial Finance, 8th edition):

• Chapter 1 (Sections 1.2 to 1.6)

• Chapter 2 (Sections 2.1. to 2.6)

2. Content

The purpose of the content below is to supplement the information in the textbook in areas where it is considered necessary. It in no way replaces or can be considered to be a substitute for the textbook. It therefore remains imperative that you work through the textbook in detail.

2.1. The impact of technology on strategy

The way in which business is conducted is evolving. Technology and industrialisation are amongst some of the components which have played a role in this evolution. This shift is across industries irrespective of the size of the entity, enabling entities to market their product or service internationally and also source raw materials from suppliers around the world. With this advanced technologies and interconnectedness there have also been significant advancements in the financial sector providing access to capital markets globally. Various stock exchanges are now accessible to most people with only bandwidth being a limiting factor. In most developing countries there has been an expansion of the reach these platforms have. In addition, there is a significant growth in the types of products available (in the form of foreign exchange contracts, options, contracts for difference, etc.). Entities are also utilising social media to communicate with customers and suppliers in real time (Twitter, Facebook, and various other applications (apps)). This has enabled real time communication which makes turnaround time shorter and enhances the customer experience. It has given the customer a platform for raising complaints or compliments and therefore assists the entity in improving their service. With the increased usage of smart phones by consumers, this form of communication has become relatively wide reaching and has impacted most industries such as: banking, insurance, flight bookings (on line bookings and on line check in), taxi (Uber) etc. The cost is relatively low with entities encouraging the use of technology as this enables these entities to also save on costs (physical rent is saved, electronic bookings save time and is more efficient thereby enhancing the customer experience). Industrialisation and the Fourth Industrial revolution has led to a trend in most industries to move towards a mechanised environment which impacts both the manufacturing and non-manufacturing/services industries. The internet of things has also influenced production processors where assets are equipped with sensors that can capture, communicate and process data. This provides the potential to create production distribution efficiencies, which benefits both manufactures and customers alike. Studies have shown that the implementation of the Internet of Things could result in significant cost savings thereby building efficiencies into an entities production process.

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It is however important to note that this shift has consequences that extend beyond increasing the profitability of the entity to include aspects relating to efficiency, effectiveness and the long term sustainability of entities or industries. One such aspect which was a theme in the World Economic Forum (WEF) held in Davos in 2016, is that which relates to the use of the surplus labour which arises from industrialisation. According to the WEF the impact of this aspect is currently unknown and needs to be considered for both developing and developed economies due to the interconnectedness of the global economy. Other risks associated with the extensive use of technology include: system failure, fraud (internal and external), reliance on service providers etc. Technology security and business continuity plans are therefore important in order for an entity to operate without unnecessary disruptions and also provides assurance to its customers, suppliers and other users. Refer to the link below for further information relating to the increased utilisation of technology and the internet of things http://www.mckinsey.com/business-functions/business-technology/our-insights/an-executives-guide-to-the-internet-of-things 2.1.1. Robotic Process Automation (RPA) In line with the topic of the internet of things and the Fourth Industrial revolution is RPM. According to Ernst and Young (2016:2), RPA is the process whereby “a software or robot emulates human execution of tasks via existing user interfaces: it captures and interprets existing applications, manipulates data, triggers responses and communicates with other systems, it can be applied to existing applications (without changing the current IT landscape).” Various industries, including manufacturing, transportation, and medical industries make use of robots to perform human driven tasks. RPA is now also becoming topical in the Finance world (Tucker, 2017), its benefits include cost efficiency, minimising the risk of error, focussing skills on deriving value creation etc. Some of the areas in which RPA can effectively be utilised within the finance space is: 1. Operational accounting (billing and collections, accounts receivable) 2. General accounting (allocations and adjustments, journal entry processing, reconciliations,

intercompany transactions etc.) 3. Financial and external reporting 4. Planning, budgeting and forecasting 5. Treasury processes (Ernst and Young, 2016) 2.2. Corporate governance

The governing body of the entity, in the case of a company this will be the board of directors, is accountable to the company and through the company to the stakeholders. Past corporate failures and the separation of ownership and management of an entity are amongst some of the reasons that have created the need for adequate and robust reporting. Such reporting will assist in ensuring stakeholders are provided with adequate information on the governance present within organisations. The governance principles relating to stakeholder’s relations with entities is contained in the King code of Corporate Governance. The King IV Code, which replaced earlier King Codes, was published in November 2016. The code has been revised to, amongst others, bring it up to date with international governance codes and best practice and increase compliance requirements and governance structures (KPMG, 2016). The effective date of the implementation of King IV is financial years beginning 1 April 2017, with earlier implementation encouraged.

http://www.mckinsey.com/business-functions/business-technology/our-insights/an-executives-guide-to-the-internet-of-things

http://www.mckinsey.com/business-functions/business-technology/our-insights/an-executives-guide-to-the-internet-of-things

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The King IV Report defines corporate governance as ‘the exercise of ethical and effective leadership by the governing body towards the achievement of the following governance outcomes: Ethical culture, Good performance, Effective control, Legitimacy’ (IoD, 2016: 20). King IV has introduced a change from the King III “apply or explain” basis to a “apply and explain” basis for the application of the code. The code now contains 17 basic principles and the Institute of Directors (“IoD”) lists the objectives of code as follows (IoD, 2016): 1. Promote corporate governance as integral to running an organisation (delivering governance

outcomes such as ethical culture, good performance, effective control & legitimacy) 2. Making the code accessible for a variety of sectors and organisations 3. Corporate governance as holistic and interrelated and implemented in an integrated manner 4. Encourage transparent and meaningful reporting 5. Present corporate governance with ethical consciousness and conduct King IV as in previous codes has a foundation in ethical and effective leadership. In addition, supplementary schedules have been incorporated into the code, with the objective of giving consideration to the various sector types (i.e. municipalities, non-profit organisations, retirement funds, SME’s and state owned entities (IoD, 2016). For purposes of this course only sector supplements relating to SME’s is required to be studied, whereby a basic knowledge is required. The following principles, as well as the recommended practices, as contained in King IV should be studied:

• Ethical leadership

• Organisation values, ethics and culture

• Responsible corporate citizenship

• Strategy implementation, performance

• Reports and disclosure

• Role of the governing body

• Composition of the governing body

• Committees of the governing body

• Performance evaluations

• Delegation to management

• Risk and opportunity governance

• Technology and information governance

• Compliance governance

• Remuneration governance

• Assurance (Financial report related)

• Stakeholder inclusive approach

• Responsibilities of shareholders 2.2.1. King IV and integrated reporting Integrated reporting requires more than just mentioning sustainability information, but must be integrated with other aspects of the business process and managed throughout the year. King IV has therefore introduced the notion of integrated thinking and requires the governing body to oversee the publication of the following, for access by stakeholders: 1. Corporate governance disclosures required in terms of King IV (see part 3: King IV Application

and disclosures) 2. Integrated reports 3. Annual financial statements and other external reports

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An integrated report encompasses the following: 1. an annual report 2. statutory financial information and sustainability information 3. sufficient information to record how the organisation has affected the economic life of the

community, both positively and negatively, and

forward-looking information on how the board feels it can enhance the positive aspects and negate the negative aspects Activity 1.1.1 Answer Practice Question 1–4 in Managerial Finance (8th edition) Feedback to Activity 1.1.1

Find the solution after the practice question in the textbook. Activity 1.1.2 Answer Practice Question 2–4 in Managerial Finance (8th edition) Feedback to Activity 1.1.2

Find the solution after the practice question in the textbook. Activity 1.1.3 Answer Practice Question 2–6 in Managerial Finance (8th edition) Feedback to Activity 1.1.3

Find the solution after the practice question in the textbook. 3. Self-assessment questions After working through all the relevant sections in the textbook, guidance and activities provided by this learning unit, you should now be able to attempt the following self-assessment questions.

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QUESTION 1 11 MARKS (16.5 MINUTES plus reading time) Perform the required part (c) of Question 1 (Medico Group), which can be found in the Question Bank Part 2. The relevant required part is repeated below. (At this point it is not necessary to attempt to do other parts of the question; you should, however, take notice of the way in which all the various parts integrate and relate to the scenario.)

REQUIRED MARKS

(c) Draft a formal report directed to the directors of MGSA, highlighting the results of: 2. An assessment of the current opportunities and threats that could be linked to

the group; 3. Shortcomings in the group’s current vision-statement, if any. Incorporate knowledge of the group and pharmaceutical industry in your answer, and specifically consider the South African context.

(9)

(2)

Solution question 1

Find the suggested solution to the relevant parts in the Question Bank. QUESTION 2 9 MARKS (14 MINUTES plus reading time) Perform the required parts (d) and (h) of Question 3 (Insimbi Limited), which can be found in the Question Bank Part 2. The relevant required parts are repeated below. (At this point it is not necessary to attempt to do other parts of the question; you should, however, take notice of the way in which all the various parts integrate and relate to the scenario.)

REQUIRED MARKS

(d) Evaluate the circumstances of Insimbi Limited and the behaviour of Mr West from an ethical and corporate governance perspective, and provide recommendations for improvement.

(5)

(h) List eight key areas recommended for inclusion in an Integrated Report. (4)

SOLUTION QUESTION 2

Find the suggested solution to the relevant parts in the Question Bank. BIBLIOGRAPHY AND ADDITIONAL READING Littler, D. 2011. Corporate strategy. [Online.] New York: Wiley-Blackwell. Available on a subscription basis from: <http://www.blackwellreference.com> [Accessed 7 December 2011] Skae, FO. 2017. Managerial Finance. 8th edition. LexisNexis: Johannesburg. Tucker, I. 2017. Are you ready for your robots? [online]. Montvale: Strategic Finance. Available from:

http://sfmagazine.com/about-strategic-finance-and-ima/ [Accessed 27 August 2018].

Ernst and Young, 2016. Robotic process automation in the Finance function of the future [online]. United Kingdom: Ernst and Young. Available from: https://www.ey.com/Publication/vwLUAssets/EY__Robotic_process_automation_in_the_Finance_function_of_the_future/$FILE/EY-robotic-process-automation-in-the-finance-function-of-the-future-2016.pdf. [Accessed 27 August 2018].

https://www.ey.com/Publication/vwLUAssets/EY__Robotic_process_automation_in_the_Finance_function_of_the_future/$FILE/EY-robotic-process-automation-in-the-finance-function-of-the-future-2016.pdf



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LEARNING UNIT 1.2 – PUBLIC SECTOR

1. Introduction

Since the public sector plays a pivotal role and has a major impact on the economy in South Africa, and CAs(SA) play a prominent role and make a significant contribution to the public sector, it is important for you to have a basic awareness and understanding of the public sector, including the applicable legal system and legal framework. The information provided within this Tutorial Letter provides you with a high level overview of the key public sector legislation and how this legislation impacts the various aspects of Management Accounting (i.e. Strategy, Risk Management and Governance, Financial Management and Management Decision Making and Control). After working through this content you should have an awareness and understanding of the high-level principles relating to public entities. You are therefore not expected to know and apply the details. Section 195(1)(b) of the Constitution states that public administration must be governed by democratic values and principles, including the following: ✓ A high standard of professional ethics must be promoted and maintained; ✓ Efficient, economic and effective use of resources must be promoted; ✓ Public administration must be development oriented; ✓ Services must be provided impartially, fairly, equitably and without bias; ✓ People’s needs must be responded to, and the public must be encouraged to participate in policy

making; ✓ Public administration must be accountable; ✓ Transparency must be fostered by providing the public with timely, accessible and accurate

information; ✓ Good human-resources management and career-development practices to maximise

human potential must be cultivated. ✓ Public administration must be broadly representative of the South African people.

2. Content

2.1. Public Sector legislation

Legislation applicable to the public sector is very comprehensive. The notes included below therefore provide you with a summary of public sector enabling legislation necessary to understand the public sector.

The Constitution of the Republic of South Africa The Constitution provides for, as part of the Bill of Rights, access to information held by the state that is required for the protection of any rights and the right to administrative action that is lawful, reasonable and procedurally fair. The Constitution provides for the enacting of legislation to give effect to these rights (sections 32 and 33). Of particular importance to prospective CAs is chapter 13 of the Constitution, relating to finance. Section 213 requires that all money received by government be paid into a National Revenue Fund that can only be used in terms of an appropriation by an Act of Parliament. The appropriation provides for the equitable division of revenue raised by the three spheres of government and each province receives an equitable share of that revenue. All money received by provincial government is paid into a provincial revenue fund and the money can be withdrawn in terms of an appropriation by a provincial act (section 226).

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The Constitution also provides for national legislation to prescribe the form, timelines and content of national, provincial and municipal budgets (section 215). It further provides for the establishment of a national treasury in each sphere of government that will introduce generally recognised accounting practice, uniform expenditure classifications and treasury norms and standards (section 216). It requires procurement of goods and services in accordance with a system that is fair, equitable, transparent, competitive and cost effective (section 217). The South African Reserve Bank is the central bank of the Republic and the primary objective of the Bank is to protect the value of the currency in the interest of balances and sustainable economic growth (section 224). Refer to the following link for more information: https://www.gov.za/documents/constitution/constitution-republic-south-africa-1996-1 Different pieces of legislation were enacted as a result of the Constitution, some of which are described below. The Public Finance Management Act (PFMA) The PFMA is a key instrument for reform of financial management in the public sector in South Africa and gives effect to various sections of the Constitution. The PFMA is positioned very high in the statutory order, as clearly reflected in section 3(3) that states ‘in the event of any inconsistency between this Act and any other legislation, this Act prevails’. The objective of the PFMA, as described in section 2, is to secure transparency, accountability and sound management of the revenue, expenditure, assets and liabilities of the institutions to which it applies. The PFMA applies to departments, public entities, constitutional institutions, Parliament and the provincial legislature (section 3). Refer to the following link for more information: http://www.treasury.gov.za/legislation/PFMA/default.aspx Treasury Regulations

National and provincial treasuries are key role players in the public finance management process (PFMA, chapters 2 & 3). The National Treasury was established in accordance with the PFMA and is responsible for financial and fiscal matters, including the budget preparation process, control over the implementation of the national budget, monitoring the implementation of provincial budgets and promoting and enforcing transparency and effective management. To perform these functions, the National Treasury must prescribe norms and standards that are included in Treasury Regulations and instructions. Refer to the following links for more information: http://www.treasury.gov.za/legislation/pfma/regulations/default.aspx http://www.treasury.gov.za/legislation/pfma/TreasuryInstruction/default.aspx The Municipal Finance Management Act (MFMA)

The MFMA is one of the important pieces of legislation relevant to local government. The objective of the MFMA is described in section 2 and is to secure sound and sustainable management of the fiscal and financial affairs of municipalities and municipal entities by establishing norms and standards and other requirements in the areas of fiscal and financial affairs, revenues, expenditures, assets and liabilities, budgetary and financial planning, borrowing, handling of financial problems in municipalities and supply chain management.

https://www.gov.za/documents/constitution/constitution-republic-south-africa-1996-1

http://www.treasury.gov.za/legislation/PFMA/default.aspx

http://www.treasury.gov.za/legislation/pfma/regulations/default.aspx

http://www.treasury.gov.za/legislation/pfma/TreasuryInstruction/default.aspx

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A student who understands the PFMA should be able to make the transition to understanding the MFMA with relative ease. Refer to the following links for more information: http://mfma.treasury.gov.za/MFMA/Legislation/Local%20Government%20-%20Municipal%20Finance%20Management%20Act/Municipal%20Finance%20Management%20Act%20(No.%2056%20of%202003).pdf The Division of Revenue Act

The Division of Revenue Act is published every year in compliance with section 214(1) of the Constitution to provide for the equitable division of revenue raised nationally among the three spheres of government. This includes the province’s equitable share of the provincial share of the provincial revenue and other allocations to provinces, local government or municipalities from the national government’s share of revenue. The objective of the Act, as described in section 2, is to promote predictability and certainty in respect of all allocations to provinces and municipalities, in order that provinces and municipalities may plan their budgets over a multi-year period and thereby promote better coordination between policy, planning and budgeting. The objective also includes promoting transparency and accountability in the resource allocation process by ensuring allocations are reflected in the budgets of provinces and municipalities and the expenditure of conditional allocations is reported on by the receiving provincial departments and municipalities. Refer to the following link for more information: http://www.treasury.gov.za/legislation/acts/2014/Division%20of%20Revenue%20Act,%202014%20(Act%20No.%2010%20of%202014).pdf. Key features of this Act include the following: Procurement legislation

Section 76(4)(c) of the PFMA provides that National Treasury should determine a framework for an appropriate procurement and provisioning system that is fair, equitable, transparent, competitive and cost effective. National Treasury has issued various documents to give effect to this requirement. The policy strategy to guide uniformity in procurement reform processes in government provided for devolved the responsibility and accountability for procurement-related functions to accounting officers/authorities with the aim of promoting uniformity in the various spheres of government with regard to the interpretation of government’s preferential procurement legislation. The former procurement and provisioning practices in government were replaced by a supply chain management function and a systematic competitive procedure for the appointment of consultants as an integral part of financial management. The Supply Chain Management Framework was published in 2003 as part of Treasury Regulations in terms of section 76(4)(c) of the PFMA. Other relevant legislation includes the Preferential Procurement Policy Framework Act, 2000 (Act 5 of 2000) and the Preferential Procurement Regulations, 2001 that pertain to this Act. Refer to the following link for more information: http://www.treasury.gov.za/legislation/pfma/supplychain/Policy%20to%20Guide%20Uniformity%20in%20Procurement%20Reform%20Processes%20in%20Government.pdf

http://mfma.treasury.gov.za/MFMA/Legislation/Local%20Government%20-%20Municipal%20Finance%20Management%20Act/Municipal%20Finance%20Management%20Act%20(No.%2056%20of%202003).pdf



http://www.treasury.gov.za/legislation/acts/2014/Division%20of%20Revenue%20Act,%202014%20(Act%20No.%2010%20of%202014).pdf

http://www.treasury.gov.za/legislation/acts/2014/Division%20of%20Revenue%20Act,%202014%20(Act%20No.%2010%20of%202014).pdf

http://www.treasury.gov.za/legislation/pfma/supplychain/Policy%20to%20Guide%20Uniformity%20in%20Procurement%20Reform%20Processes%20in%20Government.pdf

http://www.treasury.gov.za/legislation/pfma/supplychain/Policy%20to%20Guide%20Uniformity%20in%20Procurement%20Reform%20Processes%20in%20Government.pdf

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Public Audit Act (PAA)

The PAA Act is the key piece of legislation relevant to auditing and assurance in the public sector in South Africa. Public sector auditors have an expanded mandate in that an audit includes the audit of financial statements, compliance with laws and regulations, and the audit of performance against predetermined objectives (sections 20(2)(c) and 28(1)(c)). Refer to the following link for more information: http://www.agsa.co.za/About/Legislation.aspx

2.1.1. Impacts of legislation on Management Accounting

In addition to the above public sector legislation, you need to understand how the public sector enabling legislation impacts on the various aspects of Management Accounting (i.e. Strategy, Risk Management and Governance, Financial Management and Management Decision Making and Control), this is addressed in the sections that follow. 2.1.1.1. Strategy, Risk Management and Governance Strategy

The public sector is bound by legislation and regulations resulting in many aspects of strategy, risk management and governance components being included in legislative requirements. In the private sector, achievement of the entity’s overall objectives involves the development and implementation of strategies that take advantage of identified opportunities while minimising the damage that risks can do to the achievement of organisational goals. This process is informed by the competitive environment, the availability of sustainable resources and the importance of stakeholder relationships. Collectively, this is communicated through the integrated report. This process is echoed in the public sector, although cognisance is taken of the fact that the formulation of strategies is driven by the constitutional and legislative mandates as well as policy priorities of government and is performance driven rather than competitive driven. The mandate of public institutions needs to inform the strategic focus areas with the emphasis on service delivery. Strategic objectives are set for the strategic focus areas and performance indicators and targets are defined to enable measurement of performance. Public sector institutions are required to prepare strategic plans and annual performance plans that incorporate strategic outcomes, objectives, indicators and targets. Ultimately the budgets of public institutions need to be aligned to the strategic plans and strategic priorities of the particular institution so that the spending which takes place allows the strategic objectives and strategic priorities to be addressed. Performance of government is measured and monitored by the public and other stakeholders by way of actual against planned performance and budgets. The Treasury Regulations in section 3.2 require that the internal audit function assist the accounting officer in achieving the objectives of the institution by evaluating and developing recommendations for the enhancement or improvement of processes through which the objectives are established, the achievement of objectives is monitored, accountability is ensured and corporate values are preserved. A very unique legislative requirements related to strategy within the public sector is the requirements to report on pre-determined objectives and that the information being reported is subjected to an audit. Treasury Regulations require that annual reports include information about the institution’s efficiency, economy and effectiveness in delivering programmes and achieving its objectives and outcomes against the measures and indicators set out in the strategic plan.

http://www.agsa.co.za/About/Legislation.aspx

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Risk Management

Risk management in the context of the public sector focuses on the importance of service delivery and the identification and response to risks that could affect service delivery and compliance with laws and regulations (given that the public sector is highly regulated). Key focus areas for risk management in the public sector include procurement (supply chain management) and contract management due to high levels of tender fraud and corruption. Detailed legislation and guidance in these areas include: the PFMA Treasury Regulations 16A, Preferential Procurement Policy Framework Act, Broad Based Black Economic Empowerment Act and Supply Chain Management Regulations and related Practice Notes. Refer to the following links for more information: http://www.treasury.gov.za/legislation/pfma/supplychain/default.aspx http://www.treasury.gov.za/legislation/pfma/practice%20notes/default.aspx Another key risk area is the lack of performance or risks in terms of service delivery performance. The Auditor-General issues a general report on the outcomes of the audits conducted every year after completion of the audits. The general report includes reference to different risk areas, such as the following: ✓ Quality of submitted financial statements ✓ Quality of submitted performance reports ✓ Supply chain management ✓ Financial health ✓ Human resource management ✓ Information technology. Refer to the Auditor-General website (http://www.agsa.co.za/) to be informed about the identified risk areas as part of the reporting on the outcomes of the audits completed each financial year. Section 3.2 of the Treasury Regulations describes the requirements of internal control and the need for the accounting officer to ensure that a risk assessment process is conducted regularly to identify emerging risks. A risk management strategy, including a fraud prevention plan, must direct the work of internal audit. Governance

You should be aware of the governance structures within a public sector entity. There are different governance structures in the public sector and various layers of governance structures exist. Functions of government can be divided into the legislative authority, the executive authority and the administrative authority, each of which are discussed below:

• The legislative authority

This is a legal political institution that makes, amends and repeals laws for the community. In South Africa the legislative authority consists of the national sphere of government, vested in Parliament, the provincial sphere of government vested in the provincial legislatures, and the local sphere of government vested in municipal councils.

http://www.treasury.gov.za/legislation/pfma/supplychain/default.aspx

http://www.treasury.gov.za/legislation/pfma/practice%20notes/default.aspx

http://www.agsa.co.za/

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• The executive authority

In South Africa this authority is entrusted to the President and the cabinet (Constitution of Republic of South Africa, section 85). Cabinet members are elected political representatives and members of Parliament. The President appoints one minister for each portfolio and decides on the membership of the Cabinet. The President can inter alia appoint and dismiss ministers and have various other functions and authority described in section 85, including to implement legislation, develop and implement national policy, co-ordinate the functions of state departments, and prepare and initiate legislation.

• The administration authority

This consists of the various administrative institutions or departments that need to execute the policies and decisions of the legislature and the executive authority. Administration also consists of all accounting officers, the chief financial officers, financial officers, internal auditors and other officials. The roles and responsibilities of the different role-players are described below. a) The accounting officer

The accounting officer (sections 36-43 of the PFMA) or the accounting authority (sections 49-57 of the PFMA): Every department and every constitutional institution must have an accounting officer. The accounting officer is the head of the department or the chief executive officer of a constitutional institution. The appointment and roles and responsibilities of accounting officers are described in sections 36‒41 of the PFMA. The following are some of the general responsibilities: ✓ To ensure effective, efficient and transparent systems of financial and risk management and

internal control are in place and are maintained (section 38(a)(i)); ✓ To ensure a system of internal audit under the control and direction of the audit committee (section

38(a)(ii)); ✓ To ensure an appropriate procurement and provisioning system that is fair, equitable, transparent,

competitive and cost effective (section 38(a)(iii)); ✓ To ensure a system for properly evaluating all major capital projects prior to a final decision on the

project (section 38(a)(iv)); ✓ To ensure the effective, economical and transparent use of resources (section 38 (b)); ✓ To take effective steps to collect all money due and prevent unauthorised, irregular fruitless and

wasteful expenditure and losses resulting from criminal conduct and manage working capital efficiently and economically (section 38(c));

✓ To take responsibility for management, safeguarding and maintenance of assets (section 38(d)); ✓ To report to Treasury any unauthorised, irregular or fruitless and wasteful expenditure (section

38(g)); ✓ To take effective and appropriate disciplinary steps against any official that contravenes the PFMA,

commits an act that undermines the financial management and internal control system or make or permit unauthorised, irregular or fruitless and wasteful expenditure (section 38(h)).

The accounting officer is also responsible for budgetary control including reporting to the executive authority any variances on the budget (section38). The reporting responsibilities of the accounting officer include keeping full and proper records of the financial affairs and preparing and submitting financial statements to the Auditor-General within two months after the year end. Within five months after the year end the annual report for departments must be submitted to the relevant treasury and the executive authority and those of constitutional institutions to Parliament. The annual report and audited financial statements must:

• fairly present the state of affairs of the department, trading entity or constitution, its business, its financial results and its performance against pre-determined objectives and its financial position as at the end of the financial year; and

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• include particulars of any material losses through criminal conduct, and any unauthorised expenditure, irregular expenditure and fruitless and wasteful expenditure and criminal or disciplinary steps taken as a result thereof.

Reporting also includes monthly reporting on revenue and expenditure with an explanation of any material variances and corrective steps taken. b) The accounting authority

This should consist of a board or controlling body, or the chief executive officer if no controlling body exists, and other officials at public entities have similar responsibilities to those described for the accounting officers and other officials. c) Chief financial officer

Each institution must have a chief financial officer who is directly accountable to the accounting officer and assists the accounting officer in discharging the duties related to effective financial management, including budgetary management, operation of internal controls and timely production of financial reports. d) Other officials

The responsibilities of other officials are also legislated, contrary to the private sector, and are described in sections 44‒57of the PFMA. Some of these are as follows:

• To ensure the system of financial management and internal control is carried out in the area of responsibility;

• To be responsible for the effective, efficient and economical and transparent use of financial and other resources within the area of responsibility;

• To take effective and appropriate steps to prevent any unauthorised expenditure, irregular expenditure and fruitless and wasteful expenditure, also with regard to the collection of revenue;

• To be responsible for management, including the safeguarding of assets and the management of the liabilities.

e) Audit committee

Ultimately, those charged with governance need to account to various oversight bodies, including the public accounts committees and the audit committees. Public sector audit committees are regulated by national legislation including the PFMA, Treasury Regulations and the MFMA. The PFMA prescribes the composition of the audit committee (with the focus on independence) and the frequency of meetings (at least twice a year). The PFMA provides that Treasury may set additional regulations for audit committees, their appointment and functioning. This is addressed in Treasury Regulation 3.1, in terms of which an audit committee must operate in terms of a written terms of reference that needs to be reviewed annually. Audit committees must review the following:

• The effectiveness of the internal control systems;

• The effectiveness of the internal audit function;

• The risk areas of the institution’s operations to be covered in the scope of external and internal audits;

• The adequacy, reliability and accuracy of the financial information provided to management;

• Any accounting and auditing concerns identified as a result of internal and external audits;

• The institution’s compliance with legal and regulatory provisions;

• The activities of the internal audit function; and

• Its evaluation of the annual financial statements.

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In the annual report of the institution the audit committee must comment on the effectiveness of internal control, the quality of the year’s management and monthly/quarterly reports. If a report from any source implicates the accounting officer of fraud, corruption or gross negligence, the chairperson of the audit committee must report this promptly to the relevant executive authority. f) Internal audit

Another important component of governance is internal controls, including an internal audit function. As indicated above, the accounting officer or the accounting authority is responsible for ensuring that there is an effective, efficient and transparent system of internal control. The internal audit function must assist the accounting officer in this regard by evaluating the controls for effectiveness and efficiency and developing recommendations for improvement. According to section 3.2 of the Treasury Regulations the requirements of internal control and internal audit include the following:

• The accounting officer must ensure a risk assessment is conducted regularly to identify emerging risks. A risk management strategy, including a fraud prevention plan, must direct the work of internal audit.

• An internal audit function must be established.

• The purpose, authority and responsibility of the internal audit function must be formally defined in an internal audit charter.

• An internal audit must be conducted in accordance with the standards of the Institute of Internal Auditors.

• The internal audit function must complete a rolling risk-based three-year strategic internal audit plan and an annual internal plan for the first year, indicating the proposed scope of each audit, and report quarterly to the audit committee on performance against the annual internal audit plan.

• The internal audit function must be independent of activities audited and report directly to the accounting officer.

• The internal audit function must co-ordinate with other internal and external providers of assurance to ensure proper coverage, but limit duplication.

• Controls subjected to evaluation should include the information systems environment, reliability and integrity of financial and operational information and the effectiveness of operations, safeguarding of assets and compliance with laws, regulations and control.

2.1.1.2. Financial Management

Within government there has been a major focus on improving financial management. Treasury at a national and provincial level has a critical role to play as part of the financial management process in government as part of the responsibility to manage South Africa’s national government finances. Supporting efficient and sustainable public financial management is fundamental to the promotion of economic development, good governance, social progress and a rising standard of living for all South Africans. Chapter 13 of the Constitution mandates the National Treasury to ensure transparency, accountability and sound financial controls in the management of public finances. The National Treasury’s legislative mandate is also described in chapter 2 of the PFMA, which mandates the National Treasury to –

• promote government’s fiscal policy framework;

• coordinate macroeconomic policy and intergovernmental financial relations;

• manage the budget preparation process;

• facilitate the Division of Revenue Act, which provides for an equitable distribution of nationally raised revenue between national, provincial and local government; and

• monitor the implementation of provincial budgets.

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The following provides an overview of relevant sections in the PFMA and Treasury Regulations related to financial management:

• Revenue collection, cash collection and cash management

Government revenue includes taxes, sales, transfers, fines, penalties and forfeits, interest, dividends and rent on land, as well as transactions in financial assets and liabilities. The PFMA (section 40) requires the accounting officer to submit a report each month that include information on the actual revenue and expenditure for the previous month and the amounts anticipated for that month. Within 15 days after month end, a report is issued to treasury and the executive authority on the information for the month, with a projection of expected expenditure and revenue collection for the remainder of the financial year; explanations on any material variances; and a summary of steps taken to ensure projected expenditure and revenue remain within budget. Section 7 of the Treasury Regulations describes the requirements for revenue management and specifically to manage revenue efficiently and effectively by developing and implementing appropriate processes to provide for identification, collection, recording, reconciliation and safeguarding of information about revenue. In terms of section 7 of the PFMA, the National Treasury must prescribe a framework for cash management and section 15 of the Treasury Regulations include the frameworks for banking, cash management and investments. As part of the control of the revenue funds each treasury is responsible for the effective and efficient management of its revenue fund and ensuring sufficient money is in the revenue fund to meet the appropriated expenditure and cash flow requirements. All revenue received by a department must be paid daily into its paymaster-general (bank) account. Appropriated funds requested by departments from Treasury must be in accordance with approved cash flow requirements. At the end of the financial year, the accounting officer must surrender any unexpended voted money to the relevant treasury. Treasury Regulations also prescribe the general principles for banking and cash management, as follows:

• Collecting revenue when due and banking it promptly;

• Making payments no earlier than necessary;

• Avoiding prepayments for goods and services;

• Pursuing debtors to ensure amounts receivable are collected and banked promptly;

• Managing cash flow;

• Taking action to avoid locking up money, for example in unnecessarily high inventory levels;

• Performing daily bank reconciliations;

• Separating duties to minimise incidences of fraud.

• Expenditure management

The PFMA requires that the accounting officer should ensure effective, efficient, economical and transparent use of the resources of the institution and prevent unauthorised, irregular and fruitless and wasteful expenditure and losses resulting from criminal conduct. The accounting officer is responsible for ensuring that the expenditure is in accordance with the vote of the department and should report under-collection of revenue, shortfalls in budgeted revenue and overspending to the relevant treasury (sections 38‒39). Unauthorised expenditure includes overspending of the total amount appropriated per department or expenditure not in accordance with its main purpose. If unauthorised expenditure is incurred, Parliament or the provincial legislature must authorise the expenditure, otherwise funding allocated in future years need to be utilised for the unauthorised expenditure (section 34 of the PFMA). Irregular expenditure is expenditure, other than unauthorised expenditure, incurred in contravention of or not in accordance with a requirement of any applicable legislation. Fruitless and wasteful expenditure is expenditure that was made in vain that could have been avoided had reasonable care been exercised.

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The accounting officer must exercise reasonable care to prevent and detect these types of expenditure. Where such expenditure incurs the necessary reporting should take place and the amount must be disclosed as a note to the annual financial statements of the institution.

Section 8 of the Treasury Regulations require that the accounting officer must ensure internal procedures and internal control measures are in place for payment approval and processing. The controls should provide reasonable assurance that all expenditure is necessary, appropriate, paid promptly and adequately recorded and reported. No amounts may be spent or committed without obtaining the necessary approval. The Regulations also require all payments due to creditors to be settled within 30 days from receipt of an invoice. The PFMA further allocates responsibility to ensure a system for properly evaluating all major capital projects prior to a final decision on the project to the accounting officer (section 38). At the centre of government’s development plan is the provision of economic infrastructure to support growth. Government planned expenditure on infrastructure is significant.

• Asset management

The PFMA allocates responsibility for the management, including the safeguarding and maintenance of assets, to the accounting officer (section 38). Treasury Regulations require that the accounting officer should ensure proper control systems exist and that preventative mechanisms are in place to eliminate theft, losses, wastage and misuse. Stock levels should be optimum and at an economical level. Processes and procedures should be in place for the effective, efficient, economical and transparent use of the assets (section 10). Treasury Regulation further require that the accounting officer take effective and appropriate steps to collect money due timeously. Regulations also cover recovery of debts, writing off of debts and interest payable on debts in section 11.

• Liabilities

The PFMA allocates responsibility for the management of the liabilities to the accounting officer (section 38). The PFMA includes specific requirements on borrowing within government and places a limitation of the ability to enter into loan agreements without prior approval (sections 66 and 71). With the exception of entering into operating leases, the accounting officer of the department and other relevant staff can be guilty of financial misconduct if financing agreements are entered into without the prior approval of Treasury.

• Supply chain management

Extensive legislative requirements for supply chain management exist. The PFMA allocates responsibility for ensuring an appropriate procurement and provisioning system that is fair, equitable, transparent, competitive and cost effective to the accounting officer (section 38). Section 16 of the Treasury Regulations covers the requirements for supply chain management and states that the accounting officer must develop and implement an effective and efficient supply chain management system that must be consistent with the Preferential Procurement Policy Framework and provide for at least the following:

• Demand management

• Acquisition management

• Logistics management

• Disposal management

• Risk management

• Regular assessment of supply chain performance.

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The accounting officer must establish a separate supply chain management unit that can implement the supply chain management system. The procurement of goods and services through quotations or through the bidding process must be within the threshold value determined by National Treasury. The supply chain management system must, in the case of procurement, provide for a bidding process that includes ‒

• the adjudication of bids through a bid adjudication committee;

• the establishment, composition and functioning of bid specification, evaluation and adjudication committees;

• the selection of bid adjudication committee members; and

• the approval of bid evaluations and/or adjudication committee recommendations.

The accounting officer must take reasonable steps to prevent abuse of the supply chain management system and investigate any allegations against an official or other role player of corruption, improper conduct or failure to comply with the supply chain management system. 2.1.1.3. Management Decision Making and Control

As part of Management Decision Making and Control, budgeting and monitoring are key elements that will inform decision making and control. Section 214(1) of the Constitution requires that a Division of Revenue Act determine the equitable division of nationally raised revenue between national government, the nine provinces and the municipalities every year. This process takes into account the powers and functions assigned to each sphere of government. The Intergovernmental Fiscal Relations Act, 1997 (Act 79 of 1997)) prescribes the process for determining the equitable sharing and allocation of nationally raised revenue. Section 214 of the Constitution requires that the annual Division of Revenue Act be enacted after factors in sub-sections (2)(a) ‒(j) of the Constitution have been taken into account. These include national interest, debt provision, the needs of national government, flexibility in responding to emergencies, resource allocation for basic services and developmental needs, the fiscal capacity and efficiency of provincial and local government, reduction of economic disparities, and promotion of stability and predictability. The national interest is encapsulated by governance goals that benefit the nation as a whole. The National Development Plan, endorsed by Cabinet in November 2012, sets out a long-term vision for the country’s development and includes 14 priority outcomes. The medium-term strategic framework (MTSF) is adopted by Cabinet to give effect to the priority outcomes over the next five years. In the Medium Term Budget Policy Statement, the Minister of Finance outlines how the resources available to government over the medium-term expenditure framework (MTEF) would be allocated to help achieve these goals. Provincial and local government equitable share allocations are based on estimates of nationally raised revenue. If this revenue falls short of the estimates within a given year, the equitable shares of provinces and local government will not be adjusted downwards. Allocations are assured (voted, legislated and guaranteed) for the first year and are transferred according to a payment schedule. To contribute to longer-term predictability and stability, estimates for a further two years are published with the annual proposal for appropriations. More information on the budget can be obtained from National Treasury’s website (http://www.treasury.gov.za/documents/national%20budget/2015/review/default.aspx). Sections 26‒35 of the PFMA describe the budget requirements. Parliament and each provincial legislature appropriate money for each financial year for the requirements of the state and provinces. The budget must contain estimates of all expected revenue to be raised during the financial year, estimates of current expenditure per vote and per main division within the vote, estimates of interest and repayment on loans, estimates of capital expenditure per vote and main divisions within the vote for the financial and future years, proposals for financing any anticipated deficit and the intentions regarding borrowing and other public liability that will increase public debt.

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In February of each year, the Finance Minister tables the national budget in Parliament, at which the Minister announces government’s spending, tax and borrowing. Once Parliament approves the budget, it is adopted and becomes Parliament’s budget. The budget must include the projected revenue, expenditure per vote and per main division and borrowing for the previous financial year and include multi-year budget information. The budget announces government spending for the next three financial years, that is, the years of the MTEF. In contrast to the function-based process, the Appropriation Bill, tabled by the Minister of Finance as part of the budget, is set out in terms of each budget vote. Generally, a vote specifies the total amount of money appropriated to a national government department. Through the Appropriation Bill the executive seeks Parliament’s approval and adoption of its national government spending plans for the first year of the MTEF period. The abridged estimates of national expenditure publication is the explanatory memorandum to the Appropriation Bill and contains detailed information regarding the allocations to each national government vote. Key performance indicators are included for each national government vote and entity showing what the institutions aim to achieve by spending their budget allocations in a particular manner. This information provides Parliament and the public with the necessary tools to hold government accountable against the 14 outcomes set out in the MTSF. Each public institution is also required to compile a strategic plan (called an integrated development plan in the case of municipalities) and an annual performance plan (called a service delivery budget implementation plan in the case of municipalities) that include strategic outcomes, objectives, key performance indicators and targets. The requirements for planning and budgeting are included in sections 5 and 6 of the Treasury Regulations. These planning documents are used as a basis for monitoring performance through in-year reporting (finance monthly and performance/non-financial quarterly) and annual reporting. This information provides Parliament and the public with the necessary tools to hold government accountable against the 14 outcomes set out in the MTSF and the objectives and targets set out in the plans. 2.1.2. Summary The information above has provided an understanding of the key public sector legislation and how this impacts on the:

• Strategy, risk management and governance;

• Financial management; and

• Management decision making and control of public sector organisations. Please refer to the study material of your other modules for the impacts on:

• Accounting and external reporting;

• Auditing and assurance; and

• Taxation.

Activity 1.2.1 List the key enabling legislation a public sector entity would need to implement.

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Feedback to Activity 1.2.1

• The Constitution of the Republic of South Africa

• The Public Finance Management Act (PFMA)

• Treasury Regulations

• The Municipal Finance Management Act (MFMA)

• The Division of Revenue Act

• Procurement legislation

• Public Audit Act (PAA)

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LEARNING UNIT 2 – RISK MANAGEMENT

LEARNING OUTCOMES After studying this learning unit, you should be able to further apply your knowledge and skills achieved through your prior learning (see below) to a scenario, on an integrated basis.

PRIOR LEARNING ASSUMED

In your undergraduate and Advanced Management Accounting studies you have already mastered the learning outcomes indicated below. If you want to refresh your knowledge, please refer to your undergraduate material, prescribed textbook and MAC4861 Tutorial Letter 102/2020 (available under ‘additional resources’ on myUnisa). For your convenience we also provide textbook references.

Learning outcome

References

• Identify and evaluate opportunities and risks on an advanced level.

• Critically assess risks (including IT risks) and how they are managed.

• Understand and explains the critical components of an Enterprise Risk Management (ERM) framework

• Evaluate an entity’s risk management programme.

• Recommend courses of action to help manage risks.

• Apply your theoretical knowledge relating to risk management to a given scenario, and provide value added assessments and comments in this regard.

• Chapter 3

• MAC4861 TL102

INTRODUCTION A rational investor should expect a higher return on a higher risk investment. It is thus imperative to not only quantify risk accurately, but at the same time, to manage risk so that the uncompensated risks can be minimised. Your prior learning for this learning unit included a fair amount of theory. You can obtain a better understanding of the theory by working through a sufficient number of questions/case studies. This learning unit will assist you in this regard. THIS LEARNING UNIT CONSISTS OF THE FOLLOWING SUB LEARNING UNITS: LEARNING UNITS TITLE LEARNING UNIT 2.1 RISK MANAGEMENT

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LEARNING UNIT 2.1 - RISK MANAGEMENT

1. Introduction

We have already noted that risks are relevant in everybody's day-to-day lives. In the financial world, one finds different types of risk. Risks can come from uncertainty, such as uncertainty from the future rand/dollar exchange rates, possible project failures, possible legal liabilities, granting of credit, accidents, possible natural disasters, possible fraud and error, and several other unknowns. In the field of Management Accounting, the concepts of risk assessment and management are pervasive. You have already encountered some of the related concepts before and will also encounter others in later learning units. For example, in assessing risk, the concepts of probability and sensitivity have already been considered earlier as part of decision-making techniques. Risk will also be considered when evaluatin1g investment and financing decisions. Later you will also be reacquainted with hedging techniques, which is a transaction that can lower or even eliminate risk in certain areas.

2. Content There is no additional content to be studied at this level. All content has already been addressed in your prior learning. If you want to refresh your knowledge, please refer to the earlier section ‘Prior learning assumed’. The activity below, the self-assessment questions provided later in this learning unit, and the integrated self-assessment at the end of this tutorial letter will help you to apply your knowledge. Activity 2.1.1 List some risks that may be relevant to a South African entity manufacturing paper from tree pulp. Assume that the entity exports to various clients in South America and Africa, and that the entity utilises 80% debt capital. Feedback to Activity 2.1.1

There could be numerous types of risks and the following are just a few examples that you could have considered:

• environmental risks caused by air pollution from the paper mill (paper manufacturing plant)

• environmentalists may place pressure on the entity and cause restrictions on the cutting of trees if a conscious effort is not made to ensure the sustainability of the water resources, fertile land, natural forests and the biological system in the area

• the high level of gearing increases the financial risk and could place restrictions on future expansion as loans require fixed repayments and are often secured by assets

• the entity exports to South America and other African countries, which increases currency risk as contract values may change with currency fluctuations.

Activity 2.1.2 Perform Practice Question 3-3 in Managerial Finance (8th edition). Feedback to Activity 2.1.2 Find the solution after the practice question in the textbook.

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3. Self-assessment questions After working through all the relevant sections in the textbook, guidance and activities provided by this learning unit, you should now be able to attempt the following self-assessment questions. QUESTION 1 (24 MARKS 36 MINUTES plus reading time) Perform the required part (c) of question 3 (Insimbi Limited), which can be found in the Question Bank. The relevant required part is repeated below. (At this point it is not necessary to attempt the other parts of the question; you should, however, take notice of the way in which all the various parts integrate and relate to the scenario.)

REQUIRED

Marks

(c) For each of the risk factors indicated below, describe the reason why Insimbi Limited may consider this a key risk factor and further suggest ways in which Insimbi could mitigate these risk factors. In your answer you should make use of a table in the following format:

(24)

Risk factor Reason why this may represent a key risk factor

Mitigation

• Regulatory, political and legal matters (2 marks) (2 marks)

• Inadequate supporting infrastructure (1 mark) (1 mark)

• Impact on the environment (2 marks) (2 marks)

• Foreign exchange (1 mark) (2 marks)

• Commodity price and demand (3 marks) (2 marks)

• Employees’ health and safety

(3 marks) (3 marks)

Solution to question 1 Find the suggested solution to the relevant part in the Question Bank. QUESTION 2 40 MARKS (60 MINUTES plus reading time) Perform the required sub-part (a) of Question 15 (H Ltd Goup), which can be found in the Question Bank. The relevant required part is repeated below.

REQUIRED Marks

(a) Identify and explain the key risks the H Ltd group faces with regard to its group operations and describe ways, if any, in which the group could mitigate these risks.

(40)

Solution to question 2 Find the suggested solution to the relevant part in the Question Bank.

BIBLIOGRAPHY AND ADDITIONAL READING

Skae, FO. (2017). Managerial Finance, 8th edition. LexisNexis: Johannesburg.

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LEARNING UNIT 3 – COST OF CAPITAL AND CAPITAL INVESTMENT

APPRAISAL

LEARNING OUTCOMES After studying this learning unit, you should be able to further apply your knowledge and skills achieved through your prior learning (see below) to a scenario, on an integrated basis. In addition, after studying this learning unit, you should be able to:

• recommend ways in which project and investment appraisal could be approached differently with the aim of sustainable value creation

• perform and evaluate a foreign investment decision

• quantify the effect of specific scenarios on the net present value and/or internal rate of return of a proposed investment

• describe how Monte Carlo simulation could help measure the impact of risk on a proposed investment


Learning outcome

Reference Managerial Finance

(8th edition):

✓ Understand the concept of risk vs. return, including the

underlying theory. ✓ Integrate multiple sources of knowledge to determine the fair

value of different types/forms of preference shares and debt, incorporating complications in discounted cash flow and relevant income tax treatments.

✓ Analyse an entity’s cost of capital and capital structure. ✓ Calculate the weighted average cost of capital and its various

components. ✓ Understand the circumstances in which a project specific cost

of capital will be utilised, including the calculation thereof. ✓ Differentiate between asset and equity betas, including the

calculation thereof. ✓ Perform and evaluate an investment decision on an advanced

level, utilising various capital budgeting techniques ✓ Address complications of an investment decision, including

dealing with the effects of inflation, risks, taxation, capital rationing and projects with different lifecycles.

✓ Evaluate the alternative of asset-specific finance. ✓ Perform sensitivity analysis upon an investment decision. ✓ Discuss the purpose and benefits of a post-investment audit. ✓ Recommend ways in which project and investment appraisal

could be approached differently with the aim of sustainable value creation.

• Chapter 4 (sections 4.1-4.12)

• Chapter 5

• Chapter 6 (parts 6.1 to 6.8)

• Chapter 10

• Management and Cost Accounting, 9th edition: Chapter 13

• MAC4861 TL102

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INTRODUCTION

Capital investment appraisals are long-term decisions, where it will take several years to earn a return on the capital investment made. The topic of capital investment appraisals integrates many other management accounting topics (including strategy, cost of capital and relevant costing), and frequently serves as the precursor to the financing decision. It further integrates with the subject of taxation. The cost of capital is important as it directly affects the choice of investments. A too low cost of capital could lead to the acceptance of investments earning insufficient returns; whereas a too high cost of capital could lead to not accepting profitable investments. Both cost of capital and capital investment appraisal have in the past frequently been examined in this subject and also on the level of SAICA’s professional examinations. Thorough knowledge of these learning units – on an advanced level – is therefore important.

THIS LEARNING UNIT CONSISTS OF THE FOLLOWING SUB LEARNING UNITS:

LEARNING UNITS TITLE LEARNING UNIT 3.1 WEIGHTED AVERAGE COST OF CAPITAL

LEARNING UNIT 3.2 CAPITAL INVESTMENT APPRAISAL – ISSUES IN INVESTMENT

APPRAISAL

LEARNING UNIT 3.3 FOREIGN INVESTMENT

LEARNING UNIT 3.4 SCENARIO ANALYSIS AND MONTE CARLO SIMULATION

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LEARNING UNIT 3.1 - WEIGHTED AVERAGE COST OF CAPITAL

1. Introduction The cost of capital is important as it directly affects the investment decision and the choice of investments. The weighted average cost of capital (WACC) is the dominant indicator of the cost of capital of an entity and is determined based on a weighted average of other costs. Here, an entity’s capital may consist of several forms of capital, including equity, preference shares and debt. This learning unit is based on selected sections of the following chapters in your prescribed textbook (Managerial Finance, 8th edition):

• Chapter 4: Capital structure and the cost of capital

• Chapter 5: Portfolio management and the Capital Asset Pricing Model

• Chapter 10: Valuations of preference shares and debt

2. Content There is no additional content to be studied at this level. All content has already been addressed in your prior learning. If you want to refresh your knowledge, please refer to the earlier section ‘Prior learning assumed’. The activity below, the self-assessment questions provided later in this learning unit, and the integrated self-assessment at the end of this tutorial letter will help you to apply your knowledge. Activity 3.1.1 Attempt question 4.6 in Managerial Finance, 8th edition, without referring to the suggested solution.


Find the suggested solution after the question in the textbook.

3. Self-assessment questions After working through all the relevant sections in the textbook, guidance and activities provided by this learning unit, you should now be able to attempt the following self-assessment questions. QUESTION 1 14 MARKS (21 MINUTES plus reading time) Perform the required part (a) of Question 1 (MEDICO GROUP), which can be found in the Question Bank. The relevant required part is repeated below. (At this point it is not necessary to attempt the other parts of the question; you should, however, take notice of the way in which all the various parts integrate and relate to the scenario.)

REQUIRED Marks

(a) Calculate the weighted average cost of capital for MGSA as at 31 March 2013 based on available information and ignoring any effect of a possible merger or acquisition.

(14)

Solution to question 1 Refer to the suggested solution to this part in the Question Bank. BIBLIOGRAPHY AND ADDITIONAL READING

Skae, FO. 2017. Managerial Finance. 8th edition. LexisNexis: Johannesburg.

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LEARNING UNIT 3.2 – CAPITAL INVESTMENT APPRAISAL – ISSUES IN

INVESTMENT APPRAISAL

1. Introduction

Capital investment appraisals are long-term decisions, where it will take several years to earn a return on the capital investment made. Here, it is important to take cognisance of the similarities and differences between capital investment appraisals and business valuations. When assessing a proposed capital investment using discounted cash flow methods (e.g. projecting cash flows and calculating a net present value or internal rate of return), a capital investment appraisal displays many similarities to a business valuation (using, for example, an enterprise discounted cash flow model, based on free cash flow). From your prior knowledge, you should recall that a capital investment appraisal frequently assesses a project over a fixed term (e.g. 5 years), where end-of-period cash flows should be accounted for (e.g. the re-sell value of a machine). In contrast, a business valuation frequently accounts for a continuing value using, for example, the Gordon Growth Model. An investment decision can also be complicated by various factors, including the effects of inflation, relevant costs and revenues, taxation, capital rationing and projects with different lifecycles. Often in the past, capital investment appraisals were made by considering only economic aspects. In these enlightened times, however, appraisers are starting to consider other issues as well with the ultimate goal of sustainable value creation. This learning unit is based on the following chapters in your prescribed textbooks: Managerial Finance – 8th edition:

• Chapter 6: The investment decision

2. Content

There is no additional content to be studied at this level. All content has already been addressed in your prior learning. If you want to refresh your knowledge, please refer to the earlier section ‘Prior learning assumed’. The activity below, the self-assessment questions provided later in this learning unit, and the integrated self-assessment at the end of this tutorial letter will help you to apply your knowledge

3. Self-Assessment questions After working through all the relevant sections in the textbook, guidance and activities provided by this learning unit, you should now be able to attempt the following self-assessment questions.

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QUESTION 1 29 MARKS (44 MINUTES plus reading time) Perform the required parts (a) (b) and (c) of Question 2 PART B (D&S TEC), which can be found in the Question Bank. The relevant required part is repeated below. (At this point it is not necessary to attempt the other parts of the question; you should, however, take notice of the way in which all the various parts integrate and relate to the scenario.)

REQUIRED Marks

(a) Calculate the weighted average cost of capital (WACC) of D&S TEC at 31 March 2012 based on the target structure.

(6)

(b) Without further calculations, explain the impact that a new bank loan, to finance the investment, will have on D&S TEC’s (i) cost of equity (ii) cost of debt; and (iii) weighted average cost of capital.

(2) (2) (2)

(c) Use the discounted cash-flow model to determine what the resale value of the computer and other equipment will need to be, to achieve a required return of 19%. Your answer should include detailed calculations and indicate key assumptions or items omitted from your evaluation. (i) Calculations (ii) Assumptions

(14) (3)

Solution to question 1 Refer to the suggested solution to this part in the Question Bank.


International Federation of Accountants (IFAC). 2012. Exposure draft: Project and Investment Appraisal for Sustainable Value Creation. New York: IFAC Skae, FO. 2017. Managerial Finance. 8th edition. LexisNexis: Johannesburg.

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LEARNING UNIT 3.3 – FOREIGN INVESTMENT

1. Introduction An appropriate capital investment decision can only be made after considering several quantitative and qualitative factors. Quantitative appraisal of a proposed capital investment usually requires forecasting of investment-related and associated cash flows, which is then discounted at an appropriate risk-adjusted discount rate based on WACC. This process is complicated further when involving a foreign investment as we then have to consider additional factors, such as country risk and different currency units. This learning unit is based on the following chapter in your prescribed textbook: Managerial Finance – 8th edition Chapter 6: The investment decision, part 6.9 2. Content


2.1. Quantitative analysis of a local capital investment decision In performing a quantitative appraisal of a proposed local investment, we usually calculate the net present value (NPV) of the projected investment-related and associated cash flows (excluding finance-related cash flows), by discounting the cash flows using an appropriate risk-adjusted discount rate. Then, once all quantitative and qualitative factors have been considered, a capital investment decision is made. (These concepts are described in detail in the textbook. Next we consider additional considerations when contemplating the discount rate for foreign investment. 2.2. Country risk

According to author, Luis Pereiro (2002), country risk represents the combined risk from the following country-specific risk components (with examples in brackets):

• Currency risk and the risk resulting from inflation, including devaluation and volatility in the local currency (think of the volatility of South African rand a few years ago and of the recent devaluation in several emerging market currencies against benchmark currencies).

• The credit risk of the government, including the possibility of defaulting on international debt funding, such as government bonds (think of the euro-crisis, and recent changes in the perceived credit risk of Greece and Portugal).

• Social or political problems (think of recent events in Syria and Egypt).

• Possibility of government expropriation and nationalisation of private assets (think of recent events in Zimbabwe and Bolivia).

• Potential barriers to free capital flow in and out of the country (think of South Africa).

Pereiro (2002) adds that country risk is relevant where investment is not diversified geographically, either through practical limitations, due to countries restraining investors from entering and exiting (for example, South African exchange control partially restrains investors in this regard), or willingly, where investors choose to invest only in a single country and therefore effectively choose not to diversify geographically.

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Next we consider ways of adjusting for the effects of country risk as part of foreign investment appraisal.

Although little consensus exists amongst experts as to the best technique to use for the adjustment of country risk, numerous techniques have been described, with various levels of complexity. (Complex techniques for the adjustment of country risk fall beyond the scope of the curriculum.) We recommend that you study the techniques described in this section rather than section 6.9, entitled “International capital budgeting”, as in the prescribed textbook. In this section we discuss two basic techniques that are commonly used; both are based on the Capital Asset Pricing Model. (This discussion is adapted from descriptions by Correia [2011], Pereiro, [2002] and Damodaran [2009].) a) Technique 1 This technique allows for the adjustment of country risk in components: partially at the level of projected cash flows and partially at the discount rate. Apply the following steps in evaluating a foreign investment: 1. Estimate future cash flows in the foreign currency.

2. Convert to local currency (rand) using forecasted spot exchange rates for each year. (This step accounts for the effect of currency risk and is similar to the one used in analysing foreign finance. Refer to learning unit 4.2 in this regard.)

3. If available, add or deduct the incremental insurance premium (in rand, as obtained from Lloyds of London, for example) to account for the difference in political risk, expropriation risk, etc. (If the foreign country has a higher risk than South Africa then the incremental insurance premium should be deducted; if a lower risk then the incremental premium should be added.)

4. Determine/obtain the discount rate for the investor company (in South Africa, based on rand) and adjust for foreign country risk factors not incorporated in step 3.

5. Adjust the local discount rate (South African, based on rand) for the effect of improved geographical diversification benefits, if any. (This may result in a lowering of the rate.)

6. Further adjust the local discount rate (South African) for undiversified investment-specific risks, not accounted for as part of the forecasted cash flows.

7. Determine the net present value by discounting the cash flows (in rand) using the adjusted local (South African) discount rate.

b) Technique 2 This technique allows for the adjustment of country risk mainly at the level of the discount rate, where it incorporates a “country risk premium”. Country risk premium A country risk premium is the additional return required over a benchmark risk-free rate, due to the effects of incremental country risk. A country risk premium is often calculated based on the spread of a sovereign bond (belonging to the country of investment) over a benchmark bond (often taken as US T-Bonds or German Bonds), both with the same monetary denomination (thus normally US dollars or euro) and both with a similar maturity date close to the life expectancy of the proposed investment.

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One way of determining this spread is to refer to the rating allocated to the country’s debt by one of the rating agencies and then to refer to the published spreads relative to the US T-bond, for instance. Tables 3.1 and 3.2 provide an indication of these bond-spreads. (Spreads are indicated in basis points; 100 basis points equals 1%. We do not provide a more recent representation because US corporate bond spreads in recent times approached their widest on record due to the international financial crisis, making later figures less representative.) Activity 3.3.1 Determine the country risk premium of a proposed 10-year investment in Brazil, using the information

in Table 3.3.1. Assume that the credit rating of Brazil’s sovereign debt is rated at BBB.

Feedback to Activity 3.3.1 The country risk premium of a proposed investment in Brazil is calculated as follows: A 10 year BBB

rated bond has a spread of 292 basis points compared to US T-bonds (per Table 10.3.1), or 2,92%,

which equals the Brazilian country risk premium over the US.

Steps in applying technique 2

Apply the following steps in evaluating a foreign investment using this technique: 1. Estimate future cash flows in the foreign currency.

2. Convert to a benchmark currency (US dollar or euro) using forecasted spot exchange rates for each year.

3. Determine a risk-adjusted discount rate (US dollar or euro-based) as follows:

WACCfi = (Kd x d%) + (Ke x e%)

Where:

WACCfi= The weighted average cost of capital for the proposed foreign investment

Ke = Cost of equity

Kd = After-tax rate of return on debt capital (sometimes increased by the after tax country risk premium [Rc]

d% = The debt component in the target capital structure, or debt capital as a percentage of the sum of the debt and ordinary equity capital (based on market values)

e% = The equity component in the target capital structure, or ordinary equity capital as a percentage of the sum of the debt and ordinary equity capital (based on market values)

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Calculation of Ke

Ke = (Rfg + Rc) + ß (MRP) + Ri

Where:

Rfg = Global risk free rate (for example equal to the yield on a US T-bond or German Bond with a maturity date close to the life expectancy of the investment)

Rc = Country risk premium (for example calculated based on the spread of a sovereign bond [belonging to the country of investment] over a benchmark bond, both denominated in the same currency and both with the same maturity date)

ß = Representative Beta coefficient

MRP = Representative equity market risk premium

Ri = Premium for undiversified investment-specific risks, not accounted for as part of the forecasted cash flows.

4. Determine the net present value by discounting the cash flows (in US dollar or euro) using the (US dollar or euro) risk-adjusted discount rate.

5. Convert the net present value to rand using the current spot rate.

Table 3.3.1: Yield spread over US T-bond by bond rating, May 2009 (Bloomberg)

This sum equals the (US dollar or euro denominated) risk free rate of the foreign country

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The general meaning of credit rating opinions is summarised below:

AAA Extremely strong capacity to meet financial commitments. Highest Rating.

AA Very strong capacity to meet financial commitments.

A Strong capacity to meet financial commitments, but somewhat susceptible to adverse economic conditions and changes in circumstances.

BBB Adequate capacity to meet financial commitments, but more subject to adverse economic conditions.

BB Less vulnerable in the near term but faces major on-going uncertainties to adverse business, financial and economic conditions.

B

More vulnerable to adverse business, financial and economic conditions but currently has the capacity to meet financial commitments.

CCC

Currently vulnerable and dependent on favourable business, financial and economic conditions to meet financial commitments.

CC Currently highly vulnerable.

C Currently highly vulnerable obligations and other defined circumstances.

D Payment default on financial commitments.

Additional “+” or “-” ratings are sometimes indicated for finer classification.

Table 3.3.2 Meaning of credit rating opinions (Standard & Poor’s, 2018)

Activity 3.3.2

Attempt the following illustrative example and compare your answer to the suggested solution.

Foreign investment

Assume you are the financial manager of a large South African firm who is contemplating an investment

in Brazil.

You have already gathered or estimated the following information:

• The investment has a life expectancy of 3 years.

• Forecasted net cash flows per annum: Million Million Million Million

Years from now 0 1 2 3

Forecasted net cash flows (currency: Brazilian real) (4) 3 5 7

• Rates

1 USD 8.13 ZAR Spot 1 USD 1.83 BRL Spot 1 USD 2.10 BRL Forward rate (1 year)

1 USD 2.31 BRL Forward rate (2 years) - estimated

1 USD 2.49 BRL Forward rate (3 years) - estimated

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Acronyms used:

USD = US dollar

BRL = Brazilian real

ZAR = South African rand

• Yield on a note with a maturity close to that of project life-expectation US treasury note 1.2% • International equity market risk premium 5.0% • Brazilian bond spread relative to US treasury 2.9% (Based on credit ratings)

• Information specific to the Brazilian investment

o Beta coefficient (estimated) 2.0 o Undiversified investment-specific risk 5.0%

• Other information

o Value of international diversification (rand [million]) 1 (Estimated)

REQUIRED Marks

Perform a quantitative analysis of the proposed Brazilian investment to determine if the investment will yield a positive net present value.

(10)


Investment in Brazil Marks

0 1 2 3

BRL (million) cash flows (4,00) 3,00 5,00 7,00

Forward exchange rates (USD1 = BRL_) 1,83 2,10 2,31 2,49

USD (million) cash flows (2,19) 1,43 2,16 2,81 (1)

Foreign discount rate

Ke = (Rfg + Rc) + ß (MRP) + Ri = (1, 2%+2, 9%) [1] + 2(5%) [1] + 5%[1] Marks as indicated in square brackets, total: 3

= 19,1%

19,1% 1,000 0,840 0,705 0,592 (1)

Factors or calculator steps shown

Discounted values (USD [million]) 2,20 (2,19) 1,20 1,53 1,66 (1)

Spot exchange rate (1USD = ZAR_) 8,13 Converted to ZAR (million) 17,92 (1) Value of international diversification (ZAR [million]) 1,00 (1)

Net present value of Brazilian investment (ZAR [million]) 18,92 Note: figures may not total due to rounding.

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BIBLIOGRAPHY AND ADDITIONAL READING Correia, C et al. 2011. Financial Management. 7th edition. Juta & Co: Cape Town.

Damodaran, A. 2009. Strategic Risk Taking: A Framework for Risk Management. New York: Pearson Prentice Hall. Pereiro, LE. 2002. Valuation of companies in emerging markets. New York: John Wiley & Sons. Skae, FO. 2017. Managerial Finance. 8th edition. LexisNexis: Johannesburg Standard & Poor’s. 2018. S&P Global Ratings Definitions [Online.] New York: Standard & Poor’s. Available from: < https://www.standardandpoors.com/en_US/web/guest/article/-/view/sourceId/504352> [Accessed 5 July 2018].

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LEARNING UNIT 3.4 - SCENARIO ANALYSIS AND MONTE CARLO SIMULATION

1. Introduction Traditional discounted cash flow techniques used to evaluate a proposed investment, attempt to capture the effects of risk and uncertainty into a single figure – a single net present value (NPV) or internal rate of return (IRR) for the investment. Yet these techniques incorporate several variables, each subject to a degree of uncertainty. In consequence, by attempting to capture the effects of overall risk and uncertainty into a single figure, these techniques do not fully highlight the potential effects these may have. (Traditional discounted cash flow techniques are described in detail in the textbook). To help address this weakness, an appraiser can employ certain techniques that shed greater light on the effects of risk and uncertainty. Two such techniques are scenario analysis and Monte Carlo simulation. This learning unit is based on the following chapters in your prescribed textbook: Managerial Finance – 8th edition

• Chapter 6: The investment decision, part 6.7 2. Content

The purpose of the content below is to supplement the information in the textbook in areas where it is considered necessary. It in no way replaces or can be considered to be a substitute for the textbook. It therefore remains imperative that you work through the textbook in detail. 2.1. Scenario analysis Scenario analysis is an extension of sensitivity analysis performed on a capital investment appraisal. Firstly, a brief summary of sensitivity analysis: Here we change a single variable in the analysis (whilst keeping the other constant or independent) and note the outcome on the appraisal, such as the effect on the investment’s net present value (NPV) or internal rate of return (IRR). We can also plot the results on a sensitivity graph. With scenario analysis we determine the outcome of an investment appraisal for different scenarios (often in three levels, such as best-case, worst-case and intermediate-case). In contrast to sensitivity analysis, here we have the luxury of assuming interdependence of variables. For example, under a worst-case scenario, if we assume a smaller market share we can also lower the expected selling price of the product.

2.2. Monte Carlo simulation

Monte Carlo simulation was developed by nuclear physicists to help solve complex problems incorporating a fair degree of uncertainty. Practitioners in managerial finance later realised that it would be helpful also in performing capital investment appraisals, specifically for proposed investments incorporating a large degree of uncertainty. A Monte Carlo simulation utilises a computer programme (Microsoft Excel® or a dedicated software programme) to generate a large number of scenarios (similar to those described in the preceding section), given probabilities for inputs. A random number is then generated for each of the uncertainties that, in turn, is input into a formula to generate an outcome for a single scenario. This is then repeated for thousands of scenarios. Before we explore the intricacies of Monte Carlo simulation, let’s assume that regular discounted cash flow analysis was performed on two investments. Further assume that this analysis revealed an expected internal rate of return (IRR) of 9,2% for Investment X and an IRR of 10,3% for Investment Y.

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Based on these internal rates of return only, a financial manager will typically choose Investment Y, due to its higher IRR (if this is in excess of the company’s weighted average cost of capital). A paper on risk analysis in capital investment, written by David Hertz as long ago as 1964, highlights the additional insight that could be obtained through Monte Carlo simulation. Table 3.4.1 shows the results of a Monte Carlo simulation performed by Hertz for two proposed investments, Investment X and Investment Y, based on thousands of scenarios. If assumptions are aligned, the peak of the distribution plotted for each investment should equal the results of a regular discounted cash flow analysis. (Notice that the peak of the distribution plotted for Investment X equals the 9,2% IRR described earlier and likewise, the distribution plotted for Investment X equals the 10,3% IRR described earlier.) However, Monte Carlo simulation offers additional insight into the two investments. For example, Table 3.4.1 reveals the following:

• Investment X has a one-in-twenty chance of a negative IRR, and a one-in-fifty chance of an IRR in excess of 30%.

• Investment Y has a one-in-ten chance of a negative IRR, and a one-in-hundred chance of an IRR in excess of 30%.

Table 3.4.1 Results of a Monte Carlo simulation: Various possible internal rates of return for two proposed investments (Hertz, 1964:96)

Activity 3.4.1

Assume you are the financial manager of the company considering the two investments for which a Monte Carlo Simulation was performed in Table 3.4.1. Further assume that the company has a weighted average cost of capital equal to 9%, with enough funds only for a single investment. Would you recommend Investment X or Y, given the following information? 1. The company is neither risk averse nor an extreme risk taker and aims to maximise expected

returns from investments. 2. The company is risk-averse and wants to avoid a loss-making investment where possible. 3. The company favours an investment with a greater possibility of becoming a “shooting star” (by

offering great returns).

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Feedback to Activity 3.4.1 1. Investment Y. This investment has the higher expected internal rate of return (10, 3% per annum

vs 9,2%). 2. Investment X. The expected internal rates of return of the two investments do not differ

considerably (9,2% vs. 10,3%) and Investment X has half the chance of incurring a loss (1/20 vs 1/10 chance).

3. Investment X. The expected internal rates of return of the two investments do not differ

considerably (9,2% vs. 10,3%) and Investment X has double the chance of earning an exceptional return of 30% per annum (1/50 vs 1/100 chance).

3. Self-assessment questions After working through all the relevant sections in the textbook, guidance and activities provided by this learning unit, you should now be able to attempt the following self-assessment questions. QUESTION 1 45 MARKS (68 MINUTES) Attempt question 6-6 in chapter 6 of Managerial Finance, 8th edition, without referring to the suggested solution. Compare your answer to the suggested solution and establish reasons for differences. Solution to question 1 Compare your answer to the suggested solution in the textbook and establish reasons for differences. BIBLIOGRAPHY AND ADDITIONAL READING

Hertz, DB. 1964. ‘Risk analysis in capital investment’, Harvard Business Review, 42(1): 95–106.


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LEARNING UNIT 4 – SOURCES AND FORMS OF FINANCE AND FOREIGN

FINANCE

LEARNING OUTCOMES

After studying this learning unit, you should be able to do the following:

• Further apply your knowledge and skills achieved through your prior learning (see below) to a scenario, on an integrated basis.

• Detail the most prominent forms of foreign finance available to business entities in South Africa and, for each, further detail the typical business users, sources of finance or investors, and associated requirements.

• Determine the most appropriate form of finance for a South African business entity, given a specific narrative, by performing appropriate calculations for various financing options (including foreign finance) and consideration of other relevant factors.



Learning outcome

Managerial Finance,

8th edition

Sources and forms of finance

• Identify potential sources of funds on an intermediate level.

• Critically assess the suitability of different forms of finance to different types of business entities, different types of assets financed and different intended purposes.

• Describe the role, characteristics, advantages and disadvantages of different sources of financing to an entity after considering its strategies and objectives.

• Perform and evaluate a financing decision (incorporating the effect of tax, including section 24j of the Income Tax Act).

• Explain the terms “project finance”, “securitisation”, “asset securitisation” and “syndication”.

• Apply common business vocabulary and terms in your discussions.

• Identifies the strengths and weaknesses of the financial proposal or financing plans

• Review the alignment of a proposal or plan with strategic objectives.

• Chapter 7, including Appendix 1

• MAC4861 TL102

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INTRODUCTION Finance (funding) represents the lifeblood that enables a business to grow, expand, thrive, and sometimes, merely survive. Raising finance is therefore a very important aspect for any business enterprise. The aim of the financing decision is to decide on the best financing option for a proposed investment – best not only in terms of cost (determined by calculating the net present cost or IRR), but also fit (determined by considering various entity-specific factors). THIS LEARNING UNIT CONSISTS OF THE FOLLOWING SUB LEARNING UNITS: LEARNING UNIT TITLE

LEARNING UNIT 4.1 SOURCES AND FORMS OF FINANCE AND THE FINNACING

DECISON

LEARNING UNIT 4.2 SOURCES AND FORMS OF FOREIGN FINANCE

LEARNING UNIT 4.3 QUANTITATIVE ANALYSIS OF FOREIGN FINANCE, BASED ON

DISCOUNTED CASH FLOW

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LEARNING UNIT 4.1 SOURCES AND FORMS OF FINANCE AND THE

FINANCING DECISON

1. Introduction The subject of this learning unit has already been introduced as part of the introduction above. This learning unit is based on the following chapter in your prescribed textbook (Managerial Finance, 8th edition):

• Chapter 7: The financing decision

2. Content The purpose of the content below is to supplement the information in the textbook in areas where it is considered necessary. It in no way replaces or can be considered to be a substitute for the textbook. It therefore remains imperative that you work through the textbook in detail. 2.1. Alignment with strategic objectives

Successful development of strategy requires a clear understanding by the strategic planning team of perceived future capital limitations. If the strategy being formulated exceeds those limitations, the need for additional sources of capital becomes itself a strategic issue and the process of considering strategic alternatives begins.

2.2. Interaction between the finance and investment decisions The financing decision normally takes place after a capital investment appraisal, where the investment appraisal indicated that a particular investment should be made (usually accompanied by a positive net present value). The only exception is where there is a particular cheap form of finance available and this form of finance is directly linked to the particular investment (e.g. a favourable leasing option of a particular asset). In this case the finance decision can influence the outcome of an investment decision, because here the cheap finance and asset are intricately linked. In such a case the favourable asset-specific finance can provide an additional advantage, which may turn a capital-investment decision’s negative net present value, into a positive. 3. Self-assessment questions After working through all the relevant sections in the textbook, guidance and activities provided by this learning unit, you should now be able to attempt the following self-assessment questions. QUESTION 1 12 MARKS (18 MINUTES plus reading time) Perform the required part (f) of Question 3 (Insimbi Limited) which can be found in the Question Bank. The relevant required part is repeated below. (At this point it is not necessary to attempt the other parts of the question; you should, however, take notice of the way in which all the various parts integrate and relate to the scenario.)

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REQUIRED Marks

(f) Determine if Insimbi Limited’s proposed bond issue would represent a cost effective form of debt finance to the company (for 8 marks), and critically evaluate the appropriateness of the bond issue on matters besides cost, by considering the company’s circumstances and operating environment (for 4 marks). You are required to show the full impact of income tax in your calculations.

(12)




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LEARNING UNIT 4.2 - SOURCES AND FORMS OF FOREIGN FINANCE 1. Introduction Raising finance is a very important aspect for any business enterprise. In deciding on a form of finance, an enterprise should consider several factors, including the following:

• suitability to the type of business and/or asset financed

• true cost

• impact on cash flow

• constraints associated with the form of finance, including the effect of debt covenants

• impact on the overall risk profile

• how it pairs with existing finance

• availability

The present financial crisis has not only restricted the access to finance for many business entities, but placed renewed focus on the risk of using excessive debt finance. For the new, smaller business it is often a case of using whatever form of finance is available, at whatever cost. In contrast, a larger business – with a track record – can often apply more of the knowledge and skills highlighted in this learning unit, to secure the right form of finance, at the right time, and at the right cost. Under certain circumstances, foreign finance will provide the right match to such a business enterprise. In this learning unit we explore the specialist field of foreign finance, as it applies to the South African business entity.

Now study the following subsections in Managerial Finance (8th edition) and attempt the activities included therein (if any):

Chapter Subsection

7 7.16 Foreign Finance

2. Content

The purpose of the content below is to supplement the information in the textbook in areas where it is considered necessary. It in no way replaces or can be considered to be a substitute for the textbook. It therefore remains imperative that you work through the textbook in detail. Foreign finance is increasingly important to the larger business entity, especially firms earning foreign income and those with operations in other countries. However, when contemplating the use of foreign finance, it is important that a business consider not only the related benefits (e.g. natural hedging opportunities and diversification of the sources of finance), but also the additional risks (e.g. foreign exchange exposure). 2.1. Sources and forms of foreign finance Notwithstanding the effects of the financial crisis, several forms of finance are nonetheless available to the South Africa business, from several sources – local and foreign. It is important to place sources and forms of foreign finance within the greater context of the financing field. The more common forms of foreign finance include debt financing in the form of:

• foreign currency loans

• medium-term notes, issued in a foreign currency

• foreign bonds

• eurobonds

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Sources of foreign debt finance include:

• South African development finance institutions (DFIs), such as the Industrial Development Corporation (IDC)

• foreign DFIs

• foreign banks

• foreign institutional and retail investors

Certain foreign investors may also invest directly in the equity of South African businesses, which is referred to as “foreign direct investment”.

2.2. Detailed description of specific forms of foreign finance

a) Foreign bonds A foreign bond is a bond issued by an entity to investors in a foreign country, in the currency of that foreign country. For example, foreign bonds, may be issued by a South African business to investors in the UK bond market, in pound sterling (Emery, Finnerty & Stowe, 2007). Foreign bonds may also be listed on foreign securities exchanges in order to promote their liquidity on the secondary market.

b) Eurobonds

Eurobonds represent bonds issued by an entity to European investors, denominated in a currency other than that of the entity’s home country or country of issue (Levinson, 2006). For example, a South African business may issue euro-denominated Eurobonds to investors in the UK. Eurobonds are frequently denominated either in euro, US dollar or Swiss francs. (The name Eurobond is derived from the European investors to which it is issued, not the euro currency). Eurobonds are frequently listed on the London Stock Exchange and is subject to less regulation as it is issued only to institutional investors, not retail investors (London Stock Exchange, no date).

2.3. Uses of foreign finance Foreign finance is used predominately by large companies, for the following reasons:

• To obtain access to finance, where local sources of finance is limited.

• To diversify the sources of finance.

• To refinance existing debt.

• Foreign finance may be more affordable than local finance.

• To act as a natural hedge, where the company earns foreign income. 2.4. Additional considerations when using foreign finance A South African business using foreign finance has to take cognisance of additional considerations, including:

• Foreign exchange risks and associated cost of hedging this risk.

• South African Reserve Bank requirements.

• Credit rating agency reviews and ratings (This is normally only required where credit risk is not intrinsically assessed by the debt provider, such as a foreign bank. An example where it may be necessary is before a foreign bond issue; this function is then typically performed by one of the three main rating agencies, which are Standard & Poor’s, Fitch and Moody’s.)

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LEARNING UNIT 4.3 - QUANTITATIVE ANALYSIS OF FOREIGN FINANCE, BASED ON DISCOUNTED CASH FLOW 1. Introduction The aim of the financing decision is to decide on the best financing option for a particular investment, as planned by a particular business. In choosing the best financing option several factors have to be considered, including: 1. Financing options: what are the available options, including foreign finance options?

2. Capital structure: does the business have capacity for more debt; how close is the business to its optimal (target) capital structure; and is there an opportunity to move closer to the target level?

3. Cost considerations: which viable financing option is the most cost effective?

4. Impact: what is the impact of each viable choice of finance on the business (e.g. the impact on control, and the impact of conditions and debt covenants)?

5. Matching: is there a proper match between expected investment cash inflows and finance cash outflows?

6. Other benefits: does the financing option allow for other benefits, such as the opportunity to form a natural hedge to foreign exchange risk? (For example, a company earning income from foreign operations in US dollar, for instance, may opt to also take out a foreign loan denominated in US dollar.)

2. Content The purpose of the content below is to supplement the information in the textbook in areas where it is considered necessary. It in no way replaces or can be considered to be a substitute for the textbook. It therefore remains imperative that you work through the textbook in detail. 2.1. Determining the most cost-effective form of finance When comparing the cost of several viable financing options, it is important to compare like to like. Therefore, a financial manager should attempt to compare the cost of different financing options where these have similar conditions, security requirements and covenants. If the options are not directly comparable in this way, these factors should be adjusted for in the calculation (which may involve a great deal of subjective adjustment, which in turn, will reduce the reliability of the results). In deciding on the most cost-effective form of finance, you should calculate and compare the following for each viable finance option

• the net present cost/ internal rate of return of the associated finance-related cash flows (including the implications of taxation), using an appropriate risk-adjusted discount rate;

This process is fairly simple when comparing, for example, different loan options denominated in rand. However, foreign debt finance introduces further complications as foreign finance exposes a business to the effect of foreign currency movements, which normally have an additional cash flow implication. We therefore have to incorporate the effect of expected foreign currency movements into the discounted cash flow analysis.

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a) Determining the net present cost / internal rate of return of foreign debt finance When a South African business wishes to incur foreign debt finance, an evaluation of this financing option will require certain adjustments to be made, including adjustment for the effects of changes in exchange rates and foreign exchange risk. Author, Luis E Pereiro (2002), detailed adjustment methods that can be used when evaluating foreign debt finance in a book on valuation in emerging markets. Although this publication is written from a US perspective, the methods are equally relevant in a SA perspective. More specialised methods are available, but the description in this section is based on the simplified method described by Pereiro and we therefore acknowledge the contribution made by this author. A financial manager of a South African business, determining the net present cost (NPC) or internal rate of return (IRR) of foreign debt should preferably make use of the following method. Suggested method (This method is adjusted for a SA perspective and slightly adapted. According to this method the effects of changes in exchange rates and foreign exchange risk are incorporated in the exchange rates used to convert the foreign currency to the home currency.) You should apply the following steps: 1. Project the financing-related cash flows in the foreign currency. 2. Project the applicable taxation effect of the financing cash flows, but express as a foreign currency. 3. Total the financing-related cash flows. 4. Convert the total cash flows into rand using a forecast spot exchange rate at each time interval,

based on (in order of preference):

a. Forward exchange rates published by banks (normally only available for a 12-month horizon and only for major currencies).

b. Relative interest rates, using the International Fisher Effect, based on this formula:

(ZAR/FC)t = (ZAR/FC)0 x (1+rt)t (1+rFt)t

Where:

(ZAR/FC)t = the exchange rate of South African rand compared to the foreign currency at time t

(ZAR/FC)0 = the current spot exchange rate rt

= the spot South African interest rate at term t (often determined based on the yield to maturity of an appropriate South African government bond)

rFt = the spot foreign country interest rate at term t (often determined based on the yield to maturity of an appropriate foreign government bond)

(Variables in italics are usually provided in an examination.)

5. Determine the NPC by discounting the forecast total rand-converted cash flows using an appropriate discount rate (usually the risk-adjusted after-tax cost of new debt); or determine the IRR based on the initial rand-equivalent loan advance and forecasted total rand-converted cash flows.

(We demonstrate the use of this method in the activity below.)

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b) Quantitative analysis of foreign finance: other important procedures In cases where a business elects not to hedge the foreign exchange risk or is unable to do so, it is important to perform additional procedures to explore the effects of risk and uncertainty. These procedures may include:

• sensitivity analyses, based on changes in the forecast spot exchange rates

• allocating probabilities to different outcomes such as “optimistic”, “expected” and “pessimistic” to weigh the effect of uncertainty on forecast cash flows (refer to learning unit 3.4 for more detail on this technique)

• a Monte Carlo simulation (refer to learning unit 3.4 for more detail on this technique) Activity 4.3.1 Construction and mining group The management of a construction company, listed on the JSE recently approved the investment in a R770 million mining fleet by a subsidiary company (Newco). This investment will allow the group to enter the contract mining market. The management has been in discussions with various parties regarding the financing of this fleet. The company has received two proposals but has not yet made a final decision on which option to pursue. Details of the proposals are as follows: 1. A loan by the group’s usual commercial bankers

The bank is prepared to advance a five-year loan of R770 million to Newco, secured by means of a notarial bond over the fleet. The loan will bear interest at an effective annual rate of 8,65%. (This is deemed to be Newco’s pre-tax cost of new debt.) 2. €70 million Eurobond

The second alternative is that Newco issue a €70 million Eurobond. The Eurobond will be secured by means of a notarial bond over the fleet. The bond will have a fixed coupon of 5,65% per annum payable annually in arrears. The Eurobond will be listed on various European bond exchanges. The bond will be redeemable five years after issue at the par value of €70 million. Other market information:

• The current R : € exchange rate is 11,00 : 1,00.

• The 12 month forward R : € exchange rate published by a bank is 11,70 : 1,00.

• Recent data on government bonds are as follows:

Maturity date (years from now)

Latest yields

South Africa Eurozone

2 years 6,3% 0,4% 3 years 6,5% 0,5% 4 years 6,8% 0,8% 5 years 7,0% 1,1%

You can assume that:

• Newco’s tax rate is 28% per annum.

• No other hedging instruments are available to Newco.

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REQUIRED Marks

(a) Determine the most cost-effective form of finance to be used by Newco to finance the fleet investment.

(10)

(The example is based on the 2011 Qualifying Examination, Part 2, question 2: updated, adapted and requirement changed [SAICA, 2011].) Feedback to Activity 4.3.1

Determination of net present cost (NPC) and internal rate of return (IRR) Marks A loan by the group’s usual commercial bankers

As the loan’s effective annual rate of 8,65% per annum is equal to Newco’s pre-tax cost of new debt (kd before tax), this rate will dictate the loan’s NPC and IRR. (NB: This is a specific condition with a specific outcome). kd of Newco = 8,65% x 0,72 = 6,228%. (1) Therefore: IRR/YR of this loan = 6,228%; and NPC of this loan = (R770 000 000) (equal to the loan amount advanced, but negative) Due to the lack of transaction fee and other complicating factors, a simplified calculation has been shown in the suggested solution for the SA taxation effect. Students should specifically refer to Tutorial Letter 102 of MAC4861 (available under Additional Resources on myUnisa) to ensure they are up to date with the impact of Section 24J of the Income Tax Act on the financing decision. In this regard, you should let the wording in the required-section and the number of allocated marks guide you towards using a “short” or “long” approach. The superior approach, when there is a transaction fee involved, is the long approach as described in chapter 7 of the prescribed textbook.

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Eurobond Year 0 1 2 3 4 5 Marks

Interest (EUR) 5.65% (3 955 000) (3 955 000) (3 955 000) (3 955 000) (3 955 000) (1)

SA taxation effect (28% on interest) (stated in EUR) 1 107 400 1 107 400 1 107 400 1 107 400 1 107 400 (1)

Redeem bond (EUR) (70 000 000) (1)

Finance-related cash flows (after tax) (EUR) 0 (2 847 600) (2 847 600) (2 847 600) (2 847 600) (72 847 600)

Forecast spot exchange rate (see below) 11,70 12,33 13,09 13,86 14,61

Finance-related cash flows (after tax) (ZAR) 0 (33 316 920) (35 110 908) (37 275 084) (39 467 736) (1 064 303 436) (1)

IRR/YR 10.16%C5 Calculator steps shown (1)

NPC, discounted at: 6.228% 1,0000 0,94137 0,88618 0,83422 0,78532 0,73927 (1)

Discount factors / calculator steps shown

NPC (911 379 616) 0 (31 363 595) (31 114 588) (31 095 792) (30 994 611) (786 811 030)

Note: your answers may differ due to rounding differences.

Determination of forecast spot exchange rate (ZAR/EUR):

Current spot rate (ZAR/EUR)0 = 11,00

Forward exchange rate (ZAR/EUR)1 11,70 not available not available not available not available (1)

Based on relative interest rates (ZAR/EUR)t 12,33C1 13,09C2 13,86C3 14,61C4

Increase in exchange rate 6,4% 5,4% 6,2% 5,9% 5,4%

Example calculation (11,70-11,00)

11,00 (12,33-11,70)

11,70

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Conclusion Marks The loan by the group’s usual commercial bankers will represent the most cost effective form of finance, as it has the lower NPC (compare its NPC of – R770 000 000 to – R911 379 616 of the Eurobond) and the lower IRR (compare 6,228% to 10,16%).

(1)

Calculations Calculation 1 – 4 based on:

(ZAR/EUR)t = (ZAR/EUR)0 x (1+rt)t (1+rFt)t

C1 (ZAR/EUR)2 = 11,00 x (1+6,3%)2)/(1+0,4%)2 = 12,33 (1) C2 (ZAR/EUR)3 = 11,00 x (1+6,5%)3)/(1+0,5%)3 = 13,09 (1) C3 (ZAR/EUR)4 = 11,00 x (1+6,8%)4)/(1+0,8%)4 = 13,86 (1) C4 (ZAR/EUR)5 = 11,00 x (1+7,0%)5)/(1+1,1%)5 = 14,61 (1) Calculation 5: Calculator steps (e.g. HP10bII) - 1 P/YR

CF0 CF1 CF2 CF3 CF4 CF5 770 000 000 (33 316 920) (35 110 908) (37 275 084) (39 467 736) (1 064 303 436)

IRR/YR = 10,16% Available marks 13 Maximum marks 10

Focus notes

• The effect of changes in foreign exchange (or associated hedging costs) often has a significant impact on the NPC/IRR of a financing option.

• When determining the forecast spot exchange rates, we make use firstly of published forward exchange rates and, where this is not available, we use the effect of relative interest rates applying the International Fisher Effect, as shown.

• A simple reasonability check to the forecast spot exchange rates is to compare the difference between the interest rates in the two currency zones for a specific year to the increase in the forecast exchange rate for that year; these two percentages should be comparable, but not necessarily equal to one another. (For example, the difference in the yield percentages for year 5 is 5,9% [7,0% - 1,1%], the increase in the forecast exchange rate for year 5 is 5,4%.)

3. Self-assessment questions After working through all the relevant sections in the textbook, guidance and activities provided by this learning unit, you should now be able to attempt the following self-assessment questions.

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QUESTION 1 31 MARKS (47 MINUTES plus reading time) Perform the required parts (b) (c) (d) and (e) of Question 21 (Cloth Group) which can be found in the Question Bank. The relevant required part is repeated below. (At this point it is not necessary to attempt the other parts of the question; you should, however, take notice of the way in which all the various parts integrate and relate to the scenario.)

REQUIRED Marks

(b) 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. Ignore all tax implications.

(15)

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

(6)

(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)

Solution to Question 1 Refer to the suggested solution to this part in the Question Bank. BIBLIOGRAPHY AND ADDITIONAL READING

Emery, DR, Finnerty, JD and Stowe, JD. 2007. Corporate Financial Management. 3rd edition. New Jersey: Pearson Education. Levinson, M. 2006. Guide to Financial Markets.4th Edition. London: The Economist. London Stock Exchange (LSE). No date. A practical guide to listing debt in London. London: London Stock Exchange. Pereiro, LE. 2002. Valuation of companies in emerging markets. New York: John Wiley & Sons. Skae, FO. 2017. Managerial Finance. 8th edition. LexisNexis: Johannesburg. Skae, FO and De Graaf, A. Foreign Finance. Prepared for a future publication in Managerial Finance. Unpublished.

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PART 1 LEARNING UNIT 5 – DIVIDEND DECISION

LEARNING OUTCOMES After studying this learning unit, you should be able to further apply your knowledge and skills achieved through your prior learning (see below) to a scenario, on an integrated basis, as well as incorporate tax considerations.



Learning outcome

Managerial Finance, 8th edition

• Identify factors affecting the dividend decision.

• Understand, at an intermediate level, the relevance and irrelevance theories and its impact on dividend decisions.

• Identify and discuss the different methods and forms (including alternative forms) that an entity may choose in paying dividends, on an intermediate level.

• Discuss the various factors to be considered before declaring a dividend / setting a dividend policy, on an intermediate level.

• Evaluate the dividend decision, on an intermediate level.

• Recommend, on an intermediate level, the most appropriate method to distribute profits

• Chapter 14

• MAC4861 TL102

INTRODUCTION Surprisingly, successful companies display widely divergent dividend policies. Here, some companies choose to pay strong, consistent dividends whilst others choose to not pay any dividends at all. This may lead one to predict that dividend policy is irrelevant. Yet, statutory requirements, shareholder preferences and the effect of taxation make this a more complex matter. Besides, regardless of the policy, you can never please everyone: somewhere, somehow there is likely to be a disgruntled person in the form of a shareholder, an employee, a director, or… (fill in the blank). This learning unit refers to inter alia some of the different methods and forms of dividends, and factors to be considered before setting a dividend policy. THIS LEARNING UNIT CONSISTS OF THE FOLLOWING SUB LEARNING UNITS: LEARNING UNIT TITLE LEARNING UNIT 5.1 DIVIDEND DECISION

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LEARNING UNIT 5.1 - DIVIDEND DECISION


• Chapter 14: The dividend decision

2. Content


2.1. Tax implications

In terms of the Income Tax Act, dividends tax is payable on the distribution of profits at a rate of 20% and share-holders will thus effectively receive 80% of the declared dividend. Specific exclusions in terms of the Income Tax Act should be considered. There is no additional content to be studied at this level. All content has already been addressed in your prior learning. If you want to refresh your knowledge, please refer to the earlier section ‘Prior learning assumed’. The activity below, the self-assessment questions provided later in this learning unit, and the integrated self-assessment at the end of this tutorial letter will help you to apply your knowledge.

Activity 5.1.1 Attempt question 14-2 in chapter 14 of Managerial Finance, 8th edition. Solution to Activity 5.1.1 Find the suggested solution after the question in the textbook. 3. Self-assessment questions After working through all the relevant sections in the textbook, guidance and activities provided by this learning unit, you should now be able to attempt the following self-assessment questions.

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QUESTION 1 4 MARKS (6 MINUTES plus reading time) Perform the required part (d) of Question 1 (Medico Group) which can be found in the Question Bank. The relevant required part is repeated below. (At this point it is not necessary to attempt the other parts of the question; you should, however, take notice of the way in which all the various parts integrate and relate to the scenario.)

REQUIRED Marks

(d) Discuss the benefits and limitations of MGSA’s current dividend policy.

(4)




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LEARNING UNIT 6 – MANAGEMENT OF WORKING CAPITAL LEARNING OUTCOMES After studying this learning unit, you should be able to further apply your knowledge and skills achieved through your prior learning (see below) to a scenario, on an integrated basis.

1 PRIOR LEARNING ASSUMED


Learning outcome


• Analyse an entity’s accounts receivable, inventories, accounts payable and total working capital, and suggest improvements.

• Calculate and evaluate the effect of changes in credit terms/policy.

• Analyse the entity’s financing of working capital and suggest improvements.

• Discuss the role of IT systems (incl Enterprise Resource Planning (ERP) and Customer Relationship Management (CRM) systems) in working capital management.

• Assess an entity’s cash management and make recommendations for improvement (You can exclude the Baumol and Miller-Orr models.)

• Chapter 9

• MAC4861 TL102

INTRODUCTION Working capital management involves the management of current assets and current liabilities with the aim of maintaining these at efficient levels. But what do we mean by efficient levels? To paraphrase a fairy tale, these levels are not too low, not too high, but just right. Why is this important? Maintaining levels of working capital that are too high are expensive (it may generate insufficient returns) and it may negatively affect the entity’s cash flow; levels that are too low may result in lost opportunities. This learning unit is concerned with the range of skills required to manage working capital, including ways in which it could be financed. THIS LEARNING UNIT CONSISTS OF THE FOLLOWING SUB LEARNING UNITS: LEARNING UNIT TITLE LEARNING UNIT 6.1 MANAGEMENT OF WORKING CAPITAL

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LEARNING UNIT 6.1 - MANAGEMENT OF WORKING CAPITAL

1. Introduction The subject of this learning unit has already been introduced as part of the introduction above. This learning unit is based on selected sections of the following chapters in your prescribed textbook (Managerial Finance, 8th edition): Chapter 9: Working capital management.

2. Content

There is no additional content to be studied at this level. All content has already been addressed in your prior learning. If you want to refresh your knowledge, please refer to the earlier section ‘Prior learning assumed’. The activity below, the self-assessment questions provided later in this learning unit, and the integrated self-assessment at the end of this tutorial letter will help you to apply your knowledge.

Activity 6.1.1 Attempt question 9-3 in chapter 9 of Managerial Finance, 7th edition, without referring to the suggested solution. Feedback to Activity 6.1.1 Find the suggested solution after the question in the textbook. 3. Self-Assessment questions After working through all the relevant sections in the textbook, guidance and activities provided by this learning unit, you should now be able to attempt the following self-assessment questions. QUESTION 1 16 MARKS (24 MINUTES plus reading time) Perform the required parts (c) and (e) of Question 14 (Ithemba Engineering) which can be found in the Question Bank. The relevant required part is repeated below. (At this point it is not necessary to attempt the other parts of the question; you should, however, take notice of the way in which all the various parts integrate and relate to the scenario.)

REQUIRED Marks

(c) Estimate and conclude on the impact that the introduction of the proposed settlement discount for customers could have on the profits and cash flows of Ithemba.

(12)

(e) Discuss how Ithemba should account for the 10% settlement discount that the Board of Directors is considering.

(4)


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QUESTION 2 12 MARKS (18 MINUTES plus reading time) Perform the required part (k) of Question 1 (Medico Group) which can be found in the Question Bank. The relevant required part is repeated below. (At this point it is not necessary to attempt the other parts of the question; you should, however, take notice of the way in which all the various parts integrate and relate to the scenario.)

REQUIRED Marks

(k) Critically assess MGSA’s credit policies and procedures in respect of trade receivables, supporting where appropriate your comments with calculations.

(12)

Solution to question 1 Refer to the suggested solution to this part in the Question Bank. BIBLIOGRAPHY AND ADDITIONAL READING Skae, FO. 2017. Managerial Finance. 8th edition. LexisNexis: Johannesburg.

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LEARNING UNIT 7 – TREASURY FUNCTION




Learning outcome


• Discuss the role of the treasury function.

• Integrate your knowledge of the workings of foreign exchange and interest rates.

• Identify risks related to foreign exchange and interest rates.

• Identify and discuss hedging techniques and risk management.

• Analyse various derivative instruments that are available to mitigate risks

• Develop and evaluates risk management policies related to financial risk, at a basic level

• Monitor risk exposure, taking into account changes within the entity and within the economy, and recommend changes to risk management policies.

• Identify the need for and evaluate the usefulness of derivatives (including forward and future contracts, swaps, put and call options).

• Set up different hedges and calculate the cost thereof (at an intermediate level).

• Suggest appropriate derivative instruments to manage the risk

• Make use of the Black Scholes model to value options.

• Distinguish between the use of derivatives for purposes of hedging and speculation.

• Chapter 15

• Chapter 16

• MAC4861 TL102

INTRODUCTION The corporate treasury function fulfils multiple, important roles within most organisations. (The function may be interwoven with the other duties of the financial manager for smaller entities.) The treasury function is concerned with managing the entity’s payments, receipts and cash to make sure that the entity has sufficient liquidity to meet its obligations, whilst simultaneously, managing currency, interest rate and other financial risk. To fulfil these roles effectively requires a proper understanding of several areas, including the functioning of foreign exchange markets and currency risk, as well as interest rates and interest rate risk. THIS LEARNING UNIT CONSISTS OF THE FOLLOWING SUB LEARNING UNITS: LEARNING UNIT TITLE LEARNING UNIT 7.1 THE TREASURY FUNCTION

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LEARNING UNIT 7.1 - THE TREASURY FUNCTION

1. Introduction The subject of this learning unit has already been introduced as part of the introduction above. This learning unit is based on the following chapters in your prescribed textbook (Managerial Finance, 8th edition):

• Chapter 15: The functioning of the foreign exchange markets and currency risk

• Chapter 16*: Interest rates and interest rate risk

*Please note that you are not required to know detailed calculations relating to interest rate swaps, caps, floors and collars. 2. Content

There is no additional content to be studied at this level. All content has already been addressed in your prior learning. If you want to refresh your knowledge, please refer to the earlier section ‘Prior learning assumed’. The activity below, the self-assessment questions provided later in this learning unit, and the integrated self-assessment at the end of this tutorial letter will help you to apply your knowledge.

Activity 7.1.1 Attempt question 15-5 in chapter 15 of Managerial Finance, 8th edition, without referring to the suggested solution. Feedback to Activity 7.1.1 Find the suggested solution after the question in the textbook. Activity 7.1.2 Attempt question 15-6 in chapter 15 of Managerial Finance, 8th edition, without referring to the suggested solution. Feedback to Activity 7.1.2 Find the suggested solution after the question in the textbook. Activity 7.1.3 Attempt question 16-2 in chapter 16 of Managerial Finance, 8th edition, without referring to the suggested solution. Solution to Activity 7.1.3 Find the suggested solution after the question in the textbook. 3. Self-Assessment questions After working through all the relevant sections in the textbook, guidance and activities provided by this learning unit, you should now be able to attempt the following self-assessment questions.

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QUESTION 1 8 MARKS (12 MINUTES plus reading time) Perform the required part (i) of Question 1 (Medico Group) which can be found in the Question Bank. The relevant required part is repeated below. (At this point it is not necessary to attempt the other parts of the question; you should, however, take notice of the way in which all the various parts integrate and relate to the scenario.)

REQUIRED Marks

(i) Explain, with supporting calculations, how the currency option could be used to hedge against exchange rate movements with regard to the machine purchased for the production of ZDT. In your answer you should make use of the quoted rates and premiums. Assume a spot rate in the currency market of ZAR10,9/€1 on the strike date.

(8)

Solution to question 1 Refer to the suggested solution to this part in the Question Bank. QUESTION 2 7 MARKS (11MINUTES plus reading time) Perform the required part (b) of Question 14 (Ithemba Engineering) which can be found in the Question Bank. The relevant required part is repeated below. (At this point it is not necessary to attempt the other parts of the question; you should, however, take notice of the way in which all the various parts integrate and relate to the scenario.)

REQUIRED Marks

(b) Explain how forward and option contracts could be used to hedge Ithemba’s current and future exposure to movements in foreign currencies.

(7)


Skae, FO. 2017. Managerial Finance.8th edition. LexisNexis: Johannesburg.

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2 PART 2 – FUNCTION OF FINANCIAL MANAGEMENT

PURPOSE

The purpose of Part 2 is to reinforce and enhance your existing competencies related to the function of financial management, and to assist you in applying your knowledge to a scenario on an integrated basis. The specific competencies referred to above relate to the analysis of the entity’s financial situation, advisory services to a financially troubled business, and estimating the value of a business. This part also develops and applies specific competencies referred to in Part 1. In addition, the purpose of the numerous activities and self-assessment activities included in this part is also to enhance your pervasive qualities and skills – the professional qualities and skills that Chartered Accountants are expected to bring to all tasks. These professional qualities include ethical behaviour and professionalism, personal attributes, and professional skills.

The diagram below contains a schematic presentation of the content of this part, as well as earlier and later parts.


Learning units

1. Strategy and governance 2. Risk management 3. Cost of capital and capital

investment appraisal 4. Sources and forms of

finance 5. Dividend decision 6. Management of working


Learning units



10. Valuations

Learning units



Tutorial letter 102

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LEARNING UNIT 8 – ANALYSIS AND INTERPRETATION OF FINANCIAL

AND NON-FINANCIAL INFORMATION



Learning outcome


• Clearly distinguish between the different objectives and areas of analysis (including the ratios/calculations suitable to the different areas).

• Perform financial analysis, interpret results and draw conclusions as to an entity’s present and future financial situation (at an advanced level).

• Analyse and interpret non-financial information.

• Identify and incorporate the influence of the entity’s competitive, economic, social, political and internal environment upon your results.

• Integrate your knowledge of sustainability, and environmental, social and governance factors as part of your analysis.

• Chapter 8

• MAC4861 TL102

INTRODUCTION Analysis and interpretation of information are important functions of financial management. These tasks are essential as they form the basis for a better understanding – an understanding that could then be used for several purposes. Perhaps unsurprisingly, the traditional focus of these endeavours was on financial information; however, these days, non-financial information is starting to assume more weight – specifically, where this relates to matters of sustainability, and environmental, social and governance factors. THIS LEARNING UNIT CONSISTS OF THE FOLLOWING SUB LEARNING UNITS: LEARNING UNITS TITLE LEARNING UNIT 8.1 ANALYSIS AND INTERPRETATION OF FINANCIAL AND NON-

FINANCIAL INFORMATION

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LEARNING UNIT 8.1 - ANALYSIS AND INTERPRETATION OF FINANCIAL AND


1. Introduction In this learning unit we further explore an important function of financial management, which involves the analysis and interpretation of financial and non-financial information. Financial information is analysed, in part, to asses both business and financial risk. This includes the calculation and comparison of ratios within the entity over time, within the industry/similar entities as well as the discussion of, and conclusion on, the calculated ratios. The wider scope of this topic also requires analysis and interpretation of non-financial information, including information on sustainability, and environmental, social and governance matters. Additional material on the integrated report and KING IV in Learning Unit 1.1, and in your prior learning. This learning unit is based on the following chapters in your prescribed textbook (Managerial Finance, 8th edition):

• Chapter 8: Analysis of financial and non-financial information 2. Content At an applied management accounting level, students should not expect too many marks solely for being able to calculate a ratio. More important is to understand and interpret the ratio, trend and cash flows which are supported by possible and credible reasons for unexpected variances. A discussion of an entity’s financial position must be logical and structured and should add value and should not only indicate an increase or decrease in the ratio. 3. Self-Assessment question After working through all the relevant sections in the textbook, guidance and activities provided by this learning unit, you should now be able to attempt the following self-assessment questions.

QUESTION 1 16 MARKS (24 MINUTES plus reading time) Attempt question 8-2 in chapter 8 of Managerial Finance,8th edition, without referring to the suggested solution. Solution to question 1 Find the solution after the practice question in the textbook.

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QUESTION 2 34 MARKS (51 MINUTES plus reading time) Perform the required part (b) of Question 3 (Isimbi) which can be found in the Question Bank. The relevant required part is repeated below. (At this point it is not necessary to attempt the other parts of the question; you should, however, take notice of the way in which all the various parts integrate and relate to the scenario.)

REQUIRED Marks

(b) Analyse (for 18 marks) and interpret (for 16 marks) the performance of Insimbi Limited for the year 2012, including a comparison with the market/competitors, in the following three categories: Operational, social and environmental. (You are not required to address the effect of fluctuations in the exchange rate for this part.)

(34)



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LEARNING UNIT 9 – BUSINESSES IN DIFFICULTY


PRIOR LEARNING ASSUMED In your undergraduate and Advanced Management Accounting studies you have already mastered the learning outcomes indicated below. If you want to refresh your knowledge, please refer to your undergraduate material, prescribed textbook and MAC4861 Tutorial Letter 102/2020 (available under ‘additional resources’ on myUnisa). For your convenience we also provide textbook references. 3

Learning outcome

Managerial Finance,

8th edition

• Identify tools that can be utilised to measure performance of an organisation

• Identify and advise financially-troubled businesses (at a basic knowledge level).

• Identify the tax implications of the possible courses of action.

• Suggest appropriate means of refinancing a business.

• Prepare a preliminary analysis of the sources of financial difficulty, the severity of the situation and the potential for the success or failure of the recovery plans.

• Understand the business rescue principles as set out in the Companies Act.

• Integrate your knowledge of business performance measurement tools and ways of business restructuring (at a basic level), in attempting an integrated question.

• Chapter 13

• MAC4861 TL102

INTRODUCTION Business entities may find themselves in financial distress for a multitude of reasons. One of the functions of financial management is to assist these businesses, in the form of sound advice and with assistance in using the appropriate tools at their disposal. Here, businesses could restructure/reorganise themselves within the guidelines of the Companies Act; they could enter into voluntary liquidation; or restructure by means of divestiture, or an absorption or amalgamation with another entity. Restructuring in the form of disinvestment may help with dealing with financial distress, but may also form part of a strategy of ‘best-practice parenting’. According to this strategy, holding companies should display a superior means of ‘parenting’ the subsidiary and, if not possible, it should then consider divesting. Here, the level of ‘difficulty’ in which the subsidiary finds itself necessitates a broader reading. THIS LEARNING UNIT CONSISTS OF THE FOLLOWING SUB LEARNING UNITS: LEARNING UNITS TITLE LEARNING UNIT 9.1 BUSINESSES IN DIFFICULTY

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LEARNING UNIT 9.1 BUSINESSES IN DIFFICULTY


• Chapter 13: Financial distress

2. Content

There is no additional content to be studied at this level. All content has already been addressed in your prior learning. If you want to refresh your knowledge, please refer to the earlier section ‘Prior learning assumed’. The activity below and the integrated self-assessment at the end of this tutorial letter will help you to apply your knowledge. 3. Self-assessment question After working through all the relevant sections in the textbook, guidance and activities provided by this learning unit, you should now be able to attempt the following self-assessment questions. QUESTION 1 40 MARKS (60 MINUTES plus reading time) Attempt question 13-4 in chapter 13 of Managerial Finance, 8th edition, without referring to the suggested solution. Solution to Question 1 Find the suggested solution after the question in the textbook. BIBLIOGRAPHY AND ADDITIONAL READING


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LEARNING UNIT 10 – VALUATIONS

LEARNING OUTCOMES After studying this learning unit, you should be able to further apply your knowledge and skills achieved through your prior learning (see below) to a scenario, on an integrated basis. In addition, after studying this learning unit, you should be able to

• use a range of skills to perform, and professionally present, business and equity valuations using a model based on EVA®/MVA


Learning outcome Managerial Finance,

8th edition

• Perform a valuation of convertible securities

• Display an understanding of the complexities and uncertainties underlying the various valuation approaches, methodologies, methods and models suitable to business and equity valuations.

• Use a range of skills to perform, and professionally present, advanced business and equity valuations using the following valuation methodologies/methods/models: (1) price of recent investment, (2) net assets, (3) earnings multiples (several), (4) market price multiples, (5) Gordon Dividend Growth Model, and (6) models based on free cash flow.

• Discuss the various considerations and recommend ways in which an entrepreneur could prepare for the sale of his/her business.

• Identify the critical assumptions and facts that underlie the valuation estimate.

• Chapter 11:

• MAC4861 TL102

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INTRODUCTION Valuations is not only fascinating, but pervasive: it incorporates several principles learnt in preceding learning units and further serves as a springboard of knowledge to later learning units. In order to master the learning outcomes of this learning unit, you will thus require a strong foundation in your prior learning and the preceding learning units included in this tutorial letter, including, but not limited to: the cost of capital, capital investment appraisal and sources and forms of financing. In turn, this learning unit of valuations will serve as an introduction to further, more advanced learning units, such as mergers and acquisitions. As a Chartered Accountant you may one day perform professional valuations, but even if you don’t, your skill set will still demand a good understanding of valuation principles. In this learning unit you will learn a couple of new methods/models of valuation, but mainly, you will be dealing with more complex valuations. In short, you will be enhancing and applying your prior learning. THIS LEARNING UNIT CONSISTS OF THE FOLLOWING SUB LEARNING UNITS: LEARNING UNITS TITLE LEARNING UNIT 10.1 VALUATIONS

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LEARNING UNIT 10.1 - VALUATIONS

1. Introduction A successful Applied Management Accounting student is required to display advanced knowledge and engagement in the topic of Management Accounting. In addition to this demanding requirement, you will also have to show that you are able to apply your knowledge to complex scenarios (as implied by the title of the course). 2. Content The content within this learning unit builds on the concepts introduced in your prior studies and in the preceding learning units of this tutorial letter. Some new concepts and valuation models (i.e. EVA®/MVA.) will also be learnt. This learning unit is based mainly on the following chapter in your prescribed textbook (Managerial Finance, 8th edition):

• Chapter 11 – Business and equity valuations To help you track your overall progress, be advised that combined revision of prior learning and new study required for this learning unit will be based on all subsections of this chapter (i.e. no subsection is to be excluded; Appendix 2 of chapter 11 is for noting only, but the valuation outlines in Appendix 1 of chapter 11 may be very helpful). 3. Self-assessment questions After working through all the relevant sections in the textbook, guidance and activities provided by this learning unit, you should now be able to attempt the following self-assessment questions. QUESTION 1 42 MARKS (63 MINUTES) Perform the required parts of practice question 11-2 in the Managerial Finance (8th edition) textbook. Solution to question 1 Find the solution after the practice question in the textbook. QUESTION 2 24 MARKS (36 MINUTES)

Perform the required parts of practice question 11-3 in the Managerial Finance (8th edition) textbook. Solution to question 2 Find the solution after the practice question in the textbook.

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QUESTION 3 38 MARKS (57 MINUTES plus reading time) Perform the required parts (e) and (g) of Question 7 (The Entertainment Group) which can be found in the Question Bank. The relevant required part is repeated below. (At this point it is not necessary to attempt the other parts of the question; you should, however, take notice of the way in which all the various parts integrate and relate to the scenario.)

REQUIRED Marks

(e) Identify five key valuation issues applicable to the valuation of South African business entities that are to be considered specifically given the current economic crisis.

(5)

(g) Determine the fair value of the enterprise of Movies (Pty) Ltd as at 31 August 2010 based on the information and projections provided by the directors, and other relevant information of this company, using a discounted cash flow approach. Marks will be allocated as follows: (i) Calculation of a weighted average cost of capital.

(ii) Determination of value by calculating free cash flows.

(7) (7)

Solution to question 3 Refer to the suggested solution to this part in the Question Bank



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PART 3 – MERGERS AND ACQUISITIONS AND BUSINESS PLANS

PURPOSE

The purpose of Part 3 is to reinforce and enhance your existing competencies related to the evaluation of mergers and acquisitions, and the development of business plans/proposals. In addition, its purpose is to assist you in applying your knowledge to a scenario on an integrated basis. This part also develops and applies specific competencies referred to in Part 1 and 2. In addition, the purpose of the numerous activities and self-assessment activities included in this part is also to enhance your pervasive qualities and skills – the professional qualities and skills that Chartered Accountants are expected to bring to all tasks. These professional qualities include ethical behaviour and professionalism, personal attributes and professional skills.

The diagram below contains a schematic presentation of the content of this part as well as earlier parts.


Learning units

1. Strategy and governance 2. Risk management 3. Cost of capital and

capital investment appraisal

4. Sources and forms of finance

5. Dividend decision 6. Management of working


Learning units


9. Businesses in difficulty 10. Valuations

Learning units



Tutorial Letter 102

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LEARNING UNIT 11 – MERGERS AND ACQUISITIONS (M&A’s)


PRIOR LEARNING ASSUMED In your undergraduate and Advanced Management Accounting studies you have already mastered the learning outcomes indicated below. If you want to refresh your knowledge, please refer to your undergraduate material, prescribed textbook and MAC4861 Tutorial Letter 102/2020 (available under ‘additional resources’ on myUnisa). It is also essential to have mastered the outcomes of learning unit 10 (Valuations) before attempting this learning unit.

Learning outcome Managerial Finance, 8th edition

• Analyse the risks and financial implications of a merger, acquisition, proposed start-up, strategic alliance or divestiture, including:

• the strategic context

• behavioural implications

• legal implications

• pricing considerations

• impact of synergy

• financing considerations

• management buy-outs

• Black Economic Empowerment (BEE)

• post-acquisition review

• industry regulation

• environmental, social and governance implications

• Based on the analysis, suggest:

• the form of the transaction

• financing options and terms

• due diligence procedures

• systems, information, confidentiality and disclosure requirements

• conflict of interest issues

• key risks and rewards

• Use a range of skills to perform advanced valuations for purposes of mergers & acquisitions (M&As), using various valuation methodologies/methods/models and incorporating the effect of synergies.

• Chapter 12

• MAC4861 TL 102

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INTRODUCTION The business of mergers and acquisitions is an unforgiving business, whereby massive amounts of money are either spent or lost. As a chartered accountant you may well be involved in these transactions, in some capacity or another. This learning unit therefore conveys important concepts that will lay the necessary groundwork in your studies but possibly also in your future area of specialism. THIS LEARNING UNIT CONSISTS OF THE FOLLOWING SUB LEARNING UNITS: LEARNING UNITS TITLE LEARNING UNIT 11.1 VALUATION FOR PURPOSES OF M&As: SYNERGIES LEARNING UNIT 11.2 OTHER CONSIDERATIONS

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LEARNING UNIT 11.1 VALUATION FOR PURPOSES OF M&As: SYNERGIES

1. Introduction Valuation for purposes of M&As builds to a large extent on the concepts already addressed in the learning unit of Valuations (learning unit 10). It incorporates an extraordinary phenomenon with a combined effect greater than the sum of the parts – a synergy effect. This learning unit is based on the following chapters in your prescribed textbook (Managerial Finance, 8th edition):

• Chapter 11

• Chapter 12

2. Content


o Valuation of for purposes of M&A: Synergies Business and equity valuations form a very important part of M&As. In this area you would draw heavily from the range of specialist skills mastered in the topic of valuations (learning unit 17). In performing a valuation for purposes of M&As, you may represent either the acquirer, or the target, or otherwise, act as an independent appraiser. As a result, you may have to determine (1) a minimum price of the target (normally to be considered by the target organisation), (2) a maximum price of the target (payable by the acquirer without them destroying value by overpaying), or (3) a fair value of the target (normally acting as an independent appraiser). Here, the following guidelines apply:

• When determining a minimum value of the target organisation, all synergies are usually disregarded.

• When determining a maximum value, all specific (unique) synergies that may exist between the target and the acquirer are usually quantified and included in the maximum price.

• Finally, if determining a fair value of the target organisation, only synergies that could exist in general (also with other acquirers) are quantified and included in the fair value – unique synergies are disregarded here. The reason for this is because competition between different bidders will create a market for the synergies that are achievable by more than one potential bidder.

Note We could quantify synergies using a number of valuation methodologies, methods or models. However, we normally value synergy using a discounted cash flow method. Activity 11.1.1 Bidder Ltd (“Bidder”) is seeking accelerated growth through the acquisition of compatible, external business organisations.

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In this regard, a committee of Bidder, tasked with identifying suitable candidates for acquisition, has suggested the purchase of Target Ltd (“Target”) – a company in a different, but compatible industry. In case of a takeover of Target by Bidder the following specific synergies and related costs are expected:

• 50 employees of Target would immediately be made redundant at an after-tax retrenchment cost of R1,2 million.

• Annual post-tax wage savings are expected to be R750 000 (at current prices). Future wage increases would have grown at double the inflation rate for next year and at a rate equal to inflation for years thereafter.

• Some land and buildings of Target would be sold for R800 000 (after tax) and do not need to be replaced (the combined entity will have sufficient office space).

• Fixed advertising and distribution cost savings of R150 000 (before tax) would be saved in the next year and for each year thereafter.

• Legal and other acquisition-related cost at present value are expected to amount to R3 million (after tax).

The following additional information is available:

• The weighted average cost of capital of Target has been estimated at 18%.

• The income tax rate is 28%.

• The current rate of inflation is 5% per annum and is expected to remain at approximately this level in the foreseeable future.

• Unless otherwise mentioned, all fixed expenses will grow by inflation only.

• The intrinsic equity value of Target has been estimated at R20 million (this value was determined using an income approach and excludes all possible synergies).

• If a company, other than Bidder, were to acquire Target, it is expected that only 40% of the net synergy benefit will be realised.

Required Marks

(a) Calculate the value of all specific synergies, after associated costs, between Bidder

and Target, based on available information. (10)

(b) Determine a minimum selling price which Target may consider. (1) (c) Determine a maximum bid price which Bidder may offer. (1) (d) Determine the fair value of Target (2) (e) Critically discuss reasons why Bidder should consider offering less than the

maximum bid price (determined in part (c)) for Target and recommend a more suitable bid price.

(5)

(Source: UNISA, TOE408W, test 3 [2011] – updated, truncated and adjusted)

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Feedback to Activity 11.1.1 Part (a) Present value of synergies and related cost Year 0 Year 1 Marks Wage savings and associated cost R

R

• Employees – retrenchment costN1 (1 200 000) (1)

• Wage savings for Year 1 (R750 000 x (1+ (2 x 5%))

825 000 (1)

• Wage savings for years after Year 1:

Apply the Gordon Growth ModelN2 P0 = Cf1/(WACC-g), adjusted for the appropriate

year:

P1 = Cf2/(WACC-g) = R825 000 aboveN3 x (1,00 + 0,05) 6 663 462 (2) (18% – 5%) (1) Land and buildingsN1 800 000 (1) Advertising and distribution

Apply the Gordon Growth Model P0 = Cf1/(WACC-g)

= R150 000N4 x (1 – 28%) 830 769 (1) (18% – 5%) (1) Legal and other costN1 (3 000 000) (1)

Totals (2 569 231) 7 488 462

Discount factors (for a rate of 18%) 1,000 0,847 (1)

(Mark awarded for using discount factors or financial

calculator – calculations shown)

Discounted values (2 569 231) 6 342 727

Total present value of specific synergies, after associated costs

3 773 496

(Figures may not total correctly due to rounding.)

Notes N1 This figure is already after-tax and already a present value. N2 We can apply the Gordon Growth Model only where constant growth is expected (in this case:

inflation growth only, from Year 2). N3 This figure is already after-tax. N4 We do not increase the R150 000 by inflation here as it already represents the saving in one

year’s time.

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Part (b) Minimum selling price This will equal the intrinsic value of Target (excluding all possible synergies): R20 million. (1) Part (c) Maximum bid price This will equal the intrinsic value of Target plus the value of all specific synergies (net of associated cost): (R20 000 000 + R3 773 496, calculated in part (a)) = R23 773 496. (1) Part (d) Fair market value of Target This will equal the intrinsic value of Target plus the net value of synergies obtainable by more than one potential acquirer: (R20 000 000 + (3 773 496 x 40%)) = R21 509 398. (2) Part (e) Critical discussion Bidder should seriously consider offering less than the maximum bid price (R23 773 496) for Target, for the following reasons –

• The nearest other bidder is likely to offer no more than the fair market value: R21 509 398 (determined in part (d)), since no synergies above the 40%-level would be available to it. (1)

• The specific synergies between Bidder and Target relate mainly to the reduction in duplicated facilities and staff. (1)

• Since Bidder will contribute to this benefit (for example, through use of its facilities or staff by the combined entity), the specific synergy benefit should be shared. (1)

• If Bidder pays the maximum price of R23 773 496 (determined in part (c)), including the full price of all net synergies, it would be paying for the full synergy benefit (to Target’s shareholders) and none of the specific synergy benefits would accrue to its shareholders (Bidders existing shareholders). (1)

Recommend a suitable bid price The eventual bid price will be a matter of negotiation, but it is recommended that Bidder bids less than the maximum price (R23 773 496 from part (c)), closer to the minimum price (R20 million from part (b)), likely to end up close to the fair market value (R21 509 398 from part (d)). (1)

(Source: UNISA, TOE408W – adapted)

✓ Self-Assessment questions After working through all the relevant sections in the textbook, guidance and activities provided by this learning unit, you should now be able to attempt the following self-assessment questions. QUESTION 1 36 MARKS (54 MINUTES plus reading time) Perform the required parts (b) (c) (d) and (f) of Question 9 (X) Factor Holdings which can be found in the Question Bank. The relevant required part is repeated below.

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REQUIRED Marks

(b) Recommend a maximum bid price in Australian Dollar that Countryside could offer for a 70% shareholding in Bedazzled as at 30 June 2013. Support your recommendation by calculating a value using a method based on a forward EV/EBIT multiple and the available information. Motivate the appropriateness of this valuation method, the recommended price, the components of your calculation, and any adjustments made.

(21)

(c) Describe some of the factors that would influence the eventual purchase price that Countryside is likely to pay for Bedazzled (excluding the effect of synergy)

(3)

(d) Draft a formal letter to the directors of Countryside, describing the risks to the company paying for acquisition synergy-benefits, without first performing detailed supporting calculations and without creating a roadmap to its realisation.

(3)

(e) Describe the limitations of a valuation method based on (any) earnings multiple, in the case of Bedazzled.

(3)

(f) Indicate the potential sources of synergy should Countryside acquire Bedazzled. Incorporate knowledge of these companies and general knowledge of the clothing industry in your answer.

(6)

Solution to Question 3 Refer to the suggested solution to this part in the Question Bank

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LEARNING UNIT 11.2 OTHER CONSIDERATIONS

1. Introduction Befitting the complicated nature of M&A, these transactions normally involve numerous specialists, at great expense. As a chartered accountant, you may assist in this process and therefore also require a good working knowledge of some of the other M&A considerations. In this learning unit we will address some of these, including funding considerations, Black Economic Empowerment (BBBEE) considerations, post-acquisition reviews, and due diligence investigations. This learning unit is based on the following chapters in your prescribed textbook (Managerial Finance, 8th edition):

• Chapter 12 2. Content


2.1. The form of the transaction

Expansion can occur in various different forms, some of which are discussed below: Expansion through franchising

Franchising refers to the process whereby the Franchisor grants the Franchisee the right to distribute its products or services in return for a franchise fee and a percentage of monthly sales. This results in the following risks and rewards:

▪ The expansion is funded by an external party. ▪ The franchisee has a direct interest in the business and is thus more likely to work harder and be

more motivated than an employee. ▪ The costs involved in developing a franchise are high. ▪ It is not easy to terminate a franchise.

Purchase shares in another company This process is initiated with an offer by the acquiring firm. Should the shareholder accept the offer, the shareholder will exchange his shares for cash and or securities. This results in the following risks and rewards:

▪ Offeror can deal directly with the shareholders. ▪ Control can be obtained by purchasing less than 100%. ▪ No shareholders’ meeting required if total control is not the objective. ▪ Existing leases and contracts stay in place. ▪ Employment contracts need not change. ▪ If the assets of the target are encumbered as security, consent by the holders of the security is

not required. ▪ There may be stamp duty implications. ▪ The acquiring company becomes exposed to the risks of the company.

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Purchase the assets of another company

A company may choose to expand by purchasing the assets of another company rather than purchasing shares in that company. This results in the following risks and rewards:

▪ The Companies Act prohibits a company from giving financial assistance to a buyer of its shares.

However, if an asset is purchased, the asset itself may be used as security for the loan. ▪ Marketable securities tax and stamp duties are not payable. ▪ If assets are bought as a going concern, no VAT is payable. ▪ Interest on a loan to purchase assets would normally be tax deductible. ▪ Transfer duty on the assets purchased is payable and can be costly. ▪ Disposal of a major asset requires approval by ordinary resolution. Joint ventures

This is when two or more companies make an agreement to do business in one specific area. They share resources to pursue a common goal. This results in the following risks and rewards:

▪ It is an easy way to enter new markets. ▪ Access to better resources and expertise. ▪ Dissolution of a joint venture (JV) is simple. ▪ Costs to establish a joint venture is low. ▪ Failure of clear communication between management can result in many disputes. ▪ Objectives of parties to the joint venture are not always in line with one another resulting in

conflict. ▪ Different cultures and management styles usually becomes problematic. Alliance A strategic alliance is the sharing of resources for the benefit of all partners. It differs from a joint venture with regards to formality and permanence of the agreement. A joint venture is a legal relationship between the parties and usually results in the formation of a new business whereas a strategic alliance entails an agreement (which is usually not legally binding) to combine resources and information in order to achieve a specific goal. The risks and rewards of an alliance are as follows:

▪ It is not time consuming. ▪ Not very capital intensive. ▪ Breaking the alliance is much easier than a JV. ▪ The risk of sharing too much information resulting in an alliance partner becoming a competitor. ▪ Failure to clearly define the roles and responsibilities of each partner can be detrimental.

2.2. Funding considerations The manner in which M&A transactions are funded is an important consideration as it could affect market sentiment and in some cases, even the success or failure of the deal. There are a number of factors which need to be considered when making this decision; these are detailed within the following subsection in Managerial Finance (8th edition):

Chapter Subsection

12 12.4 Funding for mergers and acquisitions

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2.3. Industry regulation

Companies which are controlled in terms of the Banks Act, the Long-Term Insurance Act and the Short-Term Insurance Act need approvals, respectively, from the Minister of Finance or the Registrar of Banks, the Registrar of Non-Banking Financial Institutions, i.e. the Executive Officer of the Financial Services Board (FSB) for any change in control in such companies.

Approval is needed from the Department of Mineral Resources for a change of control in any companies that hold mining or prospecting rights. In certain industries, such as mining, one of the factors that is taken into account in granting approval for a change of control is the level of shareholding by previously disadvantaged South Africans in the target, post-acquisition. Other industries also have industry specific regulations and statutes such as the telecommunications industry and the gambling industry, where approval may be required for a change of control. 2.4. BEE transactions Over the past decade or so, BEE credentials have become an increasingly large motivation for business entities to engage in a merger or acquisition transaction, since it directly affects ownership.

Broad-Based Black Economic Empowerment (B-BBEE) is driven by both legislation and regulation, in the form of the B-BBEE Act, No. 53 of 2003, which empowers the Minister of Trade and Industry to issue Codes of Good Practice, and publish Transformation Charters. The process of B-BBEE works in collaboration with other acts and regulations, including those in the areas of Employment Equity and Preferential Procurement.

The Codes of Good Practice prescribe a Generic Scorecard with certain targets and weights. However, there are also Transformation Charters, which considers particular industries and their unique activities and circumstances (normally resulting in a slightly different permutation of targets and weights when compared to the Generic Scorecard).

The Generic Scorecard considers the ownership of an entity as an important area, but since its goal is to promote broad-based empowerment, it has a much wider scope. As the Generic Scorecard also forms the basis of most other Charters, it is important for you to know the different criteria. As indicated below, the Generic Scorecard has five elements, each allocated a certain weighting (indicated in brackets below). The Scorecard includes bonus points, so it is possible to achieve more than 100 points.

1. Ownership (25) 2. Management control (19) 3. Skills development (20) 4. Enterprise and supplier development (40) 5. Social-economic development (5)

(DTI, 2019) Business entities have to be assessed annually by an accredited Verification Agency, which issues a B-BBEE verification certificate indicating the scorecard information and assessment result in the form of a contributor-rating. Depending on the score, an entity will be rated from a Non-Compliant Contributor (the lowest rating), to a Level Eight Contributor (just above the lowest rating), all the way up to a Level One Contributor (the highest rating for entities achieving more than 100 points) (DTI, 2019)

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Many large South African companies aim to achieve the requirements relating to ownership by disposing of a large proportion of their shares to black shareholders. The problem with such transactions is that often financing becomes an issue as the black shareholders do not have sufficient funds to pay for these shares and thus a number of creative arrangements are developed to assist in financing these BEE transactions. 2.5. Post-acquisition review Although conducting a formal post-acquisition review is not always performed, it is a vital stage within the merger/acquisition process. This review not only enables an assessment of the transactions success (allowing them to take any corrective action, if possible), it can also improve the strategy and execution of later merger/acquisition transactions. As a result, companies engaging in merger/acquisition transactions will do well by developing such teams to conduct such reviews. Team members should have a good understanding of the company, the objectives/goals of the merger or acquisition as well as the risks pertaining to the transaction. As part of this process, such a team – often referred to as a post-acquisition review team – can compare certain key indicators before and after an acquisition. These indicators include:

(a) return on assets (b) profitability (c) earnings per share (d) price-earnings ratio 2.6. Due diligence investigations A due diligence investigation refers to a detailed examination of the target company prior to the merger or acquisition. The aim of such investigations is to verify/audit, amongst others, the financial, legal and operational information of the target company so as to ensure that the acquiring company makes an informed decision. These procedures are usually carried out by a special team who have experience in this field, and consist of employees of the acquiring company and some experts if necessary. The results of such procedures could lead to a change in the terms of the proposed merger or acquisition, or even a cancellation of the transaction. 2.7. Systems, information, confidentiality and disclosure requirements

The compatibility of the information and computer systems, between the two companies, should be considered as a part of the due diligence procedures.

The due diligence process will give the acquiring company access to detailed financial and other business information relating to the target company. A confidentiality agreement is normally signed in order to protect the interests of the target company.

The information that is required to be made public in relation to a merger or acquisition is regulated by the JSE Listings Requirements (for listed entities) and the Companies Act (which includes the Takeover Regulations).

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Disclosure of the following is normally required: ✓ consideration payable ✓ the asset that is being acquired ✓ special dealings (arrangements) ✓ the effect on listing ✓ conditions and timing 2.8. Conflict of interest issues (manager’s vs shareholders) When entering into a negotiation for a potential merger/acquisition transaction, managers may experience a conflict of interest between acting in their own best interest and acting in the interest of the shareholders (which is their responsibility). This usually occurs when, for example the manager sees the merger/acquisition transaction as an opportunity to advance his/her career (by being involved in a larger corporation or an industry which he/she may have an interest in). The transaction may not necessarily maximise shareholder wealth, but management will pursue the opportunity in order to benefit themselves. It should be noted that such unethical motivation for a merger/acquisition is one of the key reasons for failed transactions. For this reason, amongst others the pre- and post-acquisition reviews are important procedures for consideration.

3. Self-assessment questions

After working through all the relevant sections in the textbook, guidance and activities provided by this

learning unit, you should now be able to attempt the following self-assessment questions. QUESTION 1 8 MARKS (12 MINUTES plus reading time) Perform the required part (h) of Question 1 (Medico Group) which can be found in the Question Bank. The relevant required part is repeated below.

REQUIRED Marks

(h) Draft a memo to the management accountant of MGSA discussing: ✓ Possible reasons why the Acti-Pharm acquisition may not be successful. ✓ The advantages and disadvantages of carrying out a post-acquisition review

with regard to the purchase of an interest in Acti-Pharm.

(5)

(3)

Solution to question 1 Refer to the suggested solution to this part in the Question Bank

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Ansoff, IH. (1965). Corporate Strategy. New York: McGraw-Hill. Bowman Gilfillan (2013) Getting the Deal Through: Mergers and Acquisitions. This document is available from: http://www.bowman.co.za/FileBrowser/ArticleDocuments/Getting-the-Deal-Through-MergersandAcquisitions.pdf London: Law Business Research Ltd Research Correia, C, Uliana, DFE, and Wormald, M. (2011). Financial Management, seventh edition. Juta & Company Cape Town Department of Trade and Industry (DTI). (2019). Codes of Good Practice On Broad Based Black Economic Empowerment. Available from: <https://www.bbbeecommission.co.za/wp-content/uploads/2019/06/42496_31-5_Amended-Statement-000-300-and-400.pdf> (accessed 11 September 2019). DTI: Pretoria Ltd Sirower, ML and Sahni, S. (2006). Avoiding the “synergy trap”: practical guidance on M&A decisions for CEOs and boards, Journal of Applied Corporate Finance, 18(3):83–95. Skae, FO. 2017. Managerial Finance. 8th Edition. LexisNexis: Johannesburg.

http://www.bowman.co.za/FileBrowser/ArticleDocuments/Getting-the-Deal-Through-MergersandAcquisitions.pdf

http://www.bowman.co.za/FileBrowser/ArticleDocuments/Getting-the-Deal-Through-MergersandAcquisitions.pdf

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LEARNING UNIT 12 – BUSINESS PLANS AND FINANCIAL PROPOSALS


PRIOR LEARNING ASSUMED In your undergraduate and Advanced Management Accounting studies you have already mastered the learning outcomes indicated below. If you want to refresh your knowledge, please refer to your undergraduate material, prescribed textbook and MAC4861 Tutorial Letter 102/2020 (available under ‘additional resources’ on myUnisa). For your convenience we also provide textbook references. It is important to realise that this learning unit relies heavily on the learning outcomes achieved in prior learning units, including the function of financial management, strategy, risk management, sources of finance, valuations, and the treasury function. It is thus important that you have achieved the necessary learning outcomes before attempting this learning unit.

Learning outcome

Managerial Finance, 8th Edition

• Interrogate your knowledge of the purpose and audience of a business plan/proposal in their preparation, on a basic level.

• Develop new business plans and financial proposals.

• Analyse existing business plans and financial proposals.

• In preparing business plans and financial proposals, identify and address: o the business strategy and strategic plan o strengths and weakness of the plan o the resources needed o sources of financing o anticipated costs and recoveries (including its calculation) o all assumptions made.

• Critically review all assumptions made.

• Chapter 2: Sections 2.7 to 2.9

• MAC4861 TL102

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INTRODUCTION The idea for a start-up business entity often sees the light on the back of a napkin. Likewise, new growth ideas for an existing business are often born through informal discussion. But ideas are useless unless put into action. A business plan represents the detailed, long-term roadmap whereby these ideas could be implemented. Put differently, a business plan is a plan of where a business idea wants to go and how it is planning to get there. It is a sales document, selling ideas to potential debt and equity investors. It can be used at various stages of the organisation’s life. The document can also be used as a planning and control instrument by the involved parties. A related but separate document is the financial proposal. A financial proposal is not the same as a business plan; it is a request for money based upon your business plan. As a finance professional you may well one day be instrumental in the compilation of these important documents. THIS LEARNING UNIT CONSISTS OF THE FOLLOWING SUB LEARNING UNITS: LEARNING UNITS TITLE

LEARNING UNIT 12.1 BUSINESS PLANS AND FINANCIAL PROPOSALS

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LEARNING UNIT 12.1 BUSINESS PLANS AND FINANCIAL PROPOSALS

1. Introduction The subject of this learning unit has already been introduced as part of the introduction above. This learning unit is based on the following subsections in Managerial Finance, 8th edition, chapter 2:

• Chapter 2: Sections 2.7 to 2.9 2. Content

There is no additional content to be studied at this level. All content has already been addressed in your prior learning. If you want to refresh your knowledge, please refer to the earlier section ‘Prior learning assumed’. The activity below, the self-assessment questions provided later in this learning unit, and the integrated self-assessment at the end of this tutorial letter will help you to apply your knowledge. 3. Self-assessment question After working through all the relevant sections in the textbook, guidance and activities provided by this learning unit, you should now be able to attempt the following self-assessment questions. QUESTION 2 5 MARKS (8 MINUTES plus reading time) Perform the required part (m) of Question1 (Medico Group) which can be found in the Question Bank. The relevant required part is repeated below. (At this point it is not necessary to attempt the other parts of the question; you should, however, take notice of the way in which all the various parts integrate and relate to the scenario.)

REQUIRED Marks

(m) Draft a memo to the management accountant of MGSA describing matters to be included in the business proposal under the headings of:

• Industry analysis • Risk and risk management

(3) (2)

Solution to Question 2 Refer to the suggested solution to this part in the Question Bank. BIBLIOGRAPHY AND ADDITIONAL READING

Skae, FO. 2017. Managerial Finance. 8th edition. Lexis Nexis: Johannesburg.

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INTEGRATED SELF-ASSESSMENT

After studying the learning units covered in this tutorial letter the next important step is to practise the application of the acquired knowledge on an integrated level. You can use the integrated questions in this part as self-assessment. We strongly recommend that you attempt these questions under simulated examination conditions. Then, after completion, compare your answer to the suggested solution and establish reasons for differences. (If necessary, revisit the learning units in this tutorial letter, your prior study material and/or Managerial Finance, 8th edition.) Remember to make notes summarising the reasons for your mistake(s). Further indicate on a summary sheet of questions performed during the year, whether you need to revisit some of these questions, or sections of the questions, later. Now attempt the following integrated questions as well as the tests of 2018, as presented below. Integrated question 1 Perform question 6 in the Question Bank (RAPS GROUP LIMITED). Solution to Integrated question 1 Find the solution in the Question Bank. Integrated question 2 Perform question 5 in the Question Bank (CASEYWALKERCARMICHAEL SOUTH AFRICA LIMITED). Solution to integrated question 2 Find the solution in the Question Bank

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TEST 1 (2019) QUESTION 1 40 MARKS Ignore Value-Added Taxation BACKGROUND

Decadent Chocolates Pty Ltd (DC) is a private company that was founded in the early 1990’s in South

Africa by Mr. Williams, who learnt the art of making chocolate in Belgium. Mr. Williams was always

passionate about chocolate making and only uses the finest ingredients in his creations. It didn’t take

a long time for consumers to be impressed with Mr. Williams chocolate making skills and DC quickly

grew into a successful company. Customers appreciate how creative DC is in making chocolate, even

after being in operation for so many years, and trust the quality of their products.

CHANGES TO THE BUSINESS STRATEGY

Two years ago Mr. Williams became ill and handed over the management of DC to his son, Marc.

During this period Marc spent time gaining an understanding of DC’s business operations, processes

and procedures. He indicated that he now knows the business well enough and plans on implementing

changes to the business strategy. Marc would like for DC to utilise technology more within their

manufacturing processes as it is not necessary for them to spend so much of time hand crafting

chocolates when this work can be done by a machine. He is of the opinion that customers will not know

the difference and there is therefore no reason to tell them about the change.

Marc is quite excited about the use of machinery in the manufacturing process as this will enable DC

to increase its output which is in line with his vision. He is therefore trying to secure a contract with X

Ltd, a listed company within the hospitality and food service industry. Marc has heard from one of his

friends, Phillip, that X Ltd is looking for a new chocolate supplier that can fulfil their large demand at a

reasonable price. Phillip works for X Ltd and Marc has persuaded him, by gifting him and his family

with a weekend away, to provide him with confidential information regarding the quotes some of the

chocolate suppliers have provided X Ltd. Marc believes that this will assist him in ensuring that DC

provides X Ltd with the most “appropriate” offer. Marc is determined to secure X Ltd as a customer and

is willing to do whatever it takes, including utilising cheaper ingredients to ensure the contract is

profitable. He feels that since DC products are trusted and the company has a good reputation, X Ltd

will grant him the contract, if his price is reasonable.

Marc, together with the Operations Manager, have performed some research regarding chocolate

manufacturing machinery and have found a machine which they consider appropriate for DC. The

machine costs R800 000 and can be utilised for a period of 4 years. A capital allowance for taxation

purposes of 25% can be claimed on the machine and it is expected to have no value after 4 years. It

will cost DC R13 200 a year, in real terms, to maintain the machine.

FUNDING OPTIONS

The Financial Manager presented the following two funding options to Marc:

Option 1

Obtain a loan from DC’s bank for R 800 000 for a period of 4 years (2020-2023). Transaction costs amount to 2.5% of the value of the loan and is payable immediately. The loan will bear interest at 3.5% above the prime interest rate and is repayable, in arrears, in equal annual instalments, comprising capital and interest. The loan qualifies as an instrument and is deductible for taxation purposes in terms of Section 24J of the Income Tax Act.

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Marc is concerned about the risk relating to this option carrying a variable interest rate but the Financial Manager has indicated that there are instruments that can mitigate this risk. Option 2 Lease the asset for a period of 4 years, at an annual cost of R250 000 in 2020 and escalating by a nominal rate of 6% annually. The lessor will bear the maintenance costs. ADDITIONAL INFORMATION

1. The South African corporate tax rate is 28%.

2. South Africa’s prime interest rate is 10,25% and is expected to remain the same.

3. The South African inflation rate is 5,1%.

REQUIRED Marks

Sub-total

Total

(a) Determine the most cost effective funding option for Decadent Chocolates based on the Internal Rate of Return of each option. Communication: Presentation and layout

18

1

19

(b) (i) Discuss the factors that should be considered in deciding between a fixed interest rate and a variable interest rate. (ii) List four derivative instruments that can be utilised to hedge against interest rate volatility. (iii) Explain to Marc what entering into an interest rate swap agreement would entail and how it can be utilised to hedge against increasing interest rates.

5

2

7

14

(c) Comment on Marc’s behaviour from an ethical point of view and the potential impact this could have on DC. Communication: logical argument

6

1

7

TOTAL 40

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TEST 1 – SUGGESTED SOLUTION (2019)

R

PV 800 000 1/2r/w

I/YR 13,75% 1/2r/w

N 4 1/2r/w

FV 0 1/2r/w

PMT R -273 157,93 1c

Please note that marks for calculator inputs above are only given if PMT is calculated.

Option1 2019 2020 2021 2022 2023

Present value 800 000 1/2r/w

Issue costs -20 000 1/2r/w

Tax on issue costs 5 600 1/2r/w

Payments -273 158 -273 158 -273 158 -273 158 1c

Tax on interest 28% 30 800 24 518 17 373 9 245 1c for x by 28%

S24J accrual amount (A=BXC) 110 000 87 566 62 047 33 019 2r/w

Pre-tax yield to maturity (B) 13,75% 13,75% 13,75% 13,75%

Adjusted initial amount (C) 800 000




Total cashflows 780 000 -236 758 -248 640 -255 785 -263 913

After tax RR 10,76% 1c

ALTERNATIVE

1. Determine the most cost effective funding option for DC.

Alternative to S24J interest calculation Calculator inputs must be shown 1INPUT 2ndF Amort = interest of 110 000 (1/2r/w) 2INPUT 2ndF Amort = interest of 87 566 (1/2 r/w) 3INPUT 2ndF Amort = interest of 62 047 (1/2 r/w) 4INPUT 2ndF Amort = interest of 33 019 (1/2 r/w)

1INPUT 2ndF Amort = interest of

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The following cash flows can be included in Option1 but then should not be included in Option 2 (Refer to shaded area in Option 2):

Maintenance costs (13,873) (14,581) (15,324) (16,106)

1r/w

Tax @28%

59 884 60 083 60 291 60 510

1c for x by 28%

Maintenance costs (13,873) (14,581) (15,324) (16,106)

1/2r/w

Wear and tear (200 000) (200 000) (200 000) (200 000) 1r/w

Option 2 2019 2020 2021 2022 2023

Present value 800,000 1r/w

Lease payments -250,000 -265,000 -280,900 -297,754 2r/w

Maintenance savings 13,873 14,581 15,324 16,106 1r/w

Taxation 10,116 14,117 18,361 22,861 1c 28%

Lease payments -250,000 -265,000 -280,900 -297,754 1/2r/w

Maintenance savings 13,873 14,581 15,324 16,106 1/2r/w

Wear and tear forfeited 200,000 200,000 200,000 200,000 1r/w

Total cashflows 800,000 -226,011 -236 302 -247,215 -258,787

IRR 7,91% 1c

The most cost effective option is the lease 1c

MAX 18

Commentary:

The following applies to the loan:

1. Since the loan is repayable in instalments, it is logical that the FV will be zero and since PV, I/YR and N are provided, you should deduce that you would need to calculate the PMT

2. Many students don’t seem to understand what S24 J entails an how it is accounted for. S 24 J refers to the tax on the interest portion of the repayment, therefore you would need to calculate the interest portion of the annual repayment and then only the tax on the interest is a relevant cash flow in calculating IRR

The following applies to the lease: 3. It is important to read the information carefully to know when escalation/inflation applies 4. Since with the lease, maintenance costs are not incurred, these costs represent a saving

that is relevant when comparing the two alternatives. Based on the same principle, the tax benefit of wear and tear is forfeited. However, it is important to note that only the tax impact of wear and tear is relevant and therefore wear and tear should only be included in the tax calculation and not the IRR analysis

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(i) 1. The differential cost between the two rates: (1)

The fixed rate is traditionally higher that the variable rate. (1) 2. Certainty that comes with a fixed interest rate: (1)

Will the company be able to meet their loan obligations should interest rates increase? (1) 3. Are there any hidden fees/costs with the fixed interest rate? (1)

4. Consider the timespan of the funding (long term vs short term) (1)

5. Historical trends and future projections regarding movements in variable interest rates:

(1)

interest rates have been fairly stable with the prime interest rate staying constant at 10.25 since July 2017 until March 2018 when it was cut by 25 basis points to 10%. (1)

MAX 5

(ii)

1. Forward rate agreements (½)

2. Interest rate futures contracts (½)

3. Interest rate option contract (½)

4. Interest rate swap agreements (½)

5. Interest rate cap (½)

6. Interest rate floor (½)

7. Interest rate collar (½)

MAX 2

(iii) Since DC has a variable interest rate loan but wants a fixed interest rate, they would need to identify a suitable counterparty to the swap agreement that has a fixed rate loan but would prefer a variable interest rate. (1) This counterparty would typically be a related party or a Bank. (1) The counterparties to the swap agreement would need to agree on the following: 1. fixed interest rate (½) 2. variable interest rate (½) 3. notional amount (½)

that will apply to the agreement

(i) Discuss the factors that should be considered in deciding between a fixed interest rate and a

variable interest rate.

(ii) List four derivative instruments that can be utilised to hedge against interest rate volatility.

(iii) Explain to Marc what entering into an interest rate swap agreement would entail and how it can

be utilised to hedge against increasing interest rates.

Commentary:

Once again it is important to read the required carefully. In this section you were required to discuss the factors to consider in deciding between fixed and variable rates. Many students limited their discussion to explaining what a fixed and variable rate is rather than how you would go about choosing between the two rates and therefore performed poorly within this section.

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DC and the counterparty will then swap cash flows (but not legal obligations per the original loan agreements) in terms of their swap agreement (1) DC would therefore be exchanging its payments at a fixed rate applied to a notional amount, for a series of receipts determined at a variable interest rate. (1) Should interest rates increase, the receipts received by DC from the counterparty will also increase and this can be used by DC to service the increased interest cost on their original loan with their Bank. (1) Both parties must benefit from the swap agreement and therefore the overall gain is shared between the counterparties (1)

MAX 7

1. Marc intends on changing the manufacturing process from hand crafted to machine

manufactured without informing customers, (1)

2. He also is willing to utilise cheaper ingredients to secure a contract (1)

3. this is unethical as he is not being transparent with his customers/misrepresenting DC’s

products (1)

4. He is breaching the trust that customers have in DC’s products (1)

5. Marc has obtained confidential information from his friend in exchange for a gift (1)

6. He is gaining an unfair advantage over other suppliers (1)

7. This amounts to a bribe which is unethical and illegal (1)

Impact: The potential impact of the above described unethical behaviour could be as follows: In the long term customers may lose confidence in DC’s products (1) this will not only lead to financial loss (½) but also reputational damage and (½) also potential legal action (½)

MAX 6

Communication: logical argument 1 MAX:7

(c) Comment on Marc’s behaviour form an ethical point of view and the potential impact this could have on DC.

Commentary:

The majority of students do not know what an interest rate swap is and how it works. It is important for students to have an understanding of how and when the various derivate instruments are used. This is adequately explained in the prescribed textbook.

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TEST 2 (2019)

QUESTION 1 40 MARKS

Ignore the impact of section 8 of the Income Tax Act

PART A

Ukuzwa Ltd trading as UKU, is in the broadcast sector, specialising in content distribution for television

and Video on demand (VoD). UKU was formed in 1994 and listed on the Johannesburg Stock

Exchange (JSE) in 2000.

Extract of the Statement of financial Position of UKU as at 28 February 2019

Notes 2019 2018

R’000 R’000

Share Capital 1 750 500

Retained Earnings 134 928 126 753

Non-redeemable preference shares 2 1 000 1 000

Total Equity 136 678 128 253

Non-Current liabilities

Long-term borrowing 4 6 000 8 000

Current Liabilities

Overdraft 3 613 1 412

Trade Creditors 2 451 3 137

Short-term portion of long-term borrowings 4 2 000 2 000

Accrued Interest 917 1 146

Current tax payable 490 392

Total Liabilities 12 471 16 087

Notes

1. Ordinary share capital as at 28 February 2018 comprises 5 000 000 shares at 10c per share.

The closing market price on 28 February 2018 was R55 per share. On 1 June 2018 UKU

announced a 25c per share bonus share issue, to existing shareholders, at a ratio of 1:10. In

December 2018 UKU issued a further 500 000 shares at 25c per share, all these shares were

taken up. The closing price of the shares as at 28 February 2019 was R 65 per share.

2. Non-Redeemable preference shares were issued on 30 June 2015, consisting of

1 000 000 shares with a nominal value of R1 per share. The shares carry a fixed dividend of

11%, which is payable annually arrears. The required rate of return on these shares is 8%.

3. UKU has an overdraft facility of R5 million with Digital Bank, which is utilised to fund operational

requirements.

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4. On 1 March 2017 UKU obtained a loan for R140 million from Digital Bank. The loan bears

interest at 12.5% per annum (pre-tax). The capital is expected to be settled in equal annual

instalments, in arrears, over a period of 5 years. Similar loans bear interest at a rate of 13.25%

(pre-tax). This loan qualifies as an instrument and is deductible for taxation purposes in terms

of Section 24J of the Income Tax Act.

Potential Acquisition

In the past UKU has grown organically, however from 2015 its strategy has been to diversify its portfolio

and acquire content creation companies. During the current year (2019) UKU approached, one of these

content creation companies, Umalusi (Pty) Ltd (UMA), to purchase 51% of their shares for R 50 million.

UMA is a television content creation company that focuses on South African movies. The company

was incorporated in 2011 by Kagiso, a film student, with the mission of telling untainted South African

stories in native languages. UMA focuses on a wider market, compared to most of its competitors as

their movies are translated into the nine official languages.

Extract of profit or loss and other comprehensive income for the year ended 28 February of UMA (Ltd): Notes 2019 2018 2017

R’000

R’000

R’000

Revenue 1 100 251 80 250 78 992

Cost of Sales (75 188) (60 188) (59 244)

Gross Profit 25 063 20 062 19 748

Operating Expenses 2 (11 278) (9 028) (4 937)

Operating profit 13 785 11 034 14 811

Other Income 3 42 55 55

Finance Costs 4 (180) (203) (225)

Profit before tax 13 647 10 886 14 641

Notes

1. UMA's accountant erroneously included profit on sale of equipment in the revenue account for

the period ended 28 February 2019. The cost of the asset was R500 000, the carrying amount

at the date of sale R150 000 and the proceeds on sale amounted to R600 000.

2. Operating expenses include the following:

(i) Entertainment expenses of R420 000 for 2019 and R120 000 for 2018. SARS requested

supporting documents for these expenses, but the accountant was unable provide this as

they did not represent business related expenditure (private in nature).

(ii) Depreciation on filming equipment of R 800 000 for 2019; R1 000 000 for 2018 and

R1 200 000 for 2017. Depreciation should be calculated at a rate of 25% per annum on

cost but UMA has calculated it at 20% per annum on cost.

(iii) Salaries include payments to Kagiso’s wife, who is not an employee of UMA, of R870 000

per annum.

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3. Other income relates to fair value adjustments on speculative investments. The market value

of the investments as at 28 February 2019 is R1 500 000.

4. Finance costs relates to interest on long term borrowings.

Additional Information

5. The average capital gearing ratio for the industry in which UKU operates is 40%.

6. UKU’s working capital management has been poor compared to industry standards, as the

debtors cycle is 60 days and the creditor’s cycle is 30 days. 7. UKU has been paying dividends consistently since 2001. Based on their strategy to expand

through acquisition, the company announced during 2018 that they will not pay a dividend during the current and future financial years. The share price decreased significantly as a result of this news. In order to rectify the situation UKU announced a rights issue.

8. The earnings yield of a similar JSE listed company as UMA is 9%. 9. The size of the similar JSE listed company is on average twice the size of UMA, and these

organisations have a higher cash holding than UMA. 10. In 2019 UMA received an award for its advanced level of innovation by the National Film and

Video Foundation (NFVF).

REQUIRED MARKS

Sub-total

Total

(a) 1. Calculate the capital gearing ratio of UKU as at 28 February 2019. 2. Recalculate UKU’s capital gearing ratio assuming UKU funds the acquisition of UMA by means of a loan, Assume the market value of the new loan to be R38 720 000. 3. Discuss the impact the new loan will have on UKU’s capital gearing ratio. Communication skills- logical argument

11

1

5

1

18

(b) Calculate the fair market value of a 51% shareholding in UMA as at 28 February 2019. Utilise the P/E multiple method of valuation.

Communication skills- layout and structure

16

1

17

(c) Discuss the factors that could possibly limit UKU and UMA from realising post-merger synergies.

5

TOTAL 40

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TEST 2 – SUGGESTED SOLUTION (2019) (a)

Commentary: Most students lost marks due to the following mistakes: Calculation of capital gearing ratio:

• Capital gearing ratio should be based on market values, some students used book values.

• The formula for calculating capital gearing ratio is Market Value of Debt / Enterprise Value, where Enterprise Value = Sum of Market Value of All Capital (i.e. Debt + Equity + Preference Shares). o Some students confused the capital gearing ratio with the debt-equity ratio. o Other students included items that do not form part of the permanent capital

structure (e.g. current liabilities and bank overdraft).

• The capital gearing ratio is a percentage (%). Discussion of impact of debt financing on capital gearing ratio

• Many students failed to discuss the impact,

• The discussion had to centre around how the capital gearing ratio will change because of debt financing and what impact will this change have on the business

Valuation of loan: present value of future cash flows Many students made the following principle errors:

• Not applying sec24J interest deduction on which the interest tax shield is calculated for inclusion (tax cash flows) in the analysis (3 marks).

• Not calculating the annual payment (PMT) for inclusion in the cash flow analysis (4 marks).

• Some students valued the loan in 2017. The required value was for 28 Feb 2019 thus only future cash flow until the end of the loan term (from 2020 to 2021) had to be included in the analysis.

• Not accounting for tax: Remember that after tax cash flows should be discounted at an after-tax discount rate (3 marks).

Valuation of equity: market capitalization method Some students valued the shares at their issue prices instead of the current market value of R65. Valuation of preference shares The preference shares were NON_REDEEMABLE, thus students had to value using the formula: Market Value = Annual Coupon in Rands / Annual Market Rate of Return on Similar Preference Shares.

(i) Calculate the capital gearing ratio of UKU as at 28 February 2019. (ii) Assuming UKU obtain the R 50 million loan from Digital Bank, calculate the impact this

will have on UKU capital gearing ratio. Assume the market value of the new loan to be R 38 720 000

(iii) Discuss the impact this will have on this will have on UKU’s capital gearing ratio.

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(i)

Market value of Debt

Marks should only be awarded if PMT is calculated

2019 2020 2021 2022

R'000 R'000 R'000 R'000

Payments (39,320) (39,320) (39,320) 1C

Tax on interest 28% 3,277 2,311 1,223 1C

S24J accrual amount (A=BXC) 11,704 8,252 4,369 2r/w

Pre-tax yield to maturity (B) 12.5% 12.5% 12.5%

Adjusted initial amount (C) 93,633



Total cashflows 0 (36,042) (37,009) (38,097)

Discount rate (13.25*0.72) 9.54% 1r/w

NPC 92,731 1C

Market Value of Equity using Market Capitalization Method (R’000)

Market Value (MV) of Share Capital R’000 2019

Opening Balance: Number of shares issued 5 000

Bonus Shares Issue 500

Share issue 500

Closing Balance: Number of shares issued 6 000 1r/w

Market Price per share R 65

Market Value of Equity R 390 000 1c

R'000

PV 140,000 0.5 r/w

I/YR 12.50% 0.5 r/w

N 5 0.5 r/w

FV 0 0.5 r/w

PMT R -39,320 1c

Alternative to S24J interest calculation Calculator inputs must be shown 2r/w 3INPUT 2ndF Amort = interest of 11 704 4INPUT 2ndF Amort = interest of 8 252 5INPUT 2ndF Amort = interest of 4 369

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Market Value (MV) of Non-redeemable preference shares (R’000)

𝑀𝑎𝑟𝑘𝑒𝑡𝑉𝑎𝑙𝑢𝑒 = 𝑁𝑜𝑚𝑖𝑛𝑎𝑙 𝑉𝑎𝑙𝑢𝑒 𝑋 𝐶𝑜𝑢𝑝𝑜𝑛 𝑅𝑎𝑡𝑒

𝑀𝑎𝑟𝑘𝑒𝑡 𝑅𝑎𝑡𝑒

= 𝑅 1 000 𝑋 11%

8%= 𝐑 𝟏 𝟑𝟕𝟓 𝟏𝐫/𝐰

Bank overdraft not included in capital gearing ratio calculation 1r/w

Capital gearing ratio before acquisition

𝑪𝒂𝒑𝒊𝒕𝒂𝒍 𝑮𝒆𝒂𝒓𝒊𝒏𝒈 𝑹𝒂𝒕𝒊𝒐 =

𝑀𝑉 𝑜𝑓 𝐷𝑒𝑏𝑡

𝑀𝑉 𝑜𝑓 𝐷𝑒𝑏𝑡 + 𝑀𝑉 𝑜𝑓 𝐸𝑞𝑢𝑖𝑡𝑦 + 𝑀𝑉 𝑜𝑓 𝑃𝑟𝑒𝑓𝑒𝑟𝑒𝑛𝑐𝑒 𝑆ℎ𝑎𝑟𝑒𝑠

=92 731

92 731 + 390 000 + 1 375

= 19% 1C

MAX 1

MAX 11

(ii)

Capital gearing ratio post debt financing of acquisition

=92 731 + 38 720

92 731 + 38 720 + 390 000 + 1 375

= 25% 1C

MAX 1

Alternative to new capital gearing ratio

=92 731 + 38 720

92 731 + 50 000 + 390 000 + 1 375

= 24,61% ≈ 25% 1C

109 MAC4862/102

(iii)

Capital gearing ratio after the loan caused the gearing ratio to increase from 19% to 25%. Indicating an increase in financial risk 1

Although UKU’s ratio has increased, it is still lower than the industry average of 40%. This may be an indication that the industry is optimally geared and has invested in profitable projects, whereas UKU had a lower financial risk appetite, as in the past the focus has been on organic growth rather than acquisitions.

1

1

The proposed debt funding is significantly higher (77% = 38 720 / 50 000) than the current gearing ratio (19%) and industry standard (40%). 1

The increase in financial risk will increase the expected return on equity as investors will expect a higher rate for the higher financial risk. 1

UKU may find it difficult to fulfil capital and interest repayments for the following reasons: Existing long term loans have recently been granted (i.e. they are at inception), UKU would therefore have to make interest and capital repayments on this loan for 3 more years. UKU may be experiencing cash flow problems as their working capital management is poor UKU’s decision to replace dividend with a rights issue could also be indicative of cash flow problems UKU has to pay 11% divided annually on the non-redeemable shares

1 ½

½ ½

½

Other valid point

MAX 1

Communication Skills: logical argument

1

MAX 6

Commentary: Most students lost marks in the discussion question due to:

• Listing factors instead of discussing

• Not benchmarking /comparing the ratio to industry

• Not focusing their discussion on the impact the loan will have on:

o gearing ratio o financial risk o required return to shareholders o cash flows

Students are advised to study the required carefully and thoroughly to determine what has been asked and plan their solution accordingly to improve their performance in future assessments.

Discuss the impact the new loan will have on UKU’s capital gearing ratio.

110 MAC4862/102

(b)

Commentary: Determination of maintainable earnings Many students did not normalise the earnings to arrive at sustainable maintainable earnings:

• Most students did not remove the profit on sale of fixed asset from revenue to determine maintainable revenue.

• Many students did not calculate the normalised maintainable gross profit of 25% to remove the impact of incorrect accounting entry (recognition of profit on sale of fixed asset in revenue) to determine maintainable gross profit.

• Adjustment for non-core business expenses (payment of salary to wife of business owner and reversal of entertainment expenses) were performed incorrectly, instead of being reversed they were double counted.

• Correction of accounting depreciation understatement.

• Conclude on appropriate maintainable earnings to be used for valuation: In this scenario the earnings did not show an upward trend, thus weighted average earnings had to be used in the valuation.

Determination of maintainable price earnings ratio Many students did not:

• Correctly convert the earnings yield to earnings multiple.

• Students also confused earnings yield (i.e. %) to earnings multiple (i.e. number of times). This distinction is essential in valuations: o Value of equity = Maintainable Earnings X PE Ratio o Value of equity = Maintainable Earnings ÷ Earnings Yield

Equity value calculations Most students did not adjust for the following on the equity value:

• Non-core assets (R1,5million) that had to be valued separately.

• Marketability discount since UMA is an unlisted equity.

• Control premium to account for value of control because majority is being value (i.e. greater than 50% of control).

• Calculation of equity value being at 51%.

Calculate the fair market value of a 51% shareholding in UMA as at 28 February 2019, based on the P/E multiple method of valuation

111 MAC4862/102

Calculate Maintainable Earnings for UMA

2019 2018 2017

Revenue 100 251 80 250 78 992

Adjustment for profit on sale of Asset (600-150)

(450) 1r/w

Adjusted Revenue 99 801 80 250 78 992 Cost of Sales (74 851) (60 188) (59 244) Gross Profit at 25% 24 950 20 062 19 748 1c for 25%

Operating Expenses (11 278) (9 028) (4 937) Adjustments

Decrease Entertainment 420 120 1r/w

Increase Depreciation from 20% to 25%. 2019: (8 000 / 20% X 25%) - 8 000

(200) (250) (300) 1r/w

Decrease Salaries 870 870 870 1 r/w

Adjusted Operating expenses (10 188) (8 288) (4 367) Operating profit 14 762 11 774 15381

Finance Costs (180) (203) (225) 1r/w


Taxation @ 28% (4 083) (3 240) (4 244) 1c

Profit after tax 10 499 8 331 10 912

Maintainable earnings have no trend therefore weighted average 1

Weight 3 2 1

Weight* PAT 31 497 16 662 10 912

Sum of Weight* PAT 59 071

Sum of Weight

6 1r/w

Weighted Average 9 845 1c

112 MAC4862/102

Alternative Solution: Starting at Profit before tax

2019 2018 2017

R'000 R'000 R'000 Profit before tax 13 647 10 886 14 641 Reverse: Non-recurring items

Reverse: once-off profit on sale of assets (450) 1r/w

Impact of reversal on cost of sales 337 1C

Normalisation of gross profit @ 25% (113)

Accounting error correction (200) (250) (300) 1r/w

Reverse: Current Depreciation 800 1 000 1 200 Charge: Correct Depreciation (1 000) (1 250) (1 500)

Reverse: Non-core business items

Reverse: entertainment expense 420 120 1r/w

Reverse: Kagiso's wife salary 870 870 870 1r/w

Reverse: Other income (42) (55) (55) 1r/w

Normalised profit before tax 14 582 11 571 15 156

Taxation @ 28% (4 083) (3 240) (4 244) 1C

Maintainable profit after tax 10 499 8 331 10 912

Maintainable earnings have no trend, therefore use weighted average 1r/w

Weights 3 2 1

Weightings 31 498 16 662 10 912

Sum of Weightings 59 072

Sum of Weights 6 1r/w

Weighted Average 9 845 1C

Calculations: Alternative Solution

Normalisation of Gross profit (113)

Reverse: Current Gross profit (25 063) Adjusted Gross profit @ 25% 24 950 = 99 801 X 25%

Adjusted Sales (100 251 - 450) 99 801

Reduced sales (450) = 600 - 150

Reduced cost of sales 337 = 75 188 - (99 801 * 75%)

Effect on gross profit (113)

113 MAC4862/102

Adjust the comparator P/E multiple

Earnings yield percentage 9%

P/E Multiple (1/9) 11 1r/w

Adjustments to Price Earnings Ratio

Size of the JSE comparator is twice that of UMA - 1

Innovation of UMA + 1

Access to markets + 1

UMA has less cash holdings than comparator - 1

UMA has less controls (salaries for relatives) -

Other Max1 1

Adjusted PE multiple 10

Value of 51% equity share holding of the entity

Maintainable earnings 9 845 Adjusted P/E multiple 10

98 450 1c Add Market Value of Investment 1 500 1r/w

99 950 Add Control Premium @ (99 950*5%) 4 998 1c

Less Marketability of discount (99 950* 7%) (6 997) 1c

Value at 100% 97 951

Value at 51% 49 955 1c

MAX 16 Communication skills- layout and structure: 1

MAX 17 (c)

UKU and UMA although in the same industry have different objectives and therefore different business/operating models. (UMA is a content creation organisation and UKU is a distributor). Obtaining alignment may be challenging. UKU's management skills might not be the best fit for UMA (Culture Difference).

1 1

UMA's employees may be threatened by the acquisition and UMA may lose skilled employees, making it difficult for the organisation to realise expected benefits. 1

Financial information of UMA may not be accurate and therefore not in line with UKU’s expectations as the information is based on non-audited financial statements. 1

The integrity of UMA’s management may be problematic and hinder performance as they seem to be inflating business expenses. 1

UMA's financial systems, processes and reporting may not be at a standard required by the JSE, thereby requiring UKU to incur additional costs to improve this 1

Economic climate (unfavourable change in interest rates, taxes, growth) negatively impacting customer base. 1

Any valid point MAX 1

Discuss the factors that can hinder UKU and UMA from realising post-merger synergies

4 Max

114 MAC4862/102

MAC4861 - TEST 1 (2019) QUESTION 1 40 MARKS

Piper Industrials Limited (Piper) is listed on the Johannesburg Stock Exchange. Piper is the leader in

the field of industrial mining supplies and is at the forefront of innovate advancements. Piper’s business

model includes showcasing and supplying the latest products at mining indabas and industrial shows.

Piper has showed interested in expanding into the solar power sector which has been identified as a

key focus area by the government.

Piper uses a state of the art stock management system. Inventory with a limited shelf life are tracked,

identified and scrapped on a regular basis. They also have stringent quality control procedures in place

to ensure all products sold are safe. The mining industry in which Pipers products are used is governed

by strict rules and regulations. Employees using these products need to be trained on an ongoing basis.

To remain competitive, Piper send their own staff on regular training and also train and provide

refresher courses to its clients.

Piper’s summarised statement of financial position as at 31 December 2018:

R’m

Shareholder’s Equity 2 452

Non –current liabilities

Preference shares 600

Long-term debt 950

Total equity and liabilities 4 002

Additional information:

• Shareholders equity consists of 500 million issued ordinary shares. These shares were originally

issued at R 2.00 per share and are currently trading at R 6.86 per share. Shares are actively traded

on the stock exchange and Piper’s cost of equity is 14%.

• The 10% irredeemable preference shares were issued at R 10 per share. The current market price

of similar irredeemable preference shares is R 12,50.

• The long-term debt relates to a loan obtained from SVB bank on 1 January 2017, for R1,6 billion

with a 11.5% fixed interest rate. The term of the loan is five years, and is repayable annually in

arrears in five equal annual instalments and cannot be traded in the open market. Similar market

related long-term debt can currently be raised at 12% per annum. The loan qualifies as an

instrument and is deductible for tax purposes in terms of Section 24J of the Income Tax Act.

• The corporate tax rate is 28%.

Possible expansion:

The financial director of Piper is of the opinion that the group should expand into the solar power sector.

He is proposing that the board considers the acquisition of a manufacturing plant, in order to

manufacture the Bopper Solar Panel (BSP). The engineering and marketing departments supplied the

following information regarding the proposed solar panel:

• The cost of the plant (including commissioning) is R 58 million. This will be paid for at the start of

the first year of the project.

115 MAC4862/102

• The BSP product is expected to have a 4-year product lifespan.

• It is estimated that 10 000 units a year of BSP will be sold during the first three years of production.

However demand is expected to drop to 8 000 units during the final year of production.

• The BSP will be marketed at R 15 000 per unit in the first year. In the second year this price will

increase to R 17 000, and it will increase every year thereafter by 12 % per annum.

• Direct all-inclusive costs per BSP will be R12 000 per unit in the first year of production. This cost

will increase by 10% in the second and third year of production. In the fourth and final year of

production this cost will only increase by 5%.

• Working capital requirements will be R 1.6 million at the end of the first year. This will increase to

R 1.8 million in the second year and will peak in the third year at R 2.0 million. At the end of the

fourth year only 75% of the outlay will be recovered and the balance absorbed into the existing

business.

• For the purpose of this evaluation, the Directors have stipulated a Weighted Average Cost of

Capital of 16%. The policy of the group is to apply a hurdle rate of 2.25% for investment appraisal

purposes.

• South African Revenue Services will allow an allowance on the manufacturing plant of 40% in

the first year and 20% over the next three years.

• The group applies the same policy for depreciation as for wear and tear.

• At the end of the life of the plant (4-years) it will sold for R 1 million.

REQUIRED Marks

(a) Calculate the actual Weighted Average Cost of Capital Piper Industrials Limited

(Piper), based on current market values, as at 31 December 2018.

Round all calculation to the nearest R’m.

14

14

(b) What qualitative factors should Piper consider when deciding on whether they

should supply solar panels.

6

6

(c) Advise Piper whether they should invest in the Bopper Solar Panel (BSP)

manufacturing plant based on a Net Present Value investment technique.

Round all calculations and working to the nearest R’000.

Communication, logic and layout

13

1

14

(d) Explain the current initiatives undertaken by Piper that will mitigate the risks

identified below:

i. The sale of unsafe supplies.

ii. Strong competition.

Communication: logical argument

2

3

1

6

TOTAL 40

116 MAC4862/102

TEST 1 – SUGGESTED SOLUTION (2019)

(a) Calculate the actual Weighted Average Cost of Capital (WACC), based on current market

values, as at 31 December 2018.

Market value of Equity Cost of Equity 500 X R6.86 = R3 430 1 r/w 14% 1 r/w 500 000 000 x 6,86= 3 430 000 000 1 r/w Market value of Preference shares Cost of Preference shares Number of preference shares 10% x 10/12,5 60 (600/10) = 8% 1 r/w 60 x R12, 50 = R 750 1 r/w 60 000 000 x 12,50 = 750 000 000 1 r/w Market value of long-term loan Cost of long-term loan

12 x 0.72 = 8.64% 1 r/w

The marks for the calculator inputs above v=can only be awarded if PMT is calculated

R'm

PV 1 600

I/YR 11,50% 1r/w

N 5 1rw

FV 0

PMT R -438,37 1c

Comments:

• It is important to read the Required carefully, in this case it indicated that calculations should be rounded to the nearest Rand million. Many students did not do this, this wastes time and increases the chances of making errors.

• Many students were unable to calculate the market value of the loan: ✓ Firstly, since loan is repayable in instalments, it is logical that the FV will be zero and since

PV, I/YR and N are provided, you should deduce that you would need to calculate the PMT.

✓ Secondly the market value of the loan represents the present value of future cash flows i.e. the 5 year loan was incurred in 2017 therefore at the end of 2018 only 3 years are remaining, making it only necessary for your market value calculation to project cash flows for the remaining 3 years.

✓ Lastly S 24 J refers to the tax on the interest portion of the repayment, therefore you would need to calculate the interest portion of the annual repayment and then only the tax on the interest is a relevant cash flow.

117 MAC4862/102

2019 2020 2021

R'm R'm R'm

Payments (438,37) (438,37) (438,37)

Tax on interest 28% 34,20 24,01 12,66 1c

S24J accrual amount (A=BXC) 122,13 85,76 45,21 2r/w

Pre-tax yield to maturity (B) 11,50% 11,50% 11,50%

Adjusted initial amount (C) 1 062,01



Adjusted initial amount (C)

Total cash flows -404,17 -414,36 -425,71

Kd (12*0.72) 8,64% 1r/w

NPC (1 055,11) 1c WACC

Instrument Market Value Proportion Cost Weighted

Equity 3 430 65,52% 14% 9,17%

Preference Shares 750 14,33% 8% 1,15%

Loan 1 055 20,15% 8.64% 1,74%

5 235 100% 12,06%

1 r/w 1 c

MAX 14

(b) What are the qualitative factors Piper should consider when deciding on whether they should

supply solar panels.

• Does the group have the knowledge and capabilities for the solar power industry? (1)

• What is the lifespan of a solar power panel? (1)

• What after sales service is required for the solar power products? (1)

• Will the group issue a guarantee on solar power products

• Is there potential to expand further into the solar power industry? (1)

• The product has a low carbon emission footprint, this could be used to the benefit

of the group (1)

• Does this new venture fit with the current business line? The rest of the activities is vastly

different from current operations (1)

• It might distract management from keeping focused on the main business of the group. (1)

• What are competitor products like? (Strong or weak). (1)

• Is there capacity in the market for the group’s product? (Chinese products have flooded the

market).

• Can solar power panels be recycled? (1)

• Consider repeat business (1)

MAX 6

Alternative to S24J interest calculation Calculator inputs must be shown 3INPUT 2ndF Amort = interest of 122,13 4INPUT 2ndF Amort = interest of 85,76 5INPUT 2ndF Amort = interest of 45,21

118 MAC4862/102

(c) Advise Piper whether they should invest in the BSP manufacturing plant based on a Net

Present Value (NPV) investment appraisal.

0 1 2 3 4

R'000 R'000 R'000 R'000 R'000

Cost of plant (58 000) 1r/w

Sale of plant 1 000 1r/w

Working capital required (1 600) (200) (200) 1r/w

Recoupment of working capital (2m*0.75) 1 500 1r/w

Sales 150 000 170 000 190 400 170 600 Calc 1

Cost of sales (120 000) (132 000) (145 200) (121 968) Calc 2

Tax (1 904) (7 392) (9 408) (10 509) Calc 3

Total cash flows (58 000) 26 496 30 408 35 592 40 623

Discount rate (16 + 2.25) 18,25% 1r/w

NPV R28 455 1c Since the NPV is positive, Piper should invest in the manufacturing plant 1

Calc 1: Sales

1 2 3 4

Units 10 000 10 000 10 000 8 000

Selling price 15 000 17 000 19 040 21 325

150 000 000 170 000 000 190 400 000 170 600 000 2r/w

Calc 2: Cost of sales

1 2 3 4

Units 10 000 10 000 10 000 8 000

Cost price 12 000 13 200 14 520 15 246

120 000 000 132 000 000 145 200 000 121 968 000 2r/w

Comments:

• Once again, it is important to pay attention to the rounding instruction, as explained above.

• The signage of the cash flows are important and need to be consistent income or increases in income should be represented by inflows and costs or increases in costs should be represents by out flows

• It is important to perform a separate tax calculation wherein you include all taxable income and expenses. Please note only the tax impact of wear and tear is relevant and therefore wear and tear should only be included in the tax calculation and not the NPV analysis.

mailto:[email protected]%25

119 MAC4862/102

Calc 3: Tax calculation

1 2 3 4

Sales 150 000 170 000 190 400 170 600 1/2r/w

Cost of sales -120 000 -132 000 -145 200 -121 968 1/2r/w

Sale of plant 1 000 1/2r/w

Wear and tear -23 200 -11 600 -11 600 -11 600 1r/w

Working capital write off -500 1r/w

Taxable income 6 800 26 400 33 600 37 532

Tax@28% -1 904 -7 392 -9 408 -10 509 1

MAX 13

Communication, logic and layout: 1 MAX 14

(d) For each of the risks identified below, explain the current initiatives undertaken by Piper that

will aid in mitigating the risk.

iii. The sale of unsafe supplies.

iv. Strong competition.

Risk. Attempted mitigation The sale of unsafe supplies. Piper has an advanced stock management system whereby supplies

with a limited shelf life are tracked, identified and scrapped. This limits the risk of the sale of unsafe supplies. (1)

Piper has stringent quality control procedures in place to ensure all

products manufactured are safe. (1)

Strong competition. The group is the leader in the field and tries to be innovative by

ensuring its supplies the very latest products. (1)

The group show cases and supplies its latest products at mining indabas and industrial shows. (1)

Piper send their own staff on regular training ensuring that staff are

well trained and are able to effectively assist customers. (1)

Piper gives training and refresher courses to its clients enabling

them to comply with the strict safety regulation governing their industry.

(1)

MAX 5 Communication, logical argument: 1

MAX 6

Comments: It is important to read the Required carefully, in this case the Required did not ask to explain the risks nor suggest mitigations but rather explain the initiatives Piper already has in place to mitigate the given risks.

mailto:Tax@28%25

120 MAC4862/102

MAC4861 - TEST 2 (2019) QUESTION 1 40 MARKS Khuselo (Pty) Ltd is a company that manufactures and installs vehicle-tracking devices and performs tracking services for various clients in South Africa. Customers who purchase devices from Khuselo can choose to subscribe for tracking services with Khuselo or any other service providers. Khuselo has been in operation for the past 10 years and has chosen to remain an unlisted entity.

The following financial information of Khuselo has been correctly prepared by their Management Accountant:

Extract of Statement of Profit or Loss of Khuselo (Pty) Ltd for the periods ended 30 March

Note 2019 2018 Change

R'000 R'000 %

Revenue 1 300 562 1 125 600 15,54%

Device sales revenue 585 253 450 240 29,99%

Subscription revenue 1 715 309 675 360 5,92%

Cost of Sales (702 303) (675 360) 3,99%

Gross profit 598 259 450 240 32,88%

Common size analysis

2019 2018

Revenue 100,00% 100,00%

Device sales revenue 45,00% 40,00%

Subscription revenue 55,00% 60,00%

Cost of Sales 54,00% 60,00%

Gross profit 46,00% 40,00%

1. Subscription Revenue 2019 2018 Change

Number of subscribers 425 779 375 200 13,48%

Average Annual Revenue per subscriber R 1 680,00 R 1 800,00 -6,67%

Proposal from Izinga Ltd (Izinga)

Izinga manufactures and supplies various mechanical parts for motor vehicles to distributors across Southern Africa. Izinga have communicated to Khuselo that they would like to initially acquire a 60% interest of the existing equity in Khuselo. After a year they would then like to acquire the remaining 40% equity interest and merge Khuselo and Izinga. Izinga plans on financing the acquisition of Khuselo by means of a share exchange.

Equity valuation of Khuselo

Ms. Sheshisa Nqamulela, the Management Accountant of Khuselo, took the initiative to prepare the following calculation of the equity value of Khuselo, based on the earnings multiple method of valuation:

121 MAC4862/102

Value of Equity = Profit After Tax X Price Earnings Ratio

Value of Equity of Khuselo = 247 961 000 X 11 = R2 727 571 000 ≈ R2.73 billion.

Where:

• 2019 Profit After Tax = 2019 Profit After tax of Khuselo = R247 961 000

• 2018 Profit After Tax = 2018 Profit After tax of Khuselo = R182 380 000

• Price Earnings Ratio = 2019 Price Earnings Ratio of Izinga Ltd = 11,00

Forecast Financial Information of Khuselo

The CFO of Khuselo compiled the following projected financial information to prepare for the possible negotiations with Izinga Ltd.

Notes 2020 2021 2022

R'000 R'000 R'000

Capital expenditure (i) 10 000 25 000 36 000

Depreciation and amortisation 35 000 45 000 57 000

Interest expense (ii) 56 000 56 000 56 000

Investment Income (iii) 23 307 23 307 23 307

Tax expense (iv) 99 731 112 642 129 364

Profit after tax 256 452 289 650 332 650

Notes to the forecasted financial information:

(i) Capital expenditure represents the planned capital spend on additions to property, plant and equipment. (ii) Interest expense relates to a long-term loan which has a market value of R 500 million. (iii) Khuselo invests excess cash, after considering the operational requirements

and capital investments, in short-term deposits. This cash is expected to earn a pre-tax rate of 11,00% per annum.

(iv) The tax expense is based on projected taxable income.

Working Capital requirements

2019 2020 2021 2022

R'000 R'000 R'000 R'000

Current Assets 232 015 256 000 352 620 421 560

Current Liabilities 220 125 218 490 326 360 369 665

Additional information

• The current inflation rate is 6,00% and is expected to remain the same for the foreseeable future.

• Khuselo’s target debt-equity ratio is 25,00%.

• Khuselo’s pre-tax cost of debt is 12,50%.

• The beta co-efficient of Khuselo is currently estimated at 1,15.

• The current annual yield on long-term government bonds is 6,25%, while the basket of listed companies in the same sector of Khuselo’s operation has averaged 16,25% per year.

• Assume a corporate tax rate of 28% for all periods.

• Khuselo expects its cash flows to grow at a stable rate of 6,00% per annum from 2023 onwards.

122 MAC4862/102

REQUIRED MARKS

Sub-total

Total

(a) Comment on the financial performance of Khuselo (in terms of revenue and gross profit) for the 2018 and 2019 periods. [Note: No calculations are required]

8

9

Communication skills: clarity and logic of arguments 1

(b) (i) Calculate the fair market value of a 60% equity interest in Khuselo as at 30 March 2019, using a free cash flow method of valuation and the provided information.

[Note: Provide detailed calculations for all inputs and round to the nearest R’000. The starting point of your valuation should be profit after tax]. Communication skills: presentation and layout

18 1

(ii) Identify and discuss the potential errors in the valuation performed by Ms Nqamulela [Note: No calculations are required].

4

(iii) Advise the shareholders of Khuselo of the advantages of receiving payment by means of a share exchange.

4

27

(c) Discuss key initiatives that can be implemented by Izinga after its merger with Khuselo to increase the merger’s chances of success.

4

TOTAL 40

123 MAC4862/102

MAC4861 - TEST 2 – SUGGGESTED SOLUTION (2019)

Revenue performance

Revenue improved The total company revenue has increased above the inflation rate, Thus revenue has grown in real terms.

1 1 1

This improvement in revenue is largely driven by the increase in revenue from device sales (29.9%) The selling price per device has increased This is supported by the increase in the number of subscribers (13.48%)

1 1 1

The subscription revenue increase (5,92% v 29,99%) was lower due to reduced subscription fees charged to customers compared to 2018 (R 1 680 vs. R 1 800) This could be an attempt by Khuselo to increase the number of subscribers.

1 1

The composition of revenue between subscriptions and devices sales changed as a result of a higher increase in device sales revenue compared to subscription revenue.

1

Gross profit performance

Gross profit has improved The improvement in gross profit (32,88%) is due to significantly lower increase in cost of sales (3,99%) compared to increase in revenue (15,54%).

1 1

The increase in cost of sales is lower than the increase in inflation, Therefore cost of sales is decreasing in real terms and enhancing gross profit growth.

1 1

The minimal nominal increase in cost of sales could be due to scale economies in producing and selling more devices and servicing more subscribers.

1

Khuselo is therefore effectively managing its costs. 1

This is evidenced by the decrease in the cost of sales to revenue from 60,00% to 54,00%, resulting in gross profit percentage improvement from 40,00% to 46,00%.

1

MAX 8

Communication skills: clarity and logic of arguments 1

MAX 9

(a) Comment on the financial performance of Khuselo (in terms of revenue and gross profit) for the 2018 and 2019 periods.

Comments:

• Student’s discussions were limited; remember the length of your discussion should be guided by the mark allocation

• Most students were unable to provide insightful comments i.e. linking movement to inflation, commentary of the change in the mix of subscriptions and device sales, reasons for the movements etc.

• Please note that with questions like these it is important to ask yourself, based on the information provided, what value added interpretations and conclusions can be made.

124 MAC4862/102

Calc 2: Continuing Value

= FCF2022 X (1+g) (WACC – g) = (351 554*1.06) 1c

(16%-6%) 1c

= 3 726 472

Calculations Calc 1: WACC

Debt-equity ratio 25,00% Debt =25/125 20,00%

Equity =100/125 80.00% 1r/w Pre-tax cost of debt 12,50%

12,50% X 0,72 9,00% 1 r/w

Ke = Rf + B(Rm – Rf = 6,25% + 1,15(16,25%-6,25%)

= 6,25% + (1,15 * 10,00%)

17,75% 2 r/w

Weight Cost WACC

Debt 20,00% 9,00% 1,80% Equity 80,00% 17,75% 14,20%

100,00% 16,00% 1c

b (i) Calculate the fair market value of a 60% equity interest in Khuselo as at 30 April 2019, using a

free cash flow method of valuation and the provided information.

Comments:

Students performed poorly within this section, the following points are to be noted:

• You were required to include a calculation of WACC as it is required as a discount rate and

sufficient information was provided to perform the calculation.

• Movements in working capital represent cash flows and are relevant, as they are required to

sustain the business.

• Non-operating income and expenses such as interest expense and investment income are

excluded as the instruments to which they relate are valued separately and deducted/added

to the enterprise value. Therefore the market value of these instruments would need to be

calculated, if not provided.

• Depreciation is not a cash flow but an accounting entry, therefore it should be excluded. Also

important to note is that there are no tax implications for depreciation.

• In the final year of projections i.e. 2022, a continuing value, taking into account expected

growth, must be calculated based on the principle of Gordons Growth model.

125 MAC4862/102

Calc 3: Market value of Investment 23 307/11% = 211 882 1r/w

0 1 2 3 2019 2020 2021 2022 R'000 R'000 R'000 R'000

Profit after tax 256 452 289 650 332 650

Interest 40 320 40 320 40 320

Reverse: Interest expense 56 000 56 000 56 000 1 r/w

Tax implication (15 680) (15 680) (15 680) 0.5c

Investment income (16 781) (16 781) (16 781)

Reverse: Investment Income (23 307) (23 307) (23 307) 1 r/w

Tax implication 6 526 6 526 6 526 0.5c

Subtotal 279 991 313 189 356 189

Reverse: Depreciation and Amortisation 35 000 45 000 57 000 1 r/w

Changes in working capital (25 620) 11 250 (25 635)

Current Assets (23 985) (96 620) (68 940) 1 r/w

Current liabilities (1 635) 107 870 43 305 1 r/w

Capital expenditure (10 000) (25 000) (36 000) 1 r/w

Free Cash Flow of the Firm 279 371 344 439 351 554

Continuing Value (Calc 2) 3 726 472

Net Cash Flows 279 371 344 439 4 078 026

Discount rate :16% (Calc 1) 1 c

Operating Enterprise Value 3 109 430 1c

Market Value of Other Assets (Calc 3) 211 882 0,5c

Total Enterprise Value 3 321 312

Less: Market Value of Debt (500 000) 1 r/w

Total Value of Equity 2 821 312

Marketability discount (5%) (145 864) 1c Adjusted Value of Equity 2 675 448

60% Value of Equity 1 605 269 1c

ALTERNATIVE


Reverse: Interest expense 56 000 56 000 56 000 1 r/w

Reverse: Investment Income (23 307) (23 307) (23 307) 1 r/w

EBIT: Earnings Before Interest and Tax

388 876 434 985 494 707

Tax charge (108 885) (121 796) (138 518)

Tax per income statement (99 731) (112 642) (129 364)

Reverse: Tax benefit on interest charge (15 680) (15 680) (15 680) 0.5c

Reverse: Tax on investment income 6 526 6 526 6 526 0.5c

Subtotal 279 991 313 189 356 189

MAX 18 Communication skills – l presentation and layout: 1

MAX 19

126 MAC4862/102

b(ii): Discuss the potential errors in the valuation performed by Ms Nqamulela

1

Maintainable earnings were not utilised to perform the valuation i.e. earnings were not adjusted for non-market related items, abnormal/extraordinary items etc.

1 2 The valuation is based on only the 2019 earnings, these earnings may not be truly

representative of Khuselo’s maintainable performance.

1

3 Maintainable earnings should be calculated considering whether there is a trend in historical earnings and if not a weighted average should be calculated.

1

4 The valuation is based on the PE ratio of a vehicle spare parts manufacturer, this may not be appropriate as this company is different to that of a vehicle tracking company.

1 5 The PE ratio used is not adjusted to match the risk profile, size, shares marketability,

management and operations of Khuselo.

1

MAX 4

b(iii) Advise the shareholders of Khuselo of the advantages of receiving payment by means of a share exchange.

1

Reaping benefits of long-term share price growth and future dividends in the merged company. Since the shareholders will continue to have a financial interest in the company there is potential to share in the increased earnings and market share value.

1 2 Reaping the synergistic benefits in the merged company. 1

3 Diversification benefit that the merged firm presents to shareholders thus reducing investment risk.

1

4 Tax advantages: Capital gains tax is deferred with a share exchange 1

5 Khuselo shareholders will hold shares in a listed entity, making their shareholding more marketable

1

Any valid point 1 Maximum marks 4

(c) Discuss the key measures that can be implemented by Izinga Ltd after the merger with Khuselo to increase the merger’s likelihood of success.

1

Stakeholder management/change management: engaging with affected stakeholders to consult with them and ensure their needs and interests with respect to the merger are catered for.

1

2 Uniform employee policies: kickstart a process to ensure policies applicable within the merged company are the same for employees coming from Khuselo and Izinga (remuneration, working conditions etc).

1

3 Standardization of processes and systems (operating model): ensure the ways of doing things and processes followed are standardised within the merged company. Promote the same organisational culture through-out the merged organisations to ensure same vision, mission and values are promoted and lived within the merged organisation.

1

1 4 Proper management of possible staff layoffs (retrenchments, down-sizing, right-

sizing) in the merged firm to avoid poor staff morale, litigation and costly exercises.

1

5 Enhance efficiency and eliminate duplicated functions. 1

6 They may need to train staff to ensure they have the requisite knowledge and skills. 1

Any valid point 1

Maximum marks 4