MAC3702 Assignment 2 (QUALITY ANSWERS) Semester 2 2024

This document contains workings, explanations and solutions to the MAC3702 Assignment 2 (QUALITY ANSWERS) Semester 2 2024. For assistance whats-app us on 0.6.8..8.1.2..0.9.3.4... QUESTION 1 (25 marks; 45 minutes) Lesidi Limited, a company listed on the Johannesburg Stock Exchange (JSE), specialises in manufacturing paint. Their flagship product, Yizo, has been rated the best paint by the South African Paint Association for the past ten years. This top award has driven Lesidi's success and challenged them to innovate continuously to maintain Yizo's quality standards. The company has developed various Yizo product variations and is always looking for innovative ways to improve and expand the range. Recently, Lesidi identified a promising spray paint product that could complement the Yizo product line without compromising its brand quality. They are considering acquiring Bafifi (Pty) Limited, as they are impressed with the high-quality spray paints Bafifi produces. Bafifi manufactures spray paint and primer products. Over the past five years, Bafifi has experienced significant growth, driven primarily by its innovative product development. Recently, Bafifi introduced an all-in-one, single-coat application spray paint. This new product allows customers to apply just one coat for both priming and painting, eliminating the need for separate primer and paint applications. Lesidi is considering making a bid for Bafifi. Bafifi has 10 million shares in issue. The following information relating to Bafifi is provided: Year 1 Year 2 Year 3 Year 4 2023 2024 2025 2026 R’000 R’000 R’000 R’000 Actual Forecast Forecast Forecast Revenue 260 000 291 200 * * Cost of Sales (125 000) (174 720) * * Gross Profit 135 000 116 480 * * Other Operating expenses (40 000) (46 000) * * Depreciation (23 000) (23 000) (23 000) (23 000) Profit from Operations 72 000 47 480 * * Finance Costs (24 000) * * * Profit before tax 48 000 * * * Taxation – 27% (12 960) * * * Profit after tax 35 040 * * * QUESTION 1 (continued) 1. Forecast for 2024 to 2026 Bafifi’s forecast was prepared using the following assumptions • Sales prices are projected to increase by 12% in 2024 and thereafter by a constant growth of 7%. • Bafifi’s gross profit percentage is expected to decrease in 2024 due to the introduction of a new product thereafter increase by 5% in 2025 and then return to the 2023 levels in 2026. • Bafifi’s expects to increase its operating profit margin by limiting the increase in other operating expenses, to only 5% per year from 2025. • Assume that depreciation amount equals tax allowances. • Bafifi took out a loan with Buzz bank of R100 million at the beginning of 2023 to finance the development of the new spray product. The loan bears an interest rate of 10% with interest payable annually on the last day of the year. The loan capital amount is repayable in 2025. The interest payments for 2023 included interest payments on another loan with Buzz Bank, which was fully settled in 2023. • The marginal tax rate is 27% payable in the year in which the liability arises. Continuing Value • Using year 3 as the base year, Free cash flows beyond year 3 are expected to grow at a constant rate of 5%. • Bafifi’s current weighted average cost of capital (“WACC”) equals 17% and its target WACC is 16.5%. • Lesidi’s current WACC is 16% and its present capital structure is close to a target capital structure for a company of its nature and size REQUIRED: For each question below, remember to: • Clearly show all your calculations in detail; • Where necessary, indicate irrelevant amounts/adjustments with a R0 (nil-value); and round all your workings to two decimals • Amounts must be presented in R’000 a) Complete the table by calculating Bafifi’s forecast from 2024 to 2026 taking into account the forecast information provided. (8) b) Calculate the value of the company Bafifi (Pty) Ltd using the Free cash flow valuation method. (10) c) Justify with reasons why the Free cash flow valuation method was a more appropriate valuation method for determining the company value of Bafifi (Pty) Ltd. (4) d) Justify with reasons your choice of the discount rate factor used in discounting the future free cash flows to present values. (3) Total marks for the Question 1 (25) QUESTION 2 (35 marks; 63 minutes) Odwa Ltd is a listed company considering raising new finance to fund the acquisition of a new machine. The value of machine is set at $1million. The directors of Odwa are in the process of deciding whether debt or equity finance should be used to fund the acquisition. However, if equity is to be used, the new shares will be issued at a current market price of R7.00 per share. Extracts from Odwaa Ltd’s statement of financial position at 31 December 2024: Notes 2024 2023 R’000 R’000 Share Capital Preference 1 650 000 50 000 Accumulated profit prior year 2 513 000 11 000 Revaluation Surplus/rev @ FV 3 13 000 1 500 Long term borrowings - FNB 4 24 000 32 000 Short term bank overdraft - Capitec 5 11500 17 750 Deferred taxation liability/assets 1 000 1 000 Notes 1. Odwa has an authorised share capital of 100 million, with 10 million shares already issued. The company's dividend policy is to pay a dividend that grows at a constant rate of 7.5% per year, starting from R0.50 per share in 2023. Certain shareholders have recently protested that the dividend amount should be increased at a higher growth rate due to the company's strong financial performance. 2. The company's managing director, NM Smit, has suggested using retained earnings/accumulated profit to finance machinery instead of debt or equity. She proposes that no dividend be declared for the current financial year, and that the machinery be purchased instead. 3. The company buildings are revalued annually by an independent valuator. The revaluation surplus occurs when the valuation exceeds the carrying amount of the buildings. 4. Long Term Borrowings of R40 million was obtained from Merchant Rand Corporation. The loan is repayable in five annual instalments of R8 million starting from 31 December 2023. Interest payments on the loan are paid every year. The loan bears an interest rate of a variable interest rate of 12% and currently, the market rate for similar loans at 2024 is 13%. 5. The company uses bank overdraft as and when there is an operation need for it. The overdraft is provided by Pixie bank at a rate of 16% per annum. The interest rate has remained the same for the last two years. Additional Information I. The machine is to be acquired from China. The machinery will be shipped under the terms and conditions that require the company to take the responsibility for the machinery as soon as it is shipped from China. QUESTION 2 (continued) II. The company is considering the following finance options for the acquisition of the machinery: • NM Smit’s proposal to finance the machinery using retained earnings/accumulated profit. • Obtaining an additional loan from Pixie bank of R18 million payable on the same terms as the current loan from Merchant Rand Corporation but starting on 01 January 2025 and ending after four years on 31 December 2028. The loan will also bear a variable interest rate similar to the current loan and interest payment terms will also be the same. • Obtaining a medium-term loan from the supplier in China repayable in one bullet payment after four years at a 4% fixed interest rate. • Issuing additional shares to finance the acquisition of the machinery. III. The marginal tax rate is 27%. IV. The company’s target capital structure is 40:60 (40% debt and 60% equity). V. The current exchange rate to is $1=R18 REQUIRED: For each question below, remember to: • Clearly show all your calculations in detail; • Where necessary, indicate irrelevant amounts/adjustments with a R0 (nil-value); and round all your workings to two decimals a) Calculate Odwa Ltd's debt-to-equity ratio using book values and provide commentary on the current capital structure. Use Year A and Year B instead of 2023 and 2024. (4) b) Calculate the Weighted Average Cost of Capital (WACC) of Odwa Ltd for the 2024 financial year based on the current capital structure. (please ignore the acquisition of the machinery for this part). (13) c) Discuss the factors that the board must consider when deciding on the best finance options. (Please limit your discussion to three points per finance option and address them under the following headings, only if the heading is relevant to the finance option: • Capital Structure • Cost Considerations • Financing Possibilities • Impact on the Business • Matching) (12) d) Describe the key business risks associated with the importation of the machine from China that Odwa Ltd must consider prior to purchasing the machinery, and also provide possible mitigation options for each identified risk. (Please restrict your discussion to three potential risks.) (6) Total marks for the Question 2 (35) QUESTION 3 (40 marks; 72 minutes) Molapo Kannete established a stokvel in the Eastern Cape ten years ago. Over time, it has grown to fifty members, each contributing varying amounts monthly. The money was collected from members is invested into a fixed deposit account with the local bank. In the last meeting of the stokvel members, the members took a decision to incorporate an investment company Shaka (Pty) Ltd (“Shaka”) and to transfer all the savings into the investment company. As as 30 June 2024, the date of transfer, the stokvel had a fixed deposit amount of R5 million maturing on 31 December 2024, which was transferred into Shaka. The members were presented with two mutually exclusive investment alternatives for their consideration. Molapo is advocating for Shaka to invest the R5million maturing in December, in either one of these investments. Investment A – Lot Take delivery service programme (acquisition of scooters) The stokvel is considering enrolling Shaka in a Lot Take delivery services programme. This programme is designed to empower small businesses by providing them with the opportunity to handle the transportation of Lot Take online orders. To qualify for the programme the Shaka must comply with the following: 1. Own 200 scooters that must be made available for Lot take deliveries for a period of four years. Each scooter cost R20 000. 2. Service all scooters quarterly at a cost of R500 per scooter. 3. Ensure that at least 220 riders are available for 200 scooters. Riders must be available seven days a week, and 200 riders must be on duty at all times. 4. Pay riders an annual fee of R35 000 per rider. 5. Pay insurance and fuel per scooter estimated at R250 per month. 6. Pay upfront a Lot Take delivery association fee of R100 000. This fee is fully refundable at the end of the programme. Lot Take will remunerate Shaka an annual fixed fee of R52,000 paid quarterly per scooter for the deliveries made throughout the year. Scooters are depreciated at a rate of 25% per annum for both tax and accounting purposes. The estimated resale value of the scooters at the end of year four is projected to be 10% of the original cost. Shaka expects to sell the scooters at the end of year four, when the programme ends. Investment B – Acquisition of Residential flats in Groblersdal Molapo has recently commissioned research on the commercial expansion occurring in the Groblersdal area on behalf of Shaka. According to this report, there is a significant shortage of residential accommodation due to the influx of migrant workers seeking accommodation in the region. The report suggests that investors consider are considering the opportunity of leasing and refurbishing old flats and then subletting them to the migrant workers. QUESTION 3 (continued) The report has also identified a building that houses 30 flats that is available for rental. The following information relates to the building: 1. Period of lease required by the owner of the building is four years on a monthly rental of R75 000, payable annually upfront. The first annual payment is due on the date the lease is signed, with the remaining payments to be made at the beginning of each lease year. A deposit of R300 000 is also required on signature of the lease and is refundable on last day of the lease term. 2. Expected cost of refurbishment required before occupation by the new residents is R1million. South Africa Revenue services will allow an annual deduction of 25% of the total refurbished costs. 3. Expected annual rental income from the new residents is R1 800 000 for year 1 to year 4. 4. Expected maintenance and an operating cost is R10 000 per month. 5. Water and electricity costs are estimated to be R1 000 per month per flat, payable by the new residents, and while Shaka will pay the landlord R2 000 per month for the shared area of the building. Molapo family connections with Lot Take Molapo’s wife is the General manager of Lot Take. She has provided an undertaking that should the Shaka opts for investment A, she will ensure that Shaka is prioritised and that their onboarding is fast tracked even if they have not yet acquired the 200 scooters. She has also referred Molapo to the Logistics manager of Lot Take, who is responsible for management and supplier selection of the programme, to discuss the logistics manager’s required compensation in order to fast track the selection and onboarding. Additional information • The marginal tax rate is 27%. • The targeted Weighted Average Costs of capital is 15% Page 8 of 8 QUESTION 3 (continued) REQUIRED For each question below, remember to: • Clearly show all your calculations in detail; • Where necessary, indicate irrelevant amounts/adjustments with a R0 (nil-value); and round all your workings to two decimals a) Advise the owners of Shaka (Pty) Ltd on which investment option (either A or B) should be selected using the NPV analysis. (27) b) Discuss why Shaka (Pty) Ltd would prefer Investment B over Investment A despite the investment analysis conducted in (a). Please ignore ethical matters in answering this question (b). (3) c) Assume Shaka (Pty) Ltd raises the R5million required for either Investment A or B by issuing preference shares that accrues a 13% dividend annually. Preference shares are redeemable at a discount of 5% after four years and similar preference shares are currently trading at 14%. Calculate the market value of the preference shares on date of issue. (5) d) In relation to Molapo family connections, along with the meeting with the logistics manager, discuss the potential ethical matters that are evident in this scenario.