Amounts in the question exclude VAT, except where indicated. ElectriBolt Ltd ('ElectriBolt') is an independent electricity supplier with various power-generation operations throughout South Africa. ElectriBolt is listed on the main board of the Johannesburg Securities Exchange. The company's most recent financial reporting date was 31 December 2009. Background On 1 January 1999, ElectriBolt entered into a unique hydro-electricity supply licence agreement with the South African government ('the government'). The licence agreement entitled ElectriBolt to install three turbines at the Augrabies Waterfall, which is situated in the Augrabies National Park, and generate and supply electricity for a period of 15 years. The licence agreement provides that -
• ElectriBolt is required to pay the government a fixed instalment of R800 000 annually in arrear for the right to use the site to generate electricity; and
• the agreement is not renewable at the end of the 15-year term.
ElectriBolt decided to grant the right of use of the abovementioned supply licence, from the inception date of the agreement with the government (1 January 1999), to PowerSmart Ltd ('PowerSmart'), a large electricity supplier, for a period of 15 years. All licensing rights granted to ElectriBolt by the government were transferred to PowerSmart in exchange for a fixed annual instalment of R1 million, payable in arrear to ElectriBolt. By law the final operator of an electricity supply business is solely responsible and liable for any related environmental site rehabilitation. PowerSmart may not transfer or sell the supply licence to any other party. A cancellation penalty of R900 000 is payable by PowerSmart to ElectriBolt should PowerSmart at any stage unilaterally decide on the early cancellation of the agreement. On 1 January 1999, ElectriBolt did not recognise any assets or liabilities in respect of the hydroelectricity supply licence with the government and the right of use of the licence granted to PowerSmart. The R800 000 per annum for the supply licence is expensed on an annual basis and the R1 million per annum receipt from PowerSmart is recognised as revenue on an annual basis. This accounting policy is acceptable in terms of International Financial Reporting Standards. Feasibility study on PowerSmart's Augrabies operations ElectriBolt recently established that PowerSmart is underperforming at the Augrabies site and believes that significantly more electricity can be generated during the last four years of the supply licence. The major reason for PowerSmart's disappointing performance is the regular labour disputes experienced at the Augrabies operation. ElectriBolt conducted a feasibility study in December 2009 to evaluate the possible acquisition of PowerSmart's Augrabies operations. Following this feasibility study, ElectriBolt proposed acquiring the PowerSmart Augrabies division as a going concern, including all assets and liabilities of this division except for cash and cash equivalents and taxation liabilities. The licensing agreement between ElectriBolt and PowerSmart would be terminated as part of the acquisition.
The Chief Financial Officer (CFO) of ElectriBolt prepared the following cash-flow projections, following a detailed review of historic financial information of the Augrabies division of
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PowerSmart and its budgets for the next four years, for the purposes of valuing the Augrabies division:
Year ending 31 December
Notes
2010
2011
2012
2013
R
R
R
R
Turnover
1
18 000 000
18 000 000
18 000 000
18 000 000
Operating costs
1
(4 500 000)
(4 500 000)
(4 500 000)
(4 500 000)
Opportunity cost
2
(1 000 000)
(1 000 000)
(1 000 000)
(1 000 000)
Supply licence agreement instalments
(800 000)
(800 000)
(800 000)
(800 000)
Operating cost savings
3
300 000
300 000
300 000
300 000
Cost of helicopter lease
4
(480 000)
(480 000)
(480 000)
(480 000)
Depreciation: Turbines
(700 000)
(700 000)
(700 000)
(700 000)
Interest on long-term loan
5
(897 536)
(712 469)
(503 344)
(267 032)
Environmental site rehabilitation costs
6
-
-
-
(2 500 000)
Pending legal claim
7
-
-
-
-
Taxation
8
(2 778 290)
(2 830 109)
(2 888 664)
(2 254 831)
Net cash flows
7 144 174
7 277 422
7 427 992
5 798 137
Related calculations
Notes
Weighted average cost of capital (WACC)
9
23,00%
Net present value of the future cash flows of the Augrabies division of PowerSmart
9
R17 143 393
Notes to the cash-flow projections
1 Projected turnover includes a conservative estimate of the additional electricity that ElectriBolt could generate and supply, assuming it acquired control of the operations. Operating costs exclude annual supply licence payments due by PowerSmart to ElectriBolt.
2 Opportunity cost represents annual instalments in terms of the supply licence agreement, to which ElectriBolt will no longer be entitled.
3 PowerSmart incurred research and development costs during the period 2007 to 2009 aimed at improving operating efficiency. As a result thereof, PowerSmart expects a possible annual operating cost saving of R300 000 from 2010 to 2013. The CFO of PowerSmart is of the opinion that the cost saving is only 45% probable, resulting in the development costs not meeting the recognition criteria in terms of IAS 38, Intangible Assets, for recognition as an intangible asset. It follows that development costs were immediately expensed when incurred.
4 PowerSmart leases an executive helicopter from Fly-with-Me Airways (Pty) Ltd at a fixed instalment of R360 000, payable annually in arrear. The lease agreement was correctly classified as an operating lease in terms of IAS 17, Leases. The lease agreement
commenced on 1 January 2008 and ends on 31 December 2012. On 31 December 2009, it was reliably established that similar executive helicopters can be leased at a market-related fixed instalment of R480 000, payable annually in arrear.
5 PowerSmart obtained a long-term loan of R15 million on 1 January 1999 to finance this particular operation. The long-term loan is repayable in 15 equal annual instalments, which commenced on 31 December 1999. The loan bears interest at a fixed rate of 13% per annum. The loan agreement provides that the loan cannot be repaid earlier than the agreed repayment profile. On 31 December 2009, long-term loans with a similar risk profile and remaining maturity were available at a fixed rate of 12% per annum.
6 This amount has been reliably estimated by an independent environmental rehabilitation expert.
7 Labour unrest increased after the recent dismissal of a number of PowerSmart's employees as a result of increased operational inefficiency. The trade union to which these employees belong has instituted a legal claim against PowerSmart on behalf of the employees on the grounds of unfair dismissal. The legal advisers of PowerSmart are of the opinion that -
• the dismissed employees have a valid claim against PowerSmart for unfair dismissal;
• the trade union will not be able to prove the claim for unfair dismissal in court, due to a lack of evidence; and
• it is possible but not probable that the court will require PowerSmart to make a financial settlement to the dismissed employees.
The CFO did not include any amount relating to the legal claim in the forecast cash flows. Should such a claim be successful, any amount paid by PowerSmart will not be deductible for tax purposes. The fair value of the legal claim at 31 December 2009, as reliably determined by an experienced actuary, is R450 000.
8 All items in the cash-flow budget have been assumed to be taxable or deductible for income tax purposes, except as per point 7 above.
9 The nominal WACC of ElectriBolt is 23% and the forecast cash flows have been discounted using this rate.
Financing alternatives On 31 December 2009 the Augrabies division of PowerSmart was acquired by ElectriBolt as a going concern, including all assets and liabilities of the division except for cash and cash equivalents and taxation liabilities. The purchase consideration of R16 million was paid by ElectriBolt on 31 December 2009. It was correctly established that the transaction between ElectriBolt and PowerSmart constitutes a 'business combination' as defined in IFRS 3, Business Combinations. ElectriBolt is considering various financing alternatives for the business combination transaction:
• Payment out of existing cash reserves of R16 million; or
• Obtaining a R16 million medium-term loan from ElectriBolt's bankers. The loan is to bear interest at 1% above the prevailing prime overdraft rate. This is the company's incremental cost of borrowing. The loan is to be repaid in one bullet payment at the end of four years. Interest is to be calculated and compounded annually in arrear, and capitalised into the outstanding loan balance. Transaction costs of 1% of the principal amount will be payable at the inception of the medium-term loan. The interest to be incurred on such a long-term loan is deductible for taxation purposes in terms of section 24J of the Income Tax Act; or
• The issue of compulsory convertible preference shares with a par value of R16 million. Preference shareholders will be entitled to an annual dividend calculated as 80% of the prevailing prime overdraft rate multiplied by the par value of shares held. ElectriBolt is required to pay preference dividends annually in arrear and has no discretion with regard to declaring these dividends. Each preference share will automatically convert into one ordinary share after four years. Analysts predict that the value of the converted shares at the end of year four will amount to R17 800 000.
Draft statement of financial position of the Augrabies division of PowerSmart as at 31 December 2009 The information below represents an extract from the draft statement of financial position of the Augrabies division of PowerSmart as at 31 December 2009, which contained inter alia the following:
Notes
R
ASSETS
Non-current assets
Property, plant and equipment
1
9 750 000
Current assets
Inventories
2
750 000
Trade receivables
3
300 000
Cash and cash equivalents
250 000
LIABILITIES
Non-current liabilities
Long-term borrowings
4
5 480 535
Deferred tax
5
592 200
Long-term provisions
6
-
Current liabilities
Trade payables
7
435 000
Current portion of long-term borrowings
4
1 423 590
South African Revenue Service (SARS)
115 000
Notes
a Items of property, plant and equipment are subsequently measured according to the cost model in terms of IAS 16, Property, Plant and Equipment. The market value of the property, plant and equipment as at 31 December 2009 was R14 million.
b The fair value of inventories was reliably determined at R800 000 as at 31 December 2009.
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c The balance of net trade receivables comprised the following as at 31 December 2009:
R
Gross trade receivables
480 000
Less
(180 000) : Allowance for doubtful debts*
300 000
* The SARS grants a tax deduction of 25% of the allowance for doubtful debts for taxation purposes. The fair value of trade receivables as at 31 December 2009 was reliably determined at R400 000.
d Long-term borrowings are subsequently measured according to the amortised cost model in terms of IAS 39, Financial Instruments:
Recognition and Measurement. Long-term borrowings consisted of the following as at 31 December 2009:
R
Long-term loan
6 904 125
Less
(1 423 590) : Current portion of long-term borrowings
5 480 535
e The deferred tax balance as at 31 December 2009 was calculated as follows:
Asset/liability
Carrying amount
Tax base
Temporary difference
R
R
R
Property, plant and equipment
9 750 000
7 500 000
2 250 000
Inventories
750 000
750 000
-
Trade receivables
300 000
435 000
(135 000)
Long-term loan
6 904 125
6 904 125
-
Trade payables
435 000
435 000
-
Taxable temporary differences
2 115 000
Deferred tax calculated at 28%
592 200
f No provision has been recognised in the statement of financial position of PowerSmart in respect of the environmental site rehabilitation. 70% of the damage caused to the environment occurred when the turbines were installed, while the remaining 30% of the damage to the environment is caused evenly over the duration of the contract. No environmental rehabilitation activities had been undertaken by 31 December 2009 and the CFO therefore holds the opinion that no provision should be recognised in the statement of financial position until the electricity supply operation ceases. The SARS will allow the amount incurred in respect of environmental rehabilitation costs as a deduction for taxation purposes when it is actually paid.
g The fair value of trade payables as at 31 December 2009 was reliably determined at R500 000.
h The supply licence, the use of which was granted by ElectriBolt, had a fair value of R4 500 000 at 31 December 2009 based on the terms of the licensing agreement between ElectriBolt and PowerSmart. If a similar right with payments at market rates were granted at 31 December 2009, it would have a fair value of R5 million.
Additional information Where appropriate and unless stated otherwise, the SARS accepts the acquisition date fair values of assets and liabilities for taxation purposes. The current prime overdraft rate is 10% per annum, nominal and pre-tax. REQUIRED PART A - to be answered in a separate book
(a)
Identify, with reasons, any errors in and omissions from the cash flow forecasts and discounted future cash flows of the Augrabies division of PowerSmart Ltd as prepared by the CFO of ElectriBolt Ltd.
(b)
Identify and describe any advantages and disadvantages of ElectriBolt Ltd settling the purchase consideration due to PowerSmart Ltd using its own cash resources.
(c)
With regard to ElectriBolt Ltd evaluating the financing of the acquisition of the Augrabies division of PowerSmart Ltd through obtaining the medium-term loan or through the issue of the preference shares -
(i) calculate and determine which instrument will be more cost effective for ElectriBolt Ltd to use; and
(ii) discuss any other factors ElectriBolt Ltd should consider in deciding which instrument to use.
Presentation marks: Arrangement and layout, clarity of explanation, logical argument and language usage.
PART B - to be answered in a separate book
Prepare a report to the CFO of ElectriBolt Ltd in which you discuss, with reasons, the following items at the acquisition date of the acquired operations and net assets of the Augrabies division of PowerSmart Ltd:
(i) The recognition of the pending court case between PowerSmart Ltd and the trade union;
(ii) The recognition of the provision, if any, for environmental site rehabilitation; and
(iii) The recognition and measurement of the compulsory convertible preference shares if these are issued as consideration for the acquisition.
(e)
Prepare the journal entries that should be processed by ElectriBolt Ltd on 31 December 2009 in respect of the acquisition of the Augrabies division of PowerSmart Ltd on 31 December 2009. Your solution must include the workings of the deferred taxation consequences of all recognised assets and liabilities.