Application of Financial Management Techniques

QUESTION

PART A

Simon & Son Ltd is a medium size manufacturing business that is highly dependent on electricity for production.

Due to the recent load shedding, the production and profit of the company is under massive strain. The directors have decided to invest in a solar power system as an alternative energy source, to minimise the impact of load shedding on the business as there is no other short to medium-term solution to the national electricity crisis. The project cost is estimated at R16 250 000 and will commence as soon as the funding of the project is confirmed.

The three directors of the company are still not in agreement on how to fund the project and have tasked your consulting team to investigate the three options on the table as possibilities of funding the project. They will then make a final decision based on the information provided by your consulting team.

From the minutes of the last board meeting you gathered that the views of the three directors are as follows:

Managing director

He is of the opinion that the project should be financed through the issuing of new shares as debt finance is riskier than equity finance.
Chief operating officer

He is of the opinion that the project should be financed through the issuing of cumulative redeemable preference shares. He believes that this instrument is cheaper than other debt instruments available to the company.

Finance director

She is of the opinion that the company should use a mix of debt and equity. Unfortunately, she was not able to support her recommendation with proper reasons as the meeting had to be adjourned due to time constraints and other meetings.

Your management consulting team was tasked by the finance director to

- critically evaluate each of the director's views

- calculate the cost of capital for the proposed project

- establish the capacity of the company to raise debt, equity or both

The following is an extract of the statement of financial position at 28 February 2016.

Notes

1. The issued ordinary share capital is made up of 1 million shares. The latest known share price was R66 cum div and the company has just declared a dividend of R6 per share. The dividends are expected to grow at a rate of 8% per annum.

2. The retained earnings are not available for future projects.

3. The debentures were issued at an annual pre-tax coupon rate of 11,11% redeemable at the end of eight years. Three of the eight years have already expired and similar debentures are currently yielding at an annual pre-tax coupon rate of 13,89% in the market.

4. The 9% preference shares are redeemable at a premium of 5% in 10 years' time. Dividends for the current year have been paid and the preference shares in a similar risk class are currently yielding 12% per annum.

5. The bank overdraft bears an average interest rate of 12,5% (after tax) per annum. The overdraft is used to bridge the working capital requirements when the need arises, and the balance fluctuates monthly.

6. The current effective tax rate is 28%.

7. The company has a target capital structure of 60% equity and 40% debt. The 40% target debt consists of 20% debentures and 20% preference shares.

REQUIRED

a) Calculate the cost of capital for evaluating proposed project and indicate briefly what assumptions underlie the use of this cost for the new project.

b) Prepare a memorandum to the board of directors where you critically evaluate each of the director's views on the appropriate funding instrument.

c) With supporting calculations, demonstrate the company's ability / capacity to raise debt, equity or both, if working towards the target capital structure.

d) Discuss five (5) qualitative factors that the directors should consider in the planning of the implementation of the project.

QUESTION 2

Umfula.co.za Ltd is a listed South African electronic commerce company with headquarters in Cape Town. It is the largest internet-based wholesaler in South Africa and is seen as a potential target for acquisition by financial analysts.

Umfula.co.za Ltd started as an online bookstore, but soon diversified, selling DVDs, VHSs, CDs, video and MP3 downloads/streaming, software, video games, electronics, apparel, furniture, food, toys, and jewellery. The company also produces consumer electronics - notably, Umfula.co.za e-book readers, Umlilo tablets, Umlilo TV and Umlilo Phone - and is a major provider of cloud computing services.

The value of the company has therefore been a matter of public debate in recent weeks and the following financial information is available:

Statement of financial position information on 31 December 2015

All sales were on 30 days' credit to commercial customers. In order to encourage customers to pay on time, Umfula.co.za proposes introducing an early settlement discount of 1% for payment within 30 days, while increasing its normal credit period to 45 days. It is expected that, on average, 50% of customers will take the discount and pay within 30 days, 30% of customers will pay after 45 days, and 20% of customers will not change their current paying behaviour (thus paying in 60 days).

Umfula.co.za is currently placing orders of 1 500 units of the Umlilo-Phone (U-phone) per month, the demand for which is constant. Pear Ltd is the only supplier of U-phone and the cost of U-phone purchases over the last year was R54 million. The supplier has offered a 2% discount for orders of U- phone of 3 000 units or more. The average stock on hand is 750 units (1 500/2). Each order costs Umfula.co.za R3 000 to place and the holding cost is R50 per unit per year. The revised accounts receivable policy will be financed by the overdraft facility.

Additional information

1. The shares of Umfula.co.za Ltd have a nominal (par) value of 100c per share and a market value of R5.00 per share.

2. The cost of equity of the company is 9%.

3. The business sector of Umfula.co.za Ltd has an average price/earnings ratio of 17 times.

4. The 8% debentures are redeemable at nominal (par) value of R100 per debenture in seven years' time and the after-tax cost of debt of Umfula.co.za Ltd is 6% per year.

5. The expected net realisable values of the non-current assets and the inventory are R276m and R130m, respectively.

6. In the event of liquidation, only 80% of the trade receivables are expected to be collectable.

7. Umfula.co.za has an overdraft facility charging interest of 10% per year.

REQUIRED

a) Calculate the impact on the collection period as well as the financial impact (in R'millions) of the net benefit or cost of the proposed changes in trade receivables policy and remark on your findings. Round off the rand values to million and all other calculations to 1 decimal.

b) Calculate (in millions) whether the bulk purchase discount offered by Pear Ltd is financially acceptable; and explain the assumptions outlined by your calculation.

c) Calculate the value of Umfula.co.za Ltd using the following methods:

i). market capitalisation (equity market value)

ii). net asset value (liquidation basis)

iii). price/earnings ratio method using the business sector average P/E ratio

iv). Gordon's Growth Model using:

the br_e model for growth (g = br_e)

where:

b = historic retenstion ratio{sum of the historic profit after dividend and tax/sum of the historic profit after tax}

r_e = current return on shareholders fund{Ordinary share capital/Accumulated reserves}

d) Analyse and debate the relative merits of the valuation methods in part (c) above in determining a purchase price for Umfula.co.za Ltd.

Communication skills - clarity of expression, layout and communication 

QUESTION 3

Purified H₂O (Pty) Ltd (Purified H₂O) is a private company selling purified water to companies, government departments and individuals mainly in the Gauteng area.

The company sells bottled water ranging from 500 ml to 10 litres. The business is growing faster than anticipated and as a result the directors have decided to open one more city branch in either Sandton or Pietermaritzburg. Purified H₂O has limited financial resources and can only invest in one branch.

You, as the chief financial officer, have been requested to analyse the commercial viability of the two cities and recommend which city will be the best for opening the branch. After much research, the following information is available to you:

The Sandton market

1. The new purifying machine will cost the company R600 000 and can be sold for R100 000 in five years' time. Working capital of R120 000 will be required at the opening of the branch.

2.

3. The following are prices for different bottle sizes at the Sandton branch for walk-in customers:

500ml - R5
1l - R7,50
5l - R25
10l - R50

105 000 walk-in customers ("sales volume") are projected annually for the next five years. Sales volume is expected to be equal for 500 ml, 1 l and 5 l. The 10l bottle size has a low demand and it is expected that its sales volume will be half that of 500ml. The sales mix is estimated to remain the same for the next five years.

4. The Sandton Conference Centre (SCC) is interested in securing a contract with Purified H₂O to be the sole provider of bottled water for their conference facility over a period of five years. The conference centre has 20 conference rooms that are used for 26 days in a month, with an average daily consumption of 50 units of 500 ml bottled water per conference room. A special price of R4 per 500 ml has been agreed with SCC.

5. Good Life Restaurant at Sandton Square has agreed to purchase annually 200 000 500 ml bottles on condition that the price is R4.50 per bottle for the next five years.

6. Variable costs are estimated at R1 019 000 and fixed costs, including depreciation at R975 000.

The Pietermaritzburg market

1. Purified H₂O will buy a second hand purifying machine at a cost of R500 000. The working capital of R80 000 at the start of the project.

2. Normal average sales to walk-in customers are estimated at R3 500 000 per annum and are estimated to remain the same for the next five years.

3. The company has registered on the supplier databases of government departments in Pietermaritzburg. It is estimated that an average of R200 000 sales per annum will be generated from the departments. These projections are in line with the actual sales received by the Pretoria CBD branch.

4. The contribution ratio of the total branch sales is projected at 70% for the duration of this five-year venture.

5. Cash fixed costs are estimated at R900 000 per annum.

Additional information

1. The current company tax rate is 28%.

2. The company uses a weighted average cost of capital of 12%.

3. SARS allows a wear and tear of six years for a brand new purifying machine, and five years for a second-hand machine.

4. The depreciation policy of the company is eight years for new machines and five years for second- hand machines

REQUIRED

Advise the management team of Purified H2O whether they should invest in any of the two branches

QUESTION 4

Simphiwe is the financial manager of S&S Ltd and has been instructed to find a suitable funding instrument for new equipment that needs to be purchased at a cost of R375 000. He has identified two possible funding instruments, namely a loan from CapC Bank and the issue of new shares. He has discussed the loan option with the bank manager from CapC Bank and also had discussions with a few investors that are interested in taking up some shares in S&S Ltd.

The following information is available based on the outcome of his discussions:

CapC Bank

1. The bank manager of CapC Bank has agreed to grant a loan of up to 100% of the total purchase value.

2. The loan will be granted in multiples of R75 000, and S&S Ltd can decide how many multiples they would like to borrow from the bank.

3. For a 100% loan, the risk is higher and therefore the interest rate charged for a 100% loan is 17.5% before tax.

4. For every R75 000 not taken up by S&S, the interest rate will decrease by 0.50% as the risk to the bank reduces.
Issue of new shares to prospective investors

1. Investors are very keen to invest in S&S Ltd and after discussions, Simphiwe identified enough interested parties to take up 100% of the investment amount needed.

2. If everything is financed through equity the equity holders will require a return of 15% per annum on their investment.

3. If a portion of the funds are generated through the loan the investors are of the opinion that it will increase their risk and they will therefore require a greater return on their investment. They have agreed that they will require an additional return of 0.25% for every R75 000 that is borrowed from CapC Bank.

Additional information

The tax rate of the company is 28%.

REQUIRED

Determine the optimal capital structure of S&S Ltd to finance the new equipment.