QUESTION

Brand Ltd commenced operating in the early 1960s as a manufacturer of heavy-duty industrial equipment and has over the past 20 years significantly diversified its business activities to include other equipment manufacture, industrial distribution and motor dealerships. Brand Ltd operates in ten countries, employs approximately 2 500 personnel and is considered to be an industrial brand management company.

Brand Ltd is owned by three non-related families who are not actively involved in the business. At a recent off-site meeting and as part of formulating the future growth strategy of the business, the management of Brand Ltd determined that the way forward for them and ultimately for Brand Ltd was to list on the JSE Securities Exchange in the near future. Management would as part of the listing seek to be incentivised with a reasonable equity stake. Alternatively, they propose a management buyout of Brand Ltd to be funded by a consortium that would include private equity players and financial institutions. The financial manager of Brand Ltd was requested to perform a preliminary valuation of Brand Ltd to evaluate these options. The results of that valuation are set out below:

Earnings valuation

Operating profit before depreciation and after
exceptional items
Less Dividend
2004
R'000
53 400
(9 680)
Net earnings
Earnings multiple
43 720
x 5
Earnings based value 218 600
Free cash flow valuation
2005
R'000
2006
R'000
2007
R'000
Total
R'000
Profit before taxation
Less Working capital movements
Less Tax
42 497
(15 000)
(14 838)
55 187
(5 000)
(18 944)
61 620
(10 000)
(21 647)
Free cash flow
Discount factor
Present value of free cash flows
12 659
0,870
11 013
31 243
0,756
23 620
29 973
0,658
19 722
54 355
Terminal value: 29 973 *(1+4%)/15%
Discount factor
207 813
0,658
136 741
Free cash flow value 191 096
12
The following was attached to the valuations for information purposes:
INCOME STATEMENTS
FOR THE YEARS ENDED 31 DECEMBER
AUDITED FORECAST
2002
R'000
2003
R'000
2004
R'000
2005
R'000
2006
R'000
2007
R'000
Turnover 198 240 239 870 230 276 239 487 268 225 287 001
Operating profit
Fair value adjustments
Finance costs
Income from investments
Goodwill amortisation
32 710
0
(2 810)
510
(2 132)
32 143
2 020
(2 040)
790
(3 179)
43 062
(5 120)
(1 860)
1 850
(2 274)
47 897
0
(6 400)
2 000
56 327
0
(7 240)
2 100
63 140
0
(5 170)
2 250
Profit before exceptional items
Exceptional items
28 278
0
29 734
(3 979)
35 658
2 968
43 497
(1 000)
51 187
4 000
60 220
1 400
Profit before taxation
Taxation
28 278
(9 899)
25 755
(9 620)
38 626
(13 570)
42 497
(15 478)
55 187
(19 584)
61 620
(22 286)
Profit for the year 18 379 16 135 25 056 27 019 35 603 39 334
SUPPLEMENTARY FINANCIAL INFORMATION
2002
R'000
2003
R'000
2004
R'000
2005
R'000
2006
R'000
2007
R'000
Operating profit is arrived at
after taking into account
Cost of sales
Depreciation
Operating lease charges
Research and
development
81 873
4 950
5 390
1 150
113 699
6 810
5 910
1 151
105 696
7 370
6 180
1 151
100 584
10 000
6 320
1 197
109 972
13 000
6 480
1 341
111 930
15 000
6 450
1 435
Fair value adjustments relate
to the restatement of
financial instruments
Unrealised portion
0 1 310 (3 910) 0
0
0
Finance costs comprise
Working capital funding
Loans to fund the capital
expenditure
(210)
(2 600)
(143)
(1 897)
(97)
(1 763)
273
(6 673)
349
(7 589)
528
(5 698)
Total (2 810) (2 040) (1 860) (6 400) (7 240) (5 170)
Exceptional items comprise
Profit/(loss) on sale of
plant
Asset impairment provision
0
0
(984)
(2 995)
3 281
(313)
(1 000)
0
4 000
0
1 500
(100)
Total 0 (3 979) 2 968 (1 000) 4 000 1 400
Taxation includes
Secondary tax on
companies
1 133
1 378
1 210
1 879
1 924
2 568
13
Brand Ltd has forecast capital expenditure amounting to R26 million, R24 million and R15 million for the 2005, 2006 and 2007 financial years respectively. It is anticipated that the capital expenditure will be incurred evenly during the respective financial years and will be financed solely by external borrowings.

Proceeds on the sale of plant are projected to be R8 million, R12 million and R9 million in the 2005, 2006 and 2007 financial years respectively.

As at 31 December 2004 the net asset value of Brand Ltd was R101 million. Total assets at the same date amounted to R194 million.

The weighted average cost of capital of Brand Ltd is currently 15%.

The company's expected growth rate after the 2007 financial year is 4% per annum.

The dividend policy is to distribute, as a dividend, 60% of each financial year's profit after tax in the next financial year.

REQUIRED

(a) Critically analyse the audited and forecast income statements of Brand Ltd and discuss any issues arising from your analysis.

Critically evaluate and comment on the earnings and free cash flow valuations performed by the financial manager. Your answer should include re-performing any aspect of the valuations that you consider necessary, together with your supporting reasons, and highlight any information that would be required in order to finalise the valuations.

Discuss the general shortcomings of earnings based valuations.