1. Potential Business Partnership
Trigger Description
Give a balanced view on how to finance vehicles for Prochem
Trigger Location
Document C. Page 12
Theory applicable
1. Taxation
Buying
VAT
Generally, a vendor is not entitled to deduct input tax on the acquisition of a “motor car.” This
general rule is however subject to certain exceptions which are contained in the provisos to section
17 (2)(c) of the Value-Added Tax Act 89 of 1991 (“the VAT Act”).
The Van is a motor vehicle as defined, however, it is must be constructed or converted to wholly or
mainly carry cargo in order to be able to claim VAT input)( More than 50% of surface of the vehicle
must be for cargo carriage). This can be done by only having the front seats on the van and opting
for a van specification with no windows in the back, proving it is designed for cargo. That way we
may claim VAT, else we will not be allowed to claim.
Tax
Being that we are using the vans in the production of income, we will receive tax allowances. Under
S11e motor vehicles are granted a 4 year write off period.
Leasing
VAT
If the vehicle is obtained under a financing lease structure, VAT will be claimable at commencement
of the lease (on delivery or any payment). The lease agreement itself constitutes the document
entitling the client to claim the VAT payable to the lessor. Where the lease terminates, one must not
overlook the recoupment provisions that come into operation. Recouping the portion of VAT which
has not been utilized. If the asset is acquired at the end of the lease at less that its market value,
then the difference between this market value and the consideration, if any, paid by the acquirer will
be a recoupment in terms of section 8(5)(a) read with section 8(5)(b).
If the vehicle is obtained under operating lease, the rentals will be subject to VAT as and when
payment is due.
Tax
We will receive S11a allowance for lease payments which were actually incurred during the year of
assessment. This amount would be excluding the VAT portion.
Example
Cash cost
R
100 000
VAT
14000
Finance charges
92 340
Total lease liability
206 340
Term of lease
48 months
Instalments
(per month)
4 299
or
(per annum)
51 588
Claim for tax purposes
Lease payments made
51 588
Less: 12/48 x R14 000 - i.e. VAT
adjustment
3 500
Lease payments claimable for tax
48 088
2. Cost and Financial Management
An installment loan is a loan that is repaid over time with a set number of scheduled payments.
normally at least two payments are made towards the loan. The term of loan may be as little as a
few months and as long as 30 years. A mortgage, for example, is a type of installment loan.
Generic comparison of a lease vs Buy decision:
Ownership
BUYING
LEASING
We own the vehicle and
get to keep it as long as
you want it.
We don’t own the vehicle. We get
to use it but must return it at the
end of the lease unless we decide
to buy it.
Up-Front
Costs
They include the cash
price or a down payment,
taxes, registration, and
other fees.
They can include the first month’s
payment, a refundable security
deposit, an acquisition fee, a
down payment, taxes,
registration, and other fees.
Monthly
Payments
Loan payments are usually
higher than lease
payments because you’re
paying off the entire
purchase price of the
vehicle, plus interest and
other finance charges,
taxes, and fees.
Lease payments are almost
always lower than loan payments
because you’re paying only for
the vehicle’s depreciation during
the lease term, plus interest
charges (called rent charges),
taxes, and fees.
Early
Termination
We can sell or trade in the
vehicle at any time. If
necessary, money from
the sale can be used to
pay off any loan balance.
If we end the lease early, charges
can be as costly as sticking with
the contract. On occasion a
dealer may buy the van from the
leasing company as a trade-in,
letting you off the hook.
Vehicle
Return
We will have to deal with
selling or trading in the
van when we decide to
upgrade.
We return the vehicle at leaseend, pay any end-of-lease costs,
and walk away.
Future Value
The vehicle will
depreciate, and the
market will decide the
residual value at the end
of the useful life
The future value doesn’t affect us
financially.
Mileage
We are free to drive as
many miles as you want.
Which is critical, being in
the logistics business.
Considering though that
higher mileage lowers the
vehicle’s trade-in or resale
value.
Most leases limit the number of
miles you may drive, often 12,000
to 15,000 per year. (You can
negotiate a higher mileage limit.)
You’ll have to pay charges for
exceeding your limits. These costs
may be significant.
Excessive
Wear and
Tear
Due to the nature of our
business we expect to
write down our vans in a
short period. This will
lower the vehicle’s tradein or resale value.
Most leases hold you responsible.
We will have to pay extra charges
for exceeding what is considered
normal wear and tear.
End of Term
At the end of the loan
term, you have no further
payments
At the end of the lease (usually
two to three years), you can
finance the purchase of the car,
or lease or buy another.
Customizing
The vehicle is yours to
modify or customize as
you like, although doing so
may void your warranty.
This is useful as we may
want to brand our vans for
marketing purposes.
Because you must return the
vehicle in saleable condition, any
modifications or custom parts you
add have to be removed. If there
is any residual damage, we have
to pay to have it fixed or we’ll
need to file an insurance claim
and pay a deductible.
Accept or Reject Decision: Capital Budgeting
Financial Consideration:
In deciding whether the investment shall be accepted or rejected we shall consider the Net Present
Value of all cashflows over the period. In making this assessment we require the following:
1. Initial cash flows
 Cost of acquiring the operating assets
 Staff employment costs/recruiting costs
 Proceeds from sale of existing assets
 Working Capital requirements (initial investment)
 Tax effects
 Excluding sunk costs
Information in the scenario:
Required initial investment:
Vehicles (30 fleet)
Staff recruitment costs
Procurement Costs
(R460k incl vat * 30)= R13 800m
May be sunk if already incurred, howevr
if incremental these would need to be
included. These costs include market and
interviewing cost. The month payroll
costs will be included in the annual
cashflows
To obtain finance and corresponding
assets
Research costs
2. Annual operating cashflows
 After tax cashflows
 Incremental costs/ relevant costs
 Including opportunity costs
 Excluding allocated costs (fixed overhead costs)
 Excluding finance charges. This is due to the discount rate takes into account the
financing element i.e. WACC = ke + kd
 Changes to working capital requirements
3. End of project cashflows
 Proceeds from resale of operating assets
 Recoupments, scrapping allowances
 Return of working capital (inflow)/ Disinvestment through the sale of remaining working
capital
 Tax implications
4. Life of the project
The project is over a 10 year period
5. Weighted Average cost of capital (Assumption being the project is internally funded)
The discount rate used in determining the NPV is determined as the cost of capital. The
formula applied is as follows:
WACC = WeKe + WpKp + WdKd (1-t)
In determining the cost of capital we shall adjusted the rates determined below for the
corresponding weight of each source of finance. This can be based on the current capital
structure or the targeted capital structure.
Ke being the cost of equity. The cost of equity is determined using the following methods:
 Bond Yield: Bond yield + Risk premium
 Capital Asset Pricing Model: Rf + B (Rm-Rf)
 DDM: (D1/Po) + g
Rf being the risk free rate.
B being beta represent the spread/volatility of the companies share in a pool/bucket of
shares
Rm being the market premium
Kp being cost of preference shares. This is determined using the DDM method
Kd being the cost of debt. This is determined using the following method:
 Yield to maturity
The interest on debt shall be adjusted for tax as it is deductible for tax purposes.
Capital Structure
As per the financial statement analysis the current D:E ratio is 0.75 thus meaning the Debt
Ratio is 42% of debt and 58% equity. This represent the current capital structure in DS. See
the financial statement analysis document (understanding DS)
Qualitative Consideration:
The decision of whether to accept or reject the project shall not be based solely on the financial
impact but also qualitative factors and the entities overall strategy. It is therefore important to
understanding Dynamic Supply’s overall strategy and see how the projects fits into the core
business.
The entity aims to be a leading logistics provider and be amongst the most profitable in the industry.
They aim to achieve this through providing industry specific and innovative logistical supply chain
solutions mainly to Pharma customers and E-Commerce businesses.
The proposed contract is therefore in line with our overall strategy, and furthermore as we have
been exposed to Pharma clients before we therefore have the knowledge and understanding of their
logistical requirements. This will result in a lot of saving from our side as well as their client as we
don’t have to spend much on research and designing these solutions as we can leverage off already
existing products and tools. Furthermore given the current economic client more and more
companies are looking to outsource their logistical function as to allow them to focus on their core
business, however they are looking for business partners rather than mere service provider thus
innovation and value add to the supply chain will further strength these relationships.
It is noted that ProChem is considering an innovative 3PL service provider. We would be a perfect fit
given the extensive investment in R&D and the already developed digital tools. These include
warehouse management tools and inventory management solutions, including myDigital Supply ,
Predictive Analytics (possible used in inventory management), AI and the RPA tools being developed
for warehousing facilities and the voice picking software of which will likely result in client saving on
a lot of costs and improved efficiencies was the picking and warehousing processes will be
significantly improved. The client will also benefit from project currently being developed of which
will be deployed in the near future.
Other qualitative factors to be considered include:
 Capability requirements: Knowledge, labour (additional employees to be employed) and
warehousing facilities and transport network.
 We would have to train the new employees on our business and the partners business
 Understanding of clients requirements and staying to update on the for ever change
needs.
Financing Options
Quantitative factors:
Should the project yield a positive NPV and be considered to be in line with the entities overall
strategy, they shall consider the most effective and efficient methods of finance.
The entity may either buy the required operating assets or lease them. The decision of whether to
buy or lease is evaluated through using two methods i.e. NPV or NPC
NPV: The decision is incorporated in the overall DCF calculation for both the alternatives and which
yields the highest NPV is the better decision. In relation to NPC, which ever yields the lowest NPC is
the better alternative. It is important to note that these are solely based on the financial impact, the
entity is still required to consider the qualitative impact such as the entities target capital structure,
impact on financial statement and future growth opportunities.
The discount rate and logic behind the cashflows is different from the normal DCF. The assumption is
that the entity would have funded the assets through debt and thus the appropriate discount rate to
be used is the after tax debt rate i.e. Kd (1-t).
With regards to the cashflows we are focused on lease related cashflows as well as acquisition
related cashflows. The assumption is that cost saving from any of the decisions are to be included in
the other decision. See NPV illustration below:
Lease option
T0
Cost Savings
Lease payments
Tax on Cashflows
After tax CF’s
T1
Inflow
(outflow)
Net cashflow
Net cashflow
Buy Option:
Machine Costs
Machine residual value
Cost Savings
Tax on cashflows
After tax CF
T0
Outflow
T1
Inflow
Inflow
Net cashflow
Net cashflow
The net cashflows from the above to be discounted using the debt rate, and which ever yield the
highest NPV is the better decision.
Note that the NPV method is only useful where there are cost savings. Where there are solely costs
we consider using NPC method. With the net present cost we remove the cost saving and only use
the cost incurred i.e. annual lease payment and acquisition costs to assess our decision. The decision
that yield the lowest NPC is the better alternative.
Qualitative Factors:
Buy Consideration:
The acquisition may be financed through the following (bearing in mind the entities capital
structure):
1. Cash reserves (i.e. working capital)
>Currently sitting with high receivables and low payables thus may be able to use funds from
debtors to fund the acquisition of the required assets. However this may place significant
pressure on the entities cashflows, given that debtors pay late i.e. roughly 60 days. The
entity may use their creditors to indirectly fund the acquisition given that they normally
settle them timeously i.e. 15 days, thus can afford to delay payment in order to improve
cashflows. Re-working the working capital cycle to create cash flows.
>However it is not always advisable to fund fixed assets through working capital as it is
always best to match the cash inflow generated by the asset to the required repayments.
Therefore the next best alternative would be using long term debt.
2. Debt financing
>They have a lot of unleveraged assets i.e. R142 million in assets vs R68 million in debt.
There is still sufficient headroom for further financing)
3. Reinvested retained earnings
4. Issue of preference shares
5. Issue of ordinary shares through right issue (given the recent buy back)
6. Issue of ordinary share capital (equity partner)
>Concerns over dilution of control (given entity is owner managed)
>May consider listing as to allow easy access to finance on the capital markets as to help
fund growth
>Meeting the listing requirements may not be difficult given we are already applying full
IFRS furthermore we may be an attractive investment given we are still in our growth
phase and are experiencing rapid exponential growth.
> The entity is owner managed with a strong board in terms of industry knowledge
> Possible looking at ALTX or ZARX
> Issue maybe be from compliance requirements and restructure may be required in
terms of the board. More non executives etc.
7. Crowding funding or purchase order funding should the investment be lucrative (the
peoples fund and other platforms)
Other considerations of alternative financing solutions
-
-
Owner- drivers entering to a service agreement as independent contractor. By souring
individual drivers with their own specified vans, we may avoid employing the 70-odd staff.
However, we take on the risk of not controlling the whole process. This would have to be
based on stringent service agreement and thorough procurement process.
Outsourcing a reputable small logistics company to supply vans and/or personnel. This could
be used to buy some time until the company can afford to buy its own vans.
Buying cheaper second-hand panel vans. This will have to be supported by investment in
maintenance plans which could add to the cost. However, we would save on the capital out
lay and it is advantageous as we will be using the vans excessively and not have to worry
about excess mileage cost from a lessor.
The tax benefits from the above is that the entity may claim wear and tear allowance on the vehicles
and corresponding interest charges (should debt funding be used).
Lease Consideration:
Acquire the fleet through DFR and subleased to DSS. This will prove to be advantageous given that
DFR is in the business of fleet rental and already has a financing partner thus can negotiate
favourable rates. Furthermore this will help in strengthen the asset base given that they current
have one client (i.e. Malibuye Civils).
The lease through DFR will also allow DSS to focus on their core operations and not having worry
about asset maintenance and related costs. This may prove to be fruitful given the entity is still its
growth phase, thus all its energy shall be focused on its core business. Furthermore this
arrangement may allow the asset to be used for different client after the contract ends (i.e. leased to
other clients)
The lease decision will have tax benefits in the sense that the lease repayments will be deductible
against taxable gains from the project.
Other vehicle options
VW Transporter Panel van: Starting price (VAT inclusive): R471,200
Ford Transporter Panel van: Starting price (VAT inclusive): R476,000
Toyota Transporter Panel van: Starting price (VAT inclusive): R488,000
Nissan NV2350 Panel van: Starting price (VAT inclusive): R418,000