NATIONAL UNIVERSITY OF SCIENCE AND TECHNOLOGY FACULTY OF COMMERCE FINANCIAL MANAGEMENT CAC4204 Main Examination Paper May 2023 This examination paper consists of 11 pages Time Allowed: 3 hours Total Marks: 100 Special Requirements: Financial calculator Lecturer: A. Mususa INSTRUCTIONS 1. 2. 3. 4. Answer all questions Use the examination answer book provided Use black or blue pen Begin each question on a new page MARK ALLOCATION QUESTION 1. MARKS 100 TOTAL 100 Copyright: National University of Science and Technology, 2023 Page 1 of 11 QUESTION 1 [100 MARKS] KAN Stores (Pty) Ltd (“KAN”) operates a chain of retail department stores. It retails cosmetics, ladies' and men's fashion apparel, housewares and small appliances, and ladies' accessories. KAN is a high-end retailer which offers in-house developed brands as well as external brands through large-format department stores, within premium shopping malls in Zimbabwe and Botswana. The company was founded in 1968 and currently occupies over 40 000m² of retail space spread over 12 department stores. KAN features a carefully selected range of local and international brands (sourced mainly from the United States and Europe markets) catering to the middleand upper-class consumer market. In recent years, nearly all retailers in Zimbabwe have struggled as consumer demand has hit multi-year lows as a result of high unemployment and inflation lowering disposable income. The main profit squeeze to high-end stores such as KAN came from less expensive retailers such as Zimbabwe’s Woolworths, Sweden’s H&M and Spain’s Zara, which cut into KAN’ customer base, and which frequently also managed to offer more fashionable apparel choices. The consumer slowdown has also been exacerbated by the weakening of the Zim dollar currency, which means higher prices for consumers, especially in imported branded goods. As a result, consumers buy less products, less often. According to the Chief Executive Officer (CEO) of KAN, consumers who used to buy three or four units a month and who regularly spent $5 000 to $10 000 per month, started spending between a quarter and half of those amounts. She also said that in fashion it is key to have a flexible supply chain to react to changes in the market demand. Business model The business model of KAN has always been to stock well-known luxury brands in elegant stores which occupy the most prestigious retail space in Zimbabwe and its neighbouring countries. Over decades and through many peaks and troughs of the retail cycle, KAN continued to grow, largely due to the accumulated experience of an excellent well rounded management team who had an ethos of “over-deliver always”. That same ethos still exists in the business today. KAN believes in enriching the retail experience for its customers and prides itself on maintaining meticulous stores, appealing merchandise and employing well-trained staff. KAN is supported by its professional financial Page 2 of 11 managers and its equally experienced pool of shareholders representing private equity houses and pension funds focused on retail investments. KAN competes with clothing retailers, homeware stores and multi-product groups for its share of the broader retail sector and therefore the company’s strategic approach has evolved to concentrate on the upper end of the market. Equally strategic, KAN has deliberately shifted their mix of turnover from credit to cash (at present this ratio is now credit: cash = 30:70) over the past three years, building in a measure of protection from interest rate increases and changes in consumer demands. Financial reports Extracts from the most recent annual reports of KAN are presented below KAN Stores (Pty) Ltd Statement of financial position as at 31 May 2022 Notes 2022 $000 2021 $000 Property, plant and equipment 1 403 056 453 300 Goodwill 2 54 286 81 206 Investment 3 45 714 45 714 503 056 580 220 ASSETS Non-current assets Current assets Inventories 4 646 321 445 238 Trade Receivables 5 118 432 121 098 1 267 809 1 146 556 100 000 100 000 (13 586,00) 42 310 86 414 142 310 Total assets EQUITY AND LIABILITIES Equity Share Capital Retained income/(loss) 6 Total equity Page 3 of 11 Non-current liabilities Shareholders' loans 7 300 000 300 000 Interest bearing borrowings 8 147 000 147 000 447 000 447 000 Trade and other payables 289 880 167 434 Bank overdraft 116 079 54 392 Current liabilities Short-term loan 9 300 000 300 000 Income tax payable 12 28 436 35 420 734 395 557 246 1 267 809 1 146 556 Total equity and liabilities KAN Stores (Pty) Ltd Statement of profit or loss and other comprehensive income for the years ending 31 May Notes 2022 2021 $'000 $'000 753 681 810 463 494 360 518 954 259 321 291 509 Administrative and operating expenses 265 821 301 616 Profit/(loss) before interest and taxation -6 500 -10 107 15 142 14 421 Finance cost 64 538 64 905 Profit/(loss) before tax -55 896 -60 591 0 0 -55 896 -60 591 Revenue 10 Less: Cost of sales Gross profit Other income - dividends received Taxation 11 3 12 Profit/(loss) after taxation Page 4 of 11 Notes to the financial statements: 1. The property, plant and equipment have a current market value of $512 million but are worth $362 million in case of liquidation. 2. Goodwill exists as the net result of past mergers. 3. The dividends were received from a specific unlisted investment in the equity shares of another company. This investment was bought many years ago but does not have any strategic value. The investment company has a steady dividend pay-out policy and current dividends are expected to grow at 5% per annum. Similar investments currently deliver a return of 13% per annum. 4. It is estimated that, in the case of liquidation of the company, inventories would realise $528 million. The inventory has, however, a going-concern value of $659 million. 5. Trade and Receivables include an allowance for credit losses that is presumed to be fair. 6. KAN’s current shareholding is as follows: Number of shares (‘000) Bruce 8 750 Mallon 8 000 Private equity shareholders 8 250 Percentage holding % 35 32 33 7. The Bruce family and the Mallon family have jointly (and in proportion to their current shareholding) advanced $300 million as a shareholders’ loan to KAN. This loan bears interest at 12% per annum. The interest is payable annually in arrears and the loan has no fixed repayment date. The KAN shareholders’ agreement contains a clause that provides that if any shareholder disposes of its equity to a third party the purchase consideration would first be allocated to any shareholder loan accounts and thereafter to the shares 8. The long-term loan is a loan from FinLon. The loan bears interest at the prime lending rate plus 1%. The loan is repayable in six years’ time. The loan is reflected at fair value in the financial statements. 9. The short-term loan is repayable within the next three months. This loan was advanced by FinLon and carries interest at 11% per annum. Page 5 of 11 10. Revenue from continuing operations comprises solely of retail revenue. The segmental split of retail revenue is presented below: 2022 2021 $000 $000 Cosmetics 92 778 90 443 Ladies' and men's fashion apparel 519 588 574 332 Houseware & small appliances 46 954 51 805 Ladies' accessories 56 828 57 456 Stationery products 37 533 36 427 753 681 810 463 11.The segmental gross profit percentages are as follows: 2022 (%) 2021 (%) Cosmetics 33.2 37.4 Ladies' and men's fashion apparel 35.1 36.2 Houseware & small appliances 30.5 33.6 Ladies' accessories 35.4 35.8 Stationery products 31.2 33.1 12. Although the company did not have any taxable income over the past two years some payments on final assessments with regards to previous years were still outstanding Financing alternatives Financing needed for expansion and for working capital in the form of inventory for the summer collection amounts to $200 million. This is seen as crucial to the survival of KAN as further reputational damage resulting from empty shelves could be the final blow to this retailer. The following financing options have been identified: i. A medium-term loan of $200 million from FinLon. The loan is to bear interest at 1% above the current prime rate. The loan and interest are to be repaid in one bullet payment at the end of four years. Interest is to be calculated and compounded annually in arrears and capitalised into the outstanding loan balance each year. Transaction costs of 1% of Page 6 of 11 the principal amount will be payable at the inception of the medium-term loan. The interest to be incurred on such a loan is deductible for taxation purposes. You may assume the company will have sufficient income for an interest deduction in the future. A provision of the loan is that FinLon will require the inventory and trade receivables as security for this loan. ii. One of the creditors of KAN in the South Africa (ZAR) has offered a loan of R12.5 million at a fixed interest rate of 4% per annum. The loan is repayable in five years’ time and interest is payable annually in arrears iii. A rights issue to be made to the current shareholders at a discount of 20% to current market value of the shares on a proportional basis. Management buy-out KAN has a strong management team that has the necessary experience of running a company in this sector. The management team has indicated that they are interested in buying the operations of the store in the JoinaCity Mall shopping centre. This store is one of only three stores that are still showing profits despite the decline in company profits in the past three years. Management instructed the financial manager of the store to prepare the following pro forma financial statements for the JoinaCity Mall store to facilitate a valuation of the company. The manager has no previous experience in preparing valuations. Page 7 of 11 JoinaCity Mall store Statement of profit/ loss and other comprehensive income for the years ending 31 May Sales Actual Actual Actual Forecast 2020 2021 2022 2023 $000 $000 $000 $000 (Note 1) 94 584 94 963 83 742 95 466 Less: Cost of sales 59 654 59 675 55 881 60 144 Gross profit 34 930 35 288 27 861 35 322 Administrative and operating expenses (Note 2) 11 178 12 249 10 122 11 303 Gain/(loss) on foreign currency -2 364 -1 862 1 290 -900 Operating profit before abnormal items 21 388 21 177 19 029 23 119 Abnormal/Once-off items -3 351 Profit before interest and taxation 21 388 17 826 19 029 23 119 Other income 2 824 3 012 3 839 3 839 (Note 3) 1 254 1 523 1 556 1 556 Profit before taxation 22 958 19 315 21 312 25 402 Finance cost (Note 4) Value of store: (25 402 * (1 + 6%)) / (20% - 6%) (note 5) $ 192 329 Notes to the forecasts: 1. To revive the operations of the store and to increase revenue, some marketing initiatives will be introduced and as a result management expects sales growth of 14% over the next two years. Thereafter management expects growth to stabilise at approximately 6% per annum. Management expects that by operating the store independently, they would once again be able to generate gross profit margins similar to those achieved in 2021. 2. The actual and forecast operational expenses do not include the expected additional remuneration of management at a current value of $1.25 million. This remuneration is Page 8 of 11 expected to increase with the annual inflation rate in future. Depreciation on assets is included in the administrative expenses. 3. The actual interest incurred between 2020 and 2022 relates to an $11 million loan from FinLon allocated to this specific store. This loan forms part of the group’s current longterm loan. 4. Other income consists of dividends received on an investment in a coffee shop in the JoinaCity Mall, and interest received. The store used excess cash they had to buy equity in the coffee shop as an additional investment. The company also has excess cash from previous profits of $15 million which it has invested in a fixed deposit account. 5. The cost of equity is used to discount the cash flows. The cost of equity of a competitor of KAN was used. Other information: • The current return on RBZ long-term government bonds is 8.45%. The market risk premium for the Zimbabwean equity market is 6%. • You may assume all cash flows occur at the end of a period, unless stated otherwise. • The prime lending rate in Zimbabwe is currently 10.25%. • Edgars Ltd (“Edgars”) is a company similar to KAN that is listed on the ZSE. Edgars had a price/earnings (PE) ratio of 15 as at 31 May 2022. Edgars expects an increase of 5% in earnings for the 2023 financial year. Page 9 of 11 Required: (a) Describe six business risks relating to the company importing goods from various countries for its product offerings and identify and describe how the company can mitigate each risk. Communication – Logical argument 12 1 13 7 7 20 20 (b) Determine the effective after-tax cost of the medium-term loan offered by FinLon as financing for the working capital required for 2022. (c) Make a recommendation as to which of the three identified financing alternatives for the working capital requirements for 2023 should be accepted. Your evaluation should include a discussion of any other factors that should be considered in choosing the appropriate source of finance as well as alternative and appropriate sources of finance that the company might consider. No calculations are required to be performed for this required. (d) Write a memo and critically evaluate the discounted cash flow valuation prepared by the JoinaCity Mall management team (based on the information at your disposal). You should identify any additional information you would require completing the valuation. Communication – Layout and Logical argument 16 2 18 (e) Calculate the value of the JoinaCity Mall store using the price earnings method. 10 (f) Explain which of the net present value or price earnings methods would be more appropriate to use in this circumstance. 5 Communication – Layout and structure 1 16 Comment on the operating profitability of KAN for the year ending 31 May 2022. Support your answer with relevant calculations. 20 20 Your analysis of profitability must include analysis and discussion of the following: Turnover (8 marks) Gross Profit (6 marks) Operating Profit (4 marks) Return on assets (2 marks) Page 10 of 11 (g) It has been discovered recently that a whistle-blower on the firm’s fraud hotline has anonymously accused the management of the JoinaCity Mall store of performing poorly in the 2022 year deliberately using a “go slow” tactic. KAN’s Management has asked you to provide your opinion on how they should handle the matter. Communication 5 1 TOTAL MARKS 6 100 END Page 11 of 11
