QUESTION 2
50 marks
Sultan Importers is an unlisted company trading in the retail sector. Mr Ottoman, the accountant,
calculated that they will be experiencing a cash shortfall of R5 million within the next two months,
based on existing facilities, to finance working capital. The shortfall is expected to last for up to one
year.
Before approaching the company’s bankers for bridging finance, he decided to investigate all other
possibilities and approached you for advice. He made the following information available from
recent management accounts.
STATEMENT OF FINANCIAL POSITION
ASSETS
Noncurrent assets
Fixed property
Vehicles and equipment
Current assets
Inventory
Accounts receivable
Total assets
EQUITY AND LIABILITIES
Ordinary shareholders funds
Preference shares
Mortgage bonds
Current liabilities
Accounts payable
Bank overdraft
Total equity and liabilities
8 000 000
2 000 000
10 000 000
25 000 000
24 000 000
49 000 000
59 000 000
30 000 000
4 000 000
5 000 000
39 000 000
15 000 000
5 000 000
20 000 000
59 000 000
STATEMENT OF COMPREHENSIVE INCOME FOR THE PRECEDING 12 MONTHS
Revenue
Gross profit
Net profit after taxation
240 000 000
40 000 000
6 000 000
Your enquiries brought the following information to the fore:
Forty percent of all sales is currently cash sales. The present credit policy of the company is 1/20,
60 net. 20% of credit clients avail themselves of the cash discount
The following proposals for the possible improvement of the cash flow of the company in
the following months are put forward:
1. Mr Ottoman proposed a change in the credit policy of the company to 2/15, net 45. The change
will result in a loss in credit sales that will amount to 7% of total turnover. 30% of clients are
expected to make use of the discount in future. Bad debts, calculated as a percentage of
clients who purchase on credit and do not make use of the discount, are expected to decrease
from 3% to 1.75%. The collection policy will be strictly enforced to ensure that all monies are
received on time. You can assume that inventory purchases will remain unchanged.
2. Coolfact is prepared to factor the clients of Sultan that are not making use of the discounts,
with recourse, at the following terms:
Service charge: 1.25% of the relevant turnover
Financing charge: 10% per annum
25% retention
Mr Ottoman calculates that administration of large clients not making use of discounts
amount to R370 000 per year.
3. The bank is prepared to increase the present overdraft facility from R7 million to R12 million, at
prime plus 1% for the whole facility. The company presently pays the prime rate on its existing
facility. As security for the enlarged facility, a notarial bond is required on all current assets.
4. The bank is prepared, as alternative to the increase in the overdraft facility, to make available a
90-days revolving banker’s acceptance facility for R5 million at a commission of 2,5% per
annum and at the current discount rate for 3 month liquid banker’s acceptances, which is 8%
per annum at the moment. The commission is payable at the issuance of the facility.
5. The company is currently utilizing suppliers’ credit at terms of 2/15, 60 net from company X that
supplies 25% of all stock (and turnover).
6. You can assume a prime rate of 9.25%1.
REQUIRED
Consider the alternative proposals individually and present a reasoned proposal in report format as
to which of the proposals (or combination of proposals or other possibilities) should be considered
the best for the company, taking into account the amount of finance available/reduction in finance
requirement and the effective cost/cost saving associated with the proposal.
Use 365 days per year. Ignore tax.
1Please note that students are expected to know the current prime rate, but not historical
prime rates.
QUESTION 2
45 marks
Super Lights (Pty) Limited (‘Super Lights’) is a company that specialises in manufacturing
bicycle lights and headlamps. This company was formed about two years ago and its head
office and manufacturing site is based in Kuils River.
The owner of the company, Mr Heckler, is an avid mountain biker and trail runner. He
especially loves participating in night races and saw a gap in the market for producing good
quality headlamps and bike lights which trail runners and cyclists can use when running and
cycling at night.
It is their vision to become the largest specialist light manufacturer in the outdoor sports
industry in South Africa. Some of their 2020 strategic goals are:
-
To provide excellent customer service and expert advice to their customers;
To grow their profitability by 20% year-on-year.
This new trend of night races have really gained momentum in the last two years, especially
in Stellenbosch and the surrounding Winelands areas as well as in Gauteng and
Magaliesberg. The popularity of Super Lights’ products have resulted in phenomenal revenue
growth, since its incorporation in 2017.
In 2019, the company’s growth in revenue, profits and net working capital far exceeded
comparable industry averages. Super Lights’ notable growth is mainly due to Mr Heckler
employing other outdoor enthusiasts with the necessary skills to produce a quality product
with a long-lasting battery life. Super Lights also patented this design. Currently the production
factory has been tailored to effectively produce the bike lights and headlamps and is operating
at maximum capacity.
Super Lights do not sell to the public and their main customers are sports retailers and wellknown bike shops across South Africa, who buy their products in bulk.
In December 2018 the management team decided to diversify their product range to further
include the production of mining lights, in their existing factory, as part of their growth strategy.
This decision was based on market research performed which identified the need for good,
quality mining lights. It seems that the existing suppliers of these mining lights have not been
successful in providing products which customers are satisfied with.
These lights are used on mining sites at night and are a much bigger than the lights currently
produced and are used as spotlights to provide sufficient lighting to mining trucks which
operate at night.
However, the research and development cost of this new mining light were greater than
expected, and Super Lights is approximately six months behind schedule as the new
production line will probably only become operational in August 2019, if additional funding is
sourced.
It has come to light that Super Lights’ recent applications for loan funding have been rejected
by all the major commercial banks. In addition, Super Lights is struggling to negotiate an
increase of its overdraft limit – the bank is hesitant as the facility is already almost fully-utilised.
The company’s current weighted average cost of capital is 17.9%.
The financial director calculated the following annual movements for the 2019 financial year:
Increase in revenue
27%
Increase in cost of goods sold
34%
Increase in profit before tax
10%
Increase in non-current assets
15%
Increase in current assets
29%
The following table contains financial ratios for Super Lights for the past two years from the
audited financial statements for the year ended 28 February 2019. You may assume that all
ratios have been calculated correctly and no further ratio calculations are required.
2019
2018
Debt ratio
42%
30%
Debt/equity
87.5%
42.9%
Gross profit margin (Gross profit ÷ Sales)
15%
15%
Current ratio
1.53
1.62
Quick ratio
0.94
1.20
Inventory turnover (Cost of sales ÷ Average inventory)
4.20
5.70
Accounts receivable turnover (Sales ÷ Average debtors) 7.29
8.74
Average collection period of debtors
50 days
42 days
Inventory days
87 days
64 days
Creditors days
89 days
83 days
Cash cycle
48 days
23 days
In order to reduce debtors’ days to a more manageable period of 40 days, the credit collection
department has proposed tightening Super Lights’ payment terms offered to its customers
from 10/20 net 40 to 5/15 net 30 in the 2020 financial year. Unfortunately, Super Lights’
revenue is projected to decline by R4 326 999 to R3 111 867 in the 2020 financial year (2019:
R7 438 866) as a result of the amended credit policy. The proportion of credit sales to total
sales is expected to decline from 30% to 20%, with a corresponding decline in the rate of bad
debts from 12% of credit sales to 6% of credit sales. Restricting customer credit terms is also
expected to cause a fall in the cost of early settlement discounts from R34 888 in the 2019
financial year to 5% of non-defaulting credit sales.
Super Lights is also considering delaying payments to creditors by a further 11 days to further
alleviate cash flow pressure. However, Super Lights’ suppliers already offer generous
payment terms of 120 days and the lag will result in the loss of the company’s usual 5% early
settlement discount for paying within 90 days. Alternative suggestions to improve the
company’s cash flow situation, such as invoice discounting, factoring of debtors and the use
of bankers’ acceptance letters, have been rejected by the board of directors.
QUESTION 2 REQUIRED
(a)
−
(c)
Total
explain the concept of overtrading;
evaluate and conclude on whether Super Lights (Pty) Limited
may be considered to be displaying warning signs of overtrading
during the 2019 financial year; and
recommend feasible financial strategies to improve the cash
flow situation (other than those which have already been
suggested and/or rejected).
No calculations are required.
20
Communication skills: layout and structure; logical argument
2
22
Calculate the net present value of the suggested change in Super
Lights (Pty) Limited’s payment terms offered to its customers. Use
the net (Correia) method.
Ignore taxation.
15
15
8
8
Evaluate and explain the effect on Super Lights (Pty) Limited’s
effective cost of creditor financing if it were to implement the
proposed lagging.
Show all your formulae and supporting calculations.
Total
Sub
total
Super Lights (Pty) Limited has hired you to review its financial
records for potential areas of risk. In a letter addressed to the
financial director,
−
−
(b)
Marks
45
© Carlos Correia: Solutions to Financial Management, 9e, 2019
Ch 11 Working Capital
19 December 2018
11-17
Current assets
Fixed assets
Current liabilities (50% = short-term debt)
Long term debt
Ordinary equity
0.50
0.12
Sales
EBIT
Less: Interest on short-term debt
Less: interest on long-term debt
Net income before tax
Taxation
Net income after tax
Current ratio
Net working capital = CA-CL
Debt ratio = (CL+LTD)/Total assets
Return on equity (Net income after tax/Ordinary
equity)
0.10
Plan 1
22,500,000
40,000,000
62,500,000
Tax rate
Plan 2
22,500,000
40,000,000
62,500,000
28%
Plan 3
22,500,000
40,000,000
62,500,000
22,500,000
7,500,000
32,500,000
62,500,000
15,000,000
47,500,000
62,500,000
7,500,000
22,500,000
32,500,000
62,500,000
250,000,000
250,000,000
250,000,000
40,000,000
-1,125,000
-900,000
37,975,000
-10,633,000
27,342,000
40,000,000
-750,000
39,250,000
-10,990,000
28,260,000
40,000,000
-375,000
-2,700,000
36,925,000
-10,339,000
26,586,000
1.00
0
48%
1.50
7,500,000
24%
3.00
15,000,000
48%
84%
58%
59%
16%
82%
81%
Debt-equity (interest bearing debt to equity)
Plan 1 gives a slightly higher return than plan 3, the main difference between the two alternatives
being the use of short term rather than long term borrowings. The current ratio, as is to be
expected, is much stronger with plan 3 providing greater assurance that current liabilities will be
paid when due.
Plan 2 is the least risky of the three alternatives, the debt ratio being half that of the other plans.
As a result the return is also the lowest.
Although the debt ratio of Plan 1 and 3 are the same, the debt-equity ratios (if we include only
interest bearing debt) are very different with Plan 3 indicating a higher level of risk.
In deciding which plan to accept management need to consider the risk return relationship and
the risk aversity of the shareholders. We would consider that Plan 1 may be preferable due to the
fact that interest bearing debt forms a smaller part of the financing of the company resulting in a
lower risk profile and yet achieving a high ROE, even though Plan 3 does result in a higher
current ratio.
Note: Net working capital is calculated as Current Assets less Current Liabilities, as no
indication is given of the amount of Creditors. However, since it is indicated that Current
Liabilities consist of 50% Short term loans, it could have been more accurate to exclude the
Short term loans from the calculation (for example, the Net Working Capital for Plan A would
be R22 500 000 – (50% x R22 500 000) = R11 250 000).
© Carlos Correia: Suggested solutions to Financial Management, 9e, 2019
1
© Carlos Correia: Solutions to Financial Management, 9e, 2019
Ch 11 Working Capital
11-25
Financing plans
Short-term loan
Long term loan
a)
Plan 1
Renew 1-yr loan
24,000,000
(1)
Good
Good
Average
Average
Bad
Bad
b)
EBIT
Less: Long-term interest
Less: short-term interest
Tax
Expected Net income
c)
EBIT
Interest rate - S-T debt
BEST
EBIT
Less: Long-term interest
Less: short-term interest
Tax
Expected Net income
WORST
EBIT
Less: Long-term interest
Less: short-term interest
Tax
Expected Net income
Risk-free rate
3.0%
5.0%
5.0%
7.0%
7.0%
9.0%
Plan 1
16,000,000
0
-2,220,000
13,780,000
-3,858,400
9,921,600
19 December 2018
Plan 2
Borrow R24m
long-term
Plan 3
Tax rate
Loan R12m S-T
and R12m L-T Expected EBIT
12,000,000 Interest rate ST
24,000,000
12,000,000 Interest rate LT
(2)
(3)=(1)+(2)
Risk Permium Rate to the Firm
2.0%
5.0%
2.0%
7.0%
3.0%
8.0%
3.0%
10.0%
5.0%
12.0%
5.0%
14.0%
Plan 2
16,000,000
-2,400,000
0
13,600,000
-3,808,000
9,792,000
(4)
Probability
0.125
0.125
0.250
0.250
0.125
0.125
Expected value
28%
16,000,000
8%
10%
(5)=(4)x(3)
Product
0.63%
0.88%
2.00%
2.50%
1.50%
1.75%
9.25%
Plan 3
16,000,000
-1,200,000
-1,110,000
13,690,000
-3,833,200
9,856,800
Best outcome
Worst outcome
30,000,000
2,000,000
5%
14%
Plan 1
30,000,000
0
-1,200,000
28,800,000
-8,064,000
20,736,000
Plan 2
30,000,000
-2,400,000
0
27,600,000
-7,728,000
19,872,000
Plan 3
30,000,000
-1,200,000
-600,000
28,200,000
-7,896,000
20,304,000
Plan 1
2,000,000
0
-3,360,000
-1,360,000
-1,360,000
Plan 2
2,000,000
-2,400,000
0
-400,000
-400,000
Plan 3
2,000,000
-1,200,000
-1,680,000
-880,000
-880,000
It is difficult to make a choice between the financing options and this will depend on the risk preferences of the
firm. Plan 1 will result in the highest possible Net income but also the greatest loss if the worst scenario occurs.
Plan 2 will result in a lower expected net income in the best scenario but the loss is siginificantly lower in the
worst scenario. If the firm is risk averse, it might select Plan 2 as it minimises the potential loss. A further issue
relates to the use of long term debt. The long term loan will lock in the interest rate but the firm will be
committed in the longer term. The short term loan will result in variable interest costs and the potential of the
firm paying a high interest rate and being vulnerable to interest rate movements. However, we need to analyse
the asset structure of the firm and match the financing to the assets of the firm.
If part of the short-term loan is used to finance inventory and short-term interest rates, then the firm will be able
sell inventory, collect accounts receivable and repay part of the short-term loan if sales and EBIT falls
significantly. Therefore, if this is so, then the use of 50% long-term debt and 50% short-term debt may make
sense.
© Carlos Correia: Suggested solutions to Financial Management, 9e, 2019
2
© Carlos Correia: Solutions to Financial Management, 9e, 2019
Ch 11 Working Capital
19 December 2018
Notes:
1. The interest rate applicable to the short term loan is 8% for the next year, however the
expected interest rate for short term loans for the next 10 years is estimated to be
9.25%.
2. It is indicated in the calculation that, in the “Worst” scenario, the negative taxable
income will lead to 0 tax being payable. It will, however, also lead to an assessed loss
which could be used against future taxable income in future periods. The net loss
would be smaller if the assessed loss is taken into account, however, for the purposes
of this analysis the impact as calculated above, is sufficient.
© Carlos Correia: Suggested solutions to Financial Management, 9e, 2019
3
© Carlos Correia: Solutions to Financial Management, 9e, 2019
Ch 12 Current Asset Management
19 December 2018
12-17
Natural Styles
Current assets
Cash
Accounts receivable
Inventory
Current liabilities
Accounts payable
Rm
Rm
4.2
9.6
15.4
Current assets
Cash
Accounts receivable
Inventory
4,200,000
9,600,000
15,400,000
13.5
Current liabilities
Accounts payable
13,500,000
Sales
Cost of Sales
144,000,000
54,720,000
Goods conversion
Cash conversion
127.06
37.01
Working Capital Cycle
Inventory
Accounts receivable
Operating cycle
Accounts payable
Cash conversion cycle
102.72
24.33
127.06
90.05
37.01
Working capital cycle
Accounts Receivable
Average daily sales
Debtors days sales
15
394,521
24.33
Inventory
Average daily cost of sales
Days inventory
149,917.81
102.72
Accounts Payable
Average daily purchases
Days creditors
149,917.81
90.05
2.
Cost of trade credit
Discount
1-discount
Effective rate
Effective cost of bank finance
Monthly rate
Effective rate
-
0.025
0.975
[(1+2.5/97.5)(365/(90-10)) -1]
12.245%
0.096
0.008
(1+0.08)12 -1
10.034%
3.
The effect on the operating cycle is nil. The effect on the cash conversion cycle is as follows:
Accounts payable
13,500,000
1.00
Payment on 10th day
Payment on 90 days
2,700,000
10,800,000
0.20
0.80
©Carlos Correia: Solutions to Financial Management, 9e, 2019
No. of days
Days creditors
10.00
2.00
90.05
72.04
74.04
© Carlos Correia: Solutions to Financial Management, 9e, 2019
Ch 12 Current Asset Management
19 December 2018
12.26
Amount of Bank Bill
Term of Bill (days)
Number of days in year
Discounted value
400,000
180
365
392,000
As this is a discount yield, the interest rate implied by the discount is determined as follows:
Interest rate =
[(Bank Bill - Discounted value)/Discounted value] x (No. of days in year/No. of days of bill)
Interest rate per year
2.04%
x
365
180
=
4.14%
The effective rate is determined as follows:
Effective rate
=
Effective rate
=
[1+(discount/discounted value)](365/180)] - 1
102.04%
2.02777778
=
©Carlos Correia: Solutions to Financial Management, 9e, 2019
104.18%
-1
=
4.18%
© Carlos Correia: Solutions to Financial Management, 9e, 2019
Ch 12 Current Asset Management
12-37
19 December 2018
CHARLIE LIMITED
It should be fairly clear from the information that Charlie Ltd has a very serious cash flow
problem and that there are no easy or ready-made solutions to the problem. You might
think that the question ought to be answered by writing down briefly ideas about what
should be done and then producing a revised cash flow forecast with an overdraft limit
never higher than R50m. It would probably be more appropriate, however, to discuss
various options at some length, suggest whether or not these options might work, and then,
if there is time, re-draft a cash budget to see whether Charlie's problems would be
overcome.
Solution
It would seem that Charlie Ltd relies entirely on Delta for finance, and so cannot raise
money from a bank loan or overdraft. The maximum loan from Delta is R50m, but the cash
budget projects and 'overdraft' of up to R262m (month 10).
Charlie Ltd would appear to be profitable and growing. A very rough estimate of profits in
the year could have been made by preparing a sketchy funds flow statement in reverse.
Increase in bank balance (35-30)
Increase in finished goods inventory
Net increase in debtors and raw materials
inventory less creditors
Purchases of fixed assets (70 + 10 + 15 + 5)
Dividend paid
Tax paid
Less depreciation
Profit before tax
Rm
5
114
x
100
80
120
419 + x
y
419 + x - y
A combination of seasonal business, growth in trading and fixed asset purchases would
appear to be the reason why Charlie Ltd is only expected to increase its cash balance by
R5 m over the whole year, in spite of these profits.
The options for reducing the overdraft, which might be possible are:
*
Don't pay the dividend to Delta in month 3. However, Delta is short of cash and is probably
relying on the dividend income. It would, therefore, seem unlikely that Delta Ltd would
agree to either cancel the dividend or to lend more than R50 m.
*
Delay the payment of taxation from month 9. The Inland Revenue might allow Charlie Ltd
to do this, although there would be a penalty 'interest' charge for the delay.
*
Inventory control. We do not know the total size of finished goods, but inventory levels will
rise by R114m in the year. Clearly, the increase in inventory is expected because of the
company's sales growth. However, some reductions in the investment in inventory might
be possible without prejudice to sales, in which case the cash flow position would be eased
by the amount of the value of the stores reduction.
©Carlos Correia: Solutions to Financial Management, 9e, 2019
© Carlos Correia: Solutions to Financial Management, 9e, 2019
Ch 12 Current Asset Management
19 December 2018
12-37 (continued)
*
Creditors control. Three months' credit is taken from suppliers, but raw material purchases
are every 2 months. The credit period already seems generous, and some suppliers are
probably making a second delivery of materials before they are paid for the first. Taking
longer credit would be difficult to negotiate. However, if Charlie Ltd is on very good terms
with its suppliers, and is a valued customer of those suppliers, it might be possible to defer
payments by a further 1 month of amounts payable in months 6, 8 and 10, which cover the
cash crisis period.
*
Debtors control. Two months' credit is allowed to customers. If all sales are on credit,
customers are likely to be commercial or industrial buyers, who would expect reasonable
credit terms. A shortening of the credit period is probably not possible, without damaging
goodwill and sales prospects, unless an incentive is offered for early payments, in the form
of a discount. The discount would have to be sufficiently larger to persuade customers to
take it. Suppose, for example, that from month 5 sales onwards, a 10% discount were
offered for payments inside a month. (10% would be very generous and unrealistic
perhaps, but is used here for illustration). If all customers accepted the offer, this would
affect cash flows from month 6 on, as follows.
Month
6
7
8
9
10
11
12
Original
budget
Rm
75
80
90
110
150
220
320
+ (90% of 80)
-80 + (90% of 90)
-90 + (90% of 110)
-110 + (90% of 150)
-150 + (90% of 220)
-220 + (90% of 320)
?
Revised
budget
Rm
147
81
99
135
198
288
?
Net
change
Rm
+72
+1
+9
+25
+48
+68
?
The effects on cash flow would then be substantial, although the cost of the discounts
would reduce profits by a substantial amount too.
*
Postponing capital expenditure. Since the company is growing, the option to postpone
capital expenditures on new equipment, building extensions and office furniture is probably
unrealistic. The routine replacement of motor vehicles should be deferred, but this would
only ease the cash situation by R10m.
*
Charlie Ltd has an investment, which will pay a dividend of R45 m in month 7. This is
obviously a fairly large investment. If Charlie Ltd's cash flow problems are insuperable in
any other way, the company's directors might have to consider whether this investment
could be sold to raise funds.
Summary
Charlie Ltd is a profitable company, but is faced with serious cash flow problems, which
would seem to be hard to overcome without drastic measures being taken. Because
Charlie Ltd is profitable, closure of the company is unthinkable, and it would be against the
company's long-term interests to abandon its plans for growth. Delta Ltd is acting as a
serious restraining influence on Charlie Ltd.
However, the sort of radical action and response outlined above for debtors, coupled with a
postponement of the tax payment by 3 months or so and deferral of R10 m in motor vehicle
purchases until next year, would be virtually sufficient to overcome the firm's cash flow
problems in the year, with a slight problem still in month 8 - see workings below.
©Carlos Correia: Solutions to Financial Management, 9e, 2019
© Carlos Correia: Solutions to Financial Management, 9e, 2019
Ch 12 Current Asset Management
19 December 2018
12-37 (continued)
Postpone purchase
of vehicles
Defer tax payment
Discounts for early
payment by debtors
possible effect
Change
Cumulative change
Original cash budget
Revised cash budget
balances
5
6
7
8
10
9
10
11
120
12
(120)
10
10
1
72
72
82
(71)
1
1
83
(66)
9
9
92
(144)
25
145
237
(216)
48
48
285
(262)
68
68
353
(130)
?
?
?
35
11
11
17
(52)
21
23
223
?
If Charlie Ltd is to overcome its problems within the constraints set by Delta Ltd's financial policy; it
is likely that action on debtors is the key to a practical solution.
©Carlos Correia: Solutions to Financial Management, 9e, 2019
QUESTION 1
Since their establishment as industrial chemical cleaning agent manufacturer 20 year ago, Bestmix
Chemicals Limited (‘Bestmix’) has continually strived to improve its extensive portfolio of products in order to
provide for all the needs of its clients, who requires the highest quality guarantee. Bestmix is the only business
in the industry that manufactures chemical materials exclusively for the purpose of reselling by chemical
cleaning agent wholesalers. Except for chemical cleaning agent wholesalers, Bestmix also sells directly to
contract cleaners.
Bestmix’s sales increased in spite of the downward economic cycle. Credit sales amounted to R8,4 million
and the cost of sales amounted to R3,78 million for the year ended 31 May 2012. Current assets (of which
90% is deemed permanent) consist of inventory and accounts receivable. Current liabilities consist of
accounts payable and a bank overdraft on which the bank levies 10% interest per annum. Bestmix allows
debtors to pay on average after 60 days and it takes 30 days on average to pay creditors. The cash cycle is
90 days. Bestmix's current ratio is 1.35. On 31 May 2012 no other short-term sources were used for financing.
i.
ii.
iii.
Calculate the balance of the overdraft bank account on 31 May 2012.
Identify the working capital financing policy applied by Bestmix Chemicals Limited and briefly
discuss it.
Bestmix is considering making a big change to the credit policy. This change is expected to
decrease the debtors' balance with R900 000; the decrease in the gross profit will amount to
R520 000; the decrease in the bad debt will amount to R180 000 and the increase in the
discounts allowed will be R68 000. Calculate, according to the net present value method,
whether the change should be implemented, if you assume that the policy will not be changed
again. Ignore taxation.
5
4
3
QUESTION 1 (Suggested solution)
a) Cash cycle= Inventory days + debtors’ days – creditors’ days
∴ Inventory days = 90 days – 60 days + 30 days = 60 days
∴ Inventory = 3.78m x 60/365 = R621 370
∴ Debtors = 8.4m x 60/365 = R1 380 822
∴ Current assets = R2 002 192
∴ Current liabilities = 2 002 192/1.35 = R1 483 105
∴ Creditors = 3.78m x 30/365 = R310 685
∴ Bank overdraft = 1 483 105 – 310 685 = R1 172 420
1
1
1
1
1ms
ii) Current assets = 10% variable = R200 219. The creditors and bank overdraft are much more
than the variable part of current assets.
1
If a part of permanent current assets is financed by means of short-term financing; Bestmix
follows an aggressive financing policy.
1
The aggressive financing policy carries more risk, since the overdraft bank account can be
cancelled and then Bestmix must quickly acquire an expensive form of short-term financing.
2ms
iii) NPV= (-520 000 + 180 000 – 68 000)/0.1 + 900 000 = -R3 180 000
∴ No, the policy must not be implemented.
2
1ms
Max 12 marks
QUESTION 2
40 marks
Funkiluk Limited (“Funkiluk”) manufactures cloth for onward sale to furniture manufactures. The new
managing director, who has been in this position for nineteen months, is particularly progressive and
ambitious. There are two factories; one is located in Atlantis, Western Cape, and the other in Phoenix,
KwaZulu Natal. The recently retired management team were prudent and invested little in the operating
capability of the business over the last five years.
Pro forma financial statements for Funkiluk for the most recent financial year read as follows:
Funkiluk Limited
Statement of financial position as at 30 June
Non current assets
Property and plant
2010
2009
210 820 000
205 748 000
Current assets
Inventories
Trade receivables
Cash and cash equivalents
36 196 000
11 322 000
24 874 000
0
29 593 000
9 900 000
13 798 000
5 895 000
Total assets
247 016 000
235 341 000
Equity and liabilities
Equity attributable to equity holders
9 000 000 ordinary shares
Reserves
204 410 000
90 000 000
114 410 000
201 762 000
90 000 000
111 762 000
Non current liabilities
Long term borrowings
10 908 000
19 368 000
Current liabilities
Trade payables
Dividend payable
Short term borrowings
Current portion of long term borrowings
31 698 000
12 168 000
0
15 615 000
3 915 000
14 211 000
4 122 000
6 300 000
0
3 789 000
Total equity and liabilities
247 016 000
235 341 000
2010
2009
223 290 000
9 900 000
168 889 000
(11 322 000)
167 467 000
55 823 000
33 622 000
14 108 000
8 093 000
4 412 000
1 033 000
2 648 000
159 540 000
7 070 000
122 485 000
(9 900 000)
119 655 000
39 885 000
18 662 000
10 324 000
10 899 000
1 332 000
1 638 000
7 929 000
Funkiluk Limited
Statement of comprehensive income for the year ended 30 June
Revenue
Opening inventories
Purchases
Closing inventories
Cost of sales
Gross profit
Selling and distribution expenses
Administrative expenses
Profit before interest and tax
Finance charges
Tax
Profit for the year
Financial indicators (assume the calculations are correct)
Performance Sales growth
Liquidity
Debtors’ days
Inventory days
Creditors’ days
2010
39.96%
40.66
24.47
26.30
2009
31.57
41.12
12.28
Cash management
After inspecting the above statements, Funkiluk’s management has proposed the following measures in order
to generate cash immediately:
•
Paying no dividends for the next five years.
•
Reducing the investment in working capital as this is effectively financed at Funkiluk’s weighted average
cost of capital of 17%. In this respect, the detailed proposals are as follows:
o Ensure that the credit terms of 30 days are observed by all customers. It is expected that the stringent
application of the policy will result in a decrease of 2% in sales.
o Change the discount policy, currently 1/15, net 30 to 2/10, net 30. All sales are made on credit.
Currently 15% of clients use the cash discount. It is expected that 20% of clients will use the new
discount terms.
REQUIRED
Calculate by means of the net present value method whether the proposed changes in the
working capital policy should be implemented.
Marks
10
QUESTION 2 (Suggested solution)
Decrease in gross profit = 2% x 223 290 000 x 55 823/223 290 =
Old discount = 223 290 000 x 1% x 15% =
New discount = (98% x 223 290 000) x 2% x 20% =
After tax: -R1 656 822 x 0.72 = R1 192 912
-1 116 460
[1]
334 935
[1]
-875 297
- 1 656 822
[1]
Decrease in investment in working capital:
New debtors days= 20% x 10 + 80% x 30 = 26 days
Correia-method:
Decrease in sales (R223 290 000 x 2%), thus decrease in debtors:
-4 465 800 x 40.66/365 x 167 467 000 / 223 290 000 (CP of inv) [1]
[1]
-R373 107
[1]
Existing debtors pay earlier, thus decrease in debtors:
(98% x 223 290 000) x -(40.66 – 26)/365
Total decrease in debtors
-R8 788 939
-R9 162 046
[1]
Therefore: -1 192 912 / 0.17 + 9 162 046
R2 144 917
[2]
It therefore gives a positive net present value and it is therefore worth the trouble to change the
credit policy.
[1]
(Cost of this method of financing = 1 192 912 / 9 162 046 = 13.02%, which is lower than the cost of
capital of 17%).
Total 10
OR….
Gross-method:
Decrease in sales (R223 290 000 x 2%), thus decrease in debtors:
-4 465 800 x 40.66/365
Existing debtors pay earlier, thus decrease in debtors:
(98% x 223 290 000) x -(40.66 – 26)/365
Total decrease in debtors
-R497 478
[2]
-R8 788 939
-R9 286 417
[1]
It therefore gives a positive net present value and it is therefore worth the trouble to change the
credit policy.
[1]
(Cost of this method of financing = 1 192 912 / 9 286 417 = 12.85%, which is lower than the cost of
capital of 17%).
*Alternative: Gross-method
New expected debtors: 26/365 x (98% x 223 290 000) = R15 587 477
New debtors – Old debtors = R15 587 477 - R24 874 000 = R9 286 523
Difference from R9 286 417 is because of rounding of 40.66 days.
QUESTION 1
MEMORANDUM 2
OPERATING SUBSIDIARY OF BRUM LIMITED – COOLX LIMITED (CoolX)
CoolX manufactures radiators and exhaust systems for supply to the automotive industry.
Approximately 75% of revenue is derived from supplying automotive manufacturers and
the balance from distributing products in the after-sales market. The vast majority of raw
materials is sourced locally.
Automotive manufacturing customers have 180-day payment terms with CoolX. While this
places significant pressure on the company’s cash flows, the strong negotiating power of
the automotive manufacturers has ensured that 180-day trade terms are the norm for the
industry. After-sales market customers are required to pay 60 days after delivery of
products by CoolX. The customers, in general, use the entire term of credit extension
allowed.
CoolX funds its investment in working capital by means of banking facilities provided by
ABC Bank, mainly in the form of an overdraft facility. The facility is secured by a cession of
receivables and a general notarial bond over inventory and other assets.
Further information from the financial statements of CoolX for the year ended 30 June
2010 is as follows:
2010
2009
Inventory
R5 500 000 R4 200 000
Accounts payable
R2 600 000 R1 900 000
Revenue
Cost of sales
R16 800 000 R14 400 000
R11 300 000 R9 500 000
The following is based on average statement of financial
position balances:
• Cash cycle in days
• Creditors payment cycle in days
?
?
REQUIRED
240
50
Marks
(a) (i) Calculate the cash cycle for CoolX for 2009 and 2010 in days.
4
(ii) Discuss your answer in (i) using the available information.
5
Question 1 (Suggested solution)
Inventory days = (5 500+ 4 200)/2/11 300 x 365 = 156.66 days
Debtors’ days = (.75x180+.25x60) = 150 days
Creditors’ days = (2 600 + 1 900)/2/(11 300+5 500 – 4 200) x 365 = 65.18 days
(2009: 50 days)
2
Cash cycle = 156.66 + 150 - 65.18 = 241.48 days (2009: 240 days)
1*
The cash cycle is almost the same as the previous year and the period for which the
financing must be arranged remained almost unchanged. It seems like this cash
cycle, during which CoolX must wait for their cash, is long. It would be a good idea to
compare it with the sector information.
The components of the cash cycle, namely the creditor payment period and the
working capital cycle (306.66 days in contrast with 2009’s 290 days) were however
extended.
Since creditors’ days increased, but the cash cycle remained the same, there had to
be an increase in debtors’ or inventory days.
CoolX took longer to pay their creditors than before - it could have a negative effect
on relationships with suppliers.
Inventory increased during the year, which could be the cause of the extension in the
working capital cycle. There could be obsolete inventory, or the manufacturing
process could take longer, or the products are not sold as quickly.
The debtors’ days are long, but it’s the norm in the sector, and thus can probably not
be shortened.
1
1
2*
1
1
1
2
1
Total 13
Maximum 9
QUESTION 4
40 marks
Showhouse Limited (“Showhouse”) is listed in the Consumable goods sector of the
JSE Securities Exchange. The company operates a mail order business where household goods
are advertised in catalogues from which customers can order. Most of the products in the
catalogues are imported from China. You were recently appointed as the financial manager of
Showhouse. You were immediately confronted with this large issue.
Liquidity risk
Showhouse is experiencing problems with the collection of debt from export customers.
Showhouse annually has about R10 000 000 of credit export sales to customers in various
countries in Africa. The sales are invoiced in Rand and a 60 days credit period is given. Payments
are, however, 30 days late on average. Approximately 0,5% of these sales, in value, constitute
debtors who are written off as irrecoverable. At the moment no special arrangement was made
with reference to export sales.
As a result of collection problems, Showhouse is considering one of the following: the use of a nonrecourse factoring house; or to insure the exports against non-payment. One of the directors posed
the question why the export sales are not entirely stopped?
The factoring house can offer one of two services, namely a financing service where immediate
financing of 80% of export credit sales is made available at an annual interest rate of 2 percentage
points above the prime rate. The other alternative is that the factoring house collects the debtors
and pays Showhouse the total invoiced amount when the debtors’ credit period expires. For both
alternatives the service fees for debt collection is 3% of credit sales. Utilisation of factoring can
lead to a saving of R260 000 per annum in administrative costs in both cases. As the factoring
house is specialised in collecting debt in Africa, it is not expected that debtors will extend their
approved credit terms.
The comprehensive insurance policy is 25c per R100 that is ensured, and covers 90% of the risk of
the non-payment of exports.
Showhouse has overdraft bank facilities, which is currently not utilised in full. It bears interest at an
annual rate of 2.5 percentage points above the prime rate*.
The gross profit percentage on export sales is 15%. Export customers do not make use of
discount. If exports are stopped, the cash which is gained from the collection of the debtors can be
utilised to decrease the overdraft bank facility.
REQUIRED
Marks
(b)
Identify the key procedures Showhouse Limited should follow when the
creditworthiness of new South African clients is reviewed.
(c)
Make a recommendation with regards to the following issues applicable to the
export debtors:
i.
Which method of hedging against the non-payment of foreign debtors is the
most profitable?
* Accept a prime rate of 9%
4
14
Question 4 Suggested solution
Part (b):
•
•
•
•
•
•
•
The requirements of the national credit act and FICA (ID document and proof of physical
address) must be complied with. 
Investigate the financial condition of the debtor (personal balance sheet; pay slip).
Compare the amount of credit being applied for with the monthly surplus on his
salary/earnings.
Credit history - investigate at the credit bureaus.
Check the security provided by the debtor. 
Consider the general economic condition and whether it is favourable to grant credit at this
time.
Review the debtor’s character and attitude towards payment of accounts - look at own history
of the customers’ previous transactions.
Max 4
Part (c):
There are three methods of hedging against non-payment of debtors, namely insurance, factoring
without financing and factoring with financing.
Insurance
Cost R10 000 000 x 0.25/100
Decrease bad debt 90% x 0.5% x R10 000 000
Saving
Factoring without financing
Cost 3% x R10 000 000
Administrative savings
Saving in financing cost* (9%+2.5%) x 30/365 x R10 000 000
Saving in bad debt 0.5% x R10 000 000
Factoring with financing
Cost 3% x R10 000 000
Administrative savings
Financing cost paid* (9%+2%) x 60/365 x R10 000 000 x 80%
Saving in financing cost* ((9%+2.5%) x 90/365 x R10 000 000 x 80%
+(9%+2.5%) x 30/365 x R10 000 000 x 20%
Saving in bad debt 0.5% x R10 000 000
(25 000) 
45 000
R20 000
(300 000) [½]
260 000 [½]
94 521[1½]
50 000 [½]
R104 521
.
(300 000) [½]
260 000 [½]
(144 658)[1½]
245 753 [3]
50 000 [½]
R111 095
.
Showhouse will save the most if they utilise the factoring house with the financing option. *
*See commentary on next page.
Explanation of financing cost in Showhouse:
The current situation (what would have happened if neither of the two factoring house options
are chosen) is being compared to each of the two factoring house options.
Current situation:
Normal credit period (60 days)
60 Days
1
Carrying cost (Prime + 2.5% = 11.5%)
3
90 Days
30 days late
If Showhouse did not make use of the factoring house at all, they would have had to carry the
debtors for the full 90 days (the credit period + 30 days late on average). The scenario states
that Showhouse will use any cash gained from the collection of the debtors to decrease the
overdraft bank facility. The carrying cost / cost saving is therefore equal to the cost of the
overdraft, being Prime +2.5% = 11.5%.
The factoring house provides two options:
Option 1:
Get financing of 80%
of debtors, from day 1
Pay interest on the financing
(Prime + 2% = 11%)
2
60 Days
90 Dae
Debts will be
collected earlier
Option 1: The factoring house will give Showhouse financing from day 1, on 80% of the debtors
at a cost of 11% (Prime +2%). Showhouse will have to pay interest on this advance until the
day the factoring house collects the debts. The factoring house will transfer the remaining
balance of debtors (20%) once they have collected the debt. On this day, Showhouse will stop
paying interest on the advance. There is, however, an advantage to Showhouse performing
the collection of debts as they will collect the debt within 60 days and not 90 days as
Showhouse would have done, had they performed the collection in-house. Showhouse will
therefore get their cash 90 days earlier: 80% on “loan” for the first 60 days and the full amount
for 30 days thereafter.
Comparison of Option 1 to current situation:
1. Immediately get 80% of the debtors-amount: R10m x 80% = R8m. Showhouse will
save the cost of carrying these debtors – i.e. their overdraft will be less for 60 days and
they will save interest. This saving is calculated as R8m x 11.5% x 60/365 = R151 232.
1
2. They do, however, have to pay interest to the factoring house on the 80% advance,
calculated as R8m x 11% x 60/365 = R144 657.
2
3. They also get the advantage of the fact that they will get the full amount of R10m
30 days earlier than they would have, since the factoring house will collect the debt
3
30 days earlier, as the factoring house’s collection period is 60 days, not 90 days. This
will give them a cost saving of 11.5% (that which is saved when the overdraft is not
used), calculated as R10m x 11.5% x 30/365 = R94 521.
The net effect is therefore R151 232 + R94 521 = R245 753 (as per memo) – R144 657 (as
per memo)
Option 2:
60 Days
90 Days
Debts will be
collected
Comparison of Option 2 to current situation:
1.
Showhouse will get the 30 day advantage of earlier collection (same as option 1)
= R94 521 (as per memo)
3
QUESTION 3
20 marks
Sea Pebbles Incorporated ("Sea Pebbles") is a Japanese company listed on the Tokyo Stock
Exchange, which specializes in the manufacture of cultured freshwater pearls. Sea Pebbles
operates exclusively out of its large-scale oyster farm on the shore of Lake Biwa, Japan. The
pearls are grown, harvested and processed on-site. Currently, sales are conducted on credit
directly from the farm’s admin office and are delivered countrywide. The financial yearend is
30 April.
The cultured freshwater pearls are grown by making a small incision in the shell of an oyster
and injecting the oyster meat with a sliver of the shell of a freshwater mussel. The oyster’s
immune response to the foreign sliver of mussel shell is the secretion of calcium carbonate
and proteins around the sliver, which results in the formation of a pearl. Since Sea Pebbles’
inception 18 years ago, the freshwater mussel shell has been purchased from a neighbouring
mussel farm owned by the Kawa family. The culturing process takes two to three years, from
the hatching of the oyster egg to the harvest of the pearl. Each oyster shell only yields one
pearl, which initially resembles a rough pebble. The harvested pearls are chemically polished
with a dye to simulate the shine and colour variations in natural pearls. Although the chemical
colourant currently provided by Sea Pebbles’ long-standing supplier (Hue Magic Inc.) is fairly
expensive, they are conveniently located within 30km of Sea Pebbles’ farm and offer free
delivery. Without this chemical treatment, Sea Pebbles' products are unsaleable. The oyster
farm uses approximately 200 kilograms of freshwater mussel shell and 75 kilolitres of chemical
colourant each week.
At the start of the 20x7 financial year, Sea Pebbles will change to a different supplier of the
chemical colourant. The new supplier is located more than 350km away from Lake Biwa, but
offers a significantly lower total cost price than Hue Magic Inc. Sea Pebbles is also awaiting
the May 20x6 launch of an online shopping facility which will be added to its website. The
functionality will allow Japanese and European Union customers to purchase the company’s
products online via credit card or electronic funds transfer. Sea Pebbles established an Italian
subsidiary to co-ordinate the shipping and delivery of all international orders, and will invest
further resources in the Italian subsidiary as its base for the European Union as international
demand rises. The admin team in Japan would prefer that no further credit sales transactions
be conducted by Sea Pebbles - allowing the Japanese admin office to focus solely on
managing the production process and distribution to the Japanese customer base.
Sea Pebbles’ shareholders have expressed dissatisfaction with the company’s planned
international expansion. At the recent meeting of the board of directors, the information content
of various management responses was considered. Ultimately a share buyback was proposed
at Yen 115 per share, although the chief of operations is still unclear as to why.
QUESTION 3 REQUIRED
(a) Advise Sea Pebbles Incorporated on a suitable net working capital
investment approach for the year ending 30 April 20x7.
Communication skills – logical reasoning
(b) Explain to the chief of operations what messages the share buyback
decision might communicate to Sea Pebble Incorporated’s existing
shareholders and potential investors.
Total
Marks
Sub
Total
total
14
1
15
5
5
20
QUESTION 3 - SUGGESTED SOLUTION
(a)
Maximum 15 marks:
Sea Pebbles should focus on aiming reduce risk of system breakdown or stockout (1). To this
end, they would prefer to hold higher levels of inventory (1). They would therefore tolerate a
longer net working capital cycle / days (1). Sea Pebbles could increase the net working capital
cycle by doing the following:
Debtors
They should allow their customers to have generous credit payment terms to stimulate
demand (1). This will be impossible with credit card sales and EFT, as there is no delay in
payment (1). Note that sales may also potentially be reduced by the lack of credit facilities for
customers due to credit card and EFT payment (1). Sea Pebbles could possibly allow existing
local customers to maintain their credit sale relationship (1).
Inventory
Increased level of inventory must be kept on hand to ensure availability for customers (1).
More finished goods should be kept on hand at the Japanese farm to compensate for the
additional delivery time to Italy for international sales vs delivery time for local sales (1). More
finished goods should be kept on hand to satisfy online customer expectations – they paid
immediately for the convenience of immediate fulfilment of their orders (1). More cultured
pearls (finished goods and work in progress). should be maintained on hand as the production
time for one pearl is lengthy (1). More cultured pearls (finished goods and work in progress).
should be maintained on hand as the exact production time for one pearl is uncertain and
could fall anywhere within a broad time range of 2 to 3 years (1). More cultured pearls should
be kept on hand at the Italian subsidiary, to avoid stockouts due to a delay in delivery from the
Japanese farm (1). Extra chemical colourant should be kept on hand to avoid potential
stockout, as the new supplier is much further away than Hue Magic Inc (1). Extra chemical
colourant should be kept on hand to avoidstockout due to a potentially unreliable new supplier,
with whom Sea Pebbles has no pre-existing relationship to judge their history of reliability of
supply (1). Extra finished goods should be kept on hand in case the actual sales demand from
the online facility exceeds expected demand (1).
Creditors
Suppliers must be paid promptly to build goodwill and business loyalty (1). Especially
important with the Kawa family, who may fear that Sea Pebbles will switch to a different mussel
shell supplier (as they did with the chemical colourant) (1). It is also important for Sea Pebbles
to build up a good credit history with the new supplier of the chemical colourant, (1).
However, there are risks involved with a conservative approach:
Maintaining existing credit relationships with customers will create unnecessary financing
costs, which causes unprofitability (1). There is a risk of cash flow problems due to Sea Pebble
paying for the supply of raw materials before there is cash inflow from sales demand (low risk
as all new customers will pay using credit card; however maintenance of existing credit
customers is suggested) (1). There is no risk of inventory obsolescence, given the nature of
the pearl product (1). There are various holding costs associated with holding high levels of
inventory – eg storage, insurance etc (1).
Any other valid comment, adequately explained
(1).
Conclusion: Sea Pebbles should use a conservative or moderate approach to their net working
capital investment (2).
Communication mark: Clarity of explanations and logical reasoning (1).
QUESTION 2
63 marks
Assume today is 31 December 2019.
Always-On (Pty) Limited (‘Always-On’) is a company that imports diesel-fueled generators
from China, and distributes it to various retailers in South Africa. The demand for diesel-fueled
generators increased significantly with the recent implementation of loadshedding. It is
foreseen that the current loadshedding will continue into the foreseeable future. Always-On’s
year-end is 31 December, its functional currency is South African Rands (ZAR) and the target
debt ratio is 40%. At the final board meeting for 2019, various proposals were made by
different directors.
The managing director proposed that the credit policy be changed from 1 January 2020 to
encourage sales and increase market share during this period of increased demand. Apart
from changing the payment terms, he proposed that more customers should be granted credit
and all customers’ credit limits should be increased by 20%. He estimated that credit sales
could increase by 25% if these changes are implemented. The 2019 policy was 2/10 net 50,
and 30% of debtors made use of the early settlement discount. Bad debts amounted to 3% of
the credit sales to customers who did not make use of the discount. The proposed new policy
for 2020 is 6/15 net 40. It is expected that 60% of debtors will make use of the discount, and
bad debts will increase to 7% of debtors that do not make use of the discount. Always-On
maintains a 50% gross profit margin on sales, and 40% of all sales were on credit in 2019.
Administration costs relating to debtors’ management will probably stay the same at
ZAR500 000 per annum. The opportunity cost associated with an investment in working capital
is 10% per annum.
The financial director thinks it will be a good idea for Always-On to move from a moderate to
an aggressive working capital financing policy from the start of 2020. With the aggressive
policy, 80% of the permanent current assets will be financed with short-term finance. Of the
current asset balance as at 31 December 2019, 40% are considered to be permanent. The
following three options could be used to fund this change in policy:
1) Always-On’s biggest supplier in China, Qinghai Electrics, supplies 60% of all inventory,
with credit terms of 2/30 net 65. Historically, Always-On has always made use of the
discount option. The rest of the inventory is purchased from a few very small suppliers.
2) The bank is willing to make a 90-day revolving bankers’ acceptance facility for
ZAR5 000 000 available at a commission of 2% per annum. The current 90-days
bankers’ acceptance rate is 1.25% above prime. The commission is payable at the
issuance of the facility.
3) The bank is prepared to factor all the debtors of Always-On, with recourse, at a service
fee of 5% of the projected credit turnover, and a financing charge of 11% per annum.
The retention rate is 10%.
In anticipation of the projected increase in profits, the CEO has been arguing for the
declaration of a dividend of ZAR45 000 000: ‘A dividend payout is more valuable to our
shareholders than uncertain future business growth’. The only approved new capital project
for the next year is the acquisition of Solaris Limited, a company in the solar energy industry
with an estimated return on investment of twice the weighted average cost of capital of AlwaysOn, for an amount of 2 000 000 United States Dollar (USD). The acquisition price was
adequately hedged with a money market hedge at an effective rate of USD1.00 : ZAR 20.00.
The following foreign currency futures were also available:
Contract
size
USD500 000
USD700 000
USD200 000
USD100 000
Futures price
Initiation date
Expiry
USD is depreciating at 14% per annum
against the ZAR
USD is trading at a discount of 12% per
annum to the ZAR
ZAR is appreciating at 8% per annum
against the USD
ZAR is trading at a premium of 9% per
annum to the USD
1 January 2020
31 May 2020
1 January 2020
31 July 2020
1 May 2020
30 June 2020
1 July 2020
31 July 2020
The following figures were made available from the unaudited financial statements for the year
ended 31 December 2019:
Inventory – 1 January 2019
Inventory – 31 December 2019
Debtors – 31 December 2019
Creditors – 31 December 2019
Retained earnings – 1 January 2019
Sales revenue – 2019
Net profit after tax – 2019
Spot rate on 31 December 2019
ZAR
9 432 000
15 721 000
9 860 000
6 529 000
158 467 000
258 470 000
39 252 000
USD1.00 : ZAR 16.00
Use 365 days per year.
Use a South African prime rate of interest of 9.75% per annum.
Marks
QUESTION 2 REQUIRED
(a)
(b)
(c)
(d)
Subtotal
Total
Calculate the impact of the change in credit policy on the net profit of
Always-On (Pty) Limited for the 2020 financial year.
13
Communication skills – Layout and structure
1
14
Ignore the proposed change in credit policy in your calculations.
18
18
Critically discuss the proposal to change to an aggressive working
capital financing policy.
4
4
Advise Always-On (Pty) Limited on the most appropriate way to
finance the change in working capital financing policy, should the
financing policy change be accepted.
Ignore all working capital proposals for the 2020 financial year
for this part of the question.
Present and motivate contrasting arguments to the viewpoint
expressed by the chief executive officer with respect to dividend
declaration. Support your arguments with the calculation of an
appropriate dividend for the 2019 financial year.
11
Communication skills – Logical argument
1
12
(e)
Critically discuss the effect of changes in the municipal price of
electricity on Always-On (Pty) Limited. No calculations are required.
8
8
(f)
Assume that the acquisition of Solaris Limited was concluded
on 30 June 2020 (spot rate = USD1.00: ZAR 19.50) and that a
money market hedge had never been available.
7
7
Calculate the effective exchange rate if Always-On (Pty) Limited had
instead hedged its foreign exchange exposure related to the
acquisition price of Solaris Limited on 1 January 2020 using futures.
Show all cash inflows as positive and cash outflows as negative.
Total
63
QUESTION 2 - SOLUTION
a)
Credit sales in 2019 = R258 470 000 x 40% = R103 388 000
Credit sales in 2020 = R103 388 000 x 1.25 = R129 235 000
Total sales in 2020 = R129 235 000 credit + (R258 470 000 x 60% cash sales unchanged)
= R129 235 000 + R155 082 000 = R284 317 000
ΔG
= NEW – OLD
= (R129 235 000 credit sales x 50%) [1] – (R103 388 000 credit sales x 50%) [1]
= R64 617 500 – R51 694 000
= R12 923 500
Increase in gross profit, increase in net profit
OR
= (R284 317 000 total sales x 50%) [1] – (R258 470 000 total sales x 50%) [1]
= R142 158 500 – R129 235 000
= R12 923 500
Increase in gross profit, increase in net profit
ΔB
= NEW – OLD
= (40% x R129 235 000 x 7%) [1] – (70% x R103 388 000 x 3%) [1]
= R3 618 580 – R2 171 148
= R1 447 432
Increase in bad debts, decrease in net profit
ΔD
= NEW – OLD
= (60% x R129 235 000 x 6%) [1] – (30% x R103 388 000 x 2%) [1]
= R4 652 460 – R620 328
= R4 032 132
Increase in discount allowed, decrease in net profit
ΔI
= Change in debtors x Opportunity cost %
= R1 947 377 [see calc 1 below] x 10% [1m]
= R194 738 Decrease in debtors, decrease in carrying cost, increase in net profit
Calc 1: Change in debtors
Collection days: Debtors’ balance / Credit sales x 365
Current collection days: R9 860 000 / R103 388 000 x 365
New collection days: (60% x 15) + (40% x 40)
34.8 ~35 days [1]
25 days [1]
Alternative – new collection days:
R129 235 000 x 60% x 15/365 (early-settled for discount) = R3 186 616
R129 235 000 x 40% x 40/365 (paying full price)
= R5 665 096
New debtors’ balance:
= R8 851 712
New collection days: R8 851 712 / R129 235 000 x 365 = 25 days
Increase in sales (R129 235 000 – R103 388 888), thus increase in debtors:
R25 847 000 x 25/365 [1m with new collection days]
x 50% (investment at CP of inv) [1]
+R885 171
Existing debtors pay earlier, thus decrease in debtors:
R103 388 000 x 10/365 [1m with diff in collection days]
Total decrease in debtors
-R2 832 548
-R1 947 377
Cumulative: ΔP = ΔG – ΔB – ΔD – ΔI
Increase in NP = [(R12 923 500 – R1 447 432 – R4 032 132) x 72% ] + R194 738
= R5 554 372 [1m]
Communication skills – Layout and structure [1]
[Maximum 14 marks; Available 14 marks]
b)
ADDITIONAL SHORT TERM FINANCING
Total current assets = 15 721 000 + 9 860 000 = 25 581 000
40% permanent = 25 581 000 x 40% = 10 232 400 [1]
80% to be financed with S-T finance = 10 232 400 x 80% = 8 185 920 [1]
The current policy is moderate, thus you can assume that all permanent current assets are
currently financed with LT finance. Therefore, additional ST finance required is R8 185 920.
Option 1: Creditor discount
Purchases:
129 235 000 + 15 721 000 – 9 432 000
135 524 000 [1]
60% from Qinghai:
135 524 000 x 60%
81 314 400 [1m]
Additional finance
generated:
81 314 400 x 35/365
7 797 271 [1m]
Effective cost:
(1 + D/(100-D))(365/t)-1)
(1 + 2/(98) [1]))(365/35) [1]-1)
Option 2: 90-day bankers’ acceptance
Financing costs:
(2 + 9.75 + 1.25)% x 5m x 90/365
Net proceeds:
5 000 000 – 160 274
Effective annual cost:
[1 + (160 274/4 839 726)](365/90) – 1
OR
[5 000 000 / 4 839 726] (365/90) – 1
Option 3: Factoring of debtors
Debtors
Net financing
9 860 000 – 10% retention
Service fee
Finance charges
Admin cost saving
Discount saving
Bad debts saving
Total annual cost
Net financing cost
5% x 103 388 000
11% x 8 874 000
[OLD discount in Part a]
None – with right of recourse
[-1] if included
5 025 212 / 8 874 000
Cheapest = 90-days banker’s acceptance [1m]
But insufficient financing available – i.e. only 5m available [1m]
Finance the rest by extending creditor payment days [1m]
[Maximum 18 marks; Available 18 marks]
23.45%
160 274 [1]
4 839 726 [1m]
14.13% [1m]
9 860 000
8 874 000
5 169 400
976 140
(500 000)
(620 328)
[1]
[1]
[1]
[1m]
5 025 212
56.5% [1m]
c)
An aggressive policy is more risky, because of volatility in interest rates/ availability of funding
when needed [1 for risk or reason for risk]. The demand for generators might drop
significantly if electricity supply by the government is restored [1]. Sales and debtors’ collection
might slow down, causing a delay in cash received [1], creating cash flow pressure when
short-term obligations become payable [1]. However, more short-term funding does offer more
flexibility [1].
[Maximum 4 marks; Available 5 marks]
QUESTION 1
40 marks
Assume that today is 31 August 2020.
Mzansi Safari Tours (Proprietary) Limited offers customized semi-private safari tours across the
various wildlife and nature reserves in South Africa. Due to the high-end nature of their tour
packages and elite clientele, Mzansi allows its guests to settle their tour fees 45 days after their
tour has ended. Souvenirs and keepsakes are available for sale during the course of each tour,
by cash payment. Mzansi is able to access supplier credit to purchase these souvenirs, in addition
to the company’s other tour operating costs which are also payable on credit. However, in recent
years Mzansi has been experiencing liquidity pressure as evidenced by their overdraft being
dangerously close to breaching its limit of R750 000, as well as a level of gearing which is
moderately higher than the industry norm.
Below are extracts from the management accounts of Mzansi for the past 12 months of trading:
Results for the six months ending:
Tour revenue (credit)
Souvenir revenue (cash)
Cost of souvenir sales (credit)
Tour operating costs (credit)
31 August 2020
R12 690 000
R980 000
R581 000
R6 540 000
Balances as at:
Accounts receivable
Accounts payable
Inventory
Bank overdraft
28 February 2020
R9 580 000
R750 000
R396 000
R4 710 000
28 February 2020
R2 730 000
R979 000
R131 000
R495 000
The bank overdraft is a permanent source of financing, as the company utilises it solely to
supplement its working capital cycle. The overdraft has a variable interest rate which is currently
16% per year and it is expected to increase in the near future as the prime rate increases.
Mzansi’s interest rate exposure is exacerbated by a moderate level of gearing from the company’s
start-up loan, which had an amortised book value of R5 480 000 at the 2020 financial year-end.
The small-business loan was granted on 1 September 2013 by a black empowerment consortium
with equal annual instalments payable for a period of ten years, and interest incurred at 13.5%
per annum. In prior cash-flush years, Mzansi invested in listed zero-coupon bonds with a yield of
17% per annum. These debentures are redeemable in four years’ time at the total nominal amount
of R1 000 000 and are currently trading at a total market value of R2 600 000.
1
Marks
QUESTION 1 REQUIRED
Subtotal
Total
(a)
Calculate whether Mzansi Safari Tours Limited is immunised with
respect to its interest rate risk at 31 August 2020.
12
12
(b)
Calculate whether Mzansi Safari Tours Limited would have
exceeded its overdraft limit on 31 August 2020 if the net working
capital cycle remained at the same level as 28 February 2020, and
recommend feasible working capital management remedies that
Mzansi Safari Tours Limited could have employed to avoid such a
breach.
12
12
Critically evaluate whether Mzansi Safari Tours Limited should
consider the declaration of scrip dividends instead of cash dividends
in the foreseeable future.
5
Communication skills – logical argument
1
(c)
(d)
6
If Mzansi Safari Tours Limited takes out further debt funding to
alleviate its cash flow pressure, describe the impact on the
company's WACC using
─ the traditional view of WACC, and
─ Modigliani-Miller’s view with taxes.
9
Communication skills – clarity of expression
1
Total
10
40
2
SUGGESTED SOLUTION
QUESTION 1
b) Maximum 12 marks; Available 15 marks
Debtors’ days at 28 Feb 2020
Creditors‘ days at 28 Feb 2020
Inventory days at 28 Feb 2020
52.0068 [1]
34.9917 [1]
60.3725 [1]
Accounts receivable
Accounts payable
Inventory
Estimated NWC at 31 Aug 2020
Actual NWC at 28 Feb 2020
Additional financing needed
R3 173 126 [1m]
R1 172 173 [1m]
R161 600 [1m]
R2 162 553
(9 580’ + 12 690’) x 52.0068 / 365
(396’ + 4 710’ + 581’ + 6 540’) x 34.9917 / 365
(396’ + 581’) x 60.3725 / 365
R1 882 000
R280 553 [1m]
R2 730’ - R979’ + R131’
Conclusion:
R2 730’ / R9 580’ x 365/2
R979’ / (R396’ + R4 710’) x 365/2
R131’ / 396’ x 365/2
Mzansi would have exceeded their overdraft limit, at a balance of R775 553
[R495 000 + R280 553] [1m]
Feasible remedies (Maximum 4 marks):
─
In terms of inventory management, JIT systems could be set up [1] – although this
would require close working with suppliers [1]
─
In terms of receivables management, a factoring company [1] or invoice discounting
[1] could be used to ensure liquidity. Alternatively a prompt payment discount could be
offered to guest – although this would obviously have an impact on margins. [1]
─
In terms of payables management the key to minimising the cash impact would be to
negotiate an extension of credit terms from suppliers [1], however this is unlikely given
the length to which Mzansi has already pushed creditor payments may be detrimental
to supplier relationships [1]
3
QUESTION 1
20 marks
Assume today is 31 March 2022.
Detoly Limited (‘Detoly’) is a company that imports a variety of household goods from China,
which are then distributed to various retailers in South Africa. Besides their imports, Detoly
also purchases inventory from a few local suppliers to support the “Proudly South-African”
initiative. During the pandemic Detoly experienced significant delays in the delivery of their
imported items, and as a result have been out-of-stock quite often the past two years. They
have thus decided to accept a more conservative working capital investment policy moving
forward. The financial director estimated the additional investment required at R10 000 000.
The following figures were made available from the unaudited trial balance for the year ended
31 March 2022:
2022
R’000
Dt/(Cr)
Sales
(45 477)
Cost of sales
20 705
Opening inventory
7 681
Closing inventory
8 431
Trade receivables
7 762
Trade payables
(4 786)
Detoly’s credit policy is 5/15 net 40, and 80% of all sales are on credit. Historically 30% of
debtors made use of the discount, and bad debts amounted to 2% of debtors that did not make
use of the discount. Annual administration costs relating to debtors’ management amount to
R250 000. The credit policy will remain unchanged in 2023. The opportunity cost associated
with an investment in working capital is 10% per annum. Total sales are expected to increase
by 8% in 2023, but debtors’ behaviour is not expected to change.
The bank is offering two financing options to Detoly. The first is a 60-day revolving bankers’
acceptance facility for R5 000 000 at a commission of 1.5% per annum. The current 60-days
bankers’ acceptance rate is a fixed rate of 7.2% per annum. The commission is payable at the
issuance of the facility. The second option is to increase the current overdraft facility, which
carries interest at the prime rate plus 0.75%, with a further R5 000 000.
Wiser Financial Services Limited is a nationwide financial services provider and is willing to
factor all the debtors of Detoly. The factoring will be without recourse, financed at an annual
interest rate of 9% and a retention rate of 25%. The service fee for debt collection is 3.5% of
credit sales factored.
Detoly could also possibly extend payment to one of their creditors which supplies 70% of all
Detoly’s purchases. Their credit terms are 3/30 net 90, and currently Detoly is making use of
the discount option.
Marks
QUESTION 1 - REQUIRED
Subtotal
Present a report to the directors of Detoly Limited on the most appropriate
way to finance the change in working capital investment policy. Ignore
taxation.
19
Communication skills – Structure and layout
1
Total
Total
20
20
QUESTION 1 – SUGGESTED SOLUTION
REPORT
The Financial Director Detoly Limited
31 March 2022
Dear Mr A
Financing of additional working capital investment
Instruction was received to consider alternative ways of financing the additional R10 000 000
investment in working capital for the following year. Alternatives that can be considered are
discussed below. The detail cost calculation of each option can be found in Appendix A at the
end of this report. [1]
Option 1: 60-day revolving bankers’ acceptance facility
The availability of a bankers’ acceptance credit facility of R5 000 000 million will, given the fact
that the financing costs are charged in advance, provide financing of R4 928 493. The effective
financing costs amounts to 9.16% per annum.
Option 2: Overdraft facility
Only a maximum of R5 000 000 additional funding is available on the overdraft facility, at an
effective annual cost of 8.5% at the moment. However, the prime interest rate is expected to
increase [1] during 2022 and this will have a negative impact on the cost of financing, which
cannot be quantified at this time.
Option 3: Factoring of debtors
The factoring of clients will reduce the investment in debtors by approximately R6 297 505.
The cost of factoring amounts to 8.77% on an annual basis considering the service fees,
financing costs and administrative costs.
Option 4: Using supplier credit
To extend the creditor payment period is not a viable option [1], as it only provides
R2 468 795 worth of financing at a very expensive cost of 20.36% per annum.
Recommendation
From the abovementioned discussion it is clear that the overdraft facility is currently the
cheapest option, but only provides half the funding needed. Even though there is a risk that
the bank overdraft rate will increase, it is still 0.66% cheaper than the bankers’ acceptance,
and the overdraft is much more flexible than the bankers’ acceptance. I would thus
recommend using the debtors’ factoring option, together with the overdraft.
[1m] – Recommendation | [1m] – Discussion of 4 options in report
Please call if you have any further questions.
Yours sincerely
A.U di Tor
Communication skills – Structure and layout [1]
APPENDIX A
Option 1: 60-day bankers’ acceptance
Financing costs:
(7.2 + 1.5)% x 5m x 60/365
Net proceeds:
5 000 000 – 71 507
Effective annual cost:
[1 + (71 507 / 4 928 493)](365/60) – 1
OR
[5 000 000 / 4 928 493] (365/60) – 1
Option 2: Overdraft facility
Financing costs:
Prime rate
Premium
Option 3: Factoring of debtors
Debtors days
7 762 / (45 477 x 80%) x 365
71 507 [1]
4 928 493 [1m]
9.16% [1m]
7.75%
0.75%
8.50% [1]
78 days [0.5]
Credit sales 2023
(45 477 + 8%) x 80%
39 292 128 [0.5]
Cash advance
39 292 128 x 78/365 x 75%
6 297 505 [1m]
Service fee
Finance charges
Bad debts saving
Discount saving
Admin cost saving
Total annual cost
3.5% x 39 292 128
9% x 6 297 505
39 292 128 x 70% x 2%
39 292 128 x 30% x 5%
1 375 224
566 775
(550 090)
(589 381)
(250 000)
552 528
Net financing cost
552 528 / 6 297 505
[0.5m]
[0.5m]
[0.5m]
[0.5m]
[1]
8.77% [1]
Option 4: Creditor discount
Purchases:
20 705 000 + 8 431 000 – 7 681 000
21 455 000
70% Creditor:
21 455 000 x 70%
15 018 500 [1]
Additional finance
generated:
15 018 500 x 60/365
2 468 795 [1m]
Effective cost:
(1 + D/(100-D))(365/t)-1)
(1 + 3/(97) [1]))(365/60) [1]-1)
20.36%
QUESTION 2
VinoWino (Pty) Limited (hereafter ‘VinoWino’) is a company, based in Stellenbosch, that is
well-known for selling and distributing premium South African wines, to a few sought-after
retail stores in South Africa and in Europe. These wines are sourced from carefully selected
wine farms in South Africa and their vision is “to bring quality wine into the homes of winelovers.” VinoWino has 2 000 000 issued ordinary shares at the end of the 2022 financial year.
VinoWino acts as the middleman between the retailers and these wine farms. Due to
VinoWino’s long established relationships over the last ten years with these wine farms, they
can buy these wines at below retail price, which they can then sell for a larger profit to selected
retail stores. VinoWino has long standing contracts with these wine farms, who prefer
VinoWino to do their marketing, distributing and selling of their wines to retailers, on their
behalf, due to their expertise in the wine industry. The average selling price for a bottle of wine
ranges between R390 and R550 per bottle.
Total sales for the 2022 financial year amounted to R958 630 000, of which 80% were made
on credit. As a result of the disruption in the wine industry due to the alcohol bans, a number
of VinoWino’s customers fell behind with their account payments, resulting in average debtors
days of 65. This caused significant cash flow pressure to VinoWino. In an attempt to improve
cash flow, the directors of VinoWino are proposing a tightening of credit terms from 2/10 net
60, to 3/10 net 30 from the start of the 2023 financial year. It is estimated that this change
could lead to a 5% decrease in credit sales, but that 30% of debtors will make use of the
discount instead of 15% previously. The gross profit margin of 25% will remain unchanged.
Bad debts are expected to increase from 2% to 2.5% of the credit sales to customers that do
not make use of the discount option as a result of the change in policy. The opportunity cost
associated with an investment in working capital is 12% per annum.
Hedging of inventory purchases
Waini (Pty) Limited (‘Waini’) is a young wine farm in the Overberg with an award-winning
Serpentine chardonnay and which is owned by a broad-based black economic empowerment
(B-BBEE) consortium. Waini is a new addition to VinoWino’s supplier network and the
company is eager to strengthen their relationship with Waini as much as possible, as the BBBEE shareholder consortium own a number of other premium wine farms that VinoWino
would like to offer its services to.
One of VinoWino’s largest local clients, Diamond Liquor, ordered a shipment of 150 000
bottles of Serpentine chardonnay from VinoWino for a fixed selling price of R420 per bottle on
30 April 2022 to be delivered on 31 August 2022. VinoWino consequently ordered the
Serpentine stock from Waini for delivery on 31 August 2022, payable at the spot price on
delivery date. The spot price on 30 April 2022 was R350 per Serpentine bottle, and the
company was concerned that the fluctuating cost price of the chardonnay would eat into its
profit margins. Per the financial accountant’s calculations, the cost price at which VinoWino
would break-even was R310 per bottle. VinoWino therefore immediately entered a forward
contract with AgriFin Risk Limited for R310 per Serpentine bottle on 30 April 2022 with expiry
on 31 August 2022, to hedge the commodity risk on their purchase transaction. Ultimately, the
spot price of a bottle of Serpentine chardonnay was R330 on 31 August 2022.
Strategic expansion plans
Although VinoWino invoices their European retailers in Euro (which has strengthened against
the Rand), they have still experienced financial strain in the last two years, due to COVID-19
alcoholic beverages’ sales restrictions.
The CEO of VinoWino, Ms Massima Qualità, is therefore now considering expanding
VinoWino’s business by purchasing a well-known and established beer brewery in Windhoek,
Namibia, named NamBeer, which can hopefully bring more stability to their overall income to
offset fluctuations in their local and overseas sales markets. NamBeer produces beer in
Windhoek and has been sold in large quantities in South Africa and Namibia, for the last five
years. A beer is sold for between R12 and R15. VinoWino plans to keep the manufacturing
operations in Namibia unchanged, and only add a small general management team from
VinoWino, who will oversee and managed the overall Windhoek operations at a strategic level
in conjunction with the current operational manager of NamBeer.
There are no exchange rate differences between the Rand and Namibian dollar. The political
environment is stable in Namibia and the economic growth for 2022 is expected to be 3.3% in
Namibia and 2.1% in South Africa. If NamBeer is bought, VinoWino will merge with this
company and form a new entity called Vino & Beer (Pty) Limited. The Head Office of Vino &
Beer will remain in Stellenbosch, where most human resources, payroll, IT and finance
functions will be managed. NamBeer’s IT systems will also be merged with VinoWino’s
existing IT systems, to be compatible with each other and only a small support team in each
of these departments will remain in Windhoek, whilst all other redundant administrative staff
in these areas will be retrenched.
Rights issue
Ms Qualità also holds her own share portfolio, which you manage in her stead. One of the
companies that Ms Qualità holds shares in, Felix Limited, has recently announced a rights
issue. Ms Qualità wants to know what her options are in this regard. The Felix Limited share
price grew with 10% over the past year and are currently trading at R22 per share. The
company also distributed dividends of 100 cents per share to their shareholders over the past
year.
VinoWino’s profit after tax for 2022 amounted to R27 242 450, while the total equity at yearend was R198 850 000. VinoWino has to decide on declaring a dividend for the 2022 financial
year of R5 000 000, or investing the amount in a project with an expected return of 17% per
annum.
Marks
QUESTION 2 – REQUIRED
(a)
(b)
(c)
(d)
Recommend whether VinoWino (Pty) Limited should pursue their expansion
plan by critically evaluating the relevant strategic considerations’ impact on
their business.
Communication skills – logical reasoning
(f)
Total
Total
27
1
28
Calculate the return that Ms Massima Qualità earned on her investment in
Felix Limited over the past year.
2
2
Critically discuss the courses of action that Ms Massima Qualità should
consider regarding Felix Limited’s rights offer.
8
8
17
17
Explain whether the forward contract with AgriFin Risk Limited was an
appropriate hedging strategy for the Serpentine chardonnay transaction, if
the forward contract had been:
i)
ii)
(e)
Subtotal
Gross settled; or
Net settled.
Calculate the impact of the change in credit policy on the net profit of
VinoWino (Pty) Limited for the 2023 financial year, using the gross method.
Ignore tax.
11
Communication skills – presentation
1
Write an email to the directors of VinoWino (Pty) Limited in which you explain
and quantify the effect on earnings per share of the choice between
declaring the R5 000 000 dividend or reinvesting the earnings in the new
project. Also advise them on what the best option would be.
7
Communication skills – layout and structure
1
12
8
75
Proposed Solution
(e)
Credit sales in 2022 = R958 630 000 x 80% = R766 904 000
Credit sales in 2023 = R766 904 000 x 0.95 = R728 558 800
Total sales in 2023 = R728 558 800 credit + (R958 630 000 x 20% cash sales
unchanged)
= R728 558 800 + R191 726 000 = R920 284 800
ΔG
= NEW – OLD
= (R728 558 800 credit sales x 25%) [1] – (R766 904 000 credit sales x 25%) [1]
= R182 139 700 – R191 726 000
= R9 586 300
Decrease in gross profit, decrease in net profit
OR
= (R920 284 800 total sales x 25%) [1] – (R958 630 000 total sales x 25%) [1]
= R230 071 200 – R239 657 500
= R9 586 300
Decrease in gross profit, decrease in net profit
ΔB
= NEW – OLD
= (70% x R728 558 800 x 2.5%) [1] – (85% x R766 904 000 x 2%) [1]
= R12 749 779 – R13 037 368
= R287 589
Decrease in bad debts, increase in net profit
ΔD
= NEW – OLD
= (30% x R728 558 800 x 3%) [1] – (15% x R766 904 000 x 2%) [1]
= R6 557 029 – R2 300 712
= R4 256 317
Increase in discount allowed, decrease in net profit
ΔI
= Change in debtors x Opportunity cost %
= R88 666 709 [see calc 1 below] x 12% [1m]
= R10 640 005
Decrease in carrying cost, increase in net profit
Calc 1: Change in debtors
Current collection days: Given
New collection days: (30% x 10) + (70% x 30)
65 days
24 days [1]
Decrease in sales, thus decrease in debtors:
= (R766 904 000 - R728 558 800) x 65/365 [1m]
6 828 597
Existing debtors pay earlier, thus decrease in debtors:
= R728 558 800 x (65-24)/365 [1m]
81 838 112
Total decrease in debtors:
88 666 709
Cumulative: ΔP = ΔG – ΔB – ΔD – ΔI
Decrease in NP = –R9 586 300 + R287 589 – R4 256 317 + R10 640 005
= R2 915 023 [1m]
Communication skills – Presentation [1]
QUESTION 2
48 MARKS
Trojan Security & Intelligence Limited (‘Trojan’) is a Johannesburg Securities Exchange-listed
security surveillance software company that develops and sells standardised plug-and-play
software for download. Once the download has been concluded, Trojan has no further
involvement with the program or its use as they do not offer upgrades or maintenance
services. Trojan is a registered value added tax (VAT) vendor and pays VAT on the accrual
basis. The South African Revenue Service (SARS) levies VAT at a rate of 15% for local
supplies. Export sales are zero rated. Firms that have a turnover of over R30 000 000 per year
are required to submit a VAT return each calendar month by the 25th day of the following
month.
The company became a public name internationally in July 2021 when the news broke globally
that its trademarked Perseus spyware was used by a Russian governmental agency to illegally
snoop on political activists, journalists and foreign businessmen. Several countries in the
United Nations, including the United Stated and the United Kingdom, immediately responded
by temporarily blocking the sale of Trojan cybersecurity products within their borders. Trojan’s
spyware products were also indirectly implicated in the reported hack of local online
marketplace, Makes-a-lot, during a hostile takeover bid by international e-commerce giant,
Amazam, later in 2021. The surge of negative publicity surrounding Trojan’s customers’
unlawful use of their software and the aforementioned restrictions on its distribution network
saw Trojan experience a decline of 8% in its annual revenue in the 2022 financial year.
Fortunately, market analysts view the consequent fall in Trojan’s profitability as reversible and
the company is overwhelmingly seen as an industry leader in cyber-surveillance software.
Rather than take on excessive debt funding to finance a pre-approved investment project into
synthetic media (i.e. deepfake technology), Trojan’s financial director would prefer to raise
part of the cash needed by reducing its dividend per share by 22%. However, he has not yet
formally made this proposal to the rest of the board of directors. Shareholder approvals and
all related investment calculations for the deepfake project were approved in December 2020
and the actual launch is planned for January 2023. The deepfake project was publicly
announced at the start of the 2022 financial year and was received positively by the market
with much anticipation. Trojan’s net profit after tax is forecasted to increase by 18% in the
2023 financial year, mainly due to the expected profitability of the deepfake project. Trojan
was trading at a closing price of R208.11 on 31 October 2022.
Working capital requirements of the deepfake project for the first six months of 2023
If Trojan commences with the deepfake project in January 2023, sales for the first six months
of the year is expected to be R120 000 000 per month (excluding VAT). 70% of sales is
expected to originate from local clients, and the remaining 30% from foreign clients. Suppliers
will invoice Trojan R66 530 000 per month – R57 852 174 relates to purchases and
R8 677 826 relates to VAT which Trojan will recover from SARS. In terms of Trojan’s credit
policy and arrangement with its customers and suppliers, Trojan receives and pays cash 90
days after the end of month of sale.
Extracts from Trojan’s financial statements for the year ended 31 October 2022 are
presented below:
Statement of Financial Position as at 31 October 2022
Non-current assets
Inventory
Trade receivables
Cash and cash equivalents
Total assets
Rm
57 502
7 670
1 521
3 847
70 540
Interest-bearing debt
Share capital (136 000 000 ordinary shares)
Retained Earnings
Total equity and liabilities
15 744
5 065
18 954
70 540
Statement of Comprehensive Income for the year ending 31 October 2022
Rm
Revenue
109 712
Cost of sales
(71 144)
Gross profit
38 568
Operating expenses
(32 357)
Profit from operations
6 211
Finance costs
(687)
Profit before tax
5 524
Income tax expense
(1 933)
Profit for the year
3 591
Statement of Changes in Equity as at 31 October 2022
Opening balance of retained earnings
Profit for the year
Dividends
Closing balance of retained earnings
Rm
20 966
3 591
(538)
24 019
Trojan aims to maintain financial ratios which are comparatively better than those of its
competitors in the security industry and does not set out to achieve a specific target capital
structure. The average interest cover in the security sector is 5.2 times and the average book
debt/ book equity ratio is 40%. The industry average for dividend pay-out is around 7%.
Amazam’s acquisition drive
Amazam is currently on a drive to expand their international exposure to the healthcare
industry since they are of the opinion that the international healthcare industry needs a
reinvention. They are particularly interested in Ospen Pharmacare Holdings Limited (Ospen),
a JSE-listed pharmaceutical company that provides affordable, high quality medical products
ranging from general anaesthetics and muscle relaxants to Xa inhibitors to more than 100
countries.
Amazam views the acquisition of Ospen as a good strategic fit to its existing healthcare
companies, including its online pharmacy offering, PillPackage, which it acquired in 2018.
Consequently, Amazam offered Ospen 12 American dollar (USA$12) per share to acquire the
company, which represents a 25% premium to the current share price. Ospen’s management,
however, has indicated that the offer is too low. Ospen is currently erecting a state-of-the-art
research facility, which, according to their estimates, will double its profits over the next three
years and will probably be the cornerstone of the company’s innovation in the foreseeable
future. Therefore, they feel that Amazam’s current offer is historically based and does not
consider the growth in earnings that will be realised in the near future. Amazam subsequently
reviewed the project appraisal prepared by Ospen’s project director, in which net operating
cash flows stemming from the new facility were forecast to grow by 30% per annum over the
next three years, before normalising.
Based on the review of the project appraisal, which used a cost of capital of 17% in nominal
terms, Amazam increased its offer to USA$24 per share. However, Ospen shareholders will
only receive USA$12 per share in cash, without any caveats, on acceptance of the new offer.
The remainder of the new offer will be subject to an earn-out arrangement, which stipulates
that Ospen shareholders will receive the remainder of the new offer in three equal instalments
as, and if, Ospen reaches its targeted net operating cash flows over the next three years and
only if:
•
the project’s internal rate of return exceeds 50%; and
•
the project’s profitability index exceeds two.
Should Ospen fail to reach any of the targeted net operating cash flows in any one of the
following three years or fail to meet the two additional performance measures stipulated
above, no further instalments will be made to shareholders.
Although Ospen’s management team and shareholders are confident that they will be able to
reach the net operating cash flow targets, their largest shareholder, the Public Investment
Corporation Limited (PIC), is concerned about the additional two performance measures
stipulated in the earn-out arrangement. Therefore, the PIC requested that a second opinion
be obtained prior to the acceptance of the new offer to determine whether the new project will
be able to reach the two additional performance measures as stipulated by Amazam. After
accepting this engagement, you were provided with the following additional information in this
regard:
The initial cost of erecting the new research facility will be R6 000 000 000, in real terms, and
will require updates every five years, from the beginning of year three onwards, of R200 000
000, in nominal terms. S12C wear-and-tear allowance is applicable on the initial cost, while
S11(e) is applicable on the updates. Although Ospen expects that the new facility will be able
to generate R2 500 000 000 net operational cash flows, in nominal terms, within the first year
of operations, this estimate is based on full operational capacity, which will only be reached
within six months of commencing operations. The current estimate is that the facility will only
be operating at 30% capacity over first three months, after which it will be operating at 80%
capacity until full capacity is reached, which will then be maintained into the foreseeable future.
However, to achieve the net operational cash flows, an initial investment in working capital of
R1 500 000 000 is required, after which an annual working capital investment of
R500 000 000 is required, in real terms.
QUESTION 2 – REQUIRED
(b)
Total
Prepare a monthly cash flow budget for the period January 2023 –
June 2023, indicating the effect that the working capital requirement
of the deepfake project will have on the cash flow of Trojan Security &
Intelligence Limited, and briefly advise how possible cash shortages
can be managed.
Marks
SubTotal
total
12
12
xx
QUESTION 2 - SUGGESTED SOLUTION
(b) (Maximum 12 marks; available 14)
January
February
March
April
May
June
Debtors (Local & Foreign)
Sales
VAT @15% (Only on local sales)
132 600 000
120 000 000
12 600 000
132 600 000
120 000 000
12 600 000
132 600 000
120 000 000
12 600 000
132 600 000
120 000 000
12 600 000
132 600 000
120 000 000
12 600 000
132 600 000
120 000 000
12 600 000
Creditors
Purchases
VAT
66 530 000
57 852 174
8 677 826
66 530 000
57 852 174
8 677 826
66 530 000
57 852 174
8 677 826
66 530 000
57 852 174
8 677 826
66 530 000
57 852 174
8 677 826
66 530 000
57 852 174
8 677 826
3 922 174 3 922 174 -
3 922 174 3 922 174
132 600 000
66 530 000 3 922 174 62 147 826
132 600 000
66 530 000 3 922 174 62 147 826
132 600 000
66 530 000
3 922 174
62 147 826
Cash flows
Inflow from customers
Outflow to suppliers
Nett amount payable/receivable from SARS
Net cash flow
-
0 -
The deepfake project would require R3 922 174 cash in both February and March, before the project would generate enough cash to cover the
VAT obligation. [1]
Trojan currently has a positive cash balance of R3 847 000 000, but it is unclear what the cashflow needs of the rest of the business is (e.g.
whether this cash will decrease/increase). [1]
If Trojan incurs significant capital expenditure in January and February, it may reduce the VAT payable on the deepfake project. [1]
If Trojan does need short term finance for the working capital requirements of the deepfake project, the following sources can be considered:
-
Applying for payment instalments from SARS (E.g Paying the VAT liability over a period of 6 months rather than the full amount in
February and March respectively. [1]
- Apply for an overdraft facility from Trojan’s bank. [1]
- Factoring of debtors for January/February [1] (after this period cash flow will not be a problem).
- Shortening debtors’ payment period to 30/60 days, as 90 days is quite long. [1]
- Increase creditors’ payment period to 120. Creditors might not approve as 90 days is already long, however, it might be a temporary
arrangement. [1]
Any other valid explanation can also earn marks.
[2]
[1]
[1]
[1]
[2]
[1]
QUESTION 2
41 marks
Sola Proprietary Limited (hereafter ‘Sola’) is a company that sells solar panels to solar installation
companies. These companies then install solar energy systems for both their residential and
commercial customers. Sola was one of the first companies who believed in the possibilities of
solar energy solutions in South Africa and have been in business from 2010 and currently have
a 15% market share in South Africa, with strong financial backing. Most other competitors have
a 5% - 10% market share. In this industry, competitors tend to mimic each other’s strategies
closely.
Sola buys the solar panels (the finished product) from a local manufacturer, Zemko Proprietary
Limited (hereafter ‘Zemko’), a wholesaler, who only sells their products to other companies and
not to the public. Zemko’s staff consists of several expert engineers who have been researching
and developing solar-based energy solutions for many years. Due to continuous Eskom related
power outages, the demand for installing solar systems in residential homes and commercial
businesses has escalated significantly in the last year. However, these systems are expensive
and can range from R150 000 to R2 500 000 – depending on the customer’s needs. Most
customers are now extending their mortgage loans or overdraft facilities to be able to afford these
systems.
Research has shown that the demand and use of rechargeable, longer lasting lithium-ion
batteries will keep increasing in the future. Sola’s senior management team is therefore now
considering expanding their product range by also selling these longer lasting, but much more
expensive batteries to the solar installation companies. These batteries are also manufactured
by Zemko and are used in solar systems to store power as well as being used in emergency
power backups, such as uninterruptible power supply (UPS) units. These batteries need to be
ordered and paid 3 months in advance. Due to the demand for these batteries, companies such
as Sola always needs to have sufficient stock on hand.
The South African government has also now allowed more solar-based energy to help replenish
the Eskom electricity grid. Inflation in South Africa has also been increasing in the last year.
Government responded by increasing interest rates, which has been increasing gradually in the
last year.
At the final board meeting of the 2023 financial year, the managing director proposed that the
credit policy be changed from the start of the next financial year to encourage sales and increase
market share. He proposed a more relaxed policy, as well as an increase of all customers’ credit
limits. The financial director estimated that this could lead to an increase of 35% in credit sales.
The current policy is 2/15 net 45, while the proposed new policy is 6/10 net 60. Bad debts
amounted to 5% of the credit sales to customers who did not make use of the discount, and this
figure is expected to drop to 4%. In 2023, 25% of debtors made use of the early settlement
discount, while it is expected that 20% of debtors will make use of the discount in 2024.
Administration costs relating to debtors’ management will probably increase with R500 000 per
annum. The after-tax opportunity cost associated with an investment in working capital is 12%
per annum.
The following figures were made available from the unaudited trial balance for the year ended
28 February 2023:
Sales (40% cash sales)
Cost of sales
Trade receivables
(Income)/Expense
(450 477 000)
315 334 000
29 620 000
Marks
QUESTION 2 - REQUIRED
(a)
Subtotal
Total
Calculate the impact of the change in credit policy on the net profit of
Sola Proprietary Limited for the 2024 financial year, using the
incremental method.
11
Communication skills – Layout and structure
1
12
(b)
Critically evaluate whether the change in policy is advisable, given
the impact on cash flow and profitability.
3
3
(c)
Evaluate Sola Proprietary Limited’s chances of successfully selling
lithium-ion batteries, by discussing how the relevant strategic
considerations may increase or decrease their chances of success.
25
Communication skills – Logical reasoning
1
Total
26
41
QUESTION 2 - SOLUTION
a)
Credit sales in 2023 = R450 477 000 x 60% = R270 286 200
Credit sales in 2024 = R270 286 200 x 1.35 = R364 886 370
ΔG
= NEW – OLD
= (364 886 370 – 270 286 200) [1] x 30% [1]
= 94 600 170 x 30%
= 28 380 051
Increase in gross profit, increase in net profit
ΔB
= NEW – OLD
= (80% x 364 886 370 x 4%) [0.5] – (75% x 270 286 200 x 5%) [0.5]
= 11 676 364 – 10 135 733
= 1 540 631
Increase in bad debts, decrease in net profit
ΔD
= NEW – OLD
= (20% x 364 886 370 x 6%) [0.5] – (25% x 270 286 200 x 2%) [0.5]
= 4 378 636 – 1 351 431
= 3 027 205
Increase in discount allowed, decrease in net profit
ΔI
= Change in debtors x Opportunity cost %
= 16 476 350 x 12% [1]
= 1 977 162 Increase in debtors, Increase in carrying cost, decrease in net profit
Change in debtors
Current collection days: 29 620 000 / 270 286 200 x 365
New collection days: (20% x 10) + (80% x 60)
40 days
50 days
[0.5]
[0.5]
Alternative – new collection days:
364 886 370 x 20% x 10/365
= 1 999 377
364 886 370 x 80% x 60/365
= 47 985 057
New debtors’ balance:
= 49 984 434
New collection days: 49 984 434 / 364 886 370 x 365 = 50 days
Increase in sales, thus increase in debtors:
94 600 170 x 50/365 x 70% (investment at CP of inv)
9 071 249 [2m]
Existing debtors pay later, thus increase in debtors:
270 286 200 x 10/365
Total increase in debtors
7 405 101 [1m]
16 476 350
Cumulative: ΔP = ΔG – ΔB – ΔD – ΔI
= [28 380 051 – 1 540 631 – 3 027 205 – 500 000[0.5]] x 0.72% [0.5] – 1 977 162
= 1 4807 633
[1m]
Communication skills – Layout and structure [1]
b) Available 5 marks; maximum 3 marks
The impact on profitability is positive, so yes, the change is advisable. [1m]
Given the planned expansion of Sola’s product range, the more relaxed credit policy might be
beneficial in attracting new customers (because the new range will also be more expensive) and
thus have an even greater positive effect on profitability. [1]
The change will however, require an investment in working capital of R16 476 350, which will
have a negative impact on current cash flow levels. [1m]
As Sola is expanding its product range, it will require an additional investment in inventory as
well, so it can be assumed that additional financing will be acquired in any case. The funding
should therefore just be increased to fund the additional debtors as well. [1m]
Any other valid comment. [1]
QUESTION 1
50 marks
Round your answers to the nearest two decimal points
Blue Bus Tours South Africa Proprietary Limited (‘BBT SA’) is a subsidiary of Blue Bus
International, an international group of sightseeing tour bus operators that offers sightseeing
tours to tourists in large cities across the world. BBT SA offers bus services that allow tourists
to hop on and hop off its buses at various points along popular sightseeing routes in Cape
Town. Cape Town is a popular holiday destination for local and international tourists and has
won many awards for being one of the top tourist destinations worldwide. The routes and stops
cover the major tourist attractions in and around Cape Town. BBT SA’s financial year end is
on 31 March every year.
BBT SA has been operating for a number of years and has been successful in attracting a
large number of tourists to make use of its services due to its strong brand and successful
marketing campaigns. Currently BBT SA is the only tour bus operator in Cape Town offering
this type of service and has received an operating licence from the local municipality to provide
this service, subject to conditions. Although BBT SA’s sales revenue is satisfactory, the
manager of BBT SA is concerned about maintaining its market share of offering sightseeing
options to tourists in Cape Town, as many other alternative transport options are becoming
available to tourists. BBT SA continually strives to identify more routes in the greater Cape
Town area that it could offer in the near future to remain competitive.
The strategic objectives of BBT SA include:
• To ensure financial success (by increasing its operating profit) and financial prosperity (by
increasing its return on capital employed*).
• To enhance its competitiveness, by ensuring that that the company is able to better convert
customer enquiries to sales and that customers are satisfied with the service provided.
• To enhance its efficiency, by ensuring the buses are operating optimally.
• To expand the number of bus routes offered and to employ skilled staff.
*Return on capital employed is calculated as follows: net operating profit ÷ (non-current and
net current assets)
Performance management
Blue Bus International wishes to use a balanced scorecard to measure and manage the
performance of BBT SA and its manager for FY2024. BBT SA is regarded as an investment
centre for performance management purposes.
The following extracts of the management accounts and other information relating to the
financial year ended 31 March 2024 (‘FY2024’) and FY2023 of BBT SA is available:
Revenue
Existing routes
New routes
Cost of sales
Gross profit
Operating expenses
Depreciation
Net operating profit
Notes:
1.
FY2024
R’000
79 000
72 000
7 000
(35 550)
43 450
(22 742)
(4 170)
16 538
FY2023
R’000
68 800
52 800
16 000
(30 960)
37 840
(19 748)
(3 300)
14 792
Non-current assets
Net current assets
Share capital
Retained earnings
Non-current liabilities
Notes:
2.
3.
FY2024
R’000
FY2023
R’000
97 980
9 360
107 340
92 000
6 420
98 420
40 000
30 835
36 505
107 340
40 000
13 420
45 000
98 420
Notes:
1. Assume the direct profit earned per new route is 30% of the sales revenue of each new
route, and that all new routes earn the same revenue per route in the first year of operation.
2. Assume that any additional acquisition of non-current assets were new buses, and that no
other non-current assets were sold during FY2023 and FY2024. Property, plant, and
equipment are accounted for at net book value. One bus is allowed to operate a maximum
of two bus routes.
3. The trade payables included in net current assets result from various service providers for
maintenance, consulting, and legal services. Included in the balance is an amount of
R1 275 000 payable to Cape Town Fleets Ltd. This balance remains fairly constant
throughout a year, as they are responsible for the services of all buses, as well as repairs
of any breakages. Their credit terms is 3/15 net 90. BBT SA usually makes use of the
discount option.
4. Other information: n/a
Future plans
BBT SA is also considering making tour-packages available to large international tour
operators. These tour operators can then pre-book bus tours for their clients, and receive
credit terms of 2/10 net 60. To make this more attractive, BBTSA is considering invoicing these
tour-packages in the tour operators’ local currency. Up until the 2024 year-end no customers
received credit terms.
The addition of the new foreign debtors to the working capital of BBT SA is expected to lead
to an initial short-term financing deficit of R2 000 000. BBT SA’s bank is willing to make a
90-day revolving bankers’ acceptance facility for R1 500 000 available at a commission of 1%
per annum which is payable at the issuance of the facility. The current 90-days bankers’
acceptance rate is 1.5% above the prime rate. The bank could also increase the current
available overdraft facility to R1 000 000 at the current prime interest rate.
Blue Bus International
Blue Bus International is listed on the London Stock Exchange. Their target capital structure
is a debt:equity ratio of 2.5:1. During the last few years a significant portion of long-term debt
has been repaid, leading to quite low leverage at the end of the 2024 financial year.
Blue Bus International wishes to make better use of the tax shield of debt in future. In order to
re-balance the capital structure, Blue Bus International is considering a significant share
repurchase scheme, funded by the issuance of 10 year 11% debentures.
Marks
QUESTION X – REQUIRED
(c)
Advise BBT SA on the most appropriate way to finance the
addition of debtors to working capital. Clearly show all supporting
calculations.
Subtotal
Total
10
10
Total
c)
Option 1: Creditor discount
Creditor balance:
Rx = days/365 x credit purchases
1 275 000
Credit purchases:
1 275 000 x 365 / 15
31 025 000 [0.5]
Financing available:
31 025 000 x 75 / 365
6 375 000 [0.5m]
Effective cost:
(1 + D/(100-D))(365/t)-1)
(1 + 3/(97) [1]))(365/75) [1]-1)
Option 2: 90-day bankers’ acceptance
Financing costs:
(1 + 11.75 + 1.5)% x 1.5m x 90/365
Financing available:
1 500 000 – 52 705
Effective annual cost:
[1 + (52 705/1 447 295)](365/90) – 1
OR
[1 500 000 / 1 447 295] (365/90) – 1
Option 3: Overdraft facility
Financing available:
Net financing cost
15.98%
52 705 [1]
1 447 295 [1m]
15.61% [1m]
1 000 000 [1]
11.75% [1]
The overdraft facility is the cheapest option, but does not provide sufficient financing. [1m]
Finance the short-fall with the banker’s acceptance.
[1m]
QUESTION 2
40 Marks
Pace (Proprietary) Limited (“Pace”) is the largest of two South African importers and
distributors of cardiological pacemakers to private hospitals. Pacemakers are used in
advanced heart surgery. Although Pace’s products are slightly more expensive than its
competitors’, hospitals and cardiologist-doctors place a very high premium on the expert
advice from Pace’s knowledgeable sales representatives. These representatives visit them
regularly to take orders and generally to train them on the use and selection of the most
suitable products for their specific needs. Pace’s sales representatives regularly attend
product training and international cardiology conferences to stay abreast of developments in
the field. All sales are on credit, with terms of 3/15 net 60.
The government, medical aids and patients put enormous pressure on the medical industry to
reduce costs over the entire supply chain, to make healthcare more accessible to more South
Africans. Pace’s board has mandated its management to respond to this pressure.
Consequently, Pace’s board wants to implement a Just-in-time (‘JIT’) inventory system.
Pacemakers are small and light-weighted, and while they are presently being imported per
ship and stored in bulk before distribution to hospitals, it would not cost much more to fly them
in from Spain as and when they are needed.
Medtronas, a Spanish company, is Pace’s only supplier and creditor, and has agreed to deliver
a pacemaker within 30 hours of receiving an order, directly to Pace’s hospital-customer in
South Africa. This time frame is the same as Pace’s current service level agreement with its
customers. In addition, Medtronas will package the parcels using Pace’s branded signage at
no extra cost, so that a customer will not even notice that the product had never touched
Pace’s own premises. In return for Medtronas’s flexibility in terms of order fulfilment, they
demand a reduction in its payment terms to strictly 15 days. Should Pace not comply with the
payment terms, all orders will be placed on hold.
The lease on a large section of Pace’s warehouse will be terminated, which should save
R8 000 000 in costs per year. Also, its existing sales and dispatching IT system will need to
be modified at a cost of R5 850 000 to accommodate the seamless communication of hospital
order details to Medtronas’s systems.
Pace uses the same gross profit percentage on all models of Medtronas’ pacemakers, and
this will not change during the 2025 financial year. Medtronas has also undertaken to keep all
their prices constant during 2025. The current weighted average cost of capital (WACC) is
13%.
Due to the decrease in creditor funding from Medtronas, the financial manager of Pace
realised that the debtors’ terms will have to be tightened. The proposed new terms are 3/15
net 40. He estimated that there will be a decrease of 8% in turnover volume with the
implementation of the stricter policy, and that the average debtors balance will be reduced to
R34 822 000. Pace’s loyal clients that currently make use of the early payment discount will
most likely not be affected by the change in credit terms. Bad debt, however, is expected to
increase with R1 447 500.
Pace’s most recent statement of comprehensive income and statement of financial position
for the year ended 29 February 2024 appear below:
STATEMENT OF COMPREHENSIVE INCOME FOR THE YEAR ENDED 29 FEBRUARY
Revenue
Cost of sales
Gross profit
Other income
Other expenses
Finance costs
Profit before tax
Income tax expense
Profit for the year
STATEMENT OF FINANCIAL POSITION ON 29 FEBRUARY
ASSETS
Non-current assets
Property, plant and equipment
Investments in listed shares
Current assets
Inventories
Trade receivables
Cash and cash equivalents
Total assets
EQUITY AND LIABILITIES
Equity
Share capital
Retained earnings
Liabilities
Non-current liabilities
Borrowings
Current liabilities
Borrowings
Trade payables
Current tax payable
Total equity and liabilities
2024
R’000
352 080
(264 060)
88 020
315
(49 772)
(4 882)
33 681
(9 153)
24 528
2024
R’000
10 412
1 452
11 864
43 200
62 700
13 664
119 564
131 428
5 000
11 840
16 840
42 958
42 958
3 823
67 281
526
71 630
131 428
Marks
QUESTION 2 - REQUIRED
(a)
(b)
(c)
Subtotal
Total
Calculate the effect that the changes in net working capital will have
on Pace (Proprietary) Limited’s net working capital cycle. Use 365
days per year in calculations.
4
4
Calculate the net present value of the suggested changes with
regards to Pace (Proprietary) Limited’s management of net working
capital. Ignore tax.
6
6
Critically evaluate the proposed changes in the management of
net working capital of Pace (Proprietary) Limited, taking into
consideration your calculations in (a) and (b) above.
4
Communication skills – Logical argument
1
QUESTION 2 – SUGGESTED SOLUTION
a)
Current cycle
Inventory days:
43 200 / 264 060 x 365 = 60 days
[0.5]
Debtors days:
62 700 / 352 080 x 365 = 65 days
[0.5]
Creditor days:
67 281 / 264 060 x 365 = 93 days
[0.5]
NWC:
60 + 65 – 93 = 32
[0.5me]
Inventory days:
0 days
[0.5]
Debtors days:
34 822 / 323 914 x 365 = 39 days
[0.5]
Creditor days:
15 days
[0.5]
NWC:
0 + 39 – 15 = 24
[0.5me]
New cycle
5
b)
Change in profit:
Gross profit (loss of sales)
Increase in bad debt
Decrease in lease expense
Change in annual profit
Cash inflow/(outfow):
Value of perpetuity
Reduction in debtors
Reduction in inventory
Reduction in creditors
Cash outflow - new systems
Total NPV
(323 913 600 – 352 080 000) x 25%
Given
(489 100) / 13%
62 700 000 – 34 822 000
67 281 000 – 9 983 638*
(7 041 600) [1]
(1 447 500) [1]
8 000 000 [0.5]
(489 100)
(3 762 308)
27 878 000
43 200 000
(57 297 362)
(5 850 000)
4 168 330
[1]
[0.5]
[0.5]
[1]
[0.5]
* The new creditor balance based on the new required payment terms of 15 days, and a 8%
drop in purchases, will be 15/365 x (264 060 – 8%) = R9 983 638
c)
Change to credit terms might be too strict, with an unnecessary loss in sales, as this will
shorten the NWC by 8 days. [1]
Because of the significant decrease in creditor days, debtors’ days of around 47 can still be
tolerated. [1]
Credit terms could still be made a little stricter, but care should be taken not to loose too many
customers over the tighter terms. [1]
The current debtors collection process should also be improved, as customers are already not
sticking to their payment terms (average of 65 days above maximum term of 60 days). [1]
The creditor balance was a significant portion of the funding of the investment in working
capital. [1]
The change in terms from the supplier will result in a significant cash outflow, but as the
investment in inventory and debtors will also decrease significantly, the decrease in creditor
financing will not be such a big problem. [1]
The direct cash outflow as a result of the decrease in creditors will be R57 297 362, which is
less than the direct cash inflow from the reduction in inventory and debtors of R71 078 000.
[1]
The increase in NPV is positive, so the change to a JIT system should be implemented. [1]
Available 8; Maximum 4
Communication skills – Logical argument [1]