2019 ITC JUNE EXAM MOCK 2 PAPER 1: SOLUTION

a Advise the Board on the implications to Twenty First and its Shareholders on 6
Offer 1 by FVCF.
Twenty First
1. The vision and mission of Twenty First may be diverted as FVCF will now be 1
owning a greater portion of decision-making rights.
2. The offer by FVCF has an immediate $1m cash injection into Twenty First, this 1
can be useful in financing operations and the potential acquisition.
However, as the debt injection is immediate, the conversion is in three years’ 1
time, the gearing of the company will be increased in the short to medium term
thereby increasing the interest burden and the financial risk.
3. − 50% of the loan will be repaid in share issue amounting to $750 000 1
which is a significant amount that will not only ease up on Twenty First’s
cashflows and reduce gearing but will also give us capacity to borrow
more for future developments as it seeks to expand or diverse into
Southern African markets. 1
− The shares will not be eligible for any dividend thus it will be
advantageous from a cashflow point of view to Twenty first to replace
interest earning debt with non-dividend paying equity.
4. Should FVCF decide not to convert this will may result in negative cashflow 1
implications on Twenty First as they would now need to repay the loan on top
of the additional $1million.
Shareholders
5. Power will be diluted as each member will now be owning: 2
Richard Muti= 4000/13000=30.8% x 33.3%= 10.3% + (66.7% x 20%) = 23.6%
Travis Janga= 3000/13000=23.1% x 33.3%= 7.7% + (66.7% x 15%) = 17.7%
Sarah Nhava= 3000/13000=23.1% x 33.3%= 7.7% + (66.7% x 15%) = 17.7%
FVCF =3000/13000=23.1% x 33.3%= 7.7% + (66.7% x 40%) = 34.4%
Employee Share Trust (66.7% x 10%) = 6.7%
 2019 ITC JUNE EXAM MOCK 2 PAPER 1: SOLUTION

6. The dividends of the current shareholders will not be affected as the loan is 1
convertible into Class B shares who have no rights to dividends.
7. Capital structure considerations
− Conversion will increase the amount of equity in the company 1
− This will consequently increase the cost of capital and reduce the number 1
of projects available to Twenty First which have returns higher than the
cost of capital.
− Any interest tax shields will be lost on conversion. 1

− Eventually value could be eroded. (M&M) 1

8. Valuation considerations
− Consider the company’s plans for the next 3 years. If the strategies and 1
investment opportunities are good then the value of the company will
be much more in 3 years’ time and thus the conversion will be value
destroying for existing shareholders.
− Adding a conversion option to the loan increases it value immediately.
What is Twenty First receiving in return? A premium? Lower interest 1
rates?
Total Available 15
Maximum 6

b Discuss with reference to offer 2, the approach you would take to allocate 5
the purchase price of shares between Class A and Class B shares. (No
calculations required)
There is need to get clarity from the Board if Class B shares are entitled to
liquidation value
The 1st question that needs to be addressed is whether each class of share has 1
any value attached to them.
Class A shares
 2019 ITC JUNE EXAM MOCK 2 PAPER 1: SOLUTION

These have a right to both dividends and voting, which means value can be 1
attached to the class A shares.
Class B shares
Their voting rights potential gives these shares control which is valuable as it 1
allows the controlling shareholder to derive synergic benefits.
Also, if class B shares are able to participate in the residual value of the 1
company, that would be another indicator of value that can be placed on these
shares.
Allocation basis
Class A shares can be valued, and any residual should be allocated to Class B 1
shares.
The class A shares may be valued using the dividend growth model, given their 1
rights to dividend income. or
The cashflows from the opportunities attached to class B shares may be 1
quantified and then valued and subtracted from the total equity value to
determine the value of Class B shares.
Other considerations
There is need to get clarity from the Board if Class B shares are entitled to 1
liquidation value
Total Available 8
Maximum 5

c i. Discuss the accounting treatment of the guest-for-life membership 20

for the year ended 31 December 2018.
Identify the contract
The guest for life membership meets the definition of a contract as per IFRS 15:9- 1
10
The programme of guest for life membership is a single contract since it was 1
negotiated as a package with a single commercial objective (IFRS 15:17a). In
 2019 ITC JUNE EXAM MOCK 2 PAPER 1: SOLUTION

terms of the contract, Twenty First Hotels promise to deliver 15 nights hotel
package per year and 20% discount on food and beverage purchases.
Identify the separate performance obligations
In order for these goods and services to be accounted as separate performance 1
obligations, according to IFRS 15:22a, the good or service or bundle of goods or
services should be distinct.
A good or service is distinct if both of the following criteria is met as per IFRS 1
15:27;
• The customer can benefit from the good or service on its own or together
with other resources readily available to the customer; and’
• The good or service to be transferred by the entity is separately
identifiable
As per IFRS 15:29, in assessing whether the goods or services are separately 1
identifiable, the objective is to determine whether the nature of the promise is
to transfer each of the goods or services individually or transfer a combined
item/s to which the promised goods or services to a customer.
The first criteria for the goods and services to be distinct is met as it is possible 1
that a customer may benefit from the hotel package on its own.
The goods and services are however not separately identifiable because; 1
• Twenty First is providing a significant program of integrating the goods 1
and services into a single combined output for which the customer will
be provided with
• The hotel package is significantly customised by Twenty First in 1
accordance with the programme
The entity would therefore account for the guest for life membership 1
programme as one performance obligation.
Determine the transaction price
 2019 ITC JUNE EXAM MOCK 2 PAPER 1: SOLUTION

The transaction price of the hotel package is the amount of consideration to 1

which an entity expects to be entitled in exchange for transferring promised
goods or services to a customer (IFRS 15:47).
The transaction price for the year per member would be $200 x 12 months 1
Allocation of transaction price
IFRS 15:73 states that an entity shall allocate the transaction price to each 1
performance obligation on a relative standalone selling price basis.
The stand-alone selling price is the price at which an entity would sell the 1
promised good or service separately to a customer, being $175 in this case.
Members from the guest for life programme receive a 20% discount for 1
purchasing food and beverages from restaurants in each hotel.
An entity should allocate a discount proportionately to all performance 1
obligations in the contract unless if the entire discount relates to one or more
but not all performance obligations in a contract (IFRS 15:81)
Recognise revenue
An entity shall recognise revenue when the entity satisfies a performance 1
obligation by transferring control of that asset (good or service) to a customer.
(IFRS 15:31)
At contract inception Twenty First shall determine whether in satisfies the 1
performance obligation over time or at a point in time.
The performance obligation is being satisfied over time as the customer 1
simultaneously receives and consumes the benefits provided by the entity’s
performance as the entity performs (IFRS 15:35a) and the revenue shall be
recognised over time.
Non-refundable entrance fees
Twenty First should assess whether the fee relates to the transfer of a promised 1
good or service as per IFRS 15: B49. In most cases, non-refundable upfront fees
do not result in the transfer of a promised good or service to the customer.
 2019 ITC JUNE EXAM MOCK 2 PAPER 1: SOLUTION

The upfront fee is an advance payment for future goods and services and 1
therefore would be recognised as revenue when those future goods and services
are provided.
Twenty First may according to IFRS: B51 charge the non-refundable fee in part 1
as compensation for costs incurred in setting up a contract.
Total Available 22
Maximum 20

ii. Discuss the IAS 12 tax implications resulting from the prepayments
by the guest-for-life members as at 31 December 2018. 5
The prepayments will have a carrying amount of $20 000 ($200 x 100 members) 1
at 31 December in the financial statements of Twenty First.
The tax base of the prepayments will be the sum of all the amounts that will be 1
included/deductible in determining Twenty First taxable income.
The tax base will therefore be $20 000 the amount prepaid by Twenty First which 1
is the same as the carrying amount of the liability.
Therefore, there will be no deferred tax asset/liability for the year ended 31 1
December 2018.
Carrying Amount Tax Base Temporary Diff DT @25.75%
20 000 20 000 - 1

N.B. Following the recent amendment to the Section 8 gross income definition, 1
ZIMRA and IFRS have aligned their timing of recognising prepayments.
Total available 6
Maximum 5

d For the purposes of determining an offer price for the business of Q - Brand:
i. Calculate the forecast period financial information and free
cashflows for Q-Brand for the forecast years that will give the 18
MAXIMUM purchase price.
 2019 ITC JUNE EXAM MOCK 2 PAPER 1: SOLUTION
Free Cashflow
Since the free cash flow is for purposes of determining the maximum offer price for Q-business, cash flows that do have synergistic benefits shall be used.
Details 2018 2019 2020 2021 2022
Rm Rm Rm Rm Rm Marks Notes
Revenue (97*1.24) 97.00 120.28 149.15 184.94 1 24% annual growth used, i.e with synergistic benefits

EBITDA (44 * 1.51) 44.00 61.34 77.56 96.17 2C 51% and 52% growth rates used i.e with synergistic benefits
Finance Costs (included in WACC) (2.20) - - - 1
Depn & Amort (no adjustment as earnings are
before Dpn & Amort) - - - 1C Irrevelant, non cashflow
Market related lease adjustment - - (0.10) 1 after lease term expires, expect to pay market terms.
61.34 77.56 96.07
Tax (W1) (16.17) (20.05) (24.57) 1C
Cash from Operations 45.18 57.51 71.50
Contigent Liability (0.20) - - 1 Cash outflow expected in 2019
Capex (W3) (9.62) (7.46) (5.55) 1C
Working Capital (W2) 0.50 (0.58) (0.72) 1C
Freecash Flows 35.86 49.48 65.24 1C

Tax (W1)
2018 2019 2020 2021 2022
Income - 61.34 77.56 96.07 1C
Capital Allowances (Revenue x 0.03) / 0.04 / 0.045 (3.61) (5.97) (8.32) 1 Used the depreciation and amortisation adjusted to revenue
Taxable Income 57.73 71.59 87.75
Tax @ 28% 16.17 20.05 24.57 1C

Working Capital (W2)

2018 2019 2020 2021 2022
Working Capital needs (0.03*97) / 2% / 2% / 2% 2.91 2.41 2.98 3.70 - 1

Working Capital Changes (0.50) 0.58 0.72 1C

Alternative
Revenue 120.28 149.15 184.94
Working Capital requirement (0.03*97) /2%/2%/2% 2.91 (2.41) (2.98) (3.70) - 2

Capex (W3)
2018 2019 2020 2021 2022
Revenue 97.00 120.28 149.15 184.94
Capex needs (11%*97)/ 8% / 5% / 3% 10.67 9.62 7.46 5.55 - 1

Capex Changes (1.05) (2.17) (1.91) 1C

Alternative
Revenue 120.28 149.15 184.94
Capex requirement (11%*97)/ 8% / 5% / 3% 10.67 (9.62) (7.46) (5.55) - 2

17
 2019 ITC JUNE EXAM MOCK 2 PAPER 1: SOLUTION

ii. Using the exit multiple methodology for the terminal value, calculate the enterprise value of the business of Q 8
Brand as at 31 December 2018.
See excel sheet.
Calculation of Enterprise Value 2018 2019 2020 2021 2022
Rm Rm Rm Rm Rm

Free cash Flows 35.86 49.48 65.24

Terminal Value ($96.07*7) 672.49 1C Applied exit multiple of 7 to year 2021 EBITDA
Free cash Flows 35.86 49.48 737.73
Enterprise value (R) R 596.56 1 Discount free cashflows @12%
Exchange rate ($1:R) 13 1
Enterprise value ($) $45.89 1

WACC 12% 1
4
 2019 ITC JUNE EXAM MOCK 2 PAPER 1: SOLUTION

e Identify the due diligence procedures that would have been performed as 14
part of the decision made Twenty First to acquire Q-Brand.

Communication skills: Clarity of expression 1

Review the primary players in the marketplaces in which Q-Brands competes; 1
determine the competitive niches occupied by each one, and how their actions
may impact Q-Brand.
Monitor trends in the clothing industry to verify if there have been or are 1
expected to be changes in profit levels or the size of the market.
Further, examine the expected impact of new technology on the market, and 1
how Q-Brand is positioned in relation to those technologies to gain an
understanding of the clothing market.
Analyse whether the industry has competitors that can enter and exist easily and 1
enquire from the targeted Q-Brand shareholders if there been a history of new
competitors arriving and taking significant market share, or whether market
share appear to be locked in among the current players
Obtain a chart that states the reporting relationships within the Q-Brand from 1
their website to identify who to contact for more information and who to
investigate for roles in the business if the acquisition is completed.
Perform a trend analysis over the past three years to confirm whether there 1
have been other acquisitions in the industry lately and to investigate what is
driving the trends as it could be possible that the industry is going through a
period of consolidation, which may impact the price Twenty First offers to Q-
Brand.
Perform analytical procedures on the extracts of the Q-Brand financial 1
statements using a horizontal analysis to analyse the performance of Q-Brand
over the years.
 2019 ITC JUNE EXAM MOCK 2 PAPER 1: SOLUTION

Read through newspapers with published articles on Q-Brand for any 1

discrimination claims against the company or reports on injuries at their
workplace which could affect the reputation of Q-Brand.
Investigate in the past three years if there were changes among the company’s 1
top ten customers for each product line to verify if there is a net decline or
increase in larger customers, which is an indicator of the general trend of sales.
Research on how Q-Brand prices for customized services or products on the 1
internet and enquiry from management, examine the model for reliability and
investigate whether the company has persistently lost money on incorrect
estimates in the past.
Investigate the usage level of existing systems, as well as the age of the 1
equipment to verify the capacity of Q-Brand.
Enquire from Q-Brand’s lawyers if there are any lawsuits outstanding against Q- 1
Brands and ascertain their likelihood of settling the liabilities.
Available 12
Max 12
 2019 ITC JUNE EXAM MOCK 2 PAPER 1: SOLUTION

f i. With regard to Twenty First’s evaluating the financing of the acquisition of Q-

Brand through the medium-term loan or through the issue of preference
shares – Calculate and determine which instrument will be more cost effective 8
for Twenty First’s to use; and
Loan Receipt 130.00 1
Transaction Cost (130*0.01) (1.30) 1

To discuss interest used to finance

Tax Benefit acquisition of shares not tax deductible
Loan Repayment (w1) (193.82) 1
Net Cashflows [R] 128.70 - - - (193.82)
Exachange Rate 13 12 11 9 9 1 Rand appreciating by 10% annually
Net Cashflows [$] 9.90 - - - (22.72)

11% Rand after tax cost of the loan

IRR ($) 23.09% Cost of loan 2

Working 1: Interest Accrual Interest Accrual Loan Balance

0 130.00
1 13.65 143.65
2 15.08 158.73
3 16.67 175.40
4 18.42 193.82 2

Cost of Compulsory Convertible Preference Shares

Calculator Inputs
N 4 1
(0.8*0.105*10000000) PMT (920,000.00) 1
FV (12,000,000.00) 1
PV 10,000,000.00 1
I 12.55%

The convertible preference shares are more cost efficient 12

 2019 ITC JUNE EXAM MOCK 2 PAPER 1: SOLUTION

Conclusion
The convertible preference shares will be costs effective as they have an
effective cost of 12.55% compared to the IRR of 23.09%% on the Nedbank SA
loan.

ii. Discuss any other factors Twenty First’s should consider in 6

deciding which instrument to use.
Availability of Rands to repay the loan and interest payments. 1
The interest rate is variable thus if prime overdraft rate increases Twenty First 1
will be left paying a higher interest.
How willing is Nedbank SA to advance a loan to us, given the Zimbabwean 1
country risk?
Are the loan terms favourable e.g. is the loan secured against any assets?
Do the synergistic benefits outweigh the cost of borrowing? 1
A bullet payment is required in year 4 for the loan option, will we have enough 1
cash resources to make this payment?
Either option will require us to make a cash outflow as preference dividends and 1
interest will be paid regardless of whether we make a profit or not.
Which funding matches the life span of the merged firm? The valuation has been 1
done using assumption of the business not being sold thus the conversion will
probably match the life span.
If we choose the loan, will we have recouped the initial capital investment by 1
year 4?
Are there any other funding options?
The enterprise value has been calculated using an assumption that the business 1
will be sold after 4 years which does not match a convertible preference share
as we will be left paying a dividend for a project that has ceased.
Total available 9
Max 6
 2019 ITC JUNE EXAM MOCK 2 PAPER 1: SOLUTION

g Discuss what factors Twenty First should consider in deciding whether to 12

accept the offer from Zimbabwe Rugby Union
Communication skills – clarity of expression 1
Potential permanent loss of customers turned away to accommodate ZRU 1
Does ZRU have a good credit rating in settling its debts on time? 1
How will our other clients feel if they know we discounted ZRU? Will they come 1
and demand discounts as well?
What is the potential of repeat business from either ZRU? 1
This could be a marketing opportunity to other sporting associations that may 1
want to host functions in Zimbabwe.
Do we want to be associated with ZRU? i.e. reputation 1
Is there any other special booking that could be more profitable than ZRU 1
proposal?
How would other Hotels price for such a booking? 1
Can we book the teams in different hotels? To cater for our lack of capacity and 1
also to prevent from emotions outrage that may have been created from the
fields.
Do we have adequate security measures as thieves may target the foreigners 1
knowing they have various valuables?
How efficient is our wifi and internet service to cater for 100% capacity 1
bookings?
Total Available 12
Max 12