BK1 - Sec 5 - MAF Tuts

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ITC PREPARATORY COURSE
Management Accounting and

Finance: Tutorial questions
and solutions
ITC Preparatory Course | MAF: Tutorial questions and solutions
Table of contents
Table of contents ......................................................................................................................... 2
Tutorial index .............................................................................................................................. 3
MAF 01........................................................................................................................................ 7
MAF 02...................................................................................................................................... 17
MAF 03...................................................................................................................................... 26
MAF 04...................................................................................................................................... 36
MAF 06...................................................................................................................................... 52
MAF 07...................................................................................................................................... 63
MAF 08...................................................................................................................................... 72
MAF 09...................................................................................................................................... 82
MAF 10...................................................................................................................................... 93
MAF 11.....................................................................................................................................105
MAF 12.....................................................................................................................................116
MAF 13.....................................................................................................................................128
MAF 14.....................................................................................................................................133
MAF 15.....................................................................................................................................145
MAF 16.....................................................................................................................................161
MAF 17.....................................................................................................................................175
MAF 18.....................................................................................................................................184
MAF 19.....................................................................................................................................191
MAF 20.....................................................................................................................................205
MAF 21.....................................................................................................................................222
Page 2 of 228
Tutorial index
Tutorial Name (Source) Topics Covered Skills Examined Rank
Number
MAF 1 Ubex CVP, Budgeting, Calculating: B
# (SAICA 2016) Capital Budgeting, • NPV/IRR
Risks • Break even
• Net profit per unit
Discussion:
• Variances
• Business Risks
MAF 2 Crushtide Inventory Costing Calculations:
^ (SAICA 2014J P4Q2) Transfer Pricing • Costing of joint B/C
products
• Gross profit per
unit
Discussion:
• Transfer pricing
• Joint Cost
allocation
MAF 3 Amandla Inventory costing, Variance analysis, C
# (SAICA 2009 P2 Q3) cost classification, commentary on financial
financial analysis, performance
pricing
MAF 4 Applewood Electronics Activity Based Calculations: A/B
^ (UCT 2008) Costing • Profitability of
products
• Discussion:
Usefulness and
imitations of ABC
MAF 5 Signs for Africa Standard Costing Calculations: C
(SAICA 2008 P1Q3) CVP • Variances
• Break even
Discussion:
• Profitability
MAF 6 Outdoor Holdings Financial Analysis Calculations: C
(UCT 2014) Break-even • Relevant costing
Relevant costing (minimum price,
Balanced scorecard constraints,
nested decisions)
• Variances
Discussion:
• Theory of
balanced
scorecard
MAF 7 IGL Financial Analysis Discussion: B/C
(UCT 2007) Overhead Cost • Commentary on
Allocation overhead
allocation
Page 3 of 228
• Commentary on
financial
performance
MAF 8 Eficaz Inventory Costing, Calculations: B
(SAICA 2013J P4Q2) Relevant Costing, • Profitability
Pricing, Risks analysis
• Break even
Discussion:
• NPV – project
accpetance
• Pricing model
considerations
MAF 9 Zomat Valuations Calculations:
#^ (SAICA 2007 P1Q2) Financial Analysis • Sensitivity Analysis
Working Capital • Debtor Days
(integration with Discussion: B/C
audit issues) • Valuation
Ethics considerations
• Financial
Performance
MAF 10 Electribolt Valuations Calculations: B
(SAICA 2010 P2 Q3) Capital Budgeting • DCF valuation
Sources of (review of calc)
financing • IRR/ NPV
• Financing cash
flows
Discussion:
• Due Diligence
(Acquisition)
• Financing
Alternatives
MAF 11 VPharm CVP Calculations: C
# (SAICA 2006 P1Q4) Capital Budgeting • NPV
Risks • Effect of changing
Pricing assumptions
• Break Even
Discussion:
• Risk of project
• Feasibility of BE
MAF 12 OPM Risk: Conflicts of Calculations: C
^ (SAICA 2014) interest • Estimating WACC
• DCF
Valuations • Mutiple Valuation
• NAV Valuation
Discussion:
• Preferable
Valuation method
MAF 13 Silky Mills (UCT 2003) Leasing Calculations:
• Purchase/Lease
(NPC calc) A/B
Page 4 of 228
• Change variable
and calc
Discussion:
• Applicable
Discount rate
MAF 14 Cloth Cost of capital Calculation: A/B
# (SAICA 2009 P1Q2) Sources of finance • Effective cost of
Specialised topics finance
in finance • WACC
Discussion:
• Qualitative Best
Choice of Finance
• Credit Risk
Assessment
MAF 15 Educo Capital Budgeting Calculation: C
(SAICA 2018) Sale and Leaseback • NPV
SRMG Discussion:
• Pricing
• Feasibility factors
for project
MAF 16 Electrograpp Cost allocation Calculations: C
# (SAICA 2014) CVP • Traditional costing
Relevant Costing • Break even
FCF and NAV • FCF
valuation • NAV
Pricing Discussion:
SRMG • Analysis
• Decision
evaluation
• Risk identification
• Governance
MAF 17 Rexelor Financial analysis Calculations: B
(SAICA 2015) Forecasting • Variance analysis
revenue cash flows • Break-even
Overhead analysis • Budgeted figures
Break-even Discussion:
calculation • Activity based
costing
• Variance analysis
• Strategic
considerations
Performance evaluation
MAF 18 South African Rail Relevant Costing Calculations: C
Holdings Limited Qualitative factors • Relevant costing
(UCT 2013) Balanced Scorecard • Hi-Low
Pricing • Limiting factors
Discussion:
• Qualitative factors
• Pricing
Page 5 of 228
• Balanced
Scorecard
• Strategy
MAF 19 Aquazania Cost allocation Calculations: C

(SAICA 2015) Relevant Costing • Gross margins
Operating margins • Incremental cash
Sources of finance flows
Risk identification Discussion:
• Financial analysis
• Sources of finance
• Business risk
•
MAF 20 Aero Africa Budgeting Calculations: C
(SAICA 2013) Standard Costing • Variance analysis
CVP • Break even
Financial analysis Discussion:
Hedging • Analysis
SRMG • Hedging
• Risk identification
• Governance
MAF 21 TT Transport Performance Calculations: B
(SAICA 2013) evaluation • Return of
Capital Budgeting investment
Specialised topics • IRR and NPV
in finance • Forecasting –
SRMG differential cash
flows
Discussion:
• Performance
evaluation
• Strategic
considerations
Key:
1. A Introductory level
2. B Intermediate difficulty
3. C Advanced/Integrated
4. # General tutorial commentary included
5. ^ Interdisciplinary integration
Page 6 of 228
MAF 01
58 Marks
Ignore value-added tax (VAT)
Mr Sizwe Umakhi is a 28-year old entrepreneur who has worked part-time in various positions,
including as an Ubex driver, a professional model and a real-estate agent. Mr Umakhi has managed
to save R350 000 for starting his own business. He plans to acquire ten used vehicles and form
partnerships with various Ubex drivers to generate income for himself and the drivers.
Ubex is a global software group that allows users registered with it to use its mobile application (‘app’)
to request transportation from registered Ubex private drivers. The Ubex app is available free of
charge and can be downloaded onto most cell phones. Having registered as a user with Ubex and
downloaded the app, you can request a driver to collect you at a specified location or use your
phone’s global positioning system (GPS) to enable the driver to locate you. When registering with
Ubex as a user, you are required to provide your credit or debit card details. This enables Ubex to
collect and process payment for the fare due to drivers for transporting you to your desired
destination. Ubex retains 20% of the fare and pays the rest to the driver. Ubex does not own vehicles
nor does it employ drivers. The fares chargeable vary according to the type of service requested. The
most commonly available services are UbexBLACK (luxury vehicles such as Mercedes Benz, BMW and
Audi vehicles) and UbexX (lower cost vehicles). Ubex sets the fares for rides based on a base fee
(minimum fee irrespective of time or distance travelled) plus charges per kilometre and/or minute.
When travelling faster than a certain speed, the fare is charged per kilometre. Otherwise the fare is
determined per minute travelled.
The following are the key benefits to Ubex users:

• Ease of use – users simply open the Ubex app on their cell phones and request a driver;
• Visibility – users can track where drivers are located using the Ubex app and the
estimated time of their arrival is also displayed;
• Transparency – users can access details of the driver, including his/her name, vehicle
registration number and rating;
• No cash transactions – fares are deducted via registered debit or credit cards and users do
not have to have any cash on them; and
• Record keeping – Ubex emails details of the trip and fare to users after they have used the
service.
Mr Umakhi was a registered Ubex driver for two years and is intimately aware of the benefits to drivers.
These include the following:
• Flexibility – drivers choose their own working hours and areas to operate in;
• Guaranteed payment – Ubex collects and remits amounts owing for trips;
• No negotiation – Ubex fares are standard (except in peak hours when premium fares are
charged) and users are unable to negotiate lower prices;
• Information – Ubex provides regular statistical and informational reports to drivers; and
• Networking – Ubex drivers meet a variety of different people daily.
Vehicle fleet
Mr Umakhi has negotiated the purchase of ten used Volkswagen Polo vehicles from a motor dealership
in Sandton. All the vehicles are in excellent condition and have near identical mileage. The
purchase price is R170 000 per vehicle which includes a 50 000km service plan for each vehicle
(Mr Umakhi does not have to pay for regular services to vehicles for the next 50 000 km
Page 7 of 228
travelled).Each Volkswagen Polo vehicle acquired is to be used by Ubex drivers for the next four
years. At the end of the four-year period, it is estimated that the vehicles could be sold for R51 000
each.
Mr Umakhi procured bank financing for the ten vehicles on the following terms:
• A 20% deposit per vehicle (R34 000 each);
• Equal monthly repayments in arrears for 48 months; and
• A fixed nominal annual interest rate of 10%.
Arrangements between Mr Umakhi and the drivers
Mr Umakhi has identified 20 drivers who are prepared to work in partnership with him. All drivers
have the necessary credentials, including professional driving permits, to act as Ubex drivers. The
intention is that each vehicle will be shared by two drivers. Each driver will have the use of a specific
Volkswagen Polo for 12 hours daily to ensure maximum utilisation of vehicles. The agreed terms
between Mr Umakhi and the drivers include the following:
• Mr Umakhi will pay for all the monthly operating costs of the vehicles, including fuel, tyre
replacement, service and maintenance costs, and insurance;
• Drivers will collect and return vehicles to Mr Umakhi’s home in Sandton on a daily basis. There
is an outside office at his home that drivers can use should they wish to, to take a break or
where they can get refreshments (tea, coffee, water, sandwiches and fruit);
• Drivers have agreed that Ubex will pay the fares directly into a separate bank account
established and controlled by Mr Umakhi for the venture;
• Drivers will enter the times that they collect and return vehicles (together with the
kilometre readings from the vehicle’s odometer at these times) into a log book which is kept
at Mr Umakhi’s outside office; and
• Mr Umakhi will pay drivers amounts owing to them on a monthly basis as per the
agreed profit-sharing arrangement.
Mr Umakhi and the drivers have agreed to a profit-sharing arrangement whereby Mr Umakhi will
collect amounts owing to them from Ubex and deduct the following expenses before paying the net
amount to drivers:
• Vehicle operating costs (fuel, tyre replacement, service and maintenance costs and
insurance);
• Costs for usage of vehicles (this is equivalent to the monthly vehicle loan repayment
amount);
• An ‘office’ fee of R1 000 per month per vehicle in the first year to recover costs of
parking at Mr Umakhi’s home, use of the outside office, refreshments and monthly
administration; and
• A fixed ‘profit share’ fee of R2 000 per month per vehicle payable to Mr Umakhi in the first
year, which amount will escalate by 8% per annum thereafter.
Mr Umakhi suggested the above profit-sharing arrangement based on his experience as an Ubex driver.
Mr Umakhi estimates that receiving R2 000 per vehicle per month, in addition to recovering incurred
costs, will be sufficient to generate a reasonable return on assets. Drivers will therefore be incentivised
to maximise revenue (fares paid for their driving services).
Mr Umakhi has agreed to provide drivers with a monthly report, which summarises the revenue,
operating costs, vehicle usage charges, office fee and Mr Umakhi’s profit share fee per vehicle. Drivers
will share the net profit due to them based on the revenue each of them has generated from their
designated vehicle.
Page 8 of 228
Forecast revenue per vehicle
The Volkswagen Polo vehicles to be acquired will operate as UbexX vehicles. The forecast revenue per
vehicle below in the first year of operation is based on Mr Umakhi’s insights and knowledge of acting
as an Ubex driver in the Sandton and surrounding areas of Johannesburg.
Annual revenue forecast per vehicle in year 1

Average hours annually that vehicle is operated by drivers 4 410 hours
Average number of trips per operational hour 0,8
Average fare per paid trip R100
Average kilometres travelled per paid trip 10 km
Vehicle operating costs
The forecast costs of operating each vehicle in the first year of operations is set out in the table
below. The Volkswagen Polo vehicles use diesel and are expected to be fuel-efficient.
Forecast vehicle operating costs in year 1

Fuel costs
Average annual total distance to be travelled per vehicle 50 000 km
Average number of litres to be used per each 100 km travelled 5,5 litres
Average cost per litre of diesel during the year R12,25
Tyres
Cost of replacing all four tyres per vehicle after every 25 000 km R3 200
Insurance costs
Average annual insurance premium per vehicle R11 760
Service and maintenance costs were not included in the above table as these will be covered by the
service plan to be obtained when purchasing the vehicles. It is estimated that the cost of servicing
each vehicle in the first year of operations, had the service plan not been obtained, would have
amounted to R6 800, on the assumption that each vehicle needs to be serviced after every 25 000 km
travelled.
Monthly reporting and variance analysis
Mr Umakhi aims to provide the drivers with useful information in the monthly reports. Certain vehicle
costs, such as insurance costs, vehicle repayments and Mr Umakhi’s profit share per vehicle, are
expected to remain fixed during the year. As a result, providing variance analysis on these expenses
would be a fruitless exercise.
Mr Umakhi would like to provide drivers with an analysis of deviations from forecast revenue and from
expected costs, which vary according to distance travelled.
Potential returns from venture
Mr Umakhi is not a finance expert but would like an indication of the expected internal rate of return
(IRR) and net present value (NPV) of his investment in the Volkswagen Polo vehicles and the proposed
venture with the Ubex drivers. Mr Umakhi’s required return on investment is 20% pre tax.
Page 9 of 228
REQUIRED Marks
Sub-
Total
total
(a) Calculate the estimated net profit per vehicle that will be available to be
shared by the two drivers allocated to each specific vehicle in the first year of
operation. Base your calculation on Mr Umakhi’s estimates for the first year
of operation. 10 10
(b) Estimate the monthly gross revenue that each vehicle needs to generate in
the first year of operation in order to cover the fixed monthly operating
costs of that vehicle. Assume that Mr Umakhi’s estimates for the first year
of operation are accurate. 10 10
(c) Identify the monthly variances that Mr Umakhi could calculate to provide
useful feedback on each vehicle and on each driver’s performance. Explain the
usefulness to Mr Umakhi and/or the drivers of each variance identified.
14
Communication skills – clarity of expression
1 15
(d) Estimate the potential IRR and NPV that Mr Umakhi could realise over a four-
year period from investing in the proposed venture with the Ubex drivers.
7 7
(e) Identify and discuss the key business risks that Mr Umakhi faces from investing
and participating in the proposed venture with the Ubex drivers.
14
Communication skills – logical argument; clarity of expression
2 16
Total 58
Page 10 of 228
MAF 01- Suggested Solution

Part (a) Calculate the estimated net profit per vehicle… . Marks
Revenue 352 800,00 1
Ubex share -70 560,00 1C
Fuel costs -33 687,50 1
1
Replacement of tyres (R3 200 accepted) 6 400,00 1
Insurance -11 760,00 ½
Service and maintenance costs (candidates who split out servicing costs from - ½
vehicle repayments below not to be penalised)
Vehicle repayments (alternative (1), based on annual compounding R42 904); -41 391,74 1
(alternative (2) finance costs and depreciation charged accepted instead of 1
loan repayment) (N1)
Office fee -12 000,00 ½
Umakhi’s profit share -24 000,00 1
Profit available for drivers (candidates not to be penalised for including tax) 153 000,76 ½C
Available and maximum 10
Total for part (a) 10
N1: The repayment (PMT )is what you will be paying the bank i.e. you looking at it from the bank's
perspective. The bank is not interested in what you can sell it for after 4 years, all they are interested
in is that after 4 years the loan is paid off hence FV = 0.
Using financial calculator: FV = 0; PV = 170 000 - 34 000 (deposit); n = 48; i = 0.833333% (i.e. 10% /12
months)
Therefore PMT = R3 449.31 per month x 12 = R41 391.74 per annum.
Part (b) Estimate the monthly gross revenue that each vehicle needs to generate… Marks
Fixed annual costs
Insurance 11 760,00 ½
Vehicle repayments 41 391,74 ½C
Office fee 12 000,00 ½
Umakhi’s profit share 24 000,00 ½
89 151,74 ½C
Monthly fixed costs 7 429,31 ½C
Revenue per paid trip R100,00 ½
Ubex share per paid trip -R20,00 1
R80,00
Other variable costs per trip
Fuel per trip (50 000 / 1 00 * 5.5 * 12.25) / (4 410 * 0,8) -R9,55 1
Note: All variable costs per trip as the number of trips is the sales driver
Contribution margin per paid trip (candidates not to be penalised for including 70,45% ½C
tax)
Justification of treatment of tyres 1
Justification of treatment of service and maintenance costs 1
Monthly breakeven revenue per vehicle R10 545,51 1P
Page 11 of 228
Since the annual breakeven revenue per vehicle of R126 546 (R10545,51x12) is significantly 1P
less than half the annual expected revenue per vehicle, we can conclude that less than 25
000km will be travelled to reach breakeven. Therefore the fixed costs included in the
breakeven calculation do not need to be adjusted for the cost of replacement tyres.
Available 10
Maximum 10
Total for part (b) 10
Part (c) Identify the monthly variances and explain the usefulness to Mr
Marks
Umakhi and/or the drivers of each variance identified
1. Monthly km travelled versus budget 1
• Provides information on total km travelled and useful for determining cost per km 1
• This variance also provides value information regarding customer trends in terms
of average length of trip – can be used strategically in terms of increasing fleet size
at some stage in the future
2. Monthly productive km versus total km 1
• Km travelled on fare-paying trips versus total km travelled provides useful information 1
on productive use of vehicles
3. Revenue versus budget per vehicle 1

• Provides information on individual vehicle utilisation 1
• Indicate the uptake in the market of Ubex and Mr Umakhi’s services
4. Revenue generated by each driver versus budget 1
• Required for profit-sharing calculation and indicates how productive drivers are 1
5. Average fare per trip – actual versus budget 1
• Useful to monitor average fare – the higher the fare per trip, the greater the 1
profitability
6. Number of trips per operational hour versus budget 1
• Provides an indication of productivity of vehicles and drivers 1
• From a strategic perspective would indicate the uptake in the market of Ubex
and Mr Umakhi’s services as well as customer preferences.
7. Number of productive hours worked monthly per driver and in total versus budget 1
• Provides interesting feedback on driver contributions to vehicle profitability 1
• provide information regarding the level of operation and hence partly
explain any difference between actual and expected revenue.
8. Fuel costs per km – actual versus budget 1
• Fuel, will vary with km travelled and will be useful for calculating breakeven revenue 1
9. Fuel variances further broken down into a cost and a usage variance: 1
• this will aid with identifying whether fuel costs are not being in line with budget
is due to changes in fuel price (which are uncontrollable) or using more fuel per 1
km (which provides an indication of how drivers are driving and therefore
controllable)
10.Fixed costs – actual versus budget 1
• Although Mr Umakhi indicated that he believed providing variance analysis on fixed 1
costs would be a fruitless exercise, from a cost control point of view it will be useful
to compare actual versus budgeted costs
11.Profit share per driver versus budget 1
• Provides drivers details of net take-home pay and allows Umakhi to identify star 1
performers & underperformers
Page 12 of 228
12.Unexpected cost variances by driver, for example: traffic fines, tyre bursts, 1
windscreen cracks, excess for insurance claim
• Provides information for controlling costs and monitoring the drivers’ driving 1
performance
13.Driver ratings vs average rating 1
• Provides information for monitoring the drivers performance and quality of 1
service provided
Available 26
Maximum 14
Communication skills – clarity of expression 1
Total for part (c) 15
Part (d) Estimate the potential IRR and NPV Marks

Year 0 Year 1 Year 2 Year 3 Year 4
Upfront deposit -340 000 1
Umakhi profit share 240 000 259 200 279 936 302 331 1
1
Sale of vehicles 510 000 1
-340 000 240 000 259 200 279 936 812 331 1P
IRR 79,7% 1C
NPV 593 749 1C
Alternative
Initial investment -1 700 000 ½
Loan payment recovery (N2) 413 917 413 917 413 917 413 917 ½C
Umakhi profit share 240 000 259 200 279 936 302 331 1
1
Sale of vehicles 510 000 1
-1 700 000 653 917 673 117 693 853 1 226 248 1P
IRR 28,3% 1C
NPV (N3) 305 270 1C
Note: candidates not to be penalised for including tax, unless they apply an after tax
discount rate to pre-tax cash flows or vice versa)
Available and maximum 7
Total for part (d) 7
N2: Question: When calculating the NPV of the project, why is the loan repayment a recovery as
stated in the memo and not included as a payment?
Answer: Mr Umakhi is responsible for the loan repayment, so you are 100% correct including the
loan repayment in
your solution, however the scenario also tells us that Mr Umakhi will collect amongst others the cost
of usage of the vehicles (which is equivalent to the monthly vehicle loan repayment) before paying
the drivers. So there is a loan payment to be made but this payment will be recovered from profits.
Therefore you have two choices in your NPV calculation i.r.o. the loan repayments:
Choice #1
State the loan repayment as an outflow for Y1 to Y4, and reflect the collection of the loan repayment
as an inflow in Y1 to Y4. The net effect will be 0, which is exactly what they did in alternative 1 in the
solution, they just did not show it.
Choice #2
Page 13 of 228
State the PV of loan in Y0 ( which is of course the PV of the future loan repayments in Y1 to Y4). Then
reflect the collection of the loan repayment as an inflow in Y1 to Y4. This is exactly what they did in
alternative 2 in the solution.
Technically you should get the same answer for alternative 1 and alternative 2, but the main reason
why we don't in this case is due to the fact that the NPV uses a discount rate of of 20%, where as the
PV of loan used in alternative 2, has an inherent discount rate of 10% (cost of debt).
N3: Question: Why a discount rate of 20% is used when calculating the NPV?
Answer: Normally we use WACC when discounting the NPV, but WACC is also known as the hurdle
rate or the minimum return required to break-even. In this case question the minimum rate required
is 20% (detailed in the scenario). Therefore this rate is preferred and there is in any event too little
information to calculate a WACC.
Part (e) Identify and discuss the key business risks Marks
1. The business does not generate to sufficient revenue / profit to enable Mr Umakhi 1
to receive his fixed profit share due to, for example:
• Ubex increasing fares which could make the service uncompetitive 1
• Ubex reducing fares to remain competitive without a resulting increase in the
volume of trips in Mr Umakhi’s business
• Revenue being lower than anticipated 1
• Inaccurate cost estimates (Fuel price, servicing, tyres etc) and / or price increases
which cannot be passed on to customers.
• The weak South African economy resulting in customers using cheaper forms of 1
transport
• The ability to attract and retain quality drivers with valid PDPs (potential drivers 1
may be put off due to perceived security threats such as abuse from
passengers, hi- jackings etc)
• Increased Competition, e.g. vehicle-sharing services or other transportation 1
services, Ubex taking on more drivers, the Gautrain, meter taxi companies, a switch in
customer preference to UbexX etc
• Taxi violence – taxi drivers assaulting Ubex drivers and restricting routes to what
they perceive to be unfair competition,
• Vehicles break down and require major expenditure, e.g. gearbox or electronics, 1
especially if the vehicles aren’t in as good condition as originally believed
• High accident levels due to drivers trying to fit in as many trips as possible
causing vehicle to be non-operational for an extended period
• Drivers use vehicles for non-Ubex trips and pocket cash
• The business model being reliant continuous access to technology. Should cellular 1
networks or the availability of the Ubex app become impaired, customers will
be unable to log trips required
2. Given that Mr Umakhi receives a fixed profit share, he has no upside benefit but all the 1
downside risk (he will still have to fund the full cost of the vehicles if the business is not 1
profitable).
Given the remuneration model, drivers may not get a reasonable remuneration for 1
their work resulting in them becoming demotivated undermining the business's 1
profitability
4. Mr Umakhi will be exposed, should he not have sufficient public liability insurance, to
legal claims resulting from injuries sustained by and the death of passengers and drivers, due 1
to accidents involving his vehicles. 1
Page 14 of 228
5. Non-compliance with legal requirements, for example 1

• Government/local authorities requiring Ubex to be registered as a taxi 1
service – annual registration costs, price controls?
• Is Mr Umakhi’s arrangement a labour broker arrangement resulting in compliance
implications
• Labour legislation (for example 12 hour shifts)
6. Reputational risk arising from the following 1
• Unsavoury incidents involving Ubex drivers, e.g. speeding, bribing / attempting 1
to bribe traffic officials, drunk driving or assaulting passengers which could
negatively affect the credibility of the Ubex service
• the business is dependent on the Ubex brand. Negative publicity relating to the
Ubex brand will negatively impact Mr Umakhi’s business
• Traffic delays may result in less trips and customer dissatisfaction which may
be seen as the fault of the driver
7. Liquidity and credit risk: 1
• the risk that Ubex will default on payment or delay payment to Mr Umakhi, thus 1
negatively affecting the ability of the business to meet obligations as remittances
from Ubex are the only source of cash revenue.
8. A higher use if the vehicles than expected resulting in:
• the residual value of the vehicles may decline substantially below the 1
estimated
• resulting
R51 000 in ainlower
a mismatch overall
financing returnand asset life due to high usage. This is
period 1
particularly important as the operating cost recovery is linked to time and not
mileage
Available 22
Maximum 14
Communication skills – logical argument; 1
clarity of expression 1
Total for part (e) 16
Tutorial Commentary: MAF01

1. What general areas the question covered
This question covered budgeting, break-even analysis, identifying variances that would be useful to
calculate, capital budgeting and risk identification.
2. In what respect candidates’ answers are considered to fall short of requirements.
In part (c) a number of candidates were not explicit with identifying variances that could be
calculated and therefore did not adequately address the required.
A number of candidate‟s answers in part (e) were vague and did not adequately describe the risks
that they had identified.
Page 15 of 228
3. Common mistakes made by candidates
In general examination technique were lacking as was evident from the following:
- Many candidates did not read and consider the information in the scenario carefully, or
applied it in answering the question.
- A number of candidates failed to provide the answer in a memorandum format (as was
specifically required), or provided memorandums which rather resembled a letter or an email.
- Many candidates did not present their answer in a logical way; they did not link the key
business risks to the mitigating actionsThe most common mistake in part (a) was the
ommision of the 20% share of revenue that was deducted by Ubex.
- In part (b), most candidates did not treat the tyres and service and maintenance costs as
stepped costs that would only be incurred every 25 000 kilometres (for tyre costs) and every
25 000 kilometers after the 50 000 kilometre service plan had expired (for the service costs).
- The most common mistake in part (d) was candidates failing to realise that the revenue
generated and costs incurred by the partnership were irrelevant to the NPV and IRR
calculations as the only income attributable to Mr Umkahi was his fixed profit share and the
costs incurred by Mr Umkahi were recovered from the partnership. In addition, many of the
candidates who followed the alternative approach incorrectly ommited the recovery of the
loan repayments from the partnership. Some candidates who calculated after tax cashflows
incorrectly used a pre-tax discount rate in calculating the NPV.
4. Areas that the candidates handled well
As expected, most candidates performed well in part (a).
5. Specific comments on sections of the question
Candidates, as expected, performed very well in section (a) and well in section (d).
Generally, candidates performed less well and sections (c) and (e), although those who could
adequately described the variances identified in (c) and the risks in (e) performed well.
Nearly all candidates performed poorly in section (b) due to them not identifying the step nature of
the tyre costs, incorrectly calculating the fuel costs and to a lesser extent not identifying the need to
perform a break-even calculation.
Page 16 of 228
MAF 02
53 marks
Crushtide Ltd (‘Crushtide’) is a producer and exporter of phosphoric acid, which is a commodity used
locally and internationally to make catalysts, rustproofing materials, chemical reagents, latex, dental
cements, tooth whiteners, toothpaste, disinfectants, food supplements, carbonated beverages,
polishes and animal feeds.
Crushtide is a highly successful company, which maintained profitability even during the global
financial crisis. The company has been in operation for 30 years and operates an opencast mine in
Phalaborwa and a processing plant in Richards Bay. The chief operations officer of the company, Mr
Alan de Villiers, attributes the success of the company to the risk management strategy which requires
the hedging of –
1. The phosphoric acid selling prices which are dependent on economic outlook;
2. Currency risk, as the phosphoric acid prices are quoted in US dollar (USD); and
3. Currency risk, as the company imports sulphuric acid quoted in Canadian dollar (CAD).
Mining of phosphate rock
The production of phosphoric acid by Crushtide begins with the mining of phosphate rock from the
company’s opencast mine in Phalaborwa, Limpopo Province. The mine produces between 1 200 000
and 1 500 000 tonnes of phosphate rock concentrate annually, depending on expected market
demand. Budgeted production of phosphate rock concentrate for the financial year ending 31
December 2014 is 1 400 000 tonnes.
Production of the phosphate rock concentrate at the mine entails the following key steps:
1. Drilling and blasting;
2. Crushing and milling of the ore;
3. Adding of reagents (substances used to cause a chemical reaction) to the crushed ore slurry;
and
4. Filtration and drying to drain water from the phosphate rock concentrate.
Page 17 of 228
The mining operations are heavily reliant on labour and machinery. Crushtide budgeted R52 380 000
for its miners for the 2014 financial year (‘FY2014’) based on paying its labour force of 485 miners at
an average hourly rate of R60 per miner. The mining machinery and labour are used in the drilling,
blasting, crushing, filtration and drying processes. The mining machinery was replaced five years ago
at a cost of R686 million. The machinery that was in use at the time was fully depreciated and broke
down often. When the replacement machinery was purchased it was estimated to have a useful life
of 20 years and Crushtide elected to depreciate it on the straight-line method.
A pre-determined production overhead recovery rate of R32,50 per direct labour hour is budgeted for
mining production overheads (indirect labour, water, electricity, repairs, etc.).
Reagents added to the ore slurry are sourced from local suppliers on a just-in-time basis. Crushtide
does not carry any opening or closing inventory of the reagents. The budgeted cost of reagents for
FY2014 was based on the estimated production cost and market prices and has been calculated at R4
500 000. Apart from labour, depreciation of mining equipment, production overheads and the cost of
reagents, there are no other expenses associated with the production of the phosphate rock
concentrate.
Processing of phosphate rock concentrate
Once crushed, milled, filtrated and dried, the phosphate rock concentrate is railed to the processing
plant in Richards Bay in the province of KwaZulu-Natal, 820 km away. Crushtide is budgeting to incur
a cost of R16 per tonne in FY2014 for transporting the phosphate rock concentrate via freight rail to
Richards Bay. Crushtide elected to locate its processing plant in Richards Bay due to the port
infrastructure which is necessary for the export of finished products to global markets and for
importing sulphuric acid (used in the processing of phosphate rock concentrate).
The processing of phosphate rock concentrate at the Richards Bay plant generally results in the
production of one tonne of phosphoric acid (finished product) for every four tonnes of phosphate
rock concentrate processed. Crushtide is budgeting to produce 350 000 tonnes of phosphoric acid in
FY2014, which represents normal capacity. Crushtide currently exports 60% of its phosphoric acid to
Europe and sells 40% locally. Selling prices are identical for exports and local sales and Crushtide is
budgeting to sell phosphoric acid at USD78,40 per tonne in FY2014.
In order to produce phosphoric acid, a reaction is initiated between phosphate rock concentrate and
sulphuric acid to form weak phosphoric acid in slurry form. The reaction process requires one tonne
of sulphuric acid for every ten tonne mix of phosphate rock concentrate processed. Crushtide
imports sulphuric acid from Canada at the fixed price (hedged) of CAD8,00 per tonne.
The resultant slurry is then filtered to remove gypsum particles as a waste product in order to convert
the weak phosphoric acid into the finished product (high grade phosphoric acid).
Crushtide deems the ‘split-off point’ to be at the end of this filtration process. Crushtide is budgeting
to produce 50 000 tonnes of gypsum particles in FY2014, based on the budgeted production of
phosphoric acid. Gypsum particles are disposed of in an environmentally friendly manner into the
ocean. The process of producing phosphoric acid and discharging the gypsum particles is highly
automated and relies on the use of the sophisticated and intensive plant built at the Richards Bay
plant.
The following data have been extracted from the records of Crushtide with respect to the production
costs incurred by the company on the Richards Bay plant for the current year with regard to the
production of the phosphoric acid:
Page 18 of 228
Financial year Production costs Total number of Total plant

(All variable) employees operating hours
(R)
2013 22 656 000 43 1 180 000
Plant operating hours noted above represent the number of hours the Richards Bay plant is in
operation for processing phosphate rock concentrate into the phosphoric acid. Operating hours at
the Richards Bay plant are expected to reach 1 350 000 hours, operated by 45 employees, in FY2014.
These operating hours have been calculated based on the number of machines operated at the plant
during the operating hours in a year. The average production costs per plant operating hour are
expected to increase by 7% in FY2014 from the prior year.
Crushtide does not have opening or closing inventories of phosphate rock concentrate, phosphoric
acid, sulphuric acid and gypsum particles.
Crushtide spent R12 621 780 on plant and machinery at the beginning of FY2012 to discharge gypsum
particles into the ocean in a manner that is not harmful to aquatic and marine life. This plant and
machinery have a ten-year useful life and are depreciated on a straight-line basis. In addition to the
infrastructure used to dispose of the gypsum particles into the ocean, an average cost of R4,20 per
tonne of gypsum particles is incurred during the disposal. After the filtration process to remove
gypsum particles, concentrated, high-grade phosphoric acid is produced by boiling off excess water.
This process has an estimated cost of R1 824 922 for FY2014.
New revenue stream
Crushtide researched various opportunities to generate new revenue streams that could easily be
incorporated into the company’s existing business model. The opportunity to sell gypsum particles
rather than dispose of these as a waste product was identified as the most lucrative new business
opportunity. Gypsum particles are used as a major raw material in the production of gypsum boards,
which are used for the construction of internal walls and ceilings.
On 31 December 2013, Crushtide acquired 100% of the equity of Gypsum Mauritius (Pty) Ltd (‘Gypsum
Mauritius’), a company based in Mauritius that manufactures gypsum boards. Gypsum Mauritius is
incorporated in Mauritius, has been in operation for the past eight years and has retail outlets
throughout Mauritius for the distribution of the gypsum boards. The strategic rationale for the
acquisition was for Crushtide to acquire the skills to manufacture gypsum boards, with the intention
of eventually opening a similar manufacturing facility in South Africa. Crushtide will transport the
gypsum particles produced at its Richards Bay plant to Gypsum Mauritius at an estimated
transportation cost of R15 per tonne.
The investment in Gypsum Mauritius is strategic, as any dividends declared by the company to
Crushtide will not be subject to a dividend tax because Mauritius has a tax-free dividend policy. The
corporate tax rate in Mauritius is also lower than in South Africa, with companies domiciled there
being taxed at a rate of 15% of taxable income. Crushtide and Gypsum Mauritius have commenced
with negotiations on the purchase price that Gypsum Mauritius will pay for gypsum particles
purchased from Crushtide. Gypsum Mauritius uses 75 000 tonnes of gypsum particles annually. The
two companies are considering the following two options:
Page 19 of 228
1. Cost-based transfer price; or

2. Market-based transfer price (using either the fair value or cost plus mark up).
Gypsum Mauritius currently sources gypsum particles from suppliers based in Mauritius, India and the
United States. Gypsum Mauritius paid an average of R72,00 per tonne for gypsum particles during
FY2013. Crushtide is reluctant to base the gypsum particle price on ruling market prices and would
instead like to apply its average mark up of 55% to the estimated cost of producing gypsum particles.
However, the management of Crushtide is struggling to allocate production costs to the gypsum
particles as it has not done so before.
Estimated average exchange rates for FY2014
The estimated average exchange rates for FY2014 for South African rand (ZAR) to USD and CAD are as
follows:
• ZAR10,50 : USD1
• ZAR11,05 : CAD1
Page 20 of 228
REQUIRED Marks
Sub- Total
total
(a) Calculate the estimated per unit gross margin that will be earned by 14 14
Crushtide for the production and sale of phosphoric acid in the financial
year ending 31 December 2014, assuming it continues with the disposal of
the gypsum particles into the ocean.
(b) Assuming that gypsum particles will be sold in future instead of being 11
disposed of into the ocean:
i. Estimate the unit cost of producing gypsum particles in
the financial year ended 31 December 2014 by allocating
joint product costs at the split-off point using –
• The sales value method; and

• The physical measures method; and
ii. Critically discuss the results of each method in part (i) 5

above.
Communication skills – logical argument 1 17
(c) Discuss the application of section 31 of the Income Tax Act to Crushtide if 4 4
it sells gypsum particles to Gypsum Mauritius at production cost.
(d) Discuss all key considerations which should be taken into account by the 16
Crushtide group if it uses each of the following pricing options to
determine a selling price for gypsum particles from Crushtide to Gypsum
Mauritius:
i. Cost-based transfer price; and
ii. Market-based transfer price.

Communication skills – clarity of expression; logical argument 2 18
Total 53
Page 21 of 228
MAF 02 – Suggested solution

Part (a) Per unit Per unit
Cost of producing & transporting phosphate rock Phos.
concentrate Concentrate Acid
Labour costs R37.41 R149.66 52,380,000 ½
Depreciation [686 million / 20 years) R24.50 R98.00 34,300,000 1
Production overheads [873 000 hours x R32,50] R20.27 R81.06 28,372,500 1C
Labour hours (R52 380 000 / R60 per hour) 873,000 1
Reagents R3.21 R12.86 4,500,000 ½
Transport cost to Richards Bay
[1 400 000 tonnes x R16] R16.00 R64.00 22,400,000 1
Processing cost of phosphate rock concentrate
Sulphuric acid [140 000 tonnes x C$8 x 11,05] R35.36 12,376,000 1C
Tonnes of sulphuric acid required 140,000 ½
Production costs [R20,544 x 1 350 000] R79.24 27,734,400 1C
FY2013 cost per plant operating hour
[22 656 000/1 180 000] (N1) R19.20
FY2014 cost per plant operating hour (19.20 x 1.07) R20.54 1
Depreciation (12 621 780 / 10 ) R3.61 1,262,178 1
Disposal costs of gypsum [50 000 x R4,20] R0.60 210,000 1
Boiling costs R5.21 1,824,922 ½
-
Total production costs R529.60 185,360,000 1C
Sales [350 000 x USD 78,4 * 10.50] R823.20 288,120,000 1
Gross profit [Note: Gross profit is sales less all
production costs including fixed production costs;
whereas contribution is sales less all variable
production and non-manufacturing costs) 102,760,000
Negative mark: Inconsistent calculation of per unit cost phosphate concentrate & phosphoric
acid in calculations -1
Per unit gross profit of phospheric acid
[Gross profit/350 000] R293.60 35.7% 1C
14
N1:
Q: Why do we not take the number of employees into account when calculating production cost to
change phosphate rock to the concentrate for the 2014 estimated gross profit?
i.e, why do we not say: 22 656 000 / 1180 000 * 1350 000 / 43 employees * 45 employees * 1.07
A: The production cost adjustment based on hours takes into account the variation in number of
employees - i.e. it is the increased number of employees and/or increased productivity that results
in the increased hours, and it is the increased hours that drives the cost. Employees partly drives
hours, and hours drive cost.
Page 22 of 228
Part (b)(i)
Total production costs per (a) above 185,360,000 1P
Depreciation -1,262,178 1
Disposal costs of gypsium -210,000 1
Boiling costs -1,824,922 1
Total production costs at split off point 182,062,900 1C
Labour costs 52,380,000
Depreciation 34,300,000
Production overheads 28,372,500
Reagents 4,500,000
Transport cost to Richards Bay 22,400,000
Sulphuric acid 12,376,000
Production costs 27,734,400
182,062,900 1C
Correctly transcribing costs from part (a) 1
Excluding following costs
Depreciation of gypsum processing plant 1
Disposal costs of gypsium 1
Boiling costs 1
Physical units
Phosphoric acid 350,000 87.5%
Gypsum 50,000 12.5% 1
400,000
Production costs allocated to gypsum [182 062 900 x 12,5%] 22,757,863 1C
Per unit cost of gypsum - physical method [22 757 863/50 000] R455.16 1C
Sales value
Phosphoric acid 288,120,000
Gypsum [Use R72,00 per tonne) 3,600,000 1
291,720,000
Bonus mark - Sales value of phospheric acid not $78,40 as further
processing required thereafter 1B
Production costs allocated to gypsum [182 062 900 x (3 600/291 720)] 2,246,766 1C
Per unit cost of gypsum - sales value method [2 246 766/50 000] R44.94 1C
Page 23 of 228
Part (b)(ii)
Production costs before split off point are not usually allocated to by-products (as opposed to joint
products) – these costs are incurred irrespective and by-product revenue often immaterial 2
The 'sales value' method produces a realistic result (costs versus selling price) 1
Sales price of R72 versus unit production costs of R44,94 translates into gross profit of
R12,06 (16,75%) per unit after including transport costs of R15/tonne 1
Selling prices do not determine costs hence, allocation could be flawed 1
Mark up of 55% may result in a sales price (R92.85) that is not market related 1
The 'physical measure' method
Unit production costs (R455) is significantly higher than likely selling price 1
Penalises products with low sales values per unit 1
May overstate the unit gross profit for phosphoric acid 1
The gross profit margin for phosphoric acid is 35,7% , margin for gypsum should be similar or
lower 1
Logical argument 1
17
Part (c)
Section 31 applies if:
• It is a transaction between a resident & non-resident ½
• There are terms of the transaction(s) which are not 'at arm's length' ½
• The transaction is between connected persons ½
With regards to the supply of gypsum by Crushtide to Gypsum Mauritius:
The sale of gypsum at cost is not a market related price ½
They are connected persons as Crushtide owns > 20% of Gypsum
Mauritius' equity 1
Crushtide will be deemed to have supplied product to Gypsum Mauritius at market prices, include
these deemed profits (R72 less costs) in Crushtide's taxable income - tax consequences 1
There may be a deemed loan from Crushtide to Gypsum Mauritius if the amount is not repaid
1
within the tax year, resulting in deemed interest income B
4
Page 24 of 228
Part (d)
Key considerations relevant to decision making in both options:
Production costs pre split off point incurred irrespective therefore, ignore these for decision
making 2
Crushtide should attempt to maximise group profits hence, policy should encourage sales to
Gypsum Mauritius 2
Costs (R210k) avoided by not dumping to be factored into decision making 1
Depreciation of Richards Bay plant (R1,26m) irrelevant - sunk cost 1
However, is Crushtide able to sell plant (R12,6m cost)? If not, this was an expensive mistake ! 2
More control over delivery times, product quality, payment terms etc if purchase of gypsum
inter-group 2
Crushtide should minimise income tax within 'rules' by supplying to Gypsum Mauritius at lowest
possible price 1
Performance measurement & incentivisation
Gypsum Mauritius management may be disincentived through buying at > market prices 1
Goal congruance important, all employees should be incentivised to maximise group profit 1
Richards Bay unable to supply full demand (75 000 tonnes) so need to retain alternate sources
of supply 1
Any alternate customers to purchase gypsum? Their purchase prices? 2
Cost plus pricing policy
What costs? Allocated costs at split off point? Incremental costs? 1
Cost plus pricing provides limited incentive to control costs 1
Suggested mark up of 55% seems arbitrary - basis? 2
Risk of breaching section 31 of Income Tax Act 1
Market based transfer policy
Expected FY2014 market prices ? (was R72 but could change) 1
May provide less incentive for Gypsum Mauritius to purchase from Crushtide? 1
Average price was R72 in FY2013 however, what was high and low prices from suppliers? 1
Historical volatility of market prices? 1
Limited risk of breaching section 31 of Income Tax Act 1
Clarity of expression 1
Logical argument 1
18
Page 25 of 228
MAF 03
45 marks
Amandla Engineering (Pty) Ltd (‘Amandla’) manufactures diesel generator sets (‘gensets’) at its factory
located in Johannesburg. Gensets are primarily used as a source of back-up power by customers in
commerce and industry. The demand for gensets has increased significantly over the past years as a
result of the frequent power outages.
Amandla manufactures a standard genset producing 20kVA of power. The key components of a genset
are the diesel engine, alternator, electrical control panel, steel enclosure and fuel tank. Amandla
imports diesel engines from a supplier based in Japan, which are priced in US dollars. Other
components are sourced from local suppliers.
Budgeted and actual results for the year ended 28 February 2009
The Production Director of Amandla, Mr John Wright, is most pleased with the performance of the
company for the year ended 28 February 2009. Gross profit was 23% higher than the budget. The
gross profit margin was 24,5% against a budgeted gross profit margin of 23,4%.
Earnings before interest, tax, depreciation and amortisation (EBITDA) was an impressive 41,3% higher
than the budgeted EBITDA.
Extracts from the budget for the year ended 28 February 2009 and the actual results per the
management accounts for the year are set out below:
AMANDLA ENGINEERING (PTY) LTD

BUDGETED AND ACTUAL RESULTS FOR THE YEAR ENDED 28 FEBRUARY 2009
Budget Actual
Notes R R
Revenue 1 246 330 000 289 000 000
Opening inventory 2 (14 040 000) (14 040 000)
Materials
Diesel engines 3 (120 232 500) (144 500 000)
Other material components (31 280 000) (34 425 000)
Variable manufacturing overheads (4 535 600) (4 887 500)
Fixed manufacturing overheads
Direct labour 4 (19 283 200) (21 977 120)
Other fixed manufacturing overheads (13 880 500) (14 450 000)
Closing inventory 2 14 531 250 16 162 500
Gross profit 57 609 450 70 882 880
Foreign exchange profits 5 0 1 850 000
Non-manufacturing expenses (20 000 500) (19 600 500)
EBITDA 37 608 950 53 132 380
Page 26 of 228
Notes
1. Amandla budgeted to manufacture and sell 7 820 gensets at R31 500 each during the year.
The company actually manufactured and sold 8 500 gensets.
2. Opening inventory at 1 March 2008 consisted of 750 diesel engines at an actual cost of R11
190 000 and other materials of R2 850 000. Closing inventories comprised 750 diesel engines
at an actual cost of R13 125 000 and other materials of R3 037 500. There was no opening or
closing inventory of work in progress or finished goods.
3. Budgeted purchases of diesel engines and actual costs are set out in the table below:
Year ended 28 February 2009 Budget Actual

Number of diesel engines purchased 7 820 8 500
US price per diesel engine US $2 050 US $2 000
Average exchange rate during the US $1 : R7,50 US $1 : R8,50
year
4. Amandla employed 160 production personnel and 34 electricians at its factory throughout the
2009 financial year. Production personnel are responsible for the manual labour involved in
assembling gensets. Electricians perform all the wiring required in gensets and the installation
of electrical control panels.
The budgeted and actual labour hours available for manufacturing during the year ended 28 February
2009, together with overtime and idle time, are set out below:
Year ended 28 February 2009 Budget Actual

Available hours for manufacturing
Production personnel 294 400 294 400
Electricians 62 560 62 560
Overtime hours
Production personnel 0 11 600
Electricians 0 0
Idle time
Production personnel 44 160 0
Electricians 0 3 060
Mr Wright believes that in the manufacturing environment, labour represents a fixed overhead cost
as opposed to a variable overhead cost. He bases his view on the fact that the company has to pay
production personnel and electricians irrespective of manufacturing output.
The hourly wage rate for electricians was three times that of production personnel during the 2009
financial year, which is consistent with prior years. The overtime rate is 1,5 times the normal hourly
wage rate.
5. The lead time between order and delivery of diesel engines is three months. Amandla orders
engines based on its estimate of future customer orders and sales. The Financial Director of Amandla,
Mr Guy Ciccone, takes out forward cover based on orders of diesel engines. Forward exchange
contracts are sometimes rolled over when engine deliveries are delayed. Mr Ciccone also occasionally
takes out more forward cover than is required if he believes the rand will deteriorate against the US
dollar. The foreign exchange profits of R1 850 000 earned during the 2009 financial year represent net
profits from excess forward cover and the ineffective portion of hedges.
Page 27 of 228
Costing and pricing of customer orders
The Production Division estimates the manufacturing cost of gensets and provides this information to
the Sales and Marketing Division for the purpose of quoting prices to customers. Amandla generally
marks up the estimated manufacturing cost by 30% to determine the selling price of gensets to
customers. A typical example of a costing estimate provided by the Production Division to the Sales
and Marketing Division is set out below:
Customer Gideon Enterprises Ltd

Order date 4 November 2008
Estimated delivery 28 November 2008
Order quantity 50 gensets
Manufacturing costing sheet US $ R

50 diesel engines at a total cost of 100 000 825 000
Engines are in stock and were purchased for R16 500 each
Other material costs 205 000
Materials ordered from local suppliers and costing based on
supplier quotes
Estimated variable manufacturing overheads 29 000
Total variable costs 1 059 000
Recovery of direct labour and other fixed overheads 283 250
Standard recovery of 27,5% of estimated materials costs
Estimated manufacturing cost 1 342 250
Signed off by Production Director Yes
Date 3 November 2008
All amounts exclude VAT.
Page 28 of 228
REQUIRED: Marks
Analyse and provide detailed comments on the direct labour expense for the
year ended 28 February 2009 in comparison to the budget. Your answer
(a)
should include commentary on wage rates, labour efficiencies, capacity 20
utilisation and idle time. Show all relevant ratios and calculations.
Discuss, with reasons, whether or not you agree with the Production Director’s
(b) view that the direct labour expense is a fixed manufacturing overhead cost. 5
Identify and discuss any areas for improvement in Amandla Engineering (Pty)
Ltd’s existing procedures and methodology for the costing and pricing of
(c) 10
customer orders.
Identify and describe four key business risks faced by Amandla Engineering
(d) (Pty) Ltd. 8
Presentation marks: Arrangement and layout, clarity of explanation, logical

2
argument and language usage.
Page 29 of 228

Part (a)
Hourly wage rates P.Personnel Electricians

Budget [(294 400) x (X)] + [(0) x R40.00 R 120.00 2
(1.5X)] + [(62 560) x (3X)] + [(0) x
(4.5X)] = 19 283 200;
thus X = 40; 3X =120
Actual [(294 400) x (X)] + [(11 600) x R 44.00 R 132.00 2

(1.5X)] + [(62 560) x (3X)] + [(0) x (4.5X)]
= 21 977 120
482 080 X + 17 400 X = 21 977 120
499 480 X = 21 977 120;
thus X = 44; 3X = 132
Actual wage rate versus budget 10.0% 10.0% 1
Direct labour hours per genset P.Personnel Electricians

manufactured
Budget 32.0 8.0 1
Actual 36.0 7.0 1
Budget Actual
Direct labour costs/revenue 7.8% 7.6% 1
Increase in manufacturing output versus 8.7% 1
original budget
Direct labour utilisation
Production personnel 85.0% 103.9% 1
Electricians 100.0% 95.1% 1
Actual direct labour costs versus P.Personnel Electricians
budget
Budgeted costs 11,776,000 R R 1
11,776,000 7,507,200
Wage rate increases 1,247,200 R 1,177,600 R 750,720 1
Overtime 696,000 R 765,600 R0 1
Actual costs 13,719,200 R R
13,719,200 8,257,920
Actual direct labour costs versus %
budget
Production personnel 16.5% 1
Total direct labour costs 14.0% 1
Increase in actual manufacturing hours
versus original budget
- production personnel (N1) 22.3% 1
- electricians -4.9% 1
Page 30 of 228
Comments
Wage rate
Reasons for difference between actual wage rate & budget? 1
Overtime rates 50% higher than normal adding to cost overrun for 1
production personnel
Labour efficiency 1
Poor productivity of production personnel - reasons?/possible explanations for
poor productivity
Manufacturing hours (Production personnel) up 22.3%, much higher than 1
increased output of 8.7%
Reasons for improved productivity of electricians?/possible 1
explanations
Inter-relationship between improved efficiency of electricians & decreased 1
efficiency of prod.personnel?
Increased output 1
Actual results should be compared to flexed budget as output was
higher than initial budget
Higher than budgeted output = less idle time for production 1
personnel
Other comments 1
Were budgeted standard labour hours per genset
appropriate/realistic?
Amandla is operating at near capacity from direct labour 1
perspective/constraint going forward
Amandla should employ more p.personnel as overtime rates 1
punitive
N1: The percentages increase stem from the utilization percentages earlier in the solution. So the
22.3% for production personnel is (103.9 - 85) / 85 and the -4.9% forelectricians is the difference
between 100% and 95.1% for the electricians.
Further calculations continue on the next page.
Page 31 of 228
Flexed budget
Production personnel Flexed Actual
Manufacturing 272,000 306,000 1
hours
Idle time 22,400 0 1
Hours paid 294,400 306,000
Average wage rate R 44.83 1
paid
[(294 400 x 44) +
(11 600 x 66)] / 306
000
Variances from Alternative
flexed budget
Due to higher wage - - 1
rate than flexed 1,224,000 1,479,200
budget
[(44,83 – 40) * 306
000
Due to labour - - 1
inefficiencies 1,360,000 1,360,000
Overtime premium -255,200
incurred
Variances -2,839,200 -
attributable to 2,839,200
manufacturing
division
Idle time avoided 896,000 896,000 1
Total production - -
personnel labour 1,943,200 1,943,200
variance
Electricians Flexed Actual
Manufacturing 68,000 59,500 1
hours
Idle time 0 3,060
Hours paid 68,000 62,560
Average wage rate R 124.80 1
budgeted
Total labour costs R R 1
paid 8,486,400 8,257,920
Actual labour costs -2.7% 1
versus flexed
budget
Page 32 of 228
Variances from flexed budget Alternative 1 Alternative 2

Due to higher wage rate than flexed budget -714,000 -750,720 -428,400 1
Due to labour efficiencies 1,020,000 1,020,000 1,060,800 1
Overtime premium avoided 326,400 326,400
Variances attributable to manufacturing division 632,400 595,680 632,400
Idle time incurred -403,920 -367,200 -403,920 1
Total electrician labour variance 228,480 228,480 228,480
Key reasons for variances between flexed budget & actual results
Production personnel wage rate & inefficiencies major reasons for cost over-runs 1
Electricians improved efficiency offset higher wage rates/reduced total adverse variance 1
Available 44
Maximum 20
Part (b)
Fixed costs are defined as expenses which do not vary in relation to production & sales volumes 1
Labour costs are fixed in s-term/ wages paid whether or not they produce gensets 1
However, labour costs may not be fixed in the medium/long term as management could
reduce staff #'s 1
In practice, retrenching workers is not a unilateral decision as unions/CCMA have influence 1
Overtime costs are certainly variable in nature 1
Downsizing/retrenchments are not every day occurrences so it could be argued that labour
costs are generally fixed in nature
Amandla is growing & facing capacity constraints, labour more likely to be fixed cost in short
term. 1
Wage costs may be "stepped fixed costs" as these increase at intervals to cater for
growth/downsizing 1
Conclusion: Any reasonable conclusion based on discussion 1
Maximum 5
Page 33 of 228
Part (c)
Costing of diesel engines should not be based on historic cost but rather on current order prices
- If prices are volatile then historic cost will not reflect current replacement value & Amandla
may lose new business or pass on benefits of holding inventories 2
Recovery of variable production overheads appears to be based on FY2009 budget
[R580/genset].
Amandla should revise recoveries based on latest estimates of costs and manufacturing output 2
Recovery of direct labour should be based on "normalised" manufacturing output. Failure to
do so may result in under/over-recovery of labour costs & volatile costing and pricing of gensets 2
Recovery of other fixed O/H's should be based on forecast/normalised output and/or labour
hours
Fixed O/H's will not vary in accordance with material costs 2
Recovery of direct labour should be based on labour hours rather than arbitrary measure of
material costs 2
Non-manufacturing O/H's are also relevant in pricing of gensets. Amandla should generate an
acceptable overall margin to cover all O/H's
2
Amandla should implement a formal standard costing system to regularly compare actual costs
to standards 2
Pricing should be based on what customers prepared to pay. Do market research re branding &
perception of quality etc. What do competitors charge for similar products? 2
Other valid
suggestions 2
Maximum 10
Part (d)
Adverse foreign currency movements may erode GP margins 2
Speculation in FEC contracts = unnecessary exposure to currency movements/risk of material
losses 2
Capacity constraints re labour = may not be able to deliver on orders & lose
customers/revenue 2
Risk of labour unrest & halt to production/potential skills shortage re electricians 2
Current slowdown in SA economy may result on lower revenue/bad debt risks/deteriorating
cash flow 2
Eskom may rectify power outage issue resulting in lower demand for gensets 2
Risk of increasing competition resulting in lower revenue 2
Over-reliance on one supplier of diesel engines; could result in order delays/risk of not finding
alternate 2
Costing system needs to be improved/could result in poor decision making based on incorrect
information 2
Long lead time between orders & delivery of engines; risk of halting production/loss of
business 2
Environmental risks - government etc pressure not to use gensets because of harmful 2
emissions etc
• Other valid risks 2
1 mark for identifying risk & 1 mark for describing risk
Maximum 8
Page 34 of 228

This question is typical of qualifying examination questions of the recent past. It incorporated a
number of basic management accounting principles in a single scenario with questions that were
relatively unstructured. For example, part (a) of the required is described in the examiners’ comments
as being financial analysis but required the use of basic budgeting, standard costing and broad
performance evaluation knowledge to score well. This question had the lowest average of all the
questions in the paper with an average of only 37.6% and only 16.2% of candidates passing the
question!
The major problems candidates incurred in this question stem from candidates attempting to put a
specific required in a box – i.e. link it to some specific section of theory they have learnt. For example,
many candidates assumed part 1 of the required was a standard costing questions and performed a
full-blown variance analysis (or at least tried to) followed by variance commentary. Firstly, this
company was not using a standard costing system, although some form of budgeting variance analysis
was required. Secondly, even though candidates identified variance analysis as necessary, candidates
could not exhibit competence in flexing a budget! Thirdly, candidates would ‘comment’ on their
numbers by re-hashing them in words (e.g. ‘this variance is negative and therefore unfavourable’).
The key lessons to be learnt are as follows:
1. READ THE REQUIRED! The required for part (a) specifically guided a candidate as to what
areas to comment on. Use this to break your answer up into smaller more manageable
portions. If you are not guided, plan your answer as to what areas you want to cover before
launching into volumes of unnecessary calculations and commentary.
2. Expect a question that does not fit neatly into a box (a specific module that you have learnt
before). This means you need to focus on understanding the key principles and using these
principles to answer whatever problem is laid before you. Often you can apply different
principles to the different components identified above. If you understand the principles, you
will also be able to offer better commentary.
As for the other parts of this question, parts (b) and (c) were equally poorly answered with candidates
failing to exhibit a basic understanding of whether a cost is fixed or variable and what costs are
important for consideration in pricing of products. This stems from a lack of basic understanding of
the nature of costs as well as costing systems – e.g. what does it mean to allocate overheads based on
a predetermined overhead rate and how you calculate this PDOHR?
Part (d) covered risk identification and was generally well answered.
Page 35 of 228
MAF 04
35 MARKS
Applewood Electronics, a division of Elgin Corporation, manufacturers two flat-screen television

models, the Monarch, which has been produced since 2003 and sells for R900, and the Regal, a new
model introduced in early 2006 that sells for R1,140. Based on the following income statement for the
year-ended November 30, 2007, senior management at Elgin have decided to concentrate
Applewood’s marketing resources on the Regal model and to begin to phase out the Monarch model.
Monarch Regal Total

Revenues R19,800,000 R4,560,000 R24,360,000
Cost of goods sold R12,540,000 R3,192,000 R15,732,000
Gross Margin R7,260,000 R1,368,000 R8,628,000
Selling & admin costs R5,830,000 R978,000 R6,808,000
Operating Income R1,430,000 R390,000 R1,820,000
Units produced & sold 22,000 4,000

Net income per unit sold R65.00 R97.50
Unit costs for Monarch and Regal are as follows:
Monarch Regal
Direct materials R208 R584
Direct manufacturing labour
Monarch (1.5 hours X R12) R18
Regal (3.5 hours X R12) R42
Direct machine costs
Monarch (8 hours X R18) R144
Regal (4 hours X R18) R72
Manufacturing overhead (based on
machine hours) R200 R100
Total Costs R570 R798
Applewood’s management accountant, Susan Bennett, is advocating the use of activity-based costing
and activity-based management and has gathered the following information about the company’s
manufacturing overhead costs, for the year ended November 30, 2007.
Total Units of the Cost-Allocation Base

Activity Centre
Activity
(Cost-Allocation Base) Monarch Regal Total
Costs
Soldering (number of solder points) R942,000 1,185,000 385,000 1,570,000
Shipments (number of shipment) R860,000 16,200 3,800 20,000
Quality control (number of
inspections) R1,240,000 56,200 21,300 77,500
Material handling (number of orders) R950,400 80,100 109,980 190,080
Machine power (machine-hours) R57,600 176,000 16,000 192,000
Page 36 of 228
Machine setups (number of setups) R750,000 16,000 14,000 30,000

Total manufacturing overhead R4,800,000
After completing her analysis, Bennett shows the results to Fred Zondo, the Applewood Divisional
Manager. Zondo does not like what he sees. “If you show head office this analysis, they are going to
ask us to phase out the Regal line, which we have just introduced. This whole costing stuff has been a
major problem for us. First Monarch was not profitable and now Regal.”
“Looking at the ABC analysis, I see two problems. First, we do many more activities than the ones you
have listed. If you had included all activities, maybe your conclusions would be different. Second, you
used number of setups and number of inspections as allocation bases. The numbers would be different
had you used setup-hours and inspection-hours instead. I know that measurement problems
precluded you from using these other cost-allocation bases, but I believe you ought to make some
adjustments to our current numbers to compensate for these issues. I know you can do better. We
can’t afford to phase out either product.”
Bennett knows her numbers are fairly accurate. On a limited sample, she calculated the profitability
of Regal and Monarch using more and different allocation bases. The set of activities and activity rates
she chose resulted in numbers that closely approximate those based on more detailed analyses. She
is confident that head office, knowing that Regal was introduced only recently, will not ask Applewood
to phase it out. She is also aware that a sizeable portion of Zondo’s bonus is based on division
revenues. Phasing out either product would adversely affect his bonus. Still she feels some pressure
from Zondo to do something.
REQUIRED:
1 Using activity-based costing, calculate the cost per activity and recalculate the 22
profitability of the Regal and Monarch models. Explain why these numbers differ from
the profitability of the Regal and Monarch models calculated using Applewood’s existing
costing system.
2 Comment on any possible concerns about the accuracy and limitations of ABC and 9
indicate how Applewood might find the ABC information helpful in managing its business.
3 Advise Susan Bennett on the most ethical course of action to be taken 4
TOTAL 35
Page 37 of 228

1. Applewood Electronics should not emphasize the Regal model and phase out the Monarch model.
Under activity-based costing, the Regal model has an operating income percentage of less than 3%,
while the Monarch model has an operating income percentage of nearly 43%. 1
Cost driver rates for the various activities identified in the activity-based costing (ABC) system are as
follows:
Soldering R942,000  1,570,000 = R0.60 per solder point .5

Shipments R860,000  20,000 = R43.00 per shipment .5
Quality control R1,240,000  77,500 = R16.00 per inspection .5
Purchase order R950,400  190,080 = R5.00 per order .5
Machine power R57,600  192,000 = 0.30 per machine-hour .5
Machine setups R750,000  30,000 = 25.00 per setup .5
Applewood Electronics:
Calculation of Costs of each Model under Activity-Based Costing
Monarch Regal
Direct Costs
Direct materials (R208 X 22,000; R584 X 4,000) R4,576,000 R2,336,000 0.5
Direct manufacturing labour (R18 X 22,000; R42 X 4,000) R396,000 R168,000 0.5
Machine costs (R144 X 22,000; R72 X 4,000) R3,168,000 R288,000 0.5
Total direct costs R8,140,000 R2,792,000
Indirect Costs
Soldering (R0.60 X 1,185,000; 385,000) R711,000 R231,000 0.5
Shipments (R43 X 16,200; 3,800) R696,600 R163,400 0.5
Quality control (R16 X 56,200; 21,300) R899,200 R340,800 0.5
Purchase orders (R5 X 80,100; 109,980) R400,500 R549,900 0.5
Machine power (R0.30 X 176,000; 16,000) R52,800 R4,800 0.5
Machine setups (R25 X 16,000; 14,000) R400,000 R350,000 0.5
Total indirect costs R3,160,100 R1,639,900 0.5
Total costs R11,300,100 R4,431,900 1
Profitability analysis
Monarch Regal Total

Revenues R19,800,000 R4,560,000 R24,360,000
Cost of goods sold R11,300,100 R4,431,900 R15,732,000
Gross Margin R8,499,900 R128,100 R8,628,000 1
Selling & Admin R5,830,000 R978,000 R6,808,000
Operating Income R2,669,900 R(849,900) R1,820,000 1
Per-unit calculations
Units Sold 22,000 4,000
Page 38 of 228
Gross margin per unit

(R8,499,900  22,000; R128,100  4,000) R386.36 R32.02 1
Operating income per unit
(R2,669,900  22,000; R849,900  4,000) R121,36 R(212.48) 1
Gross margin percentage 42.9% 2.8% 1
Operating income percentage 13.5% (18.6%) 1
Applewood’s existing costing system allocates all manufacturing overhead other than machine costs
on the basis of machine-hours, an output unit-level cost driver. 1
Consequently, the more machine-hours per unit that a product needs, the greater the manufacturing
overhead allocated to it. Because Monarch uses twice the number of machine-hours per unit
compared to Regal, a large amount of manufacturing overhead is allocated to Monarch. 1
A brief analysis of the unit costs shows that Regal requires double the direct labour and direct material
when compared to the Monarch and so it is unlikely that machine time is likely to be an appropriate
driver for manufacturing overhead. In addition, the machine costs are relatively insignificant in
relation to the overall manufacturing cost. 1
The ABC analysis recognises several batch-level cost drivers such as purchase orders, shipments, and
setups. Regal uses these resources much more intensively than Monarch and the ABC system
recognizes Regal’s use of these overhead resources. 1
Consider, for example, purchase order costs. The existing system allocates these costs on the basis of
machine-hours. As a result, each unit of Monarch is allocated twice the purchase order costs of each
unit of Regal. The ABC systems allocates R400,500 of purchase order costs to Monarch (equal to
R18.20 (R400,500  22,000) per unit) and R549,900 of purchase order costs to Regal (equal to R137.48
(R549,900  4,000) per unit). Each unit of Regal uses 7.55 (R137.48  R18.20) times the purchases
order costs of each unit of Monarch. 1
Regal’s more intense use of manufacturing overhead results in a much lower gross margin and
operating loss under the ABC system. By the same token, the ABC analysis shows that Monarch is quite
profitable. The existing costing system over-costs Monarch, and so made it appear less profitable.
Max: 22
Question 2:
2. When designing and implementing ABC systems, managers and management accountants need to
trade off the costs of the system against it’s benefits. 1
Adding more activities makes the system harder to understand and more costly to implement but
would probably improve the accuracy of cost information, which, in turn, would help Applewood make
better decisions. 1
Using inspection-hours and setup-hours as allocation bases would also probably lead to more accurate
cost information but would increase measurement cost. 1
The ABC analysis should not be limited to manufacturing costs as selling and administration costs are
often driven by activities that are product specific. It is not clear in this example what basis was used
Page 39 of 228
to apportion selling and administration costs to Monarch and Regal and so the use of ABC to analyse
these costs could provide valuable information at relatively low cost. 1
Activity-based management (ABM) is the use of information from activity-based costing to make
improvements in a firm. 1
A firm could revise product prices on the basis of revised cost information. For the long term, activity-
based costing can assist management in making decisions regarding the viability of product lines,
distribution channels, marketing strategies, etc. ABM highlights possible improvements, including
reduction or elimination of non-value-added activities, selecting lower cost activities, sharing activities
and other products, and eliminating waste. 1
For example, Applewood should use this revised cost information to reconsider their product mix
emphasis. The gross margin % and operating income % ratios clearly show that profitability will
decline if the sales mix were to change in favour of the Regal. 1
Applewood could also use this information to identify non value adding activities. An example would
be the number of setups. Applewood uses 16000 setups to produce 22000 Monarchs while 14000
setups are incurred to produce only 4000 Regals. Surely the number of setups for Regal could be
reduced without any loss in value. 1
ABC would use practical capacity rather than normal capacity for indirect costs that are stepped fixed
costs in relation to the activities. This refinement focuses attention on the cost of spare capacity. 1
So to summarise, ABM is an integrated approach that focuses management’s attention on activities

with the ultimate aim of continuous improvement. As a whole-company philosophy, ABM focuses on
strategic, as well as tactical operational activities of the company. 1
Max: 9
Question 3:
3. Incorrect reporting of ABC costs for the purpose of retaining both the Monarch and Regal product
lines is unethical. 1
Although the question does not mention that Bennett is a CA, which means that she may not be bound
by all of the sections of the Code of Professional Conduct (CPC), the fundamental principles contained
in the CPC are nevertheless relevant, as they are general enough to be applicable to all professional
accountants, regardless of qualification. 1
One of those fundamental principles is integrity, which requires that professional accountants are
straightforward and honest. 1
In this instance, her integrity is threatened by a self-interest threat: she obviously wants to please her
boss, but doing so would require presenting a false or misleading report 1
Another fundamental principle is objectivity, which requires accountants not to allow bias, conflicts
of interest or undue influence of others override professional judgement. 1
Adjusting the product cost numbers to make both the Monarch and Regal lines look profitable would
violate objectivity. 1
Page 40 of 228
Bennett should maintain her integrity: she should not be tempted into producing false or misleading
information, either for own sake, or others, and should therefore not change the results of her
analysis. 1
Clear reports using relevant and reliable information should be prepared. It is unethical for Bennett
to change the ABC system with the specific goal of reporting different product cost numbers that
Zondo favours. 1
If this leads to conflict with Zondo, then she should try to explain to him clearly and calmly why it is
that her results are accurate, and assure him that the new product line will not be cancelled as a result
of the report. 1
If she cannot resolve the conflict with Zondo in this manner, she should consider taking the matter to
his superior. 1
The management accountant has a responsibility to identify actual or apparent conflicts of interest
and advise all appropriate parties of any potential conflict. (If Bennett is a CA the CPC applies and the
duty is to identify and attempt to resolve conflicts of interest, as per section A) 1
Bennett may be tempted to change the product cost numbers to please Zondo. This action, however,
would violate the responsibility for integrity. Ethical conduct requires the management accountant to
communicate favourable as well as unfavourable information. 1
Bennett should indicate to Zondo that the product cost calculations are, indeed, appropriate. If Zondo
still insists on modifying the product cost numbers, Bennett should raise the matter with one of
Zondo’s superiors. 1
If, after taking all these steps, there is continued pressure to modify product cost numbers, Bennett
should consider resigning from the company, rather than engage in unethical behaviour.
(Bennett should follow the steps for conflict resolution as laid out in the CPC) 1
Max: 4
Page 41 of 228
MAF 05 (50 marks)
Signs-for-Africa (Pty) Ltd (‘Signs-for-Africa’) manufactures durable, low-cost, plastic road warning signs
at its factory situated in Rosslyn, Tshwane. The company has historically exclusively focused on export
markets but changed its focus to the South African market in 2006 because of the growth
opportunities locally. The South African National Roads Agency Ltd (SANRAL) and local authorities in
South Africa decided in 2006 to gradually replace all the existing metal road warning signs with plastic
signage. The main reasons for this change are that plastic signs are less likely to be stolen and are safer
in the event of collisions.
Signs-for-Africa manufactures two kinds of signs, namely standard road warning signs (SRWS) and
electronic road warning signs (ERWS). The only material used to manufacture SRWS is plastic, whereas
ERWS are fitted with one solar panel driven warning light, which is purchased from a supplier based
in Japan. The warning light is fitted by skilled electricians during the production process. Apart from
this, the ERWS are identical to SRWS and manufactured in the same process as SRWS.
Signs-for-Africa has operated a standard costing system for many years. The Manufacturing,
Procurement and Sales divisions are all involved in setting standards on an annual basis. Their inputs
are collectively incorporated into the company budget for the forthcoming financial years. The
Procurement division is responsible for the ordering of materials, negotiating prices with suppliers,
logistics relating to the receipt of materials and ongoing liaison with suppliers and potential suppliers.
The Manufacturing division is responsible for all production matters including recruiting and managing
all labourers involved in the production process.
The budget for the year ended 31 December 2007 was approved by the board of directors of Signs-
for-Africa in early January 2007. The budget included the following relevant information and
assumptions relating to planned sales and manufacturing volumes, and standard costs:
SIGNS-FOR-AFRICA (PTY) LTD
BUDGET FOR YEAR ENDED 31 DECEMBER 2007
Quantity R
Revenue
SRWS 6 000 units 2 100 000
ERWS 12 000 units 6 600 000
Material costs
Plastic 144 000 kg (1 872 000)
Solar panel driven warning lights 12 000 units (1 440 000)
Labour Costs
Type A labourers 18 000 hours (450 000)
Electricians 12000 clock hours (420 000)
Variable manufacturing overheads (270 000)

Fixed manufacturing overheads (90 000)
Patent costs (60 000)
Non-manufacturing overheads (2 600 000)
Budgeted profit 1 498 000
Page 42 of 228
Notes
• The standard quantity of plastic used in the manufacturing process is 8 kg for each warning sign
manufactured.
• All inventories are accounted for at standard cost.
• Type A labourers were budgeted to be paid a standard rate of R25 per hour, and the
manufacturing standard is one hour of type A labour for each manufactured product.
• Electricians were expected to operate at a productivity level of 90% and 54 minutes of electrician
time was budgeted for each ERWS product. Electricians were budgeted to be paid R35 per
standard clock hour.
• Variable manufacturing overheads were budgeted at R5 per machine hour and every product
takes a standard time of three machine hours to complete.
• Fixed manufacturing overheads are allocated to the manufacturing cost of products based on
machine hours.
• Signs-for-Africa is required to pay a standard patent fee of R5 per ERWS product sold, to its
Japanese supplier.
There was no opening inventory of materials or finished products at the start of the 2007 financial
year. No inventories of work-in-progress existed at the start or end of the financial year and none had
been budgeted to exist either.
The actual results for the year ended 31 December 2007 are summarised below:
YEAR ENDED 31 DECEMBER 2007
Quantity R
Revenue
SRWS 5 000 units 1 800 000
ERWS 7 500 units 3 750 000
Manufacturing volumes
SRWS 6 160 units
ERWS 9 240 units
Materials
Plastic purchased 150 000 kg (1 500 000)
Plastic used in the manufacturing process 138 600 kg
Solar panel driven warning lights 9 240 units (1 155 000)
Labour
Type A labourers 12 320 hours (332 640)
Electricians 8662,5 clock hours (346 500)
Variable manufacturing overheads (207 900)

Fixed manufacturing overheads (95 480)
Patent costs (45 000)
Non-manufacturing overheads (2 680 000)
Page 43 of 228
Notes
• Machine hours amounted to 38 500 in 2007.

• Signs-for-Africa calculates sales volume variances on the gross profit basis.
• Non-manufacturing overheads are fixed in nature.
The divisional managers responsible for the Manufacturing, Procurement and Sales divisions believe
that the change of focus to the South African market has adversely affected the profitability of Signs-
for-Africa. In their opinion SANRAL and local authorities did not plan the rollout of plastic road warning
signs properly and tend to place orders on an ad hoc basis. The ERWS product range has also not taken
off because of the higher price of the product compared to the SRWS range, despite the vastly superior
visibility of ERWS to motorists.
Additional information
The schedule set out below contains the list of variances which the company normally calculates. The
management accountant has already calculated some of these variances. His calculations are correct.
SCHEDULE OF VARIANCES FOR THE YEAR ENDED 31 DECEMBER 2007
Adverse Favourable
variances variances
R R
Revenue
Sales price variance: SRWS 50 000
ERWS 375 000
Sales margin mix variance:
Sales margin yield variance:
Expenses
Material price variance: Plastic material
Solar panels 46 200
Material usage variance: Plastic material
Solar panels Nil
Labour rate variance: Type A 24 640
Electricians
Labour efficiency variance: Type A 77 000
Electricians
Variable overhead expenditure variance
Variable overhead efficiency variance
Fixed overhead expenditure variance
Fixed overhead volume variance:
Fixed overhead capacity variance
Fixed overhead efficiency variance
Patent expenditure variance
Patent volume variance
Non-manufacturing overheads expenditure variance 80 000
Page 44 of 228
REQUIRED:
(a) Calculate all the possible variances for the year ended 31 December 2007 not yet
calculated by the management accountant. Using your calculated variances and 28
those of the management accountant, reconcile budgeted profit to actual profit
or loss for the year.
(b)
Based on the variances calculated in (a) and other information provided –
5
(i) identify and discuss the key reason(s) for lower than expected profitability of
Signs-for-Africa (Pty) Ltd in the 2007 financial year, and
10
(ii) provide positive feedback, if any, and negative feedback, if any, on the
performances of the Manufacturing, Procurement and Sales divisions.
(c) Calculate the number of units of standard road warning signs and electronic road
warning signs that Signs-for-Africa (Pty) Ltd needed to sell in 2007 in order to 7
break even based on the actual results for the year ended 31 December 2007.
Assume that the actual sales mix by product achieved in 2007 remains constant.
TOTAL 50
Page 45 of 228

Part (a)
Gross profit per unit calculation
SRWS ERWS Standard SRWS ERWS Marks

(Quant) (Quant) Cost of R R
Input R
(Amount) N1 N1
Selling price 350 550
Material costs 149 304

Plastic 8 8 13 104 104 ½
Solar panel lights 0 1 120 0 120 ½
Labour costs
Type A labour 1 1 25 25 25 ½
Electricians 0 1 35 0 35 ½
Variable Overhead 3 3 5 15 15 ½
Fixed Manufacturing Overhead 3 3 1.67 5 5 ½

Gross profit per unit 201 246
The patent volume variance is calculated separately but will still form part of the sales volume variance
in the reconciliation of budgeted profit to actual profit. 1
N1: The amount allocated to the product is calculated as Quantity x Amount per unit for each
product.
Page 46 of 228
Sales Variances
Legend + is favourable and – is unfavourable
Sales Sales
Budget RSQ Actual
UNITS SQ x SM AQ x SM AQ x AM Yield Mix
Margin Margin
SRWS 6 000 4 166.67 5 000 -1 833.33 833.33 1
ERWS 12 000 8 333.33 7 500 -3 666.67 -833.33 1
18 000 12 500 12 500
Yield Margin
SRWS (-1 833.33 x R201) -R 368,500
Yield Margin
ERWS (-3 666.67 x R246) -R 902,000
Mix Margin
SRWS (833.33 x R201) R 167,500
Mix Margin
ERWS (-833.33 x R246) -R 205,000
YIELD VAR MIX VAR
-R 1,270,500 -R 37,500 2
Variable Selling Cost Variances

Original Budget Actual @ std price Actual Volume Exp
Patent fee 60 000 37 500 45 000 R 22,500 -R 7,500 2
The notes below are applicable for the question:
Note 1: Flexed budget = Actual units produced x std usage (i.e. hours; kg; mhrs;) per unit x Std rate
per usage (i.e. per hour; kg; mhr)
Note 2: Total of the mix and yield variances should equal the sum of volume variances.
Page 47 of 228
Variable Manufacturing Cost Variances
SRWS ERWS FB Actual Actual Eff/Use Price/Rate

Actual volume 6 160 (FB) 9 240 (FB) At std pr
Material costs 640 640 960 960 1 601 600 1 801 800 -R 200,200 1
Plastic (6160 + 9240) x 8 x 138 600 x
(1 872 000/144 000) 1 872 000/144 000
1 950 000 1 500 000 R 450,000 1
150 000 x
1 872 000/144 000
Solar panel lights 1 108 800 1 108 800 1 108 800 1 155 000 R0 -R 46,200 0
9240 x 1 x 9240 x
(1 440 000/12 000) (1 440 000/12 000)
Labour costs 154 000 231 000 385 000 308 000 332 640 R 77,000 -R 24,640 0
Type A labour (6160 + 9240) x 1 x 12 320 x
(450 000/18 000) 450 000/18 000
323 400 323 400 303 187.5 346 500 R 20,213 -R 43,313 2
(9240) x 1 x 8 662.5 x
Electricians (420 000/12 000) 420 000/12 000
92 400 138 600 231 000 192 500 207 900 R 38,500 -R 15,400 2
Variable Overhead (6160 + 9240) x 3 x 5 38 500 x 5
Fixed Manufacturing Cost Variances
SRWS ERWS Applied Budget Actual Volume Exp

30 800 46 200 77 000 90 000 95 480 -R 13,000 -R 5,480 2
Fixed Manufacturing Overhead (6 160+9 240) x 5/3 x 3
FB Act hr x Bud FOH Bud hr x Bud FOH Efficiency Capacity
Machine hours 1.67 77 000 64 167 90 000 R 12,833 -R 25,833 2
38 500 x 5/3
Page 48 of 228
Calculation of increase in closing inventory at standard cost
Inventory Units R
Plastic 11 400 R 148,200
SRWS 1 160 R 172,840
ERWS 1 740 R 528,960
R 850,000 1
Calculation of actual profit for the period
Revenue R 5,550,000
Material R 2,655,000
Labour R 679,140
Variable O/Hs R 207,900
Fixed O/Hs R 95,480
Patent R 45,000
Non manufacturing O/Hs R 2,680,000
R 6,362,520
Less; Closing inventory R 850,000
Cost of sales R 5,512,520 1
Actual Profit R 37,480 1
Reconciliation of budgeted profit to actual profit
Budgeted profit R 1,498,000

Sales volume margin -R 1,285,500 2
Standard profit margin R 212,500
Sales price variances -R 325,000 1
-R 112,500
Total cost variances R 149,980 1
Materials R 203,600
Labour R 29,260
Patent fee -R 7,500
Variable O/H R 23,100
Fixed O/H -R 18,480
Non manf O/Hs -R 80,000
Actual Profit R 37,480 1
Page 49 of 228
QUESTION 2:
Key reasons for lower than budgeted profit
• The major reason for poorer than expected profitability is the lower revenue (R5,55m) than
budgeted (R8,7m), reflecting in negative variance of R1,6m at GP level 1
• ERW sales volumes were much lower than expected – 37,5% below budget (or R1,1m lower
gross profit) 1
• The average sales price per ERW unit was also 10% lower than budgeted at R500 (translating
to lower GP of R0,375m) 1
• SRW product sales were 14,3% lower than budgeted mainly due to volumes being 16,7% lower
than forecast 1
• Strategically, the company may have erred by placing too much focus on ERW product and
government as a customer (concentration risk). Perhaps continuing to focus on export
markets whilst pursuing local orders would have been a better strategy? 2
Feedback on Manufacturing division
• Plastics purchase price variance was R415.8k positive yet usage variance was R200.2k
negative. This may indicate that infer quality material was purchased & usage suffered? 1
• Labour rate variances were both negative indicating poor planning and/or budgeting on the
part of the department. 1
• Labour efficiency variances for positive for both type A labour and electricians, which may
indicate labour force operated more effectively or that was a natural consequence of lower
production volumes (labour less tired & stressed). 1
Feedback on Procurement division
• Average purchase price of plastics was significantly lower than budgeted (R10/kg versus
budgeted R13). This certainly assisted in negating lower gross profit achieved. 1
• Purchase price of solar panels was higher than expected but this may have been due to the
devaluation of Rand against the Yen? 1
Feedback on the Sales division
• The sales team was unable to secure budgeted orders from SANRAL and local authorities. This
may be due to ineffectively selling the overall cost benefits of electronic warning signs over
SRW/traditional metal signage. 1
• The key reason for lower orders needs to be investigated. A delay in placing orders may be
acceptable long term due to factors beyond division’s control (eg. inefficiencies of SANRAL
and/or local authorities). 1
• The division should perhaps have reacted faster to pricing pressure from customers and
focused more on selling the SRW product? 1
Page 50 of 228
• The long term concern is whether there will be sufficient demand for the ERW product line –
do SANRAL and local authorities have budgets for these products?
• Lowering selling price on ERW products did not stimulate sales volumes and further added to
lower gross profits achieved. 1
Part (c) Marks

SRW ERW Total
Actual sales mix (volume) 40% 60% 1
Fixed costs 2 775 480 1
- Manufacturing overheads 95 480
- Non-manufacturing overheads 2 680 000
Contribution per unit 234.90 206.40 2
- Revenue 360.00 500.00
- Plastic cost [138600xR10]/[6160+9240] -90.00 -90.00
- Solar panels -125.00
- Type A labour [332640/(6160+9240)] -21.60 -21.60
- Electricians -37.50
- Variable overheads [207900/(6160+9240)] -13.50 -13.50
- Patent costs [45000/7500] -6.00
Weighted contribution [40% x 234.90]+[206.40 x 60%] 217.80 1
Breakeven total # of units [2775480/217.80] 12 743.25 1
- SRW & ERW [12743.25 x 40%] 5 097.30 7 645.95 1
Page 51 of 228
MAF 06
OUTDOOR HOLDINGS (54 Marks : 72 Minutes)
Outdoor Holdings Limited (“OHL”) is a divisionalised investment holding company. Each subsidiary of
the group is considered a division of OHL and all subsidiaries manufacture and retail some form of
camping equipment or outdoor apparel. The Board of Directors of OHL are currently evaluating the
financial performance of the group for the financial year ended 31 October 2014. This exercise
includes identifying underperforming subsidiaries (i.e. divisions) and identifying ways to improve
profitability of these subsidiaries. Your services as a management consultant have been requested by
the Board of OHL to assist in evaluating the performance of one such underperforming subsidiary,
Bobb (Pty) Ltd (“Bobb”).
The Bobb Division
Bobb is a manufacturer of basic, outdoor kettle braais. Bobb kettle braais are differentiated from
competitor products through an innovative, cool-to-the-touch base that allows the user to carry the
Bobb kettle braai while the braai is alight. While the Bobb kettle braai is only large enough to
accommodate a single roast chicken, its small size makes it portable and therefore ideal for camping
as well as for over-landing enthusiasts. This small size also makes the Bobb braai more fuel efficient
than its competitors’ products.
Competitor products include low-cost, low-quality unbranded mini-kettle braais and disposable
braais, as well as internationally established brands such as the Weber mini-kettle braai. Despite these
competing products, consumers have indicated that the value of the Bobb products lie in the quality,
user-friendliness, portability and efficiency of the Bobb braais.
Bobb manufactures two different models: the Coal Bobb and the Gas Bobb. The Coal Bobb makes use
of charcoal briquettes – available at most stores and petrol garages – as its heat source. The Gas Bobb
uses Liquid Petroleum Gas (LPG) as a heat source, which requires the user of the Gas Bobb to carry an
LPG gas bottle with them. While the Gas Bobb is cleaner (no smoke), and can in fact be used indoors,
the need to carry a gas bottle reduces the benefits of portability. Increased uncertainty over electricity
supply in South Africa has increased demand for and prices of LPG gas, and has resulted in several gas
shortages in recent years – this too has negatively impacted demand for the Gas Bobb.
Page 52 of 228
Financial Performance Review:
Below is a summarised statement of profit and loss for Bobb (Pty) Ltd for the past two years:
Statement of Profit and Loss for Years Ended 31 October

Note 2013 2014
R R
Revenue 1 75 500 000 61 600 000
Cost of Sales 2, 3, 4 -64 925 000 -53 341 000
Opening Inventories 3 131 250 3 131 250
Production 64 925 000 64 925 000
Closing Inventories -3 131 250 -14 715 250
Gross Profit/Loss 10 575 000 8 259 000
Operating Exenditure 5 -11 500 000 -8 800 000
Net Operating Profit/Loss -925 000 -541 000
1. The table below indicates a breakdown of revenue and sales volumes for the two Bobb
products for each of the two years.
Revenue by product:
2013 2014
Coal Bobb Units Sold (Units) 35 000 32 000

Coal Bobb Revenue (Rand) 45 500 000 41 600 000
Gas Bobb Units Sold (Units) 15 000 10 000

Gas Bobb Revenue (Rand) 30 000 000 20 000 000
Total Revenue (Rand) 75 500 000 61 600 000
2. The following table indicates production capacities as well as levels of production and
inventories of the respective products.
Production information by product and year: 2013 2014

Coal Bobb Gas Bobb Coal Bobb Gas Bobb
Opening Inventories (Units) 2 000 500 2 000 500
Production (Units) 35 000 15 000 35 000 15 000
Closing Inventories (Units) 2 000 500 5 000 5 500
Practical Capacity (Units) 45 000 20 000 45 000 20 000

Normal Capacity (Units) 35 000 15 000 35 000 15 000
3. The table below reflects the costs are incurred in the manufacture of the Coal Bobb and Gas
Bobb. Welding and assembly staff are paid an hourly wage of R130. Production overheads are
allocated to products on a traditional, unit basis according to a predetermined overhead rate.
Page 53 of 228
The cost of manufacture of both products has not changed over the past 3 years – i.e. it cost
the same to produce a Coal Bobb or Gas Bobb (per unit) in 2012, 2013 and 2014 financial
years, in accordance with the table below:
Production costs per unit: Coal Bobb Gas Bobb

(R) (R)
Direct Materials 550 750
Direct Labour 325 585
Manufacturing overheads (Note 4) 286 286
Total cost of production per unit 1 161 1 621
4. The manufacturing overheads can be further analysed in accordance with the table below. It
should be noted that the variable overheads of water and electricity are incurred at a rate of
R20 per direct labour hour. Indirect material costs (such as lubricants and welding rods) are
driven by both direct labour hours and product intensity. The Gas Bobb consumes twice the
indirect materials per direct labour hour than the Coal Bobb. The table with detailed costs is
presented overleaf.
Manufacturing overheads: 2013 2014

(R) (R) Nature of cost
Salaried production staff 2 500 000 2 500 000 Fixed
Factory and warehouse rental 3 500 000 3 500 000 Fixed
Depreciation of equipment 750 000 750 000 Fixed
Water & electricity 3 100 000 3 100 000 Variable
Indirect materials - gas and lubricants 2 225 000 2 225 000 Variable
Sundry fixed production costs 2 200 000 2 200 000 Fixed
Total manufacturing overheads 14 275 000 14 275 000
Pre-determined overhead rate (per unit) 286 286
Due to the more intricate nature of the Gas Bobb, as well as additional safety precautions, the
Coal Bobb and Gas Bobb share equally in the usage of salaried production staff (predominantly
supervisors and quality control specialists) as well as factory and warehouse floor space.
Depreciation is most closely correlated to labour hours while sundry fixed production costs
are facility sustaining.
5. The following table presents a breakdown of the other operating expenditure (all fixed in
nature) by year. 40% of the sales and marketing and 50% of the R&D relate to the Gas Bobb
while the remainder is facility sustaining.
6.
Operating expenditure: 2013 2014

(R) (R)
Sales and marketing 3 000 000 1 800 000
Research and development 5 000 000 3 700 000
Administrative expenses 3 500 000 3 300 000
Total operating expenditure 11 500 000 8 800 000
Page 54 of 228
In an attempt to generate profits in the 2015 financial year, the Managing Director (MD) of Bobb (Pty)
Ltd has proposed two projects. These projects are independent of one another and will be accepted
or rejected (independently) based on approval by the Board of OHL. A number of directors of the OHL
Board have expressed concern regarding the current performance incentive system currently in place
– the MD currently receives a bonus based on improvements in divisional profits. The OHL Board are
keen to bear this in mind when evaluating the MD’s proposals.
Proposal 1: 5% discount on Gas Bobb
In an effort to increased demand for the Gas Bobb once more, the MD plans to launch an advertising
campaign on television and radio. The MD believes the perpetual strain on electricity supply in South
Africa offers Bobb an opportunity to sell the Gas Bobb as a realistic alternative to electric ovens. The
advertising campaign will run with the slogan “Lighting up your dark nights”, and will cost the company
R1.5 million. However, to further drive demand, the MD proposes advertising the Gas Bobb at a 5%
discount for the duration of the 2015 financial year.
The marketing company employed by Bobb believe the advertising and discount are likely to increase
sales volumes by 40%. However, this increased sales volume may come partly from customers who
would have purchased a Coal Bobb – the marketing company foresees a loss of 5% of current Coal
Bobb sales volume.
Proposal 2: Introduction of Limited Edition Mega Bobb
While the 2014 festive season is closing in fast, the MD is keen to launch a new product called Mega
Bobb. The Mega Bobb is a larger version of the Coal Bobb designed to compete with larger kettle
braais, such as your standard Weber kettle braais. An amount of R1.8 million has already been spent
on the research and development of the Mega Bobb, and the Development Manager has indicated
that the Mega Bobb is ready to go into trial production. The MD would like to use this trial production
as an opportunity to generate additional profits in 2015 by branding each of the trial products as being
a “Limited Edition”.
Due to the seasonal nature of the products, the MD wishes to produce the Limited Edition Mega Bobbs
in the first two weeks of December 2014, just in time for the festive season. Customers are believed
to have the most liquidity immediately prior to Christmas and sales volumes are generally low in
January and early February as customers recover from the festive season’s spending.
The following information relates to the Mega Bobb production requirements:
1. Each Mega Bobb unit will require twice the materials and 75% more direct labour time to
manufacture than the standard Coal Bobb.
2. In addition to these materials and labour requirements, each Mega Bobb will require a
stainless steel metal stand – the Coal Bobb is small enough to place on a table, but the Mega
Bobb will require its own stand to ensure stability. Each stand will require 6 kilograms of
stainless steel and will require one and a half hours to manufacture.
3. All materials are readily available from suppliers, but the stainless steel for the stand will have
to be purchased in batches of 1 000 kg, at a cost of R12 650. Unused stainless steel will be
returned to the supplier for a 50% refund according to the weight returned.
Page 55 of 228
4. Bobb has 80 production staff providing direct labour, each working a maximum of 8 hours per
day – no overtime is permitted due to the intensity of the work required. The Mega Bobb
production will take place over a 10 day period during which time the production of 1 400
Coal Bobbs and 300 Gas Bobbs was planned. The MD has indicated that cutting production of
Coal Bobbs would be “unacceptable in his mind” given its popularity and price, especially
during the festive season sales.
5. However, it is anticipated that the Mega Bobb will cannibalise some Coal Bobb sales. The
marketing company estimates one in every ten people who buy the Mega Bobb would have
purchased a Coal Bobb.
6. Based on prior research, Bobb needs to manufacture 800 Mega Bobb units to have any impact
in the market and provide enough data to evaluate the Mega Bobb as a long term product.
Each Limited Edition Mega Bobb will sell for R2 700.
While this scenario makes reference real companies and brands, this scenario is fictional and does
not represent actual operations or transactions.
Page 56 of 228
Marks
REQUIRED
Sub-
Total
total
(a) Critically evaluate the performance of Bobb (Pty) Ltd for the 2014 financial
year. Ensure your analysis addresses both:
10
i) The performance of each product individually;
ii) The overall performance of the company. 5
Show all workings used in support of your analysis.
1 16
Communication skills – structure and layout
(b)
Determine the levels of sales at which Bobb (Pty) Ltd could return to
profitability.
8 8
(c)
Advise the Board of Directors of OHL regarding the two proposals by the MD
as outlined in the information presented:
i) The proposal to reduce the selling price of the Gas Bobb; 6

ii) The proposal to introduce the limited edition Mega Bobb.
Your answer should address qualitative considerations as well as include any 15
supporting calculations you deem necessary to support your analysis.
Communication skills – structure and layout, clarity of expression

2 23
(d) Discuss how the use of a Balanced Scorecard can overcome the shortcomings 6
of the current performance evaluation system. Your answer should identify
the shortcomings of the current system as well as the attributes of the
Balanced Scorecard that will address these shortcomings.
1 7
Communication skills – clarity of expression
TOTAL 54
Page 57 of 228
MAF 06 – Suggested Solution

1 Critically evaluate the performance of Bobb for the 2014 financial year
Immediate impressions:
a) Declining revenue caused by decline in sales volumes; 1
b) Use of a traditional absorption costing system and increasing inventories has
resulted in the deferral of production overheads, therefore inflating the
position of profitability (in this case reducing the loss); 1
c) Reduction of discretionary expenditure of marketing and R&D may have in part
resulted in the declining volumes, and may have longer term implications, but 1
most obviously again reduced the size of the loss in 2014. 1
Firstly, in analysing revenue, we can see no change in selling prices of either product, but 1
sales volumes have declined by 8.6% and 33% for the Coal Bobb (R1,300) and Gas Bobb
(R2,000) respectively. 1
Given the Gas Bobb is sold for the higher amount, the reduced volumes of this product is 1
most responsible for the overall decline in revenue of 18.4%. 1
When analysing the cost of sales (down 17.8%), it is clear the saving is related to the 1
inflated closing balance of inventories – production remained constant year on year while 1
sales volumes declined.
Closing inventories have increased by 8,000 units across the two products deferring
approximately R1,432,000 fixed overheads that otherwise would have been expensed in 1
the current year.
[14.275m – (3.1m + 2.225m) = R8.95m / 50,000 units: 2
NB principle here is Fixed MOH divided by higher of actual or normal production; thus
R179/unit x 8,000 units]
But, it is not clear that this statement of profit and loss is indicative of the true 1
profitability of the company or of the individual products – it appears that the two
products consume resources differently. Especially as decrease in volume sold led to
increase in profits – which does not seem right.
Variable Costing Income Statement 2014 (N1) 1
Coal Bobb Gas Bobb Total
Revenue (units sold) 41 600 000 20 000 000 61 600 000
Variable Costs -30 400 000 -15 150 000 -45 550 000
Direct Materials 17 600 000 7 500 000 0.5
Direct Labour 10 400 000 5 850 000 0.5
Variable W&E 1 600 000 900 000 1
Variable Indirect Mat -W1 800 000 900 000 (refer below) 1
Contribution Margin 11 200 000 4 850 000 16 050 000
Fixed Manufacturing Expenses -8 950 000
Fixed Operating Expenses -8 800 000
Net Operating Profit -1 700 000
Working 1: Coal Bobb Gas Bobb Total
Direct labour cost per unit R325 R585
Direct labour rate per hour R130 R130
1
Labour Hours per unit (hrs) 2.5 4.5
Total unit production (units) 35 000 15 000
1
Total labour hours (hrs) 87 500 67 500 155 000
Intensity factor (Tlh x intens) 1 2
Equivalent hours for indirect materials 87 500 135 000 222 500 1
Page 58 of 228
Total indirect material cost R2 225 000

Variable indirect materials rate (R/hr) R10 1
Product profitability Coal Bobb Gas Bobb
Contribution Margin 11 200 000 4 850 000
Traceable Fixed Costs -3 423 387 -5 896 613
Salaried production staff* 1 250 000 1 250 000
1
Factory and warehouse rental* 1 750 000 1 750 000
Depreciation of equipment* 423 387 326 613 1
Traceable sales and marketing - 720 000 .5
Traceable R&D - 1 850 000 .5
Traceable product profit/loss 7 776 613 -1 046 613
The distortion of the absorption costing system becomes clear in the variable costing
income statement which indicates poorer profitability than in 2013. 1
When further analysing each product according to their traceable costs using activity- 1
based thinking, we can see that Gas Bobb is currently unable to cover the costs
attributable to its production and distribution. Questions need to be raised regarding the 1
non-manufacturing fixed costs attributable to Gas Bobb. 1
*The above calculations still include the cost of spare capacity, which in terms of ABC
should be removed from costing of the two products.
However, it is clear that Gas Bobb’s lack of profitability is largely due to pressure on sales
volumes and is otherwise a profitable product, as indicated by the positive contribution 1
margins.
Total 30
Max 15
Notes:
Q: Why does the solution have a variable costing income statement but this was not explicitly
asked in the required?
A: The company asks for a critically evaluation of the performance of Bobb (Pty) Ltd, however
the financial information given was based on absorption costing which does not give a true
reflection of performance. Therefore in order to do an informed critical evaluation, it
advisable to convert an absorption costing income statement to a variable costing income
statement when asked to critically evaluate performance. This also links to identifying the key
issue in the scenario which was a costing issue of the products resulting in losses.
N1: A variable income statement expenses all fixed costs in the period that they are incurred and not
allocated to the product. Further variable costs are expenses only to the extent that they relate to
products which were sold. Therefore, it matches costs with sales through the consideration of the
nature of the costs.
Page 59 of 228
2. Determine the levels of production and sales at which Bobb could return to
profitability
Coal Bobb Gas Bobb Total 1

Selling price per unit 1 300 2 000
Direct Materials -550 -750
1
Direct Labour -325 -585
1
Variable W&E -50 -90
Variable Indirect Materials -25 -90
Contribution Margin per unit 350 485 1
Historic product mix 70% 30% 1
Weighted Average CM 245 146 391
1
Total Fixed Costs 2014 17 750 000 1
Break even units: (FC/CM) 31 818 13 636 45 455
Total Fixed Costs 2013 20 450 000 1

Break even units: 36 658 15 711 52 369
In this case, the historic sales mix was used to calculate the weighted average
contribution. One can quite equally take the 2014 mix of 76.2%:23.8% which is also 1
correct if justified appropriately.
Holding Gas Bobb constant: 1

Total Fixed Costs 2014 17 750 000
Less Gas Bobb Contribution [10,000 x R485] -4 850 000 2
Net FC to be covered by Coal Bobb 12 900 000
Break even units: [R12.9m / R350] 36 857
The premise of being able to increase sales of Gas Bobb is flawed given weakening 1
demand.
Total Fixed Costs 2013 20 450 000

Less Gas Bobb Contribution -4 850 000
Net FC to be covered by Coal Bobb 15 600 000
Break even units: 44 571
Furthermore, the premise that the 2014 fixed costs will remain indicative of fixed cost
levels in the future is equally flawed. 1
When analysing all of the scenarios, it is clear that the company is not far off from
break-even point, but weak demand for Gas Bobb places increasing pressure on Coal 1
Bobb to the extent that production capacity for Coal Bobb could become a problem – 2
break even of 44,571 and practical capacity of 45,000 units.
Total 17
Max 8
Page 60 of 228
3 Advise the Board of Directors of OHL regarding the two proposals by the MD
.
i) The advertising campaign will result in a future cash outflow of R1.5 million. 1
The 5% discount will result in net loss of revenue on existing sales of:
10,000 units x R2,000 x 5% = R1,000,000 1
The increase in sales volume will generate incremental contribution of:
10,000 units x 40% x (R485 – R100) = R1,540,000 1
Increased Gas Bobb cannibalising Coal Bobb will result in lost contribution of:
32,000 x 5% x R350 = R560,000 1
The net financial impact from pursuing the discount amounts to a loss of R1,520,000. This
would hardly be seen as increasing profitability. 1
However, we have not considered the longer term gains from increased market
penetration of Gas Bobb and that in the longer term, the advertising campaign costs may 1
disappear leaving a negligible negative financial impact. 1
ii Financial impact of Mega Bobb:
) Limited Edition Revenue [800 x R2,700] 2 160 000 .5
Direct materials cost [800 x R550 x 2] -880 000 1
Direct labour costs [800 x R325 x 1.75] -455 000 1
.5
Variable W&E [800 x R50 x 1.75] -70 000
.5
Variable Indirect Materials [800 x R25 x 1.75] -35 000
Materials for the stands [5 x R12,650 - 200 x 12.65 x 50%] -61 985 2
Direct labour costs for stands [800 x 1.5 x R130] -156 000 1
Opportunity Cost [300 x R485 + 720 x R350] -397 500 .5
Financial Impact 104 515

Working 1:
Total available labour 6 400 Limiting factor 1
Required for: -9 550 2
Coal Bobb 3 500
Gas Bobb 1 350
Limited edition 3 500
Stands 1 200
Shortfall -3 150
Cut Gas Bobb 1 350 300 units 1
Cut Coal Bobb 1 800 720 units 1
The Mega Bobb production run will generate a positive financial impact, although small,
and therefore should go ahead on this basis alone. 1
The timing is right for the order, but any delays could push them past Christmas leaving 1
the company with Mega Bobb inventories that they cannot sell in January. This could 1
create cash flow issues. 1
The success of Mega Bobb now can pave the way forward for the introduction of a new 1
product which could assist in returning the company to profitability. 1
One must question to probability of success give the nature of the product – the bigger
product with stand violates the portability and convenience aspects of the Coal Bobb. A 2
rushed order can furthermore undermine the quality of the product. Any over-estimation 1
1
Page 61 of 228
of sales volumes is likely to have leave the company struggling to cover the R1.75million
investment in their manufacture (excl. opportunity cost).
However, introduction of the Mega Bobb is likely to have a major impact on sales volumes
for the other two products at this critical time of year. Dropping Gas Bobb production 1
completely may increase pressure to generate sales volumes in 2015 and place increased 1
pressure on Coal Bobb to recover fixed overheads – which were deemed irrelevant for the 1
purposes of the above calculation.
Total 3
2
Max 2
1
4. Discuss how a Balanced Scorecard can be used to overcome the shortcomings of the
current performance incentive system.
Firstly, the shortcomings of based a bonus on profits are as follows:
• Ignores effectiveness of asset utilisation; 0.5
• Encourages the cutting of discretionary expenditure (as can be seen here); 0.5
• Does not discourage investment in non-value-adding projects or investments;
• Encourages ‘big bath’ syndrome – forego bonus in one year, ensuring as many
losses are brought forward in one year creating a small base off which it is easy
to improve; 1
• Ignores non-financial performance aspects; 1
• Ignores cash flows.
Currently, 23% of Bobb’s capacity is spare, potentially as a result of overinvestment in
assets in the hope of generating volume and hence increased revenue. 1
There has also been a cut in discretionary expenditure and increase in inventory levels to
improve the profits visibly. This is not in the long term interest of the company. 1
A Balanced Scorecard will hopefully bring the following benefits:
• More closely align the performance goals of the MD with the overall strategy of
the business; 1
• Evaluate the MD on both financial and non-financial aspects. 1
There are several key features that create value for the customer, including quality, user- 1
friendliness, portability and efficiency. By nature the product is an innovative product.
Therefore, the 4 pillars of the Balanced Scorecard are ideally suited to evaluate the MD.
Given the innovative nature of the products, it seems essential that the MD is rewarded 1
for fruitful research and development expenditure. 1
Given the struggling sales volumes, but seemingly happy customers, the MD should be 1
rewarded for sales and marketing spend provided this translates into customers.
Total 11
Max 6
Page 62 of 228
MAF 07
55 Marks
IGL International Inc. (“IGL”) is a global consulting group that operates on five continents and has
offices in 43 countries. The head office is in New York, USA, and the group employs in excess of 23 000
professional staff worldwide. IGL provides a wide range of consulting services to multinational and
large corporations, and the group has been in existence since 1962. IGL South Africa (Pty) Ltd (“IGLSA”)
was founded in 1995 and is a wholly-owned subsidiary of IGL. IGLSA has become a leading consultancy
firm in South Africa and currently employs 91 professional staff, which includes management. The
management team of IGLSA consists of the chief executive officer (CEO) and the vice-presidents of
each operating division. IGLSA has three operating divisions.
Strategic consulting division
This division provides consulting services to clients covering business restructuring, new product
development, market research, business process re-engineering, business improvement strategies,
enterprise-wide systems and revenue growth strategies. The strategic consulting division works with
its clients to find solutions to pressing corporate issues and has a track record of adding significant
value to clients in the South African market over the past 11 years.
Intellectual capital division
The intellectual capital division offers consulting services to major companies regarding most aspects
of organisational human resource systems including remuneration models, succession planning,
design and development of job descriptions, work flow analysis, performance management systems
and people development strategies. The division uses patented IGL software tools to identify and
analyse human resource issues in organisations and to develop performance management systems
for clients.
The intellectual capital and strategic consulting divisions focus on servicing the top 100 companies by
market capitalisation on the JSE Ltd and large multinational companies operating in South Africa.
Employee services division
This division assists multinational corporations with deployment of senior managers and executives
to their South African operations or establishment of local subsidiaries. The employee services division
provides various services to client employees relocating on a temporary or permanent basis to South
Africa, including obtaining residence and work permits on their behalf; registration for income tax
purposes, advice on structuring of remuneration and tax allowances, and submission of annual tax
returns; finding temporary accommodation; arranging appropriate security and home protection
services; advice on schools and universities, and facilitating entrance into preferred establishments;
and arranging introductory programmes on local culture and recreational activities.
The employee services division of IGLSA was started in 2002 and employs CAs, lawyers and
administrative staff to assist client employees in making the transition from other countries to South
Africa. IGL has employee services divisions in 21 other countries and interaction between the various
global operations is a major competitive advantage. Most of the current work undertaken by the IGLSA
employee services division is sourced from referrals by the IGL head office and their global
subsidiaries.
Page 63 of 228
Relationship between IGL and IGLSA
IGL maintains strict operational and ethical standards worldwide. There are annual audits of
compliance by IGLSA and other global subsidiaries with operational and ethical codes published by the
head quarters in New York.
IGLSA and subsidiaries in other countries pay an annual license fee to IGL, equivalent to 5% of revenue,
in return for use of the IGL brand, access to global intellectual capital, software tools and research
findings.
The IGLSA management team (CEO and three vice-presidents) are incentivised through the
participation in profits of the local subsidiary. These managers are entitled to collectively participate
in 10% of the profit before tax of IGLSA as an annual bonus. The allocation of this bonus pool to
individuals is determined by various factors including relative basic salaries, scoring in their individual
key performance indicators and relative divisional financial performance.
Client satisfaction survey
In June 2006 IGLSA mandated a local market research company to ascertain the level of client
satisfaction with the services provided by each division and to rank them against major competitors
in South Africa. The results of this survey can be summarised as follows:
Strategic consulting Intellectual Employee

division capital services
division division
Satisfaction index (expressed as
a percentage) 76% 64% 81%
Relative position in SA market Upper quartile Upper Upper 10%
quartile
Page 64 of 228
2006 financial results
The operating results for the year ended 30 September 2006 are summarised below:
IGL SOUTH AFRICA (PTY) LTD

ABRIDGED INCOME STATEMENTS FOR THE YEAR ENDED
30 SEPTEMBER 2006
Notes Strategic Intellectual Employee Total
consulting capital services IGLSA
division division division
R’000 R’000 R’000 R’000
Revenue 1 44 712 19 440 30 983 95 135

Staff costs (19 003) (6 318) (14 872) (40 193)
Gross margin 25 709 13 122 16 111 54 942
Overheads
Administration and support staff 2 (1 258) (585) (1 550) (3 393)
Office infrastructure costs 3 (2 883) (1 167) (3 638) (7 688)
Professional development costs 4 (1 630) (516) (556) (2 702)
Public indemnity insurance 5 (1 744) (758) (1 208) (3 710)
IGL International Inc. fees (2 236) (972) (1 549) (4 757)
Management team salaries 6 (2 140) (1 609) (1 451) (5 200)
IT support and development costs
7 (1 629) (2 872) (1 179) (5 680)
Entertainment and conferences 8 (1 272) (320) (1 426) (3 018)
Operating profit 10 917 4 323 3 554 18 794
Interest income 560
Profit before bonuses 19 354
Management bonuses (1 935)
Profit before tax 17 419
Page 65 of 228
Notes
1. Number of employees per division and other relevant information:
Strategic Intellectual Employee Total

Actual chargeable hours for the year

ended 30 September 2006 37 260 19 440 61 965
Available hours of professional staff members in
the 2006 financial year 62 100 24 300 72 900
Strategic Intellectual Employee Total

Number of employees 42 17 53 113
CEO 1
Vice-presidents 1 1 1 3
Professional staff 34 13 40 87
Administration and support staff 7 3 12 22
Average revenue per client assignment R378 967 R310 822 R24 438
1.1 Staff turnover has been very low at IGLSA and the above employee statistics
represent the actual number of employees per division throughout the 2006
financial year.
1.2 IGLSA invoices clients based on actual hours multiplied by employee charge out rates.
The company does not charge project based fees as it is difficult to accurately estimate
the time that will be spent on assignments.
1.3 The CEO devotes her time to managing IGLSA, liaising with IGL and building client
relationships. The vice-presidents spend approximately 50% of their time on consulting
work and the balance on managing their divisions.
2. Administration and support staff costs represent the salary costs of employees in each
division.
3. Office infrastructure costs include rental of premises, water and electricity, office
refreshments, office equipment rental, depreciation of office furniture and communications
expenses. Office infrastructure costs are allocated to each division based on the number of
employees in that division.
4. Professional development costs represent the costs of attending training courses at South
African educational institutions and at the IGL head office in New York.
5. Public indemnity insurance is arranged through local short-term insurance brokers with
international underwriters. The cost of public indemnity insurance cover to IGLSA currently
amounts to 3,9% of annual revenue.
Page 66 of 228
6. Management team salaries comprise the salaries of the CEO and three divisional vice-
presidents. The salary of the CEO is allocated to divisions based on their revenue as a
percentage of company revenue.
7. General IT support costs amounting to R2 million in the 2006 financial year were paid to an
external firm in terms of a service level agreement. These IT support costs are allocated to
divisions based on the number of employees in each division. Other IT costs of R3 680 000 are
attributable to specific expenditure incurred by divisions in the development of software
applications and tools to support their operating activities.
8. Each operating division arranges conferences and client entertainment activities and the
accompanying costs are allocated to the relevant division. IGL encourages each global
subsidiary to spend approximately 3% of annual revenue on strengthening client relationships
and building the IGL brand.
The CEO of IGLSA also entertains clients to market the company’s services and build relationships. This
expenditure is allocated to operating divisions based on the revenue of each division.
Future of the employee services division
The CEO of IGLSA is concerned about the operating results of the employee services division. Her view
is that this division is underperforming relative to the other two divisions, and should therefore be
sold to a third party or closed down. She believes that the nature of services provided by the employee
services division differs fundamentally from that of the strategic consulting and intellectual capital
divisions, and hence there is no reason that it should form part of IGLSA.
REQUIRED: Marks
(a) Critically comment on the bases used by IGL South Africa (Pty) Ltd to allocate the
various components of overhead expenditure to operating divisions. 10
(b) Review and discuss the revenue performance of each of the operating divisions of
IGL South Africa (Pty) Ltd for the year ended 30 September 2006. Calculate relevant
ratios to highlight revenue generation and performance, and show all workings.
15
(c) Analyse and discuss the profitability of each operating division of IGL South Africa
(Pty) Ltd for the year ended 30 September 2006. You should calculate relevant
profitability ratios, and discuss the results of your ratio analysis as part of your
answer. Show all workings. 10
(d) List the key issues to be considered in evaluating whether to close down the
10
employee services division.
(e) Identify and list ways in which IGL South Africa (Pty) Ltd could improve its operating
profits in future. 10
55
TOTAL
Page 67 of 228

Part (a)
Allocation methods: Overheads
The allocation described below is based on the principle that costs should be allocated on the basis
of resource consumption, in order to reflect the economic contribution of each division, and to
create awareness within the divisions of how their actions and decisions impact costs incurred at
head office level. Where head office costs would be incurred regardless of the existence of the
division or not, these costs should not be included in the assessment of the economic contribution
of the division. However, if the purposes is to compare the division against competitors, then these
costs should be allocated in order to achieve net profit figures that are comparable to external
companies.
• Office infrastructure costs are allocated based on staff numbers. This may be the most practical
way of allocating these costs (rent, water & electricity, depreciation of office equipment).
• Further research should be done to ensure that respective divisions occupy floor space and use
office infrastructure costs in proportion to employee numbers. It may transpire that the consultants
in the Strategic consulting and Intellectual capital divisions spend most of their time out of the office
at client premises and hence, “use” of office infrastructure may be lower than for the Employee
service division.
• Public indemnity costs are allocated according to revenue, hence allocation is appropriate
• The Employee services division may be deemed to be a less risky business and not require as
comprehensive PI cover as the other two divisions. Perhaps Employee services is biased – need to
check what PI cover would cost for the division as an independent entity?
• IGL International fees are allocated to divisions based on revenue – which is correct
• Allocation of CEO’s salary based on revenue is not appropriate. The CEO’s time allocation needs
to analysed to determine whether such an allocation basis is actually appropriate. The CEO’s salary
is a corporate overhead and should be reflected in “head office” division. CEO may spend more time
with newer divisions or underperforming divisions. However, it may be undesirable to allocate costs
on this basis, as it may create resentment towards the CEO spending time with a division, as the
decision as to how much time the CEO spends directly with the various divisions is her decision, and
not that of the divisions. It may be desirable to not allocate this cost at all, as the CEO’s salary would
be paid regardless of any change that can be effected at divisional level. However, if a portion of
the CEO’s bonus is dependant on divisional performance, then this should be allocated to divisions.
• The allocation of general IT costs appears appropriate – these costs tend to be related to number
of system users.
• Inspect the agreement with the external party to check whether it has an estimate of cost per
user – this should support the allocation of general IT costs based on employee numbers.
Page 68 of 228
• The allocation of the CEO’s entertainment expenditure to divisions is inappropriate. This

expenditure should be separately controlled and allocated to “head office”. There is currently no
control over the CEO’s expenditure. Also, divisions may feel that they are “disenfranchised” because
CEO may be incurring unnecessary expenses with little benefit to them.
Part (b)
Strategic Intellect. Employee
consulting capital services
Revenue/professional staff member (R’000) 1 277 1 389 756
Revenue/actual chargeable hours (R) 1 200 1 000 500
Actual hours/total available 60% 80% 85%
Revenue contribution as % of total 47% 20% 33%
% of total professional staff 39% 16% 45%
• The revenue per professional staff member of Employee services is much lower than other
divisions. This is to be expected given the “lower” level of services provided.
• Revenue per chargeable hour of Strategic consulting is higher than that of the other two divisions.
• Revenue per employee in the Intellectual capital division is higher than in Strategic consulting,
mainly due to higher utilisation of staff.
• Staff utilization in Intellectual Capital and Employee Services is excellent.
• Strategic consulting division staff is not being utilised optimally, and reasons for this need to be
determined – 60% is way below the other divisions.
• The ability of Employee services staff to continue operating at 85% capacity needs to be
investigated – fatigue could be a major problem as could be loss of staff due to perceived unfair
working conditions.
• Strategic consulting division is the major contributor to revenue (47%) due to higher number of
professional staff and high charge-out rates.
• It should be of concern to IGLSA that the Employee services division employs 45% of total
professional staff yet only produces 33% of total revenue.
Part (c)
Strategic Intellect. Employee
consult. capital services
Gross margin % 57,5% 67,5% 52,0%

Operating income/revenue 24,4% 22,2% 11,5%
Overhead costs/revenue 33,1% 45,3% 40,5%
Average cost per employee p.a. (R’000)
- professional staff 559 486 372
- admin/support staff 180 195 129
Professional development costs/professional staff 48 40 14
Page 69 of 228
Specific IT costs 879 2 568 233

Entertainment/revenue 2,8% 1,6% 4,6%
• Gross margin of Intellectual capital division is far higher than other divisions mainly due to better
utilisation of staff.
• Operating income/revenue ratio of Employee services division is problematic – it is almost half
that of other divisions.
• Overhead costs of Intellectual capital division are very high, mainly due to IT costs.
• Employees in Strategic consulting and Intellectual capital divisions are paid higher salaries than
Employee services division staff – which is to be expected given the nature of the services rendered.
• IT costs in the Intellectual capital division are high but expected given the use of technology in the
consulting process. The company should investigate whether any of these costs need to be
capitalised.
• The Intellectual capital division spending on entertainment, etc., is below international

benchmark – why?
• The Employee services spending on entertainment, etc., is much higher than the benchmark. This
seems very strange, particularly as most work is referred from IGL International!
• Management team salaries are very high in comparison to other professional staff (R1,3 million
versus average of R462k for divisions). The CEO and VPs also receive 10% of PBT as bonus pool –
seems inequitable?
Part (d)
Issues to consider in closing down the Employee services division
• Retrenchment costs/closure costs
• Utilisation of spare office space?
• Allocated overheads to the division are significant. Without the contribution from this division,
these costs (office infrastructure, management team, IT support) will need to be absorbed by other
divisions.
• IGL International’s view given that Employee services divisions operate in 21 other countries.
• Cross selling opportunities could be missed in future – new executives will be well disposed to
using IGLSA if they have been helped by them when relocating to SA.
• Impact on morale of other divisions. Strong performing employees may be lost.
• Impact on IGLSA brand? Perceived weakening?
• Operating income of the division of R4 million will significantly reduce the management team
bonus pool.
• Clients’ reaction? Market survey indicated that clients were satisfied with Employee services
work.
Page 70 of 228
Part (e)
Revenue
• Strategic consulting division is operating at 65% capacity (chargeable hours versus available
hours). IGLSA should attempt to improve utilisation of professional staff and charge out more hours.
• Given high utilisation of staff in Intellectual capital division, consider employing further
consultants?
• Can IGLSA increase its charge out rate in Employee services division?
• Introduce BEE shareholder to pursue public sector opportunities.
• Employee services could provide services to SA executives moving abroad and leverage off
international group expertise?
• Intellectual capital division should continue to invest in technology tools and products and
increase market share.
Cost reduction/control
• Capitalise IT development costs to correctly reflect investment in future revenue generation?
• Reduce entertainment expenditure in Employee services division

• Management bonuses should be based on wider criteria than EBT – they should benefit if
shareholder value increases.
• Rationalise support staff? Perhaps have a centralised support staff for all divisions?
• Improve overhead allocation methods to reflect more accurate divisional profitability.
• CEO should not be allowed to allocate her entertainment expenditure and salary costs to divisions
– make her accountable for these costs.
• Employ less qualified staff in Employee services?
Page 71 of 228
MAF 08
56 Marks
Eficaz (Pty) Ltd (‘Eficaz’) is an engineering company that manufactures and supplies consumable
products for use in the mining and industrial fluid transfer industries. The key raw material used in its
manufacturing processes is steel and Eficaz uses a range of machining technologies to make end
products.
The current chief executive officer of Eficaz, Mr Rob Oliveira, acquired 100% of the shares in issue in
2004 from the founding shareholders. The business has been transformed since then by expanding
the product range and focusing on production efficiencies. Mr Oliveira would like to grow the business
further in anticipation of the sale of the company in a few years’ time.
Eficaz’s target gross profit margin is 30% and the company has achieved or exceeded this over the past
three financial years.
Eficaz has unutilised manufacturing capacity. For the year ending 31 December 2013, it is estimated
that Eficaz will have 18 400 machine hours and 25 600 direct labour hours available for the
manufacture of additional products. A total of 132 000 direct labour hours (excluding any overtime) is
available for the 2013 financial year.
Potential opportunities
The company has been approached by two potential customers to manufacture specific products for
them on an ongoing basis. Details of the estimated manufacturing costs and proposed selling prices
of these products are summarised in the table below:
XYZ ABC
Potential customer Notes Mining Industrial

Product code M134 IN223
Proposed selling price per unit 1 R120,00 R80,00
Raw material costs per unit manufactured R40,00 R15,00
Estimated production time per unit manufactured
Machine hours 0,50 0,20
Direct labour hours 2 0,60 0,50
Number of units required annually by potential customer 3 35 000 60 000
Estimated variable manufacturing overheads per unit R7,50 R8,50
Fixed manufacturing overheads per unit 4 R6,50 R2,60
Page 72 of 228
Notes
1. XYZ Mining has indicated that its existing supplier charges R120 per unit. XYZ Mining is
dissatisfied with this supplier as the order lead times are far too long (currently 30 days from
order to delivery whereas XYZ Mining requires products to be delivered within 15 days of
order). The M134 product is currently manufactured by Eficaz and sold to a variety of mining
customers
Product IN223 would replace one of the existing products currently purchased and used by
ABC Industrial. The existing product has some safety deficiencies and ABC Industrial has
identified Eficaz as the appropriate partner to manufacture the new product (IN223), given its
engineering expertise and manufacturing excellence. ABC Industrial has patented the IN223
product design and will not make this product available to anyone else in South Africa. It is
estimated that Eficaz will need to make a once-off investment of R308 180 in plant and
machinery modifications to enable it to manufacture product IN223. ABC Industrial has
offered to pay R50 000 of the plant and machinery modification costs. Eficaz plans to expense
its share of the modification costs, as the company is uncertain as to how to allocate these
costs to future units of IN223 manufactured.
2. The average direct labour cost for both the IN223 and M134 products is R60 per hour.
Employees directly involved in manufacturing have indicated that they are prepared to work
overtime, if necessary, provided they are paid 1,5 times their normal hourly rate.
3. XYZ Mining has committed to purchase 35 000 units of M134 in 2013. However, it cannot
accurately predict volumes in future years. If commodity prices decline, XYZ Mining may have
to scale back on mining operations in the short term until prices recover.
ABC Industrial is prepared to enter into a three-year contract with Eficaz for 60 000 units per
annum to provide Eficaz with some assurance of recovering the initial investment in the supply
arrangement. ABC Industrial estimates that annual order volumes of IN223 will increase by
10% per annum from 2014 for the foreseeable future.
4. Annual fixed manufacturing overheads are budgeted to be R1 300 000 in the 2013 financial
year. These overheads are allocated to all products based on estimated machine hours to
manufacture individual products, multiplied by an overhead recovery rate. The overhead
recovery rate is determined as fixed manufacturing overheads divided by the total available
machine hours. There are 100 000 machine hours available for the manufacture of products
in 2013. Planned machine hours, excluding the potential M134 and IN223 opportunities, are
81 600 hours for the 2013 financial year.
Mr Oliveira is uncertain which opportunity Eficaz should pursue – should Eficaz manufacture
M134 for XYZ Mining or IN223 for ABC Industrial? Eficaz has insufficient manufacturing
capacity to pursue both opportunities and will for the next two years not have the financial
resources to invest in further plant and machinery to expand capacity. It does, however, have
sufficient resources to invest in modifying the existing plant and machinery to pursue the
IN223 opportunity.
Page 73 of 228
Selling prices
Eficaz has been grappling with the best way to determine selling prices for its products. Historically, it
has estimated product manufacturing costs and added a standard mark up on costs to arrive at the
selling price. Mr Oliveira is becoming increasingly concerned about this approach as it tends to result
in the company favouring products which have higher manufacturing costs. He has heard that a more
appropriate way of pricing products is to determine a standard recovery rate per machine hour and
add this recovery to manufacturing costs to arrive at a selling price.
This alternate price determination strategy is illustrated below for an existing product (not M134 or
IN223):
Per unit
R
Raw material costs 60,00
Direct labour costs 30,00
Variable manufacturing overheads 10,00
Fixed manufacturing overheads 6,50
Total manufacturing cost per unit 106,50
Machine hour recovery (0,5 hours x R80,00 per hour) 40,00
Selling price 146,50
Page 74 of 228
Marks
REQUIRED: Sub-
Total
total
Calculate and evaluate which of the M134 and IN223 products

would be the most profitable for Eficaz to manufacture in the 2013
(a) 15 15
financial year.
Justify any decisions made to exclude specific manufacturing costs.
Identify and discuss the factors to be considered by Eficaz in

evaluating whether to pursue the opportunity to supply XYZ Mining 15
or ABC Industrial.
(b)
Communication skills – logical argument; clarity of expression 2 17
Calculate the selling prices Eficaz should charge for the M134 and
IN223 products if it used a machine hour recovery rate methodology
(c) and the recovery rate is R80 per hour. 10 10
Include fixed manufacturing overheads allocated to products in your
calculations.
Discuss the potential merits and pitfalls of adopting a selling price

strategy of adding a machine hour recovery rate to manufacturing 8
costs per unit.
(d)
Estimate the allocation of fixed manufacturing overheads to the

(e) M124 and IN223 products during the 2013 financial year based on 5 5
direct labour hours as opposed to machine hours.
Total 56
Page 75 of 228

Part (a) Calculate and evaluate which of the M134 and IN223 products would be the most Marks
profitable for Eficaz to manufacture in the 2013 financial year
PRODUCT M134 PRODUCT IN223
Per Unit Total Per Unit Total
R R R R
Selling price 120.00 4 200 000 80.00 4 800 000

Raw material costs -40.00 -1 400 000 -15.00 -900 000
Variable manufacturing overheads -7.50 -262 500 -8.50 -510 000
Subtotal for given data – correctly used 72.50 2 537 500 56.50 3 390 000 1
Check Total DL:
R1 536’ (25600 hrs x
R60) + 396’ (4400
hrs x R60 x 1.5)
Direct labour(0.6h; 0.5h)xR60 = R1 932’ = ∑* -36.00 -1 260 000 -30.00 -*1 800 000
Contribution 36.50 1 277 500 26.50 1 590 000 1

Overtime premium (N1) -2.20 -*132 000
Modification costs (N2)
(or used R258 180/R308 180) -1.43 -86 060 1P
Fixed manufacturing costs - - - - 1
Total increase - 2013 profit 36.50 1 277 500 22.87 1 371 940 1
N1:
Estimated machine hours to be use
(35000 x 0.5; 60000 x 0.2) 17 500 hrs 12 000 hrs 1
Sufficient machine capacity to manufacture either product
(both < 18400 hrs) 1
Estimated direct labour hours required

(35000 x 0.6; 60000 x 0.5) 21 000 hrs 30 000 hrs 1
While there is sufficient capacity to manufacture M134,
overtime would be required to produce IN223
(max DLhrs before OT = 25600) 1
Overtime hours required

(30000hrs – 25600hrs) 4 400 hrs 1
Overtime premium (50% x R60) = R30 x 4 400) R132 000 1
Premium - IN223 per unit [R132 000 / 60 000] R2.20
N2:
Machine modifications
Modification costs (R308 150 – R50 000) R258 180 1
Estimated manufacturing period for units 3 years
Annual cost to be charged to production (R258 180 / 3) R86 060 1
Fixed manufacturing O/H irrelevant - unavoidable costs (won’t change). NOT sunk costs 1
Page 76 of 228
Alternatively, the fixed cost may represent an opportunity cost as acceptance of any option may
1
eliminate potential future cutbacks on fixed expenditure in lieu of spare capacity
Evaluation (and supporting arguments)

Profit seeks an annualised (equal) cost for the 3 year investment (and to a certain degree
rectifies the non-use of more appropriate NPV approach) OR 1
Expensing full amount of R258 180 in Y1 is conceptually in line with its relevant cost
A long-term decision (not the case here as 2013 profit was required) would be based on 1
contribution per limiting factor and in this case M134 would be the preferred choice.
This approach assumes certainty regarding future levels of sales volumes . 1
If full modification cost is expensed in 2013, this will eliminate IN223 i.t.o. 2013 profits only, but
1
IN223 will be more profitable in subsequent years
CONCLUSION: I.t.o. 2013 profitability only select product IN223, however this decision ignores data
relating to subsequent years 1P
Available 20
Maximum 15
Part (b) Identify and discuss the factors to be considered by Eficaz in evaluating whether
Marks
to pursue the opportunity to supply XYZ Mining or ABC Industrial
Customer due diligence

Consider going concern, reputation, credibility, creditworthiness (if credit sales) of ABC vs XYZ 1
Industry analysis
Products to be used in mining, demanding higher safety requirements with a concomitant
higher risk of damages (for defective products) – reason why ABC was selected with its perceived
reliability. 1
M134 is, however, currently sold which to an extent negates the safety concerns. 1
Mining industry (M134) is more cyclical & forecast units could vary significantly each year 1
Financial implications
It will require a working capital investment, which may differ significantly for either option 1
Having access to sole right on the patent, eliminates any competitors in supply of IN223 1
Forecast costs (RM, lab., var. OH’s) & volumes may not be accurate, this could have serious
implications; for M134 this data is known & more certain (ABC would be less certain) 1
Gross profit margins likely to be <30% for either options - establish the long term reaction of
respective customers to price increases for potential changes in Eficaz’s own cost structure? 1
Taking on lower margin customers may lead to a general decline in the gross profit and the
impact hereof needs to ascertained in the long term volatility of each of the options 1
Utilising cash re modification of machines (ABC) may hamper medium term cash-flows 1
Specific customer considerations
ABC is prepared to enter into a three-year contract, provides more comfort re ongoing supply 1
Are XYZ’s reasons for changing suppliers valid or are they just search for better prices? How
will existing customers react to a difference in price? 1
Will Eficaz have to offer volume discounts’, given the size of the orders and the fact that their
Page 77 of 228
selling price is same as its competitors with regard to product M134 – R120? 1
Customer risk - e.g. M134 (broad customer base); IN223 over-reliance on
a single customer. ABC cannot leverage production through economies of scale. 1
Will Eficaz be able to meet 15-day order lead time on the M134 option? 1
Contractual obligations re ABC may result in legal issues/exit difficulties in adverse times. 1
Manufacturing considerations
M134 affords the company with spare capacity, to be applied for future potential opportunities 1
Eficaz can employ additional workforce (± 3 people) eliminating labour shortage & overtime
costs - improves preference & profitability of ABC option. Ongoing overtime is not 1
sustainable, particularly if the existing business grows (ABC) 1
Impact of virtual/full machine cap. on the maintenance of machines. More room in XYZ option. 1
Are there alternative options for the modified machines if ABC withdraws 1
IN223 is a new, unknown and untried product. Does Eficaz have the required knowledge? 1
How will 10% increase in volumes impact on already limited available future resources? 1
Other considerations
Eficaz should prepare a capital budget spanning 3–5 years to estimate NPV and IRR. 1
This will take into account for differences in investments, lifespans, risks etc of options. 1
Determining contribution per limiting factors is more suitable approach, especially for the
longer term, then a mere profitability analysis in year 1. How divisible are the quantity sizes? 1
Will additional resources be required eg. training of operators, technical support on modified
machines? Learning curve may initially apply to IN224, affecting supply volumes 1
Are there any other profitable opportunities which combined with the spare capacity XYZ are
be better than ABC alone. 1
Risk that Eficaz may lose its focus re existing customers (M134) option as the requirement to
deliver in 15 days may impact on its existing operations and relations with customers. 1
Available 29
Maximum 15
Communication skill 1
Page 78 of 228
Part (c) Calculate the selling prices Eficaz should charge for the M134 and IN223 products
if it used a machine hour recovery rate methodology and the recovery rate is R80 p.h.
Marks
M134 IN224
R R
Raw material costs 40.00 15.00
Direct labour 36.00 30.00
Variable manufacturing overheads 7.50 8.50
Subtotal – correct inclusion of these costs 83.50 53.50 1
Fixed manufacturing overheads
Recovery rate
(see N1 - explanation) 6.50 2.60 1
Overtime premium – product specific
(see part a) - 2.20 1
Machine modifications – product specific
(see part a) - 1.43 1
Total Manufacturing costs 90.00 59.73
Machine hour recovery (R80 x 0.5MH; x 0.2MH) 40.00 16.00 2
Selling price 130.00 75.73 1P
In comparison to the existing price of R120.00 R80.00

This approach could potentially jeopardise the M134 contract and favour the 1
IN223 contract
Fixed manufacturing overheads do not have to be allocated on the basis of normal hours for
management purposes (this is financial accounting [IFRS] convention) 1
Available capacity supports long term decision making as it determines more accurately the
cost of using one more unit of resource. 1
In the above case the cost based on normal capacity would slightly increase the recovery rate
(and hence the selling price) as both products will not fully utilize the remaining available
capcity. 1
N1:
FMOHR = R1,300,000/100,000hrs
= R13 per Mhr
M134: 13 x 0.5 Mhrs = R6.5

IN224: 13 x 0.2 = R2.6
Available 11
Maximum 10
Page 79 of 228
Part (d) Discuss the potential merits and pitfalls of adopting a selling price strategy of
adding a machine hour recovery rate to manufacturing costs per Marks
unit
Potential pitfalls
If the R80 per machine hour is an arbitrary amount, the base rate will have a profound
impact
on pricing. The basis for determining this rate needs to be established to form a
meaningful 1
opinion in this regard. 1
It may jeopardise the achievement of 30%+ gross profit margins as the range of different
products will have varying mark-up on costs. This issue will be further complicated if vast 1
fluctuations occur between planned and actual volumes of products. 1
The end result (selling price) may be unrelated to market prices, which may result in a loss
of 1
revenue. It does not recognise prices charged by competitors or its price
sensitivity. 1
The question is whether machine hours are the correct allocation basis and whether direct
labour hours may not be more appropriate? Further to this it identifies a single resource
as the 1
driver of sales prices and this simplistic approach could yield distorted
sales prices. 1
The recovery rate limits the potential profitability per product, while target costing may 1
result in higher contributions. Target costing, for example, will by its concept incorporate
many
other factors that affect sales price. 1
The pricing strategy may be contrary to competitors’ strategies, which could result in a 1
change in the customer base as more customers will buy under-priced products & vice
versa. 1
The approach may not facilitate other financial measures such as headline earnings, ROI etc 1
Merits It may promote a greater focus on cost efficiencies rather than passing cost
inefficiencies on to customers. The only way to improve profitability is to lower costs. 1
(This includes if candidates argue the other way i.e. it may result in inefficiencies as the
more machine hours applied, the higher the resulting margins earned). 1
It may result in a fairer allocation of desired profitability to individual products,

although this may be argued if products with contrasting cost structures are involved eg. 1
A machine intensive product with low direct product costs (poor quality) will have a
sizeable profit margin, as opposed to a product with high direct product costs (high
quality) and very low machine activity. 1
Charges are more appropriately allocated for value added (manufacturing time and
expertise) than simply marking up higher input costs 1
Available 18
Maximum 8
Logical argument 1
Page 80 of 228
Part (e) Estimate the allocation of fixed manufacturing overheads to the M124 and IN223 products
during the 2013 financial year based on direct labour hours as opposed Marks to machine hours.
M134 IN224
R R
Available direct labour currently 132 000 132 000 1
Increase in capacity – overtime capacity (see part a) 0 4 400 1
Total available labour capacity 132 000 136 400
The available labour capacity incorporates overtime hours,

as they are planned for (and thus part of practical capacity).
These hours are not the result of inefficiencies. 1
Planned fixed manufacturing overheads R1 300 000 R1 300 000
Fixed manufacturing overheads per labour hour R9.85 R9.53 1P
Allocated in total to M134 & IN224 (see N1 explanation) R206 818 R285 924
OR 1P
Allocation to M134 & IN224 R5.91 R4.77
N1:
M134: 35000 units x 0.6 DLhrs per unit = 21 000hrs
9.85… x 21 000 = 206 818
IN224: 60000 units x 0.5 DLhrs per unit = 30 000hrs

9.53… x 30 000 = 285 924
Available 5
Maximum 5
Total for question 56
Page 81 of 228
MAF 09
55 marks
Zomat (Pty) Ltd (“Zomat”) is a black economic empowered (BEE) group that supplies products to
customers in the building and construction industries. BLM Investments, a broad based BEE group,
currently holds 26% of Zomat’s shares and the executive directors hold 74%. Zomat has quarries in
the provinces of the Free State and Limpopo and raw materials from these operations is used to make
concrete blocks and bricks as well as ready-mix concrete.
The group extracts and crushes dolerite rock from its quarries. This material is processed into what is
commonly known as aggregates, namely sand (fine particles of rock) and stone (larger particles of
rock). These aggregates are sold to customers involved in road building and construction activities.
Zomat also uses aggregates as a raw material in the manufacture of concrete blocks and bricks as well
as ready-mix concrete.
Zomat has numerous factories in the Free State and Limpopo that manufacture concrete blocks and
bricks. The factories are situated close to major customers to minimise transport costs.
Zomat has its own fleet of trucks that delivers ready-mix concrete to customers at construction and
building sites. The construction industry is experiencing significant growth because of spending on
infrastructure by government and parastatal organisations, and the continued boom in the non-
residential building sector.
The shareholders of Zomat have been approached by Al Zenbah L.L.C. (“Al Zenbah”), a major building
products group based in Dubai, United Arab Emirates. Al Zenbah has proposed the acquisition of 100%
of the issued share capital of Zomat as it is eager to participate in the continued growth in the
construction industry in South Africa over the next five years. Some of Al Zenbah’s customers are also
active in building new stadiums in South Africa in preparation for the Soccer World Cup in 2010.
Al Zenbah has submitted a formal purchase offer of R60 million for the total equity of Zomat to its
shareholders. The Chief Executive Officer (CEO) of Zomat, Mr Roots, is of the opinion that the
purchase price offered is far too low. His opinion is based on the price-earnings (PE) multiples of
similar listed companies on the JSE Ltd, such as the following:
Page 82 of 228
Most Current Audited

recent year Annual share earnings
Nature of business end revenue price per share
R’000 c c
Civil engineering and
Altan Ltd construction June 2006 475 000 1 400 87,5
Retailer of building
KMLO Ltd products June 2006 1 050 000 1 800 120,0
Manufacturer and
supplier of building
Gigan Ltd products June 2006 2 607 000 950 76,0
Mr Roots also noted that Al Zenbah recently acquired a major concrete brick manufacturer in France
based on an historic PE multiple of 13. He told his fellow shareholders in Zomat that a slight discount
to this multiple of 13 would be appropriate for Zomat given the weakness of the rand against major
international currencies. Mr Roots has suggested a fair value of R160 million for Zomat based on
forecast profit after tax of R13,3 million for the year ending 30 June 2007 and using a PE multiple of
12.
The income statements for the years ended 30 June 2005 and 2006 of Zomat are summarised below,
together with the forecast for the year ending 30 June 2007:
Page 83 of 228
ZOMAT (PTY) LTD

INCOME STATEMENTS FOR THE YEARS ENDED / ENDING 30 JUNE
Notes 2005 2006 2007
Forecast
Audited Audited
R’000 R’000 R’000
Revenue 1 49 495 52 100 70 400
Cost of sales (25 235) (24 890) (33 440)
Gross profit 24 260 27 210 36 960
Other income 675 740 1 050
Operating expenses (13 545) (15 170) (17 445)
Operating profit 11 390 12 780 20 565
Investment income 250 280 350
Finance costs 2 (2 480) (2 360) (2 140)
Profit before tax 9 160 10 700 18 775
Tax (2 656) (3 104) (5 445)
Profit for the year 6 504 7 596 13 330
Notes
1 Revenue for the half year ended 31 December 2006 amounted to R35 million (2005: R26 million).
The executive directors of Zomat are confident that the company will achieve revenue of over
R70 million during the 2007 financial year, based on the current order book.
2 Zomat’s average borrowing cost is currently 11% per annum and it earns 7,5% per annum on call
deposits with banks.
Page 84 of 228
Working capital
The finance director of Zomat, Ms Tshabalala CA(SA), is concerned about the increasing level of accounts
receivable. At 30 June 2006 the accounts receivable balance net of provisions for impairments was R6 850
000 (2005: R5 750 000). The forecast accounts receivable balance at 30 June 2007 is R10 680 000.
Ms Tshabalala has had informal discussions with major customers of Zomat to determine why they are
delaying payment of amounts due. According to these customers their cash flows are under pressure
because of high revenue growth and retention monies held by their customers, which generally amount
to 10% of total construction contract values. As a result, they have been forced to delay payments to
Zomat each month to improve their own cash flows.
The Zomat policy on credit terms is that customers are required to pay amounts due within 30 days of
invoice. Ms Tshabalala is considering introducing a settlement discount (5% of invoice value if paid within
30 days of invoice date) to customers to improve the collection period. It is estimated that 75% of Zomat’s
customers would make use of such a settlement offer.
Other matters
Ms Tshabalala recently reviewed an expense claim by Mr Roots. The claim totalled R38 500, comprising
air fares of R10 400, golf green fees of R6 600, accommodation costs of R14 400 and restaurant bills of
R7 100. After further enquiries to the CEO’s personal assistant and the marketing manager of Zomat, she
discovered that Mr Roots had taken three of his friends (who are neither customers nor employed by
customers of Zomat) on a golfing trip to KwaZulu-Natal.
Ms Tshabalala confronted Mr Roots about the expense claim and stated that she would not authorise
its payment as the expense had not been incurred for official company business. Mr Roots reacted with
indignation and instructed Ms Tshabalala to pay the amount into his bank account immediately. He said
that if she failed to authorise and pay the claim, he would make her life at Zomat a misery and he would
not recommend that she be offered shares in the company. Ms Tshabalala is not currently a shareholder
in Zomat, but the minutes of a recent shareholders’ meeting recorded their intention to offer her a 5%
interest in Zomat if her performance appraisal in August 2007 was satisfactory. Mr Roots has a 28%
shareholding in Zomat.
Page 85 of 228
REQUIRED
Marks
(a) Discuss
• whether the purchase price offered by Al Zenbah L.L.C. represents a fair
value for the full issued share capital of Zomat (Pty) Ltd; and 21
• the fair value recommended by Mr Roots.
(b) Using ratio analysis, comment on the forecast profitability of Zomat (Pty) Ltd for
the year ending 30 June 2007 versus the actual results achieved in the 2006
financial year. 10
(c) Calculate the debtors’ days’ ratios in 2005, 2006 and 2007 (forecast) and
indicate what further enquiries Ms Tshabalala should make and what analysis
she should perform to identify the key reasons for the deterioration in the
collection periods. Use 365 days per annum for your calculation. 8
(d) Estimate and discuss the potential impact that the introduction of settlement
discounts may have on the profitability and cash flows of Zomat (Pty) Ltd. 6
(e) Discuss the issues arising from the submission of the expense claim by Mr
Roots and his threats to Ms Tshabalala if she were to refuse to authorise and
pay the expense claim. Indicate what action, if any, Ms Tshabalala should take
following this instruction and these threats. 10
Page 86 of 228

Part (a) Marks
There is insufficient information to perform a FCF valuation, therefore the 1
earnings yield method should be used
The FCF method should, however, also be performed prior to expressing any opinion
about the fair value of Al Zenbah’s offer price 1
APPROPRIATE PE RATIO FOR ZOMAT

PE ratios (historic) • Altan 16,0
Similar listed co’s • KMLO 15,0
• Gigan 12,5 1
Factors/issues of using similar listed companies PE ratios
• Altan/KMLO/Gigan have the same year ends as Zomat therefore no 1
adjustments needed
• Altan & KMLO nature of businesses are very different to Zomat and 1
hence, their PE ratios are not that relevant
• However, Altan & KMLO PE ratios are useful given that are consumers of 1
Zomat’s products
• Gigan’s business is most similar to Zomat and its PE ratio is most 1
relevant for our purposes
• The % of revenue and profits derived by Zomat from quarrying versus 1
manufacturing of building products would be useful. If a high % of
revenue and profit is derived from quarrying activities then Gigan’s PE
ratio would be less relevant as opposed to similar “mining” operations
• The earnings forecasts of Altan, KMLO and Gigan for the year ending 1
June 2007 would be very useful to compare this to Zomat
Starting point – Gigan’s historic PE ratio 12,5 1
• *discount for size ( say 15%) – Gigan’s revenue 50 times larger -2,5 1
• *discount for unlisted status/limited transferability of shares (say 25%) -3,1 1
• *high forecast growth (say 10%) 1,3 1
• *any other valid issue (BEE credentials, deteriorating working capital, 1
proximity to customers etc)
Appropriate PE ratio for Zomat 8,2
* Note that the important thing here is the direction of your multiple adjustment. The only way
to get these adjustments incorrect would be to either:
- leave out the adjustment factor
- get the direction of the adjustment incorrect
- use an exaggerated size for your adjustment number – keep the size reasonable
Page 87 of 228
MAINTAINABLE/SUSTAINABLE EARNINGS OF ZOMAT

• Is forecast PAT for 2007 financial year sustainable or is this an unusually 1
profitable year?
• The PAT/Revenue ratio of 18,9% in F2007 is much higher than prior 1
years (14,6% in 2006, 13,1% in 2005), therefore is the higher margin
sustainable in the future?
• Is the forecast expense growth (15%) in F2007 reasonable given the 1

projected revenue increase of 75%?
• Are the PAT forecasts in F2008 and beyond available? Has management 1
completed budgets for the next 3 years?

• Given the long lead times in construction industry, the current Zomat 1
order book should provide a useful indicator of future revenue/profits
There is a compelling argument to use the F2007 forecast PAT for valuation 1
purposes given short time period until year end
Conclusion – Maintainable PAT = R13,33m (or any other valid PAT) 1
FAIR VALUE FOR ZOMAT
Award mark if candidates use their PE x PAT – 8,2 x R13,3m = R109m 1
Reasonability tests – NAV or PE ratios of similar unlisted companies recently 1
sold
PURCHASE PRICE OFFERED BY AL ZENBAH

• Represents 4,5 historic and 7,9 forward PE 2
• Zomat will lose its BEE status if Al Zenbah acquires 100%. Al Zenbah 2
would need to have BEE credentials to supply construction companies
and hence, Al Zenbah would need to introduce a BEE shareholder at
some stage. This may impact on their offer price?
• A control premium should be paid (20%+ increase in offer price) by Al 1
Zenbah given that they propose acquiring 100% of Zomat
• Will Al Zenbah need to incentivise Zomat management to stay on and 1
how will this affect offer price?
• Are there any revenue growth opportunities that can be unlocked by Al 1
Zenbah or improvements they can make to business? This could affect
the purchase price they offer
Conclusion - R60m offer price is well below the fair value of Zomat 1
MR ROOTS’ VALUATION
• Assumes that R13,3m of PAT is achievable and sustainable 1
• PE multiples in France have limited relevance to SA 1
• SA is an emerging market compared to France and PE multiples may be 1
discounted due to perceived political and economic risks in SA
• We do not know the size of French business acquired by Al Zenbah 1
therefore, the 13 historic PE paid is difficult to assess without further
information about this business
• Mr Roots’ discount from 13 to 12 for the PE ratio due to foreign exchange 1
risks is very subjective and cannot be substantiated
Conclusion: R160 million valuation is too high and not justifiable 1
Maximum^ 20
Page 88 of 228
^ Note the limitation to the possible marks here in comparison to all the factors you could raise in your
solution. It is imperative to keep moving in a question like this and ensure you do not spend too much time
because there is a lot to say – and then not finish the paper.
Part (b) Marks

2006 2007
Revenue growth 35,1% 1
Revenue growth is significantly above that in 2006
however, industry is booming, half year revenue is on track 1
Gross profit % 52,2% 52,5% 1
GP% relatively stable 1
Increase in operating expenses 15,0% 1
Or operating expenses/revenue 29,1% 24,8%
Reasonability of expense forecasts in 2007 given revenue 1
growth of 35% is questionable
Operating profit/revenue 24,5% 29,2% 1
Or PAT/revenue 14,6% 18,9%
Improvement in 2007 due to operating expenses not 1
increasing in line with revenue growth
Interest cover (or decrease of 9,3% in net finance costs) 6,1 11,5 1
Net finance costs declining is indicates that debt levels are 1
Reducing
Effective tax rate 29,0% 29,0% 1
Zomat is clearly not paying significant dividends/ the mining 1
tax implications associated with quarrying division need to
be investigated
Increase in PAT (or 60% increase in operating profit) 75,5% 1
PAT increasing due to revenue growth and/or operating
costs increasing by < revenue growth 1
Maximum 9
Page 89 of 228
Part (c) Marks

Debtors’ days 2
- 2005 [5750/49495 x 365] 42,4
- 2006 (using average debtors days) [6850/52100 x 365] 48,0
[(6850+5750)/2]/52100x365 44,1
- 2007 [10680/70400 x 365] 55,4
[(6850+10680)/2]/70400 x 365 45,4
Further enquiries/analysis required
• Obtain and review detailed ageing (<30 days, 30-60, >60 days) 1
• Review age analysis per division (quarries, concrete blocks etc) 1
• Identify whether particular debtors are slow payers or whether
collection period is deteriorating for majority of customers 1
• Are competitors having similar problems? Is this an industry issue? 1
• Are customers aware of Zomat’s credit policy and trade terms? 1
• Are credit limits set and imposed per customer? 1
• Is interest charged on overdue accounts? 1
• Investigate average time between supply and invoices being issued 1
• Are invoices posted or sent electronically? 1
• Are queries outstanding on customer accounts responsible for non-
payment or delays in payment? Review correspondence with 1
customers to establish whether this is an issue
• Review bad debts history and write offs to identify whether Zomat is 1
supplying problematic customers
• Perform credit checks on customers with long outstanding balances 1
• Are long overdue accounts followed up or handed over to 1
attorneys?
• Enter into further discussions with major customers to identify 1
mutually acceptable solutions to deteriorating payment issue
• Review internal controls to ensure that debtors system is operating
efficiently and accurately – prompt and correct invoicing etc 1
Maximum 7
Part (d) Marks

Average debtors F2007 (R000’s) 10 680 8 765
Average debtors’ days per (c) above 55.4 45.4
Average debtors days after 5% discount introduced 1
75% x 30/365 + (25% x 45.4/365) 36.35 33.8
Reduction in average debtors days during F2007 19.05 11.6 1
Improved cash flow 70 400 x 11.6/365 (R000’s) 3 674 2 235 1
Also 1 mark here if candidate makes comment that debtors days ↓
and/or cash inflow from introducing discount without doing calc’s
Interest saving (net debt position so use 11%) 11% x 2235 (404 based 246 1
on average debtors days reduction)
• Cash inflow benefit from introducing settlement discount will be 1
once off not ongoing
Impact on profits and cash flow:
Page 90 of 228
- discounts 70 400 x 75% -2 640 1

Further mark for candidates stating 5% is significant (in absolute or 1
relative terms)
- reduction in interest expense 404 246
- net tax effect 648 694 1
-1 588 -1 700 1
• Introduction of a settlement discount is difficult to reverse, and may 1
have a long term negative effect on profits and/or cash flow of

Zomat
Maximum 6
Part (e) Marks

Ethical issues arising
• Mr Roots’ action of submitting an expense claim in respect of personal
expenditure represents attempted misappropriation of company funds and a 1
breach of his fiduciary duties as a director 1
• Mr Roots’ actions may constitute a reportable irregularity 1
• Mr Roots’ actions in his capacity of CEO and shareholder in Zomat:
- As CEO his actions are setting a poor example and may weaken the control
Environment 1
- What else has he done which has not been detected? 1
• Mr Roots’ threats to FD is unacceptable
- “Making her life a misery” implies that he will not act in a fair manner
towards FD, perhaps not objectively in performance appraisals, etc. 1
- Rifts between directors will have a negative impact on general staff morale
and executives should be united 1
- Threatening to vote against share allocation to FD is blatantly unfair 1
• As Ms Tshabalala is a CA(SA), she needs to consider threats to compliance
with the fundamental ethical principles in terms of section 310 of SAICA Code:
- Compliance with Roots’ request would compromise her integrity 1
- She should not bow to pressure to act contrary to laws/regulations 1
- Consider significance of intimidation threats 1
- She should be careful not to breach confidentiality in resolving issues 1
Action to be taken by FD (ito section 100 and 310 of SAICA Code)
• She should investigate all of the CEO’s expense claims 1
• She should document the substance of the matter fully and discussions had 1
• She should report the theft to the board of directors and audit committee 1
• She should seek legal advice and/or from SAICA as to the way forward 1
• As it may be difficult to take action re threats, she may be left with no alternative 1
but to resign and set out reasons for her resignation letter
Maximum 9
Presentation
- layout/legible 2
- language/logical argument 2
Page 91 of 228
Tutorial Commentary: MAF 09

This is a question from the 2007 Qualifying Examination (now ITC). It covered earnings based valuations
(an area students battled with particularly), working capital management and ethics. Overall, the
question resulted in a 28% pass rate and 42% average, although the working capital sections were better
answered than the others – mostly due to candidates being able to calculate ratios.
A big reason for bad performance was candidates failure to READ THE REQUIRED! Part c of this question
in particular asked for “further equiries” and “analysis” in order to “identify the key reasons for the
deterioration in collection period”: In other words: what questions need to be asked and what
calculations need to be performed… The question did not ask for causes of the decline, it asked for your
professional investigation in order to isolate possible reasons. It was also clear from question d that
students do not understand the effects that changing working capital balances, settlement discounts
and credit payment terms have on cash flows.
Page 92 of 228
MAF 10
40 marks (of scenario worth 100)
Amounts in the question exclude VAT, except where indicated.
ElectriBolt Ltd (‘ElectriBolt’) is an independent electricity supplier with various power-generation

operations throughout South Africa. ElectriBolt is listed on the main board of the Johannesburg Securities
Exchange. The company’s most recent financial reporting date was 31 December 2009.
Background
On 1 January 1999, ElectriBolt entered into a unique hydro-electricity supply licence agreement with the
South African government (‘the government’). The licence agreement entitled ElectriBolt to install three
turbines at the Augrabies Waterfall, which is situated in the Augrabies National Park, and generate and
supply electricity for a period of 15 years. The licence agreement provides that –
• ElectriBolt is required to pay the government a fixed instalment of R800 000 annually in arrear
for the right to use the site to generate electricity; and
• the agreement is not renewable at the end of the 15-year term.
ElectriBolt decided to grant the right of use of the abovementioned supply licence, from the inception
date of the agreement with the government (1 January 1999), to PowerSmart Ltd (‘PowerSmart’), a large
electricity supplier, for a period of 15 years. All licensing rights granted to ElectriBolt by the government
were transferred to PowerSmart in exchange for a fixed annual instalment of R1 million, payable in arrear
to ElectriBolt. By law the final operator of an electricity supply business is solely responsible and liable for
any related environmental site rehabilitation. PowerSmart may not transfer or sell the supply licence to
any other party. A cancellation penalty of R900 000 is payable by PowerSmart to ElectriBolt should
PowerSmart at any stage unilaterally decide on the early cancellation of the agreement.
On 1 January 1999, ElectriBolt did not recognise any assets or liabilities in respect of the hydroelectricity
supply licence with the government and the right of use of the licence granted to PowerSmart. The R800
000 per annum for the supply licence is expensed on an annual basis and the R1 million per annum receipt
from PowerSmart is recognised as revenue on an annual basis. This accounting policy is acceptable in
terms of International Financial Reporting Standards.
Feasibility study on PowerSmart’s Augrabies operations
ElectriBolt recently established that PowerSmart is underperforming at the Augrabies site and believes
that significantly more electricity can be generated during the last four years of the supply licence. The
major reason for PowerSmart’s disappointing performance is the regular labour disputes experienced at
the Augrabies operation. ElectriBolt conducted a feasibility study in December 2009 to evaluate the
possible acquisition of PowerSmart’s Augrabies operations. Following this feasibility study, ElectriBolt
proposed acquiring the PowerSmart Augrabies division as a going concern, including all assets and
liabilities of this division except for cash and cash equivalents and taxation liabilities. The licensing
agreement between ElectriBolt and PowerSmart would be terminated as part of the acquisition.
The Chief Financial Officer (CFO) of ElectriBolt prepared the following cash-flow projections, following a
detailed review of historic financial information of the Augrabies division of PowerSmart and its budgets
Page 93 of 228
for the next four years, for the purposes of valuing the Augrabies division:
Year ending
31 December Notes 2010 2011 2012 2013
R R R R
Turnover 1 18 000 000 18 000 000 18 000 000 18 000 000
Operating costs 1 (4 500 000) (4 500 000) (4 500 000) (4 500 000)
Opportunity cost 2 (1 000 000) (1 000 000) (1 000 000) (1 000 000)
Supply licence
agreement instalments (800 000) (800 000) (800 000) (800 000)
Operating cost savings 3 300 000 300 000 300 000 300 000
Cost of helicopter lease 4 (480 000) (480 000) (480 000) (480 000)
Depreciation: Turbines (700 000) (700 000) (700 000) (700 000)
Interest on long-term
loan 5 (897 536) (712 469) (503 344) (267 032)
Environmental site
rehabilitation costs 6 – – – (2 500 000)
Pending legal claim 7 – – – –
Taxation 8 (2 778 290) (2 830 109) (2 888 664) (2 254 831)
Net cash flows 7 144 174 7 277 422 7 427 992 5 798 137
Related calculations Notes

Weighted average cost of capital (WACC) 9 23,00%
Net present value of the future cash flows of the Augrabies
division of PowerSmart 9 R17 143 393
Notes to the cash-flow projections
1 Projected turnover includes a conservative estimate of the additional electricity that ElectriBolt
could generate and supply, assuming it acquired control of the operations. Operating costs
exclude annual supply licence payments due by PowerSmart to ElectriBolt.
2 Opportunity cost represents annual instalments in terms of the supply licence agreement, to
which ElectriBolt will no longer be entitled.
3 PowerSmart incurred research and development costs during the period 2007 to 2009 aimed
at improving operating efficiency. As a result thereof, PowerSmart expects a possible annual
operating cost saving of R300 000 from 2010 to 2013. The CFO of PowerSmart is of the opinion
that the cost saving is only 45% probable, resulting in the development costs not meeting the
recognition criteria in terms of IAS 38, Intangible Assets, for recognition as an intangible asset.
It follows that development costs were immediately expensed when incurred.
4 PowerSmart leases an executive helicopter from Fly-with-Me Airways (Pty) Ltd at a fixed
instalment of R360 000, payable annually in arrear. The lease agreement was correctly classified
Page 94 of 228
as an operating lease in terms of IAS 17, Leases. The lease agreement commenced on 1 January
2008 and ends on 31 December 2012. On 31 December 2009, it was reliably established that
similar executive helicopters can be leased at a market-related fixed instalment of R480 000,
payable annually in arrear.
5 PowerSmart obtained a long-term loan of R15 million on 1 January 1999 to finance this particular
operation. The long-term loan is repayable in 15 equal annual instalments, which commenced on
31 December 1999. The loan bears interest at a fixed rate of 13% per annum. The loan agreement
provides that the loan cannot be repaid earlier than the agreed repayment profile. On 31 December
2009, long-term loans with a similar risk profile and remaining maturity were available at a fixed
rate of 12% per annum.
6 This amount has been reliably estimated by an independent environmental rehabilitation expert.
7 Labour unrest increased after the recent dismissal of a number of PowerSmart’s employees as a
result of increased operational inefficiency. The trade union to which these employees belong has
instituted a legal claim against PowerSmart on behalf of the employees on the grounds of unfair
dismissal. The legal advisers of PowerSmart are of the opinion that –
• the dismissed employees have a valid claim against PowerSmart for unfair dismissal;
• the trade union will not be able to prove the claim for unfair dismissal in court, due to a lack of
evidence; and
• it is possible but not probable that the court will require PowerSmart to make a financial
settlement to the dismissed employees.
The CFO did not include any amount relating to the legal claim in the forecast cash flows. Should
such a claim be successful, any amount paid by PowerSmart will not be deductible for tax purposes.
The fair value of the legal claim at 31 December 2009, as reliably determined by an experienced
actuary, is R450 000.
8 All items in the cash-flow budget have been assumed to be taxable or deductible for income tax
purposes, except as per point 7 above.
9 The nominal WACC of ElectriBolt is 23% and the forecast cash flows have been discounted using
this rate.
Financing alternatives
On 31 December 2009 the Augrabies division of PowerSmart was acquired by ElectriBolt as a going
concern, including all assets and liabilities of the division except for cash and cash equivalents and taxation
liabilities. The purchase consideration of R16 million was paid by ElectriBolt on 31 December 2009. It was
correctly established that the transaction between ElectriBolt and PowerSmart constitutes a ‘business
combination’ as defined in IFRS 3, Business Combinations.
Page 95 of 228
ElectriBolt is considering various financing alternatives for the business combination transaction:
• Payment out of existing cash reserves of R16 million; or

• Obtaining a R16 million medium-term loan from ElectriBolt’s bankers. The loan is to bear interest
at 1% above the prevailing prime overdraft rate. This is the company’s incremental cost of
borrowing. The loan is to be repaid in one bullet payment at the end of four years. Interest is to be
calculated and compounded annually in arrear, and capitalised into the outstanding loan balance.
Transaction costs of 1% of the principal amount will be payable at the inception of the medium-
term loan. The interest to be incurred on such a long-term loan is deductible for taxation purposes
in terms of section 24J of the Income Tax Act; or
• The issue of compulsory convertible preference shares with a par value of R16 million. Preference
shareholders will be entitled to an annual dividend calculated as 80% of the prevailing prime
overdraft rate multiplied by the par value of shares held. ElectriBolt is required to pay preference
dividends annually in arrear and has no discretion with regard to declaring these dividends. Each
preference share will automatically convert into one ordinary share after four years. Analysts
predict that the value of the converted shares at the end of year four will amount to R17 800 000.
Draft statement of financial position of the Augrabies division of PowerSmart as at 31 December 2009
The information below represents an extract from the draft statement of financial position of the
Augrabies division of PowerSmart as at 31 December 2009, which contained inter alia the following:
Notes R
ASSETS
Non-current assets
Property, plant and equipment 1 9 750 000
Current assets
Inventories 2 750 000
Trade receivables 3 300 000
Cash and cash equivalents 250 000
LIABILITIES
Non-current liabilities
Long-term borrowings 4 5 480 535
Deferred tax 5 592 200
Long-term provisions 6 –
Current liabilities
Trade payables 7 435 000
Current portion of long-term borrowings 4 1 423 590
South African Revenue Service (SARS) 115 000
Page 96 of 228
Notes
a Items of property, plant and equipment are subsequently measured according to the cost model in
terms of IAS 16, Property, Plant and Equipment. The market value of the property, plant and
equipment as at 31 December 2009 was R14 million.
b The fair value of inventories was reliably determined at R800 000 as at
31 December 2009.
c The balance of net trade receivables comprised the following as at 31 December 2009:
R
Gross trade receivables 480 000
Less: Allowance for doubtful debts* (180 000)
300 000
* The SARS grants a tax deduction of 25% of the allowance for doubtful debts for taxation purposes.
The fair value of trade receivables as at 31 December 2009 was reliably determined at R400 000.
d Long-term borrowings are subsequently measured according to the amortised cost model in terms
of IAS 39, Financial Instruments: Recognition and Measurement. Long-term borrowings consisted
of the following as at 31 December 2009:
R
Long-term loan 6 904 125
Less: Current portion of long-term borrowings (1 423 590)
5 480 535
e The deferred tax balance as at 31 December 2009 was calculated as follows:
Carrying Temporary
Tax base
Asset/liability amount difference
R R R
Property, plant and equipment 9 750 000 7 500 000 2 250 000
Inventories 750 000 750 000 –
Trade receivables 300 000 435 000 (135 000)
Long-term loan 6 904 125 6 904 125 –
Trade payables 435 000 435 000 –
Taxable temporary differences 2 115 000
Deferred tax calculated at 28% 592 200
Page 97 of 228
f No provision has been recognised in the statement of financial position of PowerSmart in respect
of the environmental site rehabilitation. 70% of the damage caused to the environment occurred
when the turbines were installed, while the remaining 30% of the damage to the environment is
caused evenly over the duration of the contract. No environmental rehabilitation activities had
been undertaken by 31 December 2009 and the CFO therefore holds the opinion that no provision
should be recognised in the statement of financial position until the electricity supply operation
ceases. The SARS will allow the amount incurred in respect of environmental rehabilitation costs as
a deduction for taxation purposes when it is actually paid.
g The fair value of trade payables as at 31 December 2009 was reliably determined at R500 000.
h The supply licence, the use of which was granted by ElectriBolt, had a fair value of R4 500 000 at 31
December 2009 based on the terms of the licensing agreement between ElectriBolt and
PowerSmart. If a similar right with payments at market rates were granted at 31 December 2009, it
would have a fair value of R5 million.
Additional information
Where appropriate and unless stated otherwise, the SARS accepts the acquisition date fair values of assets
and liabilities for taxation purposes.
The current prime overdraft rate is 10% per annum, nominal and pre-tax.
REQUIRED
Marks
(a) Identify, with reasons, any errors in and omissions from the cash flow forecasts
and discounted future cash flows of the Augrabies division of PowerSmart Ltd 16
as prepared by the CFO of ElectriBolt Ltd.
(b) Identify and describe any advantages and disadvantages of ElectriBolt Ltd
settling the purchase consideration due to PowerSmart Ltd using its own cash 6
resources.
(c) With regard to ElectriBolt Ltd evaluating the financing of the acquisition of the
Augrabies division of PowerSmart Ltd through obtaining the medium-term loan
or through the issue of the preference shares –
(i) Calculate and determine which instrument will be more cost effective for
ElectriBolt Ltd to use; and 10
(ii) Discuss any other factors ElectriBolt Ltd should consider in deciding 6
which instrument to use.
Presentation marks: Arrangement and layout, clarity ofexplanation, logical 2

TOTAL 40
Page 98 of 228
Part (a)
Errors/omissions Reasons
PowerSmart may not transfer supply licence i.e. no
No indication of perspective of valuation: other potential bidders. Ths, PowerSmart’s
fair market value, or intrinsic value? alternative to selling to ElectriBolt is intrinsic value
1 (current management with future expectations as 1
originally anticipated).
I.e. quantify intrinsic value.
Projected turnover includes additional Specific synergies should be quantified separately,
electricity generated and supplied (thus 1 but excluded from the intrinsic valuation. (Synergies 1
incorporating efficiencies/synergy contributed preferably not paid for as fully contributed by
by ElectriBolt) ElectriBolt)
Forecast revenues and operating costs do not Revenue and/or costs are likely to change annually
change over forecast period due to inflation/tariff increases/rain fall
1 expectations etc
1
Or Cash flows have not been adjusted for inflation
Or A nominal WACC has been used to and are real cash flows a real WACC should be used
discount future real cash flows to determine the NPV
Business of PowerSmart is being valued hence, only

Including R1m & R800 000 outflow relating to 1 costs & revenue relevant to this business should be 1
supply licence; description of ‘opportunity included in FCF (only R1m outflow)
cost’.
Probability of achieving cost savings ~45%,
insufficient to justify including in FCF
Operating costs savings included 1
Or (45%*300,000=135,000) But rather include this
potential in a sensitivity analysis. 1
- Helicopter lease payments included at 1 PowerSmart has negotiated a contract hence use 1
market value. actual contractual cash flows until expiry of contract
- Question unclear as to what will happen to (end of 2012). Thereafter, use estimated costs for
the lease on acquisition/ probably be 1 2013 at fair market values.
transferred over
Depreciation included in forecasts, is not a

cash 1 Wear and tear should be included 1
flow item.
Interest should be excluded for these cash flows
Interest on long term loan included 1 should exclude all fin costs, as it should be
distributable to all capital providers / interest is 1
incorporated in WACC.
Market value of long-term debt should be deducted
from discounted cash flows to derive equity value.
Taxation projections will be incorrect due Estimated tax to be paid should be based on
changes in cash flows indicated here 1 amended forecasts taking into account adjustments 1
Cash flows for sale of assets and payment of

No inclusion of terminal values for assets and liabilities should be included in cash flow.
liabilities.
1 1
Page 99 of 228
Changes in working capital ignored. 1 - Forecasts should include estimated changes in

inventories, accounts receivable and trade payables 1
as these are cash flows.
- Recoupment of working capital should be incl. 1

ElectriBolt’s WACC used to discount cash
flows. 1 - PowerSmart’s WACC should be estimated Or
ElectriBolt’s WACC should be adjusted for higher
risk associated with Augrabies operation/ smaller 1
size.
- WACC appear to be too high, not explained why 1

Potential costs associated with labour action 1 To be conservative, estimated costs of settling 1
ignored. dispute should be included as a cash outflow. Use
actuarial calculated value (R450 000).
Other very valid points (Must be core) 1 1

Available 31
Maximum 16
Page 100 of 228

Part (b)
Advantages
Interest earned on cash are currently low (1), hence utilising cash for acquisitions should yield higher return
on equity than having cash on deposit (1) 2
PowerSmart division should generate positive cash flow (1) hence using cash to settle purchase
consideration should not have adverse impact on overall cash resources / cash required for day-to-day 2
requirements (1)
Less time, effort (1) and cost (1) is devoted to reviewing loan agreements/drafting preference share
agreements & obtaining necessary approvals from shareholders/JSE 2
Cash purchase will avoid dilution in control from convertible preference shares (2) 2
Disadvantages
Using cash will void opportunity to move closer to target WACC (where a firm minimises finance
cost) (2)
Or A reasonable degree of overall leverage lowers WACC and enhances shareholder value (using cash will 2
negate this) (2).
Preserving cash allows more flexibility to pursue growth/acquisitions. 2
In the current liquidity crisis / recessionary environment, company should be retaining cash for liquidity
strength (1) in a period where it is costly and difficult to obtain finance (1) 2
Available 14
Maximum 6
Part (c)(i)
Medium term loan 2009 2010 2011 2012 2013
Initial advance 16 000.0
Transaction fees (after tax) -160.0 1
Tax on transaction fees 44.8 1
Tax – interest expense 492.8 547.0 607.2 674.0 1
Bullet payment (capitalized loan balance) -24 289.1 1
Cash flows 15 884.8 492.8 547.0 607.2 -23 615.1
IRR/Inherent interest rate 8.11% 1
Or NPV approach (with disc rate = 11%x(1-0.28) -115.15
Interest calculation
Interest for the year 1 760.0 1 953.6 2 168.5 2 407.0 1
Loan balance – EOY 17 760.0 19 713.6 21 882.1 24 289.1
Page 101 of 228

Preference shares 2009 2010 2011 2012 2013

Preference share issue 16 000.0
Preference share dividends -1 280.0 -1 280.0 -1 280.0 -1 280.0 1
Conversion into equity -17 800.0 1
Cash flows 16 000.00 -1 280.00 -1 280.00 -1 280.00 -19 080.00
Discussion re value of equity at end of year 4, 1
Amount is an estimate of the value of the share on that date only. Sensitivity should be performed.
IRR/Inherent interest rate 10.41% 1
Or NPV approach (using same disc % as for loan) -1,369.45
Cost of medium term loan is much cheaper than preference share based on info
provided
(Candidate compared like to like and offered a conclusion in line with
this) 1
Available 11
Maximum 10
Part (c)(ii)
Factors to consider
Matching cash flows to business operation acquired
- Medium term loan: repayable in one bullet payment at end of 2013 – Augrabies should generate
sufficient cash but financial discipline required to ensure sufficient reserves kept in anticipation.
- Preference share: automatically convertible hence no cash outflow to repay capital in 2013. 2
Site rehabilitation costs in 2013: Preference shares better cash flow match than medium-term here as
loan’s bullet payment also payable in 2013.
1
Automatic conversion of preference shares into equity will dilute shareholding of ordinary shareholders. 1
Depending on share price in 4 year’s time, this dilution may be significant or favourable to ordinary
shareholders
Current dividend yield of ordinary shareholders? If < 8% then preference shareholders receive higher yield
with less risk 1
Impact on EPS
- Medium loan will not dilute # of shares and may have minimal impact on EPS 1
- Preference shares are dilutive and impact on EPS needs to be determined 1
Other terms of preference shares – any restrictive covenants? May reduce the flexibility of the firm to pay
dividends and/to, acquire or dispose assets, raise further finance. 1
JSE requirements re issue of preference shares? 1

Loan covenants may restrict use of debt financing. 1
Page 102 of 228

Shareholder approvals required? 1
If Co has STC credits, other investments yielding div’s (or credits to lender), Pref shares may be cheaper. 1
Consider the firm’s current vs. target capital structure. In medium term both will increase gearing, but only
preference option will guarantee increase in equity in 4 years time. 1
Available 13
Maximum 6
Presentation – Language and clarity of expression 1
Structure and appearance 1
Maximum 2
Page 103 of 228

Q & A: MAF 10
Q: How is the discount rate used for the loan and the pref shares calculated?
A: Given that both forms of finance are medium term in nature, the variable prime interest rate applies
(10%) and the medium term finance was available at 1% above prime, meaning an after tax discount
rate of 7.92%.
Q: As part of the errors/omissions in part a, the solution said that synergies should not be included in
the valuation, however in the video tutorial (Grapp) part D, they included the annual cost savings
arising from the potential acquisition in the valuation. In addition: MAF19 states that the acquiree's
WACC should be used to discount the fcfs as the acquiring company's wacc will have a different risk
profile. In the video tut (grapp), the acquiring company's wacc is used and not the acquiree's WACC.
A: The inclusion of synergies and the use of WACC depends on what you are trying to achieve. For the
Electribolt valuation, Electribolt are looking to purchase in which case the purchasing company would
preferably not want to give away the value of the synergies. The company being acquired however,
would rather share some of the value of the synergy, but don't necessarily have rights to those
synergies.
When valuing a company, one should always use a discount rate that represents the risk profile of
the company - therefore, if the WACC of the company being acquired is 15% but as the acquirer, you
feel that the risk is higher and needs a discount rate of 17%, we should use 17%. The big no-no is
using the discount rate of the acquiring company - in Electro-Grapp, KMA uses 12% to evaluate
potential acquisition targets, that doesn't mean that their WACC is 12%.
Q: When calculating the dividends tax in part c, should 2012 and 2013 not reflect the fact that the
dividends tax legislation changed and the shareholders only receive the net amount after dividends
tax?
A: Only problem with the change to a withholding tax is it effectively reduces the percentage yield on
preference shares. It is more likely that companies would still pay out the same percentage dividend
but have to declare a higher dividend to take into account the withholdings tax to keep the payment
consistent.
Page 104 of 228

MAF 11
50 MARKS
VPharm (Pty) Ltd (‘VPharm’) is a manufacturer and supplier of a range of pharmaceutical products. The
head office is based in Johannesburg and manufacturing plants are situated in Cape Town, Durban and
Port Elizabeth. VPharm has expanded rapidly over the past five years through the acquisition of smaller
pharmaceutical companies, which is why manufacturing plants are located in different cities.
The company manufactures tablets and capsules covering various therapeutic fields. Products are used as
prescription treatments for respiratory, gastro-intestinal and cardiovascular ailments. VPharm also
manufactures over-the-counter medicines that can be purchased without a prescription.
VPharm is currently negotiating a licence agreement with BSK plc, a major international pharmaceutical
group, regarding the manufacture and distribution of their world leading anti-malaria tablets. It is
envisaged that VPharm will acquire the exclusive rights to manufacture and distribute the anti-malaria
tablets of BSK plc in sub-Saharan Africa for a period of ten years. The licence period will commence when
the production facility has been commissioned and is operational.
The company will have to build a new manufacturing facility to produce the anti-malaria tablets. The
existing manufacturing plants are operating at more than 80% capacity and growth is expected in the
existing product ranges. VPharm has decided that the new plant will be erected in Johannesburg and has
prepared the following initial capital budget:
VPHARM (PTY) LTD
ANTI-MALARIA TABLET PLANT
CAPITAL BUDGET
Notes Year 0 Year 1 Year 2 Year 3 Year 4
R’000 R’000 R’000 R’000 R’000
Acquisition cost of licence 1 (8 000)

Plant and equipment 2 (10 000) (28 000)
Revenue 3 45 000 80 000 120 000

Raw material costs (17 100) (28 000) (42 000)
Factory overheads 4 (5 400) (7 800) (10 600)
Quality control overheads 5 (1 800) (1 890) (1 985)
Gross profit margin 20 700 42 310 65 415
Warehouse expenses 5 (2 100) (2 205) (2 315)
Royalties 1 (3 375) (6 000) (9 000)
Rental of premises 6 (1 200) (1 296) (1 400) (1 512)
Sales and marketing expenses 7 (2 250) (4 000) (6 000)
Logistical expenses 8 (2 700) (2 800) (4 200)
Other indirect overheads 5 (6 200) (6 510) (6 835)
Allocated head office costs 9 (2 500) (2 750) (3 025)
EBITDA (1 200) 279 16 645 32 528

Change to Working capital 10 (5 900) (4 700) (5 460)
Net cash flows (18 000) (29 200) (5 621) 11 945 27 068
Page 105 of 228

Notes
1 The initial payment on signing the licence agreement with BSK plc is estimated to be R8 million.
VPharm has approached the South African Revenue Service (SARS) for guidance regarding the tax
allowance applicable to the licence agreement. The SARS have agreed to an allowance of 10% per
annum (not to be pro rated) in terms of section 11(gC) of the Income Tax Act. The first allowance
will be claimed in the first year of production (year 2). VPharm will pay a royalty of 7,5% of revenue
in respect of anti-malaria tablets produced and sold and SARS has indicated that it will permit a
deduction of these royalties paid for income tax purposes.
2 VPharm is to engage an independent engineering company to build the manufacturing plant. It will
take a year for the engineering firm to complete the order, assembly and installation of the
manufacturing plant. VPharm will have to pay an upfront deposit of R10 million for the plant and
equipment and the balance (R28 million) will be due once the plant has been installed and
commissioned. The plant will have an expected useful life of ten years. After ten years, the plant
could be decommissioned and sold piecemeal for an estimated 10% of initial cost. Alternatively,
the plant could be upgraded and used for the manufacture of other VPharm products.
VPharm has approached the SARS for guidance regarding the tax allowances applicable to the plant
and equipment. The SARS has indicated that a section 12C allowance for manufacturing activities
may be claimed on the following basis:
• 40% in the year that the plant is brought into use, and
• 20% will be deductible in each of the three subsequent years.
The current statutory normal tax rate for companies is 29%.
3 Revenue is expected to increase over time as VPharm increases its share of the market for anti-
malaria tablets. After year 4 revenue growth is expected to be 10% per annum, which is the current
average growth in the anti-malaria tablet market.
4 50% of factory overheads are variable in nature. Depreciation has not yet been calculated and as a
result has not been included in factory overheads.
5 VPharm intends to have world-class quality control procedures in place to ensure that tablets are
manufactured in accordance with BSK plc standards. Quality control costs, warehouse expenses
and other indirect overheads will be fixed in nature and will not vary with production volumes.
6 The property on which the new manufacturing facility is to be erected is to be leased for a period
of 11 years and rentals will escalate by 8% per annum. Negotiations with the landlord are nearing
completion and VPharm expects to enter into a lease agreement as soon as the licence agreement
with BSK plc has been finalised.
7 VPharm employs 150 sales representatives to market and sell the company’s basket of products.
These sales representatives are remunerated mainly through sales commission, at a rate of 5% of
invoiced and banked revenue. These representatives will market anti-malaria tablets to VPharm’s
existing customer base of private health care providers and pharmacists.
8 Distribution of finished products to customers is to be outsourced to an independent third party.
VPharm has negotiated a variable fee arrangement with the third party of 3,5% of invoiced revenue
subject to a minimum aggregate charge of R2,7 million per annum for services rendered.
9 Head office cost allocations relate to accounting and human resource functions performed on
behalf of the anti-malaria division. It is estimated that it would cost the anti-malaria division R1,8
million in year 2 to provide these services in-house, and that the expense would increase by 5% per
annum thereafter.
Page 106 of 228
10 The annual incremental investment in working capital is expected to increase by 10% per annum
from year 5 onwards.
11 VPharm forecasts that, for year 5 and thereafter –
• gross profit margins will be 55%; and
• warehouse expenses, other indirect overheads and allocated head office expenses will increase
by 5% per annum.
12 For the purposes of the draft capital budget, it has been assumed that all cash flows occur at the
end of the year. This is consistent with the normal policy of the company when evaluating potential
new projects.
13 All cash flows are exclusive of VAT.
14 VPharm does not derive taxable income from any other source.
Cost of capital
VPharm has determined its cost of capital to be 15%. The company has no external borrowings at present
and has sufficient cash resources to fund the acquisition of the anti-malaria tablet plant.
MBX Ltd
MBX Ltd is a distributor of pharmaceutical products in Southern Africa. The company has recently been
awarded various tenders to supply anti-malaria tablets to government departments in South Africa,
Botswana and Mozambique. MBX Ltd has approached VPharm to purchase its entire planned production
for year 2 and 3 to fulfil its supply obligations. MBX Ltd has also offered to collect finished products from
VPharm’s warehouse at their own cost, and be responsible for distribution of products to their customers.
VPharm planned to supply products to the private sector (pharmacists and private health care providers)
and had not intended to target the public sector.
The board of directors of VPharm is considering the MBX Ltd proposal but is uncertain as to how to price
the proposed order.
Page 107 of 228

REQUIRED Marks
(a) Calculate the net present value at year 0 of the expected cash flows associated with
the acquisition of the anti-malaria plant and equipment and with the operation of the 20
division, using a discount rate of 15%.
(b) Calculate the revenue required in year 3 to enable the anti-malaria division to break
even in that year. Include non-cash flow items but exclude tax. 9
(c) (i) Evaluate the minimum revenue that VPharm should derive from supplying
MBX Ltd in years 2 and 3 in order to match the forecast profit contribution by 6
the anti-malaria division.
(ii) In addition, identify and list other key issues that should be considered in 6
pricing the MBX Ltd order.
9
(d) Identify and list the key risks facing VPharm in pursuing the anti-malaria project.
TOTAL MARKS 50
Page 108 of 228


Part (a)
Year 0 Year 1 Year 2 Year 3 Year 4
Cash flows per question (18 000) (29 200) (5 621) 11 945 27 068
Adjustment for head office alloc
costs
= (Total Amt – Amt Allocated to Div) 700 860 1 041
Taxation payable 0 0 0 (5 235)

- Tax loss b/f 0 (1 200) (16 221) (7 116)
- EBITDA (1 200) 279 16 645 32 528
- Capital allowances (12C) (15 200) (7 600) (7 600)
40%; 20%; 20% of 38mil
- Adj for head office costs 700 860 1 041
- License cost amort 11g(C) ( 800) ( 800) ( 800)
10% of 8mil
Taxable income/(loss) (1 200) (16 221) (7 116) 18 053
Tax loss c/f (1 200) (16221) (7 116) 0
Net cash flows (18 000) (29 200) (4 921) 12 805 22 873
Discount factor 1.0000 0.8696 0.7561 0.6575 0.5718
Discounted cash flows (18 000) (25 392) (3 721) 8 419 13 079
Page 109 of 228

Year 5 Year 6 Year 7 Year 8 Year 9 Year 10 Year 11

Revenue 132 000 145 200 159 720 175 692 193 261 212 587 233 846
Gross profit (55%) 72 600 79 860 87 846 96 631 106 294 116 923 128 615
Variable expenses (16%) (21 120) (23 232) (25 555) (28 111) (30 922) (34 014) (37 415)
- sales and marketing (5%) (6 600)
- logistics (3.5%) (4 620)
- royalties (7.5%) (9 900)
Expenses escalating by 5% p a (11 691) (12 276) (12 890) (13 534) (14 211) (14 921) (15 667)
- warehouse expenses (2 431)
- other indirect overheads (7 177)
- Accounting/HR (2 084)
Rent exp (8% esc) (1 633) (1 764) (1 905) (2 057) (2 222) (2 399) (2 591)
Working capital (10%) (6 006) (6 607) (7 267) (7 994) (8 793) (9 673) (10 640)
Plant and equipment
(10% of cost) 3 800
Recovery of Working Capital 73 040
(Sum of all invested WC)
Tax (8 629) (12 119) (13 542)) (15 117) (16 860) (18 789) (22 023)
-EBITDA 38 156 42 589 47 497 52 929 58 939 65 588 72 941
- Capital allowance (7 600) 0 0 0 0 0 0
- Recoup Plant 3 800
- License amortisation ( 800) ( 800) ( 800) ( 800) ( 800) ( 800) ( 800)
Taxable income 29 756 41 789 46 697 52 129 58 139 64 788 75 941
Net cash flow 23 521 23 863 26 687 29 817 33 286 37 127 117 118
Discount factor 0.4972 0.4323 0.3759 0.3269 0.2843 0.2472 0.2149
Discounted cash flows 11 694 10 316 10 032 9 747 9 463 9 178 25 169
NPV of anti-malaria plant 59 984
Page 110 of 228

Part (b)
Year 3 Year 3 (N1)
Variable costs as % of revenue 0.57 0.53
Raw materials 0.35 0.35
Factory overheads 0.05 0.05
Royalties 0.08 0.08
Sales and marketing 0.05 0.05
Logistical expenses (N1) 0.04 -
Fixed costs 22 395 25 095

Logistical expenses (N1) - 2 700
Factory overheads 3 900 3 900
QC costs 1 890 1 890
Warehouse expenses 2 205 2 205
Rent 1 400 1 400
Other indirect overheads 6 510 6 510
Allocated head office overheads 1 890 1 890
Depreciation 3 800 3800 Note that CM equivalent here
License amortisation 800 800
= (1- VC % or Rev)
Breakeven revenue levels 52 081 . 53 394
= FC / CM equivalent
Page 111 of 228

N1:
The nature of this cost is variable as it is driven by revenue. (3.5% of revenue rounded to 4%)
However it is not driven by revenue if 3.5% of the total revenue amount is to less than R2,7m.
If revenue is low enough for that to occur, then the nature of the cost becomes fixed at 2.7million.
In the above BE calc (left column), we initialyy assume that logistics is a VC.
However, by doing this it is clear that the BE revenue (52 mil) x 3.5% < 2.7 million (coming to roughly 1.8 million).
Thus, for this BE level, the logistics cost is actually fixed in nature.
So the solution would therefore have gone further (right column) by removing the logistical costs completely from the VC.
The R2,7m should have been added to fixed costs making it R25 095 000 divided by 0,47 (1 -0,53) equals R53 393 617.
Part (c) (i)
Year 2 Year 3 ALTERNATIVE ANSWER: Attempt at Total cost

Projected costs 44 721 63 355
Adjustments Current Revenue 45 000 80 000
Sales and marketing expenses (2 250) (4 000) Adjusted for savings:
Allocated head office expenses ( 700) ( 860) - Sales and Marketing (2 250) (4 000)
Logistical expenses (2 700) (2 800) - Logistical Expenses (2 700) (2 800)
39071 55 695 - HO Costs corrected ( 700) ( 860)
Depreciation 0 0 Minimum Revenue 39 350 72 340
License cost 0 0
Relevant costs 39 071 55 695
Forecast profits 279 16 645
Minimum pricing 39 350 72 340
Page 112 of 228

Part (c) (ii) Other considerations IN REGARD TO THE PRICING OF THE MBX ORDER:
Product mark up should be consistent in year 2 and 3
Opportunity cost of not supplying private sector should be evaluated
- lower than expected revenue in year 4 could be significant
- competitors actions
Prospects of continued supply to MBX Ltd
Evaluate the payment and credit terms for the contract
What about other options vs selling/closing plant?
Quality of outsourcing arrangements
Costs of re-entering the market
Consider the reputation of MBX Ltd
Tender arrangements firm?
Consider pricing at a discount from a CSR perspective and build other bus thru reputation
Can capacity be built into the plant (through pricing) to allow production for the retaining of pvt sect mkts?
Page 113 of 228

Part d
Reliant on formulations and support of licensee. What if medicine proves too unreliable or ineffective against malaria?
Ability of licensee to cancel agreement (minimum performance criteria etc)
Capital expenditure is significant and it will take a number of years to recoup
Lack of experience in the field of malaria products
Accuracy of cash flow projections/predictions
Nature of the product is subject to season and dependent on outbreak of malaria, difficult to forecast growth rate & make prediction.
Technological Risk arising from new equipment and the need to train staff to operate the equipment
Flaws in the licensing contract entered into.
Ability to penetrate new market (anti-malaria) is unknown
Competitors actions - price reductions etc in response to new entry
Substitute products/generic products
Legal and Insurance risks e.g. being sued by patients contracting malaria from product failure
Foreign exchange risks
Costs of dismantling the plant
Government or political interference
Cure for malaria?
Risk profile of MBX
Medicine Council approvals/being withdrawn
Threats of patent attacks by competitors
Government intervention eg. price controls, restricting mark ups
Any other point
Page 114 of 228


This question is what the majority of candidate would term a typical Financial Management question. Students
tend to fair better in the Financial Management questions, potentially due to the structured nature of many of
the questions and solutions. Students a therefore better able to know how and where to start with the question
and use some form of structured solution to derive answers. This is definitely reflected in the results for this
question which is described as ‘fair to easy’ in the examiners’ comments and had a 63% pass rate and 55%
average. Nevertheless, this question covers many foundational principles and serves to highlight several weak
areas.
Part (a) of the required tested basic capital budgeting principles but in a format that made exam technique a
challenge. Candidates were given information for years 1 to 4 and asked to complete a present value analysis
up to year 11. In dealing with this time-consuming exercise, some students wasted time by repeating the
information for years 1 to 4 that was already given in the question. In terms of exam technique, it is also
important to note that it is more valuable to complete one year of the remaining 7 years of analysis including
all line items for that year, rather than trying to complete a single line item for all 7 years! WHY? Because you
are awarded marks for exhibiting an understanding of the basic principles and applying these to the scenario
– you need to find the most efficient way to deal with repetitive calculations to avoid wasting time.
This question highlighted yet again how few candidates understood basic cost behaviour (defining what
expenses are fixed and what are variable) as well as how many candidates fail to understand the basic principle
underlying break even. Much of this could be attributed to candidates attempting to ‘learn’ break-even by
memorising formulas. Similarly, for part (c) requiring commentary on pricing, generic lists were used by
candidates, much of which scored few marks. Part (c) was the most infrequently and poorly answered part of
this question, again potentially a result of the question being seemingly unfamiliar to students. Unfamiliar
questions should be treated with caution, but are far from impossible: Note down what the key issue is in the
required or if it has multiple sections. Then, you need to ask what issues you need to cover to address the key
issues identified. For pricing, there are a number of issues you can consider: Pricing is important for generating
profit. Other components of profit include sales volume, supplier costs and production volumes. We can now
discuss pricing in relation to costs (i.e. mark-ups) as well as how this relates to sales volumes (competitors,
price elasticity of demand, capacity and others).
Part (d) covered risk identification and was generally well answered.
Page 115 of 228

MAF 12
60 Marks
OPM (Pty) Ltd (‘OPM’) is a private equity company that invests in established small to medium unlisted
companies that have growth potential, within the agricultural and industrial sectors.
Due to the higher risk associated with private equity investments, the directors target a return from OPM’s
investments of an average of five percentage points above the return on the Johannesburg Stock Exchange’s
Top 40 index in the medium to longer term. OPM has just over R2 billion invested at present, with individual
investments ranging in size from R50 million to R150 million.
Prior to making a new investment, OPM performs a thorough due diligence investigation of the target firm.
Investment terms are stipulated to ensure success. These include incentives for operating managers of the
target firm, a retention period for senior management and representation on the board of the target firm
by OPM executives.
In addition to senior management and the board of directors, OPM has the following staff complement:
Deal initiators – employees responsible for sourcing new private equity investments (target firms) and
presenting findings to senior management. Deal initiators also negotiate with the target firm, based on a
mandate from senior management that has been approved by the board of directors. The remuneration
packages of all deal initiators have a performance element that is linked to the value created by their
investments.
Back office staff – employees responsible for undertaking due diligence investigations and valuing
investments for financial reporting and performance management purposes. This is undertaken for
both potential new investments and existing OPM investments. It is done independently of the deal
initiators, whose performance is based on the value created by investments.
Accountants and administrative assistants – employees responsible for compiling monthly management
accounts, financial statements and other matters related to administration.
Cleaning and security staff.
Back office division and Investment Oversight Committee
The firms in which OPM has invested submit compulsory management and financial reports. When deemed
necessary, back office staff undertakes surprise visits to these firms. These provide valuable information that
assists with the monitoring of investments.
Quarterly valuations are performed by the back office team and submitted to the Investment Oversight
Committee of the board of directors. This Committee considers the assumptions used, assesses the accuracy
of the data used and approves the final valuations. The Investment Oversight Committee comprises the
following four members:
• Mr Brian Heynes, CA(SA) – finance director and chairman of the Investment Oversight Committee. He
has 15 years’ work experience within the financial services industry and has held these two positions
at OPM for the past three years.
Page 116 of 228

• Mr Edward Sithole – chief executive officer and chairman of the board. He has recently been appointed
to these positions after working for many years at a leading international mining group as
managing director of their South African operations.
• Ms Brenda Koopman, CA(SA) – a senior deal initiator who was co-opted onto the Committee
during the 2013 financial year (‘FY2013’) after the resignation of a senior board member who was
also a member of this Committee. She is the best qualified private equity finance professional at
OPM and is the wife of Mr Henry Koopman, who manages OPM’s back office division.
• Prof. Melanie Naicker – independent non-executive director, who sits on the boards of two other
listed companies. She has a PhD in strategy and has been employed with the specific aim of
providing OPM with strategic insights with respect to their investment decisions.
Investment in Crescent Chickens (Pty) Ltd
In June 2014 Mr Henry Koopman tasked back office staff with performing the work necessary to value all of
OPM’s investments at the end of OPM’s most recent financial year on 31 May 2014. Mr Koopman reviews
all valuations before submission to the Investment Oversight Committee and his performance and
remuneration are linked to the accuracy of the valuations as assessed by the Investment Oversight Committee.
Details collected by a back office staff member relating to one of OPM’s investments, namely Crescent Chickens
(Pty) Ltd (‘CC’), are presented in appendices A and B. The valuation of CC has not yet been completed as
the staff member responsible for valuing the company has been booked off sick for an extended period.
However, the deadline for submission of all of OPM’s investment valuations by the back office division to
the Investment Oversight Committee is Monday, 30 June 2014.
Appendix A: Information relating to the valuation of CC

Company background
CC is a poultry producer operating within South Africa and was established in 1978. The company’s
operations are predominantly located in KwaZulu-Natal, and through various brands it provides quality,
affordable poultry products to customers throughout the country. The customer base of CC mainly
comprises major food retailers as well as companies operating in the food services industry (such as fast
food outlets).
CC is regarded as a mid-tier poultry producer with approximately a 2% market share in South Africa,
delivering an estimated 350 000 chickens per week to its customers.
Acquisition by OPM
OPM acquired a controlling stake in CC on 1 June 2010. Prior to this date the majority shareholders of
CC were the management team members who had founded the company. The management team, all of
whom are close to retirement, sold the majority of their shares to OPM in order to diversify their personal
wealth prior to retirement. The terms of the acquisition required that the management team remain in
the employ of the company until the end of FY2014.
OPM paid R65 million for 60% of the equity shares of CC in issue – the purchase price was based on a price-
earnings multiple of 8,0 applied to net profit after taxation for the year ended 31 May 2010. Subsequent
to the acquisition, OPM streamlined and aggressively expanded CC’s operations by means of debt finance,
as CC has historically had a very low gearing ratio.
Page 117 of 228

Industry and company update (as at 14 June 2014)
The poultry industry has experienced significant pressures in recent years, mainly as a result of rising input
costs and the inability to pass the cost increases on to customers. Selling prices have been constrained as
a result of a flood of cheap chicken imports, which resulted in local poultry producers being price takers at
the mercy of the large retail chains. In addition, the poultry industry remains fragmented, with no single
supplier or group of suppliers dominating the market. This has placed additional downward pressure on
operating margins.
In line with the industry, CC has struggled to remain profitable and reported losses in recent years. However,
it has managed to report a profit for its FY2014.
Extracts from the draft financial statements for FY2014 as well as a projection of expected results for the
next three financial years are presented in appendix B, together with selected supporting information which
may be pertinent for the purposes of valuing CC. The forecast has been prepared by CC’s financial manager,
who included the following comment when submitting the information to OPM’s back office:
‘OPM has increased the financial leverage of CC to an exceptionally high level; hence my forecast has included
a constant dividend policy (dividend cover of four times earnings) with excess cash being used to decrease
debt levels in future years rather than reward shareholders. In addition to reducing CC’s excessive gearing,
the implementation of a constant dividend policy will provide shareholders with greater certainty regarding
future distributions.’
Taking into consideration future economic projections and the state of the poultry industry, CC’s sustainable
nominal growth rate beyond FY2017 is expected to be 6% per annum, largely due to its smaller size. The
South African long-term nominal economic growth rate is forecast to be 8% per annum.
Surprise visits during the year
Two surprise visits were made to CC’s head office and operations by a team of back office staff members
during the past two years. The following pertinent information was noted:
22 September 2013 surprise visit
A new packaging process was installed during August 2013 which gives CC the edge over competitors, as no
other chicken producer has a similar packaging process. This process guarantees what CC describes as a
‘fresher for longer’ product.
A new operations manager was appointed on 1 September 2013 after the unexpected resignation of the
previous operations manager, who had worked for the company for 23 years. In his resignation letter the
former operations manager stated that his resignation was due to stressful working conditions and a
breakdown in relations between the operations and finance divisions.
Overall employee morale appeared lower than on previous visits.
13 June 2014 surprise visit
No significant business process changes had occurred since the surprise visit in September 2013 – all
production processes, including the new packaging process, appeared to be operating well.
Page 118 of 228

The operations manager who had been appointed on 1 September 2013 tendered his letter of resignation
during May 2014 and will be leaving the employ of the company on 30 June 2014. CC has not yet found a
suitable replacement and has no suitably qualified internal staff members who would be able to fill the
position.
Employee morale remains on the low side but seems to have improved since the last surprise visit.
Other information
The following market information has been gathered to assist with the valuation of CC:
- The current yield on the R186 long-term government bond is 7,8% per annum, while short-term
government treasury bills are yielding 4,9% per annum.
- The prime overdraft rate is presently 8,5% per annum.
- The average historic market risk premium for the South African equity market is 5,5% per annum.
- Current information applicable to listed poultry producers and the wider agricultural sector is
presented below:
Variable Average value Average

of all listed poultry producers agricultural sector
value
Levered beta 1,58 1,31
Unlevered beta 1,26 1,02
Debt-equity ratio 35% 40%
Earnings before interest, taxation, 5,5 6,7
depreciation and amortisation (EBITDA)
multiple
Mr Henry Koopman believes the most appropriate way to lever and unlever betas is to use the following
Hamada formula:
BU = BL / [1 + (1 – T)(D/E)]
Where: BU = Unlevered beta

BL = Levered beta
T = Taxation rate
D = Market value of debt
E = Market value of equity
CRESCENT CHICKENS (PTY) LTD STATEMENTS OF COMPREHENSIVE INCOME FOR THE YEARS ENDING 31
MAY
Notes Actual Forecast Forecast Forecast

2014 2015 2016 2017
R'000 R'000 R'000 R'000
Revenue 503 160 513 220 523 480 539 180
Operating expenses 1 (450 810) (459 850) (469 040) (483 110)
Depreciation (25 340) (26 280) (26 940) (27 480)
Operating profit 27 010 27 090 27 500 28 590
Page 119 of 228

Interest income 2 620 580 410 420

Interest expense 3 (7 350) (6 890) (5 130) (4 600)
Earnings before tax 20 280 20 780 22 780 24 410
Income tax (5 680) (5 820) (6 380) (6 830)
Net income 14 600 14 960 16 400 17 580
Retained income at beginning of year 159 360 170 310 181 530 193 830
Ordinary dividends declared (3 650) (3 740) (4 100) (4 400)
Retained income at end of year 170 310 181 530 193 830 207 010
CRESCENT CHICKENS (PTY) LTD STATEMENTS OF FINANCIAL POSITION AS AT 31 MAY
Notes Actual Forecast Forecast Forecast

2014 2015 2016 2017
R'000 R'000 R'000 R'000
ASSETS
Non-current assets 175 680 179 630 183 220 188 710
Property, plant and equipment 5 175 180 179 630 183 220 188 710
Deferred taxation 4 500 – – –
Current assets 103 870 100 080 104 690 106 760
Inventories 14 280 12 830 15 700 16 180
Biological assets 6 35 770 35 930 36 640 37 740
Trade and other receivables 7 39 300 41 060 41 880 43 130
Cash and cash equivalents 2 14 520 10 260 10 470 9 710
Total assets 279 550 279 710 287 910 295 470
EQUITY AND LIABILITIES

Ordinary share capital 8 12 000 12 000 12 000 12 000
Retained earnings 170 310 181 530 193 830 207 010
Non-current liabilities 52 500 38 590 35 000 29 980
Interest-bearing borrowings 3 52 500 35 000 31 340 26 210
Deferred taxation 4 – 3 590 3 660 3 770
Current liabilities 44 740 47 590 47 080 46 480
Current portion of interest-bearing 10 170 11 670 10 440 8 740
Trade and other payables 29 940 30 790 31 410 32 350
borrowings
Provisions 3 4 630 5 130 5 230 5 390
Total equity and liabilities 279 550 279 710 287 910 295 470
Page 120 of 228

Notes
1. The operating expenses for FY2014 include remuneration paid to the management team that founded
CC and who were required to remain in the employ of the company until the end of FY2014. Their
remuneration was approximately R2 500 000 less in aggregate during 2014 than the amount a similar
management team would have been paid at market rates. This has been taken into account in the forecast
figures.
2. Interest income comprises interest on CC’s cash balances. Cash and cash equivalents reflect operating cash
requirements.
3. Interest on long-term borrowings is payable at a variable rate linked to the prime overdraft rate.
The interest rate payable is set at 250 basis points (2,5%) above the prime overdraft rate.
OPM’s target long-term debt-equity ratio for CC is 25% and is based on market values, although
the forecast which was prepared by the financial manager did not incorporate this.
4. CC had an unutilised assessed tax loss of R12 580 000 on 31 May 2014. This has correctly been
accounted for and the benefit thereof was fully recognised in accordance with IAS 12, Income Taxes,
resulting in a net deferred tax asset balance in the 2014 statement of financial position.
5. CC accounts for all property, plant and equipment in accordance with the cost model of IAS 16, Property,
Plant and Equipment. Property, plant and equipment are reflected at a book value close to the assets’
market value, except for the items specified below:
• Land and buildings acquired on 1 June 1990 at a cost of R3 800 000 now have a market value of R30
million. The property is used for operations and had a book and tax value of R2 million on 31 May
2014. The fair value of the property was R12 500 000 on 1 October 2001.
• Equipment with a book value of R15 600 000 has an estimated market value of approximately R4
million.
6. Biological assets comprise chicken breeding stock and broilers (chickens specifically bred for meat
production). These assets are measured at their market value.
7. When the financial manager submitted the financial information to OPM’s back office he indicated that
a major customer had filed for bankruptcy on 12 June 2014. The customer comprised 4% of the
outstanding trade and other receivables balance at 31 May 2014, after 50% had been provided for in
the form of an inclusion in CC’s allowance for doubtful debts at year end due to a poor settlement
history and long overdue invoices. Initial indications are that CC will receive no compensation in respect
of the amount owed.
Page 121 of 228

8. Ordinary share capital comprises 1 500 000 shares in issue. The shares are held as follows:
Number of Percentage
Shareholder shares held shareholding
OPM 900 000 60%

Management team (founders) 450 000 30%
Employees 105 000 7%
Ms Lauren Heynes (wife of Mr Brian Heynes – 45 000 3%
the Finance Director of OPM)
The transferability of CC’s ordinary shares is restricted in terms of a ‘right of first refusal’ clause in
the shareholders’ agreement in terms of which shareholders are required to offer any shares they
intend to sell to other shareholders before such shares may be offered to third parties.
Page 122 of 228


Part (a) Identify and describe the conflicts of interest that arise from the Marks
composition of the Investment Oversight Committee of OPM
• Ms Brenda Koopman is a deal initiator with a vested interest in the valuation of OPM's 1
investments, as her remuneration is linked to the value created from investments
• Ms Koopman's husband manages the back office of OPM and is responsible for due
diligence and valuations. This creates two problems. 1
▪ First, Ms Koopman may not be objective in assessing the accuracy of her 1
husband's work (valuations), his performance and remuneration is linked to
accuracy.
▪ Second, Mr Koopman may not be objective during due diligence investigations 1
or the valuation of the portfolio as his wife is a senior deal initiator.
• Lauren, the wife of Mr Heynes who chairs Investment Oversight Committee, has an 1
equity interest in CC.
• Mr Heynes may feel pressured to inflate the value of CC and/or defend actions of 1
CC to ensure his wife's investment is maximised.
• Mr Heynes (and Mr Sithole) is the Finance Director and his remuneration may be linked 1
to the performance of OPM portfolio.
• Mr Sithole is the CEO and chairman of the board. Good governance recommends that the 1
same individual should not fill both of these positions.
• A conflict of interest arises as the board’s role of overseeing the work of executive 1
management (including the CEO) may be jeopardised by Mr Sithole chairing the board
meetings in a manner that avoids the board’s interrogation of executive management’s
actions.
• Three of the four members of the Committee are executives (i.e. there is a majority 1
of executive directors on the Committee).
• A conflict of interest may arise given that they may make decisions to suit their
personal interests, rather than acting in the best interest of the company as a whole. 1
Available 11
Maximum 10
Communication skills – logical argument 1
Page 123 of 228

Part (b) Perform valuations of OPM’s equity interest in CC at 31 May 2014, using
the following valuation techniques: Free cash flow method, Earnings- based Marks
method; and Net asset value method.
Free cash flow valuation
Risk free rate 7,8% 1
Market risk premium 5,5% 1
Unlevered industry beta 1,26 1

Levered beta = 1,26 x [1+(1-28%)(25%)] 1,4868 2c
1 mark for inverting formula, 1 mark for correct
application of formula
Therefore, cost of equity 15,98% 1c
Long-term debt equity ratio (market values D/E = 25%) 20%: 80%
Cost of equity x 80% [15,98% x 80%] 12,78% 1
Cost of debt x 20% [(8,5% + 2,5%) x 72% x 20%] 1,58% 1½
½ mark for adding the spread, ½ mark for tax effects
and ½ mark for weighting
WACC therefore 14.37% 14.37% 1c
(Adjustment to the WACC for additional risks, not listed,
1
size, control, right refusal etc.)
Free Cash Flow Calculation Option 1 2015 2016 2017

Operating profit 27 090 27 500 28 590
Depreciation 26 280 26 940 27 480 1
Movement in provisions 500 100 160 ½
Interest income 580 410 420 1
Taxes paid (Or tax and deferred tax) (Tax+def tax movement) -1 730 -6 310 -6 720
-5 820 -6 380 -6 830 1
4 090 70 110 1
Reverse interest tax shield (interest) -1 929 -1 436 -1 288 1
Inventories change 1 450 -2 870 -480 ½
Biological assets change -160 -710 -1 100 ½
Trade receivables change -1 760 -820 -1 250 ½
Cash movement 4 260 -210 760 ½
Trade payables change 850 620 940 ½
Capital expenditure (Movement assets + depreciation) -30 730 -30 530 -32 970
-4 450 -3 590 -5 490 1
-26 280 -26 940 -27 480 1
Free cash flows 24 701 12 684 14 542 1c
ALTERNATIVE SOLUTION FOR FCF

Page 124 of 228
Free cash flows 2015 2016 2017

Dividends 3 740 4 100 4 400 3
Repayment of interest-bearing borrowings 16 000 4 890 6 830 3
Reverse interest tax shield (interest) -1 929 -1 436 -1 288 3
Interest expense 6 890 5 130 4 600 3
24 701 12 684 14 542 ½
Continuing value (14 542 x 1,06)/(14.37% - 6%) or 8% (246 552) 184 164 2
24 701 12 684 198 706 ½c
Enterprise value @ 2014 (disc @ WACC) 164 118 1P

Less: Interest-bearing debt (Current + Long term) -62 670 1c
Equity value 101 448
Value of OPM's stake (60%) 60 869 ½c
Available marks FCF method 23
Earnings-based method
FY2014 EBITDA (27 010 + 25 340) 52 350 1
Adjustment for executives’ salaries -2 500 1
Interest income 620 1
Sustainable EBITDA (Or 20280 + 7350 + 25340 – 2500) 50 470
EBITDA multiples of listed poultry businesses 5,5 1

Adjustments for:
• Unlisted status (illiquidity) – 25% -1,375 1
• Company is a private, marketability of shares -1.000 1
• Smaller size than listed counterparts – 5% -0,275 1
• Reliance on key management – 5% -0,275 1
+1,00
• Control premium (valuing OPM’s 60% stake 1
• Other valid adjustments (Only relative)

EBITDA multiple for OPM 3,575 Max 4
Adjusted enterprise value (3,575 x R50 470) 180 430 1P

Less: Interest-bearing debt -62 670 1
Equity value 117 760
Value of OPM's stake (60%) 70 656 1c
Available marks EBITDA method 11
NAV method
Shareholders’ equity at end of FY2014 182 310 1
Land and buildings 24 233
Revaluation to market value 28 000 1
Page 125 of 228

Tax recoupment [(3800 - 2000) x 28%] -504 1

CGT arising on disposal
[(30000 - 12500) x 66,6% x 28%] -3 263 1
Equipment -8 352
Revaluation to market value -11 600 1
Scrapping allowance [(15600-4000)x28%]
Assume book value = tax value 3 248 1
Bankruptcy of a major customer Decrease
trade receivables by [39.3mx4%] -1 572 1
Related tax shield [1,572x28%] 440 440 -1 132 1
Adjusted NAV 197 059

Value of OPM's stake (60%) 118 235 1P
Available marks NAV method 9
Available 46.5
Maximum 41
Part (c) Based on the results of your valuation workings in part (b) above, make
a recommendation, with reasons, to the Investment Oversight Committee regarding
Marks
the appropriate valuation method and value of the investment
in CC as at 31 May 2014.
• It is important to note that any valuation method is open to inaccuracies and is a
subjective exercise to a large degree. The valuation of a company requires due diligence 1
in all methodology, but the task is more of an art than an exact science.
• The FCF method is the most technically sound method to use as it focusses on cash flows,
and provides a more comprehensive calculation using a robust WACC calculation. 1
• The FCF method result is significantly higher than the EBITDA method, which may be due to:
▪ high growth rate assumed into perpetuity; and 1

▪ EBITDA multiples of listed poultry producers being suppressed due to current
1
difficulties in industry.
• The NAV method yields a much higher result than other methods:
▪ It is unusual as it is generally lower, due to it representing a liquidation value; 1
▪ It excludes liquidation costs and retrenchment costs; and 1
▪ Other methods may be understating values due to difficult current industry conditions. 1
▪ NAV method is not appropriate, as the value of individual assets is considered,
1
rather than collective ability to generate returns.
▪ May be due to the high market value of the land and buildings acquired in 1990
which is accounted for using the depreciated cost model. This significant market value
1
adjustment appears to overestimate the value of operations on a NAV basis in light of the
present challenging economic environment.
Page 126 of 228

▪ As the NAV is the highest it may be beneficial to close CC’s operations and sell
1
off the assets. Athough selling all assets at once is likely to be difficult and therefore erode
some value.
• CC incurred losses until 2014 and it may be prudent to adopt a conservative stance
1
until the turnaround proves to be sustainable.
• Accordingly, the result of the lower of the two methods, namely the FCF method result of
R60,869m, should be used. 1
(OR any other reasonable conclusion based on calculations/discussion presented)
Available 12
Maximum 7
Some issues that are worthn clarifying in MAF 12:
1. In the FCF calculation, why is there a cash movement together with the working capital
changes?
▪ The scenario tells us that cash is operating thus part of working capital.
2. Is interest income always assumed not to be part of operations?
▪ No. Only when the source of the interest (the cash in this case) is operating
3. For the adjustments to EBITDA multiple of comparable firms, do the numbers matter?
▪ No. The size of your adjustments are subjective. But it is vital that you are realistic
in your adjustments and don’t make massive movements that leave the marker
puzzled.
4. When calculating the WACC, why do you use the target capital structure in finding the
weighting of the 2 types of capital (ie. the 80 and the 20) because it says in the scenario that
they weight based on market values...
▪ When calculating WACC, the target capital structure is always the default as this
is the target split between debt and equity that the company believes is optimal
and the will strive for this over time, and since we are essentially present valuing
the future, the target structure is the best representation of what the future
debt/equity split will be.
Page 127 of 228

MAF 13
25 Marks
As part of its overall plant modernisation and cost reduction programme, Silky Mills' management has decided to
install a new automated weaving loom. In the capital budgeting analysis of this equipment, the IRR of the project
was found to be 25% versus a project required return of 18%.
The loom has an invoice price of R900 000, including delivery and installation charges. The net financing
requirement, if Silky Mills borrows the funds, would be the purchase price plus the delivery and installation
charges. Weaving Plant Ltd, the maker of the loom, has offered to arrange an asset specific loan from a financial
institution. The loan would be repaid to the financial institution over a 4-year period bearing interest at 10% in
equal annual installments at the end of each year. The manufacturer will maintain and service the loom, in the
event that it is purchased, for a charge of R80 000 per year paid at the end of each year. The full cost of R900 000
for the loom is subject to a section 12C tax depreciation allowance of 40% in the first year and 20% each year
thereafter. Silky's marginal tax rate is 30%. Silky has a normal after tax cost of debt of 9%.
Weaving Plant Ltd, has also offered to lease the loom to Silky Mills. The lease agreement requires an initial rental
of R275 000 to be paid upon delivery and installation, plus four additional annual lease rentals of R275 000, with
these rental payments to be made at the end of years 1-4. The lease agreement includes maintenance and
servicing costs and specifies that at the end of the lease period, the loom will become the property of Silky Mills.
Actually, the loom has an expected life of 8 years, at which time its expected salvage value is zero. However, after
4 years, its market value is expected to be R250 000. Silky Mills plans to build an entire new plant in 4 years, so it
has no interest in either leasing or owning the proposed loom for more than 4 years.
REQUIRED:
1 Should the loom be leased or purchased? 15
2 Silky Mills' managers disagree on the proper discount rate to be used in the analysis. Some argue 5
that the proper discount rate is the firm's cost of capital, adjusted for project risk. What effect
would a discount rate change have on the lease versus purchase decision?
3 The original analysis assumed that Silky Mills would not need the loom after 4 years. Now assume 5
that the firm will continue to use the loom after the lease expires. What effect would this
requirement have on the basic analysis?
TOTAL 25
Page 128 of 228


1. Option 1
Normal borrow option
Cash flow analysis 0 1 2 3 4

Loan repayment R -900,000.00
Depreciation allowance R 108,000.00 R 54,000.00 R 54,000.00 R 54,000.00
Service contract (after tax) R -56,000.00 R -56,000.00 R -56,000.00 R -56,000.00
R -900,000.00 R 52,001.00 R -1,998.00 R -1,997.00 R -1,996.00
Discount factor at 9% (Rd) 1 0.917431193 0.841679993 0.77218348 0.708425211
R -900,000.00 R 47,707.34 R -1,681.68 R -1,542.05 R -1,414.02
NPC at 9% R -856,930.40
Option 2
Asset specific loan option

Pv= 900 000,
The amortisation and depreciation schedules are given below: fv=0,
n= 4,
Capital amount of loan R 900,000.00 i/yr= 10
Annuity factor (4 years) 3.169865446 = R283 923.72
Instalment R 283,923.72
Loan amortisation schedule 1 2 3 4

Opening balance R 900,000.00 R 706,077.28 R 492,763.28 R 258,118.89
Interest (10%) R 90,000.00 R 70,607.73 R 49,276.33 R 25,800.84
Loan repayment R -283,923.72 R -283,923.72 R -283,923.72 R -283,923.72
Closing balance R 706,077.28 R 492,763.28 R 258,118.89 R 0.00

Loan repayment R -283,923.72 R -283,923.72 R -283,923.72 R -283,923.72
Interest shield R 27,000.00 R 21,182.32 R 14,782.90 R 7,740.25
Depreciation allowance R 108,000.00 R 54,000.00 R 54,000.00 R 54,000.00
Service contract R -56,000.00 R -56,000.00 R -56,000.00 R -56,000.00
R -204,922.72 R -264,739.41 R -271,137.82 R -278,179.47
Discount factor at 9% 0.917431193 0.841679993 0.77218348 0.708425211
R -188,002.50 R -222,825.86 R -209,368.15 R -197,069.35
NPC at 9% R -817,265.86
Page 129 of 228

Option 3
Asset specific lease

Lease rentals R -275,000.00 R -275,000.00 R -275,000.00 R -275,000.00 R -275,000.00
Tax shield R 165,000.00 R 82,500.00 R 82,500.00 R 82,500.00
R -275,000.00 R -110,000.00 R -192,500.00 R -192,500.00 R -192,500.00
Discount factor at 9% 1 0.917431193 0.841679993 0.77218348 0.708425211
R -275,000.00 R -100,917.43 R -162,023.40 R -148,645.32 R -136,371.85
NPC at 9% R -822,958.00
Thus, the best option is to use the asset specific loan as this finance option has the lowest net present
cost. Silky Mills should purchase the loom using the asset specific finance.
2. The correct discount rate is the after tax cost of debt as this is a financing decision and the cash flows
are relatively certain.
• The WACC is used for the investment decision.
• Use of the incorrect discount rate could lead to the wrong decision.
• If a discount rate of 18% was used, the benefit of the asset specific loan over the asset
specific lease would be over stated.
• This occurs as the lease option has higher initial cash outflows.
3. The extended life of the loom would have the following consequences;
• Purchase option:
i. Loose net cash inflow at the end of year 4 of R175 000 arising from the salvage value.
ii. No depreciation allowances available in years 5 to 8.
• Lease option:
i. Loose net cash inflow at the end of year 4 of R175 000 arising from the salvage value.
ii. The transfer of the loom from the lessor to the lessee for no consideration will give
rise to a recoupment of rentals in the hands of the lessee and the lessee will be taxed
on this R250 000 recoupment.
iii. The lessee can claim a section 11(e) deduction in years 5 to 8 of R62 500 per annum.
Page 130 of 228

Q & A: MAF13
Q: Firstly, how did you know to even do this option. When I read the question I only picked up on the asset
specific finance and the lease as there was not information given about a normal loan (ie. no rate given
or repayment terms).
A: The Financing decision (i.e. finance or lease) follows after the investing decision (capital budgeting) has
already been made. In capital budgeting we discount at the WACC ( which is the mix between cost of
equity and the after tax cost of debt). THEREFORE the normal loan option is the generic default option
once we have decided to invest. In this default option we make use of the after tax cost of debt (for
forecasting and discounting) which was the cost of a normal loan for the company used in the
investment decision (hence the PV of the debt being the same as the principle of 900 000). The normal
loan option is always available UNLESS the question indicates that a company cannot qualify for a
normal loan.
The rate was given at 9% after tax
Q: With regard to both the decisions, why would the sale of the loom not be taken into account for both
tax (recoupments) and inclusion of sale line item in the cash flow analyisis? Surely if the business has
no use for it after year 4 they are likely to dispose of it for the market value at that date.
Why does it only become relevant if they plan to use the asset beyond year 4 as stated in question 3?
A: The answer to your question relates to the concept of relevant cash flows. Yes, they will dispose of the
asset at MV but, this would happen whether you had the lease or the borrow to purchase. You could
have included the cash flow and related tax in both options and got a different net present cost in both
cases, but, the difference in NPC between the two options should have remained the same - i.e. the
disposal of the asset was not differential between the two options.
When you continue to use the asset, the major difference between the two options relates to the
taxation. Under the purchase option, we claim wear and tear until it is fully depreciated and continue
to used until year 8. Under the lease option, we claim lease deductions, the transfer of the asset results
in a recoupment of said lease payments up to the market value of the asset, but we can claim wear
and tear between years 5 and 8.
Q: For the normal borrow option in question 1, why are interest tax shields not taken in to account? Do
we just assume interest is paid together with the lump sum at the end? In that case, why is the lump
sum and the interest not shown on the cash flows?
A: Good question and catches a lot of students.
I want you to do an exercise for me and take the annual payments for the 4 years, work out the tax
shields and then discount the annual repayments and the interest tax shields (just these two) at the
after tax cost of debt of 9%.
You should get 900,000 original loan amount.
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Basic principle, the annual repayments and related tax shield should discount at the same normal after
tax discount rate to the original lumpsum. This a a quick and easy way to save time in a question and
avoid calculating all of the interest tax deductions. However, it only works where the interest rate and
discount rate are the same and there is no assessed loss.
Q: Following on that, why then is the NPC between the normal and specific loan different. I used 900 000
when doing both and got the same NPC. I thus concluded that the lease was the most cost effective.
A: Ah, this is where the short-cut method falls short! You can put in the original loan amount as a
replacement for the annual installments and related tax shield if, and only if, the interest rate on the
loan and the discount rate (before tax) is the same. So, if the interest rate on normal borrowing is 10%
before tax, and you discount at the normal after-tax cost of debt (10% x 72%), you are accruing interest
and discounting at the same rate.
With the special loan finance, you may receive a special interest rate of 7% before tax, therefore you
will accrued/pay interest at 7% and be discounting at 10% before tax. The annual installments we
calculate at 7% will discount at 10% to a lower amount than the original loan amount - relate this to if
the yield on an instrument goes up, the market value comes down.
Page 132 of 228

MAF 14
50 MARKS
Cloth Group Ltd (‘Cloth Group’) is a clothing retailer with 55 stores throughout South Africa. These stores,
which focus on fashion clothing, are situated in suburban shopping malls and their target market is 25 to
45 year-old females and males. Approximately 75% of sales are on credit and customers are granted 30
days’ interest-free credit from the date of the statement. If payments are not made within this period,
customers have to pay interest on the outstanding balance, calculated from the date of purchase, at the
prime overdraft lending rate (currently 15,5% per annum) plus 4%. Customers are required to settle the
full amount owing on a purchase within six months.
Cloth Group is listed on the JSE Securities Exchange. The company has performed well over the past two
years, reporting revenue of R412 million for the year ended 31 January 2009 (2008: R357 million) and
achieving a gross profit margin of 42% for the 2009 financial year (2008: 41%).
Cloth Group purchases clothing from foreign and local suppliers. Suppliers are selected based on the
quality of merchandise supplied, pricing and reliability. The majority of foreign suppliers are based in
Europe and invoice Cloth Group in euro (€).
The audited statement of financial position of Cloth Group at 31 January 2009, together with comparative
figures, is set out below:
CLOTH GROUP LTD

STATEMENT OF FINANCIAL POSITION AT 31 JANUARY
2009 2008
R’000 R’000
ASSETS
Non-current assets
Property, plant and equipment 102 280 89 180
Current assets 198 050 169 800

Inventories 49 800 43 340
Trade receivables 129 600 110 180
Cash and cash equivalents 18 650 16 280
TOTAL ASSETS 300 330 258 980
EQUITY AND LIABILITIES

Share capital 15 000 15 000
Retained earnings 192 875 153 000
Total equity 207 875 168 000
Current liabilities 92 455 90 980

Current borrowings (bank overdraft) 29 050 42 090
Trade and other payables 34 080 27 100
Shareholders for dividends 11 250 9 750
Taxation payable 18 075 12 040
TOTAL EQUITY AND LIABILITIES 300 330 258 980
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Raising of medium-term finance
The Treasury Division of Cloth Group has been tasked with raising finance of between R100 million and
R125 million. Cloth Group requires the funding to grow its trade receivables and consequently revenue.
The Treasury Division has received various formal proposals and has short-listed the following two
proposals:
1 Euro denominated bond
Total nominal value €9 600 000

Coupon (fixed) 6,9%
Issue date 31 March 2009
Maturity date 31 March 2012
Interest coupon on the bond is payable annually in arrears. The total nominal value is repayable in
full on the maturity date.
2 Syndicated loan
Principal amount R120 000 000

Nominal interest rate 3 month JIBAR plus 2,5%
Loan advance date 31 March 2009
Term 3 years
Upfront issuance cost 2% of the principal amount
Interest on the loan is to be calculated and paid quarterly in arrears. The current Johannesburg
Interbank Agreed Rate (JIBAR) is 12,5%. The principal amount is to be repaid in three equal annual
instalments, with the first repayment due on 31 March 2010. The upfront issuance cost is to be paid
by Cloth Group on the loan advance date, or the company can elect to receive 98% of the principal
amount on the advance date.
Cloth Group’s policy is to hedge all foreign currency exposure. Their commercial bankers have quoted the
following spot and forward exchange contract rates:
Current spot rate €1 : R12,50

12 months forward to 31 March 2010 €1 : R13,75
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Capital structure
Cloth Group has historically funded its growth out of its own cash flows and through short-term
borrowings, mainly in the form of bank overdrafts. The Chief Executive Officer of Cloth Group has asked
the Financial Director to determine what impact the raising of medium-term finance will have on the
weighted average cost of capital (WACC) of Cloth Group.
Information that may be relevant in determining Cloth Group’s WACC is set out in the table below:
Cloth Group
Number of shares in issue 15 000 000
Current share price R24,60
Beta co-efficient 0.90
Effective normal income tax rate 28%
Dividend per share declared on 31 January 2009 75c
Other information
Current yield of the R204 RSA government bond,
maturity date 21 December 2018 9,0%
Current yield of the R153 RSA government bond,
maturity date 31 August 2010 9,4%
Premium for market risk 8,0%
Page 135 of 228

REQUIRED
Marks
(a) Calculate and determine which debt instrument (euro denominated bond or
the syndicated loan) will be the most cost effective way for Cloth Group Ltd to
raise medium-term finance.
Ignore all tax implications. 15
(b) Identify and describe the key factors that Cloth Group Ltd should consider in
evaluating which debt instrument to issue.
6
(c) Calculate, with reasons, the weighted average cost of capital (WACC) of Cloth
Group Ltd at 31 March 2009, assuming that the company elects to issue the
12
euro denominated bond.
(d) Assuming that Cloth Group Ltd elected to enter into the syndicated loan
agreement, discuss the key factors and issues that Cloth Group Ltd should
consider in evaluating whether to change from a floating interest rate to a fixed
interest rate. 5
(e) Briefly describe the concept of asset-backed securitisation and indicate what
benefits, if any, could accrue to Cloth Group Ltd from securitising its trade
5
receivables.
(f) Identify the key procedures that Cloth Group Ltd should follow in assessing the
creditworthiness of new customers.
4
Presentation marks: Arrangement and layout, clarity of explanation, logical

3
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PART (a)
Euro denominated bond 2009 2010 2011 2012

Upfront receipt (9.6m x 12.5) 120,000,000 1
Interest paid (x Exchange rate) -9,108,000 -10,002,240 -10,995,840 2
Capital repayment -159,360,000 1
120,000,000 -9,108,000 -10,002,240 -170,355,840
• Identifying IRR used 1
• IRR 17.50% 1
Alternatively
Discount factor (say 15%) 1.00 0.870 0.756 0.658
Sum of discounted c/f -7,580 1
If 120 mil left out & justified: incremental 1
Syndicated loan
Effective annual interst rate 15.87% (See Q & A at the end of this tutorial for an explanation of 1
where this comes from)
Upfront receipt 120,000,000 1
Issuance cost -2,400,000 1
Interest paid 1
- 2010 [120,000 x 15.87%] -19,044,000
- 2011 [80,000 x 15.87%] -12,696,000 1
- 2012 [40,000 x 15.87%] -6,348,000 1
Capital repayment -40,000,000 -40,000,000 -40,000,000 1
117,600,000 -59,044,000 -52,696,000 -46,348,000
IRR 17.16% 1
Alternatively
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Discount factor (say 15%) 1.00 0.870 0.756 0.658

Sum of discounted c/f -4,103 1
Alternatively
Yr 0 Q1 – Q3 Q4 Q1 - Q3 Q4 Q1 - Q3 Q4
Upfront
receipt 120,000 1
Issuance cost
-2,400 1
Interest paid
(15%/4) = -4,500 -4,500 -3,000 -3,000 -1,500 -1,500 3
3.75%
Capital 1
re-pmt -40,000 -40,000 -40,000
117,600 -4,500 -44,500 -3,000 -43,000 -1,500 -41,500
• IRR = 4.055% per quarter 1

• Nominal rate of = 16.218% p.a. 1
• Effective rate of = 17.232% p.a. (rounding difference)
Conclusion
• Syndicated loan the cheaper of the two instruments (Must include reason) 1
• Global recession: syndicated loan advantages – lower cost & variable interest rate. 1
• Any other valid point. 1
Maximum 15
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PART (b)
• Syndicated loan - variable interest rate = interest rate risk exposure. 1

• The Euro Bond repayments of interest & principal more favourable i.t.o. cash flow:
o Interest payments annually in arrear vs. quarterly for the syndicated loan 1
o Repayment of principal on 31 March 2012 vs. 3 annual pmts of R40m 1
• Syndicated loan has better matching:
o Loan = variable interest rate, same as interest rate charged on trade receivables (for which the finance 1
is required).
o Cash received from trade receivables on a regular monthly basis, matches repayment terms on loan
(quarterly & annually) better. 1
• Detailed terms of the bond and loan? Any covenants / restrictive conditions? 1
• Other (less expensive) hedging mechanisms available for Euro Bond, e.g. currency options or currency swaps?
1
• Other (less expensive) debt financing methods? E.g. asset backed securitisation.
Syndicated loan cost significantly above prime overdraft rate. 2
• Overdrafts: more risky (can be called up on short notice) but cheaper form of finance than long term loans (in
settled economy). 1
• Syndicated loan with variable rate better than fixed rate Euro loan with current interest rate declines.
1
• Taxation treatment of syndicated loan should be investigated. 1
• Exchange control regulations relating to the Euro loan. 1
• The Euro bond might need a credit rating – this can be costly exercise. 1
• Possibility/Probability of rolling over the loans at the end of three years. 1
• Other valid point. 1
Maximum 6
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PART (c)
Cost of equity – CAPM

Risk free rate = R204 bond (long term yield) 9.00% 1
Discussion of which bond to use, justifying either correctly 1
Cost of equity therefore: 9.00% + Beta 0.90 x Market premium 8.00% 16.20% 2
• Un-levering and re-levering Beta 1

• Premium added for risk, or unsystematic risk considerations 1
Cost of equity - Gordon’s growth

Growth calc – Div or earnings 412/ 357 = 15% or 1500/ 9750 = 15.38% 1
Ke = 0.75*1.15/ 24.6%+15% = 18.5% or 0.75*1.1538/24.6%+15% = 19% 1
Cost of debt
Euro bond interest rate 6.90% / Effective rate with hedge (from a) 17.50%
Cost of debt therefore (Mark for taking tax into account) 12.60% 1
Relative weightings
Target capital structure not given, weigh on market values (estimate) 1
R000’s
Market value of equity = R24.60 x 15m shares 369,000 1
Net interest bearing overdraft at 31/1/2009 (R29 050 – R18 650) 10,400 1
Alternatively: use bank overdraft - cash is required for working capital 29,050
Debt value (utilised productively) 120,000 1
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Relative weightings therefore (mark calculation) 75.5% : 24.5% or 73.9%: 26.1% 1
WACC therefore [26.1% x 12.60%] + [73.9% x 16.2%] = 15.26% 1
• Discussion of inclusion of bank overdraft or interest bearing debt. 1

• Discussion of short term not normally being included in WACC. 1
Maximum 12
PART (d)
• The volatility of interest rates recently and current yield curves 1

• The cost of swapping into a fixed rate (premium / higher rate) 1
• Inherent hedge against interest rate movements – it lends to customers at prime + 4%. So if rates increase then income
will also increase to cover higher debt costs. 2
• Fixed rate provides certainty i.t.o. future payment commitments 1
• In current economic climate interest rates are falling. Swapping for fixed rate may not make sense.
1
• Consider alternatives, e.g. interest rate cap or interest rate collar to hedge risk. 1
• Exposure to interest rate movements decline over time as debt is repaid in equal instalments. Swap into fixed interest
rate for next year / 2 may be more cost effective 2
• Other valid point. 1
Maximum 5
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PART (e)
The transaction
There are generally 3 main parties involved in securitisation: seller, issuer and investors 1
• Tx involves selling income yielding / cash flows of assets to other party / SPV 1
• Issuer purchases assets & issues negotiable debt instruments to investors allowing investors to participate in the
income stream of underlying assets 1
• Terms of collateral negotiable, seller may retain credit risk or sell without recourse 1
• A credit enhancer may provide some protection for investors by guaranteeing some or all of the credit risk associated
with underlying assets. 1
Benefits for the funders (purchaser / issuer)
• The risk should reduce as: 1
o The assets are ring-fenced. 1
o The assets sold are normally better quality than the quality of the total pool. 1
o The bonds are normally awarded a credit rating – indicating credit risk. 1
o As a result of these factors the financing (debt issued) is obtained at a lower cost. 1
Benefits to the seller (Cloth Group)
• If structured properly around SIC12, this creates off balance sheet financing. 1
• Off B/S thus funding does not result in a weakening of the gearing. 1
• Sell assets (receivables) – may be at a discount, but no interest charged on capital thus raised. (Cost benefit should be 1
performed).
• Lower administration costs associated with trade receivables as sold to the issuer. 1
• Cash is received upfront and in future soon after the credit sale / Improves liquidity. 1
• Creating a future channel for further raising capital. 1
• If the cash obtained is invested, or shares are repurchased, the ROA also improves. 1
Maximum 5
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PART (f)
• The financial position of new customer (proof of salary, personal balance sheet, ownership of fixed property as proof 1
of residence, ID documents etc)
• Credit history: credit checks with bureaus or pervious dealings with the customer 1
• Requirements of the National Credit Act & FICA (proof of residency) 1
• The amount of credit applied for versus surplus monthly cash flow (Serviceability) 1
• Assess the attitude of debtors towards the commitment of honouring debt 1
• Security provided by the debtor 1
• Consider current economic climate 1
• Other valid procedures 1
Maximum 4
Presentation marks Structure, logical flow 1
Neatness 1
Logical argument, clarity in expression 1
Total marks 50
Page 143 of 228


Cloth consisted of a collection of finance oriented questions that collectively resulted in a 21% pass rate
and 48% average.
Failings of answers to this question included:
Candidates failed to practice exam technique, spending too long on easy questions for few marks and
neglecting longer questions that weighted higher. Candidates also did not read the entire required
before attempting individual portions and failed to plan their answers. This led to a cross-pollination of
answers – i.e. part (a) included answers to part (b) and (d) and some students writing portions of their
answer in one place and then crossing this out and re-writing it on another page – this is a gross waste
of time.
In terms of technical aspects, the key to deciding which debt instrument is an appropriate form of
finance, the rate of finance and the timing of the cash flows is important. Part (a) was a basic NPV/IRR
that many students did not identify. Other than this, it was an inability to pick out obvious facts that
crippled students solutions.
Q & A: MAF 14
Q: For part A, how was the effective interest rate calculated for the syndicated loan?
A: They are currently charging interest of 3 month JIBAR plus 2.5% nominal. At 12.5% 3 month JIBAR,
that makes the nominal rate 15% per annum or 3.75% per quarter. If we take R1, charge interest of
3.75% per quarter for 4 quarters [i.e. R1 x 1.0375^4], we get R1.1587 - i.e. an effective interest charge
per year of 15.87%.
The IRR's are also effective interest rates for the life of the loan given the initial fees, variability of interest
charges and consistent capital payments.
Q: Why do the tax effects such as the tax shield not get taken into account for the interest paid as well
as the share issue costs? Surely SARS would allow a deduction of these payments?
A: The required stated that all tax implications should be ignored but had it not said that you would have
included the tax shield for interest yes
Page 144 of 228

MAF 15
60 marks
Ignore value-added tax
Educo Holdings Ltd (‘Educo’) is the holding company of a group of companies that provides affordable
private school education. Educo is currently not listed on any stock exchange. Educo has provided
education to school learners since 2000 and believes that education is the cornerstone of any society.
The company provides education to approximately 45 000 learners in 122 schools across South Africa
and also has a presence in Botswana.
1. Background
The Educo group has grown its operations by opening new schools as well as by acquiring existing
private schools.
At the start of the financial year ended 31 December 2017 (FY2017), Educo’s trading functions were
performed through the following wholly-owned subsidiaries:
• Educo Schools SA (Pty) Ltd (‘ESSA’) – South African school portfolio; and
• MaxiLearn (Pty) Ltd (‘MaxiLearn’) – Botswana school portfolio.
ESSA has a policy of a maximum class size of 30 learners. In 2017 the average annual tuition fee at its
schools was R39 000 per learner. Enrolled learners in 2017 as a percentage of available capacity
(maximum number of learners that can be accommodated) was 74%. ESSA is proud of the calibre and
experience of its educators and the learner to educator ratio (number of learners to educators) was
17:1 in 2017.
All entities within ESSA have the South African rand (ZAR) as their functional and presentation currency.
The Educo group’s presentation currency is the ZAR.
2. Industry
The growth in South Africa’s middle class has resulted in an increasing demand for private education.
In addition, the capacity constraints experienced by the government’s Department of Basic Education
in delivering educational services by government schools have also provided the opportunity for the
private sector to fill the gap.
The perception among parents is that education is pivotal to the future success of their children and this
has also boosted enrolments at affordable private schools. However, the current economic downturn
is placing pressure on consumer spending and negatively affecting learner numbers in private schools.
Competition in the private education sector remains a key challenge for sustainable growth, with the
main role players being Curro, ADvTECH and Educo.
2.1 ESSA – new school opportunity
ESSA is considering opening a new Educo school in George, a town in the Western Cape. Although
there are established schools in the area that are providing high quality education, ESSA has identified
a demand for a new private school in George. ESSA conducts a net present value (NPV) analysis on all
Page 145 of 228

potential new schools as part of its investment decision- making process. This analysis covers a
planning period of up to six years after the initial establishment of a school, as it normally takes a new
school six years to reach its sustainable occupancy level.
In January 2017 ESSA identified a plot of land that was suitable for establishing the new proposed
school in George. During 2017 ESSA paid R1 500 000 for research into the feasibility of the new school
and to obtain land rezoning approvals, of which 40% is attributable to the research. The land in question
is owned by a farmer and ESSA negotiated an option to purchase the land for R9 million. This option is
expected to be exercised once the financial feasibility plan relating to the new school has been
successfully concluded. The construction of the school buildings and sports facilities could commence
in January 2018 and be completed by 31 December 2018, ahead of the 2019 school year.
The construction of the school buildings and the sports facilities will be outsourced to an independent
building contractor and it is expected to cost R70 million, based on the assumption that the
construction commences in January 2018. The sports facilities will be limited but sufficient to allow for
some extramural activities. The building contractor will require an advance payment of R28 million of
the total building cost, prior to the commencement of construction. The balance of R42 million will be
payable upon completion of the project at the end of December 2018. The land and buildings together
are expected to have a market value of R115 million at the end of 2024.
Furniture, fixtures and equipment for the proposed school are to be sourced from a third party at a
cost of R8 million, payable at the end of December 2018.
The management accountant of ESSA, Lwandle James, has prepared a preliminary six-year financial
feasibility plan for the proposed George school. The plan is based on the following forecast revenues
and expenses for years ended 31 December:
2019 2020 2021 2022 2023 2024

R’000 R’000 R’000 R’000 R’000 R’000
Tuition fee revenue 7 533 18 807 31 328 39 245 48 000 57 664
Entrance fees 243 347 367 195 206 219
Total revenue 7 776 19 154 31 695 39 440 48 206 57 883
Operating expenses (10 876) (16 443) (24 363) (28 852) (32 231) (35 913)
Bad debts (113) (282) (470) (589) (720) (865)
Curriculum and
extramural costs (360) (382) (404) (429) (454) (482)
Employee costs (8 340) (13 916) (21 520) (25 756) (28 863) (32 249)
Facility costs (450) (477) (506) (536) (568) (602)
IT costs (180) (194) (210) (225) (240) (257)
Marketing expenses (61) (65) (69) (73) (77) (82)
Pre-opening costs (300) 0 0 0 0 0
Printing and stationery
costs (104) (111) (117) (124) (132) (140)
Shared costs (968) (1 016) (1 067) (1 121) (1 177) (1 235)
EBITDA (3 100) 2 711 7 332 10 588 15 975 21 970

Depreciation on building (1 400) (1 400) (1 400) (1 400) (1 400) (1 400)
Depreciation on
equipment ( 1 143) ( 1 143) ( 1 143) ( 1 143) ( 1 143) ( 1 143)
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EBIT (5 643) 168 4 789 8 045 13 432 19 427

Finance charges (20 678) (14 160) (15 327) (16 140) (16 505) (16 190)
(Loss)/profit before tax (26 321) (13 992) (10 538) (8 095) (3 073) 3 237
Taxation 0 0 0 0 0 0
(Loss)/profit for the year (26 321) (13 992) (10 538) (8 095) (3 073) 3 237
Page 147 of 228

Explanatory notes
• The George school will have a maximum capacity of 1 080 learners. Because parents prefer to
send their children to new schools in either grade 1 or grade 8 rather than for example grade 7
or 12, the various grades fill up over time and new schools reach sustainable occupancy levels
by year 6.
• The average annual tuition fee is assumed to be R46 500 per learner in 2019. The George school
is expected to charge a non-refundable entrance fee of R1 500 each per new pupil enrolled at
the school. The average annual tuition fee and entrance fee are forecast to increase by 7% in
2020 and by 6% per annum thereafter. Tuition fees are paid monthly in advance while entrance
fees are paid when learners enrol.
• Curriculum expenses represent the forecast costs of developing and improving the school’s
learning materials. The extramural expenses relate to the cost of providing sport and cultural
activities for learners.
• Employee costs represent the salaries paid to educators and administration and facilities staff
employed at the George school. An average annual salary increase of 6% per annum is assumed
from 2020 onwards. The forecast number of educators and support staff is as follows:
Number of
Number of
support
educators staff
2019 15 10
2020 24 15
2021 36 20
2022 42 20
2023 45 20
2024 48 20
• Facility costs represent the estimated municipal costs (rates and taxes, water and electricity)
and maintenance costs of the George school property.
• The IT costs include the cost of providing free Wi-Fi at the school.
• Marketing expenses represent the costs of advertising the George school in the local media
(community newspapers and radio stations) and advertising boards with the school name on
them around the school.
• Pre-opening costs are expected to be incurred in 2018 and comprise marketing expenses of
R200 000 and other expenses of R100 000.
• Educo encourages learners to use iPads at school. Electronic versions of textbooks and other
learning material are made available for downloading onto iPads. Unfortunately, Educo still
needs to print materials but this is expected to decline in real terms over time. Thus the average
cost of printed material per learner is expected to decline between 2021 and 2024.
• Shared costs represent the allocated forecast head office costs relating to enrolments, finance,
curriculum development oversight, strategy development and overall management. These costs
are evenly allocated to individual schools (total head office costs are divided by the number of
open and operating schools).
• The cost of the school buildings and sport facilities (R70 million) has been depreciated over the
expected useful life of 50 years. Equipment is depreciated over an average expected useful life
of seven years.
• Finance charges represent the forecast interest on the head office loan to fund the George
school. Educo advances loans to new schools from head office at an annual interest rate of 12%.
All funding is provided by the head office to individual schools. All surplus free cash flows are
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used to repay head office loans until the loans have been paid off.
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• A newly incorporated private company will own the George school and the land and
buildings. The company would be entitled to claim a building allowance for income
tax purposes. However, the management accountant estimates that the new
company will not have any taxable income for the first six years of operation.
Educo uses a weighted average cost of capital of 14% when evaluating new school projects.
The management accountant has prepared an NPV estimation for the George school. These
forecast figures are based on the above forecast revenues and expenses and assume that
cash flows occur at the end of calendar years.
George 2017 2018 2019 2020 2021 2022 2023 2024

school NPV Rmillion Rmillion Rmillion Rmillion Rmillion Rmillion Rmillion Rmillion
Land cost (10,5) ‒ ‒ ‒ ‒ ‒ ‒ ‒
Building costs (28,0) (42,0) ‒ ‒ ‒ ‒ ‒ ‒
Equipment
costs ‒ (8,0) ‒ ‒ ‒ ‒ ‒ ‒
EBITDA ‒ (0,3) (2,8) 2,7 7,3 10,6 16,0 22,0
Finance
charges ‒ ‒ (20,7) (14,2) (15,3) (16,1) (16,5) (16,2)
Terminal value ‒ ‒ ‒ ‒ ‒ ‒ ‒ 115,0
Net cash
flows (38,5) (50,3) (23,5) (11,5) (8,0) (5,5) (0,5) 120,8
NPV @ 14% (68,0)
Lwandle estimated the terminal value at the end of 2024 to be the expected market value
of the land and buildings. He concluded that the George school may not be a financially
feasible venture given the expected negative NPV that he calculated.
Sale and leaseback

Educo is experiencing liquidity constraints given its high growth through acquisitions and
from the investments required for the development of their new schools. Both growth
avenues require significant upfront investment. While Educo would be able to fund the
acquisition of the land and buildings for the George school, the group will need to raise
additional capital to fund its operations in the first few years.
Johannesburg Merchant Bank (‘JMB’) has offered to finance the new George school through
a sale and leaseback arrangement with Educo. The proposed terms of the sale and leaseback
agreement are summarised in the table below:
JMB sale and leaseback agreement details

Assets affected Land and buildings. JMB will acquire the land and buildings on 1
January 2019.
Selling price of the Land – R15 million
assets School buildings and sports facilities – R70 million
Lease instalments Six annual instalments of R7 500 000 each payable in arrears and
commencing on 31 December 2019.
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Repurchase option Educo has the option to repurchase the land and buildings at R115
million when the lease agreement comes to an end on 31 December
2024.
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Educo is considering as an alternative the following:
• Selling the land and buildings at R110 million on 1 January 2024; and
• Entering into a lease agreement with AMZ Properties and paying it R13 million annually in arrears,
increasing at 6% per annum thereafter (Educo intends to lease the land and buildings from that
point onwards).
Pricing proposals
Educo has been considering a revision of its ESSA pricing policies in order to increase revenue. The
management team is considering the introduction of one or more of the following alternatives for
boosting revenue and/or cash flows:
• Offering parents a 2,5% discount if they settle their tuition fees annually in advance as opposed
to paying monthly in advance; and/or
• Increasing all tuition fees by a once-off 10% while simultaneously offering refunds of 10% of
annual tuition fees if a learner achieves an average of at least 80% in all his/her subjects.
2.2 MaxiLearn: Disposal of foreign operation
Educo purchased 100% of the ordinary shares in MaxiLearn on 1 March 2016, thereby obtaining control
over the company. MaxiLearn is domiciled in Botswana and has the Botswana Pula (BWP) as its functional
currency. Educo obtained a loan from ZBank Ltd to fund the purchase consideration of R200 million in
cash. The loan from ZBank Ltd is repayable in monthly instalments over 60 months and all aspects relating
to the loan have been correctly accounted for in the separate financial statements of Educo.
MaxiLearn operates the MaxiLearn brand of schools in Botswana. When it purchased MaxiLearn, Educo’s
intention was to actively pursue profitable foreign school investments. However, it has not made any
further progress and the MaxiLearn brand of schools is the only foreign school investment held by the
Educo group.
On 1 March 2016 the net asset value of MaxiLearn amounted to BWP100 million, comprising ordinary
share capital of BWP40 million and retained earnings of BWP60 million. The group financial accountant,
Ruby Red, was of the opinion that the net asset value was fairly stated in terms of IFRS 3 Business
Combinations, with the exception of the following two items where she was uncertain how it should be
accounted for:
• Learning approach: The MaxiLearn schools have developed a unique learning approach to
mathematics, called ‘The Magic of Maths’. The learning approach is a first of its kind and assists
primary school learners with understanding key concepts in mathematics by exploring different
methods of counting, such as stacking pebbles, tying knots in a string or carving notches on sticks.
Although the learning approach could be sold or licensed to any party, Ruby has mentioned that
management has no intention of selling or licencing the learning approach to any party outside
of the Educo group. Ruby has determined that the fair value of this technical expertise amounted
to BWP10 million on 1 March 2016 with a useful life of seven years from that date. The technical
expertise would not qualify for any tax allowances or deductions.
Page 152 of 228

• Buildings: The following information related to the buildings of MaxiLearn on 1 March

2016:
Cost BWP35 million

Carrying amount BWP30 million
Fair value BWP55 million
Residual value BWP40 million
Remaining useful life 10 ears
As the school properties are owner-occupied by the schools, they also qualify for tax allowances. The
following Botswana tax legislation is applicable:
- The school is entitled to an annual wear and tear allowance of 2,5% per annum of the cost of the
buildings.
- Botswana does not have capital gains tax. However, any amount received on disposal of the
buildings over and above the tax value is included in taxable income and taxed in full at 22%.
On 1 March 2016, Educo agreed with MaxiLearn’s estimates of the residual value and remaining useful
life as indicated above.
MaxiLearn did not revalue its buildings or process any adjustments relating to ‘The Magic of Maths’
learning approach as a result of the acquisition by Educo.
Ruby provided the following extracts from the trial balances at 31 December 2017. The trial balance for
the Educo group already consolidates the South African subsidiaries but excludes the consolidation of
MaxiLearn.
Extracts from the

Educo group
consolidated trial
balance, excluding MaxiLearn
consolidation of
MaxiLearn*
R’000 BWP’000
Retained earnings at the beginning of the year 3 000 000 72 000
Profit after tax for the year** 1 350 000 23 000
Dividends declared and paid (30 April 2017) ‒ (10 000)
* In the separate financial statements of Educo, all amounts relating to MaxiLearn have been correctly
accounted for in accordance with Educo’s accounting policies for subsidiaries and investments in equity
instruments.
** The profit of MaxiLearn accrued evenly throughout the year.
Page 153 of 228

In view of the need to improve liquidity, Educo disposed of 82,5% of its equity interest in MaxiLearn to
an education company based in the United Kingdom (UK) for a cash amount of BWP160 million, effective
30 November 2017. The cash consideration was received in Educo’s BWP bank account held at Botswana
National Bank (BNB). As a result of this transaction Educo no longer has any influence over the relevant
activities of MaxiLearn. The fair value of the remaining interest amounted to BWP25 million on 30
November 2017, excluding the put option. The put option has the following terms and conditions:
- Educo received a put option for the 17,5% interest retained.

- It grants Educo the right to sell the remaining interest to the UK-based education company.
- The strike price will be BWP34 million.
- The sale will take place one year after the implementation of iPad-based learning at MaxiLearn
schools. This implementation is not considered to be a relevant activity of MaxiLearn.
- The fair value of the remaining 17,5% interest amounted to BWP27 million on 31
December 2017, excluding the put option. The put option had a fair value of BWP5 million on
30 November 2017 and BWP4 million on 31 December 2017.
All adjustments in relation to the put option have been correctly accounted for in the separate financial
statements of Educo.
The following exchange rates are applicable:
Spot rate Average rate

BWP:ZAR BWP:ZAR
1 March 2016 1,372 ‒
1 March 2016 to 31 December 2016 ‒ 1,322
31 December 2016 1,286 ‒
30 April 2017 1,272 ‒
1 January 2017 to 30 November 2017 ‒ 1,269
30 November 2017 1,260 ‒
31 December 2017 1,255 ‒
3. Additional information
• The Educo group has a 31 December year end and all entities within the Educo group apply
International Financial Reporting Standards (IFRS).
• The Botswana corporate income tax is a single flat rate of 22%.
• Educo has early adopted IFRS 9 Financial Instruments and accounts for investments in equity
instruments at fair value through other comprehensive income. No equity investments are held
for trading. Investments in subsidiary companies are accounted for at cost in the separate
financial statements of Educo in terms of IAS 27 Separate Financial Statements. There were no
reserves or movements in equity other than those included in the scenario above.
• The current South African corporate income tax rate (and other prevailing tax rates) are
expected to remain unchanged for the foreseeable future.
Page 154 of 228

Marks
REQUIRED Sub-
Total
total
(a) Analyse and discuss Lwandle’s estimate of the NPV for the proposed
George school and identify any errors and/or omissions in his calculations.
19
• Assume that Lwandle’s calculations are mathematically accurate.
• It is not necessary to re-calculate the NPV.
(b) Identify the key factors, apart from the result of the NPV analysis, which
Educo should consider in evaluating the potential feasibility of the
proposed George school. 8
Communication skills – clarity of expression 1 9
(c) Calculate the after-tax NPV from Educo’s perspective of ‒

(i) entering into the proposed JMB sale and leaseback arrangement,
on the assumption that Educo exercises the option to acquire the
school property on 31 December 2024; and
(ii) entering into the alternative arrangement of owning the school 10
property until 2023 and then entering into a long-term lease
arrangement with AMZ Properties.
10
• Limit your analysis to cash flows up to 31 December 2024.
• Perform the calculations separately. 20
(d) Critically discuss the proposals to amend the ESSA pricing policies. 10
No calculations are required.
1 11
Communication skills – logical argument
Total for part I 60
Page 155 of 228

Part (a) Analyse and discuss Lwandle’s estimate of the NPV for the proposed George school and
identify any errors and/or omissions in his calculations. Marks
• Assume that Lwandle’s calculations are mathematically accurate.
• It is not necessary to re-calculate the NPV.
1. The R1,5m for the feasibility study and rezoning costs are all sunk costs and should be ignored for the 1
purposes of the NPV analysis.
The tax consequences should however be included assuming is a new entity. 1
2. Most of the cash flows occur evenly through the year (and tuition fees are received monthly in advance) – 1
perhaps discount to the factor of ½?
3. Entrance fees should be included in cash flows upfront, that is, R243 000 in 2019 should be in 2018 year- 1
end cash flows.
4. Average tuition fees at ESSA were R39 000 in 2017. The forecast tuition fees for the George school of R46 1C
500 assumes an average annual increase of 9,2% for 2018 and 2019 – is this realistic and in line with
inflation? 1
5. Forecast tuition revenue assumes an 85%/84% occupancy by FY2024 ((917x100)/1 080) – this is much 1C
higher than ESSA’s current occupancy of 74%! May be reasonable if mix of schools includes other new 1
schools.
6. How do forecast occupancies from FY2019 to FY2024 compare with other new schools 1
opened? How were they determined?
7. Learner educator ratios are forecast to reach 19:1 in FY2024 – this is much higher than the ratio of 17:1 1C
that ESSA is reaching currently. 1
8. Employee costs are forecast to increase by 6% in FY2020 – this is lower than the tuition fee increase of 7% 1
(7.7%). Will staff feel aggrieved?
9. Facility costs are forecast to increase by 6% per annum, but costs such as water and electricity, IT may 1
increase at higher/lower rates than that. 1
10. Shared costs may be pre-existing costs, which are not incremental to the George school. Perhaps one 1
should analyse which costs would increase at the George school and exclude other shared costs from the
NPV analysis. 1
11. Buildings may be depreciated by 5% per annum for tax purposes (s13quin). Wear and tear 1
on furniture should be included at the approved rate. 1
12. Finance costs should be excluded from the NPV analysis as the financing decision are already in the 1
WACC, double counting.
13. The financing will result in tax losses in the property company, and taxable income at holding company. 1
Tax structuring is therefore flawed.
14. Income tax & CGT calculations should be re-performed and included in the NPV analysis 1
once adjustments have been made.
The ability to utilise the assessed loss generated should be considered. 1
15. The terminal value is incorrectly assumed to be the market value of land and buildings in FY2024. The
continuing operations of the school should be determined as the terminal value. 1
1
16. I would strongly suggest that the terminal value be estimated using the following Gordon’s growth
formula or other valuation technique: 1
17. Free cash flow FY2025 ÷ (14% – growth in perpetuity) x 2024 PV factor. 1
18. Are bad debts included in the EBITDA actual bad debts, or a provision? Non cash flow
provision or bad debt should be excluded from the NPV analysis. (Debtors discussion) 1
19. How was the 14% discount rate calculated? Justification? Educo uses the same rate for all new schools – 1
is this appropriate?
20. Enrolments seem to vary, and decline in 2022, this seems reasonable as before this they will be spread 1
over the grades, and after they will mainly enter from grade 8. Calculated as follows:
Enrollments per year 162 216 216 108 108 108
1
21. Consider reasonability of other assumptions (maintenance, IT, marketing, staff) 1
22. There is no consideration of working capital needs of the school in the workings. 1
Available 33
Page 156 of 228

Part (b) Identify the key factors, apart from the result of the NPV analysis, that Educo should consider in
evaluating the potential feasibility of the proposed George school Marks
1. Have any other quotes obtained with regard to building costs? 1

2. Has ESSA determined what the proposed George school fees are versus other private schools in the 1
area?
3. Are there sufficient potential learners in the surrounding area to reach the ‘occupancy’ levels that ESSA 1
is forecasting? (Consider population growth for future growth figures as well.)
4. Can ESSA recruit sufficient quality educators for the new school? This may 1
result in additional costs, bonuses etc. 1
5. How does the forecast ratios compare to ESSA’s experience in opening other schools? Ratios 1
such as EBITDA/revenue could be informative in this regard. 1
6. Are there any other more potentially lucrative schooling opportunities to fund from inception? 1
7. What impact will the investment have on Educo’s solvency and liquidity? 1
8. Consider the reasonableness of all underlying assumptions. Consider performing sensitivity analysis to
identify potential risk areas where losses could be suffered. 1
9. Determine the reliability of the builder. What happens if they are not in fact finished by December 2018. 1
This does not leave a lot of time for completion before school starts in January!. Are penalties / fines
included in the contract? 1
10. What effect will the current water scarcity in the Western Cape have on the school’s viability? 1
School and building needs.
11. Consider the current economic climate, viable for a school, strategic importance of a George school? 1
12. Is the land identified for purchase suitable for building? Has the builder / architect considered the type
of ground in their designs – the Western Cape is quite sandy, how does this affect the building costs? 1
Is this the ideal location for a school? Will additional transport have to be arranged.
1
13. Has an environmental study been done? What is the impact of changing the land used for farming to a
school – any endangered species, etc.? 1
14. How strong is the competition in George? Are there other Curro, etc., private schools that might affect
projections? 1
15. Has the effect of financing the school (R28m or R70m is a substantial upfront payment) which could
change the capital structure been taken into account in the WACC calculation? 1
16. Should purchase of an existing operational school not be considered? 1
Particularly relevant considering the length of the accreditation process, has this been factored into the
timeline.
Alternatively other uses of property in growth phase.
Available 19
Communication skills ‒ clarity of expression 1
MaximumTotal for part (b) 9
Page 157 of 228

Part (c) Calculate the after-tax NPV from Educo’s perspective of ‒ Marks
(i) entering into the proposed JMB sale and leaseback arrangement, on the assumption that
Educo exercises the option to acquire the property on 31 December 2024; and
- Limit your analysis to cash flows up to 31 December 2024.
- Perform the calculations separately.
1 Jan 31 Dec 31 Dec 31 Dec 31 Dec 31 Dec 31 Dec

2019 2019 2020 2021 2022 2023 2024
R’000 R’000 R’000 R’000 R’000 R’000 R’000
Proceeds land 15 000 1
Proceeds bldg 70 000 1
Lease cash flows
(7 500) (7 500) (7 500) (7 500) (7 500) (7 500) 1
Tax shield lease 2 100 2 100 2 100 2 100 2 100 2 100 1
CGT due on sale (1)
(1 142) 1C
Cost of repurchase (115 000) 1
Cash flows 85 000 (6 542) (5 400) (5 400) (5 400) (5 400) (120 400)
Discount rate 14% Or 12%-Tax 1
NPV 10 607 Below
CALCULATION 1: CGT due on sale
Proceeds Land 15 000 1
Proceeds Bldg 70 000
Base cost Land
9000+1500x0.6 (9 900) 1
Base cost – Building (70 000) 1
Capital gain 5 100 1C
Tax due
(5 100 x 22,4%) 1 142 Below
Available 11
Maximum Total for part (c)(i) 10
Page 158 of 228

Part (c) Calculate the after-tax NPV from Educo’s perspective of ‒

(ii) entering into the alternative arrangement of owning the property until 2023 and
then entering into a long-term lease arrangement with AMZ Properties. Marks
- Limit your analysis to cash flows up to 31 December 2024.
- Perform the calculations separately.
1 Jan 1 Jan 31 Dec 31 Dec 31 Dec 31 Dec 31 Dec 31 Dec
2018 2019 2019 2020 2021 2022 2023 2024
R’000 R’000 R’000 R’000 R’000 R’000 R’000 R’000
Tax shield
(70 000 x 5% x 28%) 980 980 980 980 980 1
Proceeds – sale 110 000 2
Rental perpetuity
(13 000 x 72% / 14% -6%) (117 000) 2
CGT on sale (2) (6 742) 1C
Recoupment
(R980 x 5) (4 900) 1C
Cash flows 980 980 980 980 (6 020) (11 642)
Discount rate 14% (or debt) Above
NPV (5 575) NPV 1C
CGT on sale
Proceeds – Land and
buildings 110 000 1
Base cost – Land (9000
+ 1500 x 60%) (9 900)
Base cost – Building (70 000)
Capital gain 30 100
Tax due
(30100 x 22.4%) 6 742 1C
Available 10
Maximum Total for part (c)(ii) 10
Page 159 of 228

Part (d) Critically discuss the proposals to amend the ESSA pricing policies. Marks
No calculations are required.
Option 1 – offering parents a 2,5% discount
1. Offering parents a 2,5% discount if they settle fees annually in advance could lead to an 1
improved liquidity position as more cash flow is received upfront.
2. Furthermore, by offering a discount Educo may reduce the extent of bad debts that may occur as 1
parents are more incentivised to settle fees early.
3. In addition, receiving a greater proportion of cash upfront could lead to a better ability to budget for 1
large capex and reduce the need for bridging finance or short-term debt. 1
4. However, to the extent that this does not lead to an increase in new enrolments but is only taken up by
existing parents, it could potentially lead to lower revenues from fees. 1
5. The 2,5% discount should then be compared to the return on a risk-free investment (e.g. cash or a money 1
market fund), which could compensate for the lower revenue from fees through higher interest income.
1
6. The 2,5% discount is unlikely to be sufficient to entice parents to pay early. 1
Option 2 – increasing tuition fees by a once off 10% and then offering a 10% reduction
1. Increasing fees once off by 10% is likely to lead to an increase in bad debts, particularly 1
given the prevailing economic conditions and its likely impact on affordability. 1
2. Furthermore, it is likely to cause a drop in total enrolments as existing parents look for cheaper options 1
and potential new parents choose alternative, more affordable schools. 1
3. In the short term, it may lead to a boost in revenue. However, parents may wait a year to see if their 1
child achieves an 80% overall average.
4. Ironically, by offering a 10% refund only if learners achieve an overall average of 80% or more, the school
is incentivised to have learners achieve a lower average, so as to avoiding having to refund parents 1
1
5. In addition, questions may be raised as to who will independently verify the pass marks awarded given 1
the conflict of interest the school faces.
6. This may improve the reputation of the school, resulting in more revenue, however… 1
The current mood in education regarding fees should be considered, may damage reputation. The ethical 1
consideration of better students being subsidised by lower performers should be considered.
1
Available 19
Maximum 10
Communication skills ‒ logical argument 1
TOTAL FOR PART I 60
Page 160 of 228

MAF 16
80 marks
Ignore value-added tax (VAT).
Grand Appliances Holdings Ltd (‘Grapp’) is an investment holding company listed in the Consumer
Electronics Sector on the Johannesburg Stock Exchange (JSE). The group has been in existence for 30
years and much of the group’s initial success was attributable to its differentiation strategy.
A subsidiary, Electro-Grapp (Pty) Ltd (‘Electro-Grapp’), manufactured a range of high-quality stoves

fitted with a rotisserie. Over time the product range was expanded to include hobs with separate
ovens, and later extractor fans were added. All these products are electrically powered. The products
are sold to various appliance retail chain stores nationally.
During the last ten years, the cooking appliance market has undergone some significant changes.
First, the quality of a number of globally branded cooking appliances manufactured in South Korea has
improved dramatically. These South Korean manufacturers invest large amounts in research and
development, resulting in more sophisticated products. As a consequence, a number of major local
appliance retailers have started to import large quantities of these products at discounted prices
and to sell them locally through their respective networks of chain stores. These appliance retailers
aim to sell high volumes of products at competitive prices. The lower prices and superior quality of
imported cooking appliances have resulted in a loss of market share by Electro-Grapp and other local
manufacturers.
The second key change has been the shift, particularly among high income earners and restaurants,
from electrically powered cooking appliances to gas stoves. Electro-Grapp did not react quickly enough
to this trend and failed to capitalise on the opportunity until 2012.
Two local suppliers of gas stoves, namely Cook-with-Flair Ltd (‘CWF’) and Con-Gas Ltd (‘Con-Gas’)
anticipated the shift from electric to gas stoves and have built a substantial market share in South
Africa. CWF obtained the exclusive right to import and distribute a worldclass range of Italian gas
stoves manufactured under an international trademark. Con-Gas gained market share through the
development of a combination stove, giving consumers the choice of whether to use electricity or
gas when using the appliance. Con-Gas registered a patent to protect its intellectual property. Both CWF
and Con-Gas provide a superb level of customer support.
Changes in strategic focus of Grapp
Grapp has three subsidiaries and owns 100% of the equity in each:
Grapp recognised the strategic imperative to design, manufacture and distribute a new range of gas
stoves suitable for the household market, as well as to develop specially designed solutions for
commercial customers (restaurants, hotels and conference venues).
A new subsidiary was established in 2011, called Gas-Grapp (Pty) Ltd (‘Gas-Grapp’), to research and
develop the gas stove product range.
Page 161 of 228

Gas-Grapp manufactures the gas stove product range in its factory situated in Johannesburg. It has
identified the potential of replacing metal pipes in gas stoves with an alternative plastic pipe design which
is cleaner, more efficient and cheaper. However, the capital costs involved in setting up a gas stove
manufacturing plant utilising either metal-based piping or plastic piping are high. All the raw materials
used in the manufacture of the components for these gas stoves are sourced from local suppliers and are
readily available. The company has succeeded in penetrating the local market but remains a small player
compared to CWF and Con-Gas.
Maintain-Gas (Pty) Ltd (‘Maintain-Gas’) is a wholly-owned subsidiary of Grapp which was established in
2012 to provide customer support and maintenance services for the Gas- Grapp product range.
Outlook for the South African consumer goods market

The following is an extract from a report on the South African consumer goods industry, which was
sourced from DEPG, a large audit and advisory firm. DEPG publishes an annual report covering the outlook
for the retail and consumer goods industry in South Africa:
DEPG: Outlook for the retail and consumer goods sectors
A relatively limited number of consumer durables is produced locally in South Africa. With regard
to the white goods and electronic goods sector, the majority of brands are foreign, with South Korean
suppliers dominating the local market.
Reasons cited for the lack of competitiveness of local manufacturers of consumer durables:
• Relatively high local wages;

• Labour unrest;
• Inflexible labour policies;
• Lack of middle management skills;
• Currency volatility; and
• Long lead times of some South African manufacturers on orders of raw materials placed
abroad.
South Africa’s growing middle class is attractive to the providers of durable and non-durable
consumer goods. However, middle class income earners are increasingly becoming cost conscious.
Growth in the electrical appliance and housewares market is nevertheless expected to be 16% per
annum in nominal terms.
Domestic manufacturers have adopted various growth strategies to try to improve their situation:
There is a strong focus on increasing operational efficiencies in an attempt to reduce costs, with a
number of companies wishing to expand their manufacturing capacity, either through merger and
acquisition activity or through a process of organic growth. South Africa has also seen a growing
focus on brand development, following the trend seen in other markets.
The board of directors of Grapp is considering the discontinuation of the operations of Electro-Grapp.
Apart from the possible discontinuation itself, they are also uncertain about when the discontinuation
should be implemented.
Page 162 of 228

The following actual and forecast results are available for Electro-Grapp:
Electro-Grapp
Statements of profit and loss for the years ended 31 December
Forecast Actual
2014 2013 2012 2011
R’000 R’000 R’000 R’000
Revenue 40 985,6 39 026,2 37 396,8 36 000,0
Cost of sales (35 630,7) (32 399,1) (30 184,0) (28 000,0)
Gross profit 5 354,8 6 627,1 7 212,8 8 000,0
Other operating costs (6 918,9) (6 177,6) (5 616,0) (5 200,0)
Operating (loss)/profit (1 564,1) 449,5 1 596,8 2 800,0
Finance cost (1 449,2) (1 649,1) (1 588,6) (1 831,9)
Dividends received 300,0 300,0 300,0 200,0
(Loss)/Profit before tax (2 713,2) (899,6) 308,2 1 168,1
Tax – – (2,3) (271,1)
(Loss)/Profit after tax (2 713,2) (899,6) 305,9 897,0
Electro-Grapp
Statements of financial position as at 31 December
Forecast Actual
2014 2013 2012 2011
R’000 R’000 R’000 R’000
Property, plant and equipment 18 569,3 21 849,3 24 329,3 23 209,3
Investments 2 000,0 2 000,0 2 000,0 1 300,0
Inventories 4 453,8 4 049,9 2 934,6 2 333,3
Trade receivables 4 863,2 4 618,3 3 915,2 2 800,0
Cash and cash equivalents – – – 1 153,2
29 886,3 32 517,5 33 179,1 30 795,8
Equity 6 373,1 9 086,4 9 986,0 9 680,1

Non-current liabilities
Interest-bearing borrowings – 5 222,1 9 996,4 14 361,2
Current liabilities
Trade payables 3 147,5 2 841,4 2 626,7 2 500,0
Interest-bearing borrowings 5 222,1 4 774,3 6 836,6 3 990,5
Bank overdraft 14 821,5 10 293,3 3 453,4 –
Provisions 322,0 300,0 280,0 264,0
29 886,3 32 517,5 33 179,1 30 795,8
The following information relates to the forecast data for Electro-Grapp’s 2014 financial year (‘FY2014’).
The forecasts were prepared before the decision to discontinue operations was considered:
1. The forecast revenue is based on 19 313 units being sold. This includes an order from M&M
Developers for 2 000 electric stoves at a contractually agreed price of R1 850 each. In terms
of the contract Electro-Grapp will have to supply all the units by 30 June 2014. The sales
of the other units will take place evenly throughout the year.
2. Electro-Grapp’s inventory policy states that only negligible inventory levels of raw materials
should be carried at any given time. Production scheduling is always done in such a way that
Page 163 of 228

there is no work in progress inventory at year end. On 1 January 2014, 2 418

completed electric stoves were in stock while it is projected that 2 383 stoves will form part of
the closing inventory at the end of FY2014.
3. Production has been scheduled to take place over 300 production days during FY2014. Each
electric stove requires four hours of technician time and 20 hours of machining for
completion. It is estimated that technicians will be paid R50 per technician hour worked
during FY2014. Each unit also has a component and sheet metal cost.
4. Given the lower production figures for FY2014, the estimated total manufacturing
overheads for FY2014 are budgeted to be 94,329% of the actual total overheads incurred
during FY2013. The following information has been taken from the management accounts
for FY2013:
R’000
Components, metal sheeting and technician labour (20 009 units x R938,64)
18 781,2
Manufacturing overheads
(20 009 units x 20 hours x R37,82) 15 133,4
33 914,6
Adjustment – over-absorption of manufacturing overheads (400,2)
Cost of production for FY2013 33 514,4
5. R2,00 of the total manufacturing overhead absorption rate per machine hour for FY2014 relates
to variable manufacturing overheads. 25% of the fixed manufacturing overheads for FY2014
are discretionary and would be avoided if the decision is taken to discontinue operations. The
rest of the fixed manufacturing overheads are unavoidable for FY2014.
6. The following depreciation charges apply:
Forecast Actual
2014 2013 2012 2011
R’000 R’000 R’000 R’000
Property, plant and equipment
Manufacturing 4 740 4 448 4 256 3 178
Non-manufacturing 40 32 24 22
7. Other operating expenses for FY2014 consist of the following:
Notes R’000
Operating lease payments – office equipment 7.1 118,9
Payroll expenses – marketing, administration and finance staff 7.2 3 960,0
Depreciation – non-manufacturing assets 40,0
Marketing expenses (excluding payroll expenses) 7.3 400,0
Logistics expenses 7.4 400,0
Rental of office space 7.5 2 000,0
6 918,9
Page 164 of 228

7.1 Operating lease payments – Electro-Grapp is contractually bound to lease office

equipment from 1 January 2014 to 30 June 2014 at a cost of R50 000 for that period.
The respective lessors are willing to extend lease contracts thereafter on a month-to-
month basis. The operating lease payments are estimated to be R68 900 for the six-
month period ending on 31 December 2014.
7.2 Payroll expenses – the amount represents the payroll expense for 2014 (excluding
retrenchment costs). If the operations had been discontinued at the beginning of 2014,
retrenchment costs of R180 000 would have been incurred, while retrenchment costs
would amount to R220 000 if the operations cease at the end of FY2014.
7.3 The marketing expenses are all considered to be discretionary costs. These costs
include an incentive for sales staff to push sales to retailers. They are paid R5,00 per stove
for fixed orders. As a fixed fee of R50 000 has been budgeted to be paid to them, the
sales staff involved in selling the stoves to M&M Developers will not receive this incentive.
7.4 Logistics expenses – Electro-Grapp has a binding, long-term contract with Brilliant
Carriers for the transportation of finished goods from the warehouse to the different
retail outlets for FY2014, amounting to R200 000. Any breach of contract would result
in Electro-Grapp having to pay a penalty of R50 000. Products in excess of the quantities
specified in the Brilliant Carriers contract will be transported at an additional cost of R200
000.
7.5 The rental expense represents the rental costs of office space in Johannesburg. The lease
contract expires at the end of 2014. Electro-Grapp would be able to sub-lease the office
space at a rental of R150 000 per month.
8. The realisable value of the operating assets less the outstanding balance to creditors is
estimated to be R26 824 780 at the beginning of FY2014 (end of FY2014: R20 495 194).
Acquisition by KM Appliances
KM Appliances (‘KMA’) is a global leader in the manufacture and distribution of a range of household
appliances and has successfully grown its market share in South Africa. KMA manufactures
appliances, including electric stoves, in South Korea and exports these to markets around the
world. Mr Kim, the chief executive officer of KMA, has for some time considered acquiring
manufacturing capacity in South Africa and has identified Electro-Grapp as a potential acquisition
target.
KMA has been in discussions with the management team of Electro-Grapp for the past 12 months and
has made a firm offer of R18 million for 100% of the ordinary shares in issue of Electro-Grapp, with the
effective valuation date of 1 January 2014. The valuation methodology KMA used was a free cash flow
approach.
Page 165 of 228

Key findings of a due diligence performed on Electro-Grapp include the following:
1 The management of Electro-Grapp is of the opinion that following the acquisition, annual
cost savings of R2 500 000 could be achieved from FY2014.
2 The net realisable value of the property, plant and equipment was estimated to be R21
600 000 on 1 January 2014, an estimate which was based on the assumption that the assets
would be sold off on a piecemeal basis.
3 Investments comprise numerous shares held in JSE listed companies, which can readily
be disposed of.
4 Inventories have been disclosed net of provisions for obsolescence while the trade
receivables are disclosed net of provisions for credit losses. If the operations of Electro-Grapp
had been discontinued at the end of FY2013, the provision for obsolescence would have
increased by R120 000 and the provision for credit losses would have increased by R182 000.
5 Electro-Grapp had an assessed loss of R3 600 000 at the end of FY2013. If KMA were to acquire
100% of Electro-Grapp during FY2014, it is highly probable that the entire assessed loss
would be utilised in that financial year.
6 It is expected that the sustainable free cash flows will grow at 3% per annum from FY2015
onwards.
Additional Information
The management team of KMA have indicated that they apply a weighted average cost of capital (WACC)
of 12% to investments being evaluated in emerging markets. The management of Grapp apply a WACC
of 14% for the purposes of evaluating investment decisions.
Page 166 of 228

Marks
QUESTION 1 – REQUIRED Sub-
Total
total
(a) Calculate the fixed overhead recovery (absorption) rate applicable to
FY2014 if this rate is based on machine hours. 6 6
(b) Calculate and comment on the break-even sales volume of Electro-
Grapp for FY2014. 12 12
(c) Based on the assumption that the Grapp group has decided not to sell
Electro-Grapp to KMA, discuss, with supporting calculations –
(i) whether Electro-Grapp’s operations should be discontinued at the
beginning or end of FY2014; and 15
(ii) other factors that the management of Grapp would need to
consider when deciding which date is more appropriate. 8
Ignore tax.
Communication skills –clarity of expression 1 24

(d) Critically evaluate whether the offer price from KMA is acceptable. 14 14
(e) Critically discuss the decision made by Grapp to focus on the gas stove market.
Your answer should include a discussion on the attractiveness of the gas stove
market from a strategic perspective and any potential threats and
opportunities. 23

Total 80
Page 167 of 228


Part (a)
Actual manufacturing O/H’s FY2013 [15 133 400 – 400 200] =(N1) 14 733 200 1
Budgeted manufacturing O/H’s FY2014 [14 733 200 x 94.329%] = 13 897 680 1C
Budgeted production units FY2014 [19 313 + 2 383 – 2 418] = 19 278 1
Planned machine hours [19 278 x 20] = 385 560 1C
Total manufacturing absorption rate [13 897 680/385 560] = R36.05 ½
Less variable manufacturing O/H’s (N1) -R2.00 1
Fixed manufacturing absorption rate R34.05 ½C
Alternative approach
Budgeted manufacturing O/H’s FY2014 13 897 680
Variable manufacturing O/H’s FY2014 [19 278 x 20hrs x R2] = 771 120 1
Fixed manufacturing O/H’s therefore 13 126 560 ½C
Fixed O/H absorption rate [13 126 560/385 560] = R34.05 ½C
Available & maximum 6
N1: Actual overheads is budgeted overheads less over-absorption. The budgeted overheads pre-
determined overhead rate is based on budgeted figures in traditional costing, based on machine hours.
The budgeted overhead rate relates to all manufacturing overheads – both fixed and variable.
Part (b)
Total manufacturing costs [35 630.7 + 4 453.8 – 4 049.9] = 36 034 600 1
Total manufacturing cost per unit [36 034 600/19 278] = R1 869.21 1C
Less fixed manufacturing O/H per unit [R34.05 x 20hrs] = -R681.00 1C
Variable manufacturing costs per unit (rounding diff) R1 188.21
Total manufacturing costs [35 630.7 + 4 453.8 – 4 049.9] = 36 034 600 1
Less fixed manufacturing O/H’s -13 126 560 1C
Variable manufacturing costs 22 908 040 1C
Variable costs per unit manufactured [22 908 040/19 278] = R1 188.30
Bonus marks: If labour treated as fixed costs 2
Contribution from M&M Developers contract
Contribution [(R1 850 – R1 188.30) x 2 000] = 1 323 400 1
Marketing costs specific to M&M order agreed -50 000 1
Net contribution 1 273 400
Total fixed costs
Fixed manufacturing overheads 13 126 560 1C
Other operating costs 6 918 900 1
Less marketing costs (As variable or agreed with M&M) -400 000 1
Less contribution from M&M special order (N2) -1 273 400 ½C
18 372 060
Revenue
Excluding M&M special order [40 985 400 – 3 700 000] = 37 285 600 1
Net revenue per unit [37 285 600/(19 313 – 2 000)] = R2 153.62 1
Variable costs -R1 188.21 ½C
Marketing costs (Variable with stove sold) -R5.00 1
Contribution per unit sold R960.41
Breakeven # of units to be sold [18 372 060/R960.41] = 19 129.4 1C
Breakeven # of units to be sold including special order 21 130 1C
Net revenue excluding M&M Development order 37 285 600 1
Page 168 of 228

Marketing costs -350 000 1

36 935 600
Revenue per unit R2 133.40 1
Less variable costs -R1 188.30 ½
Contribution per unit sold R945.10
# of normal units to be sold to breakeven [18 372 060/R945.10] = 19 439.3 1P
Total number of units to be sold including special order 21 439.3 1P
Discussing marketing costs – R5 versus R350 000/17 313??? 1
Discussion or reducing fixed costs by dividend income 1
Finance charges need to be considered – costs may vary though 1
Debate regarding whether logistics costs are fixed or variable 1
Appropriate conclusion re breakeven position 1
Available 21
Maximum 12
N2: In order to break even you need to have enough contribution (i.e. Sales - VC) to cover fixed costs.
However if you already contribution from another source (i.e. special order) then you don't need to
cover the full fixed costs, hence the deduction from fixed costs.
Part (c) Jan 2014 Dec 2014 Diff.

R 000’s R 000’s
Revenue (N3) 3 700.0 1 40 985.6 37 285.6 1
Cost of sales
Depreciation (non-cash flow) - - 1 - 1
Other fixed O/H’s (N6) -6 289.9 1C -8 386.6 1 -2 096.7 2
Other COS (N7) - -22 504.1 -22 504.1
Operating lease payments -50.0 1 -118.9 -68.9 1
Payroll expenses - -3 960.0 -3 960.0
Retrenchment costs -180.0 ½ -220.0 ½ -40.0 1
Depreciation (non-cash flow) - - -
Marketing expenses -50.0 1 -400.0 -350.0 1
Logistics expenses incl penalty -250.0 1 -400.0 -150.0 2
Rental of office space -200.0 1 -2 000.0 -1 800.0 2
Finance costs (N4) - -1 449.2 -1 449.2
Dividend income (N4) - 300.0 300.0
Profit impact -3 319.9 1 1 846.8 1 5 166.7 1
Operating losses -3 319.9 1P 1 846.8 1 3 119.9 2

Realisable value of assets (work cap) 26 824.8 ½ 20 495.2 ½ -6 329.6 1
Interest bearing borrowings (N4) -9 996.4 ½ -5 222.1 ½ 4 774.3 1
Bank overdraft (N5) -10 293.3 ½ -14 821.5 ½ -4 528.2 1
Net cash flow impact 3 215.2 1 2 298.4 1 -2 983.6 1
N3: The special order has been contractually agreed, so even if they shut down on 1 Jan 2014, there is
still an obligation (i.e. past event which is the signing of the contract has taken place before 1 Jan 2014)
to fulfill the special order. If the incremental approach is used the special order revenue may be
excluded completely. Note that as the company has an assessed loss the tax impact is irrelevant.
N4: If operations are discontinued these assets and liabilities will be realized and settled at fair value on
the date of discontinuation.
N5: Recognises the change in the cash balance over the period relating to operations.
N6: At December 2014: Fixed Manufactoring OH’s – Manufactoring Depreciation = R13 126.6 – R4 740 =
R8 386.6 for the year 2014. At January 2014: R8 386.6 x 75% (as 25% is saved) = R6 289.9.
Page 169 of 228

N7: At January 2014: The opening inventory of 2 418 units is used to settle the special order therefore
no production. At December 2014: The variable costs are incurred of production = total COS – fixed
manufacturing OHs = R35 630.7 – R13 126.6 = R22 504.1 relating to variable COS for production.
• Conclusion re numerical analysis – appropriate conclusions 1

• Forecast costs of closure accurate and/or complete? 1
• Why the large reduction in realisable value of operating assets at end 2014? 1
• Are there any contractual obligations to continue to supply retail outlets? 1
• Electro-Grapp should reduce production to ensure limited inventory at year end 1
• Rumours of later closure could dampen sales as customers prefer to seek
alternate sources of supply 1
• Impact on reputation & credibility of Grapp group from closing division 1
• Other divisions are in early stage, closure would result in no sustainable business 1
• Any outstanding warranty obligations that need to be honoured? 1
• Impact on staff morale of closure of Electro-Grapp? 1
• Reaction of unions to discontinuance decision? 1
• Can employees be re-assigned to Gas-Grapp? 1
• Reconsider any planned capex in Fy2014 given discontinuance decision 1
• Have potential buyers been identified for assets? 1
• Continued support of banks? If not, closure may have to happen sooner 1
• Potential reckless trading by Grapp? Solvency & liquidity analysis 2
• Relationships with suppliers tarnished given closure. Impact on other divisions? 1
• Any group costs included in FY2014, which will be incurred regardless of closure? 1
Maximum 24
Part (d)
Loss of the year -2 713.2 ½
Alternate: EBIT 1 564.1 1½
Depreciation (non-cash flow) 4 780.0 ½
Property, plant & equipment acquired (C/B + Depre – O/B) -1 500.0 1
Working Capital: Inventories movement (C/B - O/B) -403.9 ½
Working Capital: Trade receivables movement (C/B - O/B) -244.9 ½
Working Capital: Trade payables movement (C/B - O/B) 306.1 ½
Working Capital: Provisions movement (C/B - O/B) 22.0 ½
Net movement in cash 246.1
Movement in cash and cash equivalents 246.1 4
Adjustments
Dividend income -300.0 ½
Finance charges 1 449.2 ½
M&M Developers order CM as once off -1 273.4 1
Annual costs savings 2 500.0 1
Tax effect (on-going basis) (2500 x 28%) -700.0 1
Free cash flow FY2014 (Sustainable) 1 921.9
Issues for further investigation:
• Tax cash flows from FY2015 given tax loss in FY2014? 1
• Capex to maintain operations (1 500 < depreciation of 4 780) 1
KMA discount rate of 12.0% used – maximise value for Grapp 1

PV of FY2014 free cash flows [1.12^-1 x 1 921.9] = 1 716.0 1
PV of FY2015 free cash flows onwards
Page 170 of 228
1 921.9 x 1.03/(12% – 3%) x 0.8938 19 638.5

Correct use of Gordon Growth Model 1
Discount factor at end of FY2014 not end of FY2015 1
Alternative: 1 921.9/9% = 21 354.5 3
M&M Developers order special order income generated 1 273.4 1
Any reasonable attempt to PV order contribution 1
Investments (non-operating asset) 2 000.0 1
Interest bearing debt incl overdraft (liabilities permanent source of finance) -20 289.7 1
Equity value of 100% of Electro-Grapp at 1 January 2014 4 338.2
NAV valuation (N8)
NAV at December 2013 9 086.4
PPE revaluation (R21 600 – R21 849.3) -249.3 1
Additional inventory obsolescence -120.0 ½
Additional credit losses -182.0 ½
Tax effect of above adjustments [(249.3 + 120 + 182) x 28%] 154.4 1
PV of tax loss [3 600 x 28% / (1.12^1)] 900.0 1
Adjusted NAV 9 589.5
3% growth rate in perpetuity < CPI, perhaps increase forecast? 1

How did KMA value the tax loss of R3.6m? 1
KMA offer far exceeds forecast cash position from closing 1
operations per part (c) above
Offer price > Electro-Grapp NAV at Jan 2014 1
Cost for KMA start up own operations – cheaper to buy, should attract
a premium to fair value 1
Conclusion: Offer price very attractive 1
Maximum 14
N8: NAV is basically Assets less liabilities which is equity. But more specifically it is Assets at market value
less liabilities at market value, So the adjustments that needs to be made is to get assets to market value
and liabilities to market value. Please Note that the numbers as the financial statements does not always
reflect market value.
Part (e)
Attractiveness of market
• Market research indicates high growth in demand for durable goods, 16% p.a. far exceeds 1
CPI probably reflecting growing middle class 1
• Rising cost of electricity in SA may create more demand for gas appliances 1
• Eskom may create more demand for gas for cooking
o Short term power outages may result in more consumers having gas cookers 1
o Long term supply challenges may be an opportunity for the promotion of gas
appliances generally 1
• 2 players dominate local gas stove market, easier for small player such as Grapp to
gain market share than to protect high market share 1
• Gas an attractive option to restaurant & catering market as it provides quicker, more
intense heat for cooking 1
• Raw materials required for manufacture are sourced locally – no direct exchange rate risk 1
& shorter lead times 1
• Market demand could be boosted by perception that gas is more environmentally friendly
than electricity sourced from coal power stations 1
Page 171 of 228

• Sources of supply of gas in SA may not be as established as electricity? 1

o Piped gas only available in major cities/secure supply? 1
o Gas canisters available but consumers may find it inconvenient to buy & collect these
1
Threats
• Increased competition from Korean competitors 1
o Lower cost producers 1
o Larger players and hence, apply to spend more on R&D 1
• Labour unrest in SA and on-going demand for wage increases above CPI, 1
impacting on Grapp’s ability to pass on cost increases 1
• Gas-Grapp unable to penetrate local market dominated by 2 suppliers 1
• Retail chains have strong bargaining power: 1
o May restrict Grapp’s ability to negotiate price increases 1
o Retailers may stretch repayment terms 1
o Retailers may insist on increasing volume rebates 1
• Product safety – incidents involving Grapp stoves may harm reputation & 1
credibility affecting long term product sales 1
• Threats of substitute products eg. electricity appliances using less power, other gas 1
powered cooking appliances 1
Opportunities
• Grapp’s product innovation (plastic pipes etc) may provide an opportunity to grow market 1
share. Following a differentiation strategy appropriate to penetrate market 1
• Grapp brand could be leveraged in gas market given 30 years of operations 1
• Expansion into Africa could be an option 1
• Maintenance division’s service levels
o Boost demand for Gas-Grapp gas stoves 1
o Provide a stable income source 1
• Weakening ZAR currency
o Grapp could become more price competitive versus Korean manufacturers 1
o Promote export opportunities 1
• Develop a range of other gas appliances besides stoves 1
• Grapp could focus more on gas stoves following divestment of Electro-Grapp, more 1
time & resources available to grow Gas-Grapp 1
• Merger & acquisition opportunities to bulk up/leverage synergies 1
Logical argument 1
Maximum 24

Level of difficulty
The level of difficulty was generally described as ‘moderate’ or ‘fair’ by the universities although overall
we believe this to be quite a difficult question, although still appropriate for ITC. Part (d) was found to be
more difficult as the number of marks allocated to this section required an extensive discussion with
an advanced application of the information in the question.
Page 172 of 228

General comments Part (a)
Many candidates did not know how to calculate the number of units manufactured (sold units + closing
stock – opening inventories). Instead they used the units manufactured in the prior year or units sold.
Many candidates either ignored the over-absorption of the fixed overheads, or added the over-
recovery instead of deducting the figure, showing a lack of understanding as to what over-recovered
means.
Too many candidates deducted the R2 variable cost from total manufacturing overheads before
multiplying their answer by 94,329%. This gives a slightly different answer to multiplying the total
manufacturing overheads by 94,329% and only then deducting the R2. A lack of mathematical skills and
reasoning were evident.
Part (b)
Most candidates ignored the special order when they calculated the break-even volume.
Many candidates failed to distinguish between variable and fixed costs, a fundamental premise of
determining break-even sales volumes. BE units = Fixed costs / Contribution Margin per unit.
Too many candidates assumed cost of sales were variable in nature. The question had sufficient
information for them to determine manufacturing costs and then to split these into variable and fixed
components. We would have thought that removing the impact of inventory movements to determine
actual manufacturing costs would be second nature for ITC candidates.
The conclusions based on the calculations were, however, pleasing. Most candidates correctly reached
appropriate conclusions. However, some failed to apply logic – when their calculations indicated
that the break-even number of units was lower than actual sales, they missed the fact that this could not
be true! The company was operating at a loss!
Part (c)
Part (c) flummoxed most candidates. The question required candidates to assess, with supporting
calculations, whether the subsidiary should be discontinued at the beginning or end of the financial year.
This would imply that they needed to analyse the cash flow impact of these alternatives and impact on
profits i.e. they needed to make a decision. Decision making is often focused on evaluating differential cash
flows. The errors made by candidates included –
o adopting both the total and incremental approaches

o ignoring the special once-off order
o confusing profit and cash flow effects
o failing to identify that depreciation was an irrelevant cost (company had a tax loss and hence, tax
impact was also irrelevant); and
o not recognising the time value of money element – discontinuing in a year’s time is not
equivalent to today’s money.
It was clear that some candidates failed to plan their approach to the question and then implement it,
and they performed very poorly.
The second part required candidates to discuss the factors to consider in reaching a decision about
the timing of the closure of the subsidiary. Many discussed whether the subsidiary should be closed at
all, clearly beyond the scope of the required! The mark plan was generous and those who applied
themselves diligently scored well.
Page 173 of 228

Part (d)
Although the question did not specifically ask for the performance of a FCF valuation, the offered
price could not be evaluated without some attempt at how the company had arrrived at their valuation.
When a question details critically evaluate a calculation and supporting discussion is often required. The
calculation is to focus on the question issue – the offer price and whether it is appropriate. Therefore
calculations are to focus on determining an appropriate fair value.
Too many candidates did not use the results of their calculations in part (c) to assess the offer price
It was disturbing to note how many candidates combined the FCF and NAV approaches, for example by
calculating a terminal value for the NAV or adding cost savings to NAV
Most ignored the special order in their deliberations
Many candidates used the incorrect discount rate to present value the terminal value
Too many candidates simply added the gross value of the tax loss instead of using 28% of the expected
future benefit to the acquirer.
It was apparent that valuations are not a strength of most ITC candidates.
Part (e)
In this part there was generally an insufficient depth to candidates’ answers. They could for
example identify a valid issue such as sourcing materials required for manufacture from local
suppliers but could not explain why this was a good thing (potentially shorter order lead times, no foreign
currency exposure, etc.).
Some suggestions for future candidates when answering a strategy type question:
Refer to generic issues affecting businesses in South Africa at the time, such as labour unrest,
electricity price increases, expansion into Africa, etc. This would provide some easy marks.
Never repeat points, it just irritates markers.
Let the number of marks lead you when answering questions - two pages of double-spaced writing is
insufficient when answering a 24 mark question!
Page 174 of 228

MAF 17
42 marks
Rexelor Partnership (‘Rexelor’) is an audit firm that provides assurance, tax advisory and compliance,
consulting, corporate advisory, business risk and support services. Rexelor offers its services to private
and public sector clients. The firm’s sole office is situated in Polokwane, Limpopo Province, and it employs
a total of 80 people.
Rexelor was founded three years ago by Mr Brian Sekula after he had spent ten years working at a major
auditing firm in Johannesburg. Mr Sekula asked two of his university friends, Mr Lefa Mbotya and Mr
Thabo Sehume, to join him and they remain the only partners in the firm. Mr Sekula is the managing
director of the firm and also the head of the consulting division, which provides corporate advisory,
consulting, business risk and support services. Mr Mbotya is in charge of the assurance division and Mr
Sehume is the head of the tax division. Each partner works solely within his allocated division. This
applies to other professional staff as well, each of whom is dedicated to his or her operational division.
Rexelor generated revenue of R31 181 700 in the financial year ended 31 December 2014 (‘FY2014’).
The divisional revenue performance is summarised below:
Year ended Assurance Consulting Tax Division Total

division division
31 December 2014
Revenue R15 590 850 R9 354 510 R6 236 340 R31 181 700
Percentage of total 50% 30% 20% 100%
Assurance division revenue performance, FY2014
The division provides mainly external audit services to clients in both the public and private sectors.
Rexelor’s audit approach is risk based to ensure the audit process is efficient and effective, and also
to add value to clients. The division employed four managers and 11 trainee accountants throughout
FY2014. The assurance division’s billings for FY2014 are set out in the table below:
Client Notes Billed rand Total hours Recovery

billed
Tranter 1.3 12 342 000 10 200 % 80%
Quake 1.4 2 940 300 2 430 90%
Lazier 1.5 72 600 60 110%
Vhakuni 1.6 145 200 120 60%
Nthakeni 1.7 90 750 75 50%
15 590 850 12 885
Notes
1.1 The division charges standard rates per hour depending on the seniority of staff. In FY2014 these
rates were as follows:
Staff category Hourly rate

Partner R2 800
Manager R1 600
Trainee accountant R750
Page 175 of 228

1.2 The recovery percentage is calculated as hours billed versus hours actually worked on each
assignment. Rexelor budgeted for the following mix of time spent on each assignment during FY2014:
Staff category Time spent

Partner 10%
Manager 30%
Trainee accountant 60%
The actual time spent reflects the budgeted mix of time spent.
1.3 Tranter is a state-owned enterprise with a March financial year end. Rexelor accepted the
engagement as external auditor of Tranter in FY2013 and performs the majority of audit work between
February and May each year. Rexelor expects to achieve a 90% recovery on the Tranter audit in FY2015.
1.4 Quake is a platinum mining operation, and has been a client of Rexelor since Rexelor’s incorporation.
Quake has a June year end and the majority of the external audit work is performed in July and August
annually. During FY2014 Rexelor provided a once-off agreed-upon procedure assignment to Quake.
The billing on this assignment was 200 hours, which represented a 100% recovery of time spent.
1.5 Lazier is a small pension fund and became a client in FY2013. The majority of audit work is done during
May each year. The excellent recovery percentage on the assignment is largely due to the audit
manager’s significant prior experience with pension fund audits. The recovery percentage is expected to
continue for at least the next two years.
1.6 Vhakuni is an investment holding company with a September year end. Vhakuni became a client in
FY2014 and Rexelor estimates that it can improve the recovery percentage to 75% in FY2015.
1.7 Nthakeni is a newly established supermarket in Polokwane. Rexelor audited the results for the six
months ended 30 September 2014 during November of the same year. Rexelor expects to retain
the engagement for the year ending 30 September 2015 and expects the billable hours to double and
the recovery percentage to improve to 80%.
Assurance division profitability in FY2014
At their most recent partners’ meeting Mr Mbotya was questioned about the division’s financial
performance in FY2014. The assurance division was budgeted to generate revenue of R15 200 000 and
make an operating profit of R2 million in FY2014. The division exceeded the revenue target but was
significantly below the operating profit target. Mr Mbotya explained that most of the firm’s overheads
are allocated to his division and suggested that the allocation basis be revised.
The draft results of the assurance division for FY2014 are summarised in the table below:
Assurance division – operating profit for FY2014 Notes R

Revenue 15 590 850
Direct salaries 2.1 (5 595 000)
Rental of information technology (IT) equipment 2.2 (133 000)
Allocated overheads 2.3 (7 947 000)
Partner’s salary 2.4 (1 500 000)
415 850
Page 176 of 228

Notes
2.1 The audit manager is paid R650 000 per annum. The average annual salary of a trainee accountant
was R245 000 during FY2014. All professional staff (managers and trainee accountants) are expected
to work a target of 1 600 hours per annum on client assignments. The division employs two support
staff to assist the team with administrative matters. The total salary cost of support staff was R300 000
in FY2014.
2.2 Rexelor rents laptops that professional staff members use in the performance of their duties.
Support staff at Rexelor each receive desktop computers and these are also rented.
2.3 Rexelor’s total indirect overheads for FY2014 were as follows:
Rexelor total indirect overheads 2014

R
Premises rental 5 040 000
Depreciation of office furniture and equipment 650 000
IT expenses 958 000
Office supplies, stationery and printing 860 000
Finance and administration salaries 7 730 000
Water and electricity 456 000
Other overheads 200 000
15 894 000
2.4 The three partners of Rexelor are each paid R1 500 000 per annum before their share of the firm’s
profits.
Assurance division forecast revenue for FY2015
Mr Mbotya has been asked to table a revenue budget for the assurance division for FY2015 at the
partners’ next meeting. Based on his discussions with the audit managers, the following is expected
during FY2015:
• Billable hours in respect of clients who do not have a change of scope are expected to remain
the same.
• Rexelor does not anticipate any once-off or special assignments from its existing clients during
the year.
• The division is hoping to sign up a new audit client, Excelsior, in March 2015. The estimated
hours to be spent on the assignment in FY2015 are 400 hours. However, because this is a
new client, the expected recovery percentage is 60%.
• Existing staff are to remain employed throughout FY2015 and no new staff are to be
employed.
• The mix of partner, manager and trainee accountant time on assignments will be the same
as in FY2014.
• Hourly charge-out rates of the audit managers and trainee accountants are forecast to increase
by 8% in FY2015 and the partner charge-out rate is to be increased by 4%.
Page 177 of 228

Allocation of Rexelor indirect overheads
Mr Mbotya mentioned at the most recent partners’ meeting that the current basis of allocating indirect
overheads to divisions is blatantly unfair. His staff are rarely at the office as they spend most of their time
on audit work at client premises. In contrast, the other divisions spend most of their time at the Rexelor
offices and hence should bear a higher portion of the infrastructure costs of the firm. Mr Mbotya further
stated that the assurance division only occupied 20% of the total Rexelor office space yet 50% of these
costs was allocated to it.
The partners agreed to re-evaluate the allocation of indirect overheads to divisions. They tasked
Mr Mbotya with investigating this further and tabling an alternative proposal at their next meeting.
Marks
QUESTION 2 – REQUIRED Sub-
Total
total
(a) Critically analyse and discuss the operational and financial performance
(including staff utilisation) of the assurance division in FY2014. Provide
calculations to support your discussions. 23

(b) Calculate the expected revenue to be generated by the assurance
division in FY2015. 9 9
(c) Analyse the indirect overheads of Rexelor and make recommendations for a
more appropriate allocation of individual expense items to the assurance,
consulting and tax divisions. 8
Total 42
Page 178 of 228


Part (a) Critical analysis and discussion Marks
REVENUE, OPERATIONS and PROFITABILITY PERFORMANCE
Operating profit Actual Budget Variance
Revenue (Billings) 15 590.9 15 200.0 2.6% ½
Operating costs (sum amounts from scenario for actual) 15 175.0 13 200.0 15.0% ½
½C
Operating profit 415.9 2 000.0 -79.2% ½
Operating cost % 97.3% 86.8% 12.1% ½C
Operating profit % 2.7% 13.2% -79.7% ½C
Costs as a % of revenue
Direct salaries 35.9% ½
Laptop rentals 0.9% ½
Allocated overheads 51.0% ½
Partner salary 9.6% ½
Analysis of Revenue
Tranter/total revenue 79.2% ½
Quake/total revenue 18.9% ½
Professional staff contribution Total
R’000
Billings 15 590.9
Annual professional staff salary (excl support staff) (R5 595 000 + R1 500 000 – R300 000) 6 795.0 ½
‘Annual’ contribution by professional staff (15 590.9 – 6 795) 8 795.9 ½C
Contribution by professional staff/Revenue ratio 56,4% ½C
Mark-up per staff category Partner Managers Trainees
Standard rate per hour (R) 2 800 1 600 750
Cost per hour (Total cost / billable hours) (R) 938 406 153 ½
Contribution per hour (R) 1 862 1 194 597 ½
Mark-up % 198.7% 293.9% 389.8% ½C
Hourly contribution margin % (CM hr / Std rate hr) 66.5% 74.6% 79.6% ½C
Interpretation and Commentary
Revenue
1. Division is overly reliant on two clients, Tranter and Quake, collectively representing 98% of total 1
revenue
2. The favourable Revenue variance are most likely as a result of the once-off assignment of 200 1
hours for Quake and the new Vhakuni audit (if budgeted for)
3. 16 of the 80 staff (22.5%) were responsible for generating 50% of Rexelor’s revenue, which is 1
indicates that the revenue performance of the division has been excellent in comparison to the other
divisions
Operating costs
4. All costs are fixed resulting in a high degree of operating leverage. 1
5. The allocated overheads represent 51% of total divisional costs and are likely to be the reason for 1
the adverse operating profit variance. These need to be investigated urgently.
6. These costs are not within the control of the division and are likely to be unavoidable and therefore 1
distort the performance of the division.
7. The mark-up %’s appear reasonable and one would expect the trainees to have the highest. 1
8. Despite an improvement on total budgeted revenue, the increase in operating costs have 1
eroded planned operating profit margins from a planned 13.2% to a poor 2.7%
9. A detailed budget would have enabled a more meaningful evaluation of performance. 1
Page 179 of 228

RECOVERY PERFORMANCE
Partner Managers Trainees Total
Target billable hours (total) 1 600 6 400 17 600 25 600 1
Potential billings (R’000) (Hours x Std Rate) 4 480 10 240 13 200 27 920 1
Hours billed vs worked: Billed Worked
Tranter (10 200/0.8) 10 200 12 750.0
Quake (2 430/0.9) 2 430 2 700.0
Lazier (60/1.1) 60 54.5
Vhakuni (120/0.6) 120 200.0
Nthakeki (75/0.5) 75 150.0
12 885 15 854.5 1C
% of hours worked billed (12 885 / 15 854.5) 81.3% ½C
% of target hours worked (15 854.5 / 25 600) 61.9% ½C
% of target hours billed (15 854.5 / 27 920) 50.3% ½C
Break-even number of hours (15 175 / 1 210) (N1) 12 542 1C
Alternative to break-even number of hours Partner Managers Trainees Total
Minimum annual work hours required (Salary / hrly rate) 535.7 406.3 326.7
Minimum annual capacity required 33.5% 25.4% 20.4%
Distortion of billing mix applied
Currently applied (10:30:60) 280.00 480.00 450.00 1 210.00 1
Based on actual staff mix (1:4:11) 175.00 400.00 514.63 1 090.63 1
Analysis of target hours Total Billed Worked Idle time
not billed
Hours 25 600 12 855 2 969.5 9 745.5 ½C
½C
Rand amount (R’000) (based on 10:30: 60 hourly rate) 30 976 15 591 3 593 11 792 ½C
Rand amount (R’000) (based on 1:4:11 hourly rate) 27 927 14 053 3 239 10 629
10. The Tranter audit would absorb the majority of the division’s available time in Feb to May. As a result, 1
no other assignments can be performed during these months and staff is under- utilised during the 1
rest of the year and given that staff costs are fixed this has a negative impact on profitability
11. Recovery percentages on existing clients are reasonable, but the recovery percentage on new 1
clients is much lower (Vhakuni and Nthakeni)
12. The reason for the 2 970 hours worked not billed must be investigated as it equates to R3 953k (R3 1
239k) in lost revenue which could have been avoided had trainees be assigned to other divisions
during quiet periods
13. Furthermore revenue from 9 746 hours was lost due to idle time which equates to R11 792k 1
(10 629k) which is significant
14. A 100% recovery was achieved on the once-off agreed-upon procedure assignment 1
performed for Quake and this together with a 110% recovery on Lazier is excellent
15. The break-even number of hours is very close to the actual number of hours billed resulting in 1
a low margin of safety.
16. Applying the budget mix of time (10:30:60) results in the distortion of performance as it ignores 1
the fact that there are a different number of staff at each staff level
17. This distortion results in the performance of the partners and managers being favoured to the 1
detriment of the trainees
N1: The R1 210 refers to the revenue the firm expects to earn / recover for every hour worked. Not
every hour worked can be billed or recovered. Ror example if a partner works 1 hour on a client his rate
is R 2 800 per hour but only 10% of that is expected to be recovered i.e. R 280. Following this principle:
The R1 210 = (R2 800 x 10% recovery for partner) + (R1 600 x 30% recovery manager) + (R750 x 60% TA).
Page 180 of 228

STAFF UTILISATION PERFORMANCE

Analysis of staff utilisation on Tranter audit billable hours) Billable Hours
hours worked
Hours available (Feb - May) (17 weeks x 40 hours per week x number of staff 10 880 10 880.0 1P
members)
Trantor billable hours; hours worked 10 200 12 750,0
Lazier billable hours; hours worked 60 54,5
Total hours required (Feb - May) 10 260 12 804,5 ½; ½
Spare capacity; (Overtime required) 620 -1 924,5 1C
1C
Tranter / Lazier capacity
% capacity exceeded ((12 805 – 10 880)/10 880) 17.7% ½C
18. The number of staff are likely to be a function of the Tranter audit, however as can be seen from the 1
calculations of the capacity required during Feb – May, had staff only worked the billable hours, the division
would have been slightly overstaffed during this peak period.
19. The extent of overtime worked (around 1 925 hours) by staff during February to May is high 1
and leads to the question of whether a quality audit could still have been delivered.
20. Using professional staff from other divisions during the peak February to May months would have 1
reduced the number of trainees needed / the amount of overtime that was worked
21. How would staff have reacted as it would appear as if staff have not been paid for overtime 1
on the Tranter audit.
Available 45
Part (b) Calculate the expected revenue in FY2015 Mark

Billed hours Billed hours
(Alternative)
Tranter (10 200 / 80% x 90%) 10 200 11 475 ½
Quake [2430 – 200] 2 230 2 230 1
Lazier 60 60 ½
Vhakuni (120 / 60% x 75%) 120 150 ½
Nthakeni (75 / 50% x 2 x 80%) 150 240 1
Excelsior (400 x 60%) 240 240 1
Total billed hours 13 000 hrs 14 395 hrs ½C
Charge-out rates R
Partner (2 800 x 1,04) x 10% 291.20 1
Managers (1 600 x 1,08) x 30% 518.40 1
Trainees (1 600 x 1,08) x 60% 486.00 1
1 295.60
R’000 R’000
Forecast revenue [13 000 x R1 295.60] OR (14 395 x R1 295.60) 16 843 18 650 1C
Alternative solution – based on weighted hours rather than weighted rate:
Partner Manager Trainees Total
Weighted Billed hours 1 300 3 900 7 800 13 000 1C
1C
1C
OR 1 439.5 4 318.5 8 637.0 14 395
Hourly rate 2 912 1 728 810 1 295.60
Page 181 of 228

Forecast Revenue 3 785 600 6 739 200 6 318 000 16 842 800 1C
OR 4 191 824 7 462 368 6 995 970 18 650 162
Available 9
Maximum 9
Part (c) Analyse the indirect overheads of Rexelor Marks

Analysis of indirect overhead components as a % of total:
Premises rental (Amount / 15 894 000) 31.7% 1
Depreciation of office furniture and equipment 4.1%
IT expenses 6.0% 1
Office supplies, stationery and printing 5.4%
Finance and administration salaries 48.6% 1
Water and electricity 2.9%
Other overheads 1.3%
General comments (N2)
22. Rent and salaries are the major costs to be allocated. Time and effort should be focused on allocating 1
these ‘correctly’ to divisions. The other costs are relatively immaterial.
23. The basis of allocation should be transparent and fair as this will impact the divisions’ performances and 1
possibly bonuses paid and the more closely aligned with the usage of the underlying resource the more
accurate the allocation will be.
24. Currently, indirect overheads appear to be allocated on the basis of revenue generation (assurance has 1
been allocated 50% of total indirect overheads) which is not necessarily a true reflection of their resource
consumption.
25. Both Finance and administrative salaries and costs related to premises are facility sustaining expenses 1
and most likely fixed and make up 84.43% of indirect overheads. Thus the allocation of the majority of
overheads is most likely going to be arbitrary
26. It is important to note that the benefits of the better allocation system should exceed the cost. Rexelor 1
appears to be a fairly small firm and it may be excessively costly to put in place systems to monitor usage of
printing, etc. as well as carry out time and motion studies in the finance and administration departments
27. The majority of costs are directly traceable to the division and will therefore not need to be allocated. 1
Only costs that are not directly traceable will need to be allocated 1
Costs related to premises
28. The costs related to Rexelor’s offices should be allocated based on utilisation thereof and relative floor
space occupied would probably be the best indicator. 1
29. Office space costs would include rent, depreciation of office furniture & equipment and water and
electricity and therefore these costs should be allocated on the same basis (floor space). 1
30. The assurance division occupies 20% of space and hence this would be their allocation. 1
IT expenses
31. Computers are rented and hence the cost could be allocated based on the head count in each division. 1
32. Allocation of the IT expenses relating to the finance and administration division to other divisions should 1
be on the same basis as their salary costs.
Office supplies, stationery and printing
33. These costs are likely to vary with usage within each division – is there a system in place to monitor 1
usage? The systems could include print counters and logs of stationery issued. 1
34. Usage within the finance & admin division should be allocated separately to other divisions. 1
Finance and administration salaries
35. It may be difficult to allocate these costs directly to divisions as the relative ‘usage’ of these resources 1
could be difficult to quantify.
Page 182 of 228

36. A time and motion type study could be performed – the finance activities could possibly be related to 1
number of invoices issued or number of clients.
37. The assurance division has five clients, which means the administration of their invoicing, etc., should be 1
relatively simple, however some allocation is required to ensure that the service is available.
38. The human resources function costs could be allocated based on relative head count. 1
39. Should salary costs be allocated? They could be treated as a fixed cost in the business. 1
Available 23
Maximum 8
N2: The memo does not explicitly state activity based costing (ABC) to be used but applies the principles
in the discussion. The solution runs through the different costs and discusses if alternative ways of
allocating them may be more appropriate than the current allocation method. This is in terms of ABC
principles. It is not the traditional ABC calculation but it is a very good question to show the thought
process that goes into deciding on allocation methods, cost drivers etc.- all of which is required for ABC.
As a reminder the traditional method uses one allocation method or cost driver to allocate all
manufacturing overheads, whereas ABC splits overheads into its components and discusses the
appropriate allocation base or cost driver for each component, which is what the solution has done.
Page 183 of 228

MAF 18
45 Marks
South African Railway Holdings Limited (SARHL) is a government-owned enterprise. SARHL itself is an
investment holding company with the group consisting of three wholly-owned subsidiaries:
1. South African Passenger Rail Services Limited (PRS)

2. South African Freight Rail Services Limited (FRS)
3. South African Rail Engineering Services Limited (RES)
The strategic objectives of the SARHL group include delivering reliable freight and passenger rail transport
throughout South Africa, as well as reducing their environmental impact, and increasing corporate social
investment. SARHL has divisionalised its operations for the purposes of improved decision-making and
delivery. Each of the above subsidiaries is classified as a separate division for performance evaluation
purposes.
Details of Group Operations:
1. PRS provides daily public rail transport and is responsible for operating both the trains and the
passenger railway stations. To this end, the majority of PRS revenue is generated through
passenger ticket sales. The majority of the cost base consists of staff salaries and the depreciation
and maintenance of the trains and station facilities. PRS is currently operating with an EBITDA
margin of 57.2% and contributes 35% of the group’s profits.
2. FRS provides railway freight and logistics services for the movement of goods such as vehicles,
iron ore, steel and various other mining and industrial products. With the recent increase in road
congestion and road infrastructure development, rail logistics has experienced increasing
demand. Revenue is generated through contracts for the movement of goods for clients external
to the group. The majority of the cost base includes staff salaries and the depreciation and
maintenance of the freight trains. FRS currently operates with an EBITDA margin of 40.2% and
contributes 60% of the group’s profits.
3. RES provides engineering services to PRS, FRS and clients external to the group. These services
include the manufacture of the locomotives, freight wagons and passenger coaches. Revenue is
generated through sales of locomotives, wagons and coaches to FRS and PRS as well as external
clients. RES operates at an EBITDA margin of 11.75% and only contributes 5% toward group
profits. Refer to the information below for more details on the RES operations.
Page 184 of 228

South African Rail Engineering Services Limited (RES):
RES manufactures locomotives, passenger coaches and freight wagons based on orders from clients and
the other divisions. PRS relies on RES for the supply of all locomotives and passenger coaches it uses to
deliver its public transport services. Similarly, FRS purchases all locomotives and freight wagons from RES.
Therefore, both of these divisions rely heavily on RES to fulfil orders for locomotives and coaches/wagons
to avoid disruptions to service delivery.
Due to orders being somewhat unpredictable, RES manages its operations by continuously monitoring
their performance against a 4-week rolling budget. The rolling budget for the coming 4 weeks is presented
in table 1 below. The budget is split for each of RES’s three outputs.
Passenger Freight Rolling

Table 1 Note Locomotives Coaches Wagons Budget
R'000 R'000 R'000 R'000
External revenue 45 375.00 136 000.00 0.00 181 375.00
Internal revenue 317 625.00 238 000.00 363 000.00 918 625.00
Total revenue N1 363 000.00 374 000.00 363 000.00 1 100 000.00
Energy costs N2 -8 175.29 -4 215.38 -7 664.33 -20 055.00
Maintenance costs N3 -10 496.82 -5 412.42 -9 840.76 -25 750.00
Material costs N4 -148 500.00 -222 750.00 -123 750.00 -495 000.00
Personnel costs N5 -150 828.03 -77 770.70 -141 401.27 -370 000.00
Other costs N6 -19 800.00 -20 400.00 -19 800.00 -60 000.00
EBITDA 25 199.87 43 451.50 60 543.63 129 195.00
Depreciation and
amortization N7 -6 210.94 -3 449.07 -6 340.00 -16 000.00
Net finance costs N6 -6 930.00 -7 140.00 -6 930.00 -21 000.00
Profit before taxation 12 058.93 32 862.43 47 273.63 92 195.00
Anticipated production (in units) 16 22 30

Labour hours per unit N2 40 000 15 000 20 000
Machine hours per unit N8 18 10 14
Total assets 10 987 000.00

Total liabilities N9 7 135 000.00
EBITDA margin 11.75%
Note 1: Revenue is driven by the combination of order volume from customers and prices charged
for the products. Of the 16 locomotives and 22 coaches, 2 locomotives and 8 coaches
have been ordered by private passenger railway companies (see external revenue). RES
follows a cost-plus-mark-up strategy for pricing its products, although the mark-ups are
reviewed regularly against industry standards. For each of the three products, RES aims
for a 7.5%, 13.2% and 20% mark-up-on-cost (full cost excluding depreciation,
amortization and finance costs) for locomotives, passenger coaches and freight wagons
respectively. Due to fluctuations in input costs, this mark-up isn’t always achieved as there
is a time lag between increased input prices and adjustment of quoted selling prices.
Internal and external sales are priced the same and cost the same to produce.
Page 185 of 228

Note 2: Energy costs include the cost to power the facilities, plant and machinery for the
manufacturing process. Due to the labour intensive nature of the production process,
energy consumption is generally labour-driven. At full capacity of 1 600 000 labour hours,
the total budgeted energy bill is predicted to be R20.4 million at current budgeted prices.
Energy costs are allocated to products based on budgeted labour hours utilised per
product, using an overhead absorption rate of total energy cost divided by total budgeted
labour hours.
Note 3: 20% of the total maintenance costs are fixed based on regular service intervals for
machinery. The remaining 80% is considered variable based on usage, considered to be
driven by labour hours. Like energy costs, maintenance costs variable are allocated to
products based on budgeted labour hours utilised per product, using an overhead
absorption rate of total maintenance cost divided by total budgeted labour hours.
Note 4: Material costs are fully variable and are incurred on a per unit basis.
Note 5: All personnel are permanent, salaried employees. Personnel costs are absorbed into
products based on budgeted labour hours utilised per product, consistent with energy
and maintenance costs above.
Note 6: Other costs consist of research & development costs, property leasing costs, investment
in environmental impact reduction, corporate social investment and other sundry
administrative costs. Both ‘Other costs’ and ‘Net finance costs’ are apportioned to each
product based on the proportion of revenue each product generates.
Note 7: 20% of the total depreciation charge is allocated based on budgeted machine hour usage
(refer Note 8) while the remaining 80% is allocated based on budgeted labour hour usage.
Note 8: These machine hours relate to specialised laser-cutting machinery used predominantly in
the manufacture of wheels. Practical capacity for this machinery for the coming 4 week
period amounts to 960 machine hours.
Note 9: 20% of total liabilities are current liabilities – accounts payable and overdrafts.
Performance Evaluation:
All divisions are evaluated on Return on Investment (ROI). Management are paid an incentive bonus
should they achieve an ROI in excess of the target for that particular financial year.
Proposed Industrial Action:
All production employees within the RES division are members of the United Metal Workers Union
(UMWU). Wage negotiations between management of RES and UMWU have broken down with UMWU
demanding a 14% wage increase while RES is offering a 6% wage increase (in line with inflation) for the
2014 financial year. UMWU have given management of RES their 48 hour notice prior to the
commencement of a protected industrial action. Management of RES are in the process of estimating the
possible cost of this proposed industrial action.
Management of RES believe that this strike could last for up to 4 weeks. They estimate that approximately
50% of the labour force will partake in the strike over the full 4 week period. This will result in the loss of
50% of the productive labour hours over the 4 week period, as well as loss of 30% of the productive
machine hours, with fewer staff to set-up and monitor the machine operations.
Page 186 of 228

YOU ARE REQUIRED TO:
1. Assuming the management of the South African Rail Engineering Services Limited (RES)
division wishes to minimise the financial impact of the industrial action on the division,
identify the optimal product mix for production during the 4-week industrial action.
Using this mix, calculate the anticipated financial impact (cost) of the industrial action
for the division. 20
Communication skills – clarity of workings 1
2. Briefly discuss the qualitative factors that the management of RES should consider
when altering its product mix during times of industrial action. Ensure that you include
in your discussion whether such a change in product mix aligns with the strategic
objectives of the group. 6
3. Discuss how the directors of the group holding company can make use of a balanced
scorecard as a method to evaluate the performance of RES management and how this 8
will align the performance incentives to the strategic objectives of the group. 1
Communication skills – logical argument; clarity of expression
Critically evaluate the current pricing policy of RES in light of the information presented 7
4. in the scenario above.
Communication skills – logical argument; clarity of expression 1
TOTAL FOR QUESTION 45
Page 187 of 228


Profit Maximising Mix 20
Passenger Freight
Contribution Margin Locomotives Coaches Wagon
Revenue Total 363 000.00 374 000.00 363 000.00 0.5
Variable Energy N1 -7 360.00 -3 795.00 -6 900.00 3
Variable Maintenance (@80%) -8 397.45 -4 329.94 -7 872.61 2
0.5
Materials -148 500.00 -222 750.00 -123 750.00
Contribution Margin 198 742.55 143 125.06 224 477.39
Total Units 16.00 22.00 30.00

CM/u 12 421.41 6 505.68 7 482.58 1
CM per each Limiting Factors:
CM/MHr 690.08 650.57 534.47 1
Rank per MHr 1 2 3 0.5
1
CM/LHr 0.31 0.43 0.37
0.5
Rank per LHr 3 1 2
Constraints Labour Machine

Total Capacity Available 1 600 000 960
Reduce: Industr Actn (50% & 30%) -800 000 -288
Remaining for Usage 800 000 672
Required for current orders N1 -1 570 000 -928 1
Short / Spare -770 000 -256
1
Cut Locos N2 640 000 288
Short / Spare -130 000 32 1
Roundup
[130,000 /
Cut Wagons to relieve constraint N2 7.00 20,000] 2
Most Limited Factor N2 Lhrs Mhrs

Required hrs -770 000 -256 1
To cut total Locos 19.25 14.22
To cut total Coaches 51.33 25.60
To cut total Wagons 38.50 18.29
Labour most constraining

Profit optimising mix, 22 Coaches & 23 Wagons 3
1
Total Cost of the strike
Lost Locomotive sales [16 units x CM/loco] 198 742.55
Lost Wagon sales [7 units x CM/wagon] 52 378.06 2
2
251 120.61
1
Page 188 of 228

N1: The variable energy cost is calculated based on high-low method as there are two different activity
levels and costs. This calculation is provided below.
High-low method R Hours

Budgeted full capacity R20 400 000 1 600 000
Budgeted 4 week rolling R20 055 000 1 570 000
Diffence R345 000 30 000
VC/hour R345 000 / 30 000 R11.50
Total Hours for 4-week production Labour Hours Workings

Loco 640 000 = 16 * 40 000
Passenger 330 000 = 22 * 15 000
Freight 600 000 = 30 * 20 000
Total 1 570 000
Thus variable energy

Loco R7 360 000 R11.50 * 640 000 hours
Passenger R3 795 000 R11.50 * 330 000 hours
Freight R6 900 000 R11.50 * 600 000 hours
N2: The decision to cut locos is based on the fact that labour is the most limiting factor of the 2 constraints.
The most limiting factor is determined as you are able to cut Locos first and you will meet the Mhr
constraint but not the Lhr constraint. The amount of Locos cut is the full production of 16 units of Locos
is cut. This will meet the Mhrs constraint but not the LHrs constraint. Therefore additional units are
required to be cut. This will be the freight wagons which are the second rank in terms of Lhrs limiting
factor. There will be 7 units (rounded up 130 000 hrs / 20 000hr per unit).
Linear programming is an alternate to determine which products should be cut. However, this is an oldish
SAICA question and linear programming has since been removed from the ITC syllabus. Therefore it is
unlikely that you will receive a question with 2 constraints.
2. Qualitative factors for changing product mix

RES needs to evaluate the impact of such a decision on all stakeholders in 1
their value chain.
Management will be concerned about their incentive bonus 1
PRS and FRS (and external clients) rely on the products of RES for continuity 1
of operations
External customers could potentially experience disruption to their service 1
delivery should orders not be completed on time – this is likely to affect the 1
reputation of RES.
The profit-maximising mix results in cutting locomotives which are potentially 2
a more important component in continuity of operations for RES customers
than any of the coaches or wagons.
Therefore the profit maximising mix will not necessarily deliver on the group 1
strategic objectives of reliable freight and passenger rail transport.
This is likely to create service-delivery problems in the other subsidiaries. 1
Max 6
Page 189 of 228

3. Implementation of balanced scorecard aligned to strategy

Directors of holding company can align the balance scorecard of the division (RES) 1
with the strategic objectives of the group.
A balanced scorecard is developed directly from the vision and strategic direction of 1
the company/group.
Focuses management attention on not only financial aspects but also non-financial 1
indicators that are key to creating value
If the strategic objectives are the group are reliable passenger and freight services, 2
this will come through as customer objectives in RES balanced scorecard. This we can
potentially measure by the number of on-time deliveries
Learning and growth – focus on innovation in the production of products for use in 1
the other divisions – increased reliability, decreased electricity consumption, etc. 1
This division does not contribute a significant amount to group profits, so in many 3
respects their revenue is an internal transfer price. In this case, the focus of the RES
division should be on cost control in the manufacture of the assets utilised in the other
divisions. This can be an objective of internal business processes.
Max 8
4. Critically evaluate pricing

When investigating pricing, a number of factors need to be considered. These include 1
the nature of the product and the target market, existing competition, price elasticity
of demand and others.
RES uses a cost-plus pricing structure but with a mark-up that is benchmarked against 1
the industry.
Such a system opens the company up to inaccurate pricing should the original costing 1
of the product be inaccurate.
As per the information, the company uses a traditional style costing system to allocate 1
overheads and indirect costs to the products – this builds in the cost of spare capacity
into the products.
Although, based on the current budget, there is only between 2-3% spare capacity for 1
both labour and machine hours.
RES operates in an industry that lacks competition and appears to only benchmark 1
their margins rather than price, indicating somewhat of a monopoly making a cost- 1
plus strategy appropriate.
The product of rail transport is essential to the well-being of the country, therefore it 1
is unlikely that there is much price elasticity of demand and therefore insignificant
pressure to reduce the cost of the locomotives, coaches and wagons.
This costing system also encourages transferral of cost inefficiencies from one division
to another. 1
Max 7
Page 190 of 228

MAF 19
100 Marks
Aquazania Tanks (Pty) Ltd (‘Aquazania’) is a manufacturer of water storage tanks for use in farming,
industrial and residential applications. The water storage tanks are used to collect rainwater for
irrigating small crop fields or gardens and providing drinking water for livestock and also for use in
sanitation by commercial and industrial customers. Water has become a scarce resource globally and
there is increasing focus on conserving this precious resource. The demand for Aquazania’s products
has grown dramatically in recent times as more and more companies and households embrace water
conservation practices.
Aquazania manufactures a limited range of vertical water storage tanks made from polyethylene, a
type of plastic. These tanks are used above the ground to collect rainwater directly or from rooftops.
The company previously used to manufacture tanks ranging in size from 250 litres to 15 000 litres. In
2008 Aquazania discontinued the manufacture of tanks that are smaller than 5 000 litres in size, as
the company found that manufacturing too wide a product range was not cost efficient. The
company still sells smaller water storage tanks but these are procured from outsourced suppliers.
Aquazania currently manufactures the following three products only:
Product reference Storage capacity

WS5 5 000 litres
WS10 10 000 litres
WS15 15 000 litres
Aquazania uses a manufacturing process called rotational moulding to produce water storage tanks.
The manufacturing process essentially involves three steps:
• The polyethylene powder (‘powder’) is loaded into a mould which is then transferred into a
large oven, where it is slowly rotated. The heat and rotational movement, both of which are
controlled by computers, result in the powder melting into the shape of the mould.
• The mould is then cooled by removing the heat while continuing to rotate the mould inside
the oven.
• The hollow plastic tank is later removed from the mould and various components (e.g. pipe
fittings and water level indicators) are attached to the tank.
Forecasts for the 2016 financial year
The company’s manufacturing plant and equipment are nearing the end of their useful lives and sales
volumes are being constrained by production capacity.
Page 191 of 228

The financial manager of Aquazania has produced the following production and sales forecast, together
with relevant notes, for the financial year ending 29 February 2016 (‘FY2016’) for review by the board
of directors:
Aquazania
Forecast for 12 months ending 29 February 2016
Notes WS5 WS10 WS15 Total
Units to be produced and sold 3 500 7 500 3 000 14 000
Expected selling price per unit R5 500 R10 500 R16 000
Manufacturing forecasts
Machine hours per unit 1,2 1,6 1,8
Total machine hours 1.1 4 200 12 000 5 400 21 600
Direct labour hours per unit 6,0 10,0 10,0

Total direct labour hours 1.2 21 000 75 000 30 000 126 000
Powder per unit (kg) 80,0 180,0 300,0
Direct production costs

Direct labour cost per hour R95,00 R95,00 R95,00
Powder cost per kilogram 1.3 R20,25 R20,25 R20,25
Component cost per unit R325,00 R390,00 R450,00
R per R per R per

R
unit unit unit
Production overheads
Total variable production
overheads 1.4 5 184 000
Allocation of variable production
overheads based on machine
hours 288 384 432
Fixed production overheads 11 680 000
Surplus direct labour costs 1.2 505 400
Depreciation of machinery 480 000
Other 1.5 10 694 600
Allocation of fixed production
overheads based on total
revenue 440 840 1 280
Gross profit margin

Selling price 5 500 10 500 16 000
Powder cost (1 620) (3 645) (6 075)
Direct labour (570) (950) (950)
Components (325) (390) (450)
Variable production overheads (288) (384) (432)
Fixed production overheads (440) (840) (1 280)
Gross profit per unit 2 257 4 291 6 813
Gross profit percentage 41,0% 40,9% 42,6%
Page 192 of 228

Aquazania
Forecast for 12 months ending 29 February 2016 (cont.)
WS5 WS10 WS15 Total
Notes
R
Manufacturing profit summary
Revenue 146 000 000
Powder cost (51 232 500)
Direct labour (11 970 000)
Components (5 412 500)
Variable production overheads (5 184 000)
Fixed production overheads (11 680 000)
Gross profit 60 521 000
Notes
1.1 The theoretical annual capacity is 24 000 machine hours. However, planned maintenance and
an annual three-week production shut-down result in a maximum production capacity of plant
and equipment over the 12-month period ending 29 February 2016 of 21 600 machine hours.
1.2 Available direct labour hours per annum are currently 131 320 hours. The surplus direct labour
hours (5 320 hours) are not allocated directly to units produced but rather included in fixed
production overheads.
1.3 Polyethylene prices tend to track changes in the prevailing crude oil price, which is
denominated in USD. Prices also vary depending on the global demand versus the supply of
polyethylene.
1.4 Variable production overheads comprise mainly electricity, water and consumables used in
the manufacturing process. Aquazania has historically allocated variable production overheads
based on machine hours. These are regarded as the most appropriate indicator of electricity,
water and consumables usage in the manufacturing process.
1.5 Other fixed production overheads comprise mainly indirect salaries, wages and rental costs.
FY2017 to FY2021 forecasts using new manufacturing equipment
Aquazania is considering investing in new manufacturing equipment. If they do invest, the equipment
will be installed and operational by 1 March 2016. The existing equipment will be scrapped if the new
equipment is acquired and management does not expect to receive any value for the existing
equipment. The estimated cost of the new equipment is R50 million. This will include the cost of new
moulds and industrial design services. The expected economic and useful life of the new equipment is
285 000 machine hours and it will have no residual value at the end of its useful life.
Page 193 of 228

The estimated production and sales for the year ending 28 February 2017, using the new
equipment, are summarised in the table below:
Aquazania
Forecast for 12 months ending 28 February 2017
Notes WS5 WS10 WS15 Total
Units to be produced and sold 2.1 3 500 8 250 3 000 14 750
Expected selling price per unit 2.2, 2.8 R5 940 R11 760 R17 280
Manufacturing forecasts
Machine hours per unit 1,2 1,5 1,6
Total machine hours 2.3 4 200 12 375 4 800 21 375
Direct labour hours per unit 6,0 9,0 9,0

Total direct labour hours 2.4 21 000 74 250 27 000 122 250
Notes
2.1. The demand for WS5 and WS15 products is expected to remain at FY2016 levels for the
foreseeable future. However, the demand for WS10 is increasing and Aquazania estimates
that it can manufacture and sell the following units per annum of this product:
FY2017 FY2018 FY2019 FY2020 FY2021

Annual number of WS10 units to be
manufactured and sold 8 250 9 000 9 750 10 500 11 250
2.2 The selling price increase for WS5 and WS15 is targeted to be 8% per annum for the forecast
period (FY2017 to FY2021).
2.3 The annual production capacity of the new equipment is 36 000 machine hours per annum,
after taking into account scheduled maintenance downtime and annual holidays.
2.4 Aquazania has not required labourers to work overtime in recent years due to production
capacity constraints. Should overtime be necessary, existing labourers would be able to work
a maximum of 25% more hours annually, provided they are paid 150% of normal hourly rates
for overtime worked. There are no plans to retrench any workers for the foreseeable future.
2.5 Powder usage for each product is expected to remain the same as in FY2016 throughout the
forecast period. Component costs of each product are expected to increase by 6,0% per
annum from FY2017 to FY2021.
2.6 Fixed production overheads, excluding depreciation and surplus direct labour, are expected to
increase by 7% per annum over the forecast period. The current infrastructure is sufficient to
cater for expected growth over the forecast period.
2.7 Sales and marketing expenditure has historically been 2,5% of revenue and this is expected
to continue in the future.
Page 194 of 228

2.8 The following information relates to WS10 for the forecast period:
Aquazania
Forecast for FY2017 to FY2021
FY2017 FY2018 FY2019 FY2020 FY2021
R R R R R
Selling price per unit
of WS10 11 760,00 12 700,80 13 716,80 14 814,10 16 000,00
Powder cost per
kilogram 22,68 24,50 26,50 28,50 30,80
Direct labour cost per
hour 104,50 112,80 121,90 131,60 142,10
Component cost per
unit of WS10 413,40 438,20 464,50 492,30 521,90
Variable production
overheads per
machine hour 259,20 279,90 302,30 326,50 352,60
The selling price of WS10 is to be increased by 12% in FY2017, in view of planned design
enhancements to the product and the expected increased demand.
Analysis of investing in new equipment
The board of directors has requested an incremental net present value analysis of investing in the new
equipment versus retaining the status quo to confirm whether the investment is economically viable.
The requested analysis is to be performed based on the following assumptions:
• A pre-tax weighted average cost of capital of 15% is used for Aquazania;

• The taxation and working capital consequences are ignored;
• The analysis is based on a five-year period commencing on 1 March 2016;
• All cash flows occur at the beginning or end of the year, whichever is appropriate; and
• The forecast machine hours and direct labour hours per unit manufactured in FY2017 remain
constant throughout the next four years.
Status quo
Aquazania could operate the existing equipment for the period FY2017 to FY2021 provided it spends an
extra R1 million annually on repairs and maintenance. If Aquazania were to pursue this option, the
planned production and sales quantities for FY2016 would have to be maintained (i.e. no volume growth
would be possible) throughout this period and it would service its existing customer base only. The selling
price increases of WS10 over the period FY2017 to FY2021 would be 6,0% per annum if this option is
pursued.
Given the production constraints currently being experienced, maintaining the status quo would
allow competitors the opportunity to increase their market share, particularly with regard to the
WS10 product.
Page 195 of 228

Allocation of fixed production overheads
The board of directors of Aquazania has questioned whether the allocation of fixed production
overheads using relative revenue values of products sold is appropriate. It would appear that this
favours products with a lower revenue value, which may be inaccurate. The board has requested that
an analysis be performed to determine whether allocating fixed production overheads based on direct
labour hours or machine hours would provide a better reflection of the absorption of fixed overheads
during the manufacturing process.
Funding of new manufacturing equipment
Aquazania currently has R10 million surplus cash available to invest in the new equipment. It will need
to raise the balance required, amounting to R40 million, from external sources. The company has
received two proposals to fund the planned capital expenditure.
Ziggy Commercial Bank (‘Ziggy’)
Ziggy is Aquazania’s commercial banker and has offered to advance a R40 million loan to the
company on the following terms and conditions:
• The loan will be advanced on 29 February 2016 and will be repayable in five equal annual
repayments, with the first instalment due on 28 February 2017;
• The loan will bear interest at a fixed rate of 10,0% per annum; and
• The loan will be secured by a cession and pledge of Aquazania’s trade receivables and a notarial
general bond over inventories.
ADF Infrastructure Fund (‘ADF’)
ADF has offered to subscribe for preference shares to be issued by Aquazania. The preference shares
will be created and issued on the following terms and conditions:
• 40 000 preference shares will be issued at no par value for a total subscription price of R40
million on 29 February 2016;
• The preference shareholders will have no voting rights;
• The preference shareholders will be entitled to receive annual dividends in arrears,
equivalent to 7% of the total subscription price and it will be cumulative; and
• The preference shares will be redeemable at a premium of 10% on the total subscription price on
28 February 2021 or convertible into 5% of the total ordinary shares in issue of Aquazania at the
time, at the election of Aquazania.
Page 196 of 228

Marks
QUESTION 1, PART I – REQUIRED Sub-
Total
total
(a) Calculate the forecast gross profit margin per unit for each of the WS5, WS10
and WS15 products for FY2017 assuming that –
• the new equipment is purchased and installed by 1 March 2016; and
• fixed production overheads are allocated to products using machine
hours.
15 15
(b) Calculate the forecast gross profit margin per unit for each of the WS5, WS10
and WS15 products in FY2016 if fixed production overheads are allocated using
direct labour hours. 6 6
(c) Analyse and discuss the forecast gross profit of Aquazania for FY2017, based
on your calculations in part (a), in comparison to the FY2016 forecast gross
profit, based on your calculations in part (b). 12

(d) Determine the expected incremental cash flow in FY2019 (financial year
commencing 1 March 2018 and ending on 28 February 2019) of investing in
the new equipment relative to retaining the status quo. Round off your answer
to the nearest thousand and present value your answer to 1 March 2016.
36
Communication skills – layout and structure
1 37
Total for part I 71
Marks
QUESTION 1, PART II – REQUIRED Sub-
Total
total
(e) Discuss each of the two finance proposals available to Aquazania to fund the
acquisition of the new equipment and recommend which of these should
be pursued by the company. Include any further issues that may need to be
clarified with regard to each proposal. 11
(f) Identify and describe the key business risks that Aquazania faces for the
foreseeable future, assuming that the company invests in the new
manufacturing equipment. 16

Total for part II 29
Page 197 of 228


Part (a) Calculate the forecast gross profit margin per unit for each of the WS5, WS10 and WS15
products for FY2017 assuming that
• the new equipment is purchased and installed by 1 March 2016; and Marks
• fixed production overheads are allocated to products using machine hours
WS5 WS10 WS15 Total
Selling price for FY2017 5 940,00 11 760,00 17 280,00 1
Powder cost (Quantity per unit x price 2017 (R22.68)) -1 814,40 -4 082,40 -6 804,00 1
Direct labour (Lhrs/unit x cost per hour 2017 (R104.5)) -627,00 -940,50 -940,50 1
Components (N1) -344,50 -413,40 -477,00 1
Variable production o/heads per Mhr FY2017 R259,20
Variable production overheads (VOH rate 2017 x Mhrs) -311,04 -388,80 -414,72 1
Fixed production overheads excluding depr & 11 443 222 1
surplus labour (R10 694 600*1.07)
Depreciation (based on 285 000 hrs) 3 750 000 2
(R50 million * 21 375/285 000) for period
Surplus direct labour
Surplus hours = 131 320 – 122 250 = 9 070 1
• Cost of surplus hrs. at R104.50 /hr. x 9 070 947 815 1C
Total fixed overheads for products: 16 141 037 1C
Allocated based on machine hours per -906,16 -1 132,70 -1 208,22 1C
unit (16 141 037/21 375) = R755.14 /hr 2C
Gross profit margin 1 936,90 4 802,20 7 435,56 1C
Gross profit margin 32,6% 40,8% 43,0%
An acceptable alternative is for the overhead allocation to be based on practical capacity of 36 000 hours. In this
instance the overhead allocation rate will be R448.36 and the overheads allocated R537.60; 672.00 and 716.80.
Available 15
Maximum 15
N1: The cost is determined through apportionment of the WS10 cost forecast for 2017. As an example
WS5 coponent cost = R413.40 x 325 / 390 = R344.50.
Part (b) Calculate what the gross profit margin per unit would be in FY2016 if fixed production overheads
were allocation using direct labour hours Marks
WS5 WS10 WS15 Total

Gross profit per unit (Given) 2 257.00 4 291.00 6 813.00
Add back fixed overheads 440.00 840.00 1 280.00 1
Fixed overheads per labour hour 92.70 2
(11 680 000 / 126 0001)
Allocated to products (Fixed OH rate x Lhr per unit) -556.20 -927.00 -927.00 2C
Revised gross profit 2 140.80 4 204.00 7 166.00 1C
Gross profit margin 38.9% 40.0% 44.8%
1An accepted alternative is to use 131 320 hours as long as the total fixed overhead cost was adjusted to exclude
the cost of surplus labour. The allocation rate would then be ((11 680 000 – 505 400)/131 320) = 85.09) and the
overhead allocated to products would then be R510.54; 850.09 and 850.09
Available 6
Maximum 6
Page 198 of 228

Part (c) Analyse and discuss the forecast gross profit of Aquazania for FY2017, based on your
calculations in part (a), in comparison to the FY2016 forecast gross profit, based on your Marks
calculations in part (b).
WS5 WS10 WS15 Total
FY2017 Gross profit (GP per unit x Units sold) 6 779 150 39 618 150 22 306 680 68 703 980
FY2017 Total revenue (SP x Units sold) 20 790 000 97 020 000 51 840 000 169 650 000
FY2017 Unit GP % 32.6% 40.8% 43.0% 1C

FY2017 Overall GP % 40.5% 1
FY2016 Unit GP % 38.9% 40.0% 44.8% 1C
FY2016 Overall GP % 41.5% 1
Calculation of Revised FY2017 GP % based on direct labour hour allocation
GP % calculated in (a): 1 936.90 4 802.20 7 435.56
Add: fixed cost allocation (Calc in (a)) 906.16 1 132,70 1 208.22
Revised allocation rate per Lhr (16 141 037 / 122 250) 132.03 1P
Less: revised fixed cost allocation (Rate x LHr per unit) -792.18 -1 188.27 -1 188.27 1C
Revised FY2017 margin 2 050.88 4 746.63 7 455.51
Revised FY2017 GP % 34,5% 40,4% 43,1% 40,5%
1. Gross profit is expected to increase by 13.4% compared to revenue increase of 16.2% indicating overall 1
margin erosion.
2. WS10 is expected to be the largest contributor to overall gross profit, contributing 57.2% of total 1
gross profit.
3. Revenue is expected to increase by 16.2% largely due to higher WS10 volume & price increases 1
4. The expected increase in component costs of 6% is less than the expected selling price increases, which 1
is positive for the GP margin.
5. WS10 GP% is expected to increase slightly in 2017 due to the sales price increase of 12% being 1
above the increase in direct labour, powder and other fixed overhead costs
6. The expected increase in variable production overheads per hour of 8% (259.2 / 240 (5 184 1
/ 21.6)) is less than WS10 price increase which is positive for the GP margin.
7. Direct labour per hour is expected to increase by 10% which is higher than WS5 and WS15 1
sales price increases, leading to margin erosion.
8. Powder costs are expected to increase by 12%, which is also higher than expected WS5 and WS15 sales 1
price increases.
9. The major reason for the expected decline in the gross profit percentage is the higher depreciation
(R3.75m versus R0.48m). 1
10. The increased depreciation charge will reduce the total GP% by 1,9 percentage points ((3,75m 1
– 0,48m) ÷ 169,65m). Therefore had the depreciation charge not increased, the expected total GP% will
be 42,4%
11. The reduction in the machine hours required for WS10 and WS15 from 1,6 and 1,8 hours in FY2016 to 1
1,5 and 1,6 hours in FY 2017 will result in a small increase in GP% of 0,2 percentage points and
0,3 percentage points respectively.
12. Individual product margins are not comparable to FY2016 because of the change in fixed 1
production overhead allocation.
13. The revised GP%s should be used to compare the 2017 performance of the products with 2016 1
performance so that the impact of the change in allocation basis is removed.
14. The machine hours allocation basis will result in a greater proportion of the fixed overheads being 1
allocated to WS5 (28% of total fixed overheads (1,2 hours ÷ 4.3 hours) than the direct labour hours
basis (25% of total fixed overheads (6 hours ÷ 24 hours)
Page 199 of 228

15. Overall, the expected performance is satisfactory given that if the depreciation charge did not 1
increase,the 2017 GP% could be expected to be 42,4% which will be an improvement from FY2016.
16. However,future GP% may be under pressure due to cost increases (labour,electricity,powder etc.) 1
Available 22
Maximum 12
Communication skills - clarity of expression 1
Part (d)
Incremental approach
WS10
Additional units sold (9 750 – 7 500) 2,250 1
Selling price per unit R 13,716.80 1
Powder cost (R26.50 x 180kg) - ‐R 4,770.00 1
Components cost - ‐R 464.50 1
Variable production overheads (R302.30 x 1.5 Mhrs per unit) - ‐R 453.45 1
Sales & marketing costs (2.5%x R13 716.80) - ‐R 342.92 1
Contribution Margin per Unit WS10 R7 685.93
Incremental Approach Focused on Differrential Cash Flows

Workings: Naration Workings Amount
Additional revenue per WS10 (R13 716.80 – (R10 500 x 1.06^3)) R1,211.13 2
Variable prod OH savings p unit
WS5 (R302.30 x (1.2 Mhrs - 1.2 Mhrs)) R0.00 1
WS10 (R302.30 x (1.6 Mhrs - 1.5 Mhrs)) R30.23 1
WS15 (R302.30 x (1.8 Mhrs - 1.6 Mhrs)) R60.46 1
Labour Hours Required
WS5 (3 500u x 6Lhrs) 21 000 1
WS10 (9 750u x 9Lhrs) 87 750 1
WS15 (3 000u x 9Lhrs) 27 000 1
135 750 1C
Available hours 131,320 1
Overtime required (135 750 - 131 320) 4,430 1C
Overtime rate (150% x R121.90) R182.85 1
Amount
Cash flows (000's) SOLUTION: Workings
(R 000's)
Additional contribution WS10 (2 250 x R 7 685.93) 17,293 1C 1P
Additional revenue WS10 (R1 211.13 x 7 500) 9,083 1C 1P
Less sales & marketing costs WS10 (7 500 x (2.5% x (13 716.80 - 12 505.67)) -227 1C 1P
Variable production overheads saved
WS10 (R30.23 x 7 500) 227 2C
Page 200 of 228

WS15 (R60.46 x 3 000) 181 2C

Overtime cost (182.85 x 4 430) 810 1P
Repairs costs saved 1,000 1
Net cash flow 26,748 1C
PV to start of FY2016 (26 748 / (1.15^3)) 17,587 1
Costs that are irrelevant (incurred anyway)

Direct labour 1
Fixed production overheads 1
Depreciation (non cash flow item) 1
Max: 36
Layout 1
Total 37
ALTERNATE SOLUTION (TOTAL APPROACH):
Long route - Total Approach Retain status quo New equipment

Units sold
WS5 3,500 3,500
WS10 7,500 9,750
WS15 3,000 3,000
Selling price
WS5 R 6,928.42 R 6,928.42
WS10 R 12,505.67 R 13,716.80
WS15 R 20,155.39 R 20,155.39
Powder cost per unit
WS5 R 2,120.00 R 2,120.00
WS10 R 4,770.00 R 4,770.00
WS15 R 7,950.00 R 7,950.00
Component cost per unit
WS5 R387.08 R387.08
WS10 R464.50 R464.50
WS15 R535.96 R535.96
Variable production overheads
WS5 R362.76 R362.76
WS10 R483.68 R453.45
WS15 R544.14 R483.68
Sales & Marketing
WS5 173.21 173.21
WS10 312.64 342.92
WS15 503.88 503.88
Contribution per unit
WS5 R3,885.37 R3,885.37
WS10 R 6,474.85 R7,685.93
WS15 R 10,621.41 R10,681.87
Labour Hours Required
Page 201 of 228
WS5 21000
WS10 87750
WS15 27000
135750
Available hours 131,320

Overtime required 4,430
Overtime rate 182.85
Cash flows (000's) SOLUTION Retain status quo New equipment
Contribution (based on per unit) 94,024 120,582
Repairs -1,000
Overtime -810
Net cash flow 93,024 119,772
Incremental cash flow 26,748
PV to start of FY2016 17,587
Costs that are irrelevant (incurred anyway)
Direct labour
Fixed production overheads
Depreciation (non cash flow item)
General Comment: The calculations were difficult in this question and the student needed to be aware
of the impact of the new equipment on each aspect of the product. The new machine had an impact on
each product sol. Further the information in the question was in a few different places and therefore
needed to remain on top of the scenario to get to grips with the potential impact.
Part (e) Discuss the two finance options available to Aquazania to fund the acquisition of the new equipment and
recommend which of these should be pursued by the company. Include any further issues that may need to be
clarified with regard to each option
Criteria Five year loan Preference shares
1. Cost
Effective after tax rate 7.2% Maximum effective rate 8.68% without converting
(note workings)
- Amount correct/tax influence considered 1 - Amount calculated 1
- Could try to negotiate lower rate as Ziggy is 1 - Amount correct 1
current bankers
Less costly 1 More expensive(award mark only once)
2. Capital
Five annual capital payments of R8mil - start end 1 Capital of R40 mil at end of 5 years - Cash flow 1
2017/less cash flexible holiday 5 yr: more flexible
3. Fees
Annual fees (cost/cash flow) 1 Upfront fees by ADF (cost/cash flow) 1
4. Loan Other considerations
(other) - any debt covenants imposed 1
- availability of trade receivables and inventory 1
as security(not already pledged)
- possibility of early settlement/ refinancing/ 1
(and penalties/cost)
- impact on target capital/WAC 1
- possible restrictions on future loans 1
5. Pref
Page 202 of 228

shares Possible conversion to Equity in 5 yr

( other) - expected value of company in 5yrs 1
- additional flexibility/cash flow benefit for not 1
paying back capital
- will dilute effective shareholding 1
Availability of pref sharess to issue
- authorized pref shares exist to issue 1
- does MOI allow creation - Pref shares 1
Possibility of deferring pref div’ –cash flow 1
implications
No upfront security required vs loan 1
Admin of withholding and paying div tax to SARS 1
vs paying interest
Recommendation
Appropriate recommendation 1 Appropriate recommendation
(mark only be awarded once) (mark only be awarded once)
Communication Skills Logical arguments 1
24 Available: Maximum: 12
Part (f) Identify and describe the key business risks that Aquazania faces for the foreseeable future, assuming
they invest in the new manufacturing equipment
1. Outsourcing of manufacturing of smaller units (smaller than 5000 l)
- creates the risk of poor product quality, unreliable supply/dependency risk, etc 1
- these suppliers might start competing with Aquazania – sell directly to the market 1
2. Competitive threat/loss of sales/profitability of business
- demand for WS5 & WS15 is static which might indicate competitive threat or declining market 1
- new competitors entering the market/substitute products putting pressure on selling prices 1
- in economic slowdown people may postpone purchase of items like these 1
- company dependent on only one product line 1
- negative market reaction and loss of sales relating to 12% price increase in WS10 in 2017 1
- possible market saturation/water tanks been installed long time already/cheap Chinese imports/ability of water 1
utilities to provide low cost water supply
3. Investment in new machinery
- machinery might not work as designed/production issues 1
- high capital investment required, might not result in an adequate return on capital 1
- lack (availability) of supplier support/engineering back up 1
- cost of training staff/maintenance 1
- lack of adequate staff with knowledge/expertise to operate machines 1
- raising debt will increase gearing/financial risk/cash flow risk 1
4. Powder cost (raw material) increases
- ability to pass on future price increases to customers 1
- volatility of prices/timing of price increases and planning risks (as result of fluctuating oil prices) 1
- exchange rate risks – weakening rand may result in higher prices over time. 1
- risk of dependency on one supplier (reliability/transport problems, etc) 1
5. Disruption in production
- labour unrest and potential strike action due to current labour environment/overtime work 1
- power shortages/load shedding - loss of production 1
- specific to items in moulding process become unusable/can damage mould and machines 1
- IT related risks 1
- Increase in stock holding costs 1
Page 203 of 228

6. Rising operating costs

- electricity, rent, etolls, general inflationary pressure. 1
- ability to pass on these costs through selling price increases? 1
7. Public liability and customer claims (reputational risk)
- risk of burst tanks or water contamination, etc 1
- environmental impact of plastic – could attract negative public reaction/peruse groups 1
8. Regulatory risk (municipal, health, and safety, labour relations etc) – need to comply with legislation and 1
changes thereof (harvesting and storing of water)
9. Going concern fully motivated 1
10. Consider reliability of forecasts 1
11. Operating leverage (disproportionate fixed costs versus variable costs) 1
12. Other valid risks (need be specific); specify 1
Page 204 of 228

MAF 20
100 Marks
Aero Africa Ltd (‘AA’) is an airline that listed on the Johannesburg Securities Exchange in June 2012.
AA is a decentralised company with the following divisions:
• Aero Africa;
• Aero Africa Mobilechefs (catering division);
• Aero Africa Technical (the technical division which provides aircraft maintenance services); and
• Aero Africa Travel Centres (Aero Africa’s own branded travel agencies).
United Auditors Inc., a firm of Registered Auditors, has been the external auditor of AA for the past ten
years. United Auditors Inc., based in Johannesburg, is currently comprised of three audit partners and 30
trainees. Kingston Jacobs was the audit engagement partner for AA prior to his resignation from United
Auditors Inc. in February 2012.
Governance arrangements
Prior to its listing, all the shares in AA were owned by Mr Marc Brooney, a highly successful South African
businessman. Mr Brooney introduced a policy ten years ago whereby directors on AA’s Board were
appointed for a three-year period only, in order to promote transformation. Since then the only person
who has been reappointed was Ms Luhle Jacobs, who was the information technology director. To date,
Ms Jacobs (wife of Mr Kingston Jacobs) has been a director for ten and a half consecutive years.
Prior to its listing, Mr Brooney consistently had to provide financial support to AA to enable it to continue
as a going concern. Therefore to eliminate the need for on-going financial support of the airline, Mr
Brooney proposed that –
• AA be listed at R50 per share;

• he would own 51% of the shares;
• all directors would receive share options on listing and annually thereafter;
• Mr Jacobs would be appointed as the chief executive officer (CEO); and
• Ms Jacobs would be appointed as the chief operating officer (COO).
Investors did not, however, accept Mr Brooney’s proposed listing price and shareholding. Rather, they
believed that a market related price was R20 per share, and that Mr Brooney should own no more than
40% of the shares. Mr Brooney agreed to these conditions but added a condition of his own, namely that
his shareholding would permit him to appoint the majority of the Board members. This was accepted and
the Memorandum of Incorporation of AA was amended to reflect this.
Once listed and with the approval of Mr Brooney, Kingston and Luhle Jacobs nominated and appointed
the following persons to the Board of Directors for a three-year period:
• Non-executive directors
o Mr Ryan Abbott (22), a qualified aircraft technician;
o Mr Nathan Barclay (70), a retired marketing manager who is now a director of various
companies; and
o Mr Tyler Callan (24), a travel agent.
• Executive director
o Ms Alexia Viljoen (41) CA (SA), as the chief financial officer (CFO).
Page 205 of 228

There are no other directors. An audit committee and remuneration committee were established once
the company had listed. In terms of a Board resolution the internal audit services have been outsourced
to United Auditors Inc.
Within a few months of the listing, AA stated at a press conference that Ms Viljoen had ‘resigned with
immediate effect to pursue personal interests’. In her letter of resignation to the Board of Directors of AA,
Ms Viljoen stated the following:
The high director turnover rate at AA is a consequence of the three-year contract appointments made
while it was a private company. This has resulted in the following practices, which are continuing even
though the company is now a public company and listed:
• Upon their appointment, directors negotiate very large payments that would be payable to them if
they were not reappointed after their three-year term.
• The rigging of tender processes is common practice – tenders are awarded to companies or
individuals who secretly pay incentives to the executive directors.
• There is no focus on employee recruitment, remuneration or incentives, which has resulted in
poorly skilled employees and a generally unhappy employee base.
When the CEO signed the engagement letter for the reappointment of United Auditors Inc. as the
company’s registered auditor despite my reservations, and without the knowledge of the shareholders, I
had no other option but to resign.
Shortly thereafter the public shareholders of AA began raising concerns about the company’s
commitment to compliance with the Companies Act, 2008 and its application of The Revised Code of and
Report on Governance Principles for South Africa (King III).
AA and its flight operations
The core business of the airline is to move people and goods by air. AA operates in three distinct markets:
• Domestic: AA has the most extensive domestic schedule of all airlines operating in the South African
domestic market;
• Regional: AA is one of the leading carriers and serves 20 destinations across the African continent
apart from its South African destinations; and
• International: AA connects South Africa to all continents of the globe via ten direct routes.
AA is segmented on a geographic basis into South Africa, the rest of Africa, Asia, Australia, Europe, the
Middle East, North America and South America. The CEO and COO of AA are currently reviewing the
performance of each of these segments and want a detailed performance review of the South American
segment, because this is one of the very few segments which is performing well.
South American segment
AA has landing rights for a daily flight from South Africa to the international airport at São Paolo, Brazil.
As the agreement entails operating a single landing slot, the airline has one return flight per day on the
Johannesburg to São Paolo (‘JNB-GRU’) route. This route has proved to be very popular among travellers
as AA is the only African airline linking South America to South Africa. AA currently has no other landing
slots in South America.
AA started using two new Airbus A330-200 aircraft for this route at the beginning of the financial year
ending on 31 December 2012. These aircraft represent the latest technology on offer from Airbus in
Europe, with one of their most important features being their fuel efficiency. The aircraft are financed by
Page 206 of 228

means of an operating lease entered into between AA and a European based aviation leasing company.
The aircraft are configured with 36 business class seats and 186 economy class seats.
The financial results for the JNB-GRU route for the year ended 31 December 2012 are summarised below:
Budget Actual
Notes
R R
Passenger sales revenue 1 842 678 400 909 381 200
Cargo services revenue 2 19 600 000 19 800 000
Total revenue 862 278 400 929 181 200
Direct operating expenses (218 305 824) (257 941 320)
Accommodation and refreshment costs 3 (14 625 360) (15 331 680)
Catering 4 (21 491 520) (23 354 240)
Jet fuel costs 5 (163 522 944) (200 163 600)
Navigation, landing and parking fees 6 (18 666 000) (19 091 800)
Indirect operating expenses (474 018 000) (490 931 000)
Aircraft lease costs 7 (42 140 000) (42 570 000)
Electronic data costs 8 (16 278 000) (16 456 000)
Other allocated overheads 9 (415 600 000) (431 905 000)
Operating profit for the period 169 954 576 180 308 880
Notes
1 The budget was based on the following key assumptions:
Number of one-way flights 732

Passenger numbers (average per one-way flight)
Business class 24
Economy class 148
Average one-way fare per passenger
Business class R27 000
Economy class R3 400
An evaluation of the actual results revealed the following:
• Two flights out of Johannesburg had to be cancelled – one for technical reasons and the other due
to low passenger numbers. The passengers booked on these flights as well as those booked on
the return flights from São Paolo, which had to be cancelled as well, were accommodated on AA
flights on other days.
• A total number of 19 656 business class passengers had been carried on the route at an average
one-way fare of R28 250, while 110 656 economy class passengers had been carried on the route
at an average one-way fare of R3 200 per passenger.
It is AA’s policy to price a return ticket at double the one-way fare on this particular route.
2 AA had budgeted to transport a total of 14 000 tonnes of cargo on the JNB-GRU route for the year.
Because AA has standing contracts with their customers in terms of which customers are charged
for the volume of cargo transported, it considers this revenue to be fixed in nature. The actual
quantity of cargo transported was 5% more than the budgeted quantity.
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3 This represents the cost of the subsistence allowance paid to each crew member. A fixed number
of cabin crew works on the Airbus A330-200 to São Paolo and the crew has a three-night stop-over
in São Paolo. The budgeted and actual allowance was US $150 per crew member per day. The
average budgeted exchange rate was US $1: R7,40 while the average actual exchange rate was US
$1 : R7,80.
4 Each passenger is served two meals on each flight and it is airline policy not to carry any extra meals
on a flight. The budgeted cost per business class meal was R180, while the actual cost per business
class meal was R200. The budgeted and actual cost per economy class meal was R70.
5 The standard flying time to and from São Paolo is ten hours. AA budgeted for the aircraft to
consume 4 800 litres of jet fuel per hour at a budgeted price per tonne of R4 654. The actual
quantity of jet fuel used on the route was 33 360 600 litres and the actual average flying time was
9 hours and 45 minutes. Fuel is consumed evenly throughout the flight.
6 These costs are incurred per flight. The budget was based on an average cost per flight of R25 500.
7 This represents the annual operating lease costs of the two aircraft deployed to this segment. The
operating lease payments amount to €4 300 000 for the year. The budget was based on an average
exchange rate of €1 : R9,80.
8 This is the allocated portion of the information technology costs of AA. A review of the allocation
indicates that the correct allocation rates have been used in respect of the budgeted and actual
allocations.
9 This represents the portion of the overheads AA incurred at corporate level and apportioned to the
different business segments and business units.
Performance assessment of the South American segment
AA makes use of variance analysis to evaluate the performance of its segments. The AA group does not
prepare flexed budgets but instead compares actual results to original budgets.
At a recent meeting of the Board of Directors, the COO of AA was asked how critical business class
passengers were to the profitability of the JNB-GRU route. The COO agreed to investigate the issue and
report back at the next meeting.
Jet fuel
The CEO is particularly pleased with AA’s revenue performance in the 2012 financial year given that the
actual results exceeded the budgeted results in tough economic times. However, he is concerned about
jet fuel costs which were much higher than budgeted. AA did not hedge against jet fuel price increases
and exchange rate fluctuations in the 2012 financial year. The cost of jet fuel has increased dramatically
in recent months and the Board of Directors of AA has requested its executive management to investigate
ways in which jet fuel prices could be hedged in future. Jet fuel prices are dependent on the prevailing
Brent crude oil prices in US dollar.
Page 208 of 228

Marks
PART A – REQUIRED
Sub-total Total
(a) Calculate the following variances for the year ended 31 December
2012:
• Passenger sales price variance;
• Passenger sales margin mix variance;
• Passenger sales margin quantity variance;
• Jet fuel price variance; and
• Jet fuel consumption variances. 20 20
For the jet fuel consumption variances, provide as much detail as
possible regarding the differences between budgeted and actual
amounts.
(b) Calculate the number of business class and economy class passengers
that AA needed to transport in the 2012 financial year in order to
break even. 10 10
For the purpose of your calculations, assume the same ratio of

business class passengers to economy class passengers as the actual
ratio for the year.
(c) Analyse and discuss the importance of business class passengers to
the profitability of the JNB-GRU route. 8

(d) Explain how AA could hedge against jet fuel price increases. 6 6
(e) Identify and describe four major risks faced by AA with respect to the
JNB-GRU route. 8

Total for Part A 55
Marks
PART B – REQUIRED
Sub-total Total
(f) Discuss, with reasons, any concerns you have about the current (i.e.
post-listing) corporate governance arrangements of AA. 43
Communication skills – clarity of expression; logical argument 2 45

Total for Part B 45
TOTAL 100
SAICA ITC JAN 2013
Page 209 of 228


This solution consists of two parts.
PART A
Part (a) Calculate variances for the year ended 31 December 2012 Marks
Budget Actual Difference
Business class
Number of passengers (N1) 17 568 19,656 1
Average fare R27 000 R28 250
Catering cost (2 meals per flight) -R360 -R400 ½
Sales margin R26 640 R27 850 1
Economy class
Number of passengers (N1) 108 336 110,656
Average fare R3 400 R3 200
Catering cost (2 meals per flight) -R140 -R140 ½
Sales margin R3 260 R3 060 1
Actual passenger volumes in budgeted quantities:

Flexed budgeted passengers
Business class [13,95% x (19 656 + 110 656)] 18 183 1
Economy class [86,05% x (19 656+110 656)] 112 129 1
Sale margin price variance = AQ x (AP – SP) R2 438 800 ½

Business class [19 656 x (28 250 - 27 000)] R24 570 000 1
Economy class [110 656 x (3 200 - 3 400)] -R22 131 200 1
Sales margin quantity variance = Bud CM x (AQ – SQ) R34 438 740 ½
Business class [(19 656 - 18 183) x R26 640] R39 240 720 1
Economy class [(110 656 - 112 129) x R3 260] -R4 801 980 1
Sales margin mix variance (N2) R34 543 389 ½

Business class [(19 656 – (19 656 + 110 656) x R39 359 961 1
13.95%) x R26 640
Economy class [110 656 - (19 656 + 110 656) x -R4 816 572 1
86.05%) x R3 260]
Jet fuel price variance = AQ x (AP – SP) -R44 903 368 1

[(6 000 - 4 654) x 33 360,6]
Actual fuel cost per tonne (N3) R6 000 ½
Jet fuel consumption variance = SP x (AQused – 1

SQused) R7 369 144
[(33 360,6 - 34 944) x R4 654]
Budgeted fuel (tonnes) (10hrs x 4 800l x 728 flights) 34 944 1
Saving due to four cancelled flights - 1
Saving due to less flying time (N4) 1
Alternative 1: [728 x 4 654 x (0.25) x 4.8] R4 065 734
Saving due to more efficient fuel usage 1
Alternative 1: [728 x 4 654 x 9.75 x (4 800 – 4 700)] R3 303 409
Alternative 2: [728 x 4 654 x 10 x (4 800 – 4 700)] R3 388 112
Page 210 of 228

Available 20
Maximum 20
N1: Budgeted: Business Class = 24 x 732 = 17 568 & Economy Class = 148 x 732 = 108 336. Therefore the
split is 13.95% business class and 86.05% economy class passengers budgeted per flight.
N2: The sales volume/quantity variance is further broken down into the sales mix and sales yield variances.
The sales mix variance compares the actual mix of passengers compared to the budgeted mix of
passengers multiplied by the budgeted CM.
N3: The actual cost R200 163 600 divided by 33 360 600 liters = R6/litre. 1 tonne = 1 000 lites, thus R6 000
per tonne.
N4: Actual fuel usage per hour: 33 360 000 divided by 728 divided by 9.75 = 4 700l per hour used.
An alternative is to calculate the fuel consumption variance not with a flexed budgeted and represent the
flexed element for the 728 flights separately. This is not the recommended approach although both were
marked correct by SAICA. This alternative is presented below:
Option 2 (budgeted not flexed)

Jet fuel consumption variance R8 262 711
[(33 360.6 - 35 136) x R4 654] 1P
Budgeted fuel (tonnes) (10hrs x 4 800l x 732 flights) 35 136 1
Saving due to four cancelled flights
[4 654 x (732 – 728) x 10] x 4.8 R893 568 1
Saving due to less flying time
Alternative 1: [728 x 4 654 x (0.25) x 4.8] R4 065 734 1
Saving due to more efficient fuel usage
Alternative 1: [728 x (4 800 – 4 700) x 9.75 x 4 654] R3 303 409 1
Alternative 2: [728 x 4654 x 10 x (4 800 – 4 700)] R3 388 112
Part (b) Calculate the number of business class and economy class passengers that AA needed
Marks
to transport in 2012 to break even
Business Economy Total
class class
Relative number of passengers (N5) 1,0000 5,6296 1
Contribution per passenger R27 850 R3 060 1
Contribution margin 98,725% 95,625% 1
Fixed costs 705 718 080 ½

Accommodation and refreshments 15 331 680 ½
Jet fuel 200 163 600 ½
Navigation 19 091 800 ½
Aircraft lease costs 42 570 000 ½
Electronic data costs 16 456 000 ½
Allocated overheads 431 905 000 ½
Cargo revenue (N6) -19 800 000 ½
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Breakeven contribution 705 817 080 1

Breakeven number of passengers (FC/CM) 1
705 817 080/[(27 850) + (3 060 x 5,6296)] 15 655,56 88 140,79 1
Round up 15 656 88 141 1
Available 11
Maximum 10
N5: The BE amount of passengers for each type of ticket is required. As you have a sales mix (business and
economy passengers) you need to determine the constant sales mix between the two categories. The
required indicated that the actual sales ratio for the year is to be used to determine the sales mix.
Therefore the sales mix ratio is 19 656 : 110 656 which is 1: 5,6296
This sales mix ratios must then be multiplied by the individual CM/passenger, in the formula FC/cm
perunit. The sales mix ratio can also be determined in terms of a percentage which is 15.08% business
class and 884.92% economy class passengers based on actual.
N6: In order to BE you must have enough Contribution (from passengers) to cover FC i.e. S - VC - FC = 0,
which is the same as S - VC = FC. The question asked for the number of passenger tickets (Economy +
Business) required to break-even. The passenger income is a seperate income stream compared to cargo
revenue.
Therefore if you already have cargo revenue, we do not need the tickets to cover the full fixed costs, as
the cargo revenue will help to take care of some of the fixed costs.
Therefore in order to BE, Sales from passenger tickets less Variable costs from tickets + Cargo revenue -
FC = 0. Re-written: Sales from tickets less Variable costs from tickets = - FC - Cargo revenue
Part (c) Analyse and discuss the importance of business class passengers to the profitability
Marks
of the JNB-GRU route
Total breakeven revenue: 724 333 200 1P
(Business: R442 282 000 + Economy: R282 051 200)
Total breakeven contribution: 705 731 060 1P
(Business: R436 019 600 + Economy: R269 711 460)
Business class passenger contribution/total contribution FY2012 61.8% 1P
Or: Business class passenger revenue/total revenue FY2012 61.1%
Maximum contribution from economy class passengers in FY2012 414 348 480 1P
186 x 728 x 3 060 [contribution calculated in (b)]
Maximum contribution from business class passengers in FY2012 729 892 800 1P
36 x 728 x 27 850 [contribution calculated in (b)]
Margin of safety: (19 565 – 15 656) /19 656 20% 1P
Comments
• Fixed overheads totaled R705,7m in FY2012. If the economy class was 100% full at all 2
times, this would have only contributed R414,3m to overheads.
• On the other hand, if business class was 100% full at all times, this would have more than
covered fixed overheads, given that maximum contribution equates to R729,9m.
• Business class passengers are much higher margin customers, making 9.1 times the 1
contribution per passenger compared to economy class passengers.
• Space configuration allocates 186 seats to economy and 36 to business class (5,17 times 2
ratio). Yet on a contribution basis, business class passengers contribute 9,1 times more
profits.
Page 212 of 228

• The business class contribution was 61,8% of the total contribution in FY2012, a vital 1
contribution to overall profitability.
• The breakeven revenue was R724,3m in FY2012, which was 79,7% of passenger revenue. 1
• It follows that the margin for error is very tight (20% margin of safety) and makes 1
business class passengers’ contribution even more critical.
• Another key issue is the occupancy rates of business class passengers. It is important to 2
understand the demand for business class seats, for example: if certain flights are
regularly sold out for business class passengers, it may make sense to add more business
class seats and sacrifice economy class seats
Available 16
Maximum 8
Part (d) Explain how AA could hedge against jet fuel price increases Mark
Option contracts with banks to limit the maximum fuel price it will have to pay. The option
contract could stipulate either the jet fuel price or Brent crude price. The option premium will 1
represent the maximum cost if fuel prices decline, but will provide a valuable cap on future 1
prices for the duration of the derivative contract.
To reduce the hedging costs a collar could be purchased. This will entail purchasing a call option 1
and selling a put option on jet fuel prices. In this way the option premiums paid and received
will offset one another reducing the overall hedge cost, and also reduce the variability in which 1
the jet fuel price will fluctuate.
Forward contract
The company should enter into forward cover contracts to hedge the US$/ZAR exchange rate. 1
This will not fully hedge against jet fuel price changes but will provide some protection against 1
a strengthening US$, which will indirectly translate into higher fuel prices.
The company should enter into supply contracts with jet fuel suppliers to lock in prices, which 1
would provide certainty as to costs for next 3, 6 or 12 months. 1
Purchase oil futures, where the buyer agrees to buy an underlying asset (jet fuel) at a future date 1
at a price agreed today. 1
Natural hedges (offsetting costs with income in foreign currency)
For example: The sale of tickets to foreigners in their currency (i.e.: dollars, euros). These funds 1
should be kept in foreign accounts in order to pay for fuel in a foreign currency. 1
Use of swaps, where prices are fixed with a supplier but there are actual payments made at the 1
spot rate. Adjustments are then made to decrease/increase the actual price paid in the spot 1
transaction.
AA should purchase jet fuel for future use when prices are favourable. AA will need to finance 1
these inventory holdings but will have certainty re fuel costs. 1
Available 16
Maximum 6
Page 213 of 228

Part (e) Identify & describe 4 major risks faced by AA with respect to the JNB-GRU route Mark
AA has high fixed costs, which means there is a substantial risk of making losses if passenger 1
revenue is insufficient to cover expenses. In FY2012 the breakeven revenue was ~80% of 1
actual revenue which indicates a high risk of future losses (high operating leverage)
AA is the only African airline which offers a flight from South Africa to South America. In the
event that other airlines obtain routes to South America, passenger numbers could decline 1
due to increasing competition. This could have a significant impact on the profitability and 1
sustainability of the JNB-GRU route.
Jet fuel prices are volatile and represent >26% of total operating costs. In the event that fuel 1
prices increase significantly, AA may not be able to increase airfares to cover cost increases, 1
with the result that it would incur operating losses.
Possibility of AA losing the single landing slot to JNB-GRU route due to poor business practices 1
or other uncontrollable factors (e.g.: Brazilian government intervention). Or the possibility 1
that the agreement is not renewed.
The transportation of cargo on the same flights as passengers on this route opens AA up to 1
legal/regulatory risk.
Political risk, as emerging market countries may exhibit political instability. This could reduce the 1
appeal of the country as a business and leisure destination, having a significant impact on the 1
profitability of the JNB-GRU route.
AA only has landing rights for one flight per day. Based on the key assumptions for budget 1
purposes, it will take 4 days to clear the back log of passengers if a flight was cancelled (strikes, 1
weather conditions etc.). AA may lose business if potential passengers do not have confidence
in the airline’s ability to deliver when flights are cancelled.
Available 13
Maximum 8
Communication skills – logical argument; clarity of expression 2
PART B
Part (f) Discuss, with reasons, any concerns you have about the current (i.e. post listing) Marks
corporate governance arrangements of AA
1. Appointment of directors
1.1. There is no chairman of the Board of Directors. The King No chairman Independent 1
Code requires the Board to be chaired by an independent nonexecutive chairman
non-executive director. ½
1.2. With the exception of Mr Barclay and Alexia Viljoen, the Lack of competence &
directors who have been appointed appear to lack the experience 1
necessary competence and experience required of
individuals to serve on the Board – this would be the case Example
for both Kingston and Luhle Jacobs (relevant experience) 1
and Messrs Abbott and Callan (age and experience).
1.3. King Code (2.84) requires that directors do not hold more Too many
directorships than is reasonable for them to exercise due directorships ½
care, skill and diligence. Given that Mr Barclay holds various
directorships and given his age, this could represent a Mr Barclay holds various 1
potential risk for AA. directorships
Page 214 of 228

1.4. According to King Code (2.18) the Board should be of Sufficient size, diversity &
sufficient size, diversity and demographic make-up to be demographic make-up
effective. AA needs to find independent, suitably skilled and ½
demographically acceptable directors. It can be argued that Board likely not
the Board at present is not representative in terms of representative at present
gender and a risk exists that it is also not representative in
terms of race. 1
1.5. In terms of principle 2.17 of the King Code, the Board and Board to appoint
not one of the major shareholders, i.e. Mark Brooney, as is CEO ½
the case at AA, should appoint the chief executive officer. Mark Brooney
currently appoints 1
CEO
1.6. The Board should comprise a balance of power, with a Board’s balance of power
majority of non-executive directors. The majority of the ½
nonexecutive directors should be independent (principle
2.18). However:
1.6.1. Six directors have been appointed, three executive, and No majority of non-
three non-executives – i.e. there is not a majority of executive director at 1
nonexecutives. present
1.6.2. The risk exists that none of the directors appointed to the No independent directors
Board can be considered independent, as they have been – either due to employee/
appointed by the Jacobs’s (i.e. by the CEO and COO) OR that appointment/ material 1
the individual could have been an employee of AA or that customer
the employee works for a material customer of AA. (limit to one)
1.6.3. The desirability of appointing a husband and wife Desirability of appointing

(familiarity threat to objectivity) into two of the three husband & wife
senior executive posts in AA is questionable – as this will (familiarity threatens
undermine effective control and governance (incl. objectivity) 1
segregation of duties and management oversight) and
would be a succession planning nightmare.
1.7. In terms of principle 2.19 of the King Code, directors should Formal process to appoint
be appointed through a formal process – however, with directors Jacobs’ ½
the approval of Mark Brooney, the Jacobs’ nominated the nominated & Brooney
directors approved 1
1.8. In terms of section 66(4) of the Companies Act, at least 50% At least 50% of directors
of the directors must be elected by shareholders – the elected by shareholders ½
appointments have been made without the involvement of Shareholders are not
all the shareholders. involved in election
1
1.8.1. Marc Brooney can only have a right to vote on the Marc Brooney only
appointment of directors in accordance with his entitled to vote in
shareholding. A 40% shareholding will not give him the accordance with his 40% 1
ability to appoint the majority of the Board of directors. The shareholding
other shareholders’ approval should therefore have been
sought in the appointment of the directors.
1.8.2. In addition, the JSE does not permit a minority shareholding JSE - no negative
to exercise negative control as a result of any contract or control contractually 1
agreement. Bonus
2. Remuneration of directors
Page 215 of 228

2.1. There is reason to believe that principle 2.25 of the King Fair & responsible
Code (that companies should remunerate directors and remuneration of directors ½
executives fairly and responsibly) has not been applied & executives
appropriately by AA. For example –
2.1.1. All directors (including the non-executives) will receive Non-execs should receive
share options on listing and annually thereafter - in terms of base fee & attendance
recommended practice of King Code 2.25.4 non-executive fees for meetings 1
directors should not receive share options, but rather a base
fee and attendance fees for meetings.
2.1.2. Principle 2.25.147 (King), states that companies should Remuneration
adopt remuneration policies and practices that create value policies to create long- ½
for the company over the long-term. Given that 3-year term value
appointment terms apply at AA and that directors negotiate
large termination payments if not reappointed indicates a 3-year contracts ≠ LT &
shortcoming in the corporate governance of AA. large termination
payments 1
2.1.3. This indicates a lack of a remuneration policy aligned with Remuneration policy not
the strategy of the company and linked to individual aligned to strategy and
performance (a recommended practice per the King Code). linked to individual 1
performance
2.1.4. A special resolution every two years in terms of which Shareholder approval of
shareholders is required to approve directors’ remuneration directors’ remuneration
(in terms of section 66 of the Companies Act) – the required 1
shareholders need to approve the directors’ remuneration.
2.1.5. Principle 2.27.186 (King Code) stipulates that the Shareholders entitled to
remuneration policy be discussed at the annual general express view at AGM 1
meeting with shareholders being able to express their views
on said policy.
2.1.6. Principle 2.25.150 (King), states that the remuneration Remuneration committee
committee should assist the Board in setting and to assist Board 1
administering remuneration policies across the company,
including for directors.
2.1.7. Principle 2.25.165 (King Code) – directors should not be paid No balloon payments
large (balloon) severance packages. Hence the negotiation Ethical dilemma – ½
of large severance benefits being negotiated in advance severance packages at AA
creates an ethical dilemma. 1
3. Succession planning and rotation of directors

3.1. While appointing directors on three-year contracts is Succession planning ito
acceptable, the previous practice of replacing virtually all King ½
directors on the termination of contracts is of concern.
In terms of recommended practice 2.17.5 of the King Code, 3-yr contracts with all
the Board should ensure that there is succession planning directors being replaced ≠
for the CEO and other senior executives and officers. succession planning 1
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3.2. Recommended practice 2.18.6 of the King Code states that No rotation policy
at least one third of the non-executive directors should (King) Directors’ contracts ½
rotate every year (independence of the non-execs terminate simultaneously
threatened). If all directors’ contracts terminate after three 1
years then no rotation policy exists at AA.
4. Board Committees
4.1. In terms of recommended practice 2.23.6 of the King Code King = risk committee
the company should also have established a risk committee No risk committee at ½
(in addition to the audit and remuneration committees) – present
there is no risk committee at present. 1
4.2. Moreover, in terms of recommended practice 2.19.1 of the Nomination committee
King Code, the company should have established a assist with process of
nomination committee to assist with the process of identifying Board ½
identifying suitable Board members – which does not
appear to have happened (e.g. the Board members were Jacobs’ nominate & Mr
‘nominated’ by the Mark Brooney and the Jacob’s). Brooney approves the
Board’s appointment 1
4.3. In terms of Regulation 43 of the Companies Regulations, Regulation 42 = S

2011, every listed public company (such as AA) should & E Committee ½
establish a social and ethics committee within 12 months of No Social and Ethics
the effective date of this regulation – however, no such Committee established 1
committee appears to have been established.
4.4. Given that there are no independent directors on the Board
–
4.4.1. The remuneration committee will not be adequately Remuneration committee
constituted by at least the majority of independent – no
nonexecutive directors – as recommended by par. 2.23.7 of majority of independent 1
the King Code. nonexecutive directors
4.4.2. The audit committee should be comprised exclusively of Audit Committee should
independent directors (minimum of three) – such an only have independent 1
arrangement would be contrary to par. 3.2 of the King Code. director
4.4.3. Should any of the current independent directors be elected Any of current
as chairperson of the Board, the audit committee would no independent directors
longer comply with the aforementioned requirement since become CEO – Audit 1
the chairperson may not be a member of the audit Committee (AC) problem
committee.
4.5. Regulation 42 prescribes that at least one-third of the Skills required by

members of an audit committee must have academic Audit Committee ½
qualifications, experience in economics, law, corporate
governance, finance, accounting, commerce, industry, Potentially lacking at
public affairs or human resource management – this could present as… 1
be an issue for AA (only Mr Barclay potentially has these
skills).
Page 217 of 228

4.6. The audit committee, although established, is not effective AC played no role in
as it appears to have played no role in the reappointment of reappointment of ext 1
United Auditors (in terms of King). auditors
4.6.1. The Committee is required to nominate the external auditor Section 94 ½
for appointment and approve the terms of engagement AC responsible for
(per section 94 of Companies Act). According to part 3.9 nominating & 1
of the King Code, the committee is responsible for terms of engagement
recommending the appointment of external auditors to the King (3.9)
Board – this does not appear to have happened.. AC to recommend ½
appointment to
Board 1
4.7. This committee is required to monitor and report on the AC to monitor and
independence of the external auditor – however, there are report on independence of
significant threats to the auditor’s independence which do EA ½
not appear to have been addressed (King 3.9.3). Threats to independence
at
AA 1
4.7.1. In terms of the SAICA Code of Professional Conduct (ET Cooling off period 1
290.139), in a situation where a key audit partner joins the
audit client that is a public interest entity (such as AA),
independence would be compromised given that the client
has not yet issued audited financial statements covering a
period of not less than 12 Months (cooling off period is
required).
4.8. In terms of King 3.9.4 the audit committee is required to AC should define policy for
define a policy for non-audit services by the auditor and EA to render non-audit
approve contracts for the external audit firm to render services ½
nonaudit services – however, the outsourcing of the AC not involved in
internal audit services appears to have been done without outsourcing of IAF
reference to the audit committee (it was done in terms of a 1
Board resolution).
4.9. In terms of section 290.200 of the SAICA Code of SAICA CPC ½
Professional Conduct, the appointment of United Auditors
to render internal audit services is of concern as the Code AA is public interest entity
states that for a public interest entity (such as AA), the – cannot perform IAF & 1
services shall exclude controls and systems relating to external audit
financial reporting.
4.10. King requires that the internal audit function be IAF to be independent of
independent of management. Given that the internal audit management ½
function has been outsourced to United Inc. (small firm)
where Mr Jacobs (now the CEO of AA) was a partner, would Familiarity – CEO
result in the independence of the internal audit function & audit firm
being questioned (familiarity). 1
4.11. The committee is required to review the quality and Review quality and
effectiveness of the external audit process – however, the effectiveness of EA ½
competence of the external audit firm to perform the
engagement is in doubt (King Code, par. 3.9.6). It is doubtful Doubts regarding capacity
whether three partners and 30 trainees (capacity) will of small
satisfy the ISQC 1 skills and competence requirements given audit firm 1
Page 218 of 228

that AA is a fairly large listed client, with complex

operations.
4.12. The audit committee needs to ensure that the JSE approves JSE to approve
the appointment of the audit firm – given United Inc.’s appointment – problem in 1
limited resources, this is debatable. case of AA Bonus
5. In terms of the Companies Act (section 90), the auditor Section 90 – shareholders
must be appointed at every annual general meeting of the to ½
company (i.e. by the shareholders). Only if no such appoint EA
appointment was made, can the Board of directors
proceed to make an appointment. The fact that the No shareholder
appointment was made without the knowledge of the appointment in case of AA 1
shareholders is therefore of concern.
6. The manner in which Alexia Viljoen’s resignation was
communicated gives rise to the following concerns:
6.1. The communication was done by way of a press conference SENS announcement vs
rather than a SENS announcement – which is inconsistent press conference 1
with the JSE Listings Requirements. Bonus
6.2. It is doubtful whether the communication satisfies principle Transparent & effective
8.5 of the King Code which requires transparent and communication ½
effective communication with stakeholders in order to build
and maintain their confidence – specifically, it appears that Alexis’ reason for resigning
the reason cited for Alexia’s resignation (‘to pursue personal at odds with acceptance of
interests’) is at odds with her recent acceptance of the appointment 1
appointment. The information was selectively released.
7. Given the directors’ conduct generally, there is reason to Not meeting fiduciary
believe that they are acting contrary to their statutory duties 1
fiduciary duties. For example:
7.1. In terms of section 76(2) of the Companies Act, a director Not use position for own
must not use the position as a director to gain an advantage gain Large payments/ ½
for him/herself – yet directors negotiate large payments on tender rigging (limit to
the termination of their contracts, and they participate in one)
the rigging of tender processes. 1
7.2. In terms of section 76(3) of the Companies Act, directors Act in good faith in
must exercise the powers and functions of a director in best interests of company ½
good faith, in the best interests of the company and with a Not happening given lack
reasonable degree of care and skill – however, failing of focus on employees/
to focus on the employees (in an industry where skills are tender rigging (limit to
in short supply (e.g. pilots and engineers)) and participating one) 1
the rigging of tenders, is not consistent with the statutory
requirements.
Page 219 of 228

7.3. Principle 2.14 (King) requires the board and directors of the King also requires directors
company to act in the best interests of the company, which to act in
appears not to be happening given the illegal tendering best interests of company ½
process and large severance packages paid. Not happening given large
severance packages &
tender rigging (limit to
one)
1
8. It is doubtful whether the executive directors who Need to disclose

‘secretly’ received incentives from the recipients of interest in contracts 1
tenders disclosed their interests in the contracts prior to
entering into these contracts in the manner required by
section 75 of the Companies Act.
8.1. By conducting themselves in this manner, the directors
would also not be complying with the following principles of
the King Code:
8.1.1. The Board should ensure that the company’s ethics are Effective management of
managed effectively (principle 1.3). According to the King ethics ½
Code, ‘Good corporate governance requires that the Board Board to build & sustain
takes responsibility for building and sustaining an ethical ethical corporate culture
corporate culture in the company’ the action breaches this 1
requirement since the Board is the problem.
8.1.2. The Board should ensure that the company complies Compliance with
with applicable laws (principle 6.1) – such as the applicable laws – concern 1
Prevention and Combatting of Corrupt Activities Act at AA
(PRECCA). 1
Alternatively: principle 2.9 also requires compliance PRECCA Bonus
9. The fact that there is poor corporate governance in place Fraud resulting from lack
especially from the leadership could result in fraud in other of corporate governance
parts of the company. This is more likely when employees 1
are dissatisfied.
10. Now that Alexia Viljoen has resigned, AA is operating King = CFO ½
without a financial director. King (principle 2.18.5) requires No CFO since the
the company to have a CEO and chief financial officer resignation of Alexia 1
indicating non-compliance with King.
11. There is doubt as to whether or not a company secretary Potentially no company
has been appointed which results in non-compliance with secretary 1
the
Companies Act.
12. Given the fact that the directors have contravened the Companies Act
Companies Act, the directors need to be aware that they contravened Personal legal ½
can be held personally liable in such instances where liability on part of directors
breaches in complying with the Companies Act have taken 1
place.
13. From the perspective of the external auditors of AA, they Reportable
would need to consider the requirements of the Audit irregularity exists as will be 1
Profession Act in respect of the tender rigging qualifying as proved below
a reportable irregularity which they would need to report
on.
Page 220 of 228

13.1. An unlawful act has occurred through the tender rigging as Unlawful act (must link to
well as non-compliance with various statues (refer above). act) 1
13.2. This act has been committed by management (the Board of Committed by Board
Directors) 1
13.3. Material breach of fiduciary duty (Section 76 – best interest Fiduciary duty OR
of company) has occurred OR Material financial loss (tender Financial loss OR 1
rigging and severance packages) has occurred for the Fraud
company OR Fraudulent act (tender rigging)
14. Given the relevant concerns identified one can conclude AA is not a responsible 1
that AA is not a responsible corporate citizen. corporate citizen
15. Any other valid relevant point (limited to) 1

Available 75½
Maximum 43
Communication skills – clarity of expression; logical argumentation 2
Total for Part (f) 45
Page 221 of 228

MAF 21
50 Marks
All amounts exclude value added tax.
Tip Top Transport Ltd (‘TTT’) is a logistics group listed on the Johannesburg Securities Exchange. TTT has
the following operating divisions:
Division Focus area

Commercial Goods This division services the retail industry and is responsible for the transport of
fast moving consumable goods.
Fuel Logistics This division transports petrol and diesel from refineries and oil depots to
forecourts of fuel retailers.
Agricultural Logistics This division services the agricultural industry by transporting wheat, maize,
rice, sunflower seeds, sugar and flour.
FastLiner This division operates a fleet of luxury buses which transports paying
customers between major cities in South Africa.
Servicing and This division is responsible for all servicing and maintenance of TTT’s trucks and
Maintenance buses.
Return on investment (ROI) is one of the group’s key performance measures and divisional management
is incentivised on the basis of divisional ROI. TTT’s overall ROI has declined in recent years mainly as a
result of the challenging economic conditions and operating cost increases. The operating divisions have
been asked to propose initiatives to improve ROI as part of the group’s efforts to enhance shareholder
value and returns.
TTT expects each operating division to generate a ROI in excess of 25% on a before tax basis. TTT’s
operating divisions are also expected to generate returns in excess of the group’s adjusted weighted
average cost of capital (WACC) of 20% when making capital investments. TTT’s actual WACC is lower than
20%. The operating divisions do not have control over the payment of income tax and therefore tax cash
flows are ignored when evaluating returns. As a result, operating divisions are given a higher hurdle rate
to compensate for ignoring income tax in capital investment decision making.
Commercial Goods Division: Replacement of truck fleet and budgeted performance
The Commercial Goods Division (‘CGD’) is planning to replace its entire fleet of 70 trucks in the financial
year commencing on 1 January 2014. The fleet is standardised and each new truck is forecast to cost
R900 000. CGD has purchased all its trucks from the VIS Transport Group (‘VIS’) in the past and has been
negotiating with VIS about the replacement of the fleet in 2014. VIS has agreed to sell the trucks to CGD
and arrange financing for CGD as set out below:
• VIS will deliver all 70 trucks to CGD on 1 January 2014.

• CGD is to pay an upfront deposit of R180 000 for each truck and the balance of the purchase
consideration, namely R720 000 per truck, is to be financed on the following basis:
o CGD is to pay 60 equal monthly payments of R15 297,87 per truck commencing on
31 January 2014; and
o VIS undertakes to purchase the trucks for a consideration of R225 000 each on
31 December 2018. However, the trucks will need to be maintained and serviced on a
regular basis and have travelled no more than 600 000 km in order for CGD to exercise
Page 222 of 228

this guaranteed buyback option. In the event that CGD does not meet these criteria for
any truck or chooses not to return the trucks, the balance of the capital outstanding must
be settled on 31 December 2018.
The proposed acquisition of the 70 trucks is a significant capital investment for CGD and the TTT group.
CGD has prepared an analysis of the proposed capital expenditure and the average operating performance
of each truck, which is summarised in the table below, for consideration and approval by TTT’s Board of
Directors.
You may assume that the mathematical calculations in the average profitability analysis table below are
correct.
Year ending 31 December 2014 2015 2016 2017 2018

Average profitability analysis
Notes R R R R R
per truck
Total revenue 1 404 000 1 466 600 1 609 200 1 701 000 1 792 800
Revenue 1 1 080 000 1 115 600 1 231 200 1 296 000 1 360 800
Fuel recovery charges 2 324 000 351 000 378 000 405 000 432 000
Operating costs (1 312 741) (1 380 207) (1 446 172) (1 511 807) (1 579 084)
Fuel costs 3 (360 000) (390 000) (420 000) (450 000) (480 000)
Insurance – vehicles 4 (45 000) (47 250) (49 615) (52 095) (54 700)
Other insurance costs 4 (65 000) (68 250) (71 665) (75 250) (79 015)
Driver costs 5 (120 000) (128 400) (137 400) (147 000) (157 200)
Back-up driver costs 5 (60 000) (64 200) (68 700) (73 500) (78 500)
Servicing and maintenance 6 (180 000) (192 000) (203 000) (213 000) (223 000)
Allocated overheads 7 (125 000) (135 000) (145 800) (157 500) (170 100)
Other operating costs 8 (156 000) (165 600) (174 000) (182 400) (192 000)
Depreciation 9 (135 000) (135 000) (135 000) (135 000) (135 000)
Financing costs 10 (66 741) (54 507) (40 992) (26 062) (9 569)
Operating profit per truck 11 91 259 86 393 163 028 189 193 213 716
Notes
1 Each truck travels on average 108 000 km per annum transporting customer goods (‘productive
km’). It is budgeted that customers will pay a fixed fee of R10 per km, excluding fuel costs, to CGD
in the 2014 financial year for the transportation of goods. Although the fee per km will escalate in
future years, the average productive km per truck travelled is assumed to be 108 000 km in each
year of the budgeted period.
2 Fuel costs incurred are billed separately to customers. All routes have been mapped and standard
distances agreed with customers. The average fuel consumed per km travelled by trucks on each
route is also agreed with customers. CGD invoices customers the prevailing fuel cost per litre,
multiplied by the pre-agreed number of litres consumed per km on routes. CGD does not mark up
fuel costs when invoicing customers.
3 For a variety of reasons, fuel costs are forecast to be higher than that invoiced to customers. The
most common reason is that drivers deviate from pre-agreed routes or take detours. In addition
trucks have to travel from CGD depots to the TTT Servicing and Maintenance Division’s workshops
Page 223 of 228

on a regular basis for servicing, repairs and maintenance. Each truck is forecast to travel an average
of 120 000 km annually, which is consistent with distances travelled during prior years.
4 CGD insures trucks against theft and accident damage which is budgeted to cost R45 000 per truck
in the 2014 financial year. In line with customer requirements, CGD also insures itself against
potential liability in the event of environmental damage as well as third party claims for injury and
consequential losses suffered as a result of negligence of truck drivers, mechanical breakdown or
truck malfunction. This insurance is estimated to amount to R65 000 per truck in the 2014 financial
year.
5 Drivers are budgeted to be paid R120 000 per annum on a cost to company basis in the 2014
financial year. Their salaries are expected to increase by approximately 7% per annum thereafter.
There is a pool of back-up drivers on standby, in the event that any of the primary drivers become
ill or to accompany drivers on long-distance trips. Back-up drivers are full-time employees of CGD.
6 Each truck is required to be serviced after every 10 000 km travelled. The Servicing and
Maintenance Division marks up the costs of servicing and maintaining the CGD trucks by 50% in
order to generate a reasonable return on its assets and efforts.
7 CGD analyses costs and allocates these to trucks using activity based costing principles. The
allocated costs in the budget represent divisional expenses incurred in dealing with customers (e.g.
scheduling deliveries, customer service, complaints and queries), invoicing and collecting amounts
from customers, human resource management, and general management and control of
operations.
8 Other operating costs relating to the operation of trucks are variable in nature.
9 The acquisition costs of trucks less estimated residual values are depreciated evenly over five years.
10 Financing costs have been correctly calculated on a monthly basis for the period 2014 to 2018 based
on the proposed agreement with VIS.
11 Operating profit is analysed before taxation as CGD has no control over group tax planning.
CGD: Owner driver proposal
The CGD management is considering whether an ‘owner driver’ scheme be implemented instead of
acquiring the 70 new trucks in 2014. The key rationale for the scheme is to empower drivers to become
entrepreneurs and generate wealth.
CGD’s management has researched the owner driver scheme implications and has made the following
proposals:
(a) Drivers would acquire the new trucks directly from VIS on 1 January 2014 on the same terms and
conditions negotiated between CGD and VIS. In addition the Azania Development Bank has agreed
to guarantee the obligations of each driver to VIS and will stand surety in favour of VIS in the event
that drivers default on obligations to VIS.
(b) Drivers will cease to be employees of TTT on 31 December 2013 and instead enter into a contractual
relationship with CGD to perform transport services on behalf of CGD.
Page 224 of 228

(c) Drivers will be paid a fixed fee (excluding fuel costs) per km travelled as per agreed transport routes
and distances. Fuel costs will be recovered and invoiced separately by drivers to CGD on the same
basis as agreed between CGD and its customers. The proposed fixed fees are as follows:
Fees payable by CGD to owner

2014 2015 2016 2017 2018
drivers
Fee per km travelled in
transporting customer goods R8,00 R8,35 R8,70 R9,05 R9,40
(d) Drivers will contractually agree to have their trucks serviced and maintained by the Servicing and
Maintenance Division of TTT on the same basis as previously undertaken by CGD. During the period
2014 to 2018 the Servicing and Maintenance Division will invoice drivers for services rendered on
the same basis as set out in the average profitability analysis per truck.
(e) Drivers will take full responsibility for all operating costs of trucks except for other insurance costs
and allocated overheads set out in the average profitability analysis per truck.
If the owner driver scheme is introduced, drivers are expected to travel an average total of 113 400 km
per annum per truck instead of the 120 000 km assumed in the average profitability analysis per truck.
This is because there is likely to be an increased focus by drivers on efficiency and improving operating
performance. The average productive km travelled per truck in the transport of CGD customers’ goods
will, however, remain at 108 000 km per annum for the period 2014 to 2018.
Drivers will need the services of accountants on an outsourced basis to handle the invoicing and
administration of their businesses. It is estimated that this will cost drivers R12 000 per annum in 2014,
escalating by 5% per annum thereafter.
CGD estimates that its allocated overheads will drop by 80% following the introduction of the owner driver
scheme.
Marks
QUESTION – REQUIRED Sub-
Total
total
(a) Calculate the forecast ROI per truck used by CGD for each year over the period
2014 to 2018 and the average ROI over the period, assuming that the division
acquires the 70 trucks and does not implement the owner driver scheme.
6 6
(b) Identify and explain the potential merits and pitfalls of using ROI as a measure to
evaluate the performance of management. 9

(c) Calculate the expected internal rate of return (IRR) and net present value (NPV)
per truck of CGD over the period 2014 to 2018, assuming that the division acquires
the 70 trucks and does not implement the owner driver scheme. 10 10
(d) Discuss the strategic considerations and factors that TTT should consider in
evaluating whether to implement the owner driver scheme in CGD. 12

(e) Evaluate whether the drivers will be financially better off in 2015 following the
introduction of the owner driver scheme by CGD. 10 10
TOTAL 50
Page 225 of 228


Part (a) 2014 2015 2016 2017 2018
Operating profit 91 259 86 393 163 028 189 193 213 716 1
Financing costs (added back) 66 741 54 507 40 992 26 062 9 569 1
Adjusted Operating Profit 158 000 140 900 204 020 215 255 223 285
NBV Truck (year-end) (N1) 765 000 630 000 495 000 360 000 225 000 1C
NBV Truck (average) (N2) 832 500 697 500 562 500 427 500 292 500 1P
NBV Truck (opening balances) 900 000 765 000 630 000 495 000 360 000
Discussion re replacement cost more 1
appropriate
ROI (year-end) 20.7% 22.4% 41.2% 59.8% 99.2% 1C
ROI (Ave NBV) 18.9% 20.2% 36.3% 50.4% 76.3%
ROI (Opening balances) 17.6% 18.4% 32.4% 43.5% 62.0%
Average ROI over period (N3) 38.0% 1C
Maximum 6
N1: The Net book value is based on accounting principles. Therefore the NBV must be calculated annually
taking account of the residual value and depreciation. Depreciation per annum is (900 000 – 225 000)/5 =
135 000 per annum.
N2: The average NBV is (OB + CB)/2
N3: The average ROI equals the average operating profit per annum / average NBV trucks based on year-
end values. The amounts were determined by adding the operating profit and NBV year-end separately
and then divided by 5.
Part (b):
Pitfalls
Ignores the time value of money – perhaps mitigated if replacement cost of assets used 2
ROI results can vary depending on which valuation basis used for assets (opening or average or 1
closing balances)
Positive NPV projects may be rejected for example, ROI < 25% but > WACC of 20% 2
Many projects take time to deliver attractive returns. Focusing on ROI in the short term may result
in viable long term projects being rejected (ROI < 25% in 2014 & 2015) 2
Purely a financial measure and ignores qualitative issues 1
ROI does not take into account the risks of a division/project in measurement/evaluation of
performance 2
ROI as a evaluation tool may lead to non-congruent behavior; divisions may not act in best interests
of group as a whole
Accounting treatment of assets may impact on ROI eg. impairment of assets could lead to higher
ROI in future 2
ROI not suited to service based industries as capital investment may be limited 1
Divisions may be evaluated based on non-controllable costs if these included in ROI 1
Merits
Non accountants able to understand ratio – user friendly 1
Enables easy comparison of performance between divisions & external benchmarking 1
Linked to assets under control of division which may be more informative than simply evaluating
profits and cash flows in isolation 2
Widely used in practise 1
Maximum 10
Page 226 of 228

Part (c) Calculate the expected IRR and NPV per truck over the period 2014– 2018 Marks
2013 2014 2015 2016 2017 2018
Acquisition of trucks (900 000) 1
Sale of truck 225 000 1
Discussion re R225k; risk that value not received or discussion re < 600,000km 1
Operating profit (given) 91 259 86 393 163 028 189 193 213 716 1
Depreciation (non-cash) 135 000 135 000 135 000 135 000 135 000 1
Finance charges (not 66 741 54 507 40 992 26 062 9 569 1
part of the investment
decision)
Servicing & maintenance 1P
mark up (inter-co) (N4) 60 000 64 000 67 667 71 000 74 333 1C
Net cash flows before tax (900 000) 353 000 339 900 406 687 421 255 657 618 1
IRR 34.3% 1
NPV (20%) (zero if tax 332 993 1
included in capital
budget)
Debate re allocated O/H’s regarding whether it is differential 1
Available 12
Maximum 10
N4: The service and maintenance mark-up is inter-company and should be removed. The actual costs
incurred for the service are relevant and differential. Amount in 2014 = R180 000 / 150% = R120 000is the
original cost therefore the mark-up is R60 000 (180 – 120 which is inter-company). The mark-up is
thereafter calculated in the same manner each year.
Part (d) Discuss the strategic considerations and factors that TTT should consider in
evaluating whether to implement the owner-driver scheme
Financial impact on TTT ?
o Will Group need to downscale operations? 1
o Impact on group profit? 1
o TTT may have more cash available to pursue other opportunities/WACC impact 1
o Allocated overheads recovered from other divisions? 1
Is scheme is line with overall group strategy re outsourcing of logistics? 1

Will owner driver scheme be implemented in other divisions? 1
TTT may not be able to control service levels of drivers & delivery schedules given they are not
employees 2
Drivers may operate more effectively and efficiently – goal congruence. Drivers’ financial well being
dependent on limiting costs and being efficient 2
Strategic outsourcing may be positively seen as community upliftment/empowerment 1
Drivers may offer services directly to end customers at lower rates (undercut) 1
Risk that drivers may service competitors? 1
HR implications
o Trade unions reaction? 1
o Will all drivers elect to participate? 1
o Easier to terminate services of contractors in future than employees o Retrenchment 1
costs? 1
Fixed costs now become variable expenses, changing operating leverage 2
Will drivers be able to afford R180k deposit to VIS? TTT may have to assist financially? 2
Page 227 of 228

Risk that drivers unable to pay for regular maintenance &/or vehicle insurance costs of trucks
resulting in increased breakdowns and unhappy end customers 2
Owner driver scheme sustainable in the long run? Renewed in 2018? 1
Who will bear any costs of Azania Development Bank? 1
What will transpire in event of death or disability of drivers post scheme? 1
Branding of trucks? Free advertising however, poor driving/dirty trucks could hurt TTT image 1
Logical argument 1
Maximum 14
Part (e) Evaluate whether the drivers will be financially better off in 2015 if an owner-
Marks
driver scheme is implemented
2015
Revenue [108,000 x R8.35] 901 800 1
Fuel recovery at cost [R3.25 per KM x 108,000km] 351 000 ½
Fuel costs total incurred [R390,000 ÷ 120,000km = R3.25 per KM x 113,400km] (368 550) 2
Servicing & maintenance [192,000 ÷ (120,000/10,000)] = R16k per service] (176 000) 2
Then [R16k per service x 11 services (113 400KM ÷ 10 000KM)]
Vehicle insurance (47 250) ½
Back-up driver costs (64 200) ½
Debate whether full cost of back up driver required 1
Other operating costs (165 600) ½
Accounting fees (12 600) 1
VIS repayments [R15 297.87 per month x 12 months for 1 truck] (183 574) 1
Cash available to pay own salary 235 026 1
1P
Previously salary 128 400
Conclusion: The drivers will be better off if the owner-driver scheme is
implemented. 1
Negative mark if Depreciation, Allocated Overheads, other insurance or TTT -1
revenue included in above analysis; or wrong year used 2014 or 2016
Tax implications for drivers? 1
Impact on driver’s NAV (owns asset & liability) 1
Available 15
Maximum 10
TOTAL MARKS FOR QUESTION 50
Page 228 of 228

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ITC PREPARATORY COURSE

Management Accounting and

MAF 19 Aquazania Cost allocation Calculations: C

Ignore value-added tax (VAT)

The following are the key benefits to Ubex users:

Arrangements between Mr Umakhi and the drivers

Forecast revenue per vehicle

Annual revenue forecast per vehicle in year 1

Vehicle operating costs

Forecast vehicle operating costs in year 1

Monthly reporting and variance analysis

Potential returns from venture

MAF 01- Suggested Solution

3. Revenue versus budget per vehicle 1

Part (d) Estimate the potential IRR and NPV Marks

5. Non-compliance with legal requirements, for example 1

Tutorial Commentary: MAF01

2. In what respect candidates’ answers are considered to fall short of requirements.

3. Common mistakes made by candidates

4. Areas that the candidates handled well

As expected, most candidates performed well in part (a).

5. Specific comments on sections of the question

Mining of phosphate rock

1. Drilling and blasting;

2. Crushing and milling of the ore;

Processing of phosphate rock concentrate

Financial year Production costs Total number of Total plant

2013 22 656 000 43 1 180 000

New revenue stream

1. Cost-based transfer price; or

Estimated average exchange rates for FY2014

• The sales value method; and

ii. Critically discuss the results of each method in part (i) 5

ii. Market-based transfer price.

MAF 02 – Suggested solution

AMANDLA ENGINEERING (PTY) LTD

Year ended 28 February 2009 Budget Actual

Year ended 28 February 2009 Budget Actual

Costing and pricing of customer orders

Customer Gideon Enterprises Ltd

Manufacturing costing sheet US $ R

All amounts exclude VAT.

Presentation marks: Arrangement and layout, clarity of explanation, logical

MAF 03 – Suggested solution

Hourly wage rates P.Personnel Electricians

Actual [(294 400) x (X)] + [(11 600) x R 44.00 R 132.00 2

Actual wage rate versus budget 10.0% 10.0% 1

Direct labour hours per genset P.Personnel Electricians

Further calculations continue on the next page.

Variances from flexed budget Alternative 1 Alternative 2

Tutorial Commentary: MAF03

Applewood Electronics, a division of Elgin Corporation, manufacturers two flat-screen television

Monarch Regal Total

Units produced & sold 22,000 4,000

Unit costs for Monarch and Regal are as follows:

Total Units of the Cost-Allocation Base

Machine setups (number of setups) R750,000 16,000 14,000 30,000

3 Advise Susan Bennett on the most ethical course of action to be taken 4

MAF 04 – Suggested solution

Soldering R942,000  1,570,000 = R0.60 per solder point .5

Calculation of Costs of each Model under Activity-Based Costing

Monarch Regal Total