Professional Documents
Culture Documents
Part a)
Note: refer to excel workings for details on calculations
Historic Projected
2019 2020 2021 2022 2023 2024
Inventory days (based on COS) 127 109 90 86 87 93
Inventory days (based on Sales) 65 65 45 45 45 45
Inventory %Sales 17.8% 17.9% 12.3% 12.3% 12.3% 12.3%
Accounts receivable days 37 47 30 30 30 30
Accounts receivable %Sales 10.3% 12.9% 8.2% 8.2% 8.2% 8.2%
Accounts payable days (based on COS) 59 60 120 115 116 124
Accounts payable days (based on sales) 30 36 60 60 60 60
Accounts payable %Sales 8.3% 9.9% 16.5% 16.5% 16.4% 16.4%
Cash % sales 1.5% 2.4% 1.5% 1.5% 1.5% 1.5%
Working capital cash-to-cash cycle 105 96 -1 1 1 -1
Historically Respect has followed a very conservative working capital policy when considering its
investment in inventory and debtors (current assets), most notably inventory days being 65 days
based on Sales (in excess of 100 days based on COS) which is 44% [(65 – 45) / 45] more stock than
industry averages.
All working capital ratios for inventory, accounts receivable and accounts payable are considered
worse than the industry benchmarks which at face value is concerning unless there is a specific
strategic or operational reason/benefit obtained by Respect for holding more stock, extending more
credit to customers and/or paying supplier accounts sooner than its peers in the industry. In
addition, unnecessary excess cash has also been retained when considering the 2.4% cash
percentage of sales in comparison to the industry average of around 1.5%.
The above will all have a negative impact on Respect’s ROI in comparison to other companies in its
industry that have better working capital ratios (used in Respect’s forecasted figures) due to its
greater investment in net working capital for the same level of profitability. There might even be
direct negative consequences of this on profitability such as stock obsolescence (although this is not
likely for granite) and increased bad debts or indirectly through financing costs.
Notably inventory (based on COS, which is conceptually a more accurate calculation as inventory and
COS are directly comparable and not distorted by possible margin changes) seems to have improved
in 2020 compared to 2019 with inventory days decreasing by 18 days which is encouraging. Accounts
payable days has not changed substantively between 2020 and 2019; however, a concern is that the
accounts receivable days increase by 10 days from 37 days in 2019 to 47 days in 2020. This could be
the effect of COVID19 on the market generally supported by the decrease in sales. It is also possible
that the accounts receivable balance in 2020 includes amounts that should have been written off as
bad debt.
The reasons for movements in working capital ratios need to be investigated in order to be better
understood. It is also possible that Respect’s year end balances do not reflect the average
outstanding balances during the year due to the seasonal increase in inventory and/or sales towards
the end of the year.
It also needs to be understood how Respect intends achieving the industry norms going forward if
this has not previously been done. The company’s working capital projections are very aggressive for
inventory, debtors and creditors; with an overall substantive decrease in the working capital cash-to-
cash cycle to close to zero (0) days in 2021 to 2024. This will require managing stock better, chasing
debtors and enforcing stricter repayment terms as well as negotiating longer payment terms with
suppliers and/or delaying payment to suppliers. All of this could result in additional costs and it is not
clear if these costs have been factored into the forecasted profit figures.
No information is provided about Respect’s discount policy for early settlement relating to credit
sales. This requires further investigation, especially how this compares to the industry. Similar
investigations are required to better understand how Respect’s management of stock and creditors
compares to other companies in its industry.
Part b)
Note: refer to excel workings for details on calculations
Part c)
Note: A good approach to answering a question like this dealing with the evaluation of a strategic
decision is to consider the SAF acronym (Suitable; Acceptable; Feasible). Although this framework
was not specifically referenced in this solution you will see aspects thereof come through. Remember
that this discussion was about the decision to move into granite processing as a whole i.e. it was not
about whether to do it via an acquisition or to do it via internal investment.
The decision to extend operations into granite processing should consider both financial and non-
financial perspectives.
From a financial perspective it would be necessary to assess the return on investment, whether the
company decides to construct its own granite processing facility or purchase Respect, ensuring it is
at least equal to the required return considering the risk of this investment.
From a non-financial perspective, it is important to consider the strategic, operational and risk
implications of the decision. (Note: this required specifically expected an aspect focussed on the
strategic considerations.)
Strategic considerations
Currently Hard Rock does not have a clearly articulated strategy but the fact that it has unique light
grey granite rock deposits on its land, that are becoming more in demand and can be sold for higher
prices but at the same time are limited in supply, means that it is important that Hard Rock looks to
differentiate and add more value to the deposits that it has. This is currently very difficult to do as a
granite miner as the granite mining process is relatively simple and has a low barrier to entry (other
than the need for a mining license) which means there will be more competitors (including those
selling light grey granite) and less opportunity to charge higher prices. They also can’t become a cost
leader because the operations are small and inherently limited by the license and the farm with its
supply of granite. In order to grow, the company seemingly either needs to acquire more land for
mining or expand downstream into granite processing. The decision to begin granite processing is a
good way to capture more of the value chain and extract more value from the limited quantity of
light grey granite that can be mined on the farm, particularly given its unique demand.
By investing in granite processing, Hard Rock would be able to control its own growth trajectory
outside of granite mining. Having a mining licence also comes with stringent requirements and the
risk that the licence could be taken away by the DMRE if found to be non-compliant – diversifying
operations by expanding into granite processing mitigates this risk.
An additional important consideration is whether the company should continue to supply their
existing customers with the light grey granite rock that it mines. Ceasing supply may maximise Hard
Rocks financial returns specific to light grey granite that is mined, but this may simultaneously
negatively impact relations with current customers and the sale of other granite that it mines.
Customers may then seek granite elsewhere or venture upstream into granite mining.
Based on the demand for and limited availability of the light grey granite, it is advisable for Hard
Rock to consider focusing its granite processing solely on the top end of the market, exporting where
needed, to maximise returns. In this regard, the capacity of the granite processing facility needs to
be considered, as granite processing may then follow a focus and differentiation strategy (by way of
only processing light grey granite and then only supplying polished slabs to specific granite
fabricators that service the top end of the market).
As mentioned above, expanding into granite processing will also diversify Hard Rock’s operations
which naturally reduces the company’s overall business risk. In these instances, it is important for
the company to ensure it is able to diversify operations in a way that does not result in it losing its
core focus i.e. to continue doing what it does well (mining granite).
Two further important considerations are the availability of key resources as well as expertise/skills
required for success. Water is an important natural resource that is used in large quantities when
processing granite, especially so considering its scarcity in many areas including the Eastern Cape,
therefore the availability of water and use of this scarce resource is an important consideration.
Expertise and skills needed to successfully execute expansion of operations into granite processing
are also required regardless of whether this is done inhouse or via the acquisition of Respect.
Overall, the decision to expand operations into granite processing is considered a good decision and
the logical next step for Hard Rock assuming it has the financial and non-financial resources to do so
successfully. How this is to be done then becomes the next important consideration.
Part d)
This decision also needs to be considered from both a financial and non-financial perspective.
From a financial perspective the cost and associated returns for the two options need to be assessed
(i.e. constructing a processing facility versus acquiring Respect). Then, when ignoring all else, the
option with the greatest return should be selected (provided this is equal to or greater than the risk-
adjusted required return).
The availability of funding to finance the expansion of operations, whether inhouse or via
acquisition, is also an important consideration which is highlighted by the valuation of Respect in
part (b) which far exceeds the available bank loan of R15mil; however, with the shares and/or assets
of Respect serving as security additional funding should be easy to access.
From a non-financial perspective, key considerations with acquiring the shares in Respect include:
• Hard Rock is likely to have a strong bargaining position due to the seller emigrating (if there
are no/limited other prospective buyers) which should translate into a lower purchase price.
• The overall investment required could be lower than the construction of a new facility, due
to e.g. older machinery than new machinery; however, a premium on book value will need
to be paid for goodwill associated with a going concern like Respect.
• If possible, it is not necessary to purchase 100% of the shares in Respect to gain control –
this is also advised to further protect Hard Rock (reduce risk) i.e. the purchase can be
structured in tranches with the purchase price being linked to performance targets (this is
especially important in light of some of the aggressive assumptions in the projected financial
figures such as higher sales and lower working capital investment). This can also help with
the expertise of the current owners not immediately being lost and/or the current owners
maintaining a minority shareholding as co-owners (strategic partnership).
• It will be easier to access finance for an existing business (going concern that is already cash
positive) and possibly more finance proportionately compared to a new venture like
constructing a processing facility which is riskier.
• Granite processing of Hard Rock granite can commence on Day 1 (no need to wait for
construction etc.) – this reduces risk substantially and will result in cash inflows coming in
sooner than with the construction of a new facility which can result in the faster repayment
of the initial capital outlay.
• Hard Rock would also gain access to an existing customer base of granite fabricators to start
selling light grey granite to.
• Expertise and staff skilled in granite processing does not need to be sourced when Respect’s
workforce is taken over by Hard Rock.
• Respect is located close to Hard Rock’s mine reducing travel costs and facilitating easier
management oversight of the mining and processing operations.
• Buying Respect would remove a competitor out of the market compared to when Hard Rock
establishes its own processing facility and Respect then continued operations with new
ownership.
• Buying a company includes all the staff, contracts etc. and that could include unnecessary
staff and/or other overheads of Respect that may need to be retrenched or cancelled with
unnecessary/costly penalties the being incurred e.g. retrenchment packages.
• Buying a company’s shares (and not only the operating assets) includes all the legal
obligations of the company which may include unknown issues and costly claims. This can
however be overcome with warranties that can be built into the share purchase agreement
to protect Hard Rock.
Furthermore, key considerations with constructing a new granite processing facility include:
In addition to the effective after-tax cost of the loan of 7.51%, the following key factors need to be
considered by Peter when deciding whether to issue equity or borrow from the local bank:
• Hard Rock’s current and target capital structures need to be understood and considered
when making this decision – the proportional mix of debt versus equity. This includes an
assessment of the current and intended financial risk exposure of the company. And this
needs to be also be considered within the context of an expansion of operations into granite
processing (i.e. business risk exposure, which will include as assessment of Hard Rock’s
operating leverage).
• Equity will not expose Hard Rock to financial risk while the bank loan (debt) will. Financial
risk arises due to the obligation to make interest payments and capital repayments, while
dividend distributions on equity are voluntary.
• Hard Rock’s ability to pay interest and repay capital (annually) needs to be evaluated
considering rigorous cash flow forecasts.
• It is also important to better understand the security and sureties required by the bank for
the loan, as well as any other loan covenants which are likely to be in place.
o What assets and surety are Hard Rock and/or Peter able to offer?
• The loan is a fixed rate which, when considering the current low interest rate environment,
may be a positive; however, it is important to consider whether a variable rate loan will be
cheaper (likely) and/or a better debt financing option for Hard Rock.
• Have all financing options been considered? Other sources of debt finance should be
available – what is the associated cost of these compared to the bank loan? In addition,
other debt financing options may be better suited for Hard Rock in terms of security, loan
covenants, term, repayment structuring etc.
• Equity financing has the following specific disadvantages:
o It is far more costly than debt; and
o Third party shareholders will be introduced who could potentially have a say in the
running of the business, depending on the level of control (shareholding) given
away.
• Equity however presents the opportunity to introduce a strategic partner that has
complementary strengths and/or skills that can help grow and/or better run the current
and/or expanded operations.
• Debt has the major advantage of leveraging existing equity returns upward, provided the
return on investment is greater than the cost of debt financing.
• Hard Rock should also consider a mix of debt and equity funding, as opposed to only one
source, to benefit from the main advantages of both debt and equity. This is again to be
evaluated considering the company’s current and targeted capital structure.