B21F Test 2 MACF Scenario Required (No Cover)

QUESTION 1
Overview
Smart Power Limited (‘SPL’) is a company operating in South Africa and listed on the
Johannesburg Stock Exchange (JSE). SPL specialises in the large-scale production of
industrial inverter systems. An inverter system is made up of an inverter paired with
battery storage.
When drawing power from batteries an inverter converts the direct electric current
supplied by the batteries into the normal alternating electric current that is supplied
by ESKOM, and the reverse happens when the batteries in an inverter system are
charged. The batteries in the inverter systems produced by SPL can be charged in
various ways with the most common method being with electricity obtained from
ESKOM’s national grid.
Until now SPL has focused on producing industrial inverter systems used by
businesses to power large machinery and equipment. However, after the
implementation of lockdowns (resulting from the Covid-19 pandemic) and ongoing
load shedding (by ESKOM in South Africa), the company has noted a dramatic
increase in the demand for residential inverter systems in the domestic market for
use in residential homes. With many office workers still operating from home, an
uninterrupted supply of power has become critical for them to operate effectively
when there is load shedding.
As a result, SPL is considering diversifying into the production of smaller residential

inverter systems suited for home use. In order to do this the company will require a
significant amount of additional funding to expand operations and the board of
directors still need to make a final decision as to whether this is the right move for
SPL at this point in time.
Investment in the production of residential inverter systems
Research was conducted by SPL, at a cost of R2 million, into the production and
sales of a smaller residential inverter system.
© Milpark Education Management Accounting & Finance MAC01-OS First Intake 2021 Test 2 Page 3 of 13
Based on the results from this research, the following has been established:
1. The residential inverter system produced by SPL can be differentiated from

competitors using the lithium ion battery technology instead of the older lead
acid battery technology. Despite being significantly more expensive, the lithium
ion batteries have a higher power output and significantly longer useful life than
lead acid batteries. Although there are cheaper imported inverter systems
available in South Africa, SPL is of the view that using lithium ion batteries
would provide them with a competitive edge over competing companies selling
imported residential inverter systems.
2. An investment of R44 million in plant and equipment will be required to establish

the production facility. The residential inverter systems are likely to have a
production run of 5 years after which production will cease. However, to remain
competitive, modifications would be required to the production process at the
end of the second year of production at a cost R5 million. The plant and
equipment are expected to have a scrap value of R2 million at the end of five
years, after considering dismantling and disposal costs.
SARS have indicated that the Section 12C wear and tear tax allowance will apply
to the initial investment cost, with a 40% tax deduction in the first year and a
tax deduction of 20% per annum thereafter. Depreciation will be accounted for
on a straight-line basis. The modification costs can be claimed as a deduction for
tax purposes in full in the year incurred.
3. Sales of 60 000 units are expected in the first year of production, with the
expectation that there will be an annual increase in sales of 10% in year two and
again in year three. Thereafter, the sales volume is expected to remain
constant. The sales division is confident that at a price of R8 500 per unit the
above sales volumes can be achieved.
4. Raw materials and other variable production overhead costs (excluding labour)
are expected to be R7 250 per unit.
5. The production will be managed by an engineer who is set to retire when the
production of these residential inverter systems is scheduled to start. His
retirement package was structured in a way that he would receive a lump sum
payment of R10 million now upon retirement. He has however indicated that he
would be prepared to stay on for another five years at his current salary of
R1 million per annum if the lump sum due to him upon retirement is increased
to R12 million and paid out to him at the end of working another five years.
6. Two different kinds of labour are required to produce the residential inverter
systems:
a. 10 hours of unskilled labour are required per residential inverter system.

These are labourers who perform the task of assembly and packaging. They
are paid R50 an hour and are hired on a casual basis as they are needed.
There is no limit to the amount of casual labour available for this task.
b. 30 minutes of skilled labour time is required per residential inverter system.

These are electricians that are employed on a permanent basis, who earn on
average of R250 per hour based on their salaries. Due to the scarcity of
qualified electricians in South Africa it is unlikely that SPL will be able to
employ more electricians within the foreseeable future.
The effect of the COVID-19 epidemic has resulted in depressed sales of

industrial inverters systems produced by SPL. This has resulted in enough spare
capacity of skilled labour to produce the required volume of residential inverter
systems during the first year of production. It is expected that normal
production of industrial inverter systems will resume during the remaining years
of the 5-year production run due to the national rollout of vaccines and the
resumption of normal economic activity. When normal production of industrial
inverter systems resumes there will be no available skilled labour hours to
produce residential inverter systems. The company’s policy is to retain skilled
labour rather than retrenching them when not needed due to their scarcity.
Presented in the table below is information relating to two of SPL’s industrial

inverter systems for which production and sales could be reduced to free up any
required labour hours:
SINE WAVE
Inverter System Inverter System
Contribution margin per unit R2 180 R1 950
Unskilled labour (assembly and

18 hours 20 hours
packaging) time per unit
Skilled labour (electrician) time

2.5 hours 2 hours
per unit
SPL currently produces 55 000 SINE Inverter Systems and 45 000 WAVE
Inverter Systems annually, with this level of production expected to continue for
the foreseeable future.
7. Fixed manufacturing overheads are allocated by SPL to the current production of

industrial inverter systems at a rate of R550 per unit. Fixed manufacturing
overheads are expected to increase from R82.5 million to R90 million per year
with the production of residential inverter systems.
8. Included in current allocated factory overheads is factory rental of R6 million per

year. Approximately 15% of the available factory space will be allocated to the
production of residential inverter systems. This available space is currently
sublet by SPL to another company for a rental of R50 000 per month which will
no longer be possible if residential inverter systems are produced.
9. An investment of R26 million is required to fund working capital. This investment

is not expected to increase during the production run and only 50% of it is likely
to be realised at the end of the 5-year project.
Solar panels investment option
A “grid-tied solar power system” provides electricity from both solar power 1 and
ESKOM’s national grid, with batteries used as power storage. A grid-tied solar power
system can be installed by SPL for its clients using its normal industrial inverter
system along with solar panels provided by Solar Solutions (Pty) Ltd (‘SolarSol’).
SPL has worked closely with SolarSol for many years via a joint venture whenever a
grid-tied solar power system has been required by clients who want to be less reliant
on ESKOM for the supply of electricity.
As an alternative to producing the residential inverter systems, SPL is considering

whether it should produce its own solar panels when grid-tied solar power systems
are required by clients. This could be done by the company in one of the following
two ways:
i. SPL could invest in its own production facilities; or
ii. SPL could acquire SolarSol to bring their production of solar panels inhouse.
1
Electricity obtained by harnessing the energy of the sun's rays.
Additional funding options
SPL’s directors are considering how to raise the additional funding of R70 million
required by the company if a decision is taken to expand operations to produce
residential inverter systems. Currently they are considering the following two
options:
• Raising equity funding by way of issuing additional ordinary shares; or
• Raising debt funding from Oval Bank. Oval Bank is offering SPL a 10-year term
loan which will have an annual effective fixed interest rate of 8.5% per annum,
with interest payable monthly. The capital of this loan is to be repaid in equal
instalments at the end of each year.
The directors have previously agreed that the target capital structure for SPL is
ideally a mix of equity and debt funding in the following proportions:
• Equity funding 60%
• Preference share (debt) funding 10%
• Long-term loan (debt) funding 30%
An extract from SPL’s Statement of Financial Position as at 28 February 2021 is

presented below:
EQUITY AND LIABILITIES Note R’000
Share capital 1 10 000

Retained earnings 45 240
Total equity 55 240
Preference shares 2 20 000

Long-term loan 3 40 000
Total non-current liabilities 60 000
Long-term loan 3 5 000

Trade and other payables 31 880
Bank overdraft 4 8 600
Total current liabilities 45 480
TOTAL EQUITY AND LIABILITIES 160 720
Notes
1. 1 million ordinary shares are in issue that are currently trading at a 30-day
average market price of R131.70 per share, per JSE trading data. The
company’s shares have a beta of 1.2.
2. There are 200 000 6% non-redeemable preference shares in issue. These

preference shares were issued 3 years ago for R100 each and, based on market
yields for similar instruments of 5% per annum, they are currently valued at
R120 each.
3. The long-term loan was obtained from Pentagon Bank on 1 May 2017. A variable
interest rate of 7% per annum, which is linked to the prime lending rate, is
currently payable on this loan. Interest and capital repayments occur at the end
of each year.
4. SPL’s bank overdraft is from Square Bank with whom the company has all its
trading bank accounts. This overdraft facility is capped at R10 million and is
repayable on demand. Due to this being an unsecured overdraft facility a
variable interest rate of 11% per annum, linked to the prime lending rate, is
currently payable.
Management incentive system
Currently, senior management of SPL receive an annual incentive bonus which is

dependent on whether a targeted return on investment (ROI) is achieved by the
company. The targeted ROI is set at 20%, which is the same as the required rate of
return used by SPL’s board of directors when evaluating potential investment
projects.
If the actual ROI, based on SPL’s audited annual financial statements, is equal to or
higher than the targeted ROI for a given financial year then a fixed bonus is paid to
each member of the management team equal to one month’s salary. If the actual
ROI is less than the targeted ROI then no bonuses are paid.
The senior management team have been very unhappy with this incentive system
and have requested that the board of directors amend this. Their main complaints,
included in a recent memo to the board of directors, were the following:
• The incentive system does not differentiate between managers who work harder
than others;
• It does not make sense that if managers have worked hard and the actual ROI is
less than the targeted ROI that no bonus is paid; and
• The incentive system should be simplified to only focus on a targeted net profit
percentage.
Other information
• Except where otherwise indicated, all cash flows occur at the end of a year.
• The corporate tax rate is 28% and tax payments are made at the end of the
year in which they arise.
• The historic market rate of return generated by shares trading on the JSE is
13.5% per annum.
• The South African risk-free rate, based current yields on government bonds, is
estimated at 6% per annum.
• The current prime lending rate is 7% per annum.
• Ignore inflation.
End of question 1
QUESTION 2
Overview
Spirit of Adventure (Pty) Ltd (‘SpirAd’) is a South African registered company that
operates in the travel and tourism industry within Southern Africa. It has been
operating for more than 50 years and has branches in several neighbouring
countries, including Namibia, Zimbabwe and Mozambique. The company started off
as a small family business and has grown steadily over the years, although 60% of
its equity shares are still owned by the founding family.
Historically the main business of SpirAd has been to offer traditional tours for
individuals and groups. In recent years it has expanded operations to also offer:
• Tours in extreme adventuring such as hiking to summit mountains, mountain
biking through nature reserves and white water rafting down rivers.
• Tours for public sector clients, like local municipalities and government
departments, and the company has been successful in procuring valuable
government contracts to facilitate team building tours.
As a result of strong performance and growth, particularly over the past two years
since expanding operations, SpirAd has found it necessary to approach United Bank
(‘United’) for a term loan of R5 million to fund its growing working capital
requirements.
You are the credit manager of United and are responsible for assessing all credit
applications more than R1 million. You are expected to report to United’s credit
committee regarding your findings and a recommendation as to whether loans
should be advanced or not.
To support their loan application, SpirAd have supplied extracts from their most
recent audited financial statements and other important financial information in
support of their application for a loan from United. These are presented on the next
three pages:
Spirit of Adventure (Pty) Ltd
Statement of Profit and Loss (extract) for the year ended 31 March
2021 2020
Notes R R
Turnover 1 82 564 000 50 664 000
Operating profit 2 5 780 000 4 965 000

Finance costs 3 (202 500) (78 000)
Profit before tax 5 577 500 4 887 000
Taxation (1 561 700) (1 368 360)
Profit after tax 4 015 800 3 518 640
Notes:
1. Turnover consists of service fees and commission earned on tours and travel
bookings.
2. Operating profit is stated after the following items:
Cost item 2021 2020

R R
Profit on sale of land and buildings 1 250 000 -
Loss on sale of listed investments (756 000) -
Auditors remuneration (456 000) (380 000)
Depreciation on property, plant and equipment (390 000) (420 000)
Rental charges:
Premises and equipment (550 000) (65 000)
Tour vehicles (1 250 000) (385 000)
Note regarding rental charges: all rental agreements meet the definition of
short-term leases and rental charges are therefore all expensed in the year
incurred in accordance with IFRS 16 Leases.
3. Finance costs relate solely to interest paid on the bank overdraft, on which
interest was payable at an average rate of 10% per annum (2020: 12%). The
bank overdraft is secured by means of a general cession of accounts
receivable.
Spirit of Adventure (Pty) Ltd
Statement of Financial Position as at 31 March
2021 2020
Notes R R
ASSETS
Non-current assets 1 374 000 4 653 700
Property, plant and equipment 4 560 000 2 450 000
Listed investments 814 000 2 203 700
Current assets 13 145 560 5 476 000

Inventory 201 000 126 000
Accounts receivable 12 940 000 5 215 000
Cash and cash equivalents 4 560 135 000
Total assets 14 519 560 10 129 700
EQUITY AND LIABILITIES

Share capital 5 000 5 000
Retained earnings 5 3 531 460 1 523 560
Total equity 3 536 460 1 528 560
Non-current liabilities 4 250 000 3 842 000

Shareholder loans 6 4 250 000 3 842 000
Current liabilities 6 733 100 4 759 140

Trade and other payables 7 5 608 252 3 801 140
Bank overdraft 3 1 124 848 958 000
Total liabilities 10 983 100 8 601 140

Total equity and liabilities 14 519 560 10 129 700
Notes: (continued)
4. SpirAd recently sold its main business premises as the location of the
property was no longer suitable for its operations. This property’s sale
transaction occurred in the last month of the financial year after the company
started operating from new rented premises on 1 March 2021. R50 000 of the
rental charges reflected in Note 2 dealing with “operating profit” relates to the
rental paid for this property.
5. A dividend of R2 007 900 was declared and paid to shareholders on 31 March
2021 (2020: R2 345 760).
6. Shareholder loans represent occasional advances made by shareholders to

fund cash shortfalls. These loans are interest free with no fixed terms of
repayment.
7. Trade and other payables included amounts owing to suppliers (trade

payables) of R4 850 252 (2020: R3 542 030). Other payables relate to
accruals and provisions.
End of question 2
REQUIRED ONLY
Marks
Question 1
Sub- Total
total
a. Calculate SPL’s weighted average cost of capital (WACC)

based on the company’s target capital structure. 6 6
b. Based on SPL’s required rate of return of 20%, calculate the

net present value of SPL proceeding with the production of
residential inverter systems. 27 27
c. Briefly outline 6 other key factors that SPL’s directors should

consider before making a final decision on whether to
proceed with the production of residential inverter systems. 9 9
d. Briefly outline strategic considerations that SPL’s board of

directors should consider when evaluating whether to
produce solar panels and the way in which producing solar
panels could be done given the options proposed. 5 5
e. Critically evaluate the two options for additional funding and

recommend which source of funding SPL’s board of directors
should select.
Your discussion must include the following:

i. An analysis of SPL’s capital structure, using
appropriate ratios, based on market values before
and after additional funding has been obtained; 10
ii. Advantages and disadvantages associated with the
two funding options; 3
iii. Other factors to be considered before making a final
decision. 2
You are NOT required to calculate or comment on SPL’s

WACC for this required. 15
f. Critically evaluate SPL’s current management incentive
system and make recommendations on how it can be
improved. 8
Your discussion is to include specific reference to:

i. The advantages and disadvantages of using ROI as a
measure of performance; and
ii. The complaints raised by the senior management
team. 8
TOTAL MARKS 70
Marks
Question 2
Sub- Total
total
a. Draft a memorandum to United’s credit committee in which

you:
i. Critically evaluate SpirAd’s loan application based on
the information provided using supporting ratios and
calculations focused on the following:
a. Profitability and return on investment; 9
b. Working capital management and liquidity; 7
c. Cash management; and 3
d. Capital structure and interest cover. 6
ii. Conclude on whether the SpirAd’s loan application
should be approved by United and, assuming it is
approved, any terms and conditions that should be
included by United into the loan agreement. 3
Communication marks 2 30
TOTAL MARKS 30

B21F Test 2 MACF Scenario Required (No Cover)

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QUESTION 1

As a result, SPL is considering diversifying into the production of smaller residential

Investment in the production of residential inverter systems

1. The residential inverter system produced by SPL can be differentiated from

2. An investment of R44 million in plant and equipment will be required to establish

a. 10 hours of unskilled labour are required per residential inverter system.

b. 30 minutes of skilled labour time is required per residential inverter system.

The effect of the COVID-19 epidemic has resulted in depressed sales of

Presented in the table below is information relating to two of SPL’s industrial

Contribution margin per unit R2 180 R1 950

Unskilled labour (assembly and

Skilled labour (electrician) time

7. Fixed manufacturing overheads are allocated by SPL to the current production of

8. Included in current allocated factory overheads is factory rental of R6 million per

9. An investment of R26 million is required to fund working capital. This investment

Solar panels investment option

As an alternative to producing the residential inverter systems, SPL is considering

An extract from SPL’s Statement of Financial Position as at 28 February 2021 is

EQUITY AND LIABILITIES Note R’000

Share capital 1 10 000

Preference shares 2 20 000

Long-term loan 3 5 000

2. There are 200 000 6% non-redeemable preference shares in issue. These

Management incentive system

Currently, senior management of SPL receive an annual incentive bonus which is

Operating profit 2 5 780 000 4 965 000

2. Operating profit is stated after the following items:

Cost item 2021 2020

Current assets 13 145 560 5 476 000

Total assets 14 519 560 10 129 700

EQUITY AND LIABILITIES

Non-current liabilities 4 250 000 3 842 000

Current liabilities 6 733 100 4 759 140

Total liabilities 10 983 100 8 601 140

6. Shareholder loans represent occasional advances made by shareholders to

7. Trade and other payables included amounts owing to suppliers (trade

a. Calculate SPL’s weighted average cost of capital (WACC)

b. Based on SPL’s required rate of return of 20%, calculate the

c. Briefly outline 6 other key factors that SPL’s directors should

d. Briefly outline strategic considerations that SPL’s board of

e. Critically evaluate the two options for additional funding and

Your discussion must include the following:

You are NOT required to calculate or comment on SPL’s

Your discussion is to include specific reference to:

a. Draft a memorandum to United’s credit committee in which

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