SCENARIO – QUESTION 1

Introduction
Amalgamated Concrete (Pty) Ltd is a company that specialises in the design,
manufacture, and supply of high-quality precast concrete products such as the ones
in the pictures below:

Amalgamated Concrete operates two divisions:

• Retail Division: the retail division manufactures and sells products made from
concrete for homes and offices such as tables and benches, braais, garden
pots and pavers. These products typically have more complex decorative
designs, are harder to manufacture and sold in smaller quantities but have a
higher margin. The retail division also operates 2 showrooms where retail
customers can view products before buying.

• Industrial Division: the industrial division manufactures and sells products for
the construction industry such as lintels1, concrete bricks and blocks and
retaining wall blocks. These products are standard industry items,
manufactured in bulk and sold in larger quantities but have a lower margin.

Amalgamated Concrete has a factory situated in Durban North, KwaZulu Natal and
supplies both the retail and industrial divisions. It distributes these products to
customers throughout KwaZulu Natal and into some neighbouring provinces.

Part A – Potential sale of the business

Amalgamated Concrete is a family business. The owner-managers are a husband

and wife team, Shamila and Mohamed Joosub, and who founded the company

1
A horizontal concrete support used in the construction of a building that goes across the top of a door
or window.

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24 years ago. Over the years the business has been very successful and has served
them well. But as they have been getting older, they have felt the need to think
more about retiring to spend time with their grandchildren. They are both less
involved in the day-to-day running of the business and feel like they have struggled
to keep up to date with new designs and new manufacturing technologies. They
however been reluctant to sell or give up management of the business they have
built up. This has contributed to the declining performance of the business in recent
years.

Over the last few years Shamila and Mohamed have increasingly relied on a young
manager, Henry Mokwena, to assist them. Henry has been with Amalgamated
Concrete for 3 years and has learnt a lot in that time. However, he has become
frustrated with Shamila and Mohamed’s unwillingness to innovate and invest in new
equipment and technologies.

For example, fewer and fewer customers visit the showrooms each year and
Amalgamated Concrete has been losing customers to competitors that offer online
ordering options. Henry has step up a simple website himself which has done
relatively well and helped keep sales up, but without further investment, which
Shamila and Mohamed are unwilling to provide, he cannot develop a proper website
and grow this aspect of the business.

Henry has recently received a good job offer at another manufacturing company
which has made him think about his future. This offer has now forced a situation
where Shamila and Mohamed need to consider whether they should sell the business
to him.

Your role
Shamila, Mohamed and Henry (“the management team”) have contacted you to help
them assess the potential of their business, evaluate key business decisions and, if
they are going to sell their business, to determine a fair selling price.

Today’s date is 1 June 2020.

Industry background
The construction sector which Amalgamated Concrete supplies has suffered
significant declines over the last several years in South Africa due to the tough
economic environment. Last year alone the industry shrank 4% year-on-year.
However, niche pockets within industry have fared relatively well. Significant
numbers of new residential houses in the lower- and middle-income categories have
been built. Consumers have also continued to invest in their homes with building

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supply stores and garden centers retailers growing by 6%, which is above the
general inflation rate of 4% in South Africa.

Financial Information
The latest financial information for the year ended 31 May 2020, with comparatives,
is presented below along with supplementary and explanatory notes.

List of incomes and expenses

Below is a list of Amalgamated Concrete’s incomes and expenses for their most
recent period ending 31 May 2020.

Income and expenses for year ending 31 May

Note 2020 2019
R’000 R’000

Sales income 30 369 30 730

Retail sales 16 974 16 480
Industrial sales 13 395 14 250

Other income 291 78

Rental income 3 216 0
Dividends 5 75 78

Operating expenses 25 026 24 129

Raw materials 7 617 7 324
Depreciation 1 786 1 923
Repairs and maintenance 2 544 2 156
Salaries and wages 1 6 815 6 437
Other operating expenses 3 599 3 427
Rental 2 531 2 434
Advertising 134 428

Operating profit 5 634 6 679

Finance costs 1 044 1 091

Profit before tax 4 594 5 588

Taxation 1 286 1 565

Net profit 3 308 4 023

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List of assets and liabilities
Below is a list of Amalgamated Concrete’s assets and liabilities at 31 May 2020.

Assets and liabilities as at 31 May

Notes 2020 2019
R’000 R’000
Assets

Non-current assets 22 590 24 367

Property plant and equipment 2 18 424 20 201
Loan to Eclectic Furniture CC 4 250 250
Investment property 3 1 300 1 300
Listed shares 5 2 616 2 616

Current assets 9 061 7 103

Inventories 6 445 5 156
Trade and other receivables 2 312 1 640
Cash 304 307

Total assets 40 711 38 574

Equity and liabilities

Equity 29 403 26 248

Share capital 1 1
Retained earnings 29 402 26 247

Liabilities 11 308 12 326

Non-current liabilities 5 989 7 791

FNB bank loan 6 4 989 6 791
Family loan 7 1 000 1 000

Current liabilities 5 319 4 535

Trade and other payables 3 428 2 644
Current portion of bank loan 1 890 1 890

Total equity and liabilities 40 711 38 574

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Note 1. Salaries and wages
The salaries and wages relate to the salaries of the staff employed by Amalgamated
Concrete. Due to the tough economic environment and Amalgamated Concrete’s
financial position, none of the management team have received any increases in the
last year. However, as the remaining staff have been with Amalgamated Concrete
for many years and there is deep mutual loyalty between the Joosub’s and their
staff, Amalgamated Concrete has always tried to give generous annual salary
increases. In the past year the non-management staff all received an 8% increase.

The Joosub’s each receive a salary of R650 000 per year. Henry currently earns a
salary of R320 000 per year which is below a fair market salary for his role. A
reasonable market related rate for Henry would be the same as that of the Joosub’s.
Should the Joosub’s sell the business and resign, Henry would not need to hire
anyone to replace Mohamed as Mohamed has very little involvement in the running
of the business anymore with Henry doing most of the work. Henry would, however,
need to replace Shamila but he could hire a bookkeep at a cost of R300 000 per year
to fulfil the same role.

Note 2. Production equipment

Included in the property, plant and equipment balance, is the production machinery
used in the factory to produce the various industrial and retail concrete products.
The machinery has been in use for many years and frequently breaks down. It is
also outdated and less flexible than modern machinery resulting in Amalgamated
Concrete losing potential new orders. Mohamed has insisted on keeping it going for
as long as possible and is unwilling to spend more money to buy new equipment.
The equipment should ideally be replaced and upgraded. Amalgamated Concrete
would need to spend at least R10m million to upgrade and replace the outdated
machinery to keep the business operations and sales at current levels. The new
equipment would be depreciated over 10 years. Doing this would reduce the amount
spent on repairs and maintenance by 75%.

Note 2. Vehicles
The property, plant and equipment balance also includes amounts related to
vehicles. Amalgamated Concrete has two delivery vehicles used in the business, as
well as a car that was bought as a graduation gift for Shamila and Mohammed’s
youngest son when he graduated from university but is not used as part of the
operations. The car was bought on 1 January 2019 for R350 000. Shamila was
disappointed when she noticed on http://autotrader.co.za that similar cars are
selling for R240 000 only a year after buying it. She has depreciated the car in the
books of Amalgamated Concrete to its fair market value.

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Note 3. Investment property
The investment property relates to a flat that Amalgamated Concrete bought for
Shamila and Mohammed’s children when they were studying at university. Since
their youngest son graduated last year, they have been renting the property out to
students. They currently receive rental income net of expenses of R18 000 per
month. Inflation in South Africa is 4% per annum and this is likely to continue in the
future, a fair growth rate to expect in the rental income market is 6% per annum for
these types of properties, and reasonable yield on investment rental properties is
10% per annum before tax.

Note 4. Loan to Eclectic Furnishers CC

Amalgamated Concrete granted a loan to Eclectic Furnishers CC 4 years ago. Electric
Furnishers is a small business owned by a friend of Shamila and Mohammed. As
Eclectic Furnishers is now in a better financial position, the friend has agreed to
repay the loan in 2 years' time with a premium of 50% added to the original
principle loaned of R250 000. Up to now, no interest has ever been paid or accrued
on this loan. A reasonable market related rate of interest on the loan is 12% per
annum before tax.

Note 5. Shares on the JSE

Shamila and Mohammed used excess cash that Amalgamated Concrete had several
years ago to buy some shares listed on the JSE. The portfolio is carried at historic
purchase price in the financial information provided. The current market value of the
shares is R3.5million.

Note 6. FNB bank loan

This was a loan that Amalgamated Concrete took out to fund the business
operations. Interest is calculated as prime (7.25% per annum at present) + 2% per
annum which is a fair interest rate for this type of loan.

Note 7. Family loan

This was a loan provided to Amalgamated Concrete by Shamila's father to help them
start the business 24 years ago. It was agreed that there would be no interest
charged on the loan, and that when the business was one day sold, Shamila’s father
would receive 20% of the sale proceeds.

Comparison businesses
The closest direct competitor to Amalgamated Concrete listed on the JSE is Robrik
Ltd. Robrik’s Earnings Per Share (EPS) is R1.52 and its share currently trade at
R18.25 per share. Robrik has a debt-to-equity ratio of 15%.

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Robrik Ltd is a manufacturer of industrial concrete building and decorative products.
Robrik operates in every province in South Africa and in several Sub-Saharan African
countries. Robrik’s primary customers are construction companies but they also sell
on a smaller scale to builder and garden supply stores such as Builder’s Warehouse.
They do not sell directly to consumers.

Robrik has managed the pressure from a declining construction industry through an
innovative strategy and the use of technology. Robrik identifies “hotspot” areas with
high levels of construction activity throughout South Africa and Africa and then sets
up small factories that can be built quickly and cheaply. The factories use modern
manufacturing equipment and machinery that is highly efficient and requires relative
unskilled labour to operate, keeping their costs low. When the construction activities
in the area slows down, they close the factory and move their equipment to a new
site.

Robrik also invests significantly in their brand by spending at least 5% of revenue on

advertising and marketing. Robrik also maintains a low debt-to-equity of no more
than 15%.

Part B – Discontinuation option to improve the financial performance

If Henry takes ownership of the business, he has a plan to improve the financial
performance of Amalgamated Concrete. For a while he has wanted to stop making
certain products sold by Amalgamated Concrete. To begin this process, he has
identified the retail product, retaining wall blocks (“Retail Block”), as being an
underperforming product.

Amalgamated Concrete makes a small loss on each Retail Block that it sells. Given
that this loss is before considering delivery and storage costs, Henry does not
believe that this product is worthwhile to manufacture and sell anymore.

Another reason that Henry feels that this product should be discontinued is that
Amalgamated Concrete has an industrial version of the retaining wall block product
(“Industrial Block”) that is a premium product with better technical specifications
and is slightly larger with a more modern look to it. It also is sold at a higher price
and has a higher profit per unit.

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The cost information for the two products is presented below along with further
relevant information:

Standard cost and profit card per unit Note Retail Industrial
Block Block
R’s R’s
Selling price 1 25.00 37.50
Raw materials 2 8.25 9.50
Moulds 3 3.50 4.00
Variable overheads 4 3.00 3.50
Fixed manufacturing overheads 5 10.00 15.00
Allocated administrative overheads 1.50 1.50
Total cost 26.25 33.50
Profit / (Loss) (1.25) 4.00

Note 1 – Sales
Currently Amalgamated Concrete expects to manufacture and sell 63 000 units of
the Retail Block and 21 000 units of the Industrial Block each year.

Henry believes that discontinuing the Retail Block would have a positive impact on
the sales of the Industrial Block. Some customers that previously would have
purchased the Retail Block would simply pay the higher price and buy the Industrial
Block. Henry is not sure just how great the impact will be but has estimated that
25% of customers that would have purchased the Retail Block will instead choose to
buy the Industrial Block.

Because the Industrial Block is 10% larger than the Retail Block, a customer that
chooses the Industrial Block needs less blocks for the same building area and will
buy proportionately less Industrial Blocks.

Note 2 – Raw materials

Raw materials are made up of the cement, sand and stone that are used in different
proportions to make concrete that is used in all the products manufactured by
Amalgamated Concrete. Amalgamated Concrete has a different formulation for the
Retail Division products and the Industrial Division products. The formulation effects
cost but also strength. The manufacturing process is made up of:

1. Mixing the concrete in the large concrete mixers in batches for each
formulation.
2. Pouring the formulation into the different moulds for each product being
made. Employees must work quickly to finish before the concrete sets.

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 3. Curing the concrete. This can be as simple as leaving the product to cure or
it might involve regular wetting to slow the curing to make the concrete
significantly stronger.
4. Sanding and trimming. This involves removing the rough edges that are left
over from the concrete moulding process to clean up the product for sale.

Note 3 – Moulds
The moulds are used to pour the concrete mix into to create the desired concrete
shape. They are manufactured for Amalgamated Concrete by a specialist company
and although they are quite expensive, they have a relatively long useful life.
50 000 Retail Blocks can be made from a single set of moulds before the set needs
replacing. The current set being used for Retail Block manufacturing were
purchased for R175 000 and they have a useful life of 20 000 blocks remaining.
This unit cost is simply the R175 000 divided by the 50 000 units the mould set can
make. The current price of a new mould set for Retail Blocks is R185 000.

Note 4 – Variable overheads

These costs relate to water and electricity used in the manufacturing process.

Note 5 – Fixed manufacturing overheads

Fixed overheads are mostly made up of labour costs and the depreciation of the
plant and machinery. Fixed overheads are allocated to all products at a rate of 40%
of Revenue.

Five employees are needed in the production of the Retail Blocks. Employees at this
level earn a salary of R54 000 each per annum. If the Retail Block was discontinued,
then Henry believes that Amalgamated Concrete would be able to reduce the size of
its work force. 3 of the employees would no longer be needed and the remaining 2
employees would be redirected as follows:

• 1 employee would be used as a delivery truck driver, as the company is

currently in need of an additional driver and would otherwise have to hire
one. The new delivery truck driver would have been paid R60 000 per
annum.
• 1 employee would be moved to the Industrial Division to work on the
Industrial Block in a similar role at the same pay.

There are 2 options for the 3 employees who would no longer be needed:

• The company has a large labour force and employees leave the company on a
regular basis for various personal reasons such as retirement, ill health or
alternative employment. Henry could wait for 3 staff at this level to naturally

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 leave the company, and simply not hire 3 new employees. There would be no
retrenchment costs as the staff would resign for personal reasons, but Henry
estimates it would take 2 months for 3 equivalent employees to leave the
company during which time he would still have to pay their salaries.

• Alternatively, retrench 3 employees at a cost of R7 000 per employee. This

could be done immediately.

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REQUIRED ONLY

Marks
Question 1 – Part A
Total

For required (a) – (c), consider only the information in Part A of the
scenario, as well as the Introduction

a. Using the financial information in Part A, analyse and comment on

Amalgamated Concrete’s financial performance and position. Focus
on key ratios that assist in understanding the business. Do not try
to calculate and explain every ratio.

Consider Amalgamated Concrete’s:

• Operating performance and returns,
• Liquidity, working capital and cash flow cycle,
• Financing ratios and ratio impact of this on its business.

Marks are available for:

• Calculating relevant ratios;
• Explaining what the ratio means and its impact on the
business;
• Explaining the cause of the ratio and connecting this to other
ratios or aspects of the business;

Time management:
• You do not need to follow each of the above steps for each
ratio or issue. There are significantly more ratios and marks
available than the 20 marks awarded. To do well, you need
not calculate and comment on every possible ratio. Focus on
key ratios that help you understand the business. Plan your
time carefully. 20

Continued…

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 b. Value Amalgamated Concrete’s equity shares at 1 June 2020 using
a relative PE based valuation.

• Any assumptions that you make or professional judgment that

you exercise should be justified.

In developing your answer:

• Determine an appropriate comparative PE multiple,
• Identify factors you would consider in adjusting the
comparative PE multiple.
o You do not need to quantify each adjustment, but you
should indicate whether each factor would increase or
decrease the multiple.
o Conclude on an appropriate target PE multiple
• Determine a sustainable earnings amount for Amalgamated
Concrete by making any adjustments you think are needed
based on the information in the scenario.
• Determine its value from operations,
• Consider other adjustments or sources of value that need to
be taken into account 20

c. Based on your answers above, and any other issues you have
identified from the scenario, identify and discuss any points that
Henry and the Joosub’s should consider before deciding whether to
respectively buy and sell the business. 10

Subtotal for Part A 50

Continued…

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 Marks
Question 1 - Part B
Total

For requireds (d) – (g), consider only the information in Part B of the
scenario, as well as the Introduction
d. Evaluate the financial impact of Amalgamated Concrete discontinuing
the Retail Blocks product.
• Provide commentary and / or workings to support your answers. 20
e. Assuming the Retail Block is not discontinued perform the following
Cost-Volume-Profit based analysis for the Retail Block:

i. Calculate the percentage of additional unit sales required for

the retail block to make R100 000 profit before tax at its
current sales price.
ii. Calculate the percentage price increase required for the retail
block to breakeven at its current sales volume. 10

f. Identify and discuss further considerations that Henry should take

into account before deciding whether to discontinue the Retail Blocks.
Conclude with a logical opinion on whether Amalgamated Concrete
should discontinue Retail Blocks? 12

g. Critically discuss the appropriateness of Amalgamated Concrete’s

current allocation of indirect costs. Briefly explain why an Activity
Based Costing system could be a useful decision-making tool for
Amalgamated Concrete. 8

Subtotal for Part B 50

TOTAL MARKS 100

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