DISCUSSION QUESTION #1 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 director’s 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.

Investment in Crescent Chickens (Pty) Ltd

In June 2021 Mr. Henry Koopman, OPM’s back office manager, 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 2021. 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
2021.

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 2017. 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 FY2021.

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 2017.
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.

Industry and company update (as at 14 June 2021)

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

© Endunamoo ITC Board Course 2022 Class Discussion Question -

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 FY2021.

Extracts from the draft financial statements for FY2021 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 FY2024 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 2020 surprise visit

 A new packaging process was installed during August 2020 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 2020 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 2021 surprise visit

 No significant business process changes had occurred since the surprise visit in September 2020
– all production processes, including the new packaging process, appeared to be operating well.
 The operations manager who had been appointed on 1 September 2020 tendered his letter of
resignation during May 2021 and will be leaving the employ of the company on 30 June 2021. 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.

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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:

Average value of all

Average agricultural
Variable listed poultry
sector value
producers
Levered beta 1,58 1,31
Unlevered beta 1,26 1,02
Debt-equity ratio 35% 40%
Earnings before interest, taxation,
depreciation and amortisation (EBITDA) 5,5 6,7
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

© Endunamoo ITC Board Course 2022 Class Discussion Question -

Appendix B: Financial information relating to CC

CRESCENT CHICKENS (PTY) LTD

STATEMENTS OF COMPREHENSIVE INCOME FOR THE YEARS ENDING 31 MAY
Notes Actual Forecast Forecast Forecast
2021 2022 2023 2024
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
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

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 CRESCENT CHICKENS (PTY) LTD
STATEMENTS OF FINANCIAL POSITION AS AT 31 MAYTEMENTS OF FINANCIAL POSITION
AS AT 31 MAY
Notes Actual Forecast Forecast Forecast
2021 2022 2023 2024
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 103870 100080 104690 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 borrowings 3 10 170 11 670 10 440 8 740
Trade and other payables 29 940 30 790 31 410 32 350
Provisions 4 630 5 130 5 230 5 390

Total equity and liabilities 279 550 279 710 287 910 295 470

Notes:

1. The operating expenses for FY2021 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 FY2021. Their remuneration was approximately R2 500 000 less in aggregate during 2021
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.

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4 CC had an unutilised assessed tax loss of R12 580 000 on 31 May 2021. 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 2021 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 2021. 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 2021. The customer
comprised 4% of the outstanding trade and other receivables balance at 31 May 2021,
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.

8 Ordinary share capital comprises 1 500 000 shares in issue. The shares are held as follows:

Number of shares Percentage

Shareholder
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.

© Endunamoo ITC Board Course 2022 Class Discussion Question -

REQUIRED

Marks
(a) ….. 12
Perform valuations of OPM’s equity interest in CC at 31 May 2021, using the
following valuation techniques:
 Free cash flow method,
(b)  Earnings based method; and
 Net asset value method.

Show all workings and set out the key assumptions you have used in each method. 40
Based on the results of your valuation workings in part (b) above, make a
recommendation, with reasons, to the Investment Oversight Committee regarding
the appropriate valuation method and value of the investment in CC as at 31 May
(c)
2021. 7

Communication skills – logical argument 1

TOTAL 60

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DISCUSSION SOLUTION #1

Part (b) Marks

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 - inverting formula, 1 mark - correct
application of formula
Therefore, cost of equity 15,98% 1c
Long-term debt equity ratio (market values) 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 adding the spread, ½ mark tax and ½ mark
weighting
WACC therefore 14.37% 14.37% 1c
(Adjustment to the WACC for additional risks, not
1
listed, size, control, right refusal etc.)
Free cash flows 2022 2023 2024
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
Alternative solution
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)
(Tax (5 820) (6 380) (6 830) 1
+def tax movement) 4 090 70 110 1
Reverse interest tax shield (interest) (1 929) (1 436) (1 288) 1
Inventories 1 450 (2 870) (480) ½
Biological assets (160) (710) (1 100) ½
Trade receivables (1 760) (820) (1 250) ½
Cash movement 4 260 (210) 760 ½
Trade payables 850 620 940 ½
Capital expenditure (Movement assets +
depreciation) (30 730) (30 530) (32 970)
(Movement assets (4 450) (3 590) (5 490) 1
+ depreciation) (26 280) (26 940) (27 480) 1
Free cash flows 24 701 12 684 14 542 1c
CV / TV (14 542 x 1,06)/(14.37% - 6%) or 8% (246
2
552) 184 164
24 701 12 684 198 706 ½C

© Endunamoo ITC Board Course 2022 Class Discussion Question -

 Part (b) Marks
Enterprise value 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 Marks

FY2021 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) 100%
 Company is a private, marketability of shares -1 1
 Smaller size than listed counterparts - 5% (0.275) 1
 Reliance on key management - 5% (0.275) 1
 Control premium (valuing OPM’s 60% stake + 1,00 1
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 Marks

Shareholders’ equity at end of FY2021 182 310 1
Land and buildings 23 576
Revaluation to market value 28 000 1
Tax recoupment [(3 800 – 2 000) x 28%] (504) 1
CGT arising on disposal [(30 000 – 12 500) x 80% x 28%] (3 920) 1
Equipment (8 352)
Revaluation to market value (11 600) 1
Scrapping allowance
1
[(15 600 – 4 000) x 28%] Assume book value = tax value 3 248
Bankruptcy of a major customer (1 132)
Decrease trade receivables by [39,3 m x 4%] (1 572) 1
Related tax shield [1 572 x 28%] 440 1
Adjusted NAV 196 402
Value of OPM's stake (60%) 117 841 1P
Available 46½
Maximum 41
Total 41

© Endunamoo ITC Board Course 2022 Class Discussion Question -

 Part (c) Marks
 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 1
calculation.
 The FCF method result is significantly higher than the EBITDA method, which may
be due to -
o high growth rate assumed into perpetuity; and 1
o 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:
o It is unusual as it is generally lower, due to it representing a liquidation value; 1
o It excludes liquidation costs and retrenchment costs; and 1
o Other methods may be understating values due to current industry
1
conditions.
o NAV method is not appropriate, as the value of individual assets is
1
considered, rather than collective ability to generate returns.
o 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
1
market value adjustment appears to overestimate the value of operations on a
NAV basis in light of the present challenging economic environment.
o As the NAV is the highest it may be beneficial to close CC’s operations and
1
sell off the assets.
 CC incurred losses until 2021 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 EBITDA method
result of R70, 6m, should be used. (OR any other reasonable conclusion based on 1
calculations/discussion presented)
Available 11
Maximum 7
Communication skills - logical argument 1

© Endunamoo ITC Board Course 2022 Class Discussion Question -