Power Sales (Pty) ltd Statement of Comprehensive income for the year ended 30 June 2022 Note 2022 2021 R 000 R 000 Sales 1 304 740 283 408 Cost of Sales 2 (154 747) (124 272) Gross profit 3 149 993 159 136 Operating expenses 4 (72 885) (80 452) Other operating income 5 1 350 1 244 Operating profit 78 458 79 928 Investment income 6 13 12 Finance Costs (1 565) (1 410) Profit before taxation 76 906 78 530 Taxation (21 265) (22 750) Profit for the year 55 641 55 780 Power Sales (Pty) Ltd- Statement of financial position as at 30 June 2022 note 2022 2021 R000 R000 Non-current assets 33 468 31 333 Property, plant, and equipment 7 33 370 31 235 Investment in unlisted company 6 98 98 Current assets 178 597 147 604 Inventories 37 687 23 898 Trade and other receivables 8 140 858 122 844 Cash and cash equivalents 52 862 Total assets 212 065 178 937 Equity 182 703 152 862 Share capital and premium 100 100 Retained earnings 182 603 152 762 Non-current liabilities Interest bearing debt 9 4 000 8 000 Current liabilities 25 362 18 075 Interest bearing debt 4 000 4 000 Trade payables 10 19 512 14 075 Bank overdraft 9 1 850 - Total equity and liabilities 212 065 178 937 Notes: Most of the sales of Power Sales (Pty) ltd are on credit. About 85% of the sales were on credit in 2022. In 2021 about 90% of the sales were on credit. This reduction was due to the deterioration in the credit market. Management was forced to tighten credit extension. In 2022 a larger than usual summer sale was held to try and stimulate sales and move stock. The management of David whitehead (Pty) ltd expects total sales to increase by 1.5% in real terms during the first year after acquisition and by a further 3% in real terms in the second year after acquisition. The management also plans on reducing credit sales to 80% of the total sales in the first year and to 75% thereafter. Power Sales imports a significant portion of its trading stock from the European Union, and it is denominated in euros. Power sales does not hedge against exchange rate risk. The management of David Whitehead believes that this exposure to foreign currency fluctuations increases the groups overall risk. The management of David whitehead (Pty) ltd believes that they will be able to improve the gross margin of Power Sales by 3% (in absolute terms) in the first year. In the second year the gross margin is expected to increase by 5% (in absolute terms) more than what it is currently. Lease expenses are included in operating expenses (see note 7). The leases on a number of stores were up for renewal at the beginning of the 2022 financial year. Power Sales management renewed some of them. However, there was a decision not to renew some of them in some of the prime areas due to escalating costs. Other operating income consists of rental from the office building (see note 7) and interest on overdue trade receivables. The annual rental receivable on the office building was unchanged from 2021. The investment income comes from an investment in a minority interest of 10 000 shares. The investment is shown in the Statement of Financial Position at the most recently traded price. The most recent transaction took place in 2019. The investment is illiquid. David whitehead (Pty) ltd plans to hold on to the investment after acquisition. A dividend of R1.39 per share is expected to be received in one years time and a sustainable nominal growth rate of 8% is expected. The management of David Whitehead (Pty) ltd believes that a minimum return of 18% is appropriate given the nature of the investments risk profile. Power Sales leases its premises, warehouse, and distribution centre. The head office buildings are owned by Power Sales. Power Sales also owns a small office building that they constructed four years ago. They were anticipating accelerated growth. It turned out that the growth expectations were overoptimistic and as a result the building has never been used. This building has been leased out. The management of David Whitehead plans on selling the building after acquisition. The most recent valuation of the building indicated a value of R10 200 000. The management expects that an amount of R4 100 000 will be spend on replacement and expansion of fixed assets in the year following the acquisition, and an amount of R4 750 000 in the year after. Depreciation expense (included in cost of sales and operating expense) is expected to be R3 120 000 in the first year and R3 250 000 in the second-year post acquisition. The table below gives a breakdown of trade receivables. 2022 2021 R000 R000 Trade receivable 156 837 134 938 Doubtful debt allowances (15 997) (12 110) Net trade receivables 140 840 122 828 Other receivable (short term staff loans) 18 16 Trade and other receivables at year end 140 858 122 844 The trade receivables of power sales have payment terms ranging between three and nine months. Interest is charged on overdue accounts (see note 5). The management of David Whitehead (Pty) ltd intend on putting in place a very strict debtors collection policy. The management believes that there will be no overdue accounts at the end of the first year after acquisition. Short term staff loans are expected to be repaid during the first year after acquisition. The management of David Whitehead plans on repaying interest bearing debt and overdraft immediately after acquisition. It does not have any plans to replace these with similar debt instruments. The loan agreement stipulates a 1% penalty on the outstanding principal amount for early settlement. Power Sales creditors had a payment period of 46 days for 2022, and in 2021 the payment period was 41 days. Additional information relating to David Whiteheads post acquisition projections is as follows: The management of David Whitehead did not perform a detailed tax calculation and just assumed a tax rate of 28% on net income. The net working capital balance will be brought down to 45% of total sales in the first year and 42% of total sales in the second year. A sustainable real growth rate of 4% in free cash flows is expected after the end of the second year. The management of David Whitehead have stipulated that a minimum return of 16% is required. The current WACC for Power Sales is 15,2%. The latest CPI reading came in at 6.3%. The management expects inflation to come down to 6.1 % in 2023; 6.0 % in 2024 and 5.8% thereafter. The management of David Whitehead discovered that one of Power Sales overseas suppliers employs child labour. Furthermore, this supplier subjects its staff to appalling working conditions. This was then brought to the attention of the management of Power Sales. The management of Power Sales argued that they turned a blind eye because of the cheap prices and good quality offered by the supplier. Financing Considerations The management of David Whitehead (Pty) ltd is considering several options to finance the purchase of Power Sales (Pty) ltd. The management has estimated that they would need to raise approximately R 640 million David Whitehead (Pty) ltd is considering the following options: Jebar Bank (JB) ltd is willing to advance a loan of R640 million. The principal amount of the loan is repayable in a single instalment at the end of five years. Interest on the loan is payable annually in arrears. It bears interest at a rate of 3- month JIBAR plus 5%. Fifty percent of the loan will be secured over the fixed assets of David Whitehead (Pty) ltd. The loan agreements include covenants that have to be met throughout the duration of the loan including minimum financial ratios. In the event that the covenants are breached, the interest rate on the loan will increase to 10% above JIBAR for as long as the covenant remains in breach. Jebar Bank ltd has been David Whitehead (Pty) ltd.s commercial bankers for the last 20 years. Another Bank, namely Zimbank ltd has offered to arrange a four-year syndicated loan of R640 million at a fixed interest rate of 10% per annum. Interest is payable semi-annually in arrears and the loan principal will be repayable in four annual instalments of R160 million each. Upfront issuance costs of 1.5% will be paid to Zimbank ltd for arranging syndication. Pambili ltd , a listed investment holding group, have been looking to increase their exposure to the clothing sector and had previously expressed a strong interest in acquiring a minority shareholding interest in David Whitehead. The letter of interest submitted to the directors of David Whitehead included the following details:Pambili would like to subscribe for a 27% shareholding in David Whitehead based on a P/E valuation of around 17 times their most recent audited earnings number. Pambili requires the right to be able to appoint two non-executive directors to the board of directors of David Whitehead. This letter of interest was submitted a few months ago, before David Whitehead was considering growing by acquisition. Additional information: 3- months JIBAR is currently around 6.08% Use 365 days in a year. Required: a) Evaluate the profitability and working capital management of Power Sales (Pty) for the 2021 and 2022 financial year. 23 marks b) Use the free cash flow model to determine the maximum value David Whitehead should pay for a 100% common stock in Power Sales. 15 marks c) Assess the efficacy of the projections made by management in notes 1,3,4,7, and 8 15 marks d) Evaluate the three financing options relating to the potential acquisition of Power Sales. List the factors that the management of David Whitehead should consider in deciding which option to use.