QUESTION 1 (50 Marks 90 minutes) Gaoke (Pty) Ltd is a family business that is owned by the two Gaoke brothers (Fredirick and Rassie). The company manufactures and distributes Bluetooth speakers to retailers. The Gaoke speakers are known among consumers as high-quality speakers that produce exceptional sound. The business has been in existence for more than twenty years and was founded by Mr. Marius Gaoke ("Marius") who is Fredirick and Rassie's father. Marius has recently retired and entrusted his two sons with the business to manage and to own it. Fredirick is eager to manage and expand the company. His vision for the company is to employ non-family members as top management and to constitute a board of directors. Members to be appointed to the board will be independent of both the family and the business. Rassie, on the other hand. intends to emigrate to United Arab Emirates and is interested in selling the business and equally splitting the proceeds with Fredirick. Fredirick just returned to South Africa after studying overseas. He employed a management accountant to assist him with the company's performance analysis and valuation. His immediate concern is the liquidity and profitability of the company. He has managed to obtain the following information about the company from his brother. 1. The company is heavily reliant on machines that consume a lot of electricity. Eskom recently informed the company that. due to the high level of power usage especially in the current year. Eskom would be instituting an additional fee for electricity used beyond a particular threshold. Additionally, the company is under pressure from environmental lobby groups who have requested a meeting with the company in order to discuss potential solutions to combat excessive electricity consumption. In the past, Marius had disregarded these lobby organisations, referring to them as a nuisance. 2. Marius considered the company as a family business and has always desired to limit company leadership to himself and his two sons. Employees within the company are unhappy with this strategy. with some claiming that there are no career advancement opportunities for women and non-family members. The company does not have a Broad Based Black Economic Empowerment (\"'BBBEE') certicate and has never contemplated obtaining one or complying with the BBBEE legislation since the majority of the company's customers do not require the certicate as a necessity to conduct business with the company. 3. The South African Revenue Services (SARS) has sent a letter to the company stating that. as a result of the audit conducted, the company leadership and some of its employees have been utilising the company to pay for their personal costs and the company has claimed a tax deduction on these expenses. SARS rejected all these deductions and imposed penalties on the amounts that were initially deducted. SARS levied penalties of R100 000 towards the company and R50 000 for each staff member involved in their personal capacity. 4. The company administration staff works in a very old and poorly maintained building. There are cracks in the walls. and several areas of this facility are off-limits to staff members due to its poor condition. The water pipelines in the building are also ancient, and the business has experience significant water leaks that are very costly for the company. QUESTION 1 (continued) 7. STATEMENT OF COMPREHENSIVE INCOME OF GAOKE (PTY) LTD AS AT 31 DECEMBER 2022 Description 2022 2021 2020 R'000 R'000 R'000 Revenue 6 010 4 475 3 918 Cost of sales (5 683) (4 009) (3 579) Gross profit 327 466 339 Operating costs (475) (245) (171) Depreciation (19) (25) (10) Share of profits from associate 1 3 Operating (Loss) Profit 166) 199 158 Finance costs (92) (95) (79) (Loss) Profit before taxation (258) 104 79 Taxation charge 8 (8) (Loss) Profit for the year (250) 105 71 Additional notes i. Included in operating costs for the current year is the retirement bonus of R100 000 paid to Marius and the SARS penalties. ii. During the current year Rassie negotiated what he regards as favourable terms with the company's major supplier. Rassie has agreed to pay the supplier within fifteen days of delivery of stock in exchange for a 1.5% discount on the outstanding balance. The current payment terms are 90 days from inventory delivery date. iii. A listed company similar to Gaoke had a Price Earnings ratio of 14 on 31 December 2022 and trades at 8% above an unlisted share due to its liquidity (marketability). iv . The company tax rate is 27%.QUESTION 1 (continued) 5. The company has experienced product quality issues in the current year. In comparison to the prior year, there is 20% increase in customer returns due to poor quality. Marius was previously responsible for quality control, but since his departure, the quality control manager position remained vacant. The sales team has exploited this vacancy by pushing sales and occasionally bypassing the quality process. All customer retums are repaired at the company's cost and such cost is recorded in Cost of Sales. The additional cost incurred in repairing and replacing inferior quality products has been quantied as R350 000 for the year ended 31 December 2022 (\"current year\"). Fredin'ck will, amongst his other responsibilities in the company, fill the quality control management vacancy. Some customers have delayed payment of their debtors\" accounts until their quality issues are resolved. 6. STATEMENT OF FINANCIAL POSITION OF GAOKE (PTY) LTD 31 DECEMBER 2022 ASSETS Non-current assets Property, plant and equipment Deferred tax assets Goodwill and intanible assets Other non-current assets 105 139 Current assets 1 453 1 624 Inventories 350 715 Trade and other receivables 1 098 598 5 311 Cash and cash euivalents 4 733 Total assets 1 283 1 543 Ordinary share capital and share oremium 7 745 45 Non-distributable reserves 93 103 EQUITY AND LIABILITIES Shareholders' equity Retained earnings 445 695 Non-current liabilities 1742 2 103 Interest-bearing borrowings 1 435 1 753 Deferred tax liabilities Provisions 30? 29 6 Current liabilities Interest-bearin . borrowin . s Trade and other payables 947 1 082 145 112 3 2 1 Bank overdraft Total equity and liabilities 450 96 352 9 3 972 4 733 QUESTION 2 (50 Marks 90 minutes) Kabelo Koali (\"Kabelo") is a former musician who owns a tavernipub (with a music concert venue and an entertainment area) through a company called Diboa (Pty) Ltd (\"Diboa\"). in Pretoria's GaRankuwa. The tavern is immensely popular with Ga-Rankuwa residents and often crowded on weekends. Diboa is well-known for attracting great musicians as well as selling high-quality meals at reasonable prices. It outperforms comparable and much larger establishments in the same neighbourhood. Kabelo has received Occupational Health and Safety Act training and is eager to improve his tavern's compliance with this Act. He has created a risk register that identies the business- related risks that the tavern faces. The probability of accidents occurring as a result of an overcrowded tavern is near the top of the list in terms of severity. Kabelo has recently signed a veyear contract with the three biggest music record labels in South Africa to showcase talented music artists at his tavern. The contract is expected to be effective from Year 1. Kabelo is aware that these musicians will attract more customers than what the tavern is used to and is considering leasing additional land adjacent to the tavern to capitalise on the envisaged increased customer numbers whilst at the same time. ensuring that the tavern still adheres to the Occupational Health and Safety Act. To assist Kabelo in making the lease decision. which is referred to as the project. you are provided with the following information: 1. The owner of the adjacent land is aware of Kabelo's desperation to expand. She has valued her land which is about 2 000 square meters (m2) at rental value of R100 per m2 per month. Kabelo is considering a ve-year lease agreement that runs concurrently with the existing contract with the top record labels. The rent on the lease is payable annually in advance. 2. The tavern is currently situated on a 4 000m2 plot of land. The administration building and food processing facility (food area) covers about 1 200m? The music stage and the dance floor (performance area) have a floor space of 800m2 and the seating capacity is 2000m2. 3. If the additional land is leased. Kabelo will divide the additional land as follows: Additional Area Currfnt Land Totzal m m2 m Food 1 200 500 1 700 Performance 800 500 1 300 Seating and eating 2 000 1 000 3 000 4 000 2 000 6 000 QUESTION 2 (continued) 7. Should the tavern proceed with the expansion. it will consider the following nancing alternatives for the expansions: 7.1. Issuing 20 000 preference shares at R150 per share to members of Kabelo's stokvel. The preference shares will bear a 12% dividend. Dividends are to be calculated and compounded annually in arrears and capitalised into the outstanding preference share amount. 2% issue costs on the capital amount is payable at issue. The preference shares are redeemable after five years and the accrued dividends are also payable on redemption. Assume SARS will not allow a deduction for the transaction costs. 7.2. Obtaining a loan from Mr Shark for an amount of R3 million. The loan is to bear an interest equal to 3% above the prime overdraft rate. Interest on the loan is to be calculated and payable annually. No transaction costs are payable on the loan. The loan is repayable when the lease of the adjacent land expires. 8. The current company tax rate is 27% and the current prime overdraft rate which is expected to remain the same for the duration of the lease is 11.75%. 9. Diboa's current WACC is 21.1% and its target WACC is 18%. 10. The company's current capital structure and the calculation of current WACC is as follows: Market Value Weighting Cost WAGE: Instrument R'ODO % % % Bank Loan | 2 000.00 | 29% 10.77% 3.1% Share Capital | 5 000.00 | 71% 25.23% 18.0% Total | 7 000.00 | 100% 21.1% 11. The start of the project if accepted by Kabelo, will be Year 0 and the project will commence for a period of ve years to align to the contract signed with the record labels. MAC3702 OCTOBER/NOVEMBER 2023 QUESTION 2 (continued) REQUIRED For each question below, remember to: Clearly show all your calculations in detail; Where necessary, indicate irrelevant amounts/adjustments with a RO (nil-value); and round all your workings to two decimals (a Advise Kabelo Koali as to whether he must proceed to lease the 2 000m adjacent land. (20) Your advice must be solely based on quantitative analysis and solely based on the NPV calculations. (b) Discuss qualitative factors that Kabelo should consider in deciding (6) whether to lease the adjacent land. (c) Calculate and determine which finance instrument will be more cost (15) effective for Diboa (Pty) Lid by comparing the IRR of the two financing alternatives. (d) Discuss any four factors that Diboa (Pty) Ltd must consider in deciding (4) on which finance instrument to use. (e) Applying the Traditional Capital Structure theory substantiate your (4) choice of WACC used in question (a) above. Presentation marks: Arrangement and layout, clarity of explanation, logical argument, and language usage (1) Total for Question 2 (50)QUESTION 2 (continued) 4. 6.1. 6.2. 6.3. 6.4. Kabelo plans to use the entire additional food area of the additional land (500 m?) to expand the current food facility building. The expansion costs of a temporary building are estimated to be R850 per m2. Additional food processing equipment to the value of R100 000 will be purchased for the new processing facilities. SARS will allow deductions for all expansion costs over the period of ve years from the date of rst use, which is expected to be in year 1. At the end of the lease. the temporary buildings will be demolished by the employees of the tavern while the food processing equipment will have no resale value. The performance area together with the seating and eating area will require new furniture estimated to cost R400 000. SARS will allow deductions for all capital expenditure over the period of five years from the date of rst use. which is expected to be year 1. The latest annual nancial information for the tavern currently occupying 4 000m? plot of land is presented below: Descri . ti on Note Revenue Ex - enses Profit 4 200 Drinks 6.3 25 200 18 000 7 200 Oc-eratin costs 6.4 4 725 4 725 Taxation 2 433 Prot after taxation 6 712 The tavern only operates when there is a scheduled music performance. These performances occur on weekends and public holidays. A charge of R50 per person is levied for all customers visiting the tavern. A total of 420 000 tickets were sold for the period presented above. It is expected that the expansion will result in additional 225 000 tickets being sold per year starting in year 1. The tavern serves prepared meals. Meals are available on a buffet-style dining (customers are charged a at rate to eat as much food as they want on the day). A at rate of R30 is charged per ticket holder for food. On average, each ticket holder spends R60 on drinks per music performance. Kabelo expects the gross profit \"/0 on food and drinks to remain the same during the period of leasing ofthe additional land. Working capital injection of R200 000 is required at the beginning of the expansion. Operating costs include both administrative costs and personnel costs of the tavern. 80% of these costs are variable and will increase in proportion with the increased ticket sales. The current land where the tavern is situated is owned by Kabelo and thus no rental is payable on this property. QUESTION 1 (continued) REQUIRED For each question below, remember to: Clearly show all your calculations in detail; Where necessary, indicate irrelevant amountsladjustments with a R0 (nil-value); and round all your workings to two decimals (a) Comment on the profitability and liquidity analysis of Gaoke (Pty) Ltd for the year ended 31 December 2021 and 2022, using the ratios provided below: - i. Gross prot margin (3) ii. EBITDA to revenue 3 - iii. Current ratio 3 iv. Cash conversion cycle (6) (b) Identify and discuss the non-nancial performance issues that Gaoke (8) (Pty) Ltd is experiencing and outline possible actions that could be taken to resolve them, for the year ended 31 December 2022. (0) Discuss the ethical considerations that must be taken into account by (4) the new management of Gaoke (Pty) Ltd given the letter that has been received from the South African Revenue Services. (d) Calculate the value of Gaoke (Pty) Ltd using the PE multiple model as (20) at 31 December 2022. based on the available information and recommend the amount that Fredirlck must pay to Rassie should he want to keep the business to himself. (e) Discuss any nancial risk that the shareholders of Gaoke (Rassie and (2) Fredirick) are exposed to as at 31 December 2022 and recommend how the company should mitigate such risk. Presentation marks: Arrangement and layout, clarity of explanation, logical argument, and language usage (1) Total for Question 1 (50)