Endunamoo Board Course 2022

Management Accounting (MAF)

Rendani Muthelo, Ndiambani Magadagela & Hlumelo Sidzumo
Term 1
Welcome to Term 1
Topics Live classes Screencast (Pre-recorded)
Cost of capital Yes
Capital structure Yes
Sources of finance Yes
Dividend decision Yes
Capital investment appraisal Yes
Working capital Yes
Treasury function Yes
Strategy & Risk management Yes

© Endunamoo Board Course 2022 3

Prescribed textbook
Managerial Finance, FO Skae, 8th edition

© Endunamoo Board Course 2022 4

Tutorial submission
Discussion Question: Constance
Submission Date: 16 February 2021
Discussion Date: 23 February 2021

© Endunamoo Board Course 2022 5

Screencast: Test reviews
UNISA Test 1 (2020)
CTA Level 1: Forever Diamonds
CTA Level 2: Healthy Living (Pty) Ltd

UNISA Test 1 (2019)

CTA Level 1: Piper Industrials Ltd
CTA Level 2: Decadent Chocolates (Pty) Ltd

UNISA Test 1 (2018)

CTA Level 1: Edone Ltd
CTA Level 2: Staincent Ltd / Expand SA Ltd

© Endunamoo Board Course 2022 6

Recommended list of questions
Source: Practice Questions, included as part of your notes

Previous UNISA Tests

• Quality Cement (2017)
• Legendary Foods Group (2015)
• Advanced Technology Ltd (2014)

© Endunamoo Board Course 2022 7

Recommended list of questions
Source: Management Accounting Question Banks

Cost of capital
• Medico Group SA Ltd (Q1 (a)) (Question Bank)
• Customfit-IT (Q2 PART B (a) and (b)) (Question Bank)
• Insimbi Ltd (Q3 (a)) (Question Bank)
• Brazilica Ltd (Q8 (a)) (Question Bank)
• Cloth Group (Q21) (Question Bank)

Capital investment appraisals

• Ziva’s Fashion Fanatics Ltd (Q11, PART C) (Question Bank)
• Medico Group SA Ltd (Q1 (l)) (Question Bank)
• Apex Assist Ltd (Q18) (Question Bank)

© Endunamoo Board Course 2022 8

Recommended list of questions
Source: Management Accounting Question Banks

Cost of capital
• Medico Group SA Ltd (Q1 (a)) (Question Bank)
• Customfit-IT (Q2 PART B (a) and (b)) (Question Bank)
• Insimbi Ltd (Q3 (a)) (Question Bank)
• Brazilica Ltd (Q8 (a)) (Question Bank)
• Cloth Group (Q21) (Question Bank)

Capital investment appraisals

• Ziva’s Fashion Fanatics Ltd (Q11, PART C) (Question Bank)
• Medico Group SA Ltd (Q1 (l)) (Question Bank)
• Apex Assist Ltd (Q18) (Question Bank)

© Endunamoo Board Course 2022 9

Recommended list of questions
Source: Management Accounting Question Banks

Management of working capital

• Chocci Chocs Ltd (Q13 (d)) (Question Bank)
• Ithemba Engineering (Pty) Ltd (Q14 (c)) (Question Bank)
• Medico Group SA Ltd (Q1 (k)) (Question Bank)

Treasury function
• CWC South Africa Ltd (Q5 PARTB (c), Question Bank)
• Zapphire Ltd (Q24 (b), Question Bank)
• Chocci Chocs Ltd (Q13 (b)) (Question Bank)
• Ithemba Engineering (Pty) Ltd (Q14 (b)) (Question Bank)

© Endunamoo Board Course 2022 10

Recommended list of questions
Source: Management Accounting Question Banks

Dividend decision
• Medico Group SA Ltd(Q1 (d)) (Question Bank)
• Ziva’s Fashion Fanatics (Q11 PART B(b)) (Question Bank)

Business strategy and risk management

• Medico Group SA Ltd (Q1 (b), (c) and (m)) (Question Bank)
• Insimbi Ltd (Q3 (c) and (e)) (Question Bank)
• Brazilica Ltd (Q8 (g)) (Question Bank)
• Ziva’s Fashion Fanatics Ltd (Q11, PART A) (Question Bank)
• H Ltd (Q15) (Question Bank)

© Endunamoo Board Course 2022 11

Cost of capital
Introduction to cost of capital
• Companies require capital to invest in capital investments, mergers and acquisition and/or declare dividends
• The capital may be provided by shareholders and/or lenders (‘investors’)
• Investors require a return on the capital they provide to the company, i.e. the required rate of return
• The required rate of return represents the opportunity cost of the capital (i.e. forgone return on other prospective
investments)
• From the perspective of the company, the required rate of return is the cost of capital
• A company has to ensure that the capital is invested in areas where the return earned is in excess of the cost of capital
• The minimum required rate of return from the investments is return that will ensure that all capital providers receive
their required rate of return
• In order to ensure this, the weighted average cost of capital (WACC) has to be determined
• The ultimate objective of any company is to lower the WACC
• The general formula for determining the WACC is:

𝐸 𝐷
𝑊𝐴𝐶𝐶 = 𝑥 𝐾𝑒 + 𝑥 𝐾𝑑 𝑥 (1 − 𝑡𝑎𝑥)
(𝐸 + 𝐷) (𝐸 + 𝐷)

© Endunamoo Board Course 2022 13

Determining the WACC

Market value Weighting Cost WACC

Capital source(1) (A) (B) (C) =BxC

Equity A1 A1 / Total Ke A1 / Total x Ke

Preference shares A2 A2 / Total Kp A1 / Total x Kp

Loans A3 A3 / Total Kd A1 / Total x Kd

Debentures A4 A4 / Total Kd A1 / Total x Kd

Total 100% WACC

Notes
#1: Trade payable and overdraft excluded because they are utilised for funding operational expenses

© Endunamoo Board Course 2022 14

WACC: Principle #1
Principle 1: Consider only the long-term capital structure
• Work with sources of capital included under non-current liabilities section
• Do not include trade payables as part of the capital structure or source of finance because it is a short term account
• With regards to bank overdraft, check carefully whether it is used to fund short term needs or long term needs of the
company
• Prepare the calculation for WACC using a table – and workings provided and properly referenced to the table
• Put a little note under the WACC table to identify all the items that have been excluded from your analysis to earn the
marks
• Ensure that aggregate of the weighting of all the capital sources add to 100%

© Endunamoo Board Course 2022 15

WACC: Principle #2
Principle 2: Use market rates for cost of debt
• Market rates reflects the current cost of borrowing a similar amount of debt that the company has (or the cost of
refinance its existing debt)
• Do not use the original interest rate at which the funds were borrowed because it reflects historic rate
• Do not use the coupon rate related to debentures or bonds as this also reflects historic rate
• For unlisted instruments, current market interest rates could also be determined based on rates for listed instruments
with similar risk profile and maturity

© Endunamoo Board Course 2022 16

WACC: Principle #3
Principle 3: Determine the market value of the capital sources
• Statement of financial position is based on historical information, i.e. book values
• Do not use the book values because the value at risk is not the original cost of items but their market value
• Book values are only used to the extent that they reflect market values of equity or debt
• For equity, determine the market capitalisation or the market value using the dividend growth model
• For debt, determine the present value of future cash flows (ignore historic cash flows)
• Target capital structure may be provided and if provided, a target WACC may be calculated using those target weights
• Target capital structure may be provided as a debt-equity ratio (i.e. debt / equity) or as a debt ratio (i.e. debt / total
capital)

© Endunamoo Board Course 2022 17

WACC: Principle #4
Principle 4: Consider tax implications
• SARS allows companies to deduct, from their income, interest paid on loans and debentures
• Effectively, the cost of an interest bearing instrument would be the amount of interest paid less the tax that has been
saved, meaning that the effective cost of debt is Kd x (1 – t)
• Dividends on ordinary and preference shares are not allowed as deductions
• The coupon and the interest paid to be discounted should also be after tax cash flows

© Endunamoo Board Course 2022 18

WACC: Principle #5
Principle #5: Use nominal rates
• Future cash flows are often stated in nominal terms and therefore the nominal rate is used as the discount rate (again,
for consistency)
• However, if real cash flows are used then, for consistency, the real rates are used
• Use the formula (1+rn)=(1+rr)x(1+ri) for the conversion

© Endunamoo Board Course 2022 19

LE1: Principles and formula of WACC
You are provided with the following information
Cost of equity = 20%
Market related cost of debt = 10% (real and pre-tax)
Historic cost of debt = 9% (real and pre-tax)
Tax rate = 28%
Inflation rate = 6%
The company is funded by debt and equity

Calculate WACC, assuming the following:

(i) Debt = R10 million and Equity = R5 million
(ii) Debt-equity ratio = 3:1
(iii) Debt ratio = 80%

© Endunamoo Board Course 2022 20

Cost of capital

Debt instrument
Debt instruments

• Redeemable instruments, i.e. instruments with a maturity date. The capital borrowed is generally repaid as a lumpsum
and while during the term of the loan, the instalments are generally interest only payments
• Amortising instruments, i.e. amortising instruments have regular instalments that include capital and interest
payments over the term of the loan
• Irredeemable instruments (also called perpetuity instruments), i.e. instruments without any maturity date. The
capital is not repayable
• Convertible instruments, i.e. instruments which either convert to debt or equity on maturity date

© Endunamoo Board Course 2022 22

Cost of capital

Debt instrument: Redeemable instrument

LE2A: Cost of redeemable loan

On 1 January 2019, CA Ltd borrowed R80 million from a local bank. The bank loan bears interest at a nominal fixed interest
rate of 11,50% per annum (being the market-related rate). The term of the loan is five years.

The terms of the loan require a payment of 20% of the capital amount at the end of the five year term. The balance of the
loan is then repayable over five years in equal instalments (comprising capital and interest). Transaction costs amounting
to 1,75% of the capital raised was charged by the bank.

The loan will be a qualifying instrument and interest will be deductible in terms of Section 24J of the Income Tax Act. Tax
rate is 28%. Section 24J allows an entity to deduct the accrued (amortised) interest for the purpose of determining
taxable income.

REQUIRED
Determine the cost of debt on the issue date (9 marks)

© Endunamoo Board Course 2022 24

Exam-technique: Cost of redeemable loan

Step 1: On issue date, the focus is on determining the cost of debt

Step 2: You need the following elements: PV (Loan proceeds / issue price / market value), N (term of loan), FV (any balloon
payment at payable at the end of the term), I (yield to maturity or market rate) and PMT (annual repayments – determine
if repayments include interest only or interest and capital)
Step 3: If something is outstanding from Step 2, calculate that first (ignoring tax)
Step 4: Assess whether the question requires the application of S24J. The required will make this explicit
Step 5: If S24J is required then determine the amortised interest amounts as S24J is based on these figures. If you use your
calculator, show calculator steps. If S24J is not required, use the short-cut method (see example LE2C)
Step 6: Prepare outline of the cash flows (i.e. table) based on the remaining term of the debt and incorporate S24J tax
savings from Step 5
Step 7: Be careful of the direction and timing of cash flows
Step 8: Answer the question by using the IRR function (show calculator steps) – answer needs to be reasonable!

© Endunamoo Board Course 2022 25

LE2B: Market value of redeemable bond

On 1 January 2018, CA Ltd issued a bond at its nominal value of R2 million. The bond bears an annual coupon rate of 8%
which is payable on 31 December until the redemption date. The bond is redeemable at a premium of 5% on 31 December
2022. The transaction costs incurred were immaterial.

On 31 December 2019, the prevailing prime interest rate, which is the market-related interest rate of the bond, increased
to 10,50% per annum. The bond is a qualifying instrument and interest is deductible in terms of Section 24J of the Income
Tax Act. Tax rate is 28%.

REQUIRED
Determine the market value and cost of debt on 31 December 2019

© Endunamoo Board Course 2022 26

Exam-technique: MV of redeemable loan

Step 1: During the interim of the loan, the focus is on determining the market value of debt
Step 2: You need the following elements based on the original terms of the debt: Interest, N (term of loan), FV (any balloon
payment at payable at the end of the term), I (yield to maturity or market rate) and PMT (annual repayments – determine
if repayments include interest only or interest and capital)
Step 3: If something is outstanding from Step 2, calculate that first (ignoring tax)
Step 4: Assess whether the question requires the application of S24J
Step 5: If S24J is required then determine the amortised interest amounts as S24J is based on these figures. S24J amounts
need to be determined from the inception of the debt - these are not revised during the term
Step 6: Prepare outline of the cash flows based on the remaining term of the debt and incorporate S24J tax savings from
Step 5
Step 7: Be careful of the direction and timing of cash flows
Step 8: Answer the question by discounting the cash flows by the after-tax market rate to determine the market value –
answer needs to be reasonable!

© Endunamoo Board Course 2022 27

LE2C: Cost of a redeemable bond

On 1 January 2017, CA Ltd issued a bond at its par value of R2 million. The bond bears an annual coupon rate of 8% which is
payable on 31 December until the redemption date. The bond is redeemable at a premium of 5% on 31 December 2021.
The transaction costs incurred were immaterial.

On 31 December 2018, the prevailing prime interest rate, which is the market-related interest rate of the bond, increased
to 10,5% per annum. The bond is NOT a qualifying instrument and Section 24J of the Income Tax Act is not applicable. Tax
rate is 28%.

REQUIRED
Determine the market value and cost of debt on 31 December 2018

© Endunamoo Board Course 2022 28

Cost of capital

Debt instrument: Non-redeemable

instrument
Non-redeemable / irredeemable debt
The value of a non-redeemable (irredeemable) instrument is the discounted future cash flows divided by the market
related interest rate

Market value
= Par value x interest rate / market related interest rate

The cost of a non-redeemable (irredeemable) instrument is the annual contractual cash flows divided by price or market
value of the instrument

Cost of debt
= Annual payments / market value of the instrument

© Endunamoo Board Course 2022 30

LE3: MV and cost - non-redeemable debt

On 1 January 2020, CA Ltd issued 12% R200 000 non-redeemable debentures. The market related interest rate on
debentures with similar risk profile was 11% per annum. Tax rate is 28%.

REQUIRED
Determine the market value and cost of debt on the issue date

© Endunamoo Board Course 2022 31

Cost of capital

Debt instrument: Convertible instrument

LE4: Cost of a convertible debt

On 1 January 2018, CA Ltd issued 1 000 000 R1 convertible preference shares. The preference shares are convertible into
ordinary shares in five years at a ratio of 4 preference shares to 3 ordinary shares in CA Ltd. The market value of one
ordinary share is expected to be R1,80 in five years.

If the preference shares are not converted, they will be redeemed at a premium of 8% to their par value. The dividend rate
on the preference shares was fixed at 11% per annum. The yield to maturity on similar listed preference shares (without
the conversion option) is 13% per annum. The company’s cost of equity is 15% per annum.

REQUIRED:
Determine the market value and cost of shares on the issue date, assuming the shares are convertible at the option of:
(i) the holder; and
(ii) the issuer

© Endunamoo Board Course 2022 33

Examination technique

Step 1: Determine the available future values (e.g. the conversion value, redeemable value, roll-forward value, etc.). All
these values need to be at the same point in time in order to ensure comparability
Step 2: Determine who has the option to convert – holder versus issuer. If holder, the highest future value would be
selected and if issuer, the lowest future value would be applicable
Step 3: Calculate the present value of the instrument with the available inputs and in place of the future value, use the
value determined in Step 2
Step 4: In determining the cost of preference shares, the cost of equity will be applicable if in Step 2 the conversion value
was selected and the cost of debt / preference share would apply if the redemption option was taken

© Endunamoo Board Course 2022 34

Cost of capital

Equity instruments
Determining the cost of equity capital

The cost of capital can be estimated based on the following:

• Dividend growth model: This model assumes that the required return of the equity investor is the capital appreciation
of the equity instrument and the dividend yield on that equity instrument
• Capital asset pricing model: This model assumes that the equity investor requires compensation for the foregone risk-
free return and also the additional risk that is assumed for the investment in a risky asset

© Endunamoo Board Course 2022 36

Dividend growth model

It follows that the cost of equity is:

Ke = Expected dividend yield + Capital appreciation (g)
Ke = (Dividend at T1 / Price at T0) + (Price at T1 – Price at T0)/ Price at T0)

DGM has the following underlying assumptions:

• The capital appreciation is based on a constant sustainable growth rate
• The company under consideration has a stable dividend policy – thus making it inappropriate to value a share of a start-
up company with no dividend cash flows (conversely, it could be considered more appropriate for a mature company)
• The interest being valued is a minority interest and an equity investor has limited influence on the dividend policy or
growth of the company
• The sustainable growth rate should be lower than the weighted average cost of capital

© Endunamoo Board Course 2022 37

Estimating sustainable growth rate
The (g) can be estimated based on the following principles:
• Time value of money principles based on historic performance
• g = return on equity x (1 – dividend payout ratio)
• Difference between the share price today and price in year’s time

• In terms of the DGM, (g) represents the capital appreciation of the share over one year period
• The value of a share is driven by the value of dividends. The growth in dividends is the driver of capital appreciation
• Dividends are declared from retained income and therefore the growth of earnings determines the growth in dividends.
Over a long term, the dividends growth should be below or at most equal to the earnings growth

© Endunamoo Board Course 2022 38

LE5: Cost of equity based on DGM

CA Ltd has determined that the cost of utilising retained income can be estimated based on the following information:
Earnings per share for the recent year end (cents) 180

Return on equity for the most recent year end (%) 25%

Retention ratio for the most recent year end (%) 40%

Market price of ordinary share as at today (cents) 1 350

Number of outstanding ordinary shares (thousands) 10 560

REQUIRED
Determine the market value and cost of equity for CA Ltd

© Endunamoo Board Course 2022 39

LE6: Cost of equity based on DGM

Information relating to CA Ltd for FY2017 is provided.

2017 2016 2015 2014 2013

Closing share price R185,50 R200,00 R209,68 R172,00 R121,25

Earnings per share R17,54 R18,15 R18,72 R16,23 R12,34

Dividend per share R7,95 R8,20 R8,20 R6,80 R4,80

REQUIRED
Calculate the cost of equity for CA Ltd
(5 marks)
(Extracted from UNISA Final Exam, 2016)

© Endunamoo Board Course 2022 40

LE7: Market value of ordinary shares
Example 7.1: Dividend growth is sustainable
Africa Ltd has 5 million issued ordinary shares. The required return by the equity investors is 18%. Current dividend per
share is R6. The dividend is expected to grow at 7% per annum for the foreseeable future.

Calculate the market capitalisation of equity.

Answer = R291 818 182

Example 7.2: Dividend growth is not sustainable

On 1 January 2020, CA Ltd has declared a dividend of 30c per share. The company expected a supernormal growth of 20%
per annum over the next three years and thereafter a sustainable growth rate of 5% per annum will be achieved.

Determine the ex-div value of a CA Ltd share on 1 January 2020 based on a cost of equity of 15% per annum

© Endunamoo Board Course 2022 41

Capital asset pricing model

The capital asset pricing model assumes that the equity investor requires compensation for the foregone risk-free return
and also the additional risk that is assumed for the investment in a risky asset
The formula is such that:
Ke = Rf + β(Rm – Rf)
Where:
Rf = the risk-free rate (market-related return on a longer dated government bond, i.e. a market yield and not a coupon
rate)
β = the beta of the share (takes into account financial, operating and other risks)
Rm = the return of the market portfolio (on the JSE All Share Index)
Rm – Rf = market risk premium

© Endunamoo Board Course 2022 42

Hamada relevering formula
The Hamada formula for levering and unlevering beta coefficients is as follows:

βl = βu x [1 + (1-t) x (D ÷ E)]

Where
βu = unlevered beta (before taking financial risks into account)
βl = levered beta (after taking financial risks into account)
t = income tax rate
D = market value of debt
E = equity value

© Endunamoo Board Course 2022 43

LE8: Cost of equity based on CAPM

Below is provided information pertaining to CA Ltd:

Beta 1,2
Coupons on government bonds
- R186 (maturity date: 2030) 8,0% p.a
- R157 (maturity date: 2022) 6,8% p.a
Annual yields on government bonds
- R186 (maturity date: 2030) 8,2% p.a
- R157 (maturity date: 2022) 6,5% p.a
Historical market return on the ALSI 12% p.a
Expected market return on the ALSI 15% p.a

REQUIRED: Determine the cost of equity for CA Ltd

© Endunamoo Board Course 2022 44

LE9: Cost of equity based on CAPM

Below is provided information pertaining to CA Ltd:

Levered beta – comparable listed peer 1,2
Debt-equity ratio of comparable listed peer 60%
Debt-equity ratio of CA Ltd 80%
Tax rate 28%
Risk-free rate 8,0% p.a.
Market premium 5,5% p.a.

REQUIRED
Determine the cost of equity for CA Ltd

© Endunamoo Board Course 2022 45

Capital structure
SCREENCAST
Introduction to capital structure
• Our objective now is to understand the relationship between a firm’s cost of capital, its value and its capital structure
• The issue that was ignored when determining the cost of capital of a company was whether differing capital structures
can lead to differing costs of capital, i.e. does capital structure matter?
• If capital structure does matter, the financial manager needs to determine the optimal capital structure in order to
lower the cost of capital and consequently increase the value of the firm
• Capital structure considerations deal with long term financial decisions of the firm where the firm decides on the level
of debt relative to equity
• These decisions are influenced by the financial policy that the management chooses and their ability to source the
desired type of financing they choose

© Endunamoo Board Course 2022 SCREENCAST 47

Illustrative example: Capital structure
CA Ltd is contemplating an investment in the agricultural sector which requires an initial capital investment of R20 million.

The existing capital structure of the company comprise the following:

Source of capital Market values

Ordinary share capital R36 000 000

Debentures R18 000 000

Loans R3 000 000

The company has a target capital structure of 40% equity and 60% debt. Under the target capital structure, debentures is
to be maintained at 80% of total debt.

REQUIRED:
Determine how the project should be funded, if CA Ltd is working towards the target capital structure

© Endunamoo Board Course 2022 SCREENCAST 48

Illustrative example: Capital structure / Solution
Capital % Target Current Capacity
Equity 40% R30 800 000C1 R36 000 000 (R5 200 000)
Debentures 48% R36 960 000C2 R18 000 000 R18 960 000
Loans 12% R 9 240 000C3 R 3 000 000 R6 240 000
R77 000 000 R57 000 000 R20 000 000

The company does not have capacity to raise funds through equity but can raise finance through issuing debentures and
loans.
It is therefore recommended for the entity to buy back some of its shares to the value of R5 200 000, issue new debentures
amounting to R18 960 000 and borrow R6 240 000 through a loan in order to fund the proposed project.

Workings:
C1: R77 000 000 x 40% | C2: 77 000 000 x 60% x 80% | C3: 77 000 000 x 60% x 20%

© Endunamoo Board Course 2022 SCREENCAST 49

The concept of leveraging (gearing)
• Using relatively more debt in the capital structure is known as leverage (or gearing)
• Leverage is intended to increase the return on shareholders’ funds in exchange for greater financial risk
• The use of financial leverage causes a given return on assets to be levered up to a higher return on equity. This happens
because the firm should earn a higher return on assets than the interest rate on debt
• Leverage increases the volatility of the earnings. The effect is in both ways – i.e. increases shareholders’ returns in good
years and decreases shareholders’ returns in bad years

© Endunamoo Board Course 2022 SCREENCAST 50

LE1: Leveraging (gearing)
CA Ltd and SA Ltd have the same asset, Good Asset. Good Asset was acquired at a cost of R100 000 by each of the two
companies.

However the funding for the asset was different:

CA Ltd: 80% of the purchase price was funded by debt
SA Ltd: 80% of the purchase price was funded by equity

The cost of debt for each company is 10% per annum. Tax rate is 30%.

The operating annual cash flows are R18 000 before tax.

Determine the return on asset and return on equity for each company.

© Endunamoo Board Course 2022 SCREENCAST 51

Capital structure
Capital structure theories
The Modigliani-Miller approach…
The optimal capital structure is the debt-equity ratio that the company adopts so that its weighted average cost of capital
is at the lowest point

M&M argued that such a capital structure does not exist and presented a paper based on the following assumptions:
• The individual can borrow on the same terms as a firm
• There are no taxes
• There are no transaction costs
• There are no costs associated with the financial distress
• There are no agency costs

© Endunamoo Board Course 2022 SCREENCAST 53

The Modigliani-Miller approach…
Initial theory
• M&M argued that there is no optimal capital structure because irrespective of the gearing, a firm’s weighted average
cost of capital will not change
• This occurs because, as the company increases its debt (which is cheaper than equity), it is increasing its risk. The equity
holders will require compensation for an increase in risk, so the cost of equity will rise and offset the relative benefit of
the cheaper debt
• M&M argued that it is fundamentally the assets that determine the value of a firm and not the way in which those
assets are financed
• The firm’s investment in assets generates the profit (NPV analysis) and not the way in which these assets were paid

© Endunamoo Board Course 2022 SCREENCAST 54

The Modigliani-Miller approach…
Pragmatic approach
• Having acknowledged that there are costs associated with a high level of leverage, M&M considered a more practical
approach of a world with company taxes, costs of financial distress, and related costs
• The previous position of M&M is changed since interest on debt is deductible for purposes of taxation
• Therefore the value of a geared firm will be higher by the amount of tax saved through using debt. The effect is a cost
of capital which does decline with increased gearing
• Under the M&M assumptions, with company taxes, a firm’s WACC would decrease continuously as financial leverage
increases towards 100% debt finance. Consequently, the value of the firm would increase by the present value of the
interest tax shield

© Endunamoo Board Course 2022 SCREENCAST 55

Trade off theory
• Having acknowledged that there are costs associated with a high level of leverage, M&M considered a more practical
approach of a world with company taxes, costs of financial distress, and related costs
• M&M recognised that the cost of equity and cost of debt will rise as leverage is increased
• Companies are seen to trade-off the advantages of debt financing with the costs of taking on increasing levels of
financial leverage, such as higher interest rates and potential bankruptcy
• The significance of this approach is that it considers a whole range of capital structures to be optimal

© Endunamoo Board Course 2022 SCREENCAST 56

Pecking order theory
The pecking order theory assumes that there is no target capital structure. This, to some extent, forms the basis for the
discussion on sources of capital in that it states that management will always use the lowest-cost financing alternative

Generally the hierarchy is as follows:

• Internally generated funds – retained earnings (least cost)
• Debt
• Convertible debt and preference shares
• Equity

The above hierarchy accommodates two key attributes: flexibility and control

© Endunamoo Board Course 2022 SCREENCAST 57

Signaling theory
• On the other hand, signalling theory deals with information asymmetry
• As internal managers are more likely to have better information about the firm than external investors, they would
know if the firm’s financial instruments are mispriced
• Management would therefore be reluctant to issue equity, which is under-priced, consequently an equity issue may be
interpreted as a signal that the equity is overpriced
• The issue of debt indicates that the company has excellent prospects and the equity holders wish to retain the benefits
from any future investment opportunities
• Therefore companies keep spare borrowing capacity in order to retain the flexibility of raising debt as and when
required

© Endunamoo Board Course 2022 SCREENCAST 58

Sources of finance
SCREENCAST
Sources of finance
• There are a number of factors that affect the decision on sources of finance
• A company has to consider whether it would want to issue equity or debt capital
• There are number of issues to consider when it comes to issuing equity capital
• If debt capital is issued, the nature of the instrument has to be considered as well, i.e. should the company issue a
debenture, preference share or borrow through a bank overdraft
• The major issue is around the debt component – its level and also the instrument to be used to raise such debt

© Endunamoo Board Course 2022 SCREENCAST 60

Factors affecting debt capital raising
• Security: Debt is often secured against the long term assets of the company and therefore the cost of debt is usually
cheaper
• Liquidation: On liquidation of a company, debt is ranked the highest and therefore results in them demanding a lower
return as they have limited risks
• Dilution of existing control: No impact on the shareholding
• Tax implications: Interest on debt capital is deductible for income tax purposes and therefore result in them being a
cheaper source of finance
• Commitments: Interest and capital repayments are compulsory regardless of the company’s level of profitability
• Interest rate expectations: This impact the nature of interest (variable or fixed) to be selected for the loan
• Matching principle: Interest payments and capital repayments need to be matched with cash inflows from projects
• Current level of gearing: Consider and compare the current level of gearing with the target capital structure
• Competitors’ level of gearing: Consider and compare the current level of gearing with competitors’ level of gearing
• Economic environment: The business cycle and interest rate environment impacts the attractiveness of debt
• Currency of funding: If the cash flows are in a foreign currency then it might be ideal to have the loan in the same
currency in order to avoid currency fluctuations

© Endunamoo Board Course 2022 SCREENCAST 61

Factors affecting equity capital raising
• Cost of equity: Equity holders are exposed to the greatest amount of risk and therefore demand a higher rate of return
(i.e. equity is an expensive source of capital)
• Cost of issue: Cost of marketing and professional fees, e.g. attorneys, are usually high
• Dilution of existing control: Existing shareholders may lose control if they do not participate in the share issue
• Tax implications: Dividends paid to shareholders are not tax deductible from an income tax perspective
• No commitments: It provides the advantage in that dividends are not compulsory compared to interest and capital
repayment on loans
• Legal considerations: The requirements of the Companies Act will need to be met prior to the issue of the additional
shares

© Endunamoo Board Course 2022 SCREENCAST 62

Sources of finance
Rights issue
Rights issue
• A rights issue is when a company offers its existing shareholders the chance to buy additional shares for a reduced price
• Usually, the discounted price will stand for a specified time frame, after which it is returned to normal
• A company would offer a rights issue in order to raise capital
• If current shareholders did choose to buy the additional shares, a company could use the funding to clear its debt
obligations, acquire assets, or facilitate expansion without having to take out a loan from a bank

© Endunamoo Board Course 2022 SCREENCAST 64

Example of a rights issue
Let’s suppose an investor already owns 100 shares of company XYZ, and the shares are currently trading at R20 each. In
order to raise more money, company XYZ announces a rights issue for current investors at a price of R15 a share, which will
last for 30 days.
The company also sets a conversion rate of 5 for 10, meaning that a current investor can buy 5 discounted shares for every
10 that they currently own. As a result, the investor could buy 50 more shares for R750, a discount of R250.

© Endunamoo Board Course 2022 65

Recent rights issue

• Announced a plan to raise $2 billion (about R30.66bn)

through a rights issue as part of measures to address debt.
• Sasol announced that they will execute a rights issue in 2021
calendar year as it refines 'ticket size' ... The JSE-listed group
aims to reduce its more than $10-billion debt burden by
between $4-billion and $6-billion during its current financial
year, which ends on June 30, 2021.
• Chief financial officer Paul Victor “The rights issue is an
important factor we must consider in creating a sustainable
capital structure. We are aware of the intense scrutiny of this
matter,”

© Endunamoo Board Course 2022 66

Recent Rights issue

• Oil-to-telecom conglomerate Reliance Industries Ltd's

rights issue opened for the subscription of shareholders on
20 May 20 and will close on Wednesday.
• Billionaire Mukesh Ambani's firm had on 30 April
announced fund raising of Rs 53,125 crore by way of a 1:15
rights issue -- India's biggest and the first such issue by the
firm in nearly three decades.
• Ambani had in August last year unveiled plans to cut debt
to zero by 2021. As part of this plan, RIL has been seeking
strategic partnerships across its businesses while targeting
to deleverage the balance sheet.

© Endunamoo Board Course 2022 67

Pros and cons of a rights issue
Pros of a right issue
• A rights issue is an opportunity for current shareholders to increase their stake in a company, for a reduced cost. In
doing so, they increase their exposure to a company’s stock– which could be good or bad, depending on a company’s
financial performance
• The number of new shares that an investor can buy depends on their current holdings, but it is usually proportional –
with larger shareholders being able to purchase more shares than smaller shareholders
• A rights issue is also a chance for an individual to protect their investment from the eventual dilution that will come
when the company issues more stock
Cons of a rights issue
• If the issued shares are sold on the open market, their value could be diluted relative to the increased market supply
• Rights issues can also be a risk as current shareholders may not wish to buy any more shares in the company if it is
experiencing slower growth
• The market may interpret a rights issue as a warning sign that a company could be struggling. This might even cause
investors to sell their shares, which would bring the price down. With an increased supply of shares available following a
rights issue, this could be very bad news for a company’s market value

© Endunamoo Board Course 2022 SCREENCAST 68

LE1: Pricing a rights issue
CA Ltd wishes to undertake a renounceable rights issue of R3 million equity capital. The current share price of CA Ltd is R12
and the proposed rights offer price is R7,50. There are 500 000 ordinary shares currently in issue.

SA Ltd is a 20% equity shareholder in CA Ltd and wishes sell 25% of its rights.

REQUIRED
a) Calculate the maximum price that SA Ltd could sell each right
b) Determine the maximum cash outflows to SA Ltd if it is able to sell 25% of its rights at the maximum price and
exercise the remaining rights
c) Calculate the shareholding of SA Ltd post the rights issue

© Endunamoo Board Course 2022 SCREENCAST 69

Capital investment
appraisals
Introduction
• We are concerned about the company’s long term decisions. Such decisions involve increase in increase in
manufacturing capacity, disposal of assets, new products, etc.
• Mutually exclusive projects are projects where only one of several alternatives may be chosen at a time. Therefore, if
two projects are mutually exclusive, the acceptance of one will automatically lead to the rejection of the other, e.g.
should the company acquire this building for its manufacturing activities or the other (but not both)
• For independent projects, the acceptance or rejection of one project has no bearing or influence on the acceptance or
rejection of any other project, e.g. should the company sell vehicle tyres or simply service vehicles
• Divisible projects refers to a situation where we can accept or invest in a portion of a project, e.g. acquire a smaller
machine, mine half the mine

© Endunamoo Board Course 2022 71

Capital appraisals techniques
There are different decision making techniques, many of which are based on the same principles of discounted cash flows.
These include:
• NPV analysis;
• Internal Rate of Return (IRR);
• Payback period or discounted payback period;
• Accounting rate of return;
• Profitability index (PV index or Benefit-Cost ratio) and
• Equivalent annual annuities can be used for products with different life cycles.

Each of these techniques has key assumptions which need to be remembered (some of which are not realistic), as well as
advantages or disadvantages of using the techniques rather than others which may be robust.

© Endunamoo Board Course 2022 72

Capital investment
appraisals
Net present value analysis and IRR
NPV
• NPV: Future cash flows discounted at the WACC
• If NPV>0 Accept, NPV<0 Reject (don’t forget that strategic implications may change the decision, e.g. loss on the sales
of decoder in order to generate value from subscriptions)
• NPV takes into account the time value of money
• It assumes that the cash flows generated by the project are reinvested at WACC
• NPV is consistent with shareholder value maximisation; any positive generating projects increases shareholder wealth

© Endunamoo Board Course 2022 74

IRR
• IRR: Discount rate which makes the NPV=0 (discounted inflows = cost). If IRR> WACC accept, if IRR< WACC reject.
• IRR assumes that the cash flows generated are reinvested at IRR which has the potential of overstating the benefits
• IRR has limitations as there may be more than one IRR with potentially opposite decisions if cash flows are not
conventional (conventional if initial cash flows negative and remaining cash flows positive)
• NPV and IRR are similar and will result in the same decision if cash flows are conventional and projects are independent
(decision to accept/reject this project does not affect other projects). When projects are mutually exclusive (taking one
investment prevents the taking of another investment) NPV and IRR may disagree

© Endunamoo Board Course 2022 75

Illustrative example: NPV
CA Ltd has invested R1 million into a new project. The cash flows of the project are as follows:
Year 1: R200 000
Year 2: R350 000
Year 3: R400 000
Year 4: R500 000
CA Ltd has a policy of accepting projects with a payback period of less than three years. WACC of CA Ltd is 10%.

REQUIRED: Calculate NPV and IRR and advise management on whether this project should be accepted
Discount factors applicable at a rate of 10%
Year 1 = 0,909;Year 2 = 0,826;Year 3 = 0,751;Year 4 = 0,683

© Endunamoo Board Course 2022 76

Examination technique: NPV
Approach: Start with the easy marks – marks that could be earned without a significant effort or intimate understanding of
the scenario
1) Earn the communication mark (1) by preparing the outline of cash flows and outline of tax calculation
➢ Ensure all the number of years is correct
➢ Do not be concerned about the outline spanning into two pages

2) Proceed to the initial investment amount

➢ Provide initial investment at the beginning of project (usually at T0) in cash flow outline (½)
➢ Provide the resale value at the end of the project in cash flow outline (½)
➢ Provide wear and tear allowances in the tax cash flow outline (1)
➢ Provide the recoupment / scrapping allowance in the tax cash flow outline (calculated as selling price less tax
value) (½ or 1)

3) For all non-relevant items, provide a reason for them, e.g. non-cash items, sunk and committed costs (½ - 2)

© Endunamoo Board Course 2022 77

Examination technique: NPV
4) In determining the tax calculation
➢ Start the tax cash flow outline with the operating cash flows, i.e. excluding capital investments, resale value
and working capital. This would have already been determined under the main cash flow outline (1)
➢ Show the tax rate utilised (1)
➢ Consider if there is a tax lag (1)

5) In determining the net present value, show calculation steps (i.e. CF0, CF1, CF2, etc.) (1)

6) Provide the necessary and appropriate investment advice, e.g. invest or do not invest, with a reason related to net
present value calculation (1)

© Endunamoo Board Course 2022 78

Technical guidance: NPV
1) Working capital guidance
➢ Initial injection need to be provided for
➢ Subsequently the movement in working capital balance need to be provided
➢ The working capital balance should be recovered at the end of the project
➢ Working capital balance or movement does not impact tax cash flows (because tax is based on both cash and non-
cash items)

2) Allocated overhead costs

➢ Non-incremental unless the overhead costs pool increases

3) Sunk costs
➢ Non-incremental because the cost cannot be recovered (i.e. it is not a future cash flow)

4) Committed costs
➢ Non-incremental because the cost cannot be avoided (i.e. although it is a future cash flow, it remains payable or
receivable regardless of the decision to invest)

© Endunamoo Board Course 2022 79

Technical guidance: NPV
5) Depreciation
➢ Non-incremental because it is a non-cash flow item

6) Opportunity costs
➢ These are differential cash flows and therefore included in the analysis

7) Growth estimates
➢ Inflation based versus contract based
➢ Growth could be on a line to line basis or overall, consider whether a shortcut might be available

7) Finance related cash flows

➢ Interest expense, loan repayments are dividend cash flows are excluded from the analysis
➢ These are financing decision related and do not impact the attractiveness of the project under consideration

8) Expected values
➢ If a value is subject to different outcomes at different probabilities, determine the expected value
➢ The expected value is determined as the product of the probability of the outcome and the value of the outcome

© Endunamoo Board Course 2022 80

Technical guidance: NPV
9) Appropriate WACC
• A target WACC: Based on the target capital structure
• Actual WACC: Based on the market values
• Hurdle rate WACC: Adjusted for risk premium

© Endunamoo Board Course 2022 81

Comprehensive example on NPV / IRR

CA Ltd is a manufacturer of electric geyser. Due to the recent load shedding and more households becoming green
conscious, the company is contemplating on entering the solar geyser market. In order to manufacture the solar geysers,
CA Ltd has to purchase a new plant with a purchase price of R30 million. The useful life of the plant is 5 years with a
residual value of R6 million.

The purchase price will be funded by a five-year loan from LC Bank. The loan will bear interest at a rate of 10% payable
annually and the capital amount would be repayable at the end of the five year term.

Two months ago, CA Ltd undertook an environmental study to better understand the solar conditions in South Africa. This
study assisted the company in developing an appropriate product for the South African market. The cost of this study was
R200 000.

© Endunamoo Board Course 2022 SCREENCAST 82

Comprehensive example on NPV / IRR

CA Ltd estimates that the annual demand for solar geysers in South Africa over the next five years is as follows:
Year 1: 12 000
Year 2: 15 000
Year 3: 18 000
Year 4: 22 000
Year 5: 25 000

CA Ltd estimates that its market share would be 30% throughout the five year period. The selling price of each geyser is
estimated at R10 500. The contribution margin per unit is 55%.

The sales of the solar geysers would result in lower sales volume for the electric geysers. The lost contribution would be R2
million in year 1 and this will increase by 10% each year. Net working capital is estimated at 20% of the following year’s
forecasted sales.

© Endunamoo Board Course 2022 SCREENCAST 83

Comprehensive example on NPV / IRR

Fixed costs are estimated at R20 million per annum. This amount includes depreciation on the machine and R2,5 million for
allocated fixed costs.

Additional information
• Corporate tax is 28%. SARS grants a deduction on the plant over 6 years.
• Cost of equity is 18,18%. Cost debt is 12% (pre-tax). Debt-ratio is 33%.

REQUIRED:
i) Advise CA Ltd on whether or not should invest in the project (23)
ii) Calculate the IRR of the project (2)

© Endunamoo Board Course 2022 SCREENCAST 84

Capital investment
appraisals
Payback period methods
Payback period
• Payback period is used to evaluate projects according to the time it takes to recover the cost of an investment
• This is compared to the entity’s benchmark as determined by the board to make a decision
• Advantages are that it is simple to calculate and to understand, is a risk indicator and is widely used, but the
disadvantages are that:
− it ignores cash flows after the payback. Consequently it is biased towards short term projects (i.e. against long
term projects)
− ignores the time value of money

© Endunamoo Board Course 2022 86

Discounted payback period
• Discounted payback period is also used to evaluate projects according to the number of years it takes to recover the
cost of an investment
• The advantage over the conventional payback period technique is that it overcomes one disadvantage of the payback
period because it factors in the time value of money
• Both the payback period techniques might especially be relevant for a start up company, venture capital companies or
small businesses, where there is a greater focus on the time it takes to recover the cost of the investment made than for
a well established, listed company

© Endunamoo Board Course 2022 87

Illustrative example: Payback period
CA Ltd has invested R1 million into a new project. The cash flows of the project are as follows:
Year 1: R200 000
Year 2: R350 000
Year 3: R400 000
Year 4: R500 000
CA Ltd has a policy of accepting projects with a payback period of less than three years. WACC of CA Ltd is 10%.

REQUIRED:
1) Calculate the payback period
2) Calculate the discounted payback period
3) Should this project be accepted? Motivate your answer

© Endunamoo Board Course 2022 88

Capital investment
appraisals
Accounting rate of return
Accounting rate of return
• The accounting rate of return is simply the net income/average book value [(cost-residual value)/2]
• Project is accepted if calculated return > certain benchmark return. This does not consider cash flows or time value of
money which is disadvantageous
• ARR however ignores the time value of money

© Endunamoo Board Course 2022 90

Capital investment
appraisals
Projects with unequal lives
Equivalent annual annuities
• Project with unequal life cycles are difficult to compare and simply accepting the project with the highest NPV is
incorrect
• The technique of equivalent annual annuities is applied in order to work out which project adds the most value per
period, with some key assumptions integral to make this model work:
− Projects should not be independent and they should be able to be repeated (which is unrealistic in many ways)
− Assume limited changes in technology
− Assume that cost of equipment remains the same (not impacted by inflation or currency) so that repeat cash flows
are same as initial project
• To work out the equivalent annual annuities, calculate the NPV, then use this as the PV (with FV=0) to work out the
payments in the annuity formula

© Endunamoo Board Course 2022 92

Replacement chains
• Replacement chains is calculated as the NPV with infinite replicated cash flows
• This is applicable to mutually exclusive projects
• The entity assumes the project can be repeated indefinitely and it will continue to generate the same annual cash flows
• The project essentially runs into perpetuity and the dividend growth model can therefore be applied

Replacement chains are calculated as follows:

NPV of project
PV factor over project life x discount rate
=
Equivalent annuity / discount rate

© Endunamoo Board Course 2022 93

Illustrative example: Unequal project lives
Evaluate which project should be accepted between:
• Project X - Cost at T0 of R5 200 000 with net inflows of R2 800 000 per annum over 3 years
vs.
• ProjectY – Cost at T0 of R8 400 000 with net inflows of R2 900 000 per annum over 5 years

You may assume that the projects are mutually exclusive and the projects can be repeated.

You may assume that the WACC is 14%.

Discount factors applicable at a rate of 14%
Year 1 = 0,877;Year 2 = 0,769; Year 3 = 0,675;Year 4 = 0,592

© Endunamoo Board Course 2022 94

Illustrative example: Unequal project lives / Solution
Suggested solution:
To work out the equivalent annual annuities, calculate the NPV, then use this as the PV (with FV=0) to work out the
payments in the annuity formula.

• The NPV for X is R1 300 570, with an equivalent annual annuity of R560 196 and the replacement chain value is R4 001
400
• The NPV for Y is R1 555 935, with an equivalent annual annuity of R453 218 and the replacement chain value is R3 237
271

Even though Y results in a greater NPV, X should be accepted as the value per period is higher (or higher replacement chain
value)

© Endunamoo Board Course 2022 95

Capital investment
appraisals
Capital rationing
Capital rationing

• Capital rationing refers to a situation where an entity has limited resources to undertake all positive NPV generating
projects
• Capital rationing may be soft or hard. Soft refers to limitations imposed by the group’s internal policies and hard refers
to limitations imposed by the market
• Consideration has to be made as to whether projects are mutually exclusive or independent projects, divisible or
indivisible
• In capital rationing scenarios, NPV may not be the most appropriate technique, especially since these projects may
have different life spans
• The appropriate technique would be the PI, which will help us rank projects in order of profitability, but is not always
correct if projects are indivisible and also might not be correct if projects are mutually exclusive

© Endunamoo Board Course 2022 97

Profitability index
• The profitability index measures the return of the project relative to cost
• PI= PV / Cost. If PI >1 accept and if PI <1 reject
• It is closely aligned to NPV (since NPV = PV - Cost anyway) and is useful to make decisions when there is capital
rationing and an entity wants to maximise returns relative to cost (but incorrect decision may be made where projects
are mutually exclusive)

© Endunamoo Board Course 2022 98

Illustrative example: Capital rationing
CA Ltd is a successful company which is considering launching three new different types of tents which would be sold for 5
years.

The CA (SA) has prepared an NPV analysis for each of these projects, but has advised due to the limited resources available
of R20 million, not all the projects can be accepted. Determine which projects should be accepted?

Product A would cost R15m, and will result in an NPV of R3 million.

Product B would cost R8m, and will result in an NPV of R1 200 000.
Product C would cost R10m, and will result in an NPV of R1 900 000.

© Endunamoo Board Course 2022 99

Illustrative example: Capital rationing / Solution
Suggested solution:
Since there is capital rationing we would usually use the highest PI:
PI(A) = R18m/R15m = 1,2,
PI(B) = R9,2m/R8m = 1,15,
PI(C) = R11,9/R10 = 1,19

• Product A seems to be preferable since it has the highest PI and NPV. However project A is mutually exclusive and this
means it might be incorrect.
• Note that the goal of a business to create the most wealth/value. If we invested in B and C (total cost < R20m), even though
they have lower PIs, we would add total value of R3.1m (R1.2+R1.9) as compared to the R3m, which is better and these
should be accepted
• If these projects were divisible then using PI would have been correct

© Endunamoo Board Course 2022 100

Capital investment
appraisals
Scenario and sensitivity analysis
Scenario analysis
• Any valuation or cash flow forecast contains various assumptions and uncertainties, which are subject to change
• Forecasting risk is the risk that errors in projected cash flows lead to an incorrect decision
• The NPV based on the original estimates is called the base case
• Scenario analysis is where we change more than one variable at a time to determine the impact, often to calculate the
best and a worst case scenarios
• If under the worst case scenario the NPV is still positive there is very little risk in accepting the project
• Scenario analysis helps management in gauging the potential disaster

© Endunamoo Board Course 2022 102

Sensitivity analysis
• Sensitivity analysis is a variation of scenario analysis where we just change one variable at a time
• If a small change in a variable results in a big change in NPV then the sensitivity of that variable is high and it is very
important to get an accurate estimate for that variable otherwise the decision could be incorrect
• It is useful in identifying variables that need to be managed carefully, because these carry higher forecasting risk than
less sensitive items
• Steps should be taken to minimise the impact of highly sensitive variables or assumptions (e.g. enter into fixed
contracts for supply prices, use FECs if the exchange rate is a highly sensitive input)

© Endunamoo Board Course 2022 103

Capital investment
appraisals
International projects
International projects
• Projects that include transactions with other countries have unique factors that need to be considered, most common
of which would be foreign exchange, customs regulations and foreign tax regulations
• Depending on the nature of the scenario and the set of facts available, the cash flows could be prepared in the foreign
currency, and the NPV calculated in the foreign currency and then converted to rands based on the prevailing spot rate
• Usually though there would be a combination of local and foreign cash flows in which case the foreign cash flows would
be converted to rands before they are included into the analysis

© Endunamoo Board Course 2022 105

Capital investment
appraisals
Leasing
Leasing
• It may be better to lease an asset for a project than to borrow money and purchase the asset
• Evaluation of leasing usually takes place once the investment decision has already been made, i.e. it does not
determine whether the project is accepted or not
• The evaluation compares the PV of lease cash flows to PV of borrow and purchase cash flows. This is called the Net
Present Cost (NPC). The appropriate discount rate is the after tax cost of debt, because this is a financing decision not
an investment decision
• Alternatively, the evaluation compares the IRR of the borrow to purchase cash flows against the IRR of the leasing cash
flows
• Financing cash flows include loan repayments and lease repayments, apart from cash flows that we would usually
consider (taxes, maintenance etc.)

Recommended approach: Undertake separate cash flows for the lease, and for the borrow and buy option. Choose the
lowest NPC option or IRR.

© Endunamoo Board Course 2022 107

Illustrative example: Leasing
CA Ltd has decided to invest in a project for which it needs a new manufacturing machine that costs R500 000.
• The company can borrow the money from a bank and buy the machine, in which case it will incur maintenance costs of
R20 000 p.a. and sell the asset for R75 000 after the 5 year project. The machine qualifies for S12C (i.e. 40%, 20%, 20%,
20%).
• It can also lease the asset at R130 000 per year (payable in advance) with maintenance costs borne by the lessor.
• The company’s cost of debt is 10% p.a. (pre-tax) and WACC is 15%.

Advise the management of CA Ltd whether they should borrow and purchase the asset or whether they should lease the
asset

© Endunamoo Board Course 2022 108

Management of working
capital
SCREENCAST
Investment in working capital
• Working capital is essential for all business activity
• It comprises three primary assets – inventories, accounts receivable and cash
• The amount of funds invested in working capital reflects the strategic operating plan of the business
• The amount of working capital held is also highly sensitive to the performance of the business and to economic
conditions, e.g. during recessionary times, debtors may take longer to settle their accounts, inventory sales might be
slow resulting in obsolete inventory and access to overdraft or cash might be limited
• We are therefore essentially dealing with the investment decision

© Endunamoo Board Course 2022 SCREENCAST 110

Financing of working capital
• Generally the appropriate source of funding of working capital is trade payables, which normally do not charge interest
for providing their financing - is there an implicit cost of funding?
• The portion of working capital not financed by trade payables will be financed by interest-bearing debt raised by the
company in accordance with the capital structure policy, and by bank overdrafts when working capital funding
requirements fluctuate
• We are therefore essentially dealing with the financing decision
• An appropriate working capital policy will therefore deal with decisions regarding the optimal level of investments in,
and the optimal financing of, current assets. Working capital management involves the administration of current
liabilities and current assets

© Endunamoo Board Course 2022 SCREENCAST 111

Working capital cycle
A knowledge of the working capital cash flow cycle of a particular company is essential in establishing a working capital
policy of that company

A typical working capital cycle in a manufacturing firm is as follows:

• Ordering and receiving raw materials acquired on cash or credit
• Conversion costs (overheads and labour costs) incurred to covert raw materials into finished goods
• The finished goods are then sold – either for cash or on credit
• Creditors require payment for costs incurred on credit
• Finally, the cash from credit sales is received and the cycle goes again

© Endunamoo Board Course 2022 SCREENCAST 112

Management of
working capital
Accounts receivable management
Accounts receivable management…
Collection policy
• The collection policy refers to the procedures that a firm would follow to collect overdue accounts, e.g. SABC TV lic
• A change in collection policy will influence sales, the collection period, the losses arising from bad debts, and the
percentage of customers who take discounts

Setting settlement and cash discount policy

• Another factor in the credit policy decision is the use of settlement discounts to encourage early payment
• The policy is determined by balancing the cost of the discount (e.g. reduced profit margin) against the benefit of the
cash flow (e.g. reduced collection period)

© Endunamoo Board Course 2022 SCREENCAST 114

Accounts receivable management
Change in credit policy
In changing credit policy, the balance between risk and return must be achieved. A change in credit policy would affect the
following:
• The sales turnover of the firm (and as a result it will affect gross profit)
• The amount of receivables outstanding (and as a result there will be a change in the cost of carrying these receivables)
• As the credit quality has changed, there is likely to be a change in the bad debts losses
• If there is a change in the discount policy, there will be a change in the cost of discounts

As a result, question requiring you to consider a change in credit policy should be accessed by evaluating the difference
between the four elements based on the old and the proposed policy

© Endunamoo Board Course 2022 SCREENCAST 115

LE1: Change in credit policy
VestGrow Food is a listed foodservice business with a financial year end of 30 June. An extract from VestGrow Food’s
financial statements for the year ended 30 June 2019 has revealed the following sales, cost of sales, gross profit and trade
receivables figures:
2019 2018
Sales R44 511 211 R51 134 844
Cost of sales (R35 413 910) (R41 013 324)
Gross profit R9 097 301 R10 121 520

Current assets
Trade receivables R5 308 708 R4 511 748

Management of VestGrow Food is concerned as the downward trend in sales is expected to continue in 2020 if no
intervention occurs. Management therefore intends making some changes to its current sales policy with the aim of
increasing its 2020 sales.

© Endunamoo Board Course 2022 SCREENCAST 116

LE1: Change in credit policy
The current 2019 sales policy applied is as follows:
1) Customers qualify for a 2% discount if payment is made within 10 days of date of sale [approximately 25% of
customers (in value terms) take advantage of the discount and it is expected to remain 25% should the current sales
policy remain in place for 2020].
2) All sales are on credit and there are currently no bad debts and no bad debts are expected if the current sales policy
remains in place for 2020.

Proposed changes for the 2020 sales policy are as follows:

1) The credit terms would be 4/10 net 60. Approximately 35% of total customers (in terms of value) are expected to take
advantage of this discount.
2) The change in credit terms is expected to result in a net increase of 10% in sales (based on 2019 sales figures). The
trend in sales as evidenced from 2018 to 2019 will continue into 2020 in respect of sales to existing customers, with any
increase in sales for 2020 arising from sales to new customers.
3) Bad debts are expected to amount to 2,5% of total 2020 sales.

© Endunamoo Board Course 2022 SCREENCAST 117

LE1: Change in credit policy
The cost of financing accounts receivable amounts to 13% of the total balance irrespective of the sales policy
implemented.

Calculate and conclude whether it will be profitable for VestGrow Food to change its sales policy from 2020 onwards

Please note that:

• All days should be rounded to the nearest day and all amounts to the nearest rand;
• Closing balances should be utilised;
• There are 365 days in a year; and
• You may ignore taxation for the purpose of this calculation

(18 marks + 1 communication skills)

(Extracted from UNISA Supplementary Exam, 2015)

© Endunamoo Board Course 2022 SCREENCAST 118

Management of
working capital
Inventory management
Inventory management
• In establishing an inventory policy, the nature of the business and the environment in which it operates are critical

• The objective of inventory management is the balancing of a set of costs that increase with larger stock holdings
against a set of costs that decrease with larger order sizes

© Endunamoo Board Course 2022 SCREENCAST 120

Conflicting objectives?
• The financial manager is concerned with the level of inventory because of its effect on profitability. Excessive
inventories erode profit margins as they reduce the total asset-turnover ratio and involve substantial carrying costs

• On the other hand, the production manager would be concerned with the minimum levels of both raw material and
work-in-progress inventories to ensure that there are no disruption to production

• The marketing manager is concerned with the minimum levels of inventories of finished goods to ensure that demand
is met rapidly

© Endunamoo Board Course 2022 SCREENCAST 121

Economic order quantity
Mathematically EOQ = √(2FS/H), where
F = fixed costs of placing and receiving an order
S = annual sales in units
H = holding costs of one unit of inventory for one year

EOQ is based on three main assumptions:

• Sales can be forecast perfectly
• Sales are evenly distributed throughout the year
• Orders are received with no unexpected delays

© Endunamoo Board Course 2022 SCREENCAST 122

LE2: EOQ
CA Ltd has an annual demand of 10 000 units. Each unit has a variable cost of R12 and the gross margin is 25%. The
ordering cost is R4,225 per order and the holding cost is R5 per unit. The lead time is 10 days.

Determine the EOQ and total costs, where:

• H (EOQ) = EOQ / 2 x holding cost per unit
• F (EOQ) = annual demand / EOQ x ordering cost per unit
• TC (EOQ) = H (EOQ) + F (EOQ) = √(2xFxSxC)

© Endunamoo Board Course 2022 SCREENCAST 123

Management of
working capital
Cash management
Cash management
There are four main reasons for holding cash on hand
• Transactions
• As a precaution
• Speculation
• Loan covenants

However the main disadvantage of holding cash relates to the fact that cash balances yield low returns, so excessive cash
balances result in a low return on investment and a low asset turnover (and potentially destruction of value)

© Endunamoo Board Course 2022 SCREENCAST 125

Management of
working capital
Accounts payables management
Financing current assets…
In deciding how to finance current assets, management needs to consider both the risk and return aspects of the
alternatives

Common sources of short term finance follows:

• Accruals are continually recurring short-term liabilities, e.g. accrued wages
• Trade credit from suppliers, i.e. accounts payable
• Factoring and invoice discounting
• Bank overdrafts

© Endunamoo Board Course 2022 SCREENCAST 127

Financing current assets
Advantages of short-term financing
• Lower cost (limited to no or little compensation for inflation)
• Fast
• Lower credit checks and formalities
• No loan covenants and pre-payment penalties
• Flexibility and matching

Disadvantages of short-term financing

• Volatility of interest rates
• Risk of non-extension of facility

© Endunamoo Board Course 2022 SCREENCAST 128

LE3: Cost of trade finance
CA Ltd purchases goods under the terms 3/10 net 40, but it is estimated that it can delay payment for an additional 15 days
without incurring additional penalty or interest.

Alternative short term funding is available at 30% per annum

REQUIRED
Advise management whether or not the payment should be postponed by 15 days

© Endunamoo Board Course 2022 SCREENCAST 129

Dividend decision
SCREENCAST
Dividend decision
• The dividend decision is considered to the third decision in financial management
• No optimal decision has been identified to date regarding the impact of dividends on shareholder value
• However, the general principle is that any excess cash, i.e. cash that is in the business after having invested in all
positive generating net present value projects and for the provision of working capital, should be returned to
shareholders
• This is based on the notion that the funds do not belong to the company and should not keep cash on hand other than
for strategic reasons, e.g. flexibility
• However, the issue that remains is whether the dividend decisions affects the value of the company?

© Endunamoo Board Course 2022 SCREENCAST 131

Irrelevance or relevance of the dividends
If dividend is relevant then a company should actively manage this aspect to generate value for the business
Dividend growth model assumes that dividend is relevant and the value of the company could be increased by declaring
more dividends to shareholders
Supporters of the dividend growth model purports that investors are happier with cash now rather than uncertain future
growth (i.e. the bird in the hand theory)
However, this is countered by the observation that investors normally reinvest their dividends in the market and thus
resubjecting those dividends to uncertain growth
Furthermore, dividends declared now reduces funds available for growth and thus capital appreciation will be lower

© Endunamoo Board Course 2022 SCREENCAST 132

Factors affecting the dividend decision…
• Legal requirements: Companies Act requires that the company meets the solvency and liquidity tests after declaring a
dividend
• Contractual requirements: Debt covenants may restrict the company from declaring dividends
• Availability of cash: If a company wishes to declare cash dividends, it needs to ensure that it has sufficient cash
available on hand (not only retained earnings)
• Alternative investments: Investments that are positive NPV generating should be prioritised
• Signalling theories: Dividends often signal that a company has exhausted all its growth avenues and thus returning
cash to shareholders (only applicable to listed companies – for unlisted companies, it will be the actual fact of growth
opportunities)
• Taxation: Dividends tax versus capital gains tax
• Nature of shareholders / Shareholders’ preferences (Clientele effect): Shareholders will tend to be attracted to
companies that satisfy their needs with regard to the balance between cash income and capital growth
• Capital structure: Opportunity to alter capital structure
• Improve returns or EPS: If undertaken through a sharebuyback, the EPS can be improved and returns since cash has a
lower return

© Endunamoo Board Course 2022 SCREENCAST 133

Dividend policies
Stable dividend amount
Stable payout ratio
Stable dividend plus bonus
Share buy backs

© Endunamoo Board Course 2022 SCREENCAST 134

Practical example: McDonald
Buybacks and dividends can't cheer Mickey D's investors
The fast-food juggernaut today said it would return $18 billion-$20 billion to shareholders over the next three years in the form of
dividends and share buybacks. Usually that kind of news has investors cheering, but the stock is down for good reason.
When companies can no longer find ways to invest in their businesses and grow organically they often turn to buybacks to
increase earnings per share. That appears to be what McDonald's is doing.
The big problem for McDonald's is that same-store sales fell five straight months in the U.S. until coming in flat in April. Longer
term, you can see a stagnation in growth over the last two years; this should be concerning to investors because the stock has
followed sales.
None of this is to say that McDonald's is a bad investment at the moment. Its dominant global footprint and ability to adapt to
consumer changes ensures the Golden Arches will be around for decades to come. But expectations should be muted, and
McDonald's stock should probably be seen as little more than a dividend play.
The company's days of big growth appear to be over, and McDonald's is turning to returning cash to shareholders rather than
investing in the business. That may be the right move, but investors in public markets look for growth. That's why the stock is
down today; but if you're looking for a dividend stock this could be a good opportunity to buy a company with a business that isn't
going away anytime soon.
Stable dividends are a great way to beat the market and a good long-term investment strategy for those who want to collect
income.
Source: http://www.fool.com/investing/general/2014/05/28/mcdonalds-cant-get-a-boost-from-buyback-plan.aspx

© Endunamoo Board Course 2022 SCREENCAST 135

LE1: Dividend decision
CA Ltd, a listed ice cream manufacturer, and has 1 million shares outstanding. CA Ltd is considering investing in a new ice-
cream plant worth R10 million and a new distribution fleet to the value of R3 million. The IRR of each project is 20% and
13% respectively.

The company has cash balance of R13 500 000 and a cost of capital of 13,5%. The debt ratio of CA Ltd is 80%.

CA Ltd wishes to maintain its stable dividend policy of R1,20 per share. This policy was established 10 years and the
company has consistently maintained it since then.

REQUIRED
Advise management of CA Ltd on the key considerations regarding the maintenance of the stable dividend policy
(25 marks + 1 clarity of expression + 1 logic argument)

© Endunamoo Board Course 2022 SCREENCAST 136

Treasury function
Introduction
• A central purpose of financial management is to create value

• This is achieved either through an increase in returns, or a reduction of risk, or a trade-off between the two

• This has necessitated the creation of derivative instruments in order to solve many of the problems in finance (e.g.
reduction of risk and/or cost of finance)

• This process is called financial engineering. This process sometimes lead to unintended consequences, e.g. asset-backed
securitisation that led to the global financial crisis

© Endunamoo Board Course 2022 138

Treasury function
Interest rate risk
Interest rate risk management
Forward rate agreements
• The interest differential between the agreed rate and the market rate is settled between the parties
• There is no daily mark-to-market process with forward rate agreements

Interest rate swap

• A swap occurs where one party agrees to swap commitments on a notional amount for commitments held by another
party, known as a counter-party

Interest rate futures

Matching
Collar, cap and floor

© Endunamoo Board Course 2022 140

LE1: Interest rate swaps
CA Ltd is a furniture retailer which sells goods on both credit and cash. CA Ltd has debt of R100 000 at a 12% per annum
fixed interest rate and is expecting the interest rates to decrease. It would therefore want to swap its fixed interest to a
floating interest rate. The current prime rate is 11,5% per annum. The bank is offering CA Ltd an annual variable interest
rate of prime + 2%.

CA Ltd’s bankers found a counterparty with the following profile:

• The counterparty is currently borrowing R100 000 at an annual variable rate of prime + 2,5% but wishes for a fixed
interest rate
• The bank is willing to offer a fixed rate to the counterparty at 13% per annum

© Endunamoo Board Course 2022 141

LE1: Interest rate swaps
On request of CA Ltd and the counterparty, the bank has arranged an interest swap with the following profile:
• CA Ltd pays to the counterparty an annual variable interest rate at prime + 0,75%
• The counterparty pays CA Ltd a fixed interest rate of 11% per annum

REQUIRED:
a) Discuss the key factors that CA Ltd management need to take into consideration in making a decision to enter into a
swap arrangement.
b) Determine if the swap is feasible and show movement of cashflows
(13 marks)
(Adapted from UNISA Supplementary Exam, 2015)

© Endunamoo Board Course 2022 142

Treasury function
Asset securitisation
Asset securitisation….
• Asset securitisation is the conversion of an organisation’s illiquid assets into liquid assets
• This is achieved by repackaging existing income-yielding assets into tradeable securities (e.g. trade receivables,
mortgage bond receivables), secured by the assets into negotiable instruments
• It facilitates the disposal of risky assets and replace them with liquid assets

© Endunamoo Board Course 2022 144

Asset securitisation

1 Originator sells receivable to issuer for cash

Originator
Issuer sells/debt notes to investors in order to pay the consideration for
2 receivable acquire. The collateral is the receivable acquired from Originator

3 Issuer receives cash consideration from investors

Originator receives cash consideration from issuer from proceeds raised

Clients 4 from issue of notes/debt
4 1
Clients pay their debts, i.e. capital and interest, and the cash is received by
5 issuer
Issuer utilises the cash received to pay back the capital and interest on the
5 6 notes

3
Issuer 2 Investors
6

© Endunamoo Board Course 2022 145

Treasury function

Foreign exchange risk

Foreign exchange market
• Foreign exchange markets are required in order to facilitate international trade transactions
• Exchange rates are quoted in a direct and indirect form. A direct quotation quotes an exchange rate in terms of the local
currency indicating how much one unit of a foreign currency buys of local currency, e.g. £1=R18.
• A bank quotes two rates: a buying rate (bid) and a selling rate (ask). The difference between these two rates constitutes
the dealer’s spread while the mid-rate refers to the mid-point of the bid-ask rates
• The bid-ask spread is often quoted in point, where one point is equal to 0.0001 of the exchange rates
• A bank may enter into either a spot or forward transaction

© Endunamoo Board Course 2022 147

Foreign exchange market

Source: Currencies from RMB, 22 January 2021

© Endunamoo Board Course 2022 148

Foreign exchange exposure
Foreign exchange exposure refers to the potential for gain or loss due to a change in the exchange rate. There are three
types of foreign exchange exposure:
• Translation exposure: The effect that a change in the exchange rate will have on the recorded results of a company.
There are no cash flow implications
• Transaction exposure: The potential for gains or losses which arise when one enters into transactions whose terms are
stated in foreign currency
• Economic exposure: This measures the long-term real effects of a change in the exchange rate. This exposure exists
even when a company does not have transactions in a foreign currency

© Endunamoo Board Course 2022 149

Primary hedging techniques
• Forward contracts: A forward contract is a contract whereby the exchange rate is fixed at the current date but the
payment/receipt of foreign currency is effected only at the future date. The cost of the contract is determined by the
forward premium/discount
• Money market hedge: In a money-market hedge, the firm will enter into an offsetting loan agreement in foreign or
local currency to cover the foreign currency transaction. The cost of the hedge is determined by the interest differential
• Currency options: A currency option gives a person the right, but not the obligation, to purchase (a call option) or sell (a
put option) a specified amount of foreign currency at an agreed price (a strike price)
• Currency of invoice: A firm may choose the currency of invoice which satisfies the particular requirements of a firm
engaged in international trade
• Leads and lags: Firms will utilise leads and lags when a currency is expected to move in one particular direction. Leads
and lags involve the speeding up or slowing down of payments/receipts in foreign currency
• Future contracts: A futures contract is an obligation to buy or sell a specified amount of rands in exchange for US$ at a
certain price on a specific future date
• Currency swaps: Two firms agree to exchange a specific amount of once currency for a specific amount of another at
specific dates in the future
• Natural hedge / Matching: It occurs when opposite positions are taken in the market through normal course of
business

© Endunamoo Board Course 2022 150

Treasury function
Forward exchange contracts
Forward exchange contracts
• Forward contracts involve entering into a contract with a bank
• The parties to a forward contract agree on a settlement date and exchange rate at the inception date
• No initial payment is involved at inception date
• The contract may be favourable or unfavourable on settlement
• This depends on the difference between the contracted rate and the spot rate on settlement date
• The contract may be settled on net or gross basis
❑ Net basis means that the party to whom the contract is unfavourable settled the difference, i.e. the
unfavourable portion
❑ Gross basis means that contracting party takes delivery of the currency acquired

© Endunamoo Board Course 2022 152

Illustration: Forward exchange contracts
CA Ltd entered into an FEC with Bank C. In terms of the FEC, CA Ltd is contracted to purchase $100 000 from Bank C at an
exchange rate of $1 = R14,00 in three months time.

In three months time, the spot rate was $1 = R14,25.

REQUIRED
• Did the FEC yield value to CA Ltd?
• If the contract is settled on a net basis, determine the cash flows and the direction thereof.
• If the contract is settled on a gross basis, determine the cash flows and the direction thereof.

© Endunamoo Board Course 2022 153

Illustration: Forward exchange contracts / Solution
Part a)
Without FEC: R14,25 x $100 000 = R1 425 000
With FEC: R14,00 x $100 000 = R1 400 000
Value created by FEC = R1 425 000 – R1 400 000 = R25 000

Part b)
Net basis = R1 425 000 – R1 400 000 = R25 000 inflow

Part c)
Gross basis = R1 400 000 outflow

© Endunamoo Board Course 2022 154

Treasury function
Money market hedge
Money market
Step 1: Determine the current position of the entity – determine whether the entity has foreign payable (importer) or
receivable (exporter)
Step 2: Create an offsetting position, i.e. if entity has a foreign payable, create a foreign receivable by depositing funds in
the foreign country and if entity has a foreign receivable, create a foreign payable by borrowing funds from the foreign
country
Step 3: Determine the respective funds, i.e. amount to be borrowed or to be deposited. This is achieved by determining
the PV in foreign currency as follows: N = 1 (always); FV = Amount to be received or settled at a future date; I = Annual
foreign interest rate / 12 (if borrowing, use foreign borrowing interest rate; if depositing, use foreign deposit rate)
Step 4: Convert the funds at the spot rate. This is because the proceeds from the borrowing would need to be deposited
into the South African bank account and the amount to be withdrawn from a South African bank account and deposited
into a foreign bank account
Step 5: Determine the entity’s cash position and calculate the interest income / expense. If the entity is in a net cash
position, the local deposit interest rate would be applicable and if the entity is in a net borrowing position, the local
borrowing interest rate would be applicable
Step 6: Add / Deduct the interest income / expense. If the entity is in a net cash position, the interest income or saved
interest expense would be added to the rand-equivalent borrowed funds. If the entity is in a net borrowing position, the
interest expense or the lost interest income would be added to the withdrawn funds
Step 7: If an effective exchange rate is required, the aggregate amount from South Africa is divided by the original foreign
currency amount

© Endunamoo Board Course 2022 156

LE1: Money-market hedge
CA Ltd exports aluminium products to the UK. The company has delivered an order for £300 000. Payment is due on 15
April 2020. The current exchange rate on 15 January 2020 is £1=R18,20. The local and foreign interest rates are as follows:
• UK interest rates - Borrowing: 5% p.a / Deposit: 4% p.a
• SA interest rates - Borrowing 9% p.a / Deposit: 7% p.a

The forward exchange rate on 15 April 2020 is R18,33.

Advise, with supporting calculations, which hedging option CA Ltd should elect assuming:
(i) CA Ltd is in a net borrowing position
(ii) CA Ltd is in a net cash position

© Endunamoo Board Course 2022 157

Treasury function
Currency options
Currency options
Step 1: Determine the current position of the entity – determine whether the entity is an importer or an exporter
Step 2: If the entity is an importer, it means that it will need foreign currency in order to settle that and as a result, the
would need to “buy or call” the foreign currency from a third party (a call option) whereas if it is an exporter, it means that
it would need to “sell or put” the foreign currency for another entity to buy them (i.e. a put option)
Step 3: At contract inception, the entity would need to pay a premium in order to secure its right to either call or put the
foreign currency to another party. The premium is determinable in foreign currency
Step 4: The premium is payable in the local currency so the premium has to be converted at the applicable spot rate
Step 5: The premium is considered a sunk cost because it is not recoverable regardless of the eventual decision on
settlement date
Step 6: On settlement date, the entity would need to compare the strike price against the applicable spot rate. If it has a
call option, they would want to exercise their option if the strike price is less than the applicable spot rate whereas if it has
a put option, the entity would exercise if the strike price is greater than the applicable spot rate

[An option has two primary elements: the strike price / exercise price; and a settlement date]

© Endunamoo Board Course 2022 159

LE2: Currency option
CA Ltd has tendered for a contract which could potentially result in CA Ltd receiving €100 000 on 31 March 2020. It
purchases a [____] currency option at a premium cost of 1,5%, and with a strike price of R12,25. The bid-ask spot rate on
the inception date was R11,75 – R11,85.

Fast forward →
(a) The bid-ask spot rate on 31 March 2020 is R14,00 – R14,30.
(b) The bid-ask spot rate on 31 March 2020 is R12,00 – R12,30.

Determine the option cost and for, each alternative, calculate the cash outflows on 31 March 2020

© Endunamoo Board Course 2022 160

Treasury function
Futures contracts
LE3: Futures contracts
CA Ltd entered is an exporter and has recently sold goods to the value of US$750 000 receivable in three months. CA Ltd
wishes to hedge itself against the foreign currency risk. The current contract is trading at US$0,375 per rand. The contract
size is R500 000 (i.e. Rands contract).

Fast forward → The spot rate in three months’ time is US$0,3800 per rand.

Show how CA Ltd can use the futures contract to hedge against the foreign currency risk

© Endunamoo Board Course 2022 SCREENCAST 162

Business strategy

SCREENCAST
Mission and objectives
A mission is the overall objective of an organisation

A mission statement broadly defines:

• the ultimate goal of an organisation;
• the products or services it aims to offer;
• the customer it aims to serve;
• the values of the firm; and
• the distinctive competencies of the firm

Strategy is then a course of action, including the specification of resources required, to achieve a specific objective

© Endunamoo Board Course 2022 SCREENCAST 164

Environmental analysis
• The rational model of strategy development assumes that the firm develops strategy that allows it to fit in the
environment
• As such it places a great emphasis on understanding the environment, i.e. environmental analysis
• The environmental analysis will assist the firm in identifying opportunities and threats relating to its existing or
proposed strategies (Threats and Opportunities)

© Endunamoo Board Course 2022 SCREENCAST 165

Corporate appraisal and position audit
• Having understood the environment, the firm will be in a position to undertake a corporate appraisal in order to identify
its strengths that will assist it in taking advantage of its opportunities and averting its threats (Strengths)
• It will also need to identify and address its weaknesses that could potentially prevent it from taking advantage of
opportunities and expose it further to its threats (Weaknesses)

© Endunamoo Board Course 2022 SCREENCAST 166

Environmental strategic analysis
• The strategy of an organisation must allow it to achieve ‘a good fit’ with its environment
• As part of its strategic analysis, an organisation should look at the various factors within its environment that may
represent threats or opportunities and the competition it faces (i.e. strategic risk factors)
• The external appraisal is undertaken to identify factors relevant to the organisation’s existing and future activities
• Appropriate models that may be used are:
❑ PESTEL: analysis of the general environment
❑ Porter’s Five Forces: analysis of the competitive environment

© Endunamoo Board Course 2022 SCREENCAST 167

Business strategy
PESTEL
PESTEL…
Political
• Government policy influences the economic environment, the framework of laws, industry structure and certain
operational issues
• Political instability is a cause of risk
• Different approaches to the political environment apply in different countries

Economic:
• Economic factors include the overall level of growth, the business cycle, official monetary and fiscal policy, exchange
rates and inflation

© Endunamoo Board Course 2022 SCREENCAST 169

PESTEL…
Social, demographic patterns and values
• Social change involves changes in the nature, attitudes and habits of society
• Social and cultural factors relate to two main issues.
• Demography is the study of the population as a whole: its overall size; the proportion of people of different age group;
where people live and work; ethnic origin
• Culture includes customs, attitudes, characteristic way of viewing the word and behaviour

© Endunamoo Board Course 2022 SCREENCAST 170

PESTEL
Technological
• Technological factors have implications for economic growth overall, and offer opportunities and threats to many
businesses

Ethical and environmental

• Matters such as protection laws, energy consumption issues and waste disposals

Legal
• Monopolies legislation, employment laws, product safety, etc.

© Endunamoo Board Course 2022 SCREENCAST 171

Business strategy
Porter’s five forces model
Overview of Porter’s five forces

Threat of entry

Bargaining power of Rivalry among Bargaining power of

suppliers existing firms buyers

Substitute products

© Endunamoo Board Course 2022 SCREENCAST 173

Benefits of Porter’s five forces
• The collective strength of these forces determines the profit potential and therefore industry attractiveness (i.e. the
long term return on capital invested)
• It follows that the stronger the force, the less opportunity to generate long term return on invested capital. The inverse
is also true
• Porter’s five forces model can be used in several ways:
❑ Assist management decide whether to enter a particular industry
❑ To influence whether to invest more in an industry
❑ To influence whether to exit a particular industry
❑ To identify what competitive strategy is needed

© Endunamoo Board Course 2022 SCREENCAST 174

Threat of entry…
Entrants can affect the profitability of the industry in two ways:
• Through the impact of actual entry: A new entrant will reduce profits in the industry by:
❑ Reducing prices as an entry strategy or as a consequence of increased industry capacity
❑ Increasing costs of participation of incumbents through forcing product quality improvement, greater promotion
or enhanced distribution
❑ Reducing economies of scale available to incumbents by forcing them to produce at lower volumes due to loss of
market share
• By forcing firms to follow pre-emptive strategies to stop them from entering through charging an enter-deterring price
and maintenance of high capital barriers through deliberate investment

© Endunamoo Board Course 2022 SCREENCAST 175

Threat of entry
Porter suggests that the strength of the threat of market entry depends on the availability of barriers of entry against the
entrant.

These include:
• Economies of scale
• Product differentiation
• Capital requirements
• Switching costs
• Access to distribution channels
• Government policy

© Endunamoo Board Course 2022 SCREENCAST 176

Threat of substitute products
A substitute product is a product that satisfy the same need despite being technically dissimiliar, e.g. taxi and Gautrain

Substitutes affect industry profitability in several ways:

• They put an upper limit on the prices the industry can charge without experiencing large-scale loss of sales on the
substitute
• They can force expensive product or service improvements on the industry
• Ultimately, they can render the industry technology obsolete

The power of substitutes depends on relative price or performance and extent of switching costs

© Endunamoo Board Course 2022 SCREENCAST 177

Bargaining power of buyers
Buyers use their power to trade around the industry participants to gain lower prices and/or improvements to product or
service quality

Therefore such behaviour will impact on industry participants profitability

Their power will be greater if:

• Buyer power is concentrated in a few hands
• Products are undifferentiated
• The buyer earns low profits
• Buyers are aware of alternative producer prices
• Low switching costs

© Endunamoo Board Course 2022 SCREENCAST 178

Bargaining power of suppliers
The main power of suppliers is to raise their prices to the industry and hence take over the some of its profits for
themselves

Power will be increased by:

• Supply industry dominated by a few firms
• The suppliers have proprietary product differences

© Endunamoo Board Course 2022 SCREENCAST 179

Rivalry among existing firms
Porter suggests that the factors determining competition are:
• Numerous rivals
• Low industry growth rate
• High fixed or storage costs (High operating leverage)
• Low differentiation and switching costs
• High strategic stakes
• High exit barriers

© Endunamoo Board Course 2022 SCREENCAST 180

Risk management

SCREENCAST
Concept of risk
• Business risk is risk relating to the operating activities of the company, often reflected in the company’s level of
operating leverage
• Business risks could be considered to incorporate the events which may result in decreased revenues and/or increased
costs
• Financial risk is primarily influenced by the balance between debt and equity, i.e. capital structure / financial leverage
• Financial risk comprises of interest risk, market risk, liquidity risk and capital risk (risk that on liquidation, debt has a
preferential claim against the assets)

© Endunamoo Board Course 2022 SCREENCAST 182

Examination technique: Risk management
Identification of risks need to be considered in a context and the best way to master it is to do various questions

Common issues
• Foreign exchange risk
• Single product company
• Single plant company
• Reliance on key employees
• Reliance on key supplier
• Reliance on key customer
• Competition risk
• Reputational risk
• IT risk
• BEE risk

© Endunamoo Board Course 2022 SCREENCAST 183

Term 2
Welcome to Term 2
Topics Live classes Screencast (Pre-recorded)
Financial analysis Yes
Valuation Yes
Mergers and acquisition Yes

© Endunamoo Board Course 2022 185

Tutorial
Submission Question: Mathosi Ltd
Submission Date: 30 April 2021
Discussion Date: 4 May 2021

© Endunamoo Board Course 2022 186

Screencasts
Screencast available for UNISA Test 2 (2020)
CTA Level 1: Ranger
CTA Level 2: South African Furnishers

Screencast available for UNISA Test 2 (2019)

CTA Level 1: Khuselo (Question 11 / TL103)
CTA Level 2: Ukuzwa (Question 17 / TL103)

Screencast available for UNISA Test 2 (2018)

CTA Level 1: Affordable Shopping Group
CTA Level 2: Shoppers Paradise (Question 13 / TL103)

© Endunamoo Board Course 2022 187

Recommended
Questions
Question Bank TL103
Q3: African Sun Limited (100 marks)

© Endunamoo Board Course 2022 189

Financial analysis

General approach
Examination technique: Financial ratio analysis
#1: Know your categories of ratios
Profitability ratios
Capital structure / solvency / gearing ratios
Working capital / liquidity ratios
Investor ratios
Asset efficiency management ratios

#2: Know your ratios

Be able to calculate the ratios
Know what a ratio means, e.g. net debt to equity ratio
Show detailed calculations in order to earn part marks

#3: Consider the facts

Understand the scenario and use the facts to analyse ratios

© Endunamoo Board Course 2022 191

Categories of financial ratios
Category Description
These measures the management’s ability to generate income (through an increase in
Profitability ratios
revenue and effective control over costs)
Liquidity and working capital These measure the entity’s ability to meet its short-term obligations as and when they
ratios fall due
Debt management ratios assess the impact of financial leverage on risk while the
Capital structure and solvency related profitability ratios will indicate the implications of financial leverage on
ratios shareholders’ returns. They also measure the entity’s ability to meet its long-term
obligations as and when they fall due
Evaluates the entity’s investment decision – it measures its ability to efficiently sweat
Asset management ratios
the assets and generate value from its long-term assets
Investor ratios These analyse the entity’s share price performance and other investor related ratios

© Endunamoo Board Course 2022 192

Examination technique: Financial ratios
• For financial performance ratios, do not be concerned with showing workings – only show final answer
• For other ratios (e.g. net debt ratio), show detailed calculations in order to earn part marks
• Financial performance relates to the analysis of the profit or loss statement of an entity
• Ensure that comments relate to the scenario, with a particular focus on those that are supported by the notes
• Draw links between ratios, e.g. increase in revenue might be expected to lead to an increase in cost of sales
• Compare ratios with other relevant information, e.g. inflation rate, interest rate, peers and prior performance
• Historical performance vs forecasted performance – historical performance assess current state while forecasted
performance focuses on reasonability of forecasts
• For financial performance ratios, express major line to revenue
• Provide a conclusion

© Endunamoo Board Course 2022 193

Financial analysis

Profitability ratios
Profitability ratios
Revenue growth = CY / PY - 1
• Compare to historic growth rate, inflation rates, GDP growth rates, industry growth rates and peers’ growth rates
• Breakdown revenue growth into volume and price growth if possible
• Comment on the insight obtained from your comparison
➢ Real (sales volume) vs nominal (pricing) growth
➢ If price growth is lower than inflation, the entity might not have pricing power and therefore it is might be
struggling to pass the inflationary cost increases to customer
➢ If volume growth is lower than market growth, it might highlight that the entity lost market share during the
year
➢ From a forecast perspective, consider if revenue growth is reasonable taking history and environment into
account
• Comment on issues affecting the growth, e.g. depressed economy and other company specific issues (i.e. consider the
scenario)
• Consider the sales mix to better understand the evolution of the revenue generation streams (the mix could be per
geographic, product type, sector, client type)

© Endunamoo Board Course 2022 195

Profitability ratios
Gross profit margin = GP (Sales – Cost of sales) / Revenue
• Focus on the major expense line items and consider effectiveness of control over inventory related costs (i.e. cost of
sales)
• Consider the nature of cost structure – high fixed versus variable cost structure
• Comment on specific items that could have impact the movement of in the margin, e.g. pricing power, electricity costs
• Lower revenue does not necessarily mean lower gross profit margin but it might mean lower gross profit
• Lower gross profit margin would be the result of cost control, purchasing and pricing power of the entity – its ability to
buy cost efficiently and its ability to pass increases in costs to its customers

© Endunamoo Board Course 2022 196

Profitability ratios
Operating margin = Operating income / Revenue x 100
Operating expense margin = Expense / Revenue x 100
• Focus on the major expense line items (direct your attention to the matters dealt with in the scenario)
• Consider once-off items and adjust for them specifically, or simply comment on them
• EBIT margin / EBITDA margin / Net margin
• Effective tax rates

Interest cover
• Generally a capital structure ratio
• This ratios measures the earnings ability to continue to service the cost of debt

© Endunamoo Board Course 2022 197

Financial analysis

Capital structure and solvency

Capital structure and solvency
Debt ratio (Commonly known as the gearing ratio)
= market value of total debt / market value of total assets
• The higher the debt ratio, the higher the financial risk
• However, context is key – how does it compare to the entity’s target gearing ratio as well competitors gearing ratio
• While a very high ratio might be unattractive because of the high level of risk, a very low ratio would also be
unattractive because of the leveraged returns forgone

Times interest earned (interest cover) = EBIT / interest

• This ratio measures the extent to which earnings can decline without causing financial losses to the firm and creating an
inability to meet the interest cost
• It could also be considered in evaluating liquidity position of the company

© Endunamoo Board Course 2022 199

Capital structure and solvency
Debt to equity ratio = Total debt : Total equity
This ratio measures the gearing of a company by indicating the relative proportion of shareholders equity and debt used to
finance a company’s assets

Note:
• Generally, only the interest bearing debt is considered in evaluating the company’s capital structure ratios
• The ratios may be calculated based on net interest expense

© Endunamoo Board Course 2022 200

Capital structure and solvency
In evaluating / analysis these ratios, consider factors that influence the balance of the numerator and the denominator as
follows:

Ordinary shareholders’ equity

• Declaration of dividends during the year
• Net profit generated during the year
• Share-issues and repurchases
• Increases or decreases in shareholder loans

Long term debt

• Repayment or issue of new debt
• Increases or decreases in interest rates
• Disposal or acquisition of assets

© Endunamoo Board Course 2022 201

Financial analysis

Working capital management

Liquidity ratios
Liquidity ratios
• Working capital management is evaluated in the context of the respective economic sector, e.g. clothing retailer versus
grocer retailer; a clothing manufacturer versus an airline
• Consider sector specific ratios and/or benchmarks
• It is also impacted by the level and growth of sales, i.e. a higher sales amount would require a greater amount of
investment
• The competitors’ working capital management ratios needs to be assessed and evaluated against the entity’s
working capital management ratios
• The entity’s ability to efficiently manage its working capital cycle would be assessed over time by comparing current
year ratios with prior year ratios
• The benefit of reducing the working capital cycle is that cash is made available for other opportunities and it also
reduces the operating costs (e.g. holding costs, financing costs, lost discount, etc.)
• The ratios may be based on closing or average balances

© Endunamoo Board Course 2022 203

Liquidity ratios
These ratios have a liquidation view with regards to their approach. It is assumed that the entity is closing and therefore
needs to settle its current liabilities through the proceeds from disposal of its current assets

Current ratio = current assets / current liabilities

• It has limitations because it assumes that the larger the current ratio, the more liquid the firm because it would be
easier for the firm to repay its short-term liabilities with the cash raised from the sale of its short-term assets
• Customer may delay payments and inventory may not be sold as easily
• The current ratio should be at least greater than one and preferably close to two (sector specific)

Quick ratio = (current assets – inventory) / current liabilities

• Quick ratio removes the illiquid assets from the current ratio (e.g. inventories and prepaid expenses)
• A ratio of 1:1 is often considered reasonable

© Endunamoo Board Course 2022 204

Working capital ratios
Inventory turnover = Cost of sales / Closing inventory
Inventory days = Inventory / Purchases x 365
• The number of days that the inventory is held on hand before it is sold
• Excessive inventories are unproductive and represent an investment with a low or zero rate of return
• The higher the inventory turnover, the lower the firm’s investment in inventories
• An increased number of days or decreased inventory turnover ratio would indicate that there was build-up of damaged
or obsolete inventory

Average collection period

= Accounts receivable / Credit Sales x 365
• The average length of time that a firm must wait after making a sale before receiving the cash
• It may be necessary to analyse this ratio separately for a certain group of customers, e.g. government

© Endunamoo Board Course 2022 205

Working capital ratios
Average payment period
= Accounts payable / Credit purchases x 365
• The number of days that the entity takes prior to paying its suppliers
• Accounts payable is one of the cheapest form of funding – therefore early settlement should only be done if warranted
by the attractiveness of the discount offered
• The higher the ratio, the higher the firm’s payables and the lower its working capital requirements

Operating or cash conversion cycle

= receivables’ days + inventory’s days – payables’ days
It is the time it takes to receive the cash from the time of purchase of inventory to the time of collection from the customer

© Endunamoo Board Course 2022 206

Liquidity / cash ratios
Cash conversion ratio = Operating cash flows / EBITDA
• This measures the quality of earnings from a cash perspective
• It evaluates the entity’s ability to convert its operating income to operating cash flows
• This ratio would be affected by the entity’s management of working capital

Cash ratio = cash + marketable securities / current liabilities

• This evaluates the entity’s liability to handle any shocks / unexpected demands on its operating cash flows
• Marketable securities would generally include instruments listed on highly active market, e.g. investment in shares

© Endunamoo Board Course 2022 207

Financial analysis

Asset management ratios

Return on invested capital
Return on invested capital (ROIC) = NOPAT / Invested capital
Invested capital = Net current assets + Net fixed assets
Invested capital = Long term debt + Equity – Excess cash
• It measures return from the main operations of the company (i.e. excludes interest income, dividend income)
generated from the main operating assets of the company (i.e. excludes investments, excess cash)
• Be careful of deferred tax (considered to be equity equivalent)
• This is often compared with the WACC

Return on capital employed (ROCE) = EBIT / Capital employed

© Endunamoo Board Course 2022 209

Return on invested capital
Asset turnover = Sales / Total assets
• It measures the entity’s ability to efficiently use its assets to generate revenue

Return on equity (ROE)

= Profit attributable to equity holders / Market value of equity
= Net profit margin x Asset turnover x Leverage
= (Net profit / sales) x (Sales / total assets) x (Total assets / Equity)
• This is the most comprehensive indicator of financial performance
• It brings together the outcomes of the entity’s financial, operating and investing decisions

© Endunamoo Board Course 2022 210

Financial analysis

Investor ratios
Investor ratios
Market price or share price (MPS)
• This is value / price of the listed share on stock exchange (JSE)
• It is based on the demand and supply of the share and is influenced by market perceptions (signalling effect)

Earnings per share (EPS)

= Profit attributable to shareholders / number of shares
• It measures the share’s current profitability and its analysis will be consistent with profitability ratios discussed earlier

Dividend per share (DPS)

= Total dividends (interim + final) / number of shares
• It measures the share’s ability to generate cash flows for the investor

© Endunamoo Board Course 2022 212

Investor ratios
Price-earnings ratio = MPS / EPS
• It represents the number of times of earnings (EPS) that investors are willing to pay for a share price (MPS)
• It also represents the (market) return on shareholders equity investment
• Equally it represents the number of years that investors are willing to wait before generating earnings sufficient to
cover the cost of the investment
• Entities experiencing high growth rates and perceived to be of low risk have high price earnings ratios
• The share price can be distorted with market perceptions – which impact demand and supply of the share (signalling
effect)
• General economic sentiments might affect the general levels of price earnings ratio in the market

© Endunamoo Board Course 2022 213

Investor ratios
Earnings yield = EPS / MPS
• This is the inverse of the price earnings ratio and therefore earlier analysis is applicable

Dividend payout ratio = DPS / EPS

• It represents the proportion of the entity’s earnings declared as dividend to its shareholders
• This ratio needs to be evaluated in line with our discussion regarding ‘dividend policy’

Dividend cover = EPS / DPS

• It measures the earnings ability to support the dividend per share paid by the entity
• A higher ratio is favourable because it highlights that earnings are sufficiently and comfortably able to support the
entity’s dividend policy

© Endunamoo Board Course 2022 214

Investor ratios
Dividend yield = DPS / MPS
• It measures the share’s ability to provide cash flows from the investment made in shares
• It represents a dividend return the investors derive from their investment – it should be remember that investors return
comprise the dividend while holding the share and the capital gain upon disposal
• This ratio provides to compare with other cash yielding instruments
• In evaluating this ratio, shareholder preferences are also to be considered
• Consider the component of the ratio to better understand its movement

© Endunamoo Board Course 2022 215

Financial analysis

Examination technique: Non-financial ratios

Examination technique: Non-financial ratios
• There are no standard ratios utilised for measuring non-financial performance
• Matters that have environmental, governance and social impact are included under this category – sustainability issues
• Identify them in a scenario – they fall in the category of social and environmental performance
• Although the ratios will ultimately impact profit or loss, it is not necessary to talk about financial implications
• In the commentary, clearly state whether the results / analysis reflects improved or declining performance
• Provide reasons for the performance and these need to be linked with the scenario
• If sufficient information is not provided, this should be communicated by indicating that the matter should be further
investigated
• Provide a conclusion

© Endunamoo Board Course 2022 217

Financial analysis

Discussion example
Practical examples
To do:
• Watch Screencast #1: Cape Foods Ltd
• Attempt Question #8: Best Brands Limited
• Watch CTA Level 1 UNISA Test Screencasts

© Endunamoo Board Course 2022 219

Valuations

Introduction
Company valuations
• There are many reasons management would be interested in undertaking a valuation of a company. These reasons may
include the following:
o Initial public offering
o Acquisition or disposal of a company (i.e. mergers and acquisition)
o As part of achieving the optimal capital structure of a company
o Share-buy backs and/or rights issue
• The subject of the valuation is often an unlisted company or component of a company (e.g. a division)
• Valuation is complicated and very subjective no matter which methodology is considered

© Endunamoo Board Course 2022 221

Valuation of companies
• Earnings based valuation / multiple / relative based valuation
o EV/EBITDA (MVIC/EBITDA) or its variation, EV/EBIT
o P/E (Market price / EPS) or its inverse, earnings yield
o Precedent transaction multiples
o Price-to-book ratio
• Net asset value
• Discounted free cash flows
• Dividend growth model

© Endunamoo Board Course 2022 222

Key definitions and concepts
• Enterprise value is the value of the entire operations of a company based on the operating cash flows of the entity
(without taking into consideration the capital structure)
• Equity value is the value attributable to the shareholders of the company (the enterprise value less value of debt)
• Owner level premiums are adjustments made to reflect the impact of shareholding in the entity
❑ A control premium is included when a majority shareholding is being sold or acquired
❑ A minority discount is applied when a non-controlling interest is being sold or acquired
❑ The valuation methodologies need to be considered as some inherently take into consideration these
adjustments
• Entity level premiums are adjustments that are made in order to reflect entity level adjustments, i.e., risks
adjustments. The adjustments made may either be positive or negative (or both)
• Marketability discount refers to adjustment made in order to reflect the lack of tradeability / liquidity of an equity
instrument because it is unlisted or because it is held under certain conditions, e.g., BEE shares
• MVIC is the market value of invested capital and refers to the enterprise value of a company

© Endunamoo Board Course 2022 223

Valuations

Earnings based valuation: General

Illustrative example
CA Ltd would like to acquire Shopper Ltd. Shopper Ltd is a grocery retailer based in Polokwane, a growing city in the
economy of South Africa. In the most recent year ended, Shopper Ltd generated profit after tax of R300 million. Shopper
Ltd has 4 stores in Polokwane. CA Ltd would like to determine a fair value for Shopper Ltd.
CA Ltd understands that there is a listed company, Shopsmart Ltd. Shopsmart Ltd has 200 stores across the country and
its profit after tax for the most recent year ended was R800 million. The fair value of Shopsmart Ltd’s equity is R8 billion.
REQUIRED: Estimate a fair value of Shopper Ltd?

© Endunamoo Board Course 2022 225

Illustration: Shoprite Holdings Ltd

Source: Reuters

© Endunamoo Board Course 2022 226

Earnings based valuations
The earnings based valuation techniques provide a more realisable valuation under the following assumptions:
• the business enterprise is a going concern
• the business enterprise is already established
• there is an earnings history
• continuing earnings are expected to be maintainable
• the maintainable earnings are expected to be positive (not a loss)
• a similar proxy firm is available
• non-operating assets of the entity are valued separately; and
• when used to value a multi-business entity, each business is valued separately

© Endunamoo Board Course 2022 227

Earnings based valuations: technique
Determining value of equity based on P/E
Value of equity = Maintainable profit after tax x P/E*

Determining value of equity based on earnings yield

Value of equity = Maintainable profit after tax ÷ discount rate*

Determining value of equity based on EV/EBITDA

Enterprise value = Maintainable EBITDA x EV/EBITDA multiple*
Value of equity = enterprise value less market value of debt

* These refer to the adjusted multiple of a proxy firm

© Endunamoo Board Course 2022 228

Earnings based valuations: framework
Description Rands Motivation
Enterprise value XXX If the question requires the application of the EV/EBITDA multiple
(EBITDA x EV/EBITDA multiple)
Deduct the market value of debt --- Only long-term debt has to be valued and deducted from the enterprise value
If the question requires the application of the P/E or earnings yield, this is the
Value of equity YYY
staring point
The cash is not required for operations and is immediately distributable to
Add excess cash +++
shareholders as a dividends
Add value of investments, property, etc. +++ The non-operating assets are valued separately and added to the equity value
Value of non- and operating assets WWW
Controlling premium (10% - 25%) +++ If a majority interest is being acquired
None as earning based valuation is considered to be a minority valuation
Minority discount N/A
methodology
Marketability discount (5% - 10%) --- If the valuation subject is unlisted
Total equity value ZZZ
Value of interest acquired AAA (ZZZ x % holding) when 100% is not acquired

© Endunamoo Board Course 2022 229

Earnings based valuations: multiple
• In determining the appropriate multiple, the starting point is to identify an appropriate proxy firm(s)
• A proxy firm could be considered to be a listed company within the same sector as the valuation subject and therefore
exposed to similar risks and opportunities
• If there is more than a single proxy firm, the appropriate multiple could be an average (simple or market-value
weighted) of the operating firms within the sector
• If historic earnings is used, the multiples need to be based on reported information. Conversely, if forecast
information is used, the multiples utilised need to also be forward multiples
• The nature of the multiple needs to be consistent with the nature of the earnings, e.g. an EV/EBITDA (MVIC/EBITDA)
will required EBITDA while a P/E will require net profit after tax

© Endunamoo Board Course 2022 230

Earnings based valuations: multiple
• Multiples are affected by various factors including general market environment, such as the prevailing level of interest
rates, and by factors unique to that company
• It therefore follows that adjustments need to be made in order to take into consideration the differences between the
proxy firm and the valuation subject (i.e. entity level adjustments), which may included:

➢ The size of the company (revenue and profits) ➢ BEE credentials

➢ The growth of the company (in revenue and profit) ➢ Foreign currency exposure
➢ Unlisted status (i.e. lack of marketability or tradability)
(Do not double count with the marketability discount) ➢ Geographical operations

➢ Weaknesses, e.g. overreliance on a customer, personnel ➢ Effective tax rates (P/E)

➢ Strengths, e.g. market share, brand, exclusivity ➢ Age of assets
➢ Capital structure (P/E only) ➢ etc.

© Endunamoo Board Course 2022 231

Earnings based valuations: earnings
• The objective is to determine the maintainable earnings
• The key valuation metrics are accounting based information
• Forecast or prospective accounting information are used as basis of future earnings of the entity
• Once-off and non-recurring items need to be removed (e.g. BEE expenses, penalties and restructuring expenses)
• Expenditures that are not market related need to be adjusted to make them market related (e.g. salaries of owners)
• Items relating to assets that need to be valued separately (e.g. investments, property) need to be removed (e.g.
dividend income, rental income, property costs)
• The tax adjustments of these items need to be considered

© Endunamoo Board Course 2022 232

Earnings based valuations: earnings
• Estimating the maintainable earnings might present challenges when historical earnings has experienced an erratic
trend
• If earnings growth is erratic, the general principle in determining the maintainable earnings is that a weighted average
of the historical earnings is calculated
• If it is not clear whether the recent change in earnings is unsustainable, the earnings are weighted in such a manner that
the most recent change is given greater weighting and the furthest earnings are consequently given less weighting

© Endunamoo Board Course 2022 233

Illustration: appropriate earnings
CA Ltd is contemplating on acquiring SA Ltd. The earnings of SA Ltd for the past three years are as follows:
2019: R310 500
2018: R272 500
2017: R250 000

Included in the FY2018 earnings was a once off bonus of R15 000.

The appropriate multiple was determined to be 9x.

REQUIRED: Estimate fair value of SA Ltd

© Endunamoo Board Course 2022 234

Illustration: appropriate earnings
2017 2018 2019
Earnings R250 000 R272 500 R310 500
Adjustment for once-off item - R15 000 -
Adjusted earnings R250 000 R287 500 R310 500

Growth 15% 8%

© Endunamoo Board Course 2022 235

Illustration: appropriate earnings
Solution #1
Conclusion: There is a trend. Growth is stabilising at 8% p.a.
Therefore, use 2019 earnings as maintainable earnings
Therefore, the fair value of SA Ltd is R2 794 500 (R310 500 x 9)

Solution #2
There is no apparent trend as growth moved from 15% to 8% p.a.
Therefore, weight the earnings to determine maintainable earnings
Maintainable earnings = R250 000 x 1 + R287 500 x 2 + R310 500 x 3
(1 + 2 + 3)
= R292 750
Therefore, the fair value of SA Ltd is R2 634 750 (R292 750 x 9)

© Endunamoo Board Course 2022 236

Precedent transaction valuation
• Precedent transactions valuation is based on the principles of earnings-based valuation
• The valuation of the company in this instance is based on the multiples of recent similar transaction, e.g. an acquisition
or disposal of a proxy firm
• Adjustments for differences between the acquisition target and the company being valued might need to be made as
well

© Endunamoo Board Course 2022 237

P/E vs earnings yield vs EV/EBITDA
• P/E and earnings yield lead to the same equity value
• However with regards to the adjustment, positive factors increase the P/E multiple while they reduce the earnings yield
percentage. The converse is true for negative factors
• EV/EBITDA (MVIC / EBITDA) valuation is considered to be superior to P/E and earnings yield valuation under the
following circumstances:
o The entity is highly capital intensive and therefore the depreciation expense is high and distorting the cash flow
component of the earnings figure
o The entity is highly leveraged and the interest component is distorting the performance of the company
o The effective tax rates of the proxy company and the subject valuation are very different to each other

© Endunamoo Board Course 2022 238

Valuations

Earnings based valuation

Example 1: Earnings yield valuation technique
LE1: Earnings yield valuation
CA Ltd and Africa Ltd have a 3 000m2 wine estate, which is based in Cape Town. Access to water in Cape Town is highly
restricted and this has resulted in average harvest yields of 5 tons of grapes per hectare. The winery cellar assets are
relatively old and their replacement is overdue. The annual income from the estate is R19 500 000 while the annual
operating costs are R14 400 000. The wine estate is unlisted.
The average harvest yield of listed wine estates based in South Africa is 12 tons of grapes per hectare. A recent study
revealed that the average size of a listed wine estate in South Africa is 5 000m2 and the quality of the grapes harvested
from Cape Town farms are considered to be premium relative to grapes across the country. The average earnings yield for
listed wine estates is 8% per annum (post tax).

Additional information:
• All Rand amounts are pre-tax. Tax rate is 28%.
• The ownership interest in the Cape Town wine estate is as follows: CA Ltd (75%) and Africa Ltd (25%)

REQUIRED:
Determine the value of CA Ltd’s interest in the Cape Town wine estate using the earnings yield methodology

© Endunamoo Board Course 2022 240

Valuations

Earnings based valuation

Example 2: PE multiple valuation technique
LE2: P/E multiple valuation
CA Ltd is contemplating acquiring a radio broadcasting station based in Midrand, Midrand Radio Broadcaster (Pty) Ltd
(“MBL”). MBL is a family controlled business. The year end of MBL is 30 June.
The couple have ran the business for the past 20 years and all the company’s shares were held by the couple until recently
when they sold 20% of the shares to an empowered company as part of its strategy to secure government contracts. The
transaction resulted in MBL achieving a BBBEE status of Level 3. The government currently contributes 75% of the total
advertising revenue of the business.
The couple wishes to retire and have thus approached CA Ltd as a suitable suitor to acquire 80% of the business. The
running of the business has been stressful under the current depressed COVID-19 economy.
Below are the profit after tax of MBL for the years ended:
• 30 June 2020: R3 000 000
• 30 June 2019: R3 173 455
• 30 June 2018: R2 268 478 (*)
* Included in profit after tax is a restructuring expense of R540 000 (post-tax). The restructuring expense is expected to
benefit MBL for a period of five years. The general treatment of restructuring expenses by MBL’s peers is to amortise the
expense over the period in which it estimates to benefit. SARS allows a tax deduction on restructuring expense.

© Endunamoo Board Course 2022 242

LE2: P/E multiple valuation
MBL generated profit after tax for year ended 30 June 2020 of R3 million. Included in this profit after tax figure were the
following items:
• An expense relating to the BEE share transaction of R420 000. The amount is not tax deductible.
• The couple are the managing directors of MBL and earn a total salary of R800 000 between them. CA Ltd estimated
that should it appoint its own managing directors and pay them market related salaries, the salary bill would increase to
R1 350 000. The average annual increase in salaries in the industry is 10% per annum.
• R180 000 relating to personal expenses was included in ‘other expenses’. No tax deduction was claimed for this amount.
• Dividend income of R120 000 from an unlisted company, Kyalami Motors (a retailer of second hand vehicles). The
dividends are expected to grow by 5% per annum. Cost of equity of Kyalami Motors is 11%. Dividends received are tax-
exempt. The investment in Kyalami Motors was acquired at the beginning of the year.

On 30 June 2020, MBL had a surplus cash balance of R250 000. On the same date, its long term debt had an outstanding
balance of R1 050 000.

© Endunamoo Board Course 2022 243

LE2: P/E multiple valuation
A listed broadcaster, Vorna Valley Ltd (“VVL”), was identified as a proxy firm. A brief description about VVL and its financial
information for the year ended 30 June 2020 is provided:
• VVL specialises in radio and television broadcasting. The margins for advertisement aired in television are generally
higher than radio broadcasting.
• VVL is a BBBEE Level 5 contributor.
• The earnings of VVL in the period ended 30 June 2020 was R30 million while its share price had a market value of R15 on
30 June 2020. VVL had 15 million shares outstanding on that date.
• The market value of VVL’s debt on 30 June 2020 was R75 million.
• The earnings of VVL for the year ending 30 June 2021 are expected to increase by 25%.

© Endunamoo Board Course 2022 244

LE2: P/E multiple valuation
REQUIRED:
a) Calculate the historic and forward P/E multiples of VVL
b) Determine the minimum value of the equity interest in MBL that CA Ltd is contemplating on acquiring. Provide a
reason for any adjustment you deem appropriate

© Endunamoo Board Course 2022 245

Valuations

Net asset valuation

Net asset value
• The net asset value represents the value to be obtained upon the liquidation of the company
• This technique is therefore appropriate when the going concern assumption is no longer appropriate
• The net asset value, being the book value of the shareholders’ equity, is often used as a reasonability check for
valuation
• NAV valuation technique assumes that the assets and liabilities of the business will be disposed of at their market
valued upon liquidation and liabilities settled at their nominal value
• Tax implications of disposal should be included
• The nature of the company being valued is important – asset intensive versus a service organisation
• No adjustments are made for owner level premiums as the issue of control has little significance since the business is
no longer a going concern

© Endunamoo Board Course 2022 247

Valuations

Net asset valuation

Example 3: Net asset valuation
LE3: Net asset value
An abridged statement of financial position of MBL is provided below:
STATEMENT OF FINANCIAL POSITION ON 30 JUNE 2020 Notes Rands
ASSETS
Property 1 4 950 000
Broadcasting equipment 4 000 000
Cash 250 000
Debtors 2 850 000
TOTAL ASSETS 10 050 000
EQUITY AND LIABILTIES
Share capital 2 000 000
Retained income 7 000 000
Long-term loans 3 1 050 000
TOTAL EQUITY AND LIABILITIES 10 050 000

© Endunamoo Board Course 2022 249

LE3: Net asset value
The couple’s alternative to selling MBL is to liquidate it. Additional information is applicable:
Note 1: MBL has a property with a cost of R9 million. The tax base of the property was R4 950 000. The market value of this
building was estimated to be R15 million.
Note 2: A debtor who owed the company R400 000 was recently declared insolvent and his attorney indicated that an
amount of R120 000 will be paid to MBL in settlement of the debt.
Note 3: The bank has indicated that it would charge 5% of the outstanding loan balance as a penalty for early termination.
This amount is not tax deductible.
Note 4: The retrenchment and liquidation costs are estimated at R1 570 000. These costs are tax-deductible.
Note 5: The tax bases and fair value of all other assets were equal to their carrying amounts

REQUIRED:
Determine the value of the equity interest in MBL that CA Ltd is contemplating on acquiring using a net asset valuation
basis. Tax rate is 28% and inclusion rate of 80% for capital gains tax.

© Endunamoo Board Course 2022 250

Valuations

Discounted free cash flow

Discounted free cash flow method
• The technique involves the estimation of future free cash flows and discounting this at an appropriate discount rate
• Free cash flow refers to the cash that is available for distribution to the investors of the company (i.e. dividends to
shareholders and interest and capital to debt holders)
• The discounted free cash flow (‘DCF’) is considered to be the most technically sound technique of valuation because it
takes into account the time value of money
• It also allows for rigorous review through sensitivity analysis
• Its drawback however is that it can be subjective as free cash flows, the discount rate and the perpetuity growth rate
are required to be estimated to undertake this valuation
• DCF assumes that the business is a going concern
• DCF assumes that a majority interest is being acquired

© Endunamoo Board Course 2022 252

Discounted free cash flow method
Notes Forecast 1 Forecast 2 Forecast 3
Operating cash flows, before tax 1 aa aa aa
Taxation 2 (bb) (bb) (bb)
Operating cash flows, net tax cc cc cc
Changes in working capital 3 +/-(dd) +/-(dd) +/-(dd)
Investment in capital expenditure 4 +/-(ee) +/-(ee) +/-(ee)
Free cash flows 5 ff ff ff
Terminal value 6 gg
Sum of free cash flows hh hh hh
Free cash flows discounted at the appropriate discount rate 4 YYY
Add excess cash 7 WWW
Add value of non-operating assets 8 ZZZ
Deduct value of debt (including preference shares) 9 (XXX)
Value of non-controlling interest 10 (QQQ)
Value of operating and non-operating assets TTT
Owner-level premiums / discounts 11 +/-SSS
Marketability discount 12 (UUU)
Value of shareholders’ equity VVV
Value of interest under consideration RRR

© Endunamoo Board Course 2022 253

Notes on discounted free cash flow…
1) Operating cash flows
• Only revenue from operating activities is included
• Dividend income, rental income and interest income are excluded because they do not represent operating cash
flows and required to be valued separately
• Only cash operating expenses are taken into consideration
• Non-cash operating expenses such as depreciation are excluded
• Non-operating expenses (e.g. interest) are generally excluded
• It can be argued that if cash is part of operations, then interest income should be included in the operating cash flows
• It can further be argued that if bank overdraft is utilised for regular working capital funding, then the interest
expense should also be included in the operating cash flows

© Endunamoo Board Course 2022 254

Notes on discounted free cash flow…
2) Taxation
• Taxation cash flows are taxes on operating cash flows
• If the taxation expense in profit or loss is provided:
o It needs to be adjusted for non-cash and/or non-operating items – be careful of the direction of the adjustments
o With regards to depreciation and wear & tear, consider the movement of movement deferred tax
o Movement in the deferred tax balance might need to be adjusted because it is non-cash in nature
• If the taxation expense is not provided:
o Commence with operating income before tax
o Adjust for non-cash items (other than wear & tear) and non-operating items are ignored in the calculation
o Consider SARS tax rules in making the adjustments

© Endunamoo Board Course 2022 255

Notes on discounted free cash flow…
3) Changes in working capital
• Working capital items general include inventories, accounts receivable and accounts payable
• The change in the working capital items is calculated as the difference between the opening balance and the closing
balance
• Excess cash should not be included as part of working capital
• It can be argued that cash that is held for operations and/or bank overdraft utilised for regular funding of working
capital should be included as part of working capital items
• Ideally the growth of working capital should be in line with revenue growth

© Endunamoo Board Course 2022 256

Notes on discounted free cash flow…
4) Investment in capital expenditure
• Investment in capital expenditure (‘capex’) is the investment required to maintain existing growth and support future
growth of the company
• It refers to the net purchases / sales of the non-current assets of the company (commonly this is the property, plant
and equipment)
• It is commonly calculated by working back or reconstructing the T-account for non-current assets
• Ideally the growth in investment should be in line with revenue growth and depreciation expense

© Endunamoo Board Course 2022 257

Notes on discounted free cash flow…
4) Free cash flows
• Free cash flows represent the balance of the operating cash flows after investment in working capital and investment in
capital investment
• This figure is commonly referred to as free cash flow to the firm or to the enterprise
• If the interest cost is deducted, then the figure is referred to as free cash flow to equity
• The appropriate discount rate to discount free cash flows to the enterprise is the WACC of the target, being the
discount rate that captures the risks of the company being valued
• The appropriate discount rate to discount free cash flows to equity is the cost of equity of the target

© Endunamoo Board Course 2022 258

Notes on discounted free cash flow…
5) Terminal value
• Terminal value represent the capitalised future cash flows that a company would generate into perpetuity (on a going
concern basis)
• Terminal value is determined based on a perpetuity formula / DGM

6) Enterprise value or value of operations

• The value of the operations include the present value of the free cash flows over the explicit period and the terminal
value

7) Excess cash / Surplus cash

Excess cash refers to cash that is not necessarily required for working capital purposes
This represent cash immediately available for distribution
In addition, the return profile of cash is lower than the WACC and should therefore not be discounted at the WACC

© Endunamoo Board Course 2022 259

Notes on discounted free cash flow…
8) Non-operating assets
• Non-operating assets may include investments in marketable instruments such as shares, investments in associate,
investment property, etc.
• These assets need to be valued separately because their risk profile is different from the overall risk profile of the target
• The traditional valuation techniques may be applied, e.g. DGM on the expected dividends or market values, if the
shares are listed

9) Market value of debt

• The market value of debt, including any preference shares (regardless of their nature) as well as shareholders loans,
would need to be deducted in arriving at the shareholders’ equity

© Endunamoo Board Course 2022 260

Notes on discounted free cash flow
10) Non-controlling interest
• The equity value attributable to the non-controlling interest in the subsidiaries would also need to be excluded
because the acquirer would not be entitled to this value
• This may be estimated as the equity value of the subsidiary x NCI’s percentage shareholding in the subsidiary

11) Owner-level premiums or discounts

• No controlling premium is adjusted as DCF assumes that a majority interest is being acquired
• A minority discount might be necessary if a minority interest is being acquired

12) Marketability discount

• If the target company is unlisted, then a marketability discount might be appropriate

© Endunamoo Board Course 2022 261

Valuations

Discounted free cash flow

Example 4: Discounted free cash flow
technique
LE4: Company valuations
CA Ltd has an incorporated division that manufactures bathsoaps, Cleaners (Pty) Ltd (“Cleaners”). Cleaners is unlisted
entity with operations in South Africa only. CA Ltd is considering selling 80% of its shares in Cleaners and requires
assistance with valuing the company. The statement of profit or loss of Cleaners for the year ended 31 December 2020
follows:
All amounts are in R’000 2020A 2021F 2022F 2023F
Revenue 115 000 132 250 145 475 157 113

Cost of sales (92 000) (102 494) (112 743) (121 763)

Depreciation (5 750) (6 613) (7 274) (7 856)

Interest income 900 900 900 900

Interest expense (2 700) (2 700) (2 700) (2 700)

Profit before tax 15 450 21 344 23 658 25 695

Taxation (4 158) (5 788) (6 414) (6 959)

Net profit after tax 11 292 15 556 17 244 18 736

© Endunamoo Board Course 2022 263

LE4: Company valuations
A list of assets and liabilities of Cleaners as at the reporting dates is provided below:
All amounts are R’000 2020A 2021F 2022F 2023F
Cash 22 530 22 530 22 530 22 530
Accounts receivable 51 720 59 479 65 426 70 659
Inventory 37 375 42 981 47 279 51 062
Accounts payable 57 500 66 125 72 738 78 557
PPE, at book value 51 750 59 513 65 464 70 701
Investment in shares at cost 7 500 7 500 7 500 7 500
Debentures at book value 22 500 22 500 22 500 22 500

* A = Actual figures / F = Forecast figures

© Endunamoo Board Course 2022 264

LE4: Company valuations
Notes relating to the financial information:
• Revenue includes income from sales of soaps and dividends from an unlisted company, Shampoo. In 2020, Cleaners
received dividends of R600 000 from an unlisted company, Shampoo. Shampoo’s sustainable growth rate is 12% p.a.
and its cost of equity is 18%.
• Depreciation expense is equivalent to wear and tear allowances
• The cash balance of Cleaners is considered to be surplus cash to its operational needs
• Cleaners has debenture with a par value of R22 500 000. The coupon rate is 10% p.a. These debentures are redeemable
in five years time at a premium of 25%. The market related rate of interest is 12% p.a. The market value of the debt was
R24 945 000 as at 31 December 2020.

Additional information
• One of Cleaners’ competitors is Water Ltd, is a leader in the detergent market.
• Its shares are however listed on the JSE Altx and has a market capitalisation of R300 million.
• Water Ltd generates revenues of R500 million per annum.
• The trailing MVIC/EBITDA multiple of Water Ltd is 6,50x.

© Endunamoo Board Course 2022 265

LE4: Company valuations
REQUIRED:
Determine the fair value of Cleaners as at 31 December 2020 based on the discounted cash flow valuation method. Test
the valuation for reasonability using a relative valuation techniques.You may assume that:
• The long term growth rate in free cash flows is expected to be 8,00% p.a. from FY2024
• You may assume that the WACC of Cleaners is 14,86%

(30 marks)

© Endunamoo Board Course 2022 266

Valuations

Dividend growth model: Revision

Dividend growth model
The dividend growth model has the following underlying assumptions:
• The capital appreciation rate is based on a constant sustainable growth rate
• The company under consideration has a stable dividend policy – thus making it inappropriate to value a share of a
start-up company with no dividend cash flows (conversely, it could be considered more appropriate for a mature
company)
• The interest being valued is a minority interest and an equity investor has limited influence on the dividend policy or
growth of the company – as a result, a minority discount is assumed
• The cost of equity shall be utilised because dividends are exclusively attributable to ordinary shareholders
• The sustainable growth rate should be lower than the cost of equity

© Endunamoo Board Course 2022 268

Determining the value using DGM
If dividends are not expected to grow
Value of equity = Forecast dividend / Cost of equity

If dividends are expected to grow a rate of g%

Value of equity = Forecast dividend / (Cost of equity – g%)

© Endunamoo Board Course 2022 269

LE5: Market weight of ordinary shares
On 1 January 2019, CA Ltd has declared a dividend of 30c per share. The company expected a supernormal growth of 20%
per annum over the next three years and thereafter a sustainable growth rate of 5% per annum will be achieved.

Determine the ex-div value of a CA Ltd share on 1 January 2019 based on a cost of equity of 15% per annum

[REFER TO COST OF CAPITAL SECTION FOR SOLUTION]

© Endunamoo Board Course 2022 270

Mergers and
acquisitions
Introduction
Introduction
There are essentially two ways that a firm can expand its operations – internal expansion or organic growth (i.e. capital
investment proposals) and external or acquisitive growth (i.e. mergers and acquisition (“M&A”)

General rule is that a merger should only take place when there are synergistic benefits, i.e. a merger should take place
only if the value of the combined entity is greater than the value of the separate entities added together

The key discussion issues under M&A are:

• types of mergers;
• reasons for mergers; and
• terms of successful mergers

© Endunamoo Board Course 2022 272

Types of mergers
Horizontal mergers
• These results when two firms in the same industry merge, e.g. Checkers-Shoprite and Barclays-Absa

Vertical mergers
• These occur where a firm either expands forward to the customer or expands backwards to the raw materials supplier
stage

Conglomerate mergers
• These occur where firms in unrelated lines of business decide to merge

© Endunamoo Board Course 2022 273

Reasons for mergers…
• Operating economies: A merger may result in economies in production or distribution, such as lower unit costs
through higher production runs. Operating economies may be affected by the following means: economies in
purchasing, combination of production facilities and warehouses, reduction in the number of retail outlets
• Managerial skills: A firm with strong management resources may decide to take over a firm currently earning low
returns in order to introduce improved management and reap the benefits of the expected increased returns
• Tax considerations – assessed losses: A merger could take place in order for the acquirer to protect its future income
from income tax by utilising the assessed losses of the target company. However, the acquirer should be able to set out
good economic reasons for the transaction or SARS might disallow the set-off in terms of the anti-avoidance provisions
• Use for excess liquidity: A company with surplus cash resources may decide to utilise such liquidity in order to acquire
other companies. On the other hand, a company may take over another firm in order to obtain the benefits of its strong
liquidity position
• Lower financing costs: A merger may result in an improved credit rating and thereby reduce its issue cost
• Replacement costs: A firm which wishes to increase its production capacity may find that it is cheaper to do so via the
acquisition route if the value of the target company is substantially below that of the replacement cost of the target
company’s assets
• Diversification: This was the former motivation for a merger however many argue that this is not a valid reason to
undertake a merger

© Endunamoo Board Course 2022 274

Success rate of mergers
A study revealed that mergers are highly unsuccessful, with McKinsey reporting a success rate of 23% and KPMG reporting
a failure rate of over 80%

The reasons quoted for failed mergers were, inter alia:

• An overoptimistic appraisal of market potential;
• An overestimation of synergies;
• Paying too much;
• Excessive financial leverage;
• Timing delays relating to the disposal of non-core assets;
• A poor business fit (e.g. corporate culture);
• Poor communication with employees;
• Inadequate due diligence; and
• A lack of post-acquisition integration

© Endunamoo Board Course 2022 275

Mergers and
acquisitions
Structuring transactions
Structure: assets versus shares purchase
Mergers may be structured as acquisition of assets or acquisition of shares in the target company. The key considerations
are:
• Financing costs on debt issued to acquire shares is not tax-deductible while debt applied to acquire assets may be
deductible
• Acquisition of assets at their fair values provides higher wear and tear tax shields as the cost of the assets is the
acquisition value
• Acquisition of shares exposes the acquirer to risk of undisclosed or unknown contingent liabilities
• Control over the entire asset base is obtained through the acquisition of the majority interest rather than full control –
thus making the cost of acquiring assets cheaper
• The assets do not need to change ownership with the acquisition of shares and thus transfer and registration costs are
avoidable

© Endunamoo Board Course 2022 277

Unbundling and spin offs
• In practice, the holding company often trades at a discount to the underlying asset values (‘conglomerate discount’)
• An unbundling transaction involves the holding company distributing all the shares it owns in the subsidiaries to its own
shareholders on a pro-rata basis
• An unbundling transaction is a form of divesting assets (i.e. it is an alternative to a direct disposal of assets or shares)
• No cash proceeds are received in an unbundling transaction
• The holding company is delisted and may be liquidated after the unbundling
• After the unbundling, the shareholders in the holding company become shareholders in the underlying operating
subsidiaries

© Endunamoo Board Course 2022 278

Advantages of unbundling and spin offs
• Unbundling will remove the discount to the net asset value
• The removal of a head-office structure will reduce costs and overhead expenses
• Management incentives can be more closely aligned with company performance
• The removal of a head-office structure may remove the problem of too many layers and its impact on decision making
• Unbundling may facilitate black economic empowerment
• The absence of reporting to head office improves performance and independence and saves time and allows
management to focus on the operations of the company

© Endunamoo Board Course 2022 279

Disadvantages of unbundling and spin offs
• Access to the short-term credit from holding company to enable the company to overcome temporary liquidity
problems will no longer be available
• Unbundling may involve retrenchments and management may have to deal on its own with the processes and union
pressures
• There will be a loss of managerial assistance and expertise and experience in areas such as treasury and hedging
techniques
• The costs of unbundling may be significant, e.g. legal costs, audit fees, changing leases, transfer of assets, etc.
• Unbundling could have a negative effect on corporate risk ratings and increase the cost of external finance as well as
restrict access to finance

© Endunamoo Board Course 2022 280

Management buy-outs
• In a management buy-out (MBO), the management of a firm buys out the controlling interest in the firm from the
existing shareholders
• Management buy-outs are usually structured in a such manner that management only contributes a small portion of
the purchase price from their personal resources and borrows most of the purchase price consideration from financial
institutions (e.g. ~10% of the purchase price, ~40 - 50% of senior debt and ~40 - 50% for mezzanine finance)
• Mezzanine finance is used because this debt represents subordinated debt, which means that it ranks after senior debt
for repayment

© Endunamoo Board Course 2022 281

Mergers and
acquisitions
Financial evaluation
Terms of mergers…
• The final terms of mergers are very difficult to agree on
• Often a number of takeover proposal have failed because of a lack of agreement between the target company and the
acquiring company
• The party with stronger negotiation powers often determined the final terms of the merger to its favour
• The terms of a merger may include the transaction price and also the form of settlement (shares, cash and assets)

© Endunamoo Board Course 2022 283

Determining the merger price
• The starting point is the minimum value (‘intrinsic value’) acceptable by the former shareholders of the target
company. This value does not include any synergies from the merger
• The transaction price is often closer to the fair value of the target company, being the value after taking into
consideration all the reasonable synergies that could be achieved with any party bidding for the target company, i.e.
general synergies
• The acquirer would need to determine the maximum value payable, which is the value after taking into account all
(general and specific/unique) estimated synergies from the transaction
• The above assumes that all the synergies are quantifiable
• The valuation techniques we learnt may be used to estimate or quantify the synergies

© Endunamoo Board Course 2022 284

LE1: Determining the merger price
CA Ltd wishes to acquire 75% interest in SA Ltd. SA Ltd is currently listed and its market capitalisation is currently R450
million. The book value of the shareholders’ equity of SA Ltd is currently R40 million.
CA Ltd has estimated that should it obtain control of SA Ltd, it would be able to realise the following benefits:
• SA Ltd would immediately dispose its head office for R3 800 000. The cost of the building is R500 000 and there were no
tax allowances granted by SARS.
• CA Ltd estimates to incur transaction cost amounting to R175 000 (post-tax). The average transaction cost to be
incurred by other bidders is expected to be R100 000 (post-tax).
• SA Ltd currently has 1 100 employees with an average annual salary of R120 000 (pre-tax) per employee. It is
anticipated that only 16% of these employees would be retrenched.
• The retrenchment package is R64 800 (post-tax) per employee. This would be a once-off cost and would be payable
immediately.
• The relocation costs to the new office building are estimated at R545 (pre-tax) per employee.
• CA Ltd would terminate a marketing campaign to be undertaken by SA Ltd in a years time. The cost of the marketing
campaign was expected to amount to R15 million (pre-tax) per annum over the next 3 years. If a bidder other than CA
Ltd were to acquire SA Ltd, SA Ltd would still proceed with the campaign.

© Endunamoo Board Course 2022 285

LE1: Determining the merger price
Additional information:
• Assume a tax rate of 28%.
• SA Ltd generally increase salaries by 6% each and every year.
• WACC of CA Ltd and SA Ltd is 13% and 15% respectively.
• Unless otherwise indicated, the synergies are applicable to all bidders.

REQUIRED:
Determine the minimum bid value, maximum bid value and fair transaction value for SA Ltd

© Endunamoo Board Course 2022 286

LE2: Exchange ratios
CA Ltd wishes to acquire 100% of the equity interest in SA Ltd. It made an offer of 4 shares for every for every 3 shares in
issue in SA Ltd.

CA Ltd SA Ltd

Earnings per share R1,50 75 cents

Market price R3,00 R2,00

Number of shares 500 000 900 000

REQUIRED
1.What is the minimum number of shares that CA Ltd would need to issue to acquire 100% of SA Ltd.
2.Based on the offer, what is the number of shares that CA Ltd would need to issue?
3.What is the value placed on SA Ltd based on the offer and what would be the premium on the transaction?

© Endunamoo Board Course 2022 287

Acquisition financed by share issue
• When acquisition is financed through the issue of shares in the acquiring company, the exchange ratio needs to be
determined
• Issuing shares is ideal when the P/E ratio of the acquirer is high
• The drawback is that it could result in dilution of control
• The exchange ratio is defined as the number of shares in the acquiring company to be exchanged for one share in the
target company
• The exchange ratio may be calculated based on earnings per share or market values:
- The exchange ratio based on EPS = EPS (target) / EPS (acquirer)
- The exchange ratio based on market price = MP (target) / MP (acquirer)

© Endunamoo Board Course 2022 288

Acquisition financed by cash
There are often compelling reasons to settle the purchase consideration in cash due to the following:
• Cash avoids dilution to the current shareholders as the existing shareholders of the target are bought out completely
• Issuing shares often requires the drafting of legal agreements (e.g. shareholder agreements) – less time, effort and cost
is devoted to reviewing such agreements
• The return on cash, interest income, is often very low and cash is better utilised when spent to generate a return at least
equal to the WACC of the company
• If the cash has to be funded through borrowings, the overall financial risk of the company and flexibility to take
advantage when opportunities arise need to be considered
• The target capital structure versus the actual capital structure

© Endunamoo Board Course 2022 289

LE3: Financing an acquisition
CA Ltd would like to purchase 100% interest in SA Ltd for an amount of R69 090 000. CA Ltd has a target debt to equity
ratio of 50% and earnings per share growth of 12% per annum. The financial manager is unsure as to whether to fund the
acquisition through equity or debt.

The financial information relating to the two companies is provided below:

CA Ltd SA Ltd

Current year earnings R30 000 000 R14 400 000

Forecast year earnings R33 000 000 R16 560 000

Market capitalisation R210 000 000 R57 600 000

Number of issued ordinary shares 10 000 000 12 000 000

© Endunamoo Board Course 2022 290

LE3: Financing an acquisition
The financial information relating to the two companies is provided below:
CA Ltd SA Ltd

Cash on hand R30 000 000 R7 000 000

Outstanding debt R94 500 000 R28 800 000

Additional information
• Total synergies amounting to R880 000 are expected to arise from this acquisition in the next financial year.
• The current investment and borrowing rates in South Africa are 8% p.a. and 12% p.a. respectively. All rates are quoted
pre-tax.
• It is expected the price earnings ratio of the combined firm would be 6,5x.

© Endunamoo Board Course 2022 291

LE3: Financing an acquisition
REQUIRED
1. Advise the board of directors of CA Ltd whether or not they should go ahead with the acquisition of SA Ltd, assuming
the acquisition is fully funded the issue of ordinary shares
2. Compare and contrast the impact on earnings per share and debt : equity ratio assuming the acquisition is either fully
funded by (i) the entity’s cash resources (if necessary, the entity will borrow); and (ii) ordinary shares

© Endunamoo Board Course 2022 292

Mergers and
acquisitions
Other considerations
Due diligence
• Due diligence is the process of investigating a target company, and usually focuses on financial, legal and operational
issues
• However, its scope may go beyond those areas in order to verify the assertions made by existing owners regarding the
business
• A due diligence would often involve professionals from different disciplines and can be a lengthy process, depending on
the nature of the transaction
• Due diligence should enable the company to place the merger in a strategic context and confirm that the strategic
direction that the acquisition offers is in fact the reality

© Endunamoo Board Course 2022 294

Advantages of due diligence
• Information required to make an informed decision is made available through a due diligence
• This would result in a fair price being determined for the target company, otherwise the acquirer may avoid costly
mistake
• Undisclosed liabilities may be identified
• The target company’s assertions regarding the past and future performance of the target may be verified
• The possible synergies expected to arise from the transaction may also be identified and verified
• The risks involved in the operations of the target company may also be identified

© Endunamoo Board Course 2022 295

Disadvantages of due diligence
• Due diligence requires a significant amount of time and specialised skills (e.g. legal, accounting, finance, etc.) in order
for accurate data to be collected
• Due to the specialist skills required, the exercise could be expensive
• The findings of a due diligence may be considered to be subjective

© Endunamoo Board Course 2022 296

Defensive tactics…
Proactive measures
• Improve performance
• Increase dividends
• Amendments to the memorandum of incorporation
• Sale of valuable assets
• Management contracts
• Pyramids
• Share split
• Poison pill

© Endunamoo Board Course 2022 297

Defensive tactics
Reactive measures
• Circular from the board of directors
• Alternative friendly merger
• Counter attack
• Disclosure of new information
• Litigation and court actions

© Endunamoo Board Course 2022 298

B-BBEE
• Broad Based Black Economic Empowerment (B-BBEE) is driven by both legislation and regulation, in the form of the B-
BBEE Act
• The process of B-BBEE works in collaboration with other acts and regulations, including those in the areas of
Employment Equity and Preferential Procurement
• Principally to nurture business growth in SA, start-up enterprises (only for the first year) and small business with a
turnover below R10 million are exempt from regulation
• B-BBEE Act, Codes of Good Practice and Transformation Charters are a comprehensive set of legislation that aims to
ensure sustainability with out empowerment impossible

© Endunamoo Board Course 2022 299

B-BBEE scorecard
The Codes of Good Practice prescribes a Generic Scorecard to entities with a turnover in excess of R50 million, with certain
targets and weights as illustrated below:
• Direct empowerment: Ownership: 20 / Management: 10
• HR / Individual development: Employment equity: 15 / Skills development: 15
• Indirect empowerment: Preference procurement: 15
• Enterprise development: 15
• Social-economic development: 5

If points obtained are below 30, the entity is considered to be non-compliant

The BEE levels range from Level 1 (highest) to Level 8 (lowest)

© Endunamoo Board Course 2022 300

Post-acquisition review
• The post-acquisition review involves assessment of the transaction success
• The benefits of a review is to improve the strategy and execution of merger or acquisition transactions. The success of a
merger could be assessed based on the following key financial metrics: return on assets, profitability, earnings per share
and price earnings ratio
• Non-financial measures that relate to the strategic objectives of the merger company may be considered as part of the
post-acquisition review

© Endunamoo Board Course 2022 301

Term 3
MAF: Term 3

Question Recommendations
MAF: Term 3 Question recommendations
Textbook reference: Drury, 8th edition
Textbook reference: Drury, 9th edition
Textbook reference: Drury, 10th edition

© Endunamoo Board Course 2022 304

Cost assignment, CVP, ABC and income effects 8th edition

Cost assignment: 3.15 – 3.22

Income effects: variable and absorption costing: 7.13 – 7.15

Cost volume profit analysis: 8.11 – 8.15; 8.17; 8.21 – 8.22

Activity based costing: 11.19 – 11.25

Job costing: 4.17 (Accounting entries)

Process costing: 5.12 – 5.21

Joint costs and by products: 6.10 – 6.15 (exclude 6.15 part (c))

© Endunamoo Board Course 2022 305

Cost assignment, CVP, ABC and income effects 9th edition

Cost assignment: 3.15 – 3.22

Cost volume profit analysis: 8.11 – 8.15; 8.17; 8.21 – 8.22

Activity based costing: 11.19 – 11.25

Income effects: variable and absorption costing: 7.13 – 7.16

Job costing: 4.18 (Accounting entries)

Process costing: 5.12 – 5.22

Joint costs and by products: 6.10 – 6.15 (exclude 6.15 part (c))

© Endunamoo Board Course 2022 306

Cost assignment, CVP, ABC and income effects 10th edition

Cost assignment: 3.15 – 3.22

Cost volume profit analysis: 8.11 – 8.14; 8.20

Activity based costing: 11.19 – 11.25 (for 11.22 ignore (b))

Income effects: variable and absorption costing: 7.13 – 7.18

Job costing: 4.18 (Accounting entries)

Process costing: 5.12 – 5.22

Joint costs and by products: 6.10 – 6.15

© Endunamoo Board Course 2022 307

MAF: Term 3

Tutorials & Screencasts

Tutorial
Discussion Question: Lesedi Winery
Submission Date: 1 June 2020
Discussion Date: 14 June 2020

© Endunamoo Board Course 2022 309

Screencasts: Test Reviews
Screencast available for UNISA Test 2 (2020)
CTA Level 1: Mike & Thabang
CTA Level 2: Ntate Ledwaba

Screencast available for UNISA Test 2 (2019)

CTA Level 1: Idibala Cycle Ltd
CTA Level 2: SteinSassa Industries Ltd

Screencast available for UNISA Test 2 (2018)

CTA Level 1: FABS Coms Ltd
CTA Level 2: Super Beverages (Pty) Ltd

© Endunamoo Board Course 2022 310

Introduction to
costing
Objectives of this section
• Describe the three purposes for which cost information is required
• Understand the meaning of different cost terms
• Define and illustrate a cost object

© Endunamoo Board Course 2022 312

The big picture
“Management accounting is concerned with the provision of information to people within the organisation to help them make
better decisions and improve the efficiency and effectiveness of existing operations.” – Colin Drury

The management accounting information provided to those people must satisfy the following requirements:
• Allocate costs between costs of goods sold and inventories for internal and external reporting (“Cost accumulation for
inventory valuation and profit measurement”)
• Provide relevant information to help managers make better decisions (“Information for decision making”)
• Provide information for planning, control and performance measurement (“Information for planning, control and
performance measurement”)

© Endunamoo Board Course 2022 313

Cost terms and concepts
• The most fundamental cost term that we will encounter in Management Accounting are ‘cost object’
• A cost object is any activity for which a separate measurement of costs is desired. It is anything for which one wants to
measure the cost of resources used
➢ The hotel is charging R300 per night per person sharing
➢ It costs R800 per consultation hour to see the doctor

© Endunamoo Board Course 2022 314

Direct and indirect costs
• Direct costs are those costs that can be specifically and exclusively identified with a particular cost object
• The ability to trace back costs to an individual cost object provides a strong indication of whether a cost is direct cost or
indirect cost
• As a result of indirect costs not being traceable to individual products, an estimate must be made of resources
consumed by cost objects for indirect costs
• The perspective is critical: A cost can be a direct cost for a particular cost object and the same cost can be an indirect
cost for another cost object
• The distinction of whether a cost is a variable cost or a fixed cost; or whether it is a manufacturing cost or a non-
manufacturing cost is irrelevant for the classification of direct and indirect costs

© Endunamoo Board Course 2022 315

Cost classification and terms
• Prime cost refers to direct costs and consists of direct materials and direct labour
➢ Direct material and labour costs comprise of all those materials and labour that can identified with a
specified cost object
• Manufacturing overhead consists of all manufacturing costs other than prime costs. These costs are assigned to
products using cost allocations
➢ Indirect materials cannot be identified with any one product because they are used for the benefit of all
products or entire production process, e.g. a blade of a cutting machine
➢ Indirect labour refers to those workers that do not work on the product itself but who assist in the
manufacturing operation and these are classified as overhead, e.g. an employee that is operating a machine
• Product costs are those costs that are identified with goods purchased or produced for resale. These costs may include
direct material, direct labour and (some of) indirect manufacturing costs that are normally included in inventory
valuation
• Period costs are those costs that are not included in the inventory valuation and as a result are treated as expenses in
the period in which they are incurred. No attempt is made to attach the period costs to products for inventory valuation
purposes

© Endunamoo Board Course 2022 316

Categories of costs
Traditional cost accounting systems accumulate product costs as follows:
Direct materials YY
Direct labour YY
Prime cost XX
Manufacturing overheads ZZ
Total manufacturing costs WW
Direct materials form part of prime cost and indirect materials form part of overhead cost

© Endunamoo Board Course 2022 317

Examination considerations
• The principles included in this section are not assessed individually
• However, understanding these principles assist strongly in analysing the scenario as well as identifying key issues – this
will become evident as go into detail with the rest of the costing topics

© Endunamoo Board Course 2022 318

Overhead allocation
Objectives of this section
• Describe the various denominator levels that can be used with an absorption costing system
• Justify why budgeted overhead rates should be used in preference to actual overhead rates
• Calculate and explain the accounting treatment of the under-/over-recovery of overheads

© Endunamoo Board Course 2022 320

Introduction to cost assignment
Endunamoo note:
• In this course, the terms ‘applied, absorbed, allocated and recovered’ shall be used interchangeably. You are more than
welcome to use the word most preferred.
• The term indirect costs will mean indirect fixed manufacturing costs unless otherwise evident or indicated

© Endunamoo Board Course 2022 321

Introduction to traditional costing
• The focus with cost assignment is the allocation of indirect fixed manufacturing costs for the purposes of inventory
valuation and profit measurement
• All overhead costs need to be allocated to the products because they are necessary for the production of actual units
• The issue becomes how to allocate these overhead costs to individual units
• The overhead allocation rate is determined by dividing the budgeted overhead costs (numerator) by the budgeted
level of activity during that period (denominator)
• The method described above is known as the traditional method of cost allocation

© Endunamoo Board Course 2022 322

The overhead allocation rate
• The issue is the numerator to use and the denominator, i.e.
➢ Use actual or budgeted costs as the numerator
➢ Use actual or budgeted activity as the denominator
➢ Use labour hours, units, machine hours, etc. as the denominator
• Key considerations with regards to the use of actual figures are:
➢ The use of actual overhead rate has its limitation because actual overhead rates causes a delay in the calculation of
product cost
➢ The use of actual monthly rates causes fluctuations in the overhead rates throughout the year (e.g. heaters retailer)
• To remedy these challenges we always use budgeted figures to determine the overhead allocation rate

© Endunamoo Board Course 2022 323

Accounting treatment of over/under recovery
• The overhead allocation rate is applied to actual activity to determine the amount of overheads absorbed
• The amount absorbed is then charged to cost of sales (production costs) as an expense
• If the absorbed overhead amount is less than the actual overheads, an expense is recognised to account for the under-
recovery
• On the other hand, an over-recovery is recognised in the case where the cost of sales is greater than the actual
overheads incurred. This is treated as an income item in order to reduce cost of sales amount
• Under- or over-recovery should be broken down into an expenditure and volume variance
• Under- or over-recovery do not form part of production costs and may be included above or below the gross profit
line item

© Endunamoo Board Course 2022 324

Analysis of overhead variances
Actual fixed overheads
Expenditure variance
(Budgeted – actual)

Budgeted fixed costs

Volume variance
(Allocated – budgeted)

Allocated fixed costs

(Allocation rate x Actual activity) Under-/over-recovery

Exam note
• The signs of the answers are important as they have different interpretation and accounting treatment
• Under- or over-recovery may be placed above or below the gross profit line item

© Endunamoo Board Course 2022 325

Allocation based on units versus hours
Allocation based on units
• Generally applicable for a single product environment
• If a multi-product environment, it assumes that the products are not substantially different from each other and
therefore consumes the company’s resources equally
• The process is that an overhead allocation rate is based on the budgeted production (often referred to as the blanket
overhead rate)
• This is then applied to actual production to determine the total amount of overheads recovered
Allocation based on hours
• This approach acknowledges that although the environment is volume driven, the products manufactured consume
the entity’s resources in different proportions
• The process is such that the overhead rate is initially determined based on machine or labour hours, i.e. overhead rate
per hour
• It is then applied to the individual products on a unit basis by applying it to the standard hours per unit to determine
the allocation rate per unit
• This will result in an allocation rate that is different per product
• This overhead allocation rate per unit is then applied to actual production

© Endunamoo Board Course 2022 326

LE1: Allocation of overheads
CA Ltd is involved in the manufacture of two distinct products, X and Y. X is a highly complex product and requires 10
machine hours to manufacture while Y is less complex and requires only 4 machine hours to manufacture. The total
budgeted fixed costs was R4 500 000 while actual fixed costs were R4 800 000. The production statistics are as follows:

Product X Product Y

Budget production 20 000 25 000

Actual production 22 500 24 000

REQUIRED
Calculate expenditure and volume variance, assuming the overheads are allocated based on (i) units produced, (ii) machine
hours

© Endunamoo Board Course 2022 327

Impact on decision making and pricing
• Significant over and under-recoveries might highlight problems with the entity’s decision making and pricing policies
• Pricing consideration: Under-recovery of overheads might highlight the company’s products are being under-costed
and therefore under-priced (this will be an issue if the entity utilises cost plus pricing policies)
• This might be highlighted by a situation where the company increases volume by profitability continues to decline
• Decision making consideration: Under-recovery of overheads might highlight that the entity has over-invested in its
manufacturing capacity and that is why it is unable to adequately recover or absorb all the fixed costs
• The converse will be true for an over-recovery of overheads
• The greater the difference and the more consistent the trend, the greater the problem

© Endunamoo Board Course 2022 328

Potential denominators
The following are denominator level measures that could potentially be used for the purpose of determining the
appropriate denominator:
• Theoretical maximum capacity is a measure of maximum operating capacity based on 100% efficiency with no
interruptions for maintenance or other factors
• Practical capacity represents the maximum capacity that is likely to be supplied by the machine after taking into
account unavoidable interruptions arising from machine maintenance and plant holiday closures
• Normal activity is a measure of capacity required to satisfy average customer demand over a longer term period after
taking into account seasonal and cyclical fluctuations
• Budgeted activity is the activity level based on the capacity utilisation required for the next budget period

© Endunamoo Board Course 2022 329

 Variable and
absorption costing
Objectives of this section
• Explain the differences between an absorption costing and a variable costing system
• Prepare profit statements based on an absorption and variable costing system
• Reconcile and explain the difference in profits between absorption and variable costing profit calculations
• Explain the arguments for and against variable and absorption costing

© Endunamoo Board Course 2022 331

Introduction to cost accumulation systems
• There are two distinct cost accumulation systems
• The absorption costing (also known as the full costing, conventional costing or traditional costing) system. This
method is also a requirement in terms of IAS2 Inventories
• The variable costing (also known as the marginal or direct costing method)
• The two systems have different income effects, i.e. the choice of the cost accumulation system affects the reported
profit after tax for the year

© Endunamoo Board Course 2022 332

Variable and absorption costing
Variable costing Absorption costing
Direct costs Included as product cost Included as product cost
Prime costs Included as product cost (prime and Included as product cost (prime and
direct costs same thing) direct costs same thing)
Manufacturing overheads – variable Included as product cost Included as product cost
Manufacturing overheads – fixed Treated as period cost – expense in full Included as product cost – allocated to
when incurred products based on overhead allocation
rate

Under- or over-recovery of fixed Not applicable – as all overheads Under-recovery treated as expense
overheads charged as period costs while over-recovery treated as income
Non-manufacturing costs – variable Not included as product costs – often Not included as product costs – often
(often selling expenses) vary with units sold rather than vary with units sold rather than
production production

Non-manufacturing costs – fixed Treated as period cost – expense in full Treated as period cost – expense in full
when incurred when incurred

© Endunamoo Board Course 2022 333

Format: Absorption costing statement

Revenue XXX
Cost of sales (XXX)
Opening balance YYY
Production costs (direct costs plus allocated costs) YYY
Closing balance (YYY)
Gross profit XXX
Period costs (XXX)
Expenditure variance (if actual statement required) +/-YYY
Volume variance (if actual statement required) +/-YYY
Variable selling and administration costs (YYY)
Fixed non-manufacturing costs (YYY)
PROFIT BEFORE TAX XXXX

© Endunamoo Board Course 2022 334

Format: Variable costing statement

Revenue XXX
Variable costs (XXX)
Opening balance YYY
Production costs (direct manufacturing costs only) YYY
Closing balance (YYY)
Variable non-manufacturing costs YYY
Contribution XXX
Period costs (XXX)
Fixed manufacturing costs (YYY)
Fixed non-manufacturing costs (YYY)
PROFIT BEFORE TAX XXXX

© Endunamoo Board Course 2022 335

Reconciliation of profit before tax

• As outlined below, apart from opening and closing inventory, there are no further adjustments required to explain /
reconcile the differences between the profit before tax under variable and absorption costing
• Revenue is the same under both systems because these are transactions with third parties
• Production costs are the same since these are costs payable to external suppliers.
❑ Variable costs are the same under both systems.
❑ Fixed overheads are charged in full under variable costing while under absorption, they are allocated and an
adjustment for over or under recovery of overheads is made.
• Non-production costs are charged in full under both systems and thus there is no difference between the two systems

© Endunamoo Board Course 2022 336

Reconciliation of profit before tax

Profit before tax based on variable costing YYY

Difference in opening inventory (---) Note 1
Difference is closing inventory +++ Note 2
Profit before tax based on absorption costing XXX
Note 1: Opening inventory is included in cost of sales. It is added to cost of sales and thus increases the cost of sales
expense and decreases profit before tax. Under variable costing, the opening inventory is lower because the fixed
overheads were fully charged in the previous year. However, under absorption costing the fixed costs were allocated to
production and were deferred into the current year. This means that under variable costing, the cost of sales is lower than
in absorption costing and thus the profit before tax is higher. In order to reconcile the profit before tax from the variable
costing to absorption costing, we need to DEDUCT the difference between opening inventory balances under the
respective systems.

© Endunamoo Board Course 2022 337

Reconciliation of profit before tax

Profit before tax based on variable costing YYY

Difference in opening inventory (---) Note 1
Difference is closing inventory +++ Note 2
Profit before tax based on absorption costing XXX

Note 2: Closing inventory is deducted from cost of sales and thus decreases the cost of sales and increases profit before
tax. Under variable costing, the closing inventory is lower because the fixed overheads were fully charged in the current
year. However, under absorption costing the fixed costs were allocated to production and are being deferred into the
following year. This means that under variable costing, the cost of sales is higher than in absorption costing since a lower
amount was deducted, which means that the profit before tax under variable costing is lower. In order to reconcile the
profit before tax from the variable costing to absorption costing, we need to ADD the difference between closing
inventory balances under the respective systems.

© Endunamoo Board Course 2022 338

Pros and cons of various costing systems
Variable costing
• Variable costing provides more useful information for decision making
• Variable costing removes from profit the effect of inventory changes
• Variable costing avoids fixed overheads being capitalised in unsaleable stocks

Absorption costing
• Absorption costing does not understate the importance of fixed costs
• Absorption costing avoids fictitious losses being reported
• Fixed overheads are essential for production
• Consistency with external reporting (IAS 2 Inventories)

© Endunamoo Board Course 2022 339

LE1: Variable and absorption costing
Bakers is a manufacturer of cakes. Information pertaining to the most recent financial period is provided below:
Budget Actual
Number of units produced 30 000 32 400
Number of units sold 28 000 30 000
Selling price per unit R300 R325
Variable manufacturing costs per unit R120 R155
Variable selling costs per unit R55 R54
Fixed manufacturing costs (allocation base: units) R810 000 R880 000
Fixed non-manufacturing costs R400 000 R420 000

There were 1 000 units of finished goods at the beginning of the period. The variable manufacturing cost of each item is
R130 while the fixed cost per unit is R35 per unit. Bakers uses first-in-first-out (FIFO) method to account for its closing
inventory.

© Endunamoo Board Course 2022 340

LE1: Variable and absorption costing
REQUIRED:
1) Prepare the actual statement of profit or loss of Bakers using the absorption costing method
2) Reconcile the absorption costing profit determined in part (1) to the variable costing profit

© Endunamoo Board Course 2022 341

Exam-technique: Variable / absorption costing

• Identify the easiest marks to score and make a decision of what might be required to pass the question. Easy marks can
be identified as:
➢ Level 1: Marks that you can put in without having performed any calculations (likely to be ½ marks)
➢ Level 2: Marks that you can calculate by applying a mathematical operation to figures in the scenario (likely to be ½
marks)
➢ Level 3: Marks that require a greater level of application and that might need another figure to be determined first
(likely to be a full credit or more)
• Know your format! There is likely going to be a credit for the correct layout. Variable versus absorption statement
format?
• Acknowledge that the difference between the profit determined under variable and absorption costing is due to
opening and closing stock

© Endunamoo Board Course 2022 342

Activity based
costing
Objectives of this section
• Describe the differences between activity-based and traditional costing systems
• Explain why traditional costing systems can provide misleading information for decision-making
• Identify and explain each of the four stages involved in designing ABC systems
• Apply an activity-based costing approach to costing information

© Endunamoo Board Course 2022 344

Traditional costing: Cost allocation
• Traditional costing system pools overheads by departments (described as cost centres)
• These overheads are then traced to products using a small number of allocation bases, which vary directly with the
volume produced
• Traditional costing is most appropriate in volume based environments and the allocation of overheads could be done
using volume based cost drivers
• Volume based cost drivers assume that a product's consumption of overhead resources is directly related to units
produced, e.g. depreciation of a machine, electricity costs
• The allocation bases tend to be units produced, machine hours and direct labour hours (i.e. volume-based)
• This process is referred to as cost allocation

© Endunamoo Board Course 2022 345

Activity based costing: Cost attribution
• An ABC system assigns overheads to each major activity (rather than departments)
• With ABC systems, many activity based cost centres (also known as cost pools) are established
• Cost drivers are used as the basis for allocating costs to cost objects
• The cost drivers may be volume or non-volume based and aim to highlight cause-and-effect relationships
• This process is referred to as cost attribution

© Endunamoo Board Course 2022 346

Introduction to ABC
• There is a need for a cost accumulation system to generate relevant cost information for decision making for better
and effective decision making
• The choice of an optimal cost system is based on cost/benefit analysis
• Both traditional costing system and ABC assign indirect manufacturing costs to cost objects (products) based on a two-
stage allocation process

© Endunamoo Board Course 2022 347

Cost allocation in a non-volume based environment
• In a traditional costing system, the costing of products is complicated and distorted as a result of the following factors:
➢ Non-volume related overhead costs being a large proportion of total overhead costs; and
➢ the application of product diversity
• Product diversity applies when products consume different overhead activities in dissimilar proportions – difference in
product size, product complexity and sizes of batches may cause product diversity.
• Traditional systems often tend to rely on arbitrary allocations of indirect costs because they rely extensively on
volume-based allocations
• The implication is that high volume products are likely to be assigned with a greater proportion of indirect costs
than they have consumed (consequently overpricing these products) whereas low volume products will be assigned
a lower proportion (consequently underpricing these products)
• In contrast, ABC systems recognise that many indirect costs vary in direct proportion to changes other than production
volume
• By identifying the cost drivers that cause the costs to change and assigning costs to cost objects on the basis of cost
driver usage, costs can be more accurately traced (cause-and-effect relationship) – making ABC superior

© Endunamoo Board Course 2022 348

Appropriateness of ABC…
• Both traditional and ABC systems vary in their level of sophistication but, as a general rule, traditional systems tend to
be simplistic whereas ABC systems tend to be more sophisticated
• Ultimately the chosen level of sophistication should be made on cost versus benefits criteria
• The cost of errors need to be assessed in relation to the costs of implementing and operating an ABC system. In a highly
competitive environment, the cost of error in pricing could have significant negative implications
• A sophisticated ABC may be optimal for organisation having the following characterises:
➢ intensive competition
➢ non-volume related indirect costs that are a high proportion of total indirect costs
➢ a diverse range of products, all consuming organisation resources in significantly different proportions (i.e. high
product diversity)

© Endunamoo Board Course 2022 349

ABC in a service organisation
• Service companies are ideal candidates for ABC, even more than manufacturing companies. The reasons for this are:
➢ most of its costs are indirect
➢ most of the resources are supplied in advance and fluctuations in the usage of activity resource by individual
services and customers does not influence short-term spending to supply the resources
• However, the following factors may create problems for the application of ABC
➢ Facility sustaining costs (such as property rents, etc.) represent a significant proportion of total and may only be
avoidable if the organisation ceases business. It may be impossible to establish appropriate cost drivers
➢ If it often difficult to define products where they are of intangible nature. Cost objects can therefore be difficult to
specify
➢ Many service organisation have not previously had a costing system and much of the information required to set
up ABC system will be non-existent. Therefore, introducing ABC is likely to be expensive?

© Endunamoo Board Course 2022 350

Designing an ABC system
• The key steps involved in designing ABC systems are as follows:
➢ Identifying the major activities that take place in an organisation
➢ Assigning costs to cost pools/cost centres for each activity
➢ Determine the cost driver for each major activity
➢ Assigning the cost of activities to products according to the product’s demand for activities

© Endunamoo Board Course 2022 351

LE1: ABC allocations
Alarmy is a manufacturer of alarm remote controls, ADT and Chubb. The table below shows data for next budget period:
Products ADT Chubb
Direct material per unit R160 R190
Direct labour cost per hour (variable) R200 R200
Budgeted production 50 000 80 000
Direct labour hours per unit 1,20 2,00
Machine hours per unit 0,40 0,80
Batch size 80 500
Machine setups per batch 4 5
Number of inspections per batch 2 4

© Endunamoo Board Course 2022 352

LE1: ABC allocations
The factory manager has identified the following cost pools as well as the related cost drivers:
Activity pools Amount (R) Cost drivers
Machine maintenance 10 920 000 Number of machine hours
Machine setups 8 250 000 Number of machine setups
Inspection / Quality control 3 402 000 Number of inspections
Total overheads 22 572 000

Traditional costing systems uses budgeted machine hours to allocate overhead costs.

REQUIRED:
1) Calculate the product costs of ADT and Chubb based on (i) traditional costing and (ii) activity-based costing
2) Compare the overhead per unit calculated in Part (1), and briefly discuss the reasons for the differences

© Endunamoo Board Course 2022 353

Examination technique: ABC allocations
• Identify that there are two required for part (1), and therefore four distinct answers are required
• Think about the four-stage allocation process of ABC
• Marks are often allocated for each step with a greater amount of marks allocated to determining total activities for the
cost drivers and determining the cost per cost driver
• Often cost drivers might be provided but in other cases, you might be required to identify these drivers
• The verb ‘compare’ implies that there are at least two things to compare – the question is what is being compared now
that you have four things?
• How can cost allocation theory assist you in structuring and answering the required?

© Endunamoo Board Course 2022 354

 Building blocks of ABC
Activities consist of the aggregation of many different tasks, events or units of work that cause the consumption of
resources. They tend to consists of verbs associated with objects
Facility-sustaining activities are
performed to support the facility’s • They are incurred to support the organisation as a
general manufacturing process and whole and are common and joint to all products
include general administrative staff, manufactured in the factory / by the company
plant management and property • There would have to be dramatic change in activity,
costs resulting in an expansion or contraction in the size of
the plant for facility-sustaining costs to change
Hierarchy of cost

Product-sustaining activities are performed to enable the • These costs should NOT BE assigned to products
production and sale of individual products. The costs of since they are unavoidable and irrelevant for most
product-sustaining activities are incurred irrespective of the decisions
number of units of output, or the number of batches • Instead, they are regarded as common costs to all
processed and their expenses will tend to increase as the products produced in the plant and deducted as a
number of product types manufactured is increased lump sum from the total of the operating margins
from all products
Batch level activities are performed each time a batch of goods is produced. The
cost of batch-related activities varies with the number of batches made, but is
common (or fixed) for all units within the batch
Unit level activities are performed each time a unit of the product or service is produced. The unit level
costs include direct labour and direct materials. These activities consume resources in proportion to the
number of units of products and sales

© Endunamoo Board Course 2022 355

Determining the appropriate driver
In determining the appropriate allocation base, the following issues are considered:
• Controllability: Costs that are required to support the organisation as a whole should not be allocated
• Directly attributable nature of costs: Costs that are directly attributable should NOT be subjected to the process of
allocation; otherwise, this will result in information that is meaningless and not useful for decision making
• Equivalence of the allocation base: The allocation base assumes that the consumption of resources is proportional and
this assumption should always be tested
• Cause and effect: The allocation base should represent the driver of the costs for it to be meaningful
• Cost versus benefits: Data is not always available and the cost of obtaining that data should be assessed against its
benefits

© Endunamoo Board Course 2022 356

LE2: Advanced ABC example
Take-to-the-Air SA Ltd (‘Ta-ta’) is an airline company listed on the JSE. The company operates two divisions within its
airline segment, namely Fly and Grand. The details of the two divisions can be summarised as follows:
Fly Grand

• Boeing 737B aircraft (smaller capacity)

Aircraft type Boeing 737A aircraft (larger capacity)
• Boeing 737A aircraft (larger capacity)

Model Low-cost airline Luxury model

• Business class (limited number)
Cabin type Economy class only
• Economy class (remaining seats)
Extras None Access to exclusive airport lounges
Destinations Domestic destinations only Domestic and African destinations
Meals Pay-as-you-go Complimentary snacks and refreshments
Target market Domestic tourists Foreign tourists and corporate travellers

© Endunamoo Board Course 2022 357

LE2: Advanced ABC example
The Civil Aviation Authority requires Ta-ta to report on the operating expenses of Fly and Grand annually. The CFO has pre-
populated the template with the data he has available for the recent year, but still has to complete the cost allocation:
Ta-ta SA Fly Grand
Notes
R’000 R’000 R’000

Flight operations 1 1 499 793

Maintenance and overhaul 596 941

Depreciation and amortisation 361 072

User charges and station expenses 2 976 812

Passenger services 3 596 941

Ticketing, sales and promotions 4 759 743

General and administration 4 593 600

Total 5 384 902

© Endunamoo Board Course 2022 358

LE2: Advanced ABC example

Notes
1. Flight operations comprise flight crew salaries, expenses and training, aircraft fuel and oil, insurance and uninsured
losses and operating lease charges. The strongest correlation exists between flight operation costs and block hours.
Block hours consist of the number of hours an aircraft is in use and are measured from the time the doors are closed
prior to departure until they are opened on arrival of the aircraft at its destination.
2. User charges and station expenses comprise landing and airport charges, navigation charges and airport office
expenses. These costs are based on the number of flights flown.
3. Airlines find that passenger service costs are mainly based on the number of passengers transported.
4. The CFO of Ta-ta is of the opinion that the ticketing, sales and promotion costs of Fly are 50% of those of Grand. He is
also of the opinion that the general and administration costs of Fly are 40% of those of Grand.

© Endunamoo Board Course 2022 359

LE2: Advanced ABC example
The following spreadsheet was prepared by the CFO for the recent year end:
1 Key indicator Fly Grand

2 Number of passengers transported 3 102 500 2 326 178

3 Number of flights flown 18 250 21 751
4 Number of aircraft 10 15
5 Owned 10 9
6 Leased (operating leases) 0 6
7 Total block hours (from take-off to arrival) 31 237,92 39 171, 67
8 Maintenance: Cost of aircraft parts used R178 644 380 R251 540 620
9 Maintenance: Hours spent maintaining aircraft 36 000 hours 70 800 hours
10 Depreciation and amortisation R240 714 667 R120 357 333

© Endunamoo Board Course 2022 360

LE2: Advanced ABC example

REQUIRED
1. Complete the cost allocation for the Civil Aviation Authority report by allocating the costs to Fly and Grand (12 marks)
2. Critically discuss the allocation bases used to allocate the operating expenses between Fly and Grand (15 marks)
(Source: ITC June 2018)

© Endunamoo Board Course 2022 361

Cost, volume and
profit analysis
Objectives of this section
• Describe the three purposes for which cost information is required
• Apply the numerical approach to answer break even questions
• Explain the meaning of operating leverage and how it influences profits
• Identify and explain the assumptions on which CVP analysis is based

© Endunamoo Board Course 2022 363

Introduction to CVP analysis
• This section focuses on what will happen to the financial results of an entity if a specific level of activity or volume
fluctuates
• CVP analysis examines the relationship between changes in activity and changes in total sales revenue, costs and net
profit
• The information is required for making optimal short-term output decisions

© Endunamoo Board Course 2022 364

Cost behaviour and relevant range
• The behaviour of costs is a function of time and activity
• Costs may be described as variable, fixed, semi-variable and semi-fixed/stepped-fixed cost in relation to how they
react to changes in activity
• Variable costs vary in direct proportion to the volume of activity while fixed costs remain constant over wide ranges of
activity for a specified period of time
• Variable costs per unit are constant for different level of activity; however, the total variable costs changes with
activity
• Fixed costs per unit vary with different level of activity; however, the total fixed costs remain cost when activity
changes
• Over a sufficiently long period of time virtually all costs variable
• Therefore an activity or period needs to be defined before the cost behaviour could be accurately determined
• The range that represents the output levels that the firm has had experience of operating in the past and for which cost
information is available is considered to be the relevant range

© Endunamoo Board Course 2022 365

CVP analysis assumptions
• All other variables remain constant
• Single product or constant sales mix
• Total costs and total revenue are linear functions of output
• Profits are calculated on a variable costing basis
• Costs can be accurately divided into their fixed and variable elements
• Analysis applies only to the relevant range

© Endunamoo Board Course 2022 366

Numerical approach to CVP
• The most common application of CVP is the determination of break-even point, margin of safety, application of hi-low
method and operating leverage
• The hi-low method to assist in distinguishing between variable and fixed costs in a given total cost
• Break-even refers to a point where the company makes neither a profit nor a loss
• Margin of safety refers to the excess number of units sold or budgeted to be sold above the break even units
• Scenario may deal with single product or multi-product case. If overheads are shared between the units, use multi-
product break even approach
• Operating leverage for measuring the sensitive of profit to changes in sales volume

© Endunamoo Board Course 2022 367

Cost, volume and
profit analysis
Hi-low method
Hi-low method
• Often costs are not easily distinguishable between variable and fixed costs and therefore a technique is required to
identify the nature of a cost that exhibits the behaviour of a fixed and variable nature
• The hi-low method may be used (cautiously) to analyse costs within a respective relevant range where a cost comprises
a variable and fixed component
• Hi-low method assumes that the activity levels and the related costs are representative of the cost behaviour within a
defined relevant range

Hi-low = Change in cost / Change in activity

Variable cost per unit = (Costhigh – Costlow) / (Activityhigh – Activitylow)

© Endunamoo Board Course 2022 369

LE1: Hi-low method
CA Ltd has an agreement with Eskom for the supply of electricity. In terms of the agreement, CA Ltd is charged an annual
fixed amount for access to Eskom’s grid (‘fixed access fee’). This amount is payable irrespective of whether CA Ltd utilises
electricity or not.
In addition to the fixed access fee, CA Ltd pays for electricity consumption based on the amount of Kwh of electricity it
utilises during the year. Information relating to the electricity costs over the past three years is provided below:
Financial year Kwh consumed Total costs
FY2016 780 000 R1 953 000
FY2017 700 000 R1 845 000
FY2018 850 000 R2 047 500

There were no electricity price hikes throughout the period FY2016 to FY2018. In FY2018, Eskom announced that it will
increase its fixed access fee by 10% in FY2019. The consumption rate per kwh will not be changed.
CA Ltd is expecting to produce 100 000 units in FY2019. Each units requires 9,2 Kwh to manufacture.
REQUIRED
Calculate the total budgeted electricity costs in FY2019

© Endunamoo Board Course 2022 370

LE2: Hi-low / Relevant range
CA Ltd has an agreement with Eskom for the supply of electricity. In terms of the agreement, CA Ltd is charged an annual
fixed amount for access to Eskom’s grid (‘fixed access fee’). This amount is payable irrespective of whether CA Ltd utilises
electricity or not. The fixed access considers the capacity of transmission equipment required to supply electricity and the
greater the usage, the greater the capacity of equipment required. As a result, Eskom charges a higher fixed access fee
when the usage increases above 700 000 Kwh per annum.
In addition to the fixed access fee, CA Ltd pays for electricity consumption based on the amount of Kwh of electricity it
utilises during the year. Information relating to the electricity costs over the past three years is provided below:

Financial year Kwh consumed Total costs

FY2018 400 000 R1 650 000
FY2019 680 000 R2 070 000
FY2020 900 000 R2 950 000
REQUIRED
Calculate the total budgeted electricity costs in FY2021 assuming that CA Ltd is planning to consume a total of 970 000
Kwh. There was no tariff increases over the past three years.

© Endunamoo Board Course 2022 371

Cost, volume and
profit analysis
Break-even approach
Break even formula
Break even in units = FC / contribution per unit
Contribution = Selling price less all variable costs
Or
Break even in Rands = FC / contribution margin
Contribution margin = Contribution / Sales x 100
(Break even sales = Break even units x sales price)

If the company has a target profit (i.e. the company desires to generate a profit and not merely break even), then the total
contribution generated should be sufficient to cover the total fixed costs and the required profit. To achieve this, the fixed
costs are increased by target profit

© Endunamoo Board Course 2022 373

Break even formula
• Break even point may be calculated in units or in Rand terms
• At the break even point, total contribution = fixed costs
• Fixed costs relate to all the fixed costs of the company, whether manufacturing or non-manufacturing costs
• Variable costs relate to all costs that vary with sales, whether manufacturing or non-manufacturing costs

© Endunamoo Board Course 2022 374

LE3: Single product break even
Tessa manufactures non-electric vehicles. Pertinent information relating to the operations of Tessa are provided below:
• Tessa budgeted to sell 2 000 vehicles in FY2020 at a price of R300 000 per vehicle.
• The steel component required for the manufacturing process is acquired in tonnes from an external supplier. The cost
per tonne is R2 500 and each vehicle requires 75 tonnes to be manufactured.
• Other direct materials amount to R45 000 per vehicle.
• A total of 150 direct labour hours is required for the assembly of one vehicle. The assembly staff are all permanent staff
and are paid an annual salary of R63 500 per staff. Each staff is budgeted to work a total of 1 200 hours in FY2020.
• Tessa employs its sales team on a permanent basis. The sales team is paid a fixed annual salary and a commission of
2,5% for each vehicle sold. The total budgeted costs for the sales team is R63 million.
• The total fixed manufacturing overheads are budgeted at an amount of R35 million. Included in this amount is R5
million for the depreciation on the manufacturing machine.
• Other fixed non-manufacturing overheads are budgeted to amount to R10 325 000.

© Endunamoo Board Course 2022 375

LE3: Single product break even
REQUIRED:
1) Calculate the number of vehicles that Tessa need to sell in order to break even in units and in revenue terms in FY2020
2) Calculate the margin of safety in units and in revenue terms.
3) Calculate the number of vehicles that Tessa would need to sell in order to generate an annual profit of R2 400 000.
4) If fixed overheads increase by R900 000, calculate the revised number of vehicles that Tessa would need to sell in
order to break even.
5) Discuss the impact on the break even units calculated in (1) of an increase in the sales commission rate from 2,5% to
3,5%. No calculations are required.

© Endunamoo Board Course 2022 376

Exam-technique: Single product break even
• The break-even calculation requires that the company generates sufficient contribution margin to cover the total fixed
cost (i.e. manufacturing and non-manufacturing fixed costs)
• The contribution margin per unit is the selling price per unit less all variable costs per unit (manufacturing and non-
manufacturing costs)
• The break-even point determines the number of units to be sold or the sales value required in order to generate neither
a profit nor a loss
• If the company has a target profit or additional fixed costs then the total contribution margin generated should be
sufficient to cover the total fixed costs and the required profit
• Pay attention to the required – does it require break-even units or sales value?

© Endunamoo Board Course 2022 377

Break-even complications
Break-even analysis can be complicated by the following matters:
• Items sold for no consideration, e.g. donated items
• Promotional items, e.g. buy 1 and get 1 free
• Committed revenues, e.g. a hotel with committed revenues from conference facilities and attempting to determine
break even for the number of guests required
• Transfer pricing arrangements, e.g. break-even from a divisional perspective versus company-wide perspective
• Special orders

© Endunamoo Board Course 2022 378

LE4: Multi-product break even
Vukosi Ltd is a manufacturer of soccer and tennis balls. The balls are manufactured at the company’s premises in Midrand.
The selling price of each soccer and tennis ball is R500 and R200 respectively. The balls are sold through an agent company
that charges a commission at a rate of 5% for every ball sold. The Department of Sports has approved a grant of R324 645
and this will paid to Vukosi in the upcoming period. The budget number of balls for the upcoming financial year end is:
Soccer balls Tennis balls
Number of balls to be sold 24 500 10 500
Number of balls to be produced 28 000 12 000

The following costs are applicable to Vukosi for the recent financial year end:
• Direct materials required to manufacture each ball is R120 for the soccer ball and R50 the tennis ball.
• Labour is a variable cost and is charged at R80 per hour. A soccer ball requires 30 minutes to manufacture and a tennis
ball requires only 15 minutes to manufacture.
• Variable overhead cost are absorbed at a rate of R50 per labour hour.
• Manufacturing fixed costs of R5 763 250. These costs are allocated to manufacturing using number of units produced.
• Non-manufacturing fixed costs of R2 million, includes rental of admin building and salaries of admin staff.

© Endunamoo Board Course 2022 379

LE4: Multi-product break even
REQUIRED:
1) Calculate the break-even number of balls. The break-even number of balls must be calculated in total, and then split
between soccer and tennis balls.
2) Based on the budget, is Vukosi expecting to generate a loss or profit in the upcoming period? Motivate your answer

© Endunamoo Board Course 2022 380

Exam-technique: Multi-product break even
1. Determine the appropriate sales mix based on units
➢ Do not use production mix
➢ Use budgeted figures, unless required otherwise
➢ Express the sales mix as a percentage
➢ Always check that the percentages add up to 100%
2. Calculate contribution for each unit (Contribution=SP–ALL VC)
3. Calculate the weighted average contribution using the calculated sales mix percentage and the respective
contributions
4. Calculate total fixed costs of the company – do not split these
5. Break even in units would be determined as (4) / (3)
6. Multiply your answer by the sales mix percentage to get the respective number of break even units for each product

© Endunamoo Board Course 2022 381

Cost, volume and
profit analysis
Operating leverage
Operating leverage
• Operating leverage is used as a measure of the sensitivity of profits to changes in sales. The greater the degree of
operating leverage, the more that changes in sales activity will affect profits
• The degree of operating leverage is determined by the company’s cost structure (i.e. the relative amount of fixed costs
to total costs)
• The higher the degree of operating leverage the higher the business risks of the company and vice versa
• The degree of operating leverage (DoL) can be measured for a given level of sales by the following formula:
DoL = Contribution / Profit

© Endunamoo Board Course 2022 383

LE5: Operating leverage
Given the increased labour unrest in South Africa, Tessa is considering upgrading its existing manufacturing facilities from
being labour intensive to being more automated.
Management are uncertain about the future prospects of vehicles sales given the decline in the economy and they believe
that there is a chance of a 10% decline in sales revenue and also a 20% increase in sales revenue.

All amounts in Rands Status quo Proposal

Sales revenue 1 000 000 1 000 000

Variable expenses (800 000) (200 000)

Contribution 200 000 800 000

Fixed expenses (100 000) (700 000)

Profit 100 000 100 000

REQUIRED
Evaluate the additional financial information overleaf and advise, with supporting calculations, the management of Tessa
on whether or not they should proceed with the upgrade

© Endunamoo Board Course 2022 384

Job costing
SCREENCAST
Objectives of this section
• Describe the materials recording procedure
• Distinguish between first-in-first-out (FIFO), and average cost methods of stores pricing
• Describe the accounting procedure for labour costs
• Describe the accounting procedure for manufacturing and non-manufacturing overheads
• Describe accounting procedures for jobs completed and products sold.

© Endunamoo Board Course 2022 SCREENCAST 386

Overview of job costing
• Job costing focuses on assigning costs to products incurred during a period between costs of sales and the closing
inventory
• Job-order costing relates to a costing system that is required in organisations where each unit or batch of output of a
product or service is unique
• This section does not prescribe a new method of cost accumulation, but it involves the application of traditional costing
method in a job-order environment
• The most important thing from an examination perspective is preparation of journal entries for the accumulation of
costs in order to determine the costs of goods sold and the closing inventory valuation (refer to Drury for examples and
practice)
A thorough understanding of IAS2: Inventories makes this section appear very easy

© Endunamoo Board Course 2022 SCREENCAST 387

Process costing
SCREENCAST
Objectives of this section
• Explain when process costing systems are appropriate
• Explain the accounting treatment of normal and abnormal losses
• Prepare process, normal loss, abnormal loss and abnormal gain accounts
• Prepare a process costing statement and value inventories

© Endunamoo Board Course 2022 SCREENCAST 389

Introduction to process costing
• Process costing is appropriate in those situations where masses of identical units or batches are produced thus making
it unnecessary to assign costs to individual units or batches of output
• The average cost per unit or batch of output is calculated by dividing total costs assigned to a product or service for the
period by the number of units or batches of output for that period
• The concept of equivalent and completed units is important for process costing. An equivalent unit is the equivalent of a
fully completed unit

© Endunamoo Board Course 2022 SCREENCAST 390

Accounting treatment of normal and abnormal losses
• Normal losses are inherent in the production process and cannot be eliminated. Their cost should therefore be borne by
the good production – this is achieved by dividing the costs incurred for a period by the expected output rather than the
actual output
• Abnormal losses are avoidable and their cost should not be assigned to products but recorded separately as an
abnormal loss and written off a period cost in the statement of profit or loss
• Scrap sales that results from the losses should be allocated to the appropriate process account (for normal losses) and
the abnormal loss account (for abnormal losses)

© Endunamoo Board Course 2022 SCREENCAST 391

Weighted average cost basis
• For weighted average costing basis, the current period’s costs include the cost of finishing off the opening work in
progress, and the cost of the work in progress for the current period
• The opening work in progress is intermingled with the production of the current period to form one homogeneous
batch of production
• The equivalent number of units for this batch of production is divided into the costs of the current period, plus the value
of the opening work in progress, to calculate the cost per unit

© Endunamoo Board Course 2022 SCREENCAST 392

First-in-first-out basis
• FIFO is based on the assumption that current period unit costs should be reported rather than unit costs that are
reported with the weighted average method that include costs incurred in the previous period
• Therefore, FIFO assumes that the opening work in progress is the first group of units to be processed and completed
during the current period
• The opening work in progress is charged separately to completed production, the cost per unit for the current period is
based only on the current period costs and production for the current period

© Endunamoo Board Course 2022 SCREENCAST 393

LE11: Process costing
CW Ltd makes one product in a single process. The details of the process for the most recent period were as follows. There
were 8 000 units of opening work in progress valued as follows:
Amount (R)
Material 980 000
Labour 460 000
Production overheads 76 000
During the period 18 000 units were added to the process and the following costs were incurred:

Amount (R)
Material 3 878 000
Labour 2 763 200
Production overheads 1 492 800

© Endunamoo Board Course 2022 SCREENCAST 394

LE11: Process costing
There were 5 000 units of closing work in progress, which were 100% complete for material, 90% complete for labour and
40% complete for production overheads. Material is included at the beginning of the process.
A normal loss equal to 10% of new material input during the period was expected. The loss occurs at the beginning of the
process. The actual loss amounted to 1 800 units. Each unit of loss was sold for R100 per unit.

REQUIRED:
Calculate the cost of the output for the period, assuming:
(i) FIFO basis (assuming opening stock was 60% complete)
(ii) Weighted average method

© Endunamoo Board Course 2022 SCREENCAST 395

Joint and by-products

SCREENCAST
Objectives of this section
Distinguish between joint- and by-products
Explain the alternative methods of allocating joint costs to products
Describe and apply the accounting treatment of by-products

© Endunamoo Board Course 2022 SCREENCAST 397

Introduction of joint and by-products costing
• The distinguishing feature of the production of joint and by-products is that the products are not identifiable as
different products until a specific point in the production is reached (i.e. split–off point)
• Before this point, joint costs are incurred on the production of all productions emerging from the joint production
process. It is therefore not possible to trace joint costs to individual products
• Our objective is still the same – assignment of costs to products in order to separate costs incurred during a period
between costs of goods sold and the closing inventory valuation
• The assignment of joint costs to products is of little use for decision-making

© Endunamoo Board Course 2022 SCREENCAST 398

Joint vs by-products costing
• Joint products and by-products arise in situations where the production of one product makes inevitable the production
of other products
• A by-product is however not the primary product, but it is the incidental product that arises from the joint process
• It often follows that by-products only have a minor sales value when compared with the joint products
• In contrast, joint products have a significant relative sales value
• Both products are not identifiable as different individual products until a specific point in the production process is
reached
• Generally, after the split-off point, joint products may be sold or subjected to further processing

© Endunamoo Board Course 2022 SCREENCAST 399

By products accounting treatment
By products are products that have a minor sales value and that emerge incidentally from the production of a major
product
As the major objective is to produce the joint products, it can justifiably be argued that the joint costs should be allocated
only to the joint products and that the by-products should not be allocated with any portion of the joint costs that are
incurred before the split-off point
Any costs that are incurred in producing by-products after the split-off point can justifiably be charged to the by-product,
since such costs are incurred for the benefit of the by-product only
By-product revenues or net-revenues should be deducted from the cost of the joint products (IAS2: 14)

© Endunamoo Board Course 2022 SCREENCAST 400

Methods of allocating joint costs
The methods used to allocate joint costs can be subjective and therefore difficult to defend. The main four methods are
the following:
• Physical measures: this method uses physical quantities (e.g. kgs, litres, units, etc) attributable to the joint products to
allocate the joint costs
• Sales value at split-off: this method uses sales value (Rand amount) before further processing as a basis of allocating
joint costs
• Net realisable value: this method uses the net revenues (Rand amount) after further processing as a basis of allocating
joint costs
• Constant gross profit percentage: this method determines the joint costs allocated as a residual value in order to
achieve the company’s gross profit margin percentage

© Endunamoo Board Course 2022 SCREENCAST 401

Comparison of the methods of allocation
Method Advantages Disadvantages
Physical Measurement • Simple to operate where there is a • Can distort reporting and inventory
common unit of measurement valuation
• Can be difficult to find common unit of
measurement
Sales value at split-off • Provides more realistic inventory • Assumes that sales value determines
valuations prior cost
• Assumes that a sales value at split-off
can be determined
Net realisable value • Takes further processing costs into • Can be difficult to calculate for complex
account process with many split-off
• Simple to apply if there is only one
split-off point
Constant gross profit • Appropriate only if a constant gross • Only appropriate if a constant gross
percentage profit for each joint product is a logical profit for each product makes sense
assumption

© Endunamoo Board Course 2022 SCREENCAST 402

Example: Methods of allocating joint costs
JBP Ltd is a manufacturer of four products, J, B, P and Q. These products are manufactured in the same production
facilities using a single production machine. The production process is such that the three products are not individually
identifiable until a split-off point. Product Q is considered to be an incidental product and its sales value is relatively lower
in relation to products J, B and P.
The following costs were incurred during the manufacturing process during the recent month ended 31 January 2019 for
the benefit of all products.
Salary of factory staff R600 000
Rental of factory R170 000
Electricity R44 000
Depreciation and maintenance R20 000

© Endunamoo Board Course 2022 SCREENCAST 403

Example: Methods of allocating joint costs
The following information is also applicable:
J B P Q
Units produced 50 000 30 000 20 000 5 000
Selling price per unit at split-off point R20,00 R15,00 R27,50 R8,00
Further processing costs R285 000 R90 000 R125 000 -
Sales value post further processing R1 710 000 R540 000 R750 000 -

Delivery costs of R6 000 are incurred to deliver Product Q to the respective customers.

REQUIRED
Determine the profitability of the joint products assuming that joint costs are allocated on the basis of these methods (i)
Physical measures, (ii) Sales value at split-off and (iii) Net realisable value

© Endunamoo Board Course 2022 SCREENCAST 404

Example 1 Solution: Joint costs allocated

Total costs
Salary of factory staff R600 000
Rental of factory R170 000
Electricity R44 000
Depreciation and maintenance 20 000
Total joint costs R834 000
Deduct the net revenues from by-product Q (R40 000 – R6 000) (R34 000)
Units produced and sold 5 000
Total revenues (5 000 x 8) R40 000
Delivery costs (R6 000)
Joint costs to be allocated R800 000

© Endunamoo Board Course 2022 SCREENCAST 405

Example 1A Solution: Physical measures
Proportion to Joint costs
Products Units produced
total allocated
J 50 000 50% 400 000
B 30 000 30% 240 000
P 20 000 20% 160 000
100 000 100% 800 000

Products J B P Total
Selling price per unit at split-off point 20 15 28
Units produced 50 000 30 000 20 000
Total revenue 1 000 000 450 000 550 000 2 000 000
Joint costs (400 000) (240 000) (160 000) (800 000)
Gross profit 600 000 210 000 390 000 1 200 000

© Endunamoo Board Course 2022 SCREENCAST 406

Example 1B Solution: Sales value at split-off
Sales value at Proportion to Joint costs
Products
split-off total allocated
J 1 000 000 50% 400 000
B 450 000 23% 180 000
P 550 000 28% 220 000
2 000 000 100% 800 000

Products J B P Total
Selling price per unit at split-off point 20 15 28
Units produced 50 000 30 000 20 000
Total revenue 1 000 000 450 000 550 000 2 000 000
Joint costs (400 000) (180 000) (220 000) (800 000)
Gross profit 600 000 270 000 330 000 1 200 000

© Endunamoo Board Course 2022 SCREENCAST 407

Example 1C Solution: Net realisable value

Further Net realisable Proportion to Joint costs

Products Sales value
processing costs value total allocated

J 1 710 000 (285 000) 1 425 000 57% 456 000

B 540 000 (90 000) 450 000 18% 144 000
P 750 000 (125 000) 625 000 25% 200 000
3 000 000 (500 000) 2 500 000 100% 800 000

Products J B P Total
Sales value post further
1 710 000 540 000 750 000 3 000 000
processing
Further processing costs (285 000) (90 000) (125 000) (500 000)
Joint costs (456 000) (144 000) (200 000) (800 000)
Gross profit 969 000 306 000 425 000 1 700 000
Gross profit margin 57% 57% 57% 57%

© Endunamoo Board Course 2022 SCREENCAST 408

Example 2: Constant gross profit margin
JBP Ltd is a manufacturer of three products, J, B and P. These products are manufactured in the same production facilities
using a single production machine. The production process is such that the three products are not individually identifiable
until a split-off point.
Company gross profit margin: 48% (this is assumed to be constant for each of the product produced by the company). The
following information relates the manufacturing process during the recent month ended 31 January.
Total joint costs: R800 000

J B P
Units produced 50 000 30 000 20 000
Selling price per unit at split-off point R20,00 R15,00 R27,50
Further processing costs R285 000 R90 000 R125 000
Sales value post further processing R1 250 000 R500 000 R750 000

© Endunamoo Board Course 2022 SCREENCAST 409

Example 2 Solution: Constant gross profit
Products J B P Total
Sales value post further processing 1 250 000 500 000 750 000 2 500 000
Gross profit at 48% (600 000) (240 000) (360 000) (1 200 000)
Cost of sales 650 000 260 000 390 000 1 300 000
Further processing costs (285 000) (90 000) (125 000) (500 000)
Joint costs allocated 365 000 170 000 265 000 800 000

© Endunamoo Board Course 2022 SCREENCAST 410

Example 3: Process further decision
JM Ltd is a manufacturer of two products, J and M. These products are manufactured in a joint production process. The
total joint costs for the period amounted to R1 300 000. JM allocates joint costs based on the physical measures method.

J M
Units produced 300 000 200 000
Selling price per unit at split-off point R45 R35
Further processing costs R3 400 000 R1 250 000
Sales value post further processing R17 650 000 R8 000 000

REQUIRED
Determine whether J and/or M should be processed further

© Endunamoo Board Course 2022 SCREENCAST 411

LE4: Joint and by-products
MAT Africa Ltd (MAT) and is situated in Epping, Cape Town and is a manufacturer of fibre-glass, resin, polyurethane, epoxy
and related products.
This product range consists of two products which are delivered out of a joint process, producing products GT, CP and KZ.
Products GT and CP must incur further processing, whilst product KZ is sold off at the split-off point and is considered to be
a by-product.
During September 2016, 2 000 units of raw materials at R1 400 per input unit of raw material, were processed. One input
unit of raw material delivers 6 kilogram (kg) of GT, 5 kg of CP and 2 kg of KZ.

© Endunamoo Board Course 2022 SCREENCAST 412

LE4: Joint and by-products
The following additional information is available for the month of September 2016:
GT CP KZ
Sales price – per 10 kg packaging (R) 4 300 5 800 500
Opening inventory
• Kilogram 3 000 2 500 200
• Value (R’000) 705 825 12,5
Closing inventory
• Kilogram 3 200 2 200 100
Cost of further processing
• Variable cost per kilogram (R) 108 145 -
• Fixed cost (R’000) 324 810 -

© Endunamoo Board Course 2022 413

LE4: Joint and by-products
MAT uses an absorption costing system. Inventory is valued using the first-in-first-out (FIFO) method. By-product KZ is
accounted for using the reversal cost method.
REQUIRED
Calculate the profit margin per product for products GT and CP, produced and sold by MAT Africa Ltd during September
2016
(13 marks)
(Extracted from UNISA, 2016)

© Endunamoo Board Course 2022 SCREENCAST 414

Term 4
Welcome to Term 4
Topics Live classes Screencast (Pre-recorded)
Standard costing Yes Yes
Relevant costing – foundation Yes
Relevant costing – core Yes
Decision under uncertainty Yes
Linear programming Yes
Pricing Yes
Divisional performance management Yes
Transfer pricing Yes

© Endunamoo Board Course 2022 416

MAF: Term 4
Question
recommendations
Textbook reference: Drury, 9th edition
Standard costing
17.15 (MCQ) – Q Plc (Labour variances)
17.16 (MCQ) – Sales variances
17.17 – SEWs (Backward variance analysis)
17.18 – Sticky Wicket
17.19 – Variable costing reconciliation statement
17.21 – Chaff Co
18.10 – FG
18.11 – Sales variances
18.12 – DB
18.13 (MCQ) – CTA2 only
18.14 – Bronte Ltd (Accounting for variances)
18.15 – DE
18.16 – Choc Co
18.16 – Truffle Co

© Endunamoo Board Course 2022 418

Relevant costing
Examples within the relevant costing chapter
• Example 9.1: Special short term order
• Example 9.2: Special long term order
• Example 9.3: Contribution per limiting factor
• Example 9.4: Replacement decision
• Example 9.5: Outsourcing / Make or buy decisions
• Example 9.6: Discontinuation decisions
9.15 (MCQ) – Limiting factors
9.16 (MCQ) – Labour cost
9.17 (MCQ) – Material cost (X Plc)
9.18 (MCQ) – Labour cost
9.19 (MCQ) – Discontinuation decisions (R, S & T)
9.21 – Telephone Co
9.22 – Robber Co
9.23 – Outsourcing / Make or buy decisions (WZ)

© Endunamoo Board Course 2022 419

Performance measurement
Example 19.1 (with explanation)
19.14 – (EVA calculation)
19.15 – Division L (EVA calculation)
19.16 – Southe Plc (ROI and residual income)
19.19 – Alpha Division (Residual income and EVA)
19.20 – HFG (This is in CTA Level 1 pack)
19.22 – Broad divisional performance (Division A & B)

© Endunamoo Board Course 2022 420

Transfer pricing
20.15 (MCQ) – X Plc
20.16 (MCQ) – Division A
20.17 – Bath Co (Distribution of profits)
20.18 – The DE Co
20.19 – Division A
20.20 – SSA Group (Discussion on transfer pricing)
20.21 – International transfer pricing
20.22 – JHK Coffee Machines Co

© Endunamoo Board Course 2022 421

Other
Pricing decisions
10.16 – Customer profitability analysis (ST)

Decisions under uncertainty

Example 12.1

Linear programming
Example 25.1 (with explanation)
25.10 Graphical presentation
25.11 Optimal output and shadow prices
25.12 Optimal output and shadow prices
25.13 Optimum production programme
25.14 Interpretation of the linear programming solution

© Endunamoo Board Course 2022 422

MAF: Term 4
Question
recommendations
Textbook reference: Drury, 8th edition
Standard costing
17.15 (MCQ) – Q Plc (Labour variances)
17.16 (MCQ) – Sales variances
17.17 – KHL (Reconciliation of budget and actual profit)
17.18 – SEWs (Backward variance analysis)
17.20 – Chaff Co (Interpretation of variances)
18.10 (MCQ) – SW Plc
18.11 (MCQ) – Company P (CTA2 only)
18.12 (MCQ) – CTA2 only
18.13 – Bronte Ltd (Accounting for variances)
18.14 – Crumbly Cake (Material and sales variances)
18.15 – Sales mix and quantity variances (ignore part (c))
18.16 – Traditional and ABC variance analysis

© Endunamoo Board Course 2022 424

Relevant costing
Examples within the relevant costing chapter
• Example 9.1: Special short term order
• Example 9.2: Special long term order
• Example 9.3: Contribution per limiting factor
• Example 9.4: Replacement decision
• Example 9.5: Outsourcing / Make or buy decisions
• Example 9.6: Discontinuation decisions
9.15 (MCQ) – Limiting factors
9.16 (MCQ) – Labour cost
9.17 (MCQ) – Material cost (X Plc)
9.18 (MCQ) – Labour cost
9.19 (MCQ) – Discontinuation decisions (R, S & T)
9.21 – Mutually exclusive products (Engineering company)
9.22 – Special order (M)
9.23 – Outsourcing / Make or buy decisions (WZ)
9.24 – Limiting factors and optimal production

© Endunamoo Board Course 2022 425

Performance measurement
19.14 – (EVA calculation)
19.15 – Division L (EVA calculation)
19.16 – Southe Plc (ROI and residual income)
19.18 – Alpha Division (Residual income and EVA)
19.19 – HFG (This is in CTA Level 1 pack)
19.20 – V Plc (EVA)
19.21 – Broad divisional performance (Division A & B)

© Endunamoo Board Course 2022 426

Transfer pricing
20.15 (MCQ) – X Plc
20.16 (MCQ) – Division A
20.17 – ZP Plc (Distribution of profits)
20.18 – Manuco Ltd (Excellent question)
20.19 – Division A
20.21 – SSA Group (Discussion on transfer pricing)
20.22 – Memphis plc
20.24 – P plc

© Endunamoo Board Course 2022 427

Other
Pricing decisions
10.16 – Customer profitability analysis (ST)

Decisions under uncertainty

Example 12.1

Linear programming
Example 25.1 (with explanation)
25.10 Graphical presentation
25.11 Optimal output and shadow prices
25.12 Optimal output and shadow prices
25.13 Optimum production programme
25.14 Interpretation of the linear programming solution

© Endunamoo Board Course 2022 428

Introduction
Tutorials and screencast
Tutorial
Discussion Question: Leather Leisure
Submission Date: 11 July 2021
Discussion Date: 12 July 2021

© Endunamoo Board Course 2022 430

Screencasts
Screencast available for UNISA Test 4 (2020)
CTA Level 1: High Spirits
CTA Level 2: Lock Chemicals

Screencast available for UNISA Test 4 (2019)

CTA Level 1: Delicious Foods
CTA Level 2: Cool & Cozy

Screencast available for UNISA Test 4 (2018)

CTA Level 1: Chef-In-Training Academy
CTA Level 2: Ya-Kwini Engineers

© Endunamoo Board Course 2022 431

Standard costing
Standard costing
Introduction
Objectives
After studying this section, candidates should be able to:
• Calculate and analyse variances
• Provide suitable explanations for variances found
• Reconcile budgeted income and expenses to actual income and expenses
• Decide on the appropriate accounting treatment of material variances

© Endunamoo Board Course 2022 434

Background
• Standard costing systems are generally applied and well suited in standard cost centres – although they are also applied
in revenue centres and profit centres
• The main features of a standard cost centre is that output can be measured and the input required to produce each unit
of output can be specified
• Standard costing is most suited to an organisations whose activities consist of a series of common or repetitive
operations and the input required to produce each unit of output can be specified
• It cannot be applied to activities of a non-repetitive nature, since there is no basis for observing repetitive operations
and consequently standards cannot be set

© Endunamoo Board Course 2022 435

Purpose and benefits of standard costing
• Decision making: Standard costs are based on future target costs, often based on the elimination of avoidable
inefficiencies. Therefore, a special order can be evaluated using standard costs
• Motivation: It provides the transparency required for an effective quantitative performance measurement tool
• Budgeting: It provides reliable and convenient source of data suitable for budgeting and consequently performance
evaluation
• Control mechanisms: It allows for ‘management by exception’ by highlighting areas that are not conforming to plan
and that may require corrective action
• Profit measurement and inventory valuation: It simplifies the task of tracing costs to products as the use of actual
costs could be too onerous

© Endunamoo Board Course 2022 436

Flexible budgets
• In variance analysis, standards should reflect variations in uncontrollable factors arising from the circumstances not
envisaged when the targets were set, e.g. changes in the level of activity
• Due to some costs varying with changes in the level of activity, it is essential when applying variance analysis (and
consequently performance measurement) to take into account the variability of costs, e.g. variable selling costs will be
lower than budgeted if the sales volume is lower than budgeted
• Flexible budgets can be utilised where the uncontrollable volume effects on cost behaviour are removed from the
manager’s performance reports

© Endunamoo Board Course 2022 437

Illustrative example: Flexible budgets
CA Ltd budgeted to produce 10 000 units of Product A. Product A requires 2kg of raw materials per unit. Each material
costs R15 per unit.

During the year, actual results were total production of 12 000 units and a total of 23 000 kgs were utilized. The purchase
price was R16 per kg.

REQUIRED:
• Calculate the original budget allowance of raw materials
• Calculate the revised budget allowance of raw material, based on actual production
• Comment on your answer

© Endunamoo Board Course 2022 438

Illustrative example: Flexible budgets
Original budget allowance = 10 000 x 2 = 20 000 kgs
Revised budget allowance (flexed) = 12 000 x 2 = 24 000
Actual usage = 23 000 kgs

Comment
• There was a favourable usage variance of 1 000 kgs because the production team used 23 000 kgs to produce 12 000
units whereas they should have used 24 000 kgs in accordance with the company’s standards
• It is incorrect to compare the production team’s actual performance with the 20 000 kgs because this is based on a
different level of production

© Endunamoo Board Course 2022 439

Standard costing
Material variances
Material variances
• The costs of the materials which are used in a manufactured product are determined by two basic factors
➢ the price paid for the materials; and
➢ the quantity of materials used in production
• The price variance is often within the control of the purchasing department and it normally arises due to the following:
➢ Failure by the purchasing department to seek most advantageous source of supply, changes in market conditions
(controllable?), purchase of inferior quality materials (interrelatedness of variances to be considered), etc.
• On the other hand, the usage variance is normally controllable by the production department and may arise because of:
➢ Careless handling of materials, inferior materials, theft, changes in production method or quality controls, etc.

© Endunamoo Board Course 2022 441

Material variances

Total material variance

Price variance Quantity variance

Mix variance Yield variance

© Endunamoo Board Course 2022 442

Material variances
Material price variance = (AP – SP) x Actual volumes
AP = Actual price; SP = Standard price
Material quantity variance = (AQ – SQ) x Std price
AQ = Actual quantity; SQ = Flexed budgeted quantity
Material mix variance = (AQ – ASQ) x Std price
AQ = Actual quantity; ASQ = Actual quantity in budgeted proportions
Material yield variance = (ASQ - SQ) x Std price
ASQ = Actual quantity in budgeted proportions; SQ = Flexed quantity

© Endunamoo Board Course 2022 443

Material variances – journal entries
• All adverse variances are treated as expense
• All favourable variances are treated as income
• The above guidance is also applicable when preparing a reconciliation note
• Journal entries are only processed for the main variances, i.e. the price and quantity variances
• Price variance is influenced by the choice of accounting for an entity:
➢ If an entity elects to maintain its record in actual prices, the price variance reported will be based on the materials
used in production
➢ If an entity elects to maintain its record in standard prices, the price variance reported will be based on the
materials purchased during the year

© Endunamoo Board Course 2022 444

Example 1: Material variances
CA Ltd sells product Alpha. Each Alpha unit weighs 1 kg. The production process of Alpha requires two inputs: Beta and
Vega. CA Ltd budgeted to produce 85 500 Alpha units using a total of 34 200 kgs on input Vega. The standard cost card is
provided below:
Cost
Beta (0,8kgs @ R30 per kg) R24
Vega (? Kgs @ R50 per kg) ?
Actual information
The management accounts of CA Ltd revealed that that the company spent an amount of R2 240 000 on the acquisition of
Beta. Total purchases relating to Vega were R1 925 000. A total of 89 300 Alpha units were produced. The production
requirements were as follows:
• Number of kgs of Beta purchased: 80 000 kgs
• Number of kgs of Beta issued and utilised: 75 000 kgs
• Number of kgs of Vega purchased: 35 000 kgs
• Number of kgs of Vega issued and utilised: 33 000 kgs

© Endunamoo Board Course 2022 445

Example 1: Material variances
REQUIRED:
a) Calculate all the possible material variances
b) Process the journal entries to account for the above information, assuming (i) records are kept at standard costs and
(ii) records are kept at actual costs

© Endunamoo Board Course 2022 446

Standard costing

Labour variances
Labour variances
• The costs of labour used in a manufactured product are determined by two basic factors
➢ wage rate paid for the unit of labour; and
➢ the efficiency of labour used in production

• The variances related to labour are normally controllable by the manager of the production department
➢ In South African with the outbreaks of strikes the controllability of the wage rate variance might be questionable
➢ The variances related to the efficiency of labour may arise as a result of use of inferior quality materials
(interrelatedness of variances), different grades of labour (mix and yield variances), failure to maintain machinery
in proper condition, the introduction of new equipment (relevance of standards) and changes in production
methods (relevance of standards)

© Endunamoo Board Course 2022 448

Labour variances
Labour rate variance = (AR – SR) x Actual clock hours
AR = Actual clock rate; SR = Standard clock rate
NB: Labour rate variance is based on clock figures

Labour efficiency variance = (AH – SH) x Standard work rate

AH = Actual work hours; SH = Flexed budgeted work hours
Standard work rate = Budgeted clock rate / Work time %
Work time % = Work hours / Total clock hours

Labour idle time variance = (AIH – SIH) x Standard work rate

AIH = Actual idle hours; SIH = Standard idle time
SIH = Idle time % x Actual clock hours
Idle time % = Idle time / Total clock hours

© Endunamoo Board Course 2022 449

Example 2: Labour variances
CA Ltd sells product Omega. Omega is manufactured primarily by the company’s direct labour force. Labour is variable.

Budgeted information
• Number of Omega units to be produced: 15 035 units
• Number of clock hours: 62 000 hours at R77,60 per hour
• Number of idle hours: 1 860 hours

Actual information
• Number of Omega units produced: 20 900 units
• Number of clock hours: 87 500 hours at R79,20 per hour
• Number of productive / working hours: 85 750 hours

© Endunamoo Board Course 2022 450

Standard costing

Variable overhead variances

Variable overheads
Variable expenditure variance
= Actual variable overheads – Budgeted variable overheads
Budgeted variable overheads = Actual activity x Standard rate
OR
= (Actual allocation rate – Standard allocation rate) x Actual activity

Variable overhead efficiency variance

= (Standard hours – Actual hours) x Standard rate

© Endunamoo Board Course 2022 452

LE4: Variable overheads
CA Ltd specialises in the production of components used in vehicle manufacturing. The company absorbs variable
overheads using labour hours.
Budget Actual
Components manufactured 15 000 18 000
Labour hours 30 000 38 000
Total costs R90 000 R125 000

REQUIRED
Calculate all the possible variable overhead variances

© Endunamoo Board Course 2022 453

Standard costing

Fixed overhead variances

Fixed overhead variances
Flashback:
• With the variable costing method, the fixed overheads are treated as period costs. No attempt is made to allocate a
portion of these costs to production and as a result, no volume variance will be determined
• With absorption costing, a portion of fixed overheads is allocated to production based on an overhead allocation rate
determined using budgeted figures
➢ If allocation base is units, two variances will be applicable, i.e. expenditure and the volume variance
➢ If allocation base is hours, four variances will be applicable, i.e. expenditure and the volume variance – the
volume variance will be broken down further into capacity and efficiency

© Endunamoo Board Course 2022 455

Fixed overhead variances
Expenditure variance
= Actual overheads – Budgeted overheads

Volume variance
= (Budgeted activity – Absorbed activity) x overhead allocation rate

Capacity variance
= (Budgeted activity – Actual activity) x overhead allocation rate per hour

Efficiency variance
= (Actual activity – Absorbed activity) x overhead allocation rate per hour

© Endunamoo Board Course 2022 456

Example 4: Fixed overhead variances
CA Ltd is a manufacturer of Product Aries. CA Ltd uses the absorption method in valuing the closing inventory for
management purposes. Fixed overheads are allocated based on machine hours. Information relating to Product Z is
provided below.
Budget Actual
Fixed costs R3 200 000 R3 250 000
Machine hours 80 000 92 000
Units produced 32 000 35 000

REQUIRED
Calculate all the variances relating to the information above

© Endunamoo Board Course 2022 457

Insights from the overhead variances
• The variances calculated are not particularly useful for control purposes because generally fixed overheads do not
fluctuate in relation to output in the short-term
• Any meaningful analysis of this variance requires a comparison of the actual expenditure for each individual item of
fixed overhead expenditure against the budget
• An understanding of the in/efficient use of the available capacity does not result in strategies to control costs in the
short term

© Endunamoo Board Course 2022 458

Standard costing

Sales variances
Sales variances
• Sales variances can be used to analyse the performance of the sales function or revenue centres
• In order to assess the efforts of the sales team on profitability, sales variances are determined in terms of:
➢ if absorption costing applies, standard gross profit (i.e. sales less standard manufacturing costs – standard variable
manufacturing costs plus an allocation of fixed costs); or
➢ if variable costing applies, standard contribution (i.e. sales less standard variable manufacturing costs)
• The standard manufacturing costs are used because the sales function is responsible for the sales volume and the unit
selling price (this also ensures that production variances do not distort the calculation)

© Endunamoo Board Course 2022 460

LE1SS: Sales quantity variances

Total sales variance

Price variance Volume variance

Mix variance Quantity variance

Market size variance Market share variance

© Endunamoo Board Course 2022 461

Sales variances
Sales price variance = (AP – BP) x Actual volumes
AP = Actual price; BP = Budgeted price
Sales volume variance = (AQ – BQ) x Std GP or Std contribution
AQ = Actual quantity; BQ = Budgeted quantity
Sales mix variance = (AQ – ASQ) x Std GP or Std contribution
AQ = Actual quantity; ASQ = Actual quantity in budgeted proportions
Sales quantity variance = (ASQ - BQ) x Std GP or Std contribution
ASQ = Actual quantity in budgeted proportions; BQ = Budgeted quantity

© Endunamoo Board Course 2022 462

Example 5: Sales variances
CA Ltd sells two products, Alpha and Omega. Budgeted and actual information relating to the products is provided below:

Budgeted sales information

• Alpha: 75 000 units at a selling price of R20,00
• Omega: 18 750 units at a selling price of R30,00

Actual sales information

• Alpha: 85 000 units at a selling price of R17,50
• Omega: 15 000 units at a selling price of R35,00

© Endunamoo Board Course 2022 463

Example 5: Sales variances
The standard manufacturing variable cost is R12,00 and R20,00 per unit of Alpha and Omega respectively. The
management accounts of CA Ltd revealed actual variable cost of R12,50 and R23,00 for Alpha and Omega respectively.
Fixed costs per unit is R2,50 per unit.

The total demand for Alpha and Omega products in South Africa was budgeted at 400 000 units. Due to strong
competition from substitutes, the market size for Alpha and Omega products shrunk and the actual sales volume of CA Ltd
for the two products represented a market share of 31,25%.

REQUIRED:
Calculate all the possible sales variances, if CA Ltd uses (i) the variable costing basis and (ii) absorption costing basis

© Endunamoo Board Course 2022 464

Sales variances – exam technique
1) Determine all the possible variances that relate to sales – the ability to identify all the related variances increases your
chance of passing the question
2) Determine which variances are constituents of the other variances – this will assist in double checking your answers
3) Define the variances – the ability to explain what the variances represents greatly assists in answering discussion
questions relating to the performance of a company, division or particular manager
4) Unless expected otherwise, do not determine any variance as a balancing figure
5) Identify all the elements that are required to calculate a specific variance – this will assist in identifying irrelevant info

© Endunamoo Board Course 2022 465

Insights from the sales variances
• Considering price elasticity, the analysis of the total sales variance into price and volume components could be
considered not meaningful (interrelatedness of variances)
• Although a change in the selling price is often a management decision, the decision might have been as a result of
external forces that were not controllable by management
• For control and performance appraisal it may be appropriate to compare actual market share with target market share
(CTA 2)
• In addition, the trend in market shares should be monitored and selling price compared with competitors’ prices
• A division of the sales volume variance into quantity and mix components demonstrates that increasing sales volume
may not be desirable as promoting the sales of the most desirable mix of products

© Endunamoo Board Course 2022 466

Standard costing

Ex-post variance analysis

SCREENCAST
Ex-post variance analysis
• Standards or plans are normally based on the environment that is anticipated when the targets are set
• Ex-post variance analysis approach requires that if the environment is different from the anticipated, actual
performance should be compared with a standard which reflects these changed conditions
• The variances need to be split into controllable (operational) variances and non-controllable (planning) variances
• Although not useful for cost control, the planning variance provides useful feedback information to management on
how successful they are in forecasting prices - helps them to improve future estimates
• Managerial performance needs to be fair, motivating and be based on the variances that are within management’s
control; as such managerial performance should be based on operational variances

© Endunamoo Board Course 2022 468

LE6: Ex-post variance analysis
CA Ltd is a poultry production company. The company’s main input is maize which is used in the production of feed for its
poultry. The budgeted average price of maize was R2 800 per tonne.
During the year, there was a drought in the maize areas. This resulted in the average price of maize being R3 400 per
tonne. CA Ltd purchased 300 tonnes at a price of R3 150 per tonne.

REQUIRED
Calculate the material price variance. Clearly indicate how much of this variance is attributable to planning and operational
efficiency

© Endunamoo Board Course 2022 469

LE7: Ex-post variance analysis
Abashwe (Pty) Ltd (Abashwe), one of the subsidiaries of Thobela, manufactures retail consumables and it uses three
independent divisions with dedicated directors.
The following details show direct labour requirements for the first six batches of a new product that were manufactured
last month by Enfede, a division of Abashwe:

Budget
Output (batches) 6
Labour hours 2 400
Total labour cost R96 000

© Endunamoo Board Course 2022 470

LE7: Ex-post variance analysis
The management accountant reported the following variances:

Total labour cost variance R16 000 Unfavourable

Labour rate variance Rnil
Labour efficiency variance R16 000 Unfavourable

The production manager confirmed that he forgot to inform the management accountant that he expected a 90% learning
curve to apply to at least the first 10 batches.

The HR Director received an e-mail from the office of the COO informing him that the reported labour costs variances
reflect incompetence on the part of the human resources (HR) department and that this will be considered during annual
performance appraisals.

© Endunamoo Board Course 2022 471

LE7: Ex-post variance analysis
REQUIRED
a) Calculate the planning and operational variances of Aaweh that analyses the actual performance, taking into account
the anticipated learning effect. Note: The learning can be expressed in equation form as Yx = a x b. The exponent for a
90% learning curve is -0.1520.
(6 marks)
a) Prepare a draft memorandum on behalf of the HR director responding to the COO’s email.
(5 marks)

(Adapted from UNISA, 2016)

© Endunamoo Board Course 2022 472

LE7SS: Ex-post variance analysis
Question Approach Marks
Calculate the Technical and difficult question?
planning and • Reasonably attempt it (Bonus mark) 1/1
operational • Do not anything about learning curve? Ignore it and move on, because it is simply part
variances of the steps but at least have something to move on with, e.g. 90% x 400 = 360 0/2
• Variances require you compare actual hours, original budgeted hours and learning
curve based hours and multiply by the standard rate. You therefore need to know how
to respond to the required
• Calculate standard labour rate (C) 1/1
• Calculate revised standard (C) 1/1
• Planning variance = original budget against the revised standard (C) 1/1
• Operational variance = actual results against the revised standard (C) 1/1
Prepare a draft No mark for communication this time, unusual but guess it can happen
memorandum on • The main issue was that there was an efficiency variance and not a labour rate variate 1/1
behalf of the HR • Under whose control is the efficiency variance? 1/1
director • Is it appropriate / fair / just to blame the HR department?
responding to the • Primary reason was the fact that the learning curve effect was not taken into account 1/1
COO’s email • Any other possible reason? 1/1

© Endunamoo Board Course 2022 473

Standard costing

Other considerations

SCREENCAST
Investigation of variances
• The decision to investigate a variance should depend on cost versus benefits considerations
• Variances may be due to the following causes:
➢ random uncontrollable factors when the operation is under control
➢ assignable causes, but with the costs of investigation exceeding the benefits
➢ assignable causes, but with the benefits from investigation exceeding the costs of investigation
• The methods of investigating variances include:
➢ simple rule of the thumb models
➢ statistical models that focus on the probability of the variances being out of control?

© Endunamoo Board Course 2022 SCREENCAST 475

The role of standard costing within an ABC system
• Within an ABC system variance analysis is most suited to controlling the costs of unit level activities
• It also provides meaningful information for managing those overhead costs that are fixed in the short term but variable
in the longer term if traditional volume-based cost drivers are replaced with activity-based cost drivers that better
reflect the causes of resource consumption
• Variance analysis, however, cannot be used to manage all overhead costs
• It is inappropriate for the control of facility-sustaining (infrastructure) costs because the cost of these resources does
not fluctuate in the longer term according to the demand for them

© Endunamoo Board Course 2022 SCREENCAST 476

Criticisms of standard costing
It is predicted that standard costing will demise in the future due to the following reasons:
• The changing cost structure that has resulted in the growth of indirect costs (it is claimed that standard costing is not
particularly suitable for controlling such costs)
• Inconsistency with modern management approaches (such as just in time, quality management, lead-times, etc.)
• Its over-emphasis on direct labour?
• Delayed feedback reporting

The above is based on the understanding standard costing as a control mechanism. It, however, ignores the other
purposes/benefits of standard costing (refer to an earlier slide on the benefits of standard costing)

© Endunamoo Board Course 2022 SCREENCAST 477

Accounting for variances…
• Standard costs can be used for planning, control and decision-making purposes without being entered into the books
• The benefit of incorporating standard costs into the cost accounting system is that it greatly simplifies the task of
tracing costs for inventory valuation and saves a considerable amount of data processing time
• IAS2 Inventories requires the use of standard costing in external reporting to the extent that the standard costs
approximate actual costs (i.e. standards are current and attainable)
• Only production variances are recorded, and sales variances are not entered in the accounts

© Endunamoo Board Course 2022 SCREENCAST 478

Relevant costing
Objectives of this section
• Distinguish between relevant and irrelevant costs and revenues
• Describe the key concepts that should be applied for presenting information for product-mix decisions when capacity
constraints apply
• Apply linear programming

© Endunamoo Board Course 2022 480

Introduction to relevant costing
Relevant costing is not another costing system or method.
• It is a framework or a set of principles and concepts that assist management in identifying costs that are relevant for
decision making
• Items (costs and revenues) are considered relevant if there is a differential impact on the cash flows from an outcome of
the decision at hand
• Decision makers are economical or rational in their approach

The decisions that could potentially be considered may include:

• Profitability maximisation (LE1)
• Disposal or discontinuation of operations (LE2)
• Outsourcing (make or buy) decisions (LE3)
• Special order (a once-off order) (LE4)
• Introduction or establishment of operations

© Endunamoo Board Course 2022 481

Key definitions applicable to relevant costing
• Relevant cost are essentially future costs and revenues that will be changed by a particular decision, whereas irrelevant
costs and revenues will not be affected by that decision
• Sunk costs are costs that have been incurred by a decision made in the past and that cannot be changed by any
decision that will be made in the future
• Committed costs are costs that would be incurred irrespective on the outcome of the decision
• Opportunity costs are costs that measure the opportunity that is sacrificed when the choice of one course of action
requires that an alternative is given up (i.e. benefit forgone)
• Limiting factors are scarce resources that constrain the level of output

© Endunamoo Board Course 2022 482

LE1: Profit maximisation
Power Ltd is a manufacturer of battery chemicals. Its main products are Dura, Cell and Ready. The production process is
labour intensive and requires powder and chemical (acid ingredients) as the raw materials.
The management accountant of Power Ltd is in the process of finalising the budget for the forthcoming financial period.
He recently received calls from the main suppliers of the raw materials used in the production process indicating that they
are expecting to encounter supply chain challenges in the upcoming annual period and will be only be able to supply the
following quantities:
Powder: 15 000 kilograms
Chemical: 56 000 litres
The management accountant has also ascertained that Power Ltd will only be able to source 120 000 labour hours during
the next period.

© Endunamoo Board Course 2022 483

LE1: Profit maximisation
Information relating to the upcoming budgeted period is provided below:
Dura Cell Ready
Budgeted number of units 15 000 25 000 18 000

Selling price per unit R2 200 R2 800 R3 100

Raw materials per unit
- Powder (80c per gram) (R160) (R240) (R320)
- Chemical (50c per ml) (R250) (R450) (R700)
Direct labour (R200 per direct labour hour) (R300) (R400) (R500)
Variable overheads (R100 per direct labour hour) (R150) (R200) (R250)
Fixed overheads (R150 per unit) (R150) (R150) (R150)
Gross profit per unit R1 190 R1 360 R1 180

© Endunamoo Board Course 2022 484

LE1: Profit maximisation
In accordance with the existing contracts that Power Ltd has with various customers, the company is required to deliver in
the next period 10 000 units of Dura; 18 000 units of Cell; and 12 000 units of Ready.
The external demand for Dura is limited to the number of the budgeted units to be produced whereas the demand for Cell
and Ready is unlimited.
The fixed overhead per unit is based on the maximum capacity available in the next period.

REQUIRED:
Calculate the optimal sales mix for Power Ltd and the net profit to be generated from the optimal sales mix

© Endunamoo Board Course 2022 485

Decision tree for materials relevant costs

Not on hand On hand

Do we need to replace it?

No, do not
Current purchase Yes, replace
replace
price or variable
cost Does it have an alternative use?

Yes, it does No, it does not

Current purchase
price or variable
cost

Lost Lost resale

Current purchase contribution value Plan was to throw it Plan was to throw it
price or variable Plan was to use it for Plan was to sell it away away at a cost
cost manufacture
Scrapping costs
NIL
savings

© Endunamoo Board Course 2022 486

Decision tree for labour relevant costs

Spare capacity exists No spare capacity exists

Variable cost Fixed cost

Lost Current rate of

Overtime
contribution pay

Current rate of
NIL
pay

© Endunamoo Board Course 2022 487

LE2: Discontinuing a product line
CA Ltd is a manufacturer of two products, Product A and Product B. Management of CA Ltd are considering discontinuing
the production of Product A because it is not profitable and require your expert advice. The recent financial results of the
company are presented below, along with the profitability of each product:
Notes Product A Product B Total
Total sales 1 R1 800 000 R6 200 000 R8 000 000
Direct raw materials 2 (R864 000) (R1 296 000) (R2 160 000)
Contribution R936 000 R4 904 000 R5 840 000
Attributable fixed costs 3 (R900 000) (R1 080 000) (R1 980 000)
Allocated common fixed costs 4 (R540 000) (R1 860 000) (R2 400 000)
Net profit (R504 000) R1 964 000 R1 460 000

© Endunamoo Board Course 2022 488

LE2: Discontinuing a product line
Additional notes relating to the financial results are provided below:
1) 80 000 units and 120 000 units of Product A and Product B were manufactured and sold during the period. This is
estimated to continue in the foreseeable future. Product A and B are dependent products and discontinuation of
Product A will result in a decrease in the selling price of Product B by 5%.
2) 2 units of direct material are required for production with each unit of Product A requiring 1 unit and another unit
required for Product B. The supplier grants a 10% volume rebate on each unit purchased if total purchases during the
year exceed 150 000 units.
3) Attributable fixed costs of Product A comprises of depreciation on machine (R150 000) and direct labour costs (R750
000). The machine to which the depreciation relates would be sold at profit of R50 000. The carrying amount of the
machine is R250 000. There are 8 unskilled workers and 1 supervisor. Each unskilled worker is paid a salary of R5 700
per month. If the production of Product A is ceased, the supervisor will be laid off and paid 120% of his annual salary
as a retrenchment package while 2 unskilled workers would be relocated to Product B production line and retained at
their existing annual salary. The remaining unskilled workers would be retrenched at a total cost of R400 000.
4) 4) Common fixed costs are allocated to each product line based on total revenue. Total common fixed costs are
expected to reduce by 15%.
REQUIRED: Advise management on whether Product A should be discontinued?

© Endunamoo Board Course 2022 489

LE3: Outsourcing decision
Ciesta currently purchases one of its component, Component Z, that is used in the production of ProductY.
The contribution generated from Product Y (after taking into consideration Component Z) is R20 per unit. The purchase
price of Component Z is R15 per unit. Delivery cost of R1 per unit is also incurred.
Ciesta has recently been experiencing challenges with the sourcing of Component Z and it is considering manufacturing
the component itself. Ciesta currently purchases 10 000 units of Component Z per annum, which is below the 12 000 units
required to satisfy the demand for Product Y. Should it manufacture the component internally, it will be able to fulfil its
entire demand.
Ciesta currently sells 5 000 units of ProductY. Information relating to the manufacture of Component Z is provided:
• The machine required to manufacture Component Z is available. Depreciation on this machine is R125 000 per annum
and R25 000 of this amount would be allocated to the Component Z manufacturing process.
• Total direct materials of R78 000 would be required.
• Each manufactured unit would require 0.5 direct labour hours at a rate of R20 per direct labour hour. Ciesta currently
has 1 000 labour hours available as spare capacity. Existing staff can provide 1 200 additional hours as overtime at a rate
of time and a half. The balance would be sourced from cutting down production of an existing product. The existing
product uses 2 hours per unit and generates a contribution of R30 per unit.

© Endunamoo Board Course 2022 490

LE3: Outsourcing decision
• Assume labour is variable cost.

REQUIRED:
Should Component Z continue to be acquired externally or should it be manufactured internally?

© Endunamoo Board Course 2022 491

LE4: Special order
Joshua Manufacturing Ltd (“JML”) is a manufacturer of microwaves. These are manufactured at its premises based in
Makwarela, Limpopo. These microwaves are sold nationally at a price of R5 200 each.
JML recently received a special order from a new client, Grace (Pty) Ltd (“GPL”) to manufacture and deliver 100
microwaves. GPL is an independent retail chain of stores operating nationally. The total consideration for the order is
proposed at R230 000.
The requirements of the order are as follows:
• Material A: Each manufactured microwave requires 2 units of Material A. Material A is regularly used in the
manufacture of JML’s microwaves. There are currently 300 units of Material A on hand that were originally purchased at
price of R150 per unit. The current replacement cost of Material A is R165 per unit.
• Material B: 4 units of Material B are required for one microwave. There are currently 1 000 items of Material B on hand
– these were originally bought for R120 per unit. These items are not normally used by JML and are also not readily
available. 750 items were earmarked for an order to Mr Crook for a delivery of 250 microwaves (the order is divisible and
it can be partially fulfilled). Mr Crook’s order would generate R3 780 per unit in incremental revenue and results in unit
variable costs (including Material B’s costs) of R2 600. The remaining items of Material B were going to be scrapped at a
disposal cost of R30 per unit. Alternatively, Material B could be imported from China at a cost of $11 (Assume R1 =
$0,0625). Minimum order quantity from Chinese supplier is 400 units.

© Endunamoo Board Course 2022 492

LE4: Special order
• Material C: 1 unit of Material C will also be required. 80 Material C is currently on hand as this was left from a special
order that never materialised. Before GPL’s special order, JML was contemplating on whether they should return
Material C or modify Material C to be used in its normal production instead of Material A (see above for Material A
details). If Material C is returned to the supplier, JML will be refunded an amount of R64 600. Should JML decide to
modify Material C, it will incur a modification cost of R15 per unit of Material C. The use of Material C in the production
will allow to JML to save on the purchase of 415 units of Material A. The contribution to be generated from the product
to be manufactured from Material A is R700 per unit. The replacement cost of Material C is currently R805.
• Labour: Labour is a fixed cost. A total of 800 labour hours will be required for the special order. JML currently has 500
labour hours available, of which 200 is normal time and 300 is overtime hours. The total labour costs (allocated and
actually incurred) should these employees be used on the special order will be R58 500. Overtime is paid at time and a
half. The effective cost of labour is R90 per hour.
• Additional labour hours are obtainable from the sacrifice of production of either the following items budgeted to be
produced by JML:
➢ Kettles: The selling price of a kettle is R280 per unit. The contribution earned from the sale of one kettle is R144.
Each kettle requires 1,2 labour hours.
➢ Toasters: The selling price of a toaster is R500 per unit. The contribution earned from the sale of one toaster is
R234. Each toaster requires 1,8 labour hours.

© Endunamoo Board Course 2022 493

LE4: Special order
REQUIRED:
Calculate the contribution to be generated from the special order and advise whether JML should accept / reject the order

© Endunamoo Board Course 2022 494

Decision making discussion questions
1) New client
• Creditworthiness needs to be assessed
• Reputation and credibility need to be assessed
• If customer branded, impact on company’s brand presence
2) New supplier
• Reliability with regards to quality and delivery times
3) Imported items
• Delays impacting on lead time
• Foreign exchange exposure
• Availability of spare parts
4) Order fulfilled over time
• If workers required to work overtime, question impact on morale
• Penalties for late deliveries

© Endunamoo Board Course 2022 495

Decision making discussion questions
5) Long term order
• Impact on pricing – fixed costs to be included
• Provides stability of revenue and cash flows
• Future price expectations and order volumes
6) Limited capacity
• Sacrificing existing sales negatively impacts customer goodwill
• Permanent increase in capacity should be considered
• If capacity is increased, funding thereof should be considered
• Impact on working capital and risks thereof
7) General
• Reliability of forecasts – inflation considerations / omission of costs
8) New product
• Experience, skills and expertise

© Endunamoo Board Course 2022 496

Relevant costing

Basic principles and concepts

SCREENCAST
LE4: Material available on hand
LE4.1 No alternative use
CA Ltd received a proposal to manufacture 1 000 units of Product N. Product N requires 100 m of Material C. Material C is
available on hand.

However, the company does not have an alternative use for Material C because it was a remainder from a discontinued
product. It was acquired at a price of R10 per m and the current replacement cost is R12 per m

© Endunamoo Board Course 2022 SCREENCAST 498

LE4: Material available on hand
LE4.2 No alternative use, but need to disposed
CA Ltd received a proposal to manufacture 1 000 units of Product N. Product N requires 100 m of Material C. Material C is
available on hand.

However, the company does not have an alternative use for Material C because it was a remainder from a discontinued
product. CA Ltd was expecting to incur R2,50 per m in disposing of Material C in order to provide space for other materials.

It was acquired at a price of R10 per m and the current replacement cost is R12 per m.

© Endunamoo Board Course 2022 SCREENCAST 499

LE4: Material available on hand
LE4.3 Alternative use, as stand alone
CA Ltd received a proposal to manufacture 1 000 units of Product N. Product N requires 100 m of Material C. Material C is
available on hand.

Material C is a remainder of the inputs for a discontinued product. CA Ltd had found a buyer for Material C who was willing
to pay R10,50 per m.

It was acquired at a price of R10 per m and the current replacement cost is R12 per m.

© Endunamoo Board Course 2022 SCREENCAST 500

LE4: Material available on hand
LE4.4 Alternative use, as stand alone
CA Ltd received a proposal to manufacture 1 000 units of Product N. Product N requires 100 m of Material C. Material C is
available on hand.

Material C is a remainder of the inputs for a discontinued product. CA Ltd had found a buyer for Material C who was willing
to pay R15 per m.

It was acquired at a price of R10 per m and the current replacement cost is R12 per m.

© Endunamoo Board Course 2022 SCREENCAST 501

LE4: Material available on hand
LE4.5 Alternative use, in other special product
CA Ltd received a proposal to manufacture 1 000 units of Product N. Product N requires 100 m of Material C. Material C is
available on hand.

Material C is a remainder of the inputs for a discontinued product. CA Ltd had planned to use Material C on another
product that was going to generate a contribution of R8 per m for the company. 1m of Material C is required for this
product.

It was acquired at a price of R10 per m and the current replacement cost is R12 per m.

© Endunamoo Board Course 2022 SCREENCAST 502

LE4: Material available on hand
LE4.6 Alternative use, in other special product
CA Ltd received a proposal to manufacture 1 000 units of Product N. Product N requires 100 m of Material C. Material C is
available on hand.

Material C is a remainder of the inputs for a discontinued product. CA Ltd had planned to use Material C on another
product that was going to generate a contribution of R8 per m for the company. 1m of Material C is required for this
product.

It was acquired at a price of R10 per m and the current replacement cost is R25 per m.

© Endunamoo Board Course 2022 SCREENCAST 503

LE4: Material available on hand
LE4.7 Alternative use, in other special product
CA Ltd received a proposal to manufacture 1 000 units of Product N. Product N requires 100 m of Material C. Material C is
available on hand.

Material C is a remainder of the inputs for a discontinued product. CA Ltd had planned to use Material C on another
product that requires 4m of Material C per unit. The contribution per unit from the product is R32.

It was acquired at a price of R10 per m and the current replacement cost is R25 per m.

© Endunamoo Board Course 2022 SCREENCAST 504

LE4: Material available on hand
LE4.8 Alternative use, in regular use
CA Ltd received a proposal to manufacture 1 000 units of Product N. Product N requires 100 m of Material C. Material C is
available on hand.

Material C is regularly used by the company in the production of the company’s main product. The main product generates
a contribution of R14 per m for the company.

It was acquired at a price of R10 per m and the current replacement cost is R25 per m.

© Endunamoo Board Course 2022 SCREENCAST 505

LE4: Material available on hand
LE4.9 Alternative use, in other product
CA Ltd received a proposal to manufacture 1 000 units of Product N. Product N requires 100 m of Material C. Material C is
available on hand.

CA Ltd had planned to use Material C on another product that would require 4m of Material C per unit. The use of Material
C would have avoided the company having to buy Material A which is normally used on the product. 1 Material A is required
per unit. The contribution per unit from the product is R32.

It was acquired at a price of R10 per m and the current replacement cost is R25 per m for Material C. The current
replacement cost of Material A is R12.50.

© Endunamoo Board Course 2022 SCREENCAST 506

LE5: Material not available on hand
LE5.1 In regular use, acquired per unit
CA Ltd received a proposal to manufacture 1 000 units of Product N. Product N requires 100 m of Material C. Material C is
not available on hand.

The current replacement cost is R25 per m.

© Endunamoo Board Course 2022 SCREENCAST 507

LE5: Material not available on hand
LE5.2 In regular use, acquired in batches
CA Ltd received a proposal to manufacture 1 000 units of Product N. Product N requires 100 m of Material C. Material C is
not available on hand.

Material C is only available in batches of 6m at a price of R600 per batch. The existing production will require 1,000 metres.

© Endunamoo Board Course 2022 SCREENCAST 508

LE5: Material not available on hand
LE5.3 Not in regular use, no alternative use
CA Ltd received a proposal to manufacture 1 000 units of Product N. Product N requires 100 m of Material C. Material C is
not available on hand.

Material C is only available in batches of 6m at R600 per batch. The unused materials will be thrown away.

© Endunamoo Board Course 2022 SCREENCAST 509

LE5: Material not available on hand
LE5.4 Not in regular use, alternative use
CA Ltd received a proposal to manufacture 1 000 units of Product N. Product N requires 100 m of Material C. Material C is
not available on hand.

Material C is only available in batches of 6m at R600 per batch. The unused materials can be sold to third parties at R1 per
m.

© Endunamoo Board Course 2022 SCREENCAST 510

Decision tree for labour relevant costs

Spare capacity exists No spare capacity exists

Variable cost Fixed cost

Lost Current rate of

Overtime
contribution pay

Current rate of
NIL
pay

© Endunamoo Board Course 2022 SCREENCAST 511

LE6: Labour is fixed or salaried
LE6.1 Spare capacity exists
CA Ltd received a proposal to manufacture 1 000 units of Product N. Product N requires 100 hours of labour. The existing
employee is paid a monthly salary of R12 000.

The employee is expected to work 40 hours per week. Overtime is paid at time and a half of their equivalent hourly rate.

Current production, i.e. excluding the special order, is budgeted to require 45 labour hours.

© Endunamoo Board Course 2022 SCREENCAST 512

LE6: Labour is fixed or salaried
LE6.2 No spare capacity exists
CA Ltd received a proposal to manufacture 1 000 units of Product N. Product N requires 100 hours of labour. The existing
employee is paid a monthly salary of R12 000.

The employee is expected to work 40 hours per week. Overtime is paid at time and a half of their equivalent hourly rate.

Current production, i.e. excluding the special order, is budgeted to require 120 labour hours.

© Endunamoo Board Course 2022 SCREENCAST 513

LE6: Labour is fixed or salaried
LE6.3 No spare capacity exists
CA Ltd received a proposal to manufacture 1 000 units of Product N. Product N requires 100 hours of labour. The existing
employee is paid a monthly salary of R12 000.

The employee is expected to work 40 hours per week. Overtime is paid at time and a half of their equivalent hourly rate.
The employee is working on a product that generates a contribution of R120 per unit. 1.5 labours hours are required per
unit.

Current production, i.e. excluding the special order, is budgeted to require 160 labour hours.

© Endunamoo Board Course 2022 SCREENCAST 514

LE6: Labour is fixed or salaried
LE6.4 No spare capacity exists
CA Ltd received a proposal to manufacture 1 000 units of Product N. Product N requires 100 hours of labour. The existing
employee is paid a monthly salary of R12 000.

The employee is expected to work 40 hours per week. No overtime is available. CA Ltd would be required to hire an
additional employee at the existing rate and who is capable of working the same number of hours in order to obtain the
required number of hours.

Current production, i.e. excluding the special order, is budgeted to require 160 labour hours. It is not economical to reduce
existing production.

© Endunamoo Board Course 2022 SCREENCAST 515

LE6: Labour is fixed or salaried
LE6.5 No spare capacity exists
CA Ltd received a proposal to manufacture 1 000 units of Product N. Product N requires 100 hours of labour. The existing
employee is paid a monthly salary of R12 000.

The employee is expected to work 40 hours per week. Overtime is paid at time and a half of their equivalent hourly rate.
Overtime hours is limited to 50 hours after which CA Ltd would be required to hire an additional employee at the existing
rate and who is capable of working the same number of hours in order to obtain the required number of hours.

Current production, i.e. excluding the special order, is budgeted to require 160 labour hours. It is not economical to reduce
existing production.

© Endunamoo Board Course 2022 SCREENCAST 516

LE7: Labour is variable
LE7.1 Spare capacity exists
CA Ltd received a proposal to manufacture 1 000 units of Product N. Product N requires 100 hours of labour. The existing
employee is paid wages at a rate of R80 per hour.

The employee is expected to work 40 normal hours per week. Overtime is paid at time and a half of their equivalent hourly
rate.

Current production, i.e. excluding the special order, is budgeted to require 50 labour hours.

© Endunamoo Board Course 2022 SCREENCAST 517

LE7: Labour is variable
LE7.2 No spare capacity exists
CA Ltd received a proposal to manufacture 1 000 units of Product N. Product N requires 100 hours of labour. The existing
employee is paid wages at a rate of R80 per hour.

The employee is expected to work 40 normal hours per week. Overtime is paid at time and a half of their equivalent hourly
rate.

Current production, i.e. excluding the special order, is budgeted to require 120 labour hours.

© Endunamoo Board Course 2022 SCREENCAST 518

LE7: Labour is variable
LE7.3 No spare capacity exists
CA Ltd received a proposal to manufacture 1 000 units of Product N. Product N requires 100 hours of labour. The existing
employee is paid wages at a rate of R80 per hour.

The employee is expected to work 40 normal hours per week. Overtime is paid at time and a half of their equivalent hourly
rate. The employee is working on a product that generates a contribution of R120 per unit. 1.5 labours hours are required
per unit.

Current production, i.e. excluding the special order, is budgeted to require 120 labour hours.

© Endunamoo Board Course 2022 SCREENCAST 519

Decisions under
uncertainty
SCREENCAST
Decisions under uncertainty
CA Ltd is contemplating introducing a new product next year. It has the choice of introducing Product M or Product S but
because of limited resources it can only launch one of them. The demand of the products is uncertain. Which product
should CA Ltd manufacture?
Possible profit Estimated probability
Product M
Recession R100 000 40%
Boom R120 000 60%

Product S
Recession R90 000 70%
Boom R200 000 30%

© Endunamoo Board Course 2022 SCREENCAST 521

Linear programming
SCREENCAST
Introduction to linear programming
• Linear programming is powerful mathematical technique that can be applied to the problem of rationing limited
facilities and resources amongst many alternative uses in such a way that the optimum benefits can be derived from
their utilisation
• It seeks to find a feasible combination of output that will maximise or minimise the objective function (i.e.
quantification of an objective, and usually takes the form of maximising profits or minimising costs)
• Linear programming may be used when relationships can be assumed to be linear and where an optimal solution does,
in fact, exist

© Endunamoo Board Course 2022 SCREENCAST 523

Requirements for linear programming
• The contribution per unit for each product and the utilisation of resources per unit are the same whatever quantity of
output is produced and sold within the output range being considered
• The units produced and resources allocated are infinitely divisible (i.e. it is possible to produce ½ or ¼ of a unit)
• When there is more than one scarce resource existing, the optimum production programme is ascertainable with linear
programming

© Endunamoo Board Course 2022 SCREENCAST 524

LE1: Basic example
Drury currently makes two products. The standards per unit of product are as follows:
Y Z
Selling price R110 R118
Variable costs
• Material (Y: 8 units at R4 / Z: 4 units at R4) (R32) (R16)
• Labour (Y: 6 hrs at R10 / Z: 8 hrs at R10) (R60) (R80)
• Variable overheads
(Y: 4 Mhrs at R1 / Z: 6 Mhrs at R1) (R4) (R6)
Contribution R14 R16

© Endunamoo Board Course 2022 SCREENCAST 525

LE1: Basic example
During the next accounting period, the availability of resources are expected to be subject to the following limitations:
• Labour 2 880 hours
• Materials 3 440 units
• Machine capacity 2 760 hours

The marketing manager estimates that the maximum sales potential for product Y is limited to 420 units. There is no sales
limitation for Product Z.

REQUIRED
Advise how these limited facilities and resources can best be used so as to gain the optimum benefit from them. (Drury)

© Endunamoo Board Course 2022 SCREENCAST 526

LE1SS: Basic example
Step 0: Determine whether linear programming is applicable
Step 1: Formulate the problem algebraically
Step 2: Specify the objective function (max CM or min COSTS)
Step 3: Specify the input constraints
Step 4: Include the non-negativity requirement
Step 5: Draw a graph with the axis being Product 1 and the other axis being Product 2
Step 6: Determine the interception points on the graph, by a process of substituting each variable by ‘0’
Step 7: Using the slope of the objective function, determine the point at which the objective function would be maximised or
minimised

© Endunamoo Board Course 2022 SCREENCAST 527

Shadow prices
• Shadow prices refer to the value of an independent marginal increase of a scarce resource; this is also the opportunity
cost of an additional resource required
• The rationale is that an additional unit of a scarce resource is likely to change the optimal production and consequently
might result in a higher contribution to be generated
• As a result the marginal cost (i.e. additional cost or the opportunity cost) of the additional unit to be acquired should
not exceed the contribution to be generated by the additional contribution to be generated
• In other words, the cost of the additional material is ‘the cost of the existing material + the opportunity cost (i.e. the
shadow price)

© Endunamoo Board Course 2022 SCREENCAST 528

LE2: Shadow prices
Consider the same facts as in LE1 and additional information provided below to determine the shadow prices.

The supplier of materials has advised the company that it can provide 200 additional units of materials at a total cost of:
(i) R870; and
(ii) R820.

© Endunamoo Board Course 2022 SCREENCAST 529

Uses of linear programming
• Calculation of relevant costs
• Selling different products
• Maximum payment for additional scarce resources
• Control
• Managing constraints
• Capital budgeting
• Sensitivity analysis

© Endunamoo Board Course 2022 SCREENCAST 530

Pricing decision
Pricing considerations
1) Period / Time horizon
• Pricing for short term purposes vs pricing
• In short term, all incremental costs are to be incorporated
• In the short term, fixed costs are generally irrelevant
• In long term, all variable and fixed costs are to be incorporated
• All manufacturing and non-manufacturing costs to be incorporated
• Opportunity costs need to be incorporated as well
2) Profit
• Pricing to incorporate profit-margin for the company
• Profit margin to be based on existing margins if in the same line of business
• Profit to consider market related pricing / margins
• Consider the nature of the product, commodity vs novelty status

© Endunamoo Board Course 2022 SCREENCAST 532

Pricing considerations
3) Pricing strategies
• Premium pricing vs cost plus margin pricing approach
• Differentiation / unique qualities
• Costumer base’s income levels
• Competitive nature of the industry
4) Pricing approach
• Premium pricing = price skimming
• Price penetration = low price initially
• Target-cost pricing
5) Other factors
• Expected sales demand
• Legislative pricing
• Social considerations

© Endunamoo Board Course 2022 SCREENCAST 533

 Divisional
performance
measurement
Divisional
performance
measurement
Introduction
Objectives
After studying this section, the candidate should be able to:
• Distinguish between functional and divisionalised organisational structures
• Explain the meaning of return on investment and residual income
• Distinguishing between managerial and economic performance
• Evaluate divisional performance by employing appropriate performance measures (ROI and RI)
• Discuss the influence of these measures on capital investment decisions
• Discuss various approaches that can be employed to overcome the short-term orientation associated with accounting
profit-related measures

© Endunamoo Board Course 2022 536

Functional or centralised organisation
• In this form of organisation, all activities of the enterprise are grouped and divided according to functions like
production, marketing, finance and others
• Managers have far less independence with respect to decision such as pricing, product mix and output decisions than
divisional managers
• The measurement of performance would mainly relate to non-financial measures, e.g. the number of audience reached
by a particular marketing campaign
• The organisation as a whole is an investment centre

© Endunamoo Board Course 2022 537

Divisionalisation or decentralisation
It involves the decentralisation of the decision making process

The creation of separate divisions may lead to the delegation of different degrees of authority by the corporate head office
(i.e. responsibility centres)
• Cost centres are responsibility centres whose managers are normally accountable for those costs that are under their
control
• Profit centres are responsibility centres whose managers are responsible for both sales revenue and costs
• Investment centres are responsibility centres whose managers are responsible for both sales revenue and costs and
also have responsibility and authority to make capital investment decisions

© Endunamoo Board Course 2022 538

Divisionalisation
• A divisionalised structure is most suited to large companies that are engaged in several dissimilar activities because
it is difficult for top management to be intimately acquainted with all the diverse activities of the various segments of
the business
• Activities that are closely related require carefully coordination and this might be easily achieved in a centralised
organisation structure
• For a successful divisionalisation, the activities of a division need to be as independent as possible of other activities
• However, it should not undermine the notion that such divisions are an integral part of the holding company

© Endunamoo Board Course 2022 539

Divisionalisation: Practical examples

© Endunamoo Board Course 2022 540

Advantages of divisionalisation
Divisionalisation can improve the decision-making processes
• Quality of decisions is improved because decisions can be made by the person who is familiar with the business and
therefore in a position to make more informed judgments than central management
• Speedier decisions should also occur because information does not have to pass along the chain of command to and
from top management
• Motivate managers: Delegation of responsibility to divisional manager provides them with greater freedom, thus
facilitating motivation because activities are made more challenging and provide them with an opportunity to achieve
self-fulfilment (behavioural implications)
• Free up management time: Head office management time may be freed up allowing them to focus on the growth of
the business

© Endunamoo Board Course 2022 541

Disadvantages of divisionalisation
• The biggest problem is the agency problem which could lead to a lack of goal congruency
• The managers (agent) may compete with other divisional managers excessively and the divisional managers may be
encouraged to take actions that will increase their own profits at the expense of the profits of other divisions and the
company as a whole (and consequently shareholders)
• Activities may be duplicated resulting in extra costs being incurred

© Endunamoo Board Course 2022 542

Divisional
performance
measurement
General financial techniques
Divisional performance measurement
Divisional profit
This measure would be based on the annual accounting profit

Return on investment (ROI)

ROI is based on the divisional profit divided by investment

Residual income
RI is the divisional profit less a capital charge on the investment

Economic value added (EVA)

EVA is based adjusted divisional profit less a capital charge on the adjusted investment base

© Endunamoo Board Course 2022 544

Fundamental principle: Controllability
• Controllability principle purports that it is appropriate to charge to an area of responsibility only those costs that are
significantly influenced by the manager of that responsibility (concept applicable to responsibility centres)
• The uncontrollable factors should therefore be removed in evaluating the divisional performance

© Endunamoo Board Course 2022 545

Managerial versus economic performance
In determining how divisional profitability should be measured, it must be decided whether the primary purpose is to
measure the performance of the division or that of the divisional manager

Managerial performance
• If the purpose is to evaluate the divisional manager then only those items directly controllable by the manager should
be taken into account
• Therefore allocation of head office costs ought not be included in the profitability measure

Divisional performance (economic performance)

• However, if the purpose is to evaluate the divisional economic performance, the costs that would otherwise be
avoidable if the division closed down
• This is necessary if we are comparing the performance of the division with other divisions or other competitors

© Endunamoo Board Course 2022 546

Divisional
performance
measurement
Divisional profit
Divisional profit calculation
R
Total sales revenues XX
Less controllable costs XX
Controllable profit (Manager’s performance) XX
Less non-controllable avoidable costs XX
Divisional profit contribution XX
(Division’s economic performance)
Less allocated corporate expenses XX
Divisional net profit before interest and taxes XX

© Endunamoo Board Course 2022 548

Divisional profit
• For performance measurement basis, this measure should be evaluated relative to a budgeted performance
• For measuring managerial performance the application of the controllability principle suggests that controllable profit
is the most appropriate measure because it takes into consideration the manager’s ability to use only those resources
under his control effectively
• The economic performance of the division should be evaluated after taking all the avoidable costs, even the ones
outside the control of the manager, relating to the division, therefore making the divisional profit contribution an
appropriate measure
• The allocation of the corporate costs is likely to be based on an arbitrary basis and therefore distorting the usefulness of
divisional net profit before taxes

© Endunamoo Board Course 2022 549

Advantages of divisional profit
• It is an appropriate measure for a profit centre?
• It is easily understood and common figure for any company?

© Endunamoo Board Course 2022 550

Disadvantages of divisional profit
• Divisional profit does not encourage to seek returns in excess of the cost of capital of the company
• It is an annual measure, i.e. short term in nature – may encourage managers to take decisions that are inconsistent with
NPV analysis (i.e. value destructive in the long term)
• It is based on accounting principles and therefore likely to be subject to manipulation or reflects the choices of
accounting policy chosen by management
• It is an absolute measure and difficult to compare with divisions or companies of different sizes
• Ignores time value of money
• Ignores qualitative / non-financial factors (e.g. market share)
• Accounting profit does not generally represent operating cash flows generated by the company

© Endunamoo Board Course 2022 551

Divisional
performance
measurement
Return on investment
ROI
Return on investment = Divisional operating profit x 100
Divisional net investment

• Divisional operating profit refers to profit before interest and taxes generated by the division in a specific period
• Net investment refers to the non-current assets (e.g. machinery, factory buildings, etc.) and net current assets (e.g.
cash, accounts receivable, inventory and accounts payable) that are directly attributable and within the control of the
divisional manager
• By taking into account the asset base required to generate the profit, ROI addresses some of the disadvantages of
divisional profit as a measure of performance
• Therefore, ROI is more appropriate for an investment centre

© Endunamoo Board Course 2022 553

Advantages of ROI
• It is easy to understand and calculate
• It can be used as a common denominator for comparing the returns of dissimilar businesses, such as other divisions and
competitors, and other measures such as inflation, prior year performance and budgets (i.e. it is easily comparable)
• It can be compared with the entity’s cost of capital – thus making it useful for decision making

© Endunamoo Board Course 2022 554

Disadvantages of ROI
• Because it is based on accounting profit, it carries along the disadvantages of divisional profit
• It is not suited for service industries because of low capital investment
• It does not take into account the risks of a division or project
• ROI can lead to a lack of goal congruence

© Endunamoo Board Course 2022 555

Divisional
performance
measurement
Comprehensive example
LE1: Divisional profit & ROI
CA Ltd has two divisions, namely SA Ltd and Africa Ltd. The financial results and divisional assets of the divisions for the
recent year ended are provided below:
SA Ltd Africa Ltd
Gross profit R1 500 000 R2 250 000
Other income R8 500 R16 800
Operating expense (R697 500) (R906 000)
Profit before tax 811 000 R1 360 800

Divisional assets R5 500 000 R7 000 000

Other income refers to interest income earned on the cash generated by the divisions. All the cash balances are managed
centrally by CA Ltd and the divisions are required to remit cash balances to head office on a daily basis.
Divisional assets include cash balances of R150 000 and R280 000 relating to SA Ltd and Africa Ltd respectively.

© Endunamoo Board Course 2022 557

LE1: Divisional profit & ROI
The divisions are considering investments, of which details are provided below:
SA Ltd Africa Ltd
Capital investment required R1 800 000 R2 200 000
Additional annual contribution R288 000 R418 000

CA Ltd’s weighted average cost of capital is 18% per annum.

REQUIRED:
1) Calculate the divisional return on investment for both SA Ltd and Africa Ltd. Motivate your answer (5 marks)
2) Determine whether any of the divisional managers would proceed with the proposed investment, assuming the
divisional managers’ performance is assessed on the following metrics: (a) divisional profit and (b) return on
investment (6 marks)
3) Using your answers in part (2), discuss whether the decisions of the divisional manager would lead to goal congruency
or not (4 marks)

© Endunamoo Board Course 2022 558

Divisional
performance
measurement
Residual income
Residual income
• Residual income is defined as controllable profit less a cost of capital charge on the investment controllable by the
divisional manager = Divisional profit after tax less capital charge
• If the residual income is used to measure the managerial performance of investment centres, there is chance that
managers will be encouraged, when acting in their own best interests, also to act in the best interests of the company
• It is considered superior to ROI because it takes into account the cost of capital
➢ RI is congruent with investors’ measure for overall company performance
➢ ROI, being a ratio, can be used for inter-division and inter-company comparisons

© Endunamoo Board Course 2022 560

Advantages of residual income
• Residual income is more flexible, because different cost of capital percentage rates can be applied to investments that
have different levels of risk
• It is consistent with the NPV approach as projects which yield a return higher than cost of capital return would be
acceptable (i.e. goal congruent)
• The contribution of divisions to group profit is clearly measured
• If different cost of capital rates are used, comparability may be enhanced?

© Endunamoo Board Course 2022 561

Disadvantages of residual income
• Residual income is an absolute measure – therefore difficult to compare the performance of a division with that of other
divisions or companies of different size (i.e. the size of the investment is ignored)
• It is difficult to understand
• The use of different rates presents subjectivity into the calculation – this could lead to adverse motivational effects
• Because it is based on accounting profit, it carries along the disadvantages of divisional profit

© Endunamoo Board Course 2022 562

LE2: Residual income
Assume the same information as LE1 other than the fact that managerial performance is evaluated based on residual
income

© Endunamoo Board Course 2022 563

Divisional
performance
measurement
Economic value added
Economic value added (EVA)
EVA
= NOPAT - (divisional assets x cost of capital)

NOPAT (Net Operating Profit After Tax)

= Conventional divisional profit +/- accounting adjustments

• EVA calculation seeks to ascertain whether value is being added for shareholders in terms of whether the funds
invested in the business generate a return in excess of the cost of capital
• If the EVA > 0, economic value is created/added and if EVA < 0, economic value is destroyed

© Endunamoo Board Course 2022 565

EVA adjustments
• The starting point is divisional accounting profit which is then adjusted to eliminate the distortions introduced by
financial accounting
• There are approximately more than 160 adjustments to consider – for our purpose, only the following are applicable:
➢ Non-cash items (e.g. depreciation, bad debts, etc.)
➢ Finance related costs, including the related tax
➢ Capitalisation and amortisation of discretionary expenditure (e.g. marketing, R&D, training costs)
➢ Economic depreciation
• The objective of the adjustments is to determine cash flows because this provides a better measure for EVA
• The capital charge used is normally the divisional weighted average cost of capital
• Controllable investment base to be used is the same as for the residual income and ROI adjusted for:
➢ Replacement values or market values of non-current assets need to be used where available
➢ Balance of expenditure incurred, capitalised and amortised over the period that the benefits will accrue in the
future
➢ Non-cash expenses

© Endunamoo Board Course 2022 566

Advantages of EVA
• EVA is more flexible, because different cost of capital percentage rates can be applied to investments that have
different levels of risk
• It is consistent with the NPV approach as projects which yield higher than cost of capital return would be acceptable
(i.e. goal congruent)
• EVA adjusts for distortions introduced by accounting principles
• EVA actively encourages increasing shareholders’ wealth
• It highlights the benefits of discretionary expenditures (such a training, research expenditure and marketing costs)

© Endunamoo Board Course 2022 567

Disadvantages of EVA
• Historical figures are used in an attempt to calculate economic profit – therefore not necessary an accurate figure
• Although easy to interpret, it is difficult to understand
• The use of estimates in estimating EVA presents subjectivity into the calculation – could lead to adverse motivational
effects

© Endunamoo Board Course 2022 568

LE3: EVA
CA Ltd has a division, Africa Ltd, whose performance is evaluated based on the EVA. The financial performance of Africa
Ltd for the most recent period is provided below:
Amount (R)
Total revenues 8 000 000
Cost of sales (4 000 000)
Gross profit 4 000 000
Operating expenditure (note 1) (1 800 000)
Depreciation (note 2) (750 000)
Operating cash flow 1 450 000
Interest expense (150 000)
Income tax expense (364 000)
Net income for the year 936 000

© Endunamoo Board Course 2022 569

LE3: EVA
Notes:
1. Operating expenses include bad debts (R180 000) and research and development expenditure (R800 000). The
research and expenditure incurred is expected to yield benefits to Africa Ltd over a period of four years
2. The carrying amount and market value of non-current assets at year end were R4,5 million and R5,4 million
respectively. Economic depreciation during the year was R900 000
3. Controllable investment (before EVA adjustments) is R5 million
4. WACC is estimated to be 15%. Tax rate is 28%

REQUIRED:
Calculate EVA of Africa Ltd. CA Ltd determines the controllable investment based on figures as at the end of the reporting
period

© Endunamoo Board Course 2022 570

Divisional
performance
measurement
Concluding remarks
Addressing the dysfunctional consequences
• Use of improved financial performance measures such as EVA that incorporate accounting adjustments that attempt to
overcome the deficiencies of conventional accounting measures
• Lengthen the performance measurement period (i.e. use of share scheme or bonus banks)
• Incorporate non-financial measures using the balanced scorecard approach (e.g. competitiveness, productivity, quality,
etc.)

© Endunamoo Board Course 2022 572

Transfer pricing
Transfer pricing
Introduction
Objectives
After studying this section, candidates should be able to:
• Describe the different purposes of a transfer pricing system
• Determine internal transfer pricing to assist in resolving transfer pricing conflicts
• Assist in setting transfer prices when there is no external market for the intermediate product
• Identify and describe the five different transfer pricing methods

© Endunamoo Board Course 2022 575

Objectives of transfer pricing system
• It provides information that is useful for evaluating the managerial and economic performance of the division in fair
and justifiable manner
• It provides information that motivates divisional managers to make good economic decisions (i.e. decisions that
ensures goal congruency)
• It ensures that divisional autonomy is not undermined
• It intentionally distributes profits between divisions and locations
• It encourages healthy competition between the divisions
• It is simple to operate and administer

No single transfer price is likely to meet all of the stated objectives

© Endunamoo Board Course 2022 576

Transfer pricing

Minimum transfer price

Golden rule: Minimum transfer price

Internal
Available capacity = 10 000

Spare capacity Demand

= 6 000 = 5 000

External • If the internal demand is less than the available spare

demand capacity, the minimum transfer pricing is the incremental
= 4 000 cost of supplying the products to the internal division
• The incremental cost shall refer to the variable costs plus
incremental fixed costs

© Endunamoo Board Course 2022 578

Golden rule: Minimum transfer price

• If the internal demand is greater than

the available spare capacity, the
Spare capacity minimum transfer pricing is the
Available capacity = 10 000

Internal incremental cost of supplying the

= 6 000 Demand products to the internal division plus an
= 7 000 opportunity cost
• The incremental cost shall refer to the
variable costs plus incremental fixed
costs
External • The supplying division would need to
demand sacrifice the external sales
= 4 000 • The opportunity cost of sacrificing the
external sales shall be the lost
contribution
• The total opportunity cost would be
determined and allocated to each item
transferred to the internal division

© Endunamoo Board Course 2022 579

Golden rule: Minimum transfer price
Approach
Step 1: Determine the annual manufacturing capacity of the supplying division
Step 2: Determine the quantities being supplied to external market
Step 3: Determine the spare capacity currently available
Step 4: Determine whether there is enough capacity to meet the requirements of the buying division
Step 5: Determine all the relevant costs and, if applicable, including the opportunity cost
• Relevant costs = incremental costs = variable costs + incremental fixed costs – avoidable costs
• Opportunity cost = lost contribution from the external sale to be sacrificed = Lost contribution per unit x shortfall in
Step 4 / Total number of units to be transferred

© Endunamoo Board Course 2022 580

LE1: Sufficient capacity available
CA Ltd has two divisions, Seller and Buyer. Seller manufactures Product T. The external selling price of Product T is R100
per unit. The fixed manufacturing costs per unit is R20. The total manufacturing costs amount to R80 per unit. Packaging
costs of R10 are incurred on all external sales (i.e. packaging is a selling cost). The external annual demand for Product T is
11 000 units.
Buyer uses Product T in its manufacturing process. The units that are transferred to Buyer from Seller are not packaged.
Buyer requires 18 000 units of Product T. Seller has a total annual manufacturing capacity of 30 000 Product T.

REQUIRED: Determine the minimum transfer price

© Endunamoo Board Course 2022 581

LE2: Sufficient capacity does not exist
CA Ltd has two divisions, Seller and Buyer. Seller manufactures Product T. The external selling price of Product T is R100
per unit. The fixed manufacturing costs per unit is R20. The total variable costs amount to R70 per unit. Packaging costs of
R10 are incurred on all external sales (i.e. packaging is a selling cost). The external annual demand for Product T is 11 000
units.
Buyer uses Product T in its manufacturing process. The units that are transferred to Buyer from Seller are not packaged.
Buyer requires 25 000 units of Product T. Seller has a total annual manufacturing capacity of 30 000 Product T.

REQUIRED: Determine the minimum transfer price

© Endunamoo Board Course 2022 582

LE3: Advanced minimum transfer price
Africa Ltd has two divisions, CA Ltd and SA Ltd. CA Ltd is a manufacturer of electric motors. These motors are generally
sold externally to the automotive industry as well as to the internal division, SA Ltd, which uses them in the manufacture
of generators. The annual external demand from the automotive industry is 40 000 motors while the total annual
manufacturing capacity is 75 000 motors.
CA Ltd generates a gross profit of R4 000 on each motor sold. The selling price is R9 500 per motor. The fixed
manufacturing cost amount to R1 490 per unit. The variable cost component include the motor and transport cost. The
transport cost for all units externally transferred is R800 per unit. If the units are internally transferred to SA Ltd, the
transport cost is reduced and it becomes R300 per unit.

REQUIRED: Determine the minimum transfer price is SA Ltd requires the transfer of 45 000 motors

© Endunamoo Board Course 2022 583

Transfer pricing

Maximum transfer price

Golden rule: Maximum transfer price
The maximum selling price for the buying division should be the incremental revenue less incremental costs
If there is an external market for the transferred items, the transfer price should be limited to the external selling price

Again! It is that simple!

© Endunamoo Board Course 2022 585

LE4: Maximum transfer price
Consider the same facts as LE1. Buyer manufactures Product Q.
The selling price of Product Q is R800 and the cost of production, excluding the transferred item (Product T), is R450. The
external selling price of a product similiar to Product T is R300.

Determine the maximum transfer price for Buyer.

© Endunamoo Board Course 2022 586

Transfer pricing

Transfer pricing methods

Market-based and cost transfer prices
Market-based transfer prices
• The transfer price is set at a competitive market price
• Perfectly competitive market where item is homogeneous and no individual buyer or seller can affect the market prices
need to exist
• Divisional performance is more likely to represent the real economic contribution of the division to total company
profits

Cost based transfer prices

• These may be based on marginal costs, full costs or cost plus a mark-up
• The main issue is that standard costs should be utilised and not actual costs in order to avoid inefficiencies being carried
forward to the buying division as this might result in dysfunctional behaviour

© Endunamoo Board Course 2022 588

Negotiated transfer prices
• The transfer price should lie between the minimum and maximum prices calculated (i.e. the starting point)
• The negotiated transfer prices could reduce the friction and bad feeling that may arise from centrally controlled market
prices
• It is appropriate where it is difficult to establishing a sound system of transfer pricing. This is likely to be the case where
some market imperfections exist for the transferred item, e.g. there are several different market prices
• Autonomy to buy or sell externally is a critical prerequisite
• Unequal bargaining power (as result of limited number of external selling/buying outlets, amount of internal demand
for the item, degree of operating leverage) should not exist
• The time dedicated to the process is also an important factor
• Managers are likely to have better information about the potential costs and benefits of the transfer than others in the
company

© Endunamoo Board Course 2022 589

Dual-rate transfer pricing system
• It uses two separate transfer prices to price each inter-divisional transaction - For instance, the transfer price to be
charged to the receiving division could be set at the variable cost of the supplying division while the price of the selling
division could be set at market prices
• The appropriate level of the transfer price needs to achieve goal congruency and have the appropriate motivation
implications
• The dual-rate transfer prices are not widely used because:
➢ Different transfer prices causes confusion (e.g. consolidation treatment), especially where many divisions are
involved
➢ They reduce divisional incentives to compete effectively
➢ They are artificial, i.e. create a false impression of profitability

© Endunamoo Board Course 2022 590

Two-part transfer pricing system
• The transfer price is set at the short-run variable cost plus a fixed fee for the privilege of obtaining these transfers at
short-run variable costs
• The fixed fee is intended to compensate the supplying division for tying up some of its fixed capacity in order to provide
products or services that are transferred internally
• The transfer price should cover a share of the fixed costs of the supplying division and also provide a return on capital
• The advantage of this approach is that both divisions will report inter-divisional profits and it also stimulates planning,
communication and coordination amongst the divisions
• The fixed portion could be determined through the application of ABC principles

© Endunamoo Board Course 2022 591

Rendani Muthelo
[email protected]
WhatsApp: +2782 432 1267
Thank You