Reference no: EM13489234

Super Cleaning Products (Pty) Ltd (SCP) was founded in 1988 by Mr Jones, Ms Dhlamini and Mr Gervis. During 1989 SCP entered into an agreement with Drake Inc. (Drake), a major global manufacturer of industrial cleaning equipment and related products with headquarters in the United States of America, to distribute Drake's range of cleaning equipment and chemicals in South Africa. This relationship has gone from strength to strength and SCP has over the past 20 years ensured that Drake products are the leaders in the South African industrial cleaning market. The exclusive distribution agreement between SCP and Drake was renewed again early in 2008 for a further five years. In terms of the agreement SCP has exclusive rights to the distribution of Drake products in the South African market.

Revenue derived from importing and selling Drake's products represents over 90% of SCP's annual turnover. Drake is acknowledged as a world leader with regard to both the quality and volume of the industrial cleaning machines it manufactures. SCP distributes Drake's extensive range of sweepers, scrubbers, moppers and cleaning trolleys to customers in the contract cleaning industry. SCP also sells Drake's range of cleaning chemicals used in the cleaning and maintenance of all floor types, including carpets, as well as kitchen surfaces and bathrooms.

The executive directors of SCP have positioned the company to supply quality products which provide customers with superior performance and are cost efficient and reliable. SCP's equipment range is not the cheapest in the market but is certainly price competitive given the long useful life of the products.

The executive directors and their respective shareholdings in SCP are set out below:
Executive responsibility
Shareholding
Mr Jones
Chief Executive Officer
45%
Ms Dhlamini
Chief Financial Officer
30%
Mr Gervis
Marketing Director
25%
SCP's head office is situated in Paarden Eiland, Cape Town and the company has branches in Johannesburg, Durban, Bloemfontein, East London and George.
Highlights of SCP's recent financial performance and forecasts
Information extracted from the company's financial results for the year ended 30 September 2008 and the budget for the year ending 30 September 2009 is set out in the table below:
Selected income statement information for the year ended / ending 30 September
2008
2009
Actual
Budget
Notes
R'000
R'000
Revenue
131 309
150 782
Equipment sales
1
56 404
64 865
Chemicals sales
2
64 728
74 437
Other revenue
3
10 177
11 480
Gross profit
36 965
40 208
Equipment sales
12 973
14 595
Chemicals sales
4
21 037
22 330
Other revenue
2 955
3 283
Earnings before interest, tax, depreciation, and amortisation (EBITDA)
14 905
15 213
1
Selected balance sheet information for the year ended / ending 30 September
2008
2009
Actual
Budget
Notes
R'000
R'000
Share capital
10 000
10 000
Retained profits
5
31 980
39 914
Shareholders' funds
41 980
49 914
Cash resources
6
12 991
20 079
Notes
1 Equipment sales are expected to continue growing at 15% per annum for the foreseeable future due to infrastructural spending by government and the ongoing strong demand for industrial property (which results in more office and industrial space that needs to be cleaned).
2 Chemicals sales are forecast to grow in line with the growth in equipment sales. Chemicals sales as a percentage of total revenue have historically amounted to about 50% and this trend is expected to continue.
3 Revenue from servicing and maintaining customer equipment is classified as 'other revenue' in the above income statements.
4 The gross profit percentage on chemicals sales is expected to decline to 30% in 2009 due to the expectation of SCP's executive directors that there will be a fall in the value of the rand against the US dollar. SCP's executive directors are hopeful that the rand will stabilise after 2009 as a continued devaluation may further erode margins.
5 SCP has historically declared dividends to its shareholders. The policy to date has been to pay out 30% of annual after tax profits as dividends.
6 The company has no interest-bearing debt at present. SCP is cash generative and has not borrowed monies externally or from its shareholders over the past five years.
Proposed investment in manufacturing plant to produce chemicals
SCP is considering manufacturing its own chemicals for sale to customers as opposed to importing chemicals from Drake. The strategic rationale for this initiative includes the following:
• Increasing gross margins on chemicals sales (detailed research indicates that SCP could increase its gross profit percentage on chemicals to at least 45% if the company manufactured its own chemicals);
• Reducing reliance on Drake; and
• Protecting SCP against the effects of any future adverse currency movements. The majority of raw materials required for the manufacture of the chemical product range can be sourced locally in South Africa.
The executive directors of SCP appointed a firm of external consultants, Majuwba Consulting, to research the feasibility of the proposed venture. Majuwba Consulting's preliminary findings suggested that SCP should seriously consider manufacturing its own chemicals, as this could be the appropriate strategic action and it appears to be a very attractive financial proposition.
SCP has identified a management team to establish and manage the Chemicals Manufacturing Division. This team is currently employed at a major chemicals manufacturer and has indicated that they would be prepared to move to SCP. The team is confident that they have the necessary experience to manage such an operation. The detailed chemical formulations for products would be sourced from expired international patents or developed internally by industrial chemists (two of whom form part of the management team referred to above).
2
Mr Jones has had preliminary discussions with Drake regarding the possibility of manufacturing chemicals instead of importing from them. Drake's response was -
• disappointment at the prospect of losing business from SCP;
• that the potential loss of revenue and margin for them from discontinuing supplying chemicals to SCP was immaterial financially;
• concern about the possibility that SCP would manufacture inferior chemicals which could adversely affect the performance of Drake equipment; and
• an instruction to SCP that it was not to use the Drake trade name and trademark in any of the chemical product labelling or advertising should SCP manufacture its own chemical products.
Majuwba Consulting, in conjunction with the proposed management team of the new Chemicals Manufacturing Division of SCP, has prepared a detailed capital budget for the division. The salient details of this budget are summarised below:
Extracts from the capital budget for the Chemicals Manufacturing Division:
SUPER CLEANING PRODUCTS (PTY) LTD
EXTRACTS FROM THE INCOME STATEMENT OF THE CHEMICALS
MANUFACTURING DIVISION FOR THE YEARS ENDING 30 SEPTEMBER
2010
2011
2012
Notes
R'000
R'000
R'000
Revenue
1
85 603
98 443
113 210
Cost of sales
(47 559)
(52 849)
(58 807)
Materials
2
(14 552)
(16 735)
(19 246)
Labour
3
(20 545)
(22 600)
(24 859)
Variable manufacturing overheads
4
(4 280)
(4 922)
(5 660)
Fixed manufacturing overheads
Depreciation
5
(4 000)
(4 000)
(4 000)
Rental of premises
6
(432)
(467)
(504)
Other fixed overheads
(3 750)
(4 125)
(4 538)
Gross profit
38 044
45 594
54 403
Overhead recoveries
7
(14 013)
(15 414)
(16 956)
Salaries
8
(4 800)
(5 280)
(5 808)
Interest expense
9
(6 442)
(5 003)
(1 939)
Profit before tax
12 789
19 897
29 700
Tax
10
(2 461)
(4 451)
(7 196)
Profit after tax
10 328
15 446
22 504
Earnings before interest, tax, depreciation and amortisation
23 231
28 900
35 639
3
SUPER CLEANING PRODUCTS (PTY) LTD
FORECAST CASH FLOWS FOR THE CHEMICAL MANUFACTURING DIVISION
FOR YEARS ENDING 30 SEPTEMBER
2009
2010
2011
2012
Notes
R'000
R'000
R'000
R'000
Acquisition of plant and equipment
5
(40 000)
Profit before tax
12 789
19 897
29 700
Add back: Depreciation
4 000
4 000
4 000
Tax
10
(2 461)
(4 451)
(7 196)
Movements in working capital
Inventories
11
(4 000)
(4 712)
(1 058)
(1 192)
Accounts receivable
12
(14 072)
(2 111)
(2 427)
Accounts payable
12
6 564
797
898
Repayment of head office loan
9
(2 108)
(17 074)
(23 783)
Net cash flow
(44 000)
0
0
0
Notes
1 Revenue is forecast to increase by 15% per annum over the next ten years.
2 Material costs have been budgeted to be 17% of revenue throughout the planning period.
3 Labour costs are expected to increase by 10% per annum from 2010 onwards.
4 Variable manufacturing overheads have been budgeted as 5% of annual revenue.
5 The plant and equipment cost per the detailed quote from the preferred supplier is R38 million. Installation costs and project management fees payable are expected to total R2 million, bringing the total cost of plant to R40 million. The plant and equipment is to be installed by September 2009 and manufacturing operations are set to commence on 1 October 2009. For the purposes of the capital budget, payment of the full R40 million is expected to take place on 30 September 2009. SCP has discussed the depreciation of the plant and equipment with its external auditors and the consensus is to depreciate these assets on a straight-line basis over ten years. The plant and equipment is expected to have no residual or realisable value at the end of ten years.
6 SCP has managed to secure the right to rent factory space adjacent to its existing head office for the Chemicals Manufacturing Division. The owner of this property has offered SCP a ten year lease on the premises with rentals escalating by 8% per annum.
7 Overhead recoveries represent the allocation of 50% of SCP's total overheads, excluding those specifically attributable to the Chemicals Manufacturing Division. These overheads consist primarily of finance, administration, marketing and human resource costs which the company incurs in operating its business.
8 Salaries represent the expected employment costs of the management team of the Chemicals Manufacturing Division.
9 The SCP head office will loan the necessary funds to the Chemicals Manufacturing Division. This loan will bear interest at 15% per annum and is repayable out of surplus cash flows of the division.
10 The external auditors have advised that SCP can claim the cost of the plant and equipment in terms of section 12C of the Income Tax Act. Apparently SCP can write off the cost of the plant and equipment on a straight line-basis over five years. Other assumptions on which the capital budget is based include the following:
• A normal income tax rate of 28%;
• All expenditure (apart from depreciation) will be deductible for income tax purposes; and
• All income tax due will be paid in the year incurred.
11 The budget is based on the assumption that raw materials to the value of R4 million will have been acquired and paid for by 30 September 2009. Thereafter, the capital budget assumes that year-end 4
raw material inventory balances will be equivalent to 20% of total cost of sales for the year (excluding depreciation charges).
12 The average collection period for accounts receivable is budgeted to be 60 days, and the average payment period for accounts payable (calculated based on cost of sales excluding depreciation) is forecast to be 55 days. These calculations are based on 365 days per annum. The working capital ratios set out in notes 11 and 12 are consistent with those of SCP in the 2008 financial year.
13 The forecast cash flows after 2012 are set in the table below:
Forecast cash flows for the years ending 30 September
2013
2014
2015
2016 onwards
R'000
R'000
R'000
R'000
EBITDA
43 628
53 079
64 238
Increase of 10% p.a.
Interest expense
0
0
0
0
Taxation
(9 976)
(12 622)
(17 987)
28% of EBITDA
Working capital
(3 122)
(3 584)
(4 113)
Increase of 15% p.a.
Repayment of head office loan
(1 035)
0
0
0
Net cash flow
29 495
36 873
42 138
Term loan to be raised from BZN Bank Ltd
SCP is in discussions with its commercial bank, BZN Bank, to obtain a five year term loan to finance the set-up of the Chemicals Manufacturing Division. BZN Bank has offered SCP a loan of R45 million on the following key terms and conditions:
Principal sum
R45 million to be advanced on 30 September 2009
Raising fee
A raising fee determined as 1% of the principal sum will be levied by BZN Bank upon advance of loan. The raising fee will be capitalised
Interest
A fixed interest rate of 15% over the term of the loan, calculated and payable monthly in arrears
Repayment terms
The principal sum is to be repaid in 20 equal quarterly instalments of R2 250 000 each commencing on 31 December 2009
Security
A general notarial bond over plant and equipment, a cession of accounts receivable and a limited suretyship of R10 million by SCP shareholders
Early settlement
Early settlement of the loan is permissible. However, a penalty fee of 2% of the amount of the principal sum that is repaid early will be levied
The prime overdraft interest rate has increased from 13,5% in September 2007 to 16% in October 2008. BZN Bank's economists predict that the prime rate will increase to 17% in December 2008 before declining to 15% by late 2009.
Cost of capital
Ms Dhlamini is unsure of what cost of capital to use for the purposes of evaluating the capital budget of the Chemicals Manufacturing Division. SCP has never determined its cost of capital for the company or any division.
5
Ms Dhlamini has obtained the following reliable information from BZN Bank:
REQUIRED
Marks
(a)
Estimate the cost of equity (shareholders' funds) of Super Cleaning Products (Pty) Ltd at 31 October 2008 based on the information provided by BZN Bank Ltd. Show all workings and provide reasons for using specific information provided by BZN Bank Ltd.
8
(b)
Assuming Super Cleaning Products (Pty) Ltd enters into the five year term loan agreement with BZN Bank Ltd, discuss, with reasons, how this may impact, if at all, on the discount rate(s) or weighted average cost(s) of capital used to determine the net present value of the forecast cash flows of the Chemicals Manufacturing Division. No calculations are required.
6
(c)
Critically review the forecast cash flows included in the capital budget of the Chemicals Manufacturing Division over the period 2010 to 2016 and beyond and identify, with reasons -
• any errors or omissions from the capital budget; and
• any assumptions in the capital budget which may need clarification or amendment.
20
(d)
Based on the capital budget for the Chemicals Manufacturing Division and other information above, determine the net cash flows on 30 September 2009 and for the year ended 30 September 2010 which should be discounted for the purposes of determining the net present value of the Chemicals Manufacturing Division. Show all workings.
10
(e)
Identify and describe four key business risks currently faced by Super Cleaning Products (Pty) Ltd. Ignore the risks associated with the establishment of the Chemicals Manufacturing Division.
8
(f)
Identify and describe the key business risks of establishing and operating the Chemicals Manufacturing Division. In your answer you should identify and explain at least eight risks, including key financial risks.
16
Interest rates
31 October 2008
Average over three months ended October 2008
Average over 12 months ended October 2008
SA Reserve Bank 91 day treasury bills
11,00%
11,50%
10,75%
Average annual interest rate on SA Reserve Bank 91 day treasury bills over the past 20 years
11,20%
Yield on the most liquid and traded SA government bond in issue, redeemable in 2019
10,00%
9,80%
9,50%
Equity markets
31 October 2008
31 July
2008
31 October 2007
20 year average annual return of all shares listed on the JSE Securities Exchange
14,0%
16,1%
17,0%
Average of beta coefficients of JSE listed companies, similar in size and nature of business to SCP
1.20
1.18
6
(g)
Advise the board of directors of Super Cleaning Products (Pty) Ltd regarding the approach they should follow in the financial evaluation of which strategic alternative to pursue, namely whether to establish and operate the Chemicals Manufacturing Division or whether to continue importing and distributing chemicals. Your answer should include -
• an assessment of whether the NPV and IRR techniques would be useful for the purpose of financial evaluation; and
• any factors which may impact on the evaluation of the strategic alternatives.
12
(h)
Identify and describe the factors that the directors of Super Cleaning Products (Pty) Ltd should consider in evaluating whether to continue paying out 30% of the company's after tax profits as dividends to its shareholders.
7
(i)
Critically discuss the terms and conditions of the proposed BZN Bank Ltd loan and indicate, with reasons -
• whether or not these terms meet the funding requirements of Super Cleaning Products (Pty) Ltd, and
• to which terms and conditions of the proposed loan from BZN Bank Ltd Super Cleaning Products (Pty) Ltd should request amendments and/or which should be renegotiated.
8
Presentation marks Arrangement and layout, clarity of explanation, logical argument and language usage.