HANDOUT NR 1:

9:00 – 12:00
Reading part (do not hand out answer books yet)

MAFM671
JUNE 2022
EXAM
TOTAL MARKS: 100 TIME: 3 HOURS

INSTRUCTIONS TO CANDIDATES

1. Enter your student number on the front of each answer book. Your name must not appear
anywhere.
2. You are reminded that answers may NOT be written in pencil.
3. The marks shown against the requirement(s) for each question should be taken as an
indication of the expected length and the required depth of the answer.
4. Answer the questions using:
• appropriate arrangement and presentation;
• clarity of explanation;
• logical arguments; and
• clear and concise language.
Marks will be awarded for the above.
5. Non-programmable calculators are allowed.
6. Prescribed technical books may be used.
7. Working papers must be handed in with scripts.
8. Answer each question in a separate book.
9. All books must be handed in separately.
10. With regard to open-book texts:
• You are allowed to highlight, underline, side-line and flag permitted texts.
• You may NOT make any notes anywhere in the prescribed texts.
• You MAY NOT supplement texts with ANY loose papers (whether or not affixed to the
permitted texts), EXCEPT for IAPN1000.

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QUESTION 1 (100 MARKS)

Background information

Ohdairyme Ltd (‘the company’ or ‘Ohdairyme’) is a dairy company listed on the JSE. The company
produces three products namely:
• Milk,
• Amasi – (a food produced from naturally fermented milk that tastes like cottage cheese), and
• Yoghurt – (a food produced by bacterial fermentation of milk, often sweetened, and flavoured.

The production process of yoghurt is different from the production process of amasi with a resulting
different texture and slightly different taste in its plain form, from that of amasi. The yoghurt produced
by Ohdairyme is unique in its taste and texture, and is clearly distinguishable from yogurt produced
by their competitors. The yoghurt requires an acquired taste, that are not enjoyed by all, but those
customers who gets to know it, always prefer it.

The company has a divisionalised operating and reporting structure. In addition to a corporate head
office, the company has two divisions, namely the Midlands and Eastern Cape divisions. Each
division operates a number of dairy farms in the area and each division has a processing plant where
the raw milk is pasteurised and processed further into yoghurt at the Midlands division and into
amasi at the Eastern Cape division (refer ‘Overview of operations’ below). The Midlands division
is situated in the Kwa-Zulu Natal Midlands and the Eastern Cape division in surroundings of Port
Elizabeth.

Overview of operations

The cattle are milked on site at the various dairy farms and the raw milk is transported to the
processing plants in the respective divisions. Any raw milk not required by the processing plants is
sold on site at the dairy farm as “unpasteurised (processed) milk”. Once at the processing plant,
the raw milk goes through a pasteurisation process that involves repeatedly heating and cooling the
milk in order to kill bacteria. During this process 2% of the raw milk is lost due to evaporation. The
remaining pasteurised milk is then split between that which is going to be bottled and sold as milk
and that which is going to be processed further into yoghurt or amasi.

After the pasteurisation process and prior to being bottled and sold as pasteurised milk, the milk is
first pumped through a homogenisation machine. Homogenisation is a process of mixing the milk
until the desired consistency is achieved. Both the Midlands and Eastern Cape divisions bottle their
milk into one litre plastic bottles. No milk is expected to be lost during the homogenisation and
bottling processes.

The processing of pasteurised milk into yoghurt and amasi follows a similar process. Pasteurised
milk is placed in large fermenting tanks and is left in the tanks to ferment until the desired
consistency is reached. Note that the pasteurised milk does not need to be homogenised prior to
or after fermenting. The fermentation of pasteurised milk into yoghurt takes twice as long as that of
amasi. Once the desired consistency has been reached for amasi it is then bottled into one litre
bottles. However, prior to bottling the yoghurt into one litre bottles, fruity flavouring is added. One
litre of pasteurised milk can produce one litre of yoghurt or one litre of amasi.

The bottled pasteurised milk, yoghurt or amasi is then distributed to the company’s customers.

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 Budgeted information

The following budgeted information for this quarter, which started on 1 November 2021, has been
prepared:

1. Market demand (litres):

Midlands Eastern Cape

Division Division
(litres) (litres)
Pasteurised milk:
Pick ’n Pay (“PnP”) contract 300 000 225 000
Other customers 484 000 363 000
Yoghurt 196 000
Amasi 98 000

With effect from 1 January 2021, Ohdairyme was awarded a contract to supply PnP with
pasteurised milk. Significant penalties are in place should the company default on its
contractual obligations.

2. Selling price per litre (R)

Midlands Eastern Cape

Division Division
(R per litre) (R per litre)
Pasteurised milk (PnP) 7,25 7,25
Pasteurised milk (Other customers) 7,50 7,75
Yoghurt 15,00
Amasi 8,85

Currently there is no surplus raw milk at the Midlands division, but should surplus raw milk
arise in the future it could be sold on site as “unpasteurised (processed) milk” and generate
a contribution of R1,50 per litre. Surplus raw milk at the Eastern Cape division is currently
sold on site as “unpasteurised (processed) milk” and generates a contribution of R2 per
litre.

3. Variable costs per litre (R)

Midlands Eastern Cape

Division Division
(R per litre) (R per litre)
Variable manufacturing overheads:
Pasteurisation process 1,50 1,45
Homogenisation 2,50 2,25
Fermenting – yoghurt 0,75
Fermenting – amasi 0,35
Flavouring – yoghurt 0,25
Bottles (same cost for all products) 0,60 0,60
Labels (same cost for all products) 0,15 0,15
Distribution and transport costs:
Raw milk to processing plants 0,10 -
Final product to customers 0,15 0,10

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4. Total fixed costs (R)

Midlands Eastern Cape

Division Division
R R
Dairy farming 600 000 400 000
Pasteurisation process 660 000 300 000
Homogenisation 585 000 275 000
Fermenting – yoghurt 240 000
Fermenting – amasi 175 000
Distribution and transport costs:
Raw milk to processing plants 140 000 80 000
Final product to customers 120 000 75 000

Fire at Midlands processing plant

On the evening of 27 October 2021, a devastating fire swept through the Midlands processing plant.
The fire destroyed all the machinery and resulted in the need for major repairs to be carried out to
the building. During an investigation by the company’s insurers, it was discovered that the sprinkler
system that had been installed in the plant to extinguish fires had not been appropriately maintained.
The company’s insurers have therefore indicated that they are rejecting the company’s insurance
claim.

The refurbishment of the Midlands division’s processing plant and installation of new equipment
will take three months and during this time no processing at the plant will be possible. The
company’s Chief Executive Officer (CEO) and the Chief Financial Officer (CFO) have gathered the
following information:

• The estimated cost of the refurbishment of the processing plant and new equipment will be
R25 million;

• The dairy farms and milking of the cattle have not been affected by the fire and therefore the
same quantity of unpasteurised milk is expected;

• Given the high penalties that would be incurred if the Midlands division breached their PnP
obligations, the following sources of obtaining the required milk for the Midlands division’s PnP
contract have been identified while the Midlands division’s processing plant is being
refurbished:

➢ The company could purchase one litre bottles of pasteurised and homogenised milk from
Clover (another large and reputable dairy company) for R7,50 per one litre bottle of milk.
Ohdairyme would provide Clover with their labels to ensure that the company’s branding
and not Clover’s would appear on the labels. Clover would deliver the milk to Midlands
at no extra cost;

➢ Another dairy company, KZN Dairy, have indicated that they have spare capacity to
pasteurise, homogenise and bottle raw milk supplied by the Midlands division. They
would charge R5,88 per one litre bottle of milk. The variable cost of transporting the raw
milk to KZN Dairy would be the same as the variable cost of transporting raw milk to the
processing plant. The Midlands division would provide KZN Dairy with their labels to
ensure that the company’s branding and not KZN Dairy’s would appear on the labels.
The R5,88 cost would include the cost of delivering the bottled milk to Midlands;

• The Eastern Cape’s processing plant could be adapted to process yoghurt while the Midlands

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 division’s processing plant is being refurbished. This would cost a total of R150 000
regardless of the number of litres processed. The Eastern Cape division has sufficient spare
capacity to pasteurise and homogenise the additional raw milk required to produce the
yoghurt needed to meet the Midlands division’s yoghurt demand. However, the Eastern Cape
division currently only has the capacity to milk a total of 750 000 litres of raw milk and there
is a maximum of of 465 500 fermenting hours available in the next quarter. One fermenting
hour is required to produce one litre of amasi, whereas two hours will be required to ferment
one litre of yoghurt. The variable fermenting cost of amasi is based on the required one hour
of fermenting per litre of amasi produced.

• It would not be viable to transport raw milk from the Midlands dairy farms to the Eastern Cape
processing plant. However, yoghurt could be transferred from the Eastern Cape division to
the Midlands division at a variable cost of R5 per litre.

To assist in the decision to decide between whether the pasteurised milk required by the Midlands
division for the PnP contract, while the Midlands division’s processing plant is being refurbished,
should be purchased from Clover or whether KZN Dairy should be contracted to pasteurise,
homogenise and bottle the Midlands division’s raw milk on their behalf, the assistant accountant
of the Midland division prepared the following financial analysis with accompanying notes:

Source of milk for PnP contract:

Note Clover KZN Dairy

R/bottle R/bottle
Purchase price of milk 1 7.50 -
Dairy farming 2 - 0.60
Fee for pasteurisation, homogenisation and bottling 3 - 6.00
Bottles and labels 4 0.75 0.75
Distribution and transport costs:
Cost of transporting raw milk to processing plants 5 - 0.24
Cost of transporting final product to customer 6 0.45 0.17
Cost per bottle 8.70 7.76

Notes:
1. This is the purchase price of the milk from Clover.

2. This is the fixed cost of the running of the dairy farm of R600 000 divided by the total quantity
of milk produced on the farms of 1 000 000 litres, being the total quantity of bottles produced
of 980 000, adjusted for the normal loss of 2% (980 000/98%).

3. Fee paid to KZN Dairy for pasteurisation, homogenisation and bottling adjusted for the normal
loss of 2% (R5.88/0.98).

4. Total cost of the bottle and label per bottle.

5. Variable cost of transporting the raw milk to the processing plant plus the fixed cost of this
transport, divided by the total quantity of raw milk produced.

6. Variable cost of transporting the final product to the customer; plus the fixed cost of this
transport, divided by the quantity of milk bought from Clover (R120 000/300 000) for the
Clover contract and the total quantity of milk produced for the KZN Dairy contract
(R120 000/(300 000 + 484 000 + 196 000).

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 Revision of pricing on all products

Demand for Ohdairyme’s products have been fluctuating lately and the directors are questioning
their pricing policies. It has always been Ohdairyme policy to see what competitors charge for
similar products and then charge slightly less since they are not that well known compared to their
bigger competitors in the market.

Possible acquisition

As a result of the economic downturn and in an attempt to diversify their risk the Board of directors
is considering a merger with Freightpro Limited (‘Freightpro’). Freightpro has provided logistic
support for Ohdairyme in the past. Freightpro has indicated that they are keen to start negotiations
for a possible merger.

Background information on Freightpro

Freightpro is a South African logistics company which focusses mainly on long distance movement,
storage and flow of goods for their customers. The company was founded in 1984 with a single truck
and trailer, and has subsequently grown to a fleet of 52 truck and trailer combinations. The company
transports goods between the major cities within South Africa for local and foreign customers. The
company focusses on the safe storage and delivery of their clients goods, and has a strong
emphasis on safety and security as part of their strategy. The company has performed well
historically and is viewed as one of the strongest competitors in the market. They have however in
the last few years battled from a financial perspective due the impact of COVID on their business,
and more recently were impacted by protests which impacted the trucking industry locally.

From a COVID perspective, the company has been impacted by the pandemic through the
disruptions to manufacturing industry (their clients), and the inability to ship goods due to closed
borders. Cargo was blocked at container ports, and travel restrictions led to a shortage of truck drivers
to pick up containers. This resulted in a global slowdown in production which impacted the need for
logistics services. Although manufacturing activities of their clients picked back up, a return to full
production capacity is unlikely in the short term because of the spread of the pandemic. On a global
basis, long haul trucking dropped to only 15% of previous volumes. In the recovery, this recovered to
50% of volume after a few months, and most recently was still only at 92% of previous volumes.

The company responded by closing down certain non-profitable routes. Retrenchments were
implemented in respect of a portion of the labour force, specifically truck drivers on closed routes.

Valuation of Freightpro

With regards to the possible merger with Ohdairyme, the newly appointed financial manager of
Freightpro was asked to prepare a fair market value valuation at the end of 2021 financial year
(FY2021) that could be used for the initial negotiations for the merger. The following information was
provided:

Statement of financial position

Notes 2021 2020
R’000 R’000
Total assets (net of working capital) 135 860 138 552
Equity 1 (57 906) (56 318)
Total liabilities (77 954) (82 234)
Net working capital
Current assets 10 120 9 854
Current liabilities (6 585) (8 986)

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 Statement of comprehensive income
Notes 2021 2020
R’000 R’000
Revenue 78 520 67 283
Operating expenses 2 (72 560) (54 915)
Other income 3 22 530 16 321
Impairment 4 (13 130) (15 558)
Depreciation (9 470) (11 250)
Finance costs (3 190) (3 375)
Legal costs 5 (400) –
Profit / (loss) before tax 6 2 300 (1 494)
Taxation expense (712) –
Total profit / (loss) 1 588 (1 494)

Notes:

1. Authorised share capital consists of 100 000 shares, of which 90 000 shares were in issue
throughout all three years for which the information was provided. The shares are currently
trading at a price of R450 per share. The closest competitor of the company which is smaller,
and have older trucks which require replacement shortly, have an asset Beta (unlevered) of
1.5. The market return on the JSE is currently 15%. The average pre-tax cost of existing debt
on the Statement of Financial Position is 12%. Freightpro has a target debt ratio of 40%. The
current yield on government bonds are as follows:

Residual maturity Yield

3 months 5.45%
2 years 5.46%
5 years 8.08%
10 years 9.59%

2. Included in operating expenses for FY2021 are truck driver salaries of R30 million, and
retrenchment costs for employees who were terminated which occurred in the 2021 year of
R4 million. The company had to discontinue some commercial routes due to the economic
slowdown from the COVID pandemic.

During FY2021 there were truck strikes in KwaZulu Natal where trucks were targeted by
looters, goods were stolen, and trucks were burned. Included in the FY2021 operating expenses
is an amount of R5 million for additional repairs to the trucks that were damaged in the riot
activity.

3. An insurance pay-out of R4 million for the damaged trucks is included in other income for
FY2021. The amount was less than the cost to repair the trucks, due to the insurance excess
Freightpro had to pay in terms of the insurance contract.

The company also sold a property in the FY2021 year following the COVID pandemic where
many staff were forced to work from home and the company decided to continue this
arrangement. Due to the poor state of the property market the company realized a loss of
R2 million on the sale. The book value of the property when it was sold was R8 million, the
property had been impaired in the FY2020 year by R3 million already. The company
anticipates selling another office building in KwaZulu Natal in the FY2022 year and anticipates
that they will make a profit of R5 million on the sale. The current book value of the building is
R10 million. The tax value of the building is R11 million, and 2 million of the gain is considered
to be a capital gain for capital gains tax purposes.

The remaining other income for FY2021 relates to the following:

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 Name Description Amount
R’000
Dividends received from The company has an investment in an 1 200
associate associate which is a fuel station which has a
market value of R15.2 million.
Earnings from associate Share in earnings from investment in 1 800
associate as above.
Interest received Interest received on government bonds and 15 530
operating cash. 80% of interest received is
on the government bonds with a market
value of R5 million.

4. The impairment losses relate to write-downs on the ageing truck fleet, the devaluation of the
properties and goodwill from prior acquisitions.

5. Legal costs relate to payments to the legal team made in the defence of a Commission for
Conciliation, Mediation and Arbitration (CCMA) claim by the retrenched drivers. The drivers
claimed that the losses in market share were not permanent, and that they were unfairly
dismissed. The legal team believe that there is a 50% possibility that the claim would be
successful, and that the firm would be ordered to pay damages of approximately R20 million.

6. The losses that were incurred on the routes that were discontinued amounted to R2 million
during FY2021. The company anticipates that the economic recovery will initially be slow, with
no anticipated growth in the 2022 year. They then anticipate that growth in their cash flows
will be at 2% for the following two years, after which it is expected to stabilise at 4% going
forward.

7. The company is considering moving to hybrid trucks which have a combination of diesel and
electric motors. The capital cost of these will be approximately 50% more than purchasing
normal diesel only trucks, but the running costs should be less with less fuel being used. This
is not part of the merger, and is rather a planned development which is inevitable with the
changing world, and the focus on sustainability globally.

The financial director obtained the following EBITDA multiples for the transportation industry:

Name Description Multiple

Bull Trucks Plc • Bull Trucks Plc is a British trucking company. 4
• It has a fleet size similar to that of Freightpro.
• It primarily operates in England.
Iloli Ltd • Iloli Ltd is a freight transport company operating a 5
modern fleet of trucks in all major cities in South Africa.
• The company also owns a fleet of busses focussing on
the long distance passenger market.
• The company has no debt.
Inqwelomoya Airways • Inqwelomoya Airways Ltd is a low-cost freight airline 7
Ltd that flies on the same routes that Freightpro travel.
• It has similar levels of financial gearing.
RailwaysSA Ltd • RailwaysSA Ltd offers its freight services from 6
Johannesburg to Cape Town.
• The company has net cash on its balance sheet.

Using the above information provided by the financial director, the financial manager prepared the
following preliminary valuation, which is arithmetically correct.

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Discounted free cash flow to firm valuation:

Valuation

2022 2023 2024

R’000 R’000 R’000
Revenue 78 520 78 520 78 520
Operating expenses (72 560) (72 560) (72 560)
Other income 22 530 22 530 22 530
Impairment (13 130) (13 130) (13 130)
Depreciation (removed non-cash)
Finance costs (removed)
Legal costs (400) (400) (400)
14 960 14 960 14 960
Taxation expense (712) (712) (712)
Net cash flow 14 248 14 248 14 248
Terminal value (14 248 / 15%) 94 987
Total cash flow 14 248 14 248 109 235

Discounted cash flow R'000

NPV discounted at cost of equity 15% 94 986
Adjustments
Impairment 13 130
Total adjusted profit after tax 108 116

Control premium 10 000

Benefit of moving to hybrid trucks 25 000

Total equity value 143 116

After revising the valuations performed by the financial manager of Freightpro, the CEO of
Ohdairyme sent the following e-mail to the financial director:

From: <[email protected]>
Sent: Tuesday, 3 January 2022 14:07
To: Financial Director <[email protected] >
Subject: Valuation

Good afternoon Mr C
I have performed a brief review of the valuations that we received, and I prefer the EBITDA
valuation method as it is based on market factors. The cash flow seems a bit like it’s all made
up. So would rather use the EBITDA if we are going to consider any kind of merger. But let me
know if my thinking is flawed…

Regards
CEO

MAFM671 JUNE EXAM 2022 9/10

Hamada formula:

***END OF PAPER***

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