FM202 FINAL EXAMINATION SEMESTER 2 2016 MARKING GUIDE

SECTION A

Qs 1 (10 Marks)
I. Explain what is meant by business risk and financial risk. Refer to the small business financial
statements you analysed for your project in FM 202 to explain the ratios that you used to assess
business risk and financial risk.

Business risk is the equity risk arising from the nature of the firm’s operating activity (operating
margin and asset efficiency). e.g. trends in ROA, Profit Margin, Asset Turnover, Receivables
Turnover or Days, Inventory Turnover or days., payable turnover or days.

Financial risk is the equity risk that is due entirely to the firm’s chosen capital structure. As
financial leverage, or the use of debt financing, increases, so does financial risk and hence the
overall risk of the equity. e.g. trends in D/E ratio, Debt ratio, Equity ratio, Equity multiplier,
Times interest earned, cash coverage ratio. Answers may also include current ratio, quick ratio

II. Assume that when examining the 5 years common-size income statements of the business you
analysed for your project, you noticed that the cost of goods sold as a percentage of sales has been
increasing steadily. At the same time EBIT as a percentage of sales has been decreasing.

What might account for the trend in the ratios?

 As with any ratio analysis, the ratios themselves do not necessarily indicate a problem, but simply
indicate that something is different and it is up to us to determine if a problem exists.
 An increase in the cost of goods sold as a percentage of sales occurs because the cost of raw
materials or other inventory is increasing at a faster rate than the sales price. This will result in drop
in EBIT.
 This may be a bad sign since the contribution of each sales dollar to net income and cash flow is
lower.
EXAMPLE: However, when a new product, the HDTV, enters the market, the price of one unit will
often be high relative to the cost of goods sold per unit, and demand, therefore sales, initially small.
As the product market becomes more developed, price of the product generally drops, and sales
increase as more competition enters the market. In this case, the increase in cost of goods sold as a
percentage of sales is to be expected. The maker or seller expects to boost sales at a faster rate than
its cost of goods sold increases. In this case, a good practice would be to examine the common-size
income statements to see if this is an industry-wide occurrence.

What actions will you recommend to the owner-manager to improve these ratios?

If we assume that the cause is negative, the two reasons for the trend of increasing cost of goods sold
as a percentage of sales are that:

 costs are becoming too high - the owner-manager should look at possible actions to control costs. If
costs can be lowered by seeking lower cost suppliers of similar or higher quality, the cost of goods
sold as a percentage of sales should decrease.
 the sales price is not increasing fast enough - increase the sales price to cover the increase in the cost
of goods sold. Depending on the industry, this may be difficult or impossible. For example, if the
company sells most of its products under a long-term contract that has a fixed price, it may not be
 able to increase the sales price and will be forced to look for other cost-cutting possibilities.
Additionally, if the market is competitive, the company might also be unable to increase the sales
price.

Qs 2 (15 Marks)
Ben’s Trading Ltd is a successful SME dalo exporter and the company has been growing. The
company has recently been working on its capital structure so it can finance its’ business growth
sustainably. With the help of its accountants, the company has set a target capital structure of 40%
ordinary shares, 20% preference shares and the balance as debt finance. Ben’s ordinary shareholders
expect 15% return, the preference shareholders are expect 7% return and the cost of debt is estimated
at 8%. The relevant tax rate is 20%.

a. What is Ben’s Trading Ltd’s WACC under a classical tax system?

Using the equation to calculate the WACC, we find:

WACC = E/V(Re) +Ps/V(Rps) +D/V(Rd)(1 – Tc)

WACC = 0.40(0.15) +0.20(0.07) +0.40(0.08)(1 – 0.20)
WACC = 0.06 +0.014 +0.40(0.064)
WACC = 0.06 +0.014 +0.0256
WACC = 0.0996, or 9.96%

b. After Ben, the owner and managing director of Ben Trading, reviewed the proposed capital
structure, he asked his accountants why they are proposing more debt finance compared to
preference shares since the cost of debt is higher than the cost of preference shares? How will
the accountants respond to Ben’s query?

Since interest is tax deductible and dividends are not, we must look at the after-tax cost of debt,
which is:

RD = 0.08(1 – 0.20)
RD = 0.064, or 6.4%

Hence, on an after-tax basis, debt is cheaper than the preference shares.

c. What are some ways that Ben’s Trading can follow to be able to increase its capital through
ordinary and preference shareholding?

Ben’s Trading can approach a venture capitalist (VC) like the International Finance Corporation
(IFC) to buy shares in the company, either preference shares with an option to convert to
ordinary shares or buy both preference shares and ordinary shares. The VC can also assist the
company to go public and possibly list on the SPSE in future. VCs will have the expertise to do
that. This was the case for Vision Investment.

Ben’s trading with the help of its accountants and licensed investment advisors can also
approach institutional investors like Unit Trust of Fiji, Fijian Holdings Limited , BSP Life and
FNPF and do a private placement.
 Qs 3 (15 Marks)

Pluto’s Potato has come up with a new product, the Pet Potato (they are freeze-dried to last longer).
Pluto’s paid $120,000 for a marketing survey to determine the viability of the product. It is believed
that the Pet Potato will generate sales of $725,000 per a year. The fixed costs associated with this
will be $187,000 per year, and the variable costs will amount to 20% of sales. The equipment
necessary for production of the Pet Potato will cost $835,000 and will be depreciated in a straight-
line manner for the years of the product life (as with all fads, it is thought that the sales will end
quickly). This is the only initial cost for the production. Pluto has a 40% tax rate and a minimum
required return of return of 13%.

a. Based on NPV, IRR, and PI do you recommend Pluto to go ahead with the new product and why?

First, we need to calculate the cash flows. The marketing study is a sunk cost and should be ignored.
The net income each year will be:

Sales of new product $725 000

Variable costs 145 000
Fixed costs 187 000
Depreciation 208 750
EBIT $184 250
Tax 73 700
Net income $110 550

So, the OCF is:

OCF = EBIT + Depreciation – Taxes

OCF = $184 250 + 208 750 – 73 700
OCF = $319 300

The NPV is:

NPV = –$835 000 + $319 300(PVIFA13%,4)

NPV = –$835 000 + $949 748.69
NPV = $114 748.69

And the IRR is:

0 = –$835 000 + $319 300(PVIFAIRR%,4)
IRR = 19.47%

PI = $949 748.69/$835 000 = 1.1374

Recommend acceptance of the project since the project has a positive NPV, IRR is greater than the
minimum required rate of return and PI is greater than 1

b. Being a small enterprise, how can Pluto finance this project?

Obtain a 4 years loan to fund the equipment. If Pluto can get the equipment on lease, it should go
for it as long as the cost of leasing or debt is less than 13% if it has room to be able to raise
 additional debt. Pluto should also renegotiate credit terms with exiting suppliers or negotiate
terms with new suppliers if any. If Pluto cannot raise additional debt, then it has to consider using
retained earnings and/or injecting additional capital.

SECTION B

QUESTION 1 (20 Marks)

SMEs face financial challenges

The Fiji Export Council says small businesses such as dalo farming contribute to economic
growth and development. Picture: FILE

FIJI'S small and medium enterprises (SMEs) play a strategic role in the enhancement of
economic progress.

The Fiji Export Council knows that there is a need for an increased effort to improve the sector
as we approach 2016.

There are export opportunities available for SMEs and identifying an opportunity to sell one's
products to overseas markets is only the first step for lucrative traders.

Then delivering on the opportunity comes in next, which at times can be a challenge for small
businesses since the most common challenge for Fiji SMEs in any market is their access to
finance.

Successfully closing a deal in a new market can have different financial impacts for a small
business that may not have the financial capacity to be able to fulfil the requirements of the
contract.

In recent Fiji Export Council-conducted workshops in Suva and Nadi, one of the major issues
raised by SME users and the "would be" exporters was the difficulty in accessing financing to do
business.

A kava farmer from Kadavu, who was about to export for the first time, came to the council to
seek advice when he found himself in a conundrum. The "would be" exporter had successfully
secured a large order from a Chinese pharmaceutical company. In his effort to meet the required
quantity demanded, he managed to secure only 50 per cent of the kava but needed additional
capital to secure the other 50 per cent from other farmers. The farmer was unsuccessful in his
efforts in trying to secure export financing from his bank, owing to the small size of his business
and the shortage of available security backing that is essential for funding access.

This problem is of course rife and is the reality for many existing SME exporters. The situation
that the Kadavu kava farmer found himself in is common among existing SME exporters.
Limited availability of funds many times prohibit small business from carrying out new projects,
stagnating business growth, and may consequently lead to the loss of business opportunities.

Perhaps, a solution we could consider to bridge this gap is by providing a guarantee scheme
tailored specifically for SMEs, which has the objective to accelerate growth by facilitating access
to debt finance for smaller business undertakings.

This micro guarantee scheme shall provide eligible undertakings with a guarantee on loans
which may be used to finance projects leading to business enhancement, growth and
development.

There have been many lost opportunities because of lack of finances when loan applications have
been rejected by commercial banks.

Fiji Export Council CEO Jone Cavubati pointed out that available statistics showed that in the
developed countries, SMEs were the major drivers of financial development in their economies
and were recognised as the missing link to the growth of their economies. Lost opportunities had
equated loss of employment and loss of revenue.

"It is vital that we realise at this juncture that it is the SMEs that drive and enhance the economy
in any nation. We should look at countries like NZ and USA, it is the small businesses that are
the mainstay of their business strengths," said Mr Cavubati.

Even though the council encourages exports among SMEs, it also proposes an alternate route for
SMEs before venturing into trading internationally.

Supplying established exporters and gradually growing the business locally is something the
council advises its MSME members.

"For all that we do, we need to plan and initiate ways to ensure growth. This means that as an
entrepreneur, one must reassure oneself to enable one's capability and increase quantity, quality
and continue developing capacity," said Mr Cavubati.

Small businesses do not always stay small. Local companies such as Punjas or Ben's Trading
started off as small businesses that grew to become the nation's major exporters.

Many manufacturing leaders began as tinkerers. While SMEs may not generate as much revenue
as large exporters, they are a critical component of and major contributors to the strength of local
economies. Small businesses present new employment opportunities and serve as the building
blocks of Fiji's largest companies.

Source: Fiji Times online December 19, 2015

Questions
i. Is the difficulty in accessing finance unique to SME exporters? Explain your answer in
relation to finance gap and the situation illustrated in this article.
 Most SMEs, not only SME exporters, face challenges in accessing finance because SMEs
have special and different requirements from those of large enterprises and is reflected in the
limited types of finance they can access, ability to raise funds from external sources and
relationships with lending institutions.
Finance gap describes a situation where a small enterprise had grown to a stage where it had
made maximum use of short term sources of finance but had not yet reached the stage of
being able to acquire longer term finance from external sources. Finance gap remains a
controversial and unresolved issue in small enterprise financing. This is clearly demonstrated
in this article where this Kadavu kava “ farmer was unsuccessful in his efforts in trying
to secure export financing from his bank, owing to the small size of his business and
the shortage of available security backing that is essential for funding access.”

ii. Apart from getting loan from the bank, what are other main sources of finance available to
this Kadavu farmer and what are their advantages and disadvantages?

The main sources of finance available to small enterprises are: owners’ contributions,
retained profits, trade creditors, supply chain financing, short-term finance from non-bank
financial institutions and crowd funding. The advantage of contributions from owners is that
they will have no restrictions attached but the amount of them is likely to be relatively small
unless the owner-manager is very wealthy. Retained profits are the most favoured source of
funds for many enterprises because, like owners’ contributions they do not involve
negotiations with external parties. The disadvantages of retained earnings are that they restrict
the amount available to pay dividends and they may not be adequate in times of rapid growth.
Trade creditors are a flexible way of financing, particularly for growth small enterprises but
can’t always be relied on especially if suppliers come under financial pressure themselves and
require prompter payment. Short-term loans are used extensively by small enterprises and are
flexible and relatively cheap but will involve the enterprise being restricted in its activities by
the requirements of the lender and provision of information and collateral. In supply chain
financing (SCF) the finance follows the value as it moves through the supply chain.
SCF is relatively new and is different to traditional working capital financing
methods, such as factoring or offering settlement discounts, because it promotes
collaboration between buyers and sellers in the supply chain. Traditionally there was
competition as the buyer wanted to take extended credit, and the seller wanted quick
payment. SCF works very well where the buyer has a better credit rating than the
seller. Crowdfunding involves funding a venture by raising finance from a large
number of people (the crowd) and is very often achieved over the internet. Finance
provided by crowdfunding may be invested in the debt or the equity of the ventures
seeking the finance. Crowdfunding has the potential to be very beneficial to SMEs. It
allows them to contact and appeal directly to investors, who may be willing to take
the risk involved in funding the new technologies and innovations, which SMEs are
often so good at producing

iii. Why might it be difficult to distinguish between debt and equity for a small enterprise
and why are its capital structure decisions constrained?

It might be difficult to distinguish between debt and equity for a small enterprise
because of the intertwined nature of the business and its owner(s). Small enterprise
owners can ‘lend’ to their businesses in the form of directors’ loans. These appear as
 loans on the balance sheet but in fact are more like equity because they are available
indefinitely and often the right to interest payments is waived. The reason they are
used is to give the owner the option of withdrawing the funds if necessary without
winding up the business. Conversely, what appears on the balance sheet as equity
might in fact be the proceeds of borrowing by the owner-managers especially
borrowings secured on personal collateral such as a house.

QUESTION 2 (20 Marks)

The usefulness of the CAPM in small enterprises

Controlhouse Pty Ltd is an engineering systems designer and distributor of programmable logic control
(PLC) devices specializing in safety systems for manufacturing and mining clients. While the operations
of the company are diverse, it does generate about 75 per cent of total revenues from an exclusive
geographic distribution arrangement with a major international company. Founded ten years ago by
Fred Roberts the company commenced as a commissioned sales agent for that international company
but became a wholesale distributor within two years. The company now has four sales engineers
responsible for direct sales contact with a broad customer base, three sales support staff controlling the
receipt and distribution of product, three systems engineers and two administrative staff. Fred expects
the firm which is presently only reaching around one-half of the potential market within its geographic
distribution area and is planning a concerted promotion campaign and the appointment of two more
sales engineers in an attempt to expand sales. Fred and his senior sales managers regularly assess their
activities and rate themselves as superior to local competitors with respect to product quality and
service. There is little competitive advantage through pricing. The past two years’ financial
performance of Controlhouse Pty Ltd is reflected in the following table.

Controlhouse Pty Ltd Last financial year ($) Prior year ($)
Engineering contracts 456 825 408 796
Product sales 6 850 207 5 987 243
Gross profit on product sales 1 378 967 1 204 568
Profit before interest and tax 354 278 312 769

Despite an average investment in current assets (inventory and receivables) of over $1 000 000, Fred is
proud that he has no bank debt other than a $200 000 overdraft limit that is rarely fully drawn. A good
relationship with his supplier that often sees accounts payable balances in excess of $750 000 and a
commitment to forgo profit distributions (undistributed profits are presently over $350 000) have been
typical of the financing activity of Controlhouse since its establishment.

The owner of another distribution business, Northern Distributions Pty Ltd, is an adjacent geographic
region has recently approached Fred. The owner, Sue Jonston, is in ill health and keen to sell her
business and has approached Fred as a possible buyer. Fred can see obvious benefits in expanded sales
and the opportunity to extend the engineering aspects of his work, which have not been pursued by
Northern Distribution. He is concerned that Northern Distribution has poor market penetration in its
area and that it would take some effort from his own staff to improve Northern Distribution’s
performance. To enable comparison he has asked Sue for the financial information presented in the
next below.

Northern Distribution Pty Ltd Last financial year ($) Prior year ($)
Product sales 3 860 175 3 934 953
Gross profit on product sales 743 428 756 926
Profit before interest and tax 164 788 156 338

Northern Distribution has, in addition to Sue, three sales engineers and four sales support and
administrative staff.

Source: Holmes, Hutchinson, Forsaith, Gibson and McMahon, 2003, Small Enterprise Finance, pp 88-89.

Questions

1. From the limited information available assess the relative performance of Controlhouse Pty Ltd
and Northern Distribution Pty Ltd.

Controlhouse has a gross profit margin on product sales in each year of just over 20%
and an EBIT on sales (including engineering contracts) of close to 5%. By comparison,
Northern Distribution has a gross profit margin of around 19% and an EBIT just above
4%. Despite having seven staff involved in selling and administration, Northern
Distribution only generates just under $4million sales compared to Controlhouse which
has product sales of nearly $7million from only 9 selling and administration staff
(assuming the systems engineers are only involved in generating the engineering
contracts revenue). Finally, Northern Distribution sales have declined in the last twelve
months while Controlhouse has had a significant increase. Controlhouse is clearly
performing much better than Northern Distribution.

2. How do you think Fred is likely going to evaluate the purchase of Northern Distribution?

If Fred is typical of many small enterprise owner managers, like the example of Hari Punja in his
acquisition and expansion projects in the 80s and 90s, he may not even know about the net
present value perspective. While he may consider the cash flow the acquisition could generate
and the need to make a return on his investment, he is likely to be guided by simpler capital
project considerations such as payback periods and expected ROI or the accounting rate of return.
Fred will need the assistance of his accountant and business advisor, if he can afford, to conduct
to apply DCF analysis.
 3. How does the CAPM assist Fred in evaluating the purchase?

Apart from conceptualising the risk return relationship (which Fred probably implicitly
understands) the CAPM offers very little direct benefit. This is because the most useful
output from the CAPM from a capital project evaluation perspective is the identification
of the implied premium for systematic risk (beta) that can be used to determine the cost
of equity capital. Because Fred’s ownership stake in his business is not publicly traded a
beta measure is not able to be determined in the traditional manner using the CAPM.

4. What is the basis of Fred’s approach to risk-return relationships within his business?
Fred knows there are risks and that the return he is able to get from his business should
compensate him for those risks. What he, like many small enterprise owners, doesn’t know is
how much the compensation for the additional risk should be. As there is no market for
ownership stake in his business there is no workable empirical model to help solve the problem.

QUESTION THREE (20 Marks)

Know your own worth

With consolidators swallowing up firms and accounting practices having to appraise their business, an
accurate valuation can be hard to reach. It should be a science but it appears more like an art.

Valuation expert, Wayne Lonergan, author of Valuation of Business, Shares and other Equity (3rd edition)
says: `though a valuation of a business should appear relatively straightforward according to well-
written theories found in many text books, in reality a properly conducted valuation still requires a
significant element of judgement by the valuer’. Put simply, no one size fits all.

All valuations are conceptually based on the present value of future cash flows whether shares, bonds or
a business. What price do you put on the future potential earnings of the business, which in most cases
you do not have a guarantee of receiving when you take over the business?

In reality, most valuations are based on capitalised earnings which is used much more widely than
discounted cash flows. This is because there is readily available data of comparable listed companies
such as the price/earnings ratio, which is available daily from the stock exchange they are listed on, or in
the daily press.

A private company valuation is usually based on public company values which are adjusted to reflect the
fact that they are not listed and to reflect their other differences to the comparable listed company.

Very small businesses are often valued using rules of thumb. For example, one dollar of goodwill for
every annual dollar of fees. This is a surrogate for the theoretically superior methodology of present
value of future cash flows. Lonergan argues: `Using rules of thumb valuation is likely to lead in many
cases to massive valuation errors, usually significant overvaluation of the business. Such rules of thumb
are often great for sellers and terrible for buyers’.
Some vendors (of accounting practices) even quote below cost for business to maximize fees and
increase the rule of thumb valuation. So a new owner takes over having overpaid for the business, to
find that the clients leave the business either when it changes hands or when fees are raised to more
normal commercial levels.

There are a number of professional valuers for accounting practices and other businesses. Robert
Stynes, managing director Buchmaster Hawkey, which conducts valuation for accounting practices, uses
gross maintainable fees. Stynes looks at the last financial year fees and adjusts for clients that have left,
expanded or sold their business and considers what fees are likely to be maintained over the next 12
months. He says buyers usually prefer small to medium size business clients rather than individual
clients.

`Fees are capitalized between 50 cents to $1 but most are around 80 cents to $1. The last 12 months
have been tricky for vendors as there has been a big increase in workload with the new taxes and
practices have found it difficult to find good staff. The younger buyers (28-35 age group) are already in
well-paid positions and have not been looking to move out on their own and take the risk’, Stynes says.

The other method used in valuations is the price/earnings approach. Valuers also accept that this figure
can be manipulated, although not as easily as gross fees.

Dip Jadeja, a CPA and broker for accounting practices for more than eight years, says that the rule of
thumb is still used when valuing accounting practices. Practices sell around 80 cents to $1 depending on
location, with the major cities still most popular. When a firm approaches him to sell he sends out a 10
page document which asks detailed questions on turnover, assets, software, staff, partners, history, etc.

`It’s up to the buyers to do their due best to ensure that practices are not inflating their fees for sale,’
says Jadeja. He has seen growth over the last few years because the turnover in most areas has been
increasing with the extra work accountants are now doing.

Paul Bolton, regional manager of Stockford Ltd, a company that has rolled-up a number of accounting
and financial planning practices, argues that its business model is unique in Australia: `When buying a
practice, we look for a unique type of practice with synergies for their firm. We also have to factor in
the integration costs that can total as much for a firm. We also have to factor in the integration costs
that can total as much for a firm with $2 million in fees as $10 million.’

After looking at the firm’s profile, Stockford also considers the salaries the new partners wish to be paid.
If they ask for too high a salary, as they all become employees of Stockford, then there will not be much
profit or return to shareholders, and the deal will fall over. The new partners receive shares of
Stockford but they are held in escrow for a number of years. They are allowed to sell 4 per cent of their
holding every three months, after three months. Bolton says that they value different income streams
differently and in particular, value the financial planning stream highly.

While the share price holds, Stockford is unlikely to hear too many complaints about under valuations of
a practice.
THINGS TO CONSIDER

 Are you getting cash up-front?

 Do you have to wait 12 months for the full price?

 How long before you can leave the firm completely?

 Split the fees into groups according to their profitability; financial planning is considered much more
profitable than audit?

 Are you being offered script?

 When can you sell the script?

 Have you considered the risks of selling out for script and then working for the same firm?

 What say do you have in the new principles and ethics of the firm?

 If the firm collapses you may have lost your job and your lifetime investment. (This has happened to
a number of dot.com listings).

Buyers
 How long have the clients been on the books of the firm?

 Do the last three years show steady organic growth?

 Is there any redress if the clients leave within 12 months or billings are not met?

 Do you wish the partner/s or staff to stay? If so how can you effectively tie them into the business?

 Can the existing staff open up another accounting practice?

 What is the age group of the clientele? Will they be around for another 10 years?

Source: Campbell, S. 2001, ‘Know your own worth’, Australian CPA, vol.71, no.4, pp 42-43

Questions
1. According to this article what valuation methodologies are most frequently used for valuing
accounting practices? Explain how valuations are determined using those methodologies.

The article suggests that rules of thumb are still widely used in valuing accounting practices in
Australia. These are based on multiples of gross maintainable fees. The other widely used method is
the price/earnings approach, ie, capitalisation of maintainable earnings. Price/earnings ratios can be
obtained from comparable businesses, especially where they are listed companies. The ratios can
then be adjusted to apply to the circumstances of the specific practice.
2. Why do you think these valuation methodologies are so frequently used? Are they appropriate for
valuing accounting practices?

These methodologies are more widely used because the data they require is more readily available
than for other methods such as discounted cash flow. They are probably also easier to understand.
These methods may be more appropriate for accounting practices than for other businesses,
especially where the income flows are reasonably homogeneous. Nevertheless, they can still be open
to manipulation, especially the rule of thumb method.

3. Why is it important for potential buyers of accounting practices to look behind the figures presented
by vendors in financial statements? Why might the most recent financial data for the accounting
practice be unreliable when valuing the practice?

Being able to estimate maintainable fees and earnings with confidence is important as vendors have
an incentive to boost fees or earnings by artificial means to get a higher sale price. Fees are much
easier to manipulate than earnings making the rules of thumb method particularly unreliable. Some
of the measures used to manipulate fees, such as price cutting, may have less impact on earnings.
The resulting squeeze on margins would diminish profitability of the practice, thereby offsetting the
benefits of the additional business attracted.