QUESTION 2: IRON BUTTERFLY BREWERIES (PTY) LTD PART II FINANCIAL MANAGEMENT

SUGGESTED SOLUTION

Candidate Overall mark

Part (a) Prepare a pro forma cash flow statement for FY2014 for IBB Marks
Estimated cash flows for 2014 2014
After tax earnings 1 844 000 ½
Add back: Depreciation 2 320 000 ½
Changes in working capital (631 163) ½
Increase in inventories (468 221) ½
Increase in trade receivables (482 942) ½
Increase in accounts payable 320 000 ½
Investment in land (1 200 000) 1
Financing cash flows (1 800 000) ½
Reduction in long-term loans (1 000 000) ½
Increase in short-term loans 200 000 ½
Reduction in bank overdraft (1 000 000) ½
Net change in cash and cash equivalents 532 837 1C
Opening balance 850 000 ½
Closing cash and cash equivalents 1 382 837 ½C
Available 8
Maximum 6
Total for part (a) 6

Part (b) Analyse, compare and comment on the FY2014 forecast production
performance of the Lanseria and Stellenbosch breweries. Perform relevant Marks
calculations and calculate relevant ratios
Forecast production cost per litre- adjusted on Lanseria Stellen- Diff Diff Allow for
rounding
a like-for-like basis (saleable litres produced): bosch
R cost per l R cost per l R %
COST VARIABLE TO SALES VOLUMES
Customs and excise (bonus marks) 4,33 4,50 0,17 3,9% ½
Total 4 485 880 913 500
Units sold 1 036 000l 203 000l ½
* Assuming all production will be saleable at forecast prices

Standardise the reject % to compare like-to-like 2% 2%

Saleable litres at std 2% reject rate 1 058 400l 211 680l Or discussed 1
COST OF QUALITY DIFFERENTIAL – 0,16 0,16 N/A 1
Total cost as reported 11 344 613 2 542 667
Less: Customs and excise (4 485 880) (913 500) Or discussed 1
Real Production costs 6 858 733 1 629 167
Existing allocation 6,48 7,86
Revised allocation 6,48 7,70 1
PRODUCTION COST AT NORMALISED VOLUMES 6,48 7,70
Purchases 0,78 0,77 (0,01) (1,3%) 1
Electricity and gas heating 1,33 1,78 0,45 57,7% 1
Depreciation 1,35 1,45 0,10 7,4% 1
Water 0,16 0,15 (0,01) (6,3%) 1
Salaries and wages 1,57 2,01 0,44 28,0% 1
Plant maintenance 0,39 0,38 (0,01) (2,6%) 1
Barrel maintenance and replacement 0,90 1,16 0,26 28,9% 1
Total production cost per litre 10,81 12,36 1,55 14,3%
Alternative: Any calculation based on production cost(s) / revenue 2C

1
QUESTION 2: IRON BUTTERFLY BREWERIES (PTY) LTD PART II FINANCIAL MANAGEMENT
SUGGESTED SOLUTION

Customs and excise – cost variable to sales (bonus as not directly related to production Marks
performance)
• Stellenbosch sells at R22,50 per litre while Lanseria sells at R21,65 per litre and Customs ½
and Excise is levied at constant 20% of sales, hence the cost per litre relating to the
customs and excise expense will be somewhat higher for Stellenbosch.
The need to normalise production volumes – cost of quality differential
The analysis must deal only with saleable production and not gross production, because 1
the reject volume costs are implicitly cost into saleable volumes
The Lanseria brewery is at a 2% reject rate and the Stellenbosch brewery at 4%. These 1
need to be normalised (preferably to 2%) in order to compare ‘apples with apples’ for the
production cost analysis.
Due to the higher reject percentage, Stellenbosch incurred higher production cost of 16 1
cents per litre.
Since the Lanseria plant is newer, quality efficiencies are to be expected. 1
Production cost at normalised volumes
The cost differences that arise on a normalised cost per litre basis are as follows:
Purchase costs: Almost no difference 1C
• Regardless, Stellenbosch may have performed relatively better here as cost is 2C
comparable in spite of lower volumes / greater distance to producers of raw
ingredients (e.g. barley and hops)
Electricity and gas heating: Significantly more expensive at Stellenbosch 1C
• This is probably due to the fact that Lanceria is a newer brewery, with better technology / 2C
different supplier or municipal cost structures / different mix used
Depreciation: Somewhat higher at Stellenbosch 1C
• The plant acquisition and installation capital costs may have dropped over time / bigger 1C
plant at Lanseria offers economies of scale on capital cost / building cost may be
higher in Stellenbosch
Water costs: Almost no difference in cost 1C
• This indicates that there are no economies of scale in the water consumption in the 1C
newer brewery. This is to be expected
Salaries and wages: Much higher at Stellenbosch 1C
• The newer Lanseria plant may be more automated / Lanceria could have greater 2C
economies of scale / Stellenbosch could have higher salary and wage levels /
Stellenbosch’s older plant could require greater level of skilled labour
Plant maintenance: Almost no difference 1C
• This seems exceptional given this is an older plant (and given the Cape Town 1C
experience). One would in fact expect higher maintenance at Stellenbosch
Barrel maintenance and replacement: Much higher cost at Stellenbosch 1C
• As these are older barrels (from the older plant operation), this is to be expected 1C
Any other valid comment: E.g. all significant / unexpected differences should be investigated 1C
Available 31
Maximum 24
Communication skills – logical argument 1
Total for part (b) 25

2
QUESTION 2: IRON BUTTERFLY BREWERIES (PTY) LTD PART II FINANCIAL MANAGEMENT
SUGGESTED SOLUTION

Part (c) Critically discuss the governance and control issues that have arisen with Marks
regard to the Grahamstown brewery project
The board should provide control and oversight
• In fact it appears as if the board is but a ‘rubber stamp’ for the actions of management / 1
the board does not exercise control or oversight / there seem to be no respect for the
authority of the board / the board exercises poor corporate governance in this regard
• Project management team cannot just deviate from an approved capital project in 1
terms of amounts or suppliers and place an order without authority
• There seem to be a lack of controls / controls are easily circumvented 1
Land acquisition
• The question is that if there was a purchase and sale agreement (contract for 1
R900 000), why was this not enforced?
• Should action be taken against the local attorneys as they clearly did not act in the best 1
interests of IBB?
• Grahamstown is currently facing a water crisis of some magnitude – has this been 1
factored into the brewery design, e.g. by providing for extra storage tanks?
• The funding vehicle was changed despite board approval, thereby circumventing board
control and increasing risk (IBB is now involving itself with ‘private’ funders and 1
Ms Tuesday seems to be anything but a stickler of the rules and agreements. 1
• The FD acted beyond his authority. Consider disciplinary action / investigation into 1
higher amount and funding vehicle
Land and buildings
• Forecast costs are R350 000 higher than the approved budget and only R300 000 has 1
been dealt with in the Board pack. The question that also arises is what is the remaining
R50 000 overrun?
• Work has commenced on site despite the fact that the environmental impact assessment 1
(EIA) was not in place.
• This is breach of prevailing law and could result in penalties / reputational risk 1
• If an EIA is not granted, remedial work might be required 1
• This breaches the following IBB values:
o Ethics – ‘We aspire to the highest levels of honesty and integrity’. There is no 1
integrity in ignoring the law
o Respect – ‘We treat everyone we with deal with in the manner in which we would 1
like to be treated’ It is disrespectful towards authorities to simply go ahead with a
project despite the lack of approval
o Sustainability – ‘We focus on long-term business sustainability even if it means 1
foregoing short-term profit’ Clearly this is a shortcut to optimise short-term
profitability
Equipment
• It introduces risks associated with a new supplier: 1
Unproven service history / parts availability / support 1
• It introduces risks related to different equipment: 1
Non-standardised process / different maintenance / parts not interchangeable / cannot 1
leverage existing expertise / may affect quality / may affect reject percentage / extra
teething problems
Adding two unapproved supplier options to the plant order
• The possibility of using an alternative source of energy should have been part of the initial 1
project. Electricity challenges are not new in SA! The question that therefore arises is
how well was the initial project planned?
• Committing to an additional €23 500 increases foreign currency risks 1
Available 22
Maximum 14
Communication skills – logical argument 1
Total for part (c) 15

3
QUESTION 2: IRON BUTTERFLY BREWERIES (PTY) LTD PART II FINANCIAL MANAGEMENT
SUGGESTED SOLUTION

Part (d) Identify the key risks of entering into the African Rain contract and suggest
ways in which each risk could be mitigated
Risk Marks Mitigating factor Marks
Only if
risk
identified
Restriction on competition – African Rain 1 Offshore market, therefore SA competition 1
will not stock any other beer legislation not applicable, but consider if
ethical / Check Botswana legislation
Concentration risk – as IBB is forced 1 Consider alternative pathways to expansion 1
supply to a single customer in Botswana into Africa / renegotiate the terms
Fixed price contract for 18 months 1 Find ways of also fixing cost structures to 1
protect margins:
• The subcontractor brewery contract 1
should be at a fixed price
• Try to enter into 18-month contracts with 1
regard to wages and salaries at the
Lanseria brewery
• Customs and excise duties may be 1
subject to an exemption as this is export
product
• Enter into medium-term contracts with 1
suppliers to fix purchase costs for the
duration of the contract
US$ denominated selling price leads to 1 Apply foreign exchange hedging techniques, 1
exchange rate risk e.g. Currency futures, currency forwards,
currency swaps, currency options, FEC
Reducing brewing time at Lanseria 1 This should not be done 1
negatively impacts on product quality and
therefore on the whole Gauteng market A greater volume of production should rather 1
be outsourced or capacity at Lanseria
This could have a reputational / brand risk 1 increased
Use of Iconic Breweries as a subcontractor 1 Undertake due diligence to ensure Iconic can 1
to brew beer creates risks of volume and deliver what is needed
product quality compliance / stolen IP A detailed contract should be entered into 1
with Iconic that defines time frames, quality
There is a pricing risk as Iconic is likely to 1 indicators, penalties, confidentiality (NDA), etc
increase price if at 30 days brewing instead The supply chain and quality managers from 1
of 25 days / or possibly no confirmed IBB should be put on site at Iconic to manage
outsourced partner if at 30 days and oversee the process / regular quality
checks by IBB / consider using more than
one outsourced partner
Credit risk, as exposure will be at least 1 Credit guarantee insurance, letters of credit 1
US$70 000 at any time or bank guarantees from African Rain
Exposure could be higher depending on 1
orders / if 30 days met
Counter party risk: IBB commits to 1 A performance guarantee should be 1
contracts with the subcontractor and African obtained based on the extent of exposure and
Rain folds before contract has run its course margin from African Rain
Possible insufficient capacity to meet 1 Surplus capacity should be found either 1
contract volumes (which have a sub- through capex at Lanseria or from a third
minimum value). This could result in party
volumes destined for the local market being The contract with African Rain should 1
reduced, further opening the local market carefully mitigate risks, in terms of
to competitors volumes, etc
IBB management could lose focus 1 Appoint a specific project manager to 1
handle all aspects of the contract
Insufficient project returns: Is the return 1 Perform a proper project performance 1
sufficient to compensate for the risks? evaluation. (Still, projected 14% PBT margin
exceeds existing margins.)
Government interference (SA or 1 Ensure both parties (African Rain and IBB) 1
Botswana) / changes in legislation or taxes are fully compliant with legislation
Available 34
Maximum 23
Communication skills – layout and structure 1
Appropriate style 1
Total for part (d) 25

4
QUESTION 2: IRON BUTTERFLY BREWERIES (PTY) LTD PART II FINANCIAL MANAGEMENT
SUGGESTED SOLUTION

Part (e) Critically discuss the proposed Cape Town marketing promotions and
conclude whether or not you believe IBB should follow the suggestions of Marks
its consultants
Drinking game
• A similar game (Neknomination) swept social media earlier in the year but drew severe 1
criticism due to the inherent risks and the claiming of lives.
IBB could well suffer reputational risk from being associated with the game 1
• If someone was badly hurt (or worse) from playing the game, IBB could face civil liability 1
claims
• This game will contradict IBB’s vision, which encourages responsible drinking 1
• A social media approach may reach the target audience (a positive) 1
• The game itself is likely to increase sales and profits in the short term (a positive) 1
• However, the game could have a very short lifecycle, leading to a short term ‘spike’ in
demand which should not inform capacity levels (these should be based on longer term 1
levels)
• This is unlikely to be restricted to Cape Town and may lead to widespread product
shortages which may interfere with other stable markets 1
• This contradicts the ‘sustainability’ value of IBB, which states; ‘We focus on long-term 1
business sustainability even if it means foregoing short-term profit.’
• Conclusion: Do not support this initiative 1
Zero prices increases for the 2015 year
• Not increasing prices in effect comes down to price cutting in real terms 1
• Price cutting is always a dangerous strategy 1
• The key assumptions in the strategy are as follows:
• That production will return to 95 % of planned levels in quarter 4 of 2014 and then
increase to 100% in 2015. If the higher levels cannot be met there would also not be
a need to stimulate extra demand. 1
• The drop in market demand arose from production issues which led to a problem
with product availability. It is assumed that lower demand will continue in quarter 1
4 after production has stabilised and therefore the product is readily available.
If demand increases in quarter 4, there may be no need to hold back on price 1
increases in 2015
• That the Rhino Red product offerings’ share gains come primarily from the 10% 1
price differential:
If Rhino Red’s value proposition is based on other qualities than price, then this 1
strategy would prove ineffective
• Retailers will pass on the benefit to students: There is no way of ensuring this 1
does actually happen
• Rhino Red will increase their prices, thus reducing the current 10% disparity: 1
Again, there is no way the response from Red Rhino can be predicted.
In fact, Red Rhino may be willing to get into a price war 1
•Once the market share has been regained, IBB can increase their prices at rates 1
that will allow it to ‘claw back’ its market position.
This depends on the price sensitivity of the buying population 1
• That IBB can afford not to increase prices in 2015 in this market: If the brewery
performs as it did in 2014, then margins will be under further pressure. 1
A proper financial evaluation might be required 1
• Conclusion – I would not support the 2015 zero price strategy until the quarter 4 actual 1
demand and production figures are better understood
Available 25
Maximum 14
Communication skills – logical argument 1
clarity of expression 1
Total for part (e) 16

5
QUESTION 2: IRON BUTTERFLY BREWERIES (PTY) LTD PART II FINANCIAL MANAGEMENT
SUGGESTED SOLUTION

Part (f) Discuss the key considerations that the board needs to evaluate in deciding
Marks
whether to recommend that the dividend of R2 million be declared and paid
The following Companies Act requirements have to be met since a dividend is a
‘distribution’: 1 per bullet-point, max: 2
• The dividend should be authorised by the board
• Should satisfy a general solvency test (the assets of the company (as fairly valued)
exceed the liabilities (as fairly valued))
• Should satisfy a liquidity test (company shall be able to meet its debts as they become
due in the ordinary course of business in the 12 months following the payment of the
dividend.
General considerations by the board / approach 1 per bullet-point, max: 3
• Review the 2015 budgets / forecast and assumptions: are these prepared on a realistic,
optimistic or conservative basis?
• Perform a ’stress test’ / sensitivity analysis
• Will the dividend comply with dividend policy / consider the signalling effect / would it
be sustainable?
• Will the dividend meet expectations of shareholders other than Nettling Fam Trust
• Will the dividend place constraints on future growth?
• Interpret relevant ratios: Dividend cover (would be a very low 0,9 times) / gearing before
and after
• Consider the tax implications of the dividend distribution
• Will the dividend help IBB to move closer to its target capital structure (as an
alternative, debt could be repaid)
Solvency: Matters to be considered 1 per bullet-point, max: 5
• Forecast 2014 year-end equity is at R18 591 500
• Cape Town just had to spend R470 000 on refurbishing the brewery, which was not
capitalised as it appears the net book value of the plant was overstated. How does the
fair value of the breweries compare to net book value?
• Receivables are forecast to increase by R482 942 – is this the start of a trend?
• Has appropriate provision been made for obsolescence losses in inventories? This
should have been done, given limited shelf life of product
• Is accounts payable complete or are there unrecorded liabilities that should been
taken in to account?
• Long-term loans could be revalued on a DCF basis and to the extent there is a gain or
impairment this could be brought to account
• Land and buildings could be re-valued if needed
• All things considered is unlikely that general solvency would not be met
Liquidity: Matters to be considered 1 per bullet-point, max: 5
• The forecast yearend statement of financial position reflects cash and cash equivalents
to be R1 382 837. Based on the forecast the dividend would require further borrowings
• In 2014 from the cashflow analysis above, R4 164 000 of operating cashflow is to be
generated before working capital and other investments
• Net of working capital, this reduces to R3 532 837 which implies a R2 million dividend
could be paid out of cashflow before investments and funding
• The short-term portion of the long-term loans, amounting to R2 200 000 must be paid
in the forthcoming year
• In addition R470 000 refurbishment expenditure, which should not recur in 2015, is
included in the cash flow for 2014
• Forecast assumes an improved performance by the Cape Town brewery in quarter 4.
How likely will this to be achieved?
• The company is to pay income tax from 2015 and this will reduce cashflows
• The Cape Town market is under pressure with market share losses to Red Rhino. Can
this be changed and if not, what would the financial consequences be?
• Is there any chance that the production issues at Cape Town are based on poor
maintenance in the past and, if so, could this negatively impact on the Stellenbosch
brewery’s performance in the coming year?

6
QUESTION 2: IRON BUTTERFLY BREWERIES (PTY) LTD PART II FINANCIAL MANAGEMENT
SUGGESTED SOLUTION

The new Grahamstown brewery 1 per bullet-point, max: 2

• Are the cost estimates reliable?
• What would be the worst potential financial impact of ‘late’ opening?
• It is not clear how the costs of the brewery are to be funded.
• If a line of long- term credit is not available, then additional cash outflow of –
o buildings = R1 650 000 cash outflow, and
o plant (at an estimated R:€ rate of say 14,50) ~ R3 545 250 cash outflow
Risk indicators 1 per bullet-point, max: 3
• Interest rates are expected to increase. What would be the worst case scenario if this
should happen?
• The overdraft was reduced during 2014, which seems to indicate that BXN Bank has
some concerns and also reduces liquidity flexibility
• The overdraft rate is set at a high prime plus 3%. This indicates that BXN Bank
perceives IBB to be at a high risk level
• Is there a chance there could be further pressure from the bank to reduce the bank
overdraft again and, if so, what is the worst that could happen?
• Does IBB have the capacity to raise further borrowings in 2015 should it be
necessary?
Available 20
Maximum 13
Total for part (f) 13