All Cases For Business Analysis and Valuation Using Financial Statements, 3rd Edition Krishna G. Pal

Business Analysis and Valuation: Using Financial Statements – Asia Pacific Edition, 3e

Solutions: Part 4 Further case studies Case 1 Qantas Student responses will vary. Accordingly, certain answers provide guiding principles and/or a sample of potential responses.

Solution.

PART A 1. Analyse the competitive forces facing Qantas, using the ‘five forces’ framework from the strategy literature. Evaluate Qantas’ prospects for profitability and growth in the next five years.

Threat of new entrants • Hard for new entrants due to airline industry being capital intensive (i.e., excessive costs to enter industry).

• New entrants may bring in more innovation to add new value propositions.

• Qantas needs to continually invest in innovation to tackle this threat. For example, new lounges and modern technology.

• Aviation regulations may impact new entrants ability to successfully enter the industry.

Threat of substitutes • Exceptionally low given planes are the fastest way to travel long distances • Pricing of airlines is comparable to that of alternatives (e.g., coach or train) • Airlines offer add-ons such as meals and Wi-Fi which appeal to customers when deciding how to travel Bargaining power of customers • High given service offerings differ between low-cost airlines and premium offerings.

• Price cuts and discounts are common in this industry • Qantas relies on customer loyalty and its brand to improve its competitive positioning.

Bargaining power of suppliers • Low in the airline industry as there are various suppliers from which to procure raw materials.

• Suppliers in a dominant market position with a quality product may be able to dictate prices, which may impact Qantas’ margins.

Competitive rivalry • Qantas rivals include: o Domestic: Virgin Australia o International: Singapore Airlines, Emirates, Etihad, Qatar • Price wars are common in this industry as consumers seek lower cost alternatives • Qantas introduced Jetstar as its low-cost carrier to serve the Asian tourist market.

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Domestically, Qantas relies on its strong brand to maintain its competitive advantage. For example, it sponsors various Australian sporting teams, positioning itself as the ‘Australian’ airline.

Prospects for profitability and growth Qantas needs to revise its cost structure to maintain profitability. It should invest in its low-cost carrier (Jetstar) for future growth as consumers have become more price sensitive following the COVID pandemic and rising levels of inflation.

2. Identify the limitations of this analysis. What other factors do and could affect Qantas’ competitive environment?

Potential limitations include the scope of the industry and selecting a competitor. The analysis could be conducted individually on Qantas’ domestic or international operations, which would then change the way one looks at the five forces framework. Further to this, it is difficult to find a competitor comparable to Qantas, as there is no other Australian airline operating on the scale of Qantas.

3. Discuss Qantas’ competitive strategy since 2000. Is it successful, and is it sustainable?

Qantas has pursued an integrated cost leadership/differentiation strategy since 2000. Whilst most firms struggle to do this, Qantas has focused on diversifying its products (e.g., business class, economy class as well as focussing on its brand/reputation) whilst also being able to offer customers products at low costs (e.g., Jetstar). Qantas has faced increased competition domestically (Virgin) and internationally (from various airlines). This is placing downward pressure on margins which can constrain future growth.

4. What is Qantas’ competitive advantage, if any? Apply a SWOT evaluation to it.

Qantas’ competitive advantage is its strong brand reputation Strengths • Strong international and domestic presence.

• Largest airline operating in Australia.

Weaknesses • Limited international routes compared to other airlines (such as Emirates).

• Susceptible to negative media attention (e.g., 2011 union disputes and recent delays post COVID).

Opportunities • Growth into more overseas markets.

• Further airline alliances.

Threats • Rising costs (fuel, labour).

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Increased competition within domestic market.

5. What has been Qantas’ corporate strategy across its domestic and international divisions since 2000? How has that strategy changed in response to market changes?

Have any changes been initiated by Qantas?

• • •

In response to competition domestically from Virgin, Qantas introduced Jetstar Airways in 2003 to target the low-cost market.

Introducing Jetstar has reduced the dependency on the Qantas brand alone to generate profit. Further to this, it resulted in Qantas targeting price sensitive customers, whereas it traditionally pursued customers who were not sensitive to price.

Internationally, Qantas’ market share has declined since 2000. As a result, it has introduced changes, such as moving its Asian hub to Singapore and introducing a non-stop PerthLondon route.

6. Prepare an executive summary of recommendations to the Qantas executive, based on your analysis. Identify three key changes to its structure and/or operations.

An example of key changes is summarised below: •

•

•

Qantas needs to revise its staff costs. For example, Virgin flight and cabin crew earn up to 35% less than their Qantas counterparts, and airport check-in staff pay rates can be up to 18% less. Whilst this may be an incentive for staff to join Qantas, it enables Virgin to earn higher margins in the domestic market. A solution to this may be to employ casual labour during peak periods which will reduce ongoing staff costs.

Introducing more non-stop routes. As technology advances, there is an opportunity for Qantas to introduce more non-stop routes (such as the flagged non-stop routes to New York). Customers who are sensitive to price may be persuaded to pay increased fares for the convenience of catching one flight rather than two.

Review price structure during peak periods. New low-cost airlines are adopting flatter fare structures during peak periods, while Qantas may increase fares during the same period.

Increased competition is making consumers less loyal to brands. Therefore, Qantas needs to find ways to revise its fare structure.

PART B 1. Select one accounting policy that was analysed in this case, and make an adjustment to the account of 10% of the recorded figure in either direction. Follow through the effect of this adjustment to the financial statements.

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Revenue Received in Advance (Current liabilities) ($M) Revenue Received in Advance (Noncurrent liabilities) ($M) Total

Reported figure per 2018 report ($M) 3,939

Adjusted for 10% increase 4,333

1,446

1,591

Comment

Total increase is 549

Effect of change: Effects of change

Reported figure per 2018 report ($M)

Cash and Cash equivalents ($M)

1,694

Revised figure for increase in Revenue Received in Advance 2,233

Total assets ($M)

18,647

19,196

Total liabilities ($M)

14,688

15,237

Net assets ($M)

3,959

3,959

Description

Journal entry is Dr Cash Cr Revenue Received in Advance To account for increase in cash To reflect increase in revenue received in advance No change in net assets given increase is reflected in assets and liabilities

2. Apart from the accounting policies identified in Part B, what are likely to be policies that should be closely watched by auditors and analysts for a company in the airline industry?

Why have you chosen each of them?

Examples of other significant policies include: •

Income tax

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o Given the recent downturn in the airline industry due to COVID, many companies suffered losses. Auditors would need to ensure any losses utilised are appropriate and in accordance with the relevant accounting/taxation policies.

Assets and liabilities classed as held for sale o Companies in the airline industry may sell assets to limit losses. Auditors may look at valuation of these assets (see Notes 9 and 29(E) of Qantas’ 2018 Annual Report).

3. Update the accounting analysis in Part B for the most recent Qantas annual report available to you, and re-evaluate Qantas’s accounting policies for the current year.

Examples of the updated accounting analysis are provided below for the 2022 Annual Report.

Relevant policy Revenue received in advance

Staff costs

Property, plant and equipment (PPE)

2022 Annual Report analysis Revenue received in advance (current liabilities) increased significantly in 2022 ($5,863m) compared to 2021 ($3,277m).

This represents a 79% increase.

The increase could be attributed to more customers booking flights since the easing of COVID pandemic restrictions.

Staff costs represented $3,024m in 2022.

Redundancies and related costs amount to $5m, compared to $297m in 2021.

Provisions for redundancies amount to $189m however, indicating these plans had yet to be fully realised.

PPE was recorded at $10,224m in 2022.

Aircraft and engines are the most significant depreciable asset, amounting to $7,966m or 79% of all assets. As per the 2018 Annual Report, these are depreciated over a period of 2.5-20 years with a residual value of 0-10%.

PART C 1. Evaluate Qantas’ financial performance and financial position at the end of 2018.

Key points from the analysis and the 2018 Annual Report are summarised below: • • •

Qantas recorded record Underlying Profit Before Tax due to disciplined capacity management and its dual brand strategy.

Net Debt for the 2018 year was lower than the bottom of the target range, providing Qantas with greater flexibility moving forward for its funding.

Surplus capital was distributed to shareholders given the strength of the balance sheet Copyright © 2022 Cengage Learning Australia Pty Limited

2. Update the analysis in this case for the most recent Qantas annual report available to you, and re-evaluate Qantas’ more recent financial performance and financial position.

Students should download Qantas’ most recent annual report to replicate the analysis using the ratios in the case study. Key points to note include: • • • •

Qantas have been in losses due to the COVID pandemic No dividends have been paid since 2019 Net Debt increased in 2021, but reduced significantly in 2022 Fuel costs have increased

3. Prepare a shareholder information presentation to present to current and potential shareholders with a succinct set of useful information about Qantas’ most recent report.

Include the good news highlights, and explain plausible reasons for any bad news.

Presentations will vary by student.

Students should refer to the content in the Annual Report (such as CEO/Chairman’s Report and Review of Operations) to assist in understanding how Qantas have performed.

For example, the three-year recovery plan on page 14 of Qantas’ 2022 Annual Report provides an overview of how Qantas are tracking towards their targets.

Good news items include: • • •

Positive Net Free Cash Flow Growth of Qantas Loyalty Cost savings

PART D 1 Prepare forecast financial statements for Qantas in 2019, based on the most likely forecasts.

Refer to excel spreadsheet ‘Case Study 1’ 2 Choosing the least favourable forecast for each item for which a range of possible forecasts are given, prepare a ‘worst-case’ forecast financial statements for Qantas in 2019. What level of borrowing or equity raising is required in this scenario?

Refer to excel spreadsheet ‘Case Study 1’

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3 Choosing the most favourable forecast for each item for which a range of possible forecasts are given, prepare a ‘best-case’ forecast financial statements for Qantas in 2019. What level of borrowing or equity raising is required in this scenario?

Refer to excel spreadsheet ‘Case Study 1’ 4 Update the forecast assumptions for the most recent Qantas annual report available to you. Prepare the forecast financial statements for Qantas for the following year.

Student responses may vary depending on the most recent year applicable. The template response from Questions 1-3 can be utilised.

Students are advised to take into account any positive/negative trends since 2019 when completing the forecast.

5 How confident do you feel about any of these forecasts, and why?

Student responses may vary. For example, the economic outlook for the aviation industry was negative during the COVID-19 pandemic, and has entered a stage of recovery since 2022. Other political conditions such as war may affect fuel prices, which may lead to a more pessimistic outlook for expenses.

PART E and F Please note that there are no specific responses for Parts E and F

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Case 2 Airlines: Depreciation differences Blurb text.

1. Estimate the depreciation expense to asset cost ratio using the information in Figure C2.2. Does the variation in this ratio support the variation in accounting indicated by the written accounting policies?

Air China

2012

Aircraft and flight equipment Air New Zealand

0.05 2013

Aircraft, spare engines and simulators Spares

0.08 0.07

Korean Air Lines Co., Limited

2012

Aircraft and engines

0.08

Aircraft and parts

0.05

Malaysian Airline System Berhad

2012

Aircraft Aircraft spare engines

0.03 0.12

Qantas Airways Limited

2013

Aircraft and engines

0.06

Aircraft spare parts

0.07

Singapore Airlines Limited

2013

Aircraft

0.08

Aircraft spare engines

0.1

Aircraft spares

0.05

2011 Comment There is no variation in ratio from 2011 to 2012. This indicates that assets are being 0.05 depreciated on a straight-line basis 2012 Comment Change in ratio indicates consistency with 0.07 accounting policy 0.06 As above 2011 Comment Change in ratio indicates consistency with 0.09 accounting policy No change, assets being depreciated on 0.05 straight-line basis 2011 Comment Change in ratio indicates consistency with 0.04 accounting policy 0.04 As above 2012 Comment No change, assets being depreciated on 0.06 straight-line basis Change in ratio indicates consistency with 0.06 accounting policy 2012 Comment Change in ratio indicates consistency with 0.07 accounting policy Change in ratio indicates consistency with 0.03 accounting policy Change in ratio indicates consistency with 0.04 accounting policy

2. What possible underlying differences might account for the differences in depreciation accounting policy choices?

Student responses may vary; however, differences include:

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• •

The type of asset. For example, airframes purchased may differ by supplier in terms of quality and accordingly some may depreciate faster.

Taxation purposes. A different policy may allow a company to obtain higher deductions earlier rather than later.

3. How would you go about investigating whether the accounting choices were ‘opportunistic’?

Student responses may vary. A good starting point would be the respective annual reports of each airline. For example, a company may use conservative depreciation policies may have lower/normal profits in the current year, whereas a company using aggressive policies may show better financial performance (i.e., lower depreciation expenses) in the current year.

4. To increase comparability, Heath thinks he might use either the average or most conservative ‘expense to asset ratio’ and restate the depreciation for each airline.

Without going into detailed restatement procedures, what general impact would this restatement have on return on assets (i.e., the ratio of earnings before interest (EBIT) and tax to total assets)?

Companies with lower depreciation expenses will have a higher EBIT, as EBIT takes into account depreciation expenses. As such, the Return on Assets will increase as the numerator (EBIT) would be higher.

5. On the other hand, Heath thinks he might just as well estimate return on assets using EBITDA (earnings before interest, tax depreciation and amortisation). Do you agree with this approach?

Student responses may vary depending on their opinion. It is important to note that EBITDA excludes the impact of depreciation and amortisation from the calculation. Given the companies have quite different depreciation policies, it may make sense to use the EBITDA margin as this ignores the impacts of depreciation on profit.

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Case 3 Recasting financial statements Blurb text.

1. Write a memo to Ash on your views of the appropriate treatment of interest paid in the statement of cash flows.

Student responses may vary. Things to note include: • The relevant accounting standard (AASB 107/IFRS 7) • How the treatment of interest paid and received differs based on the industry the company operates in. For example, a financial institution such as ANZ may treat interest paid and received as operating cash flows as they are linked to the main revenue producing activities of the company.

• Interest expenses linked to financing should NOT be included as an operating cash flow 2. Is diversity in accounting a good thing? What are the advantages or disadvantages?

Student responses may vary.

Advantages include: • Analysts/managers can use their judgment to interpret the correct treatment of a transaction Disadvantages include: • Accounting standards do not always reflect economic realty • Management bias

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Case 4 Cochlear: Provisions and patent disputes Blurb text.

1. In looking at Figure C4.3, what factors might cause an analyst to recast or adjust to the summary financial statements?

Student responses may vary; however, the following factors might cause an analyst to recast or adjust: • At the time the provisions were recognised, there was ambiguity as to whether an obligation had been incurred.

• It was difficult to estimate the amount of the obligation for the patent infringement. For example, a $131m claim for damages was made, but a provision of $21.3 million was recognised.

• Given the amounts actually incurred are higher, the analyst may wish to adjust the provisions recognised 2. What is the relationship between provisions, onerous contracts, contingent liabilities and other types of liabilities?

A provision is a liability of uncertain timing or amount arising out of a past event. A provision is recognised as a liability if it is probable than an outflow is required to settle the provision. If it does not meet the criteria for recognition, it should be disclosed in the notes as a contingent liability.

An onerous contract refers to a contract that will cost a company more to fulfil than what the company will receive in return. If an outflow is probable, the onerous contract will be recognised as a provision. If an outflow cannot be measured reliably, then the onerous contract will be recognised as a contingent liability.

3. The definition of provision in Figure C4.2 uses the term ‘probable’. How would you interpret ‘probable’? What percentage would you ascribe to the term? Is there any research on how this term is interpreted? (Hint: look for ‘uncertainty expressions’.)

Student responses may vary depending on their opinion and research.

As an example, probable may be considered more likely than not (i.e., greater than 50%).

Uncertainty expressions may be verbal (e.g., words such as probable, likely, possible) or numerical (50%, 6/10, 0.5) 4. Considering the features in this case, in making a provision for a legal claim what factors would influence the amount of that provision? What factors ought to influence changes to the amount of provisions in each year?

Factors influencing the amount of the provision: • Any analysis undertaken to determine the potential loss such as independent expert reports • Legal costs of settling the dispute Copyright © 2022 Cengage Learning Australia Pty Limited

Factors influencing changes to the amount of provisions include: • The damages claim of USD $131.2 million in 2014 • The Court of Appeals decision in late 2016 • The doubling of damages judgment at the district court 5. How would you interpret the market reaction on 5 November?

Student responses may vary depending on their interpretation. However, the market reaction was negative as investors sold their shares resulting in the share price of Cochlear dropping by almost 4%.

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Case 5 Accounting analysis: Cash flow reconciliation 1. The Warehouse Group cash flow reconciliation has three sub-headings: non-cash items, non-operating items and change in working capital items. What are these items and why do they appear in this reconciliation?

Non-cash items • Definition: Entries on a cash flow statement that do not involve actual cash transactions.

• Why do they appear in reconciliation? They represent money that has been spent in the past but not accounted for in current period. For example, depreciation expenses represent expenses on assets that were purchased in the past.

Non-operating items • Definition: Comprised of the cash inflows and outflows for a company from sources other than its day-to-day operations Change in working capital items • Definition: The change in current assets minus current liabilities from one year to another.

2. Recast each of the reconciliations into a common format.

Refer to Q2 tab of attached spreadsheet ‘Case Study 5.xls’ 3. Chapter 3 suggests that the profit to operating cash ratio is a useful way to summarise this table. A more complete analysis is to take each item in the table and express it as a percentage of operating cash flow. This is similar to calculating what is known as a common size statement. The idea behind common size statements is to make different firm’s financial statements comparable by scaling by size. For example, each item in the balance sheet is scaled (divided by) total assets. For the income statement the divisor is revenue. In this question the divisor will be operating cash flow. Undertake this analysis and answer the following: a. Comment on the percentages for Smith City.

Refer to Q3 tab of attached spreadsheet ‘Case Study 5.xls’ Non-cash items comprise 26% of the net cash inflow in the 2017 year. Movements in working capital comprise 44% for the same year.

Note that the 2018 results are negative and accordingly this analysis is redundant for that year. b. Often this type of analysis highlights areas where the analyst should delve a little deeper to get a better understanding of the transactions, events and conditions that have affected the financial statements (especially the accruals). For the percentages you have just calculated, list the line items that you would investigate further and why.

Examples include the 2017 depreciation and amortisation figure (26%) and the decrease in inventories of 60% due to making up a significant percentage of the ratio.

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4. Because of the possibility of negative and small operating cash flow numbers, analysts will sometime calculate per cent of cash flow reconciliation items in relation to revenue.

Repeat Question 3, scaling items by revenue. In addition, state whether you prefer scaling by operating cash flows or revenue.

Refer to Q4 tab of attached spreadsheet ‘Case Study 5.xls’.

Student responses may vary, however scaling the items by revenue may not make sense given many of the items are not related to revenue (for example, depreciation is linked to expensing an asset).

Note for instructor - there is not actually a revenue line item against which one can conduct this analysis in Case 5. We have used 'Receipts from customers' in Figure C3.1 of Case 3 as revenue in the example spreadsheet, but students will not be able to replicate this unless they are aware of this.

5. Some analysts argue that this reconciliation is a measure of accounting quality (and therefore an essential part of accounting analysis). Do you agree with this statement?

Why or why not?

Student responses may vary depending on whether they agree or not.

Arguments for: • Standardizing the analysis makes it easier to compare across companies in an easy-to-read format.

Arguments against: • This analysis does not factor in accounting policies and estimates and thereby may not be considered a proper accounting analysis.

6. One of Samantha’s colleagues has said ‘analysing cash flow statements is a waste of time. I can construct a simple measure of operating cash flow by adding back depreciation and amortisation. That is why, I just use EBITDA rather than profit for all my analysis.’ Do you agree with Samantha’s colleague? Why? Student responses may vary. In their response students should note the differences between operating cash flow and EBITDA. For example, whilst EBITDA involves adding back depreciation and amortisation, operating cash flow involves all other non-cash items such as gains or losses on PPE.

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Case 6 Valuation Ratios in the Retail Industry 2010 to 2013 This case study is artificial, as it is not the task of analysts to identify companies through ratio analysis. The case is not that easy because each company has more than one segment, which confounds the analysis. The underlying trading conditions will also have an impact on ratios.

I have used cases similar to this in the classroom. I divide the class into groups. Each group fills out a written answer and hands it in. I then write up on the board (or on a spreadsheet) each group’s answer. I then call on groups to explain the reasons for their answer. I then allow all groups to revise their answer. On occasion, I have let the groups submit a third answer, at the end of class after all questions have been done. Generally the answers improve from individuals to a group, to seeing what other market participants (i.e., groups) are doing, and using ratios holistically rather than piecemeal. It is also worthwhile asking students what other information they would like to make the decision.

It is really difficult to get the answers 100% correct. One false move causes two incorrect answers.

However, the point of this exercise is: (1) for students to ‘go beyond’ ratios and think about the underlying business; and (2) to show students that businesses are not simple ‘pure plays’. Life is a ‘blooming, buzzing confusion’ (William James). My interpretation of this is that sorting out reality is a difficult task. In writing this solution, I made my choices before ‘peeking’ at the answers. My choices are in lowercase and the correct answers are in uppercase.

1. One way to think about the differences between various retail activities is to consider two ratios: asset turnover and gross margin. Match these ratios with each firm. What is the reasoning for your selection?

Total Asset Gross My Turnover Margin Firm pick Actual 2013 2013 1 a D 2.5 28.2% 2 b A 1.4 44.5% 3 d C 0.9 29.6% 4 c B 0.6 12.5% For the asset turnover try and rank the products in terms of highest sales turnover and think about which products have the highest margin. The classic example is supermarket (high turnover, low margin) versus a jeweller (low turnover and high margin). My ranking based on product: fashion clothes (company B) would also be expected to have the highest margin and high turnover, so Company 1 seems likely. Company A (leisure sports) would also have high turnover and high margin and Company 2 seems most likely. In terms of turnover my ranking of the remaining firms is household goods (D) and then whitegoods (C).

Comments: • Each company has other segments – finance companies, investments, property and manufacturing. This can impact asset turnover– as can the use of leased assets.

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•

•

Company D seems to be doing well because it also has a property segment and some manufacturing activities. My ranking for D was lower because I thought the property might increase total assets and depress the asset turnover ratio.

Consider the positive tone in the management commentary of Company B. Yet this is at the bottom of the list in terms gross margin. Compare this, to dour management commentary of Company D, yet this is top of the list. This indicates that the results will depend on where the firm is coming from (or perhaps more correctly where investors see the company is heading). So putting the ratio results is important.

2. Match the following price-earnings multiple with each firm. What is the reasoning for your selection?

My Price-earnings Firm pick Actual 2013 1 c C 10.8 2 d B 11.1 3 a D 15.0 4 b A 22.9 The P/E is dependent upon risk, growth and whether earnings are ‘temporary’. In terms of growth my rankings are A, B, D, C. For risk my rankings are B, A, D, C. There is insufficient detail to determine whether earnings are temporarily high or low. (As mentioned previously the tone of management commentary does not seem to help.)

I thought C and D would be close, so I choose Firms 1 and 2. As with question 1, I got Company B (fashion retail) totally wrong.

3. Match the following price-to-book multiple with each firm. What is the reasoning for your selection?

My Price-to-Book Firm pick Actual 2013 1 b B 0.6 2 c D 1.9 3 d C 2.0 4 a A 3.2 It probably makes sense to look at Questions 2 and 3 at the same time. Also doing Discussion Question 5 of Chapter 7 beforehand helps provide a framework.

I thought that C and D would have a similar price-book ratio, my rankings is same the order in Question 2. My choice for the ‘star’ (high P-E and high P-B) is A. This leaves company B with the lowest price-to-book.

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Case 7 Dick Smith Blurb text.

1. Briefly (in three to four lines) explain how stock rebates work in a retail setting.

• Rebates are reductions or refunds on what has already been repaid • In the retailing industry they may be obtained for sales or marketing • For example, where a manufacturer contributes towards the retailer’s promotional costs of a new product • Other types of rebates relate to volume whereby a discount is offered for a specified volume of stock 2. Rebates are common in the retailing industry. Can you find evidence of how an Australian or New Zealand company other than Dick Smith or Target treats its rebates from an accounting perspective? This will involve a small amount of research. Try Google, but limit it to news search.

Student responses will vary depending on the research undertaken. The key is to specify the accounting treatment undertaken.

3. If you were an auditor, what evidence would you look for to determine whether a rebate was classified as a reduction in marketing costs, or a reduction in inventory costs?

Reduction in marketing costs would increase profit in the period the rebate was booked.

Reduction in cost of inventory is recorded as a reduction in cost of sales when the inventory is sold, rather than recorded as income upfront.

Auditors should look at: • The contractual form of the rebates to understand the type of rebate • The accounting treatment of the rebate (i.e., whether it was recorded as income upfront or recorded as a reduction in cost of sales when income is sold) 4. Several example scenarios in relation to rebates are provided below. Show the accounting impact of these transactions. That is, show how would the income statement and balance sheet look after each of these transactions. They are not cumulative. Assume that a company has the following income statement and balance sheet at the start of June 2017. a Inventories increase by $100 Cash decreases by $100 b Cash increases by $50 Revenue increases by $150 Cost of sales increases by $100

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c Inventory increases by $100 Cash decreases by $70 Marketing and sales costs decreases by $30 d Inventory increases by $70, cash decreases by $70 e Sales revenue increases by $150 Cost of sales increases by $100 Cash increases by $80 Marketing and sales costs decreases by $30 f Sales revenue increases by $150 Cost of sales increases by $70 Cash increases by $80

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Case 8 Resinex • • •

1. Comment on the general use of the Altman Z-score model to determine whether a company is a going concern in New Zealand.

The Altman-Z-score model weights five variables to compute a bankruptcy score.

It is an example of a model that can be used to distinguish between failing and surviving firms.

The model was originally constructed using US data; however attempts were made to reconstruct the model using New Zealand data (Ferner-Hamilton model)

2. In a second memo, assess whether Resinex Corporation Limited is a going concern. To do this, you might like to use the Ferner-Hamilton model described in Chapter 10.

Student responses will vary depending on whether they use the Ferner-Hamilton model, and their opinion of whether Resinex is a going concern.

Factors students should consider when assessing going concern include: • Projected output of world resin • Financing requirements (including split of debt and equity and ability to pay off debt) • Events subsequent to balance date • Ferner-Hamilton score (and any limitations)

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Case 9 Foster’s–Southcorp merger Part A Motivations 1. Evaluate the given reasons for the Foster’s-Southcorp merger against market conditions at the time.

Student responses will vary pending their evaluation.

As an example, Fosters promoted the takeover as a ‘a unique opportunity to create a pre-eminent global wine company, with an unrivalled collection of premium wine brands furthering Foster’s global wine leadership strategy’.

Students should refer to the content in the case study in relation to the growth of the Australian wine industry when answering this question (see third paragraph of Part A) 2. What were the risks for Foster’s in pursuing a merger with Southcorp? What were the opportunities?

Risks may include: • Overpaying • Overestimating potential synergies Opportunities include: • Developing a stronger international presence.

• Economies of scale Part B Foster’s pricing of Southcorp 3. Summarise the actions taken by Southcorp directors to resist the takeover. Using both economic and noneconomic motives, provide two explanations for their resistance.

Actions taken to resist the takeover include: • Proposing a takeover with Foster’s wine business • Releasing a report valuing Southcorp shares above the Foster’s bid • Restoring dividend payments An economic motive for the resistance would be to drive the price of the Foster’s bid up and thus acquire greater value from the sale.

A non-economic motive for the resistance would be the reluctance of Southcorp management to give up power to Foster’s as a result of the acquisition.

4. The price of Southcorp rose throughout this period. To what extent do you see this increase as a response to an expected higher premium from a likely successful takeover, or as a response to information revealed about the value of Southcorp?

Students should evaluate the information in Part B of the case study when answering this question. Information in the case study suggests that Southcorp released an independent report valuing their shares higher than the Foster’s bid, which led to a subsequent increase of Southcorp shares in the market.

5. If you were an analyst during this period, how would you separate out the value of Southcorp as a standalone firm, from the increases due to the takeover bids? How would Copyright © 2022 Cengage Learning Australia Pty Limited

Fosters’ management determine the value of Southcorp to them, first as a standalone firm, and then post-merger?

It may be necessary to look at the value of Southcorp shares more than one month prior to the acquisition offer, as there may be aggressive trading in the lead up to the takeover offer. This is only a guide and it may be necessary to look at the price even further in advance.

Earnings multiples may be used to value a target post-acquisition. See Chapter 11.

Part C Foster’s financing of Southcorp 6. Looking at the relevant financial statements of Foster’s before and after the acquisition of Southcorp, determine the change in leverage. How does their leverage ratio compare to that of a competitor, such as Lion (Lion Nathan)?

Students should download the financial statements pre- and post- acquisition. The leverage ratio can be computed as Total Debt to Total Equity.

When comparing to a competitor, students should note whether the competitor has undergone a restructure (such as an acquisition), which may affect the debt-equity composition.

Part D The outcome of Foster’s offer for Southcorp 7. Analyse the reasons for Fosters’ eventual failure and subsequent takeover. How could this have been prevented by different actions regarding Southcorp, if at all? How much of this was foreseen in 2005?

• Foster’s admitted it paid too much for Southcorp in 2008.

• Foster’s underwent a demerger of its brewing and wine business in 2011 which strengthened its balance sheet prior to its sale to SABMller.

• Students should undertake a level of research to determine whether Fosters could have foreseen the events. Factors to consider include: o Whether they overpaid for the assets acquired (look at whether Southcorp were in losses prior to the acquisition) o The increased level of competition in the wine market o Whether Foster’s overestimated the potential level of synergy between the beer and wine business.

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