QUESTION 1 (100 marks)

Carrier Ltd (“Carrier”) is a transporting entity that transports goods for customers between Gauteng and KwaZulu-Natal. The entity has a 31 January financial yearend. Carrier has a fleet of various trucks to provide the requested transport services to customers. Currently, the entity wishes to purchase another truck to add to their fleet. The decision lies between Truck X119 and Truck FGS4.

Truck X119 has a purchase price of R867 400 and an expected economic useful life of 6 years. It is estimated that Truck X119 will have a residual value of R57 000 at the end of 6 years of useful life.
Truck FGS4, on the other hand, has a purchase price of R797 500 and an expected economic useful life of 5 years. Truck FGS4’s expected economic useful life can also be extended to 6 years, but then Truck FGS4 will have to undergo a major service at the end of year three of its useful life. Such a service will cost Carrier R103 300 and will span over two weeks. During those two weeks, Carrier can lease a replacement truck from another entity at a cost of R5 150 per week, which will enable Carrier to continue with business as usual. It is estimated that Truck FGS4 will have a residual value of R46 500 at the end of 5 years and R49 600 at the end of 6 years.

A storage facility was built at a cost of R48 900 one month ago in which the truck that will be acquired can be stored and locked up safely overnight.

The following information pertains to each truck:

Carrier is operational for 50 weeks per year.

The average price of diesel during the next five to six years is estimated to be 2 660 cents per litre.

Per Carrier’s policy, all trucks must undergo a general maintenance session each month during which minor maintenance is performed as required, and the trucks’ roadworthiness and safety are ensured. The timing of the general maintenance sessions of each truck is well-planned by Carrier, so that they do not disrupt Carrier’s transporting activities. The maintenance cost of both the minor services to all trucks as well as the potential major service on Truck FGS4 may not be capitalised according to IAS 16 but are considered expenses.

Carrier will take out two insurance covers when the new truck is purchased. The first insurance will be to cover the goods that are being transported. The insurance cost for this insurance cover will be 0.01% of the value of the goods that are being transported. The average value of the goods to be transported in either of these two trucks is estimated to be R624 per kilogram transported. Carrier will, however, charge the customer 0.025% of the value of the goods that are being transported (additional to Carrier’s standard fee per kilogram) to reinstate the entity from the insurance expense and provide cover.
The second insurance cover that Carrier will take out, is to insure Carrier’s truck itself. The annual insurance premium for Truck FGS4 will be 0.2% of the purchase price of the truck. The insurance company informed Carrier that the annual insurance premium will also be 0.2% of the purchase price of the truck for Truck X119, but only if specified safety parts are installed on Truck X119. Otherwise, the annual insurance premium for Truck X119 will be increased by 45%. After performing research, Carrier has determined that the total cost to acquire and install these safety parts will amount to R88 000. The safety parts will have a residual value of zero at the end of 6 years.

Currently, Carrier’s fixed cost amounts to R2 120 000 per annum. Should Truck X119 be purchased, the fixed cost will increase by R583 000 per annum. If Truck FGS4 is purchased, the fixed costs will increase to R2 626 500 per annum. These fixed costs are excluding any other costs mentioned elsewhere in the information.

Carrier has performed market research on the demand for various kilogram quantities of goods to be transported in either Truck X119 or Truck FGS4 per trip.
Following are the results this research delivered:

Should the relevant truck be physically unable to carry the required kilograms demanded, the customer is assumed to utilise the next available quantity of kilograms.

Carrier generates revenue by charging customers a standard fee of R0.35 per kilogram to be transported.

Both Truck X119 (as well as its possible safety parts) and Truck FGS4 will qualify for a wear-and-tear allowance according to section 11(e) of the Income Tax Act under which the relevant vehicle’s cost may be written-off over 5 years (although the diminishing depreciation method is prescribed by the Act, you may use the straight- line method for Carrier, for ease’ sake). According to Carrier’s property, plant and equipment policy all vehicles are depreciated over 6 years applying the straight-line method. This depreciation expense has not been included in any of the amounts mentioned elsewhere in the information.

The South African Income Tax rate applicable to companies is 27% and the Capital

Gains Tax has an inclusion rate of companies is 80%.

Carrier will finance the new truck acquisition from the entity’s general pool of funds. Carrier’s total cost of debt before tax is 12.55%. Carrier is not listed on the Johannesburg Stock Exchange (“JSE”) and thus do not have an equity beta readily available. A similar entity to Carrier, Go-Go Ltd (“Go-Go”) is however listed on the JSE and has a levered beta of 1.15. Go-Go has a debt-equity ratio of 60%, while Carrier’s targeted capital structure is a debt-equity ratio of 55%.

The average rate of return that can be obtained from the transport sector, is 12.8% per annum. The South African long-term government bonds indicate a yield of 4.1%. You may assume that all income and expenses mentioned are taxable / deducted for income tax purposes.
Value Added Tax (“VAT”) consequences may be ignored.

REQUIRED:

1.1. Assist Carrier Ltd in determining whether it will be financially beneficial to equip the Truck X119 with the safety parts.
Utilise a net present valuation and advise accordingly. Round to the closest Rand where applicable.
For non-currency values, round to the two decimals.

For question 1.1 only, assume that Carrier Ltd has a weighted average cost of capital of 12%.(15 marks)

1.2. Assist Carrier Ltd in determining whether or not it will be financially beneficial to extend Truck FGS4’s useful life to 6 years. Utilise a net present valuation and advise accordingly.
Round to the closest Rand where applicable.

For non-currency values, round to the two decimals.

For question 1.2 only, assume the following:

• Carrier Ltd has a weighted average cost of capital of 12%.

• The net cash profit after tax generated annually from opting to incorporate Truck FSG4 in Carrier Ltd’s operations, is R1 900 000 before any of the effects regarding the major service have been taken into account. (16 marks)

1.3. Assist Carrier Ltd in determining whether the entity should opt for Truck X119 or Truck FGS4. Adress the decision by utilising net present valuations.
Should you intentionally omit any amount / item, provide a brief motivation for doing so.
Round to the closest Rand where applicable.

For non-currency values, round to the two decimals. For question 1.3 only, assume that:
• Carrier Ltd will equip Truck X119 with the safety parts as required by the insurance company when Truck X119 is acquired.
• Carrier Ltd will extend Truck FGS4’s useful life to 6 years.

The following mark allocation is applicable: Truck X119 – 36 marks
Truck FGS4 – 32 marks

Answers to Above Questions on Financial Management Techniques

Answer 1: In order to determine whether it is financially beneficial to equip the Truck X119 with the safety parts by Assist Carrier Ltd, the net present value method is applied below to reach out the most appropriate decision as follows:

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