Potential acquisition

The strategy session generated good ideas for David Whitehead (Pty) ltd. The company decided to focus on expanding their business through acquisition. Several targets for this have been identified. The leading target for this acquisition is Power Sales (Pty) ltd. The directors of David whitehead have entered preliminary negotiations with the top management and the majority shareholders of Power Sales (Pty) ltd. At this stage of the negotiations the majority shareholders of Power Sales (Pty) ltd have indicated a very strong willingness in selling their shares to David Whitehead (Pty) ltd.

Power Sales (Pty) Ltd is in the clothing business. It focuses on Womens clothing, shoes, and accessories. The company is focused on age 40+ career-oriented women and family-oriented women. The customers of Power Sales (Pty) ltd fall in the upper end of the clothing market. Powers sales buys clothes from local suppliers. These clothes are then sold under the Power sales brand. The Power Sales (Pty) ltd brand is very popular in South Africa. This has made it very attractive to David Whitehead (Pty) ltd. David whitehead plans to keep the Power sales brand. The stores are expected to continue operating in the same way post acquisition. They will not be integrated into the David White (Pty) ltd brand. The financial statements for Power Sales (Pty) ltd for the year ended 30 June 2022 are given below as follows:

Power Sales (Pty) ltd Statement of Comprehensive income for the year ended 30 June 2022
	Note	2022	2021
		R 000	R 000
Sales	1	304 740	283 408
Cost of Sales	2	(154 747)	(124 272)
Gross profit	3	149 993	159 136
Operating expenses	4	(72 885)	(80 452)
Other operating income	5	1 350	1 244
Operating profit		78 458	79 928
Investment income	6	13	12
Finance Costs		(1 565)	(1 410)
Profit before taxation		76 906	78 530
Taxation		(21 265)	(22 750)
Profit for the year		55 641	55 780

Power Sales (Pty) Ltd- Statement of financial position as at 30 June 2022
	note	2022	2021
		R000	R000
Non-current assets		33 468	31 333
Property, plant, and equipment	7	33 370	31 235
Investment in unlisted company	6	98	98
Current assets		178 597	147 604
Inventories		37 687	23 898
Trade and other receivables	8	140 858	122 844
Cash and cash equivalents		52	862
Total assets		212 065	178 937
Equity		182 703	152 862
Share capital and premium		100	100
Retained earnings		182 603	152 762
Non-current liabilities
Interest bearing debt	9	4 000	8 000
Current liabilities		25 362	18 075
Interest bearing debt		4 000	4 000
Trade payables	10	19 512	14 075
Bank overdraft	9	1 850	-
Total equity and liabilities		212 065	178 937

Notes:

1. Most of the sales of Power Sales (Pty) ltd are on credit. About 85% of the sales were on credit in 2022. In 2021 about 90% of the sales were on credit. This reduction was due to the deterioration in the credit market. Management was forced to tighten credit extension. In 2022 a larger than usual summer sale was held to try and stimulate sales and move stock.

The management of David whitehead (Pty) ltd expects total sales to increase by 1.5% in real terms during the first year after acquisition and by a further 3% in real terms in the second year after acquisition. The management also plans on reducing credit sales to 80% of the total sales in the first year and to 75% thereafter.

1. Power Sales imports a significant portion of its trading stock from the European Union, and it is denominated in euros. Power sales does not hedge against exchange rate risk. The management of David Whitehead believes that this exposure to foreign currency fluctuations increases the groups overall risk.

1. The management of David whitehead (Pty) ltd believes that they will be able to improve the gross margin of Power Sales by 3% (in absolute terms) in the first year. In the second year the gross margin is expected to increase by 5% (in absolute terms) more than what it is currently.
2. Lease expenses are included in operating expenses (see note 7). The leases on a number of stores were up for renewal at the beginning of the 2022 financial year. Power Sales management renewed some of them. However, there was a decision not to renew some of them in some of the prime areas due to escalating costs.
3. Other operating income consists of rental from the office building (see note 7) and interest on overdue trade receivables. The annual rental receivable on the office building was unchanged from 2021.
4. The investment income comes from an investment in a minority interest of 10 000 shares. The investment is shown in the Statement of Financial Position at the most recently traded price. The most recent transaction took place in 2019. The investment is illiquid. David whitehead (Pty) ltd plans to hold on to the investment after acquisition. A dividend of R1.39 per share is expected to be received in one years time and a sustainable nominal growth rate of 8% is expected. The management of David Whitehead (Pty) ltd believes that a minimum return of 18% is appropriate given the nature of the investments risk profile.
5. Power Sales leases its premises, warehouse, and distribution centre. The head office buildings are owned by Power Sales. Power Sales also owns a small office building that they constructed four years ago. They were anticipating accelerated growth. It turned out that the growth expectations were overoptimistic and as a result the building has never been used. This building has been leased out. The management of David Whitehead plans on selling the building after acquisition. The most recent valuation of the building indicated a value of R10 200 000.

The management expects that an amount of R4 100 000 will be spend on replacement and expansion of fixed assets in the year following the acquisition, and an amount of R4 750 000 in the year after. Depreciation expense (included in cost of sales and operating expense) is expected to be R3 120 000 in the first year and R3 250 000 in the second-year post acquisition.

1. The table below gives a breakdown of trade receivables.

	2022	2021
	R000	R000
Trade receivable	156 837	134 938
Doubtful debt allowances	(15 997)	(12 110)
Net trade receivables	140 840	122 828
Other receivable (short term staff loans)	18	16
Trade and other receivables at year end	140 858	122 844

Required:

a)	Evaluate the profitability and working capital management of Power Sales (Pty) for the 2021 and 2022 financial year.	23 marks
b)	Use the free cash flow model to determine the maximum value David Whitehead should pay for a 100% common stock in Power Sales.	15 marks
c)	Assess the efficacy of the projections made by management in notes 1,3,4,7, and 8	15 marks
d)	Evaluate the three financing options relating to the potential acquisition of Power Sales. List the factors that the management of David Whitehead should consider in deciding which option to use.	17 marks