QUESTION $1(40$ Marks; $120$ Minutes$)$

LUXE LIVING LIMITED

Raymond Mashaba is a South African businessman who purchased a chain of four small consumer goods$*$ retail stores, situated in the Limpopo province, from its founder in the $1980$s$.$ Shortly thereafter, a holding company was registered, and since then more stores have been added in other provinces as part of the strategic expansion of his portfolio, showcasing Raymond$$s business acumen and an understanding of market dynamics.

Given his desire to create a luxurious shopping experience for consumers, he decided to rebrand the entire store$-$chain to focus on conveying elegance, sophistication, and exclusivity. The rebranding included redesigning store layout, d$$cor$,$ packaging, and product assortment. To solidify its position in the market and to provide avenues for continued growth and investment, the holding company listed under the $$Personal Care, Drug and Grocery Stores$$ sector on the Johannesburg Stock Exchange in the late $90$s$.$ The holding company was subsequently renamed Luxe Living Limited $($Luxe Living$).$ Luxe Living went from strength to strength and soon became an established South African premium food, clothing, and homeware retailer, targeting the upper Living Standards Measure$**($LSM$)8-10$ category.

However, for the financial year ended $29$ February $2024($FY$2024),$ Luxe Living$$s financial performance worsened significantly, and its share price declined due to a drop in sales and gross profit across its various product types as well as the impact of loadshedding. Furthermore, a fierce competitor, Elite Eats Group $($Elite Eats$),$ steadily gained market share in the LSM $4-7$ category by introducing an online shopping application $($app$).$ Elite Eats$$ customers can use this app to order fresh food $($including vegetables$),$ personal care products as well as selected medicines and have them delivered to their doorstep within $60$ minutes. Market research shows that more consumers are transitioning to online shopping for convenience and are exploring more affordable alternatives without sacrificing quality. In addition to the online shopping application, Elite Eats also introduced modernised flagship stores, which proved to be stiff competition for Luxe Living.

Luxe Living$$s management is exploring different options and ideas on how it can improve $($turn around$)$ the way in which it conducts its business.

SECTION A: DISTRIBUTION NETWORK

Luxe Living makes use of a decentralised distribution network as part of its business model. It has nine distribution warehouses, with inventory located at the various warehouses spread across all nine provinces. Luxe Living receives its goods from only carefully selected suppliers, which means that the quality of products always meets high standards and delivery times are managed closely and adhered to$.$ From these warehouses, the products are distributed to various Luxe Living stores across the country, where they are sold.

Luxe Living prides itself as a company that conducts business in an environmentally sustainable way. As part of its strategy, the company is working on changing its largest warehouse in Johannesburg, Edenvale, to a $$green$$ warehouse. This means that the building design and operations reduce or eliminate any negative impact it could have on the natural environment and climate.

$*$Consumer goods: Can also be referred to as $$final$$ goods because they end up in the hands of the consumer or the end$-$user. Examples of consumer goods include food, clothing, electronics, and appliances.

$**$ Living Standards Measure $($LSM$)$ Segmentation: A tool to classify a standard of living and disposable income of consumers, with LSM $1$ being the poorest.

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To give back to the community, Luxe Living will construct a community solar farm adjacent to where the Edenvale warehouse is$.$ A solar farm is a large$-$scale solar energy production system that uses solar panels to harvest energy from the sun. This solar farm will provide power to Luxe Living$$s entire Edenvale warehouse facility as well as to the surrounding community. The total cost of building the solar farm is estimated to be R$45$ million. Of this total cost, R$13$ million will be funded by the Department of Mineral Resources and Energy in a form of a non$-$repayable grant.

Luxe Living has a target capital structure of $30\%$:$70\%($debt: equity$).$ In the target capital structure, the following should be maintained:

$$Ordinary share capital should be $60\%$ of total equity.

$$The debt portion should be split equally between loans, debentures, and total bonds.

$$In terms of the targeted capital structure, $75\%$ of total bonds is made up of Rand$-$denominatedLuxe Living $($local$)$ bonds.

$$The loans in relation to each other, should be weighed in the same proportion as they currentlyare in the extract below as per note $3\mathrm{.}1$ and $3\mathrm{.}2.$

Extract of Statement of Financial Position of Luxe Living Limited on $29$ February $2024$:

Notes

R$000$

Equity

R$85170$

Retained income

$16670$

Other reserves

$6000$

Ordinary share capital

$1$

$50000$

$9\%$ Preference shares

$2$

$12500$

Non$-$current liabilities

R$237176$

Borrowings

$3$

$187154$

Derivatives held for risk management

$8285$

Employee benefits

$11629$

Provisions

$22185$

Deferred tax

$7923$

Current liabilities

R$47212$

Short term loans

$21214$

Bank overdraft

$4$

$5521$

Employee benefits

$4276$

Trade and other payables

$16201$

Total liabilities

R$284388$

Total equity and liabilities

R$369558$

Notes to the financial statements:

$1.$Of the total authorised number of ordinary shares, $80\%$ is in issue. The historical averageissue price is $2500$ cents per share. No ordinary dividend was declared or paid in the $2024$financial year $($FY$2024)$ due to the company experiencing a decline in profits. Risk$-$freegovernment bonds currently yield $9\%$ and the market risk premium is $5\%.$ At year end, LuxeLiving reported a market capitalisation of R$400$ million, and its share has a beta of $1,1.$

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$2.$The market value of preference shares is estimated at R$15$ million. Dividends of R$1,071$ millionwere declared and paid in FY$2024.$

$3.$Borrowings$$ line item as per the extract above consists of the following debt facilities $($theborrowed amounts given are book values, unless if stated otherwise$)$:

$3\mathrm{.}1$ A secured $10-$year loan of R$41,5$ million from BZN Bank which is repayable in full after three years and carries an interest rate of prime rate $-1\%.$ Interest payments are made annually. Similar loans trade at prime rate $+2\%$ per annum $($p$/$a$).$

$3\mathrm{.}2$ A medium$-$term loan to the value of R$58,5$ million was obtained from ASBA Bank on $4$ March $2023$ at $9,5\%$ with interest being payable annually. The capital amount will be repaid in full on $28$ February $2026.$ Similar loans trade at $9,25\%$ interest p$/$a$.$

$3\mathrm{.}3$ The R$40,52$ million debentures were issued at the beginning of FY$2024(1$ March $2023)$ and will be redeemed at a premium of $5\%$ on $28$ February $2027.$ The coupon rate on these debentures is $9\%$ p$/$a payable annually, whereas the market interest rate for similar debentures is $7,5\%$ p$/$a$.$

$3\mathrm{.}4$ Rand$-$denominated Luxe Living $($local$)$ bonds had a market value of R$26,7$ million at the end of FY$2024.$ Interest is paid out semi$-$annually and similar bonds trade at $10\%$ per annum.

$3\mathrm{.}5$ Euro$-$denominated foreign bonds incurred an annual interest before tax of R$2,58$ million $($converted into South African rands$).$ Similar foreign bonds trade at $5\%$ per annum.

$4.$The bank overdraft bears an average interest rate of $13,5\%$ p$/$a and is used to bridge theworking capital requirements when the need arises, and the balance fluctuates monthly.

$5.$All the current facilities will be available for future use at the same prevailing market rates.

$6.$Luxe Living is able to increase or decrease its debt exposure as funding needsfluctuate$/$change$.$

Additional salient information:

$$The current prime interest rate is $11,75\%$ p$/$a$.$

$$The company tax rate is $27\%.$

SECTION B: WORKING CAPITAL PLANS FOR $2025$ FINANCIAL YEAR $($FY$2025)$

$$There is concern over the poor management of the company$$s working capital, especiallyregarding its inventory and trade receivables. Recent stock counts across all the company$$swarehouses revealed a big discrepancy between the inventory records and physicalinventory. Earlier in the FY$2024,$ a fire broke out at one of the company$$s largest warehouses,and some inventory was severely damaged and had to be written off.

$$Regarding trade receivables, the increasing cost of living crisis has put a lot of pressure onconsumers, especially those in the LSM $8-10$ category. Luxe Living recently implemented anew debtors management system as a response to try and manage its debtor days moreeffectively. At the end of the FY$2024,$ the balance of trade receivables was R$22,8$ million.

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The management accountant provided the following budgeted information $($closing balances$)$ for the FY$2025,$ before the consideration of any of the proposed changes to the company$$s working capital management:

Account

$2025$

R$000$

Revenue

$120000*$

Earnings before interest and tax

$27205$

Inventory

$24682$

Trade receivables

$20540$

Trade payables

$17940$

$*$Cash sales are normally $70\%$ of total revenue, and customer credit terms vary from $30$ to $60$ daysdepending on the customer$$s credit rating.

Proposed changes to the working capital management policy:

The finance team has suggested the following changes to be made to the management of working capital from the beginning of the FY$2025$:

a$)$Incentivise cash$-$paying customers by granting them a $6\%$ cash discount, and

b$)$Charge interest on trade receivable accounts outstanding for longer than $60$ days. Interest to becharged at prime interest rate.

The expected results from the above changes are set out as follows:

i$.$Cash sales as a percentage of total revenue will increase to $85\%.$

ii$.$Of credit sales, $25\%$ of sales amounts will be settled in full on the $70$th day from the date of saleand $70\%$ of the debt will be settled within $60$ days from date of sale. The remaining portion willhave their accounts written off as bad debts.

iii.The trade receivables balance is expected to average R$19$ million during FY$2025.$

iv$.$There are currently no discounts given to customers who pay cash.

v$.$It is not expected that the budgeted revenue for FY$2025$ will be affected by the proposed changesto the working capital management policy.

vi$.$Operating days for FY$2025$ are $365$ days.

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REQUIRED

For each sub$-$question below, remember to:

$$Ignore VAT.

$$Clearly show all your calculations in detail; and

$$Where necessary, indicate irrelevant amounts$/$adjustments with a R$0($nil$-$value$).$

a$)$

Evaluate the current business model of Luxe Living by applying Porter$$s Five Forces Framework.

$(5)$

b$)$

Discuss practical strategic measures that Luxe Living can take to successfully achieve a turnaround of the business.

$(5)$

c$)$

Calculate the weighted average cost of capital $($WACC$)$ for Luxe Living based on the target capital structure on $29$ February $2024.$

$(8)$

d$)$

i$.$Luxe Living is considering funding the solar farm project using a combination of anythree debt facilities that were mentioned in Section A$,$ Note $3$ above. Evaluate theprovided options and advise on the most suitable debt facilities they can consider.No calculations are necessary.

ii$.$Calculate the market values of Luxe Living$$s medium$-$term loan and debentures asat $29$ February $2024.$

$(6)$

$(4)$

e$)$

Based on the plans for the $2025$ financial year, advise the finance team as to whether it would be financially beneficial to implement the proposed changes to the working capital management policy. Assume a weighted average cost of capital of $14,5\%$ for the FY$2025.$

Support your advice with relevant and necessary calculations.

Where applicable, use average balances.

Ignore tax implications.

Calculations $5$ marks

Advice $1$ mark

$(6)$

f$)$

Identify three $(3)$ financial risks evident in Section B of the scenario and explain how Luxe Living can best respond to each of these financial risks.

Risk identification $3$ marks

Corresponding risk responses $3$ marks

$(6)$

TOTAL

$40$

Disclaimer: The scenario in this paper is fictitious and may not be a fully accurate representation of how the industry works.

$$

UNISA $2024$

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