Management Professional Competence

Suggested Answers
Multi Subject Assessments – Winter 2021

Ans.1 Uncle Azad

(a) Performance of Uncle Azad's during the year ended 31 October 2021

Financial performance
Revenues in the year ended 31 October 2021 (2021) were 32.4% below those of the
last pre pandemic year, the year ended 31 October 2019 (2019). Clearly this was
due to the impact of the coronavirus pandemic, with restrictions on the number of
diners, and lockdowns during certain periods, which did not happen in 2019. Uncle
Azad has shown some flexibility in offering takeaway food, presumably during
periods where the restaurants were forced to close, and this has reduced the 40%
decrease in food and beverages. This action would also have pleased the regular
customers, which may lead to customer loyalty in the future. Whether this drop in
revenue is normal for restaurants in Karachi is difficult to ascertain without
information about how the industry as a whole was impacted by the coronavirus
pandemic.

In terms of business mix, the share of revenue from beverages fell from 36.4% in
2019 to 32.3% in 2021, presumably because people buying takeaway food did not
buy beverages. This has an impact on margins, as beverages have a much higher
profit margin than food (81% for beverages in 2021 compared to 65% for food). In
spite of this, overall margins only fell by 1%, as there appears to have been a slight
increase in the gross profit margin on food. The improvement in the margin on
food may be related to the fact that, during periods of lockdown, the company only
offered a limited menu, and this may have led to less food wastage.

Managers' salaries rose by 10% between 2019 and 2021. This is below the 20% level
of inflation. Presumably, managers were asked to accept a lower pay rise due to the
impact of the pandemic. While such a move may have been sensible from a
financial perspective, it may have caused some resentment among the three
managers. Indeed, one of the managers has actually been stealing − this may have
been influenced to some extent by the poor pay rise.

Staff costs have fallen by 29% between the two years. It is likely that staff have been
working fewer hours due to lockdown and there may have been a reduction in
headcount. While this could lead to resentment among staff, the hospitality
industry does tend to have high staff turnover anyway, so this should have no long-
term impact. The reduction in staff costs did not match the reduction in revenue of
42% so contributed to the fall in the net profit margin. Clearly, it was difficult to
estimate exactly how much revenues would fall by and, therefore, how much staff
numbers should be reduced.

Maintenance expenditure has increased by 50%. This may be due to the restaurants
requiring more maintenance as they become older, or it may be that the company
decided to do additional maintenance during the year while business was quiet.
Depreciation rose by 6% which is less than inflation. Depreciation is generally an
expense which relates to investment decisions made in earlier periods so, from the
perspective of evaluating the performance of the company, they do not reflect the
current year so much.

Profit after tax fell by 52% between 2019 and 2021 ((Rs. 2,350,171÷ Rs. 4,866,323)
−1). This is more than the 32.4% fall in revenues. The reason is that many of the
costs of the restaurants such as the manager's salary and depreciation are fixed, so a
fall in revenue has a larger impact on the profits.

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 Management Professional Competence
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Multi Subject Assessments – Winter 2021

It is good that the company is sticking to a policy of retaining profits of

Rs. 1 million in spite of the fall in profits, as the company will have capital set aside
to finance growth, or to meet unexpected costs in the future. This does mean that
dividends paid to the family fell from Rs. 3.9 million in 2019 to Rs. 1.4 million in
2021. The year 2021 has therefore been an exceptionally poor year in terms of
providing a good share of profits to partners.

Non-financial performance
While no specific non-financial performance indicators have been provided, it is
possible to ascertain some facts from the reviews on the 'Traveller's Choice' website.
It should be recognised that only a small portion of guests bother to write reviews,
so their opinions are not necessarily representative of all guests.

An average rating of 3.5 out of 5 does not sound like guests are exceptionally
pleased with the restaurant. While no comparatives for other restaurants have been
given, it does not seem unreasonable to assume that a restaurant that consistently
pleases its guests would be likely to score above 4.

Being a service industry, it is not always clear what guests expect when they visit
the restaurant, which explains the variety of scores given by the three guests whose
reviews have been provided. All guests do mention that the quality of the food was
excellent, so this is clearly a strength of the business. Two of the guests also
appreciate the friendly service and enjoy the live music, which suggests that the
restaurant provides a welcoming, fun experience.

The business visitor was not impressed with the service, and found the music too
loud. While this can be taken as a negative point, it may simply be because Uncle
Azad is not providing the type of service that business visitors want. No restaurant
can please all types of guests, and it is more important that Uncle Azad recognises
what type of customer it wishes to appeal to, which is why Yasmin's suggestion
that the company considers a more focused approach to marketing is correct.

Conclusion
Clearly, the coronavirus pandemic has had a devastating impact on the revenues of
the business, and this has led to a 52% fall in profit after tax. However, given the
exceptional circumstances, this would not be expected to be a typical year, and
hopefully when things return to normal after the pandemic, the restaurant will be
able to achieve a higher level of profits.

In terms of quality of service, customers like the food and friendly atmosphere of
the restaurants but business customers do not find the restaurants to be smart
enough.

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 Management Professional Competence
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Multi Subject Assessments – Winter 2021

Appendix – calculation of relevant ratios

(i) Revenues
31-Oct-21 31-Oct-19 Decrease
---------- Rupees ----------
Food 7,649,762 12,749,604 –40.0%
Takeaway food 1,529,952 0
Beverages 4,380,836 7,301,393 –40.0%
Total 13,560,550 20,050,997 –32.4%

Business mix
Food 56.4% 63.6%
Takeaway food 11.3% 0.0%
Beverages 32.3% 36.4%

(ii) Gross profit margins

31-Oct-21 31-Oct-19
Food: ----------- Rupees -----------
Revenue 9,179,714 12,749,604
Cost of sales (3,212,900) (4,589,857)
Gross profit 5,966,814 8,159,747
Gross profit margin food 65% 64%

Beverages:
Revenue 4,380,836 7,301,393
Cost of sales (832,359) (1,314,251)
Gross profit 3,548,477 5,987,142
Gross profit margin beverages 81% 82%

Overall
Revenue 13,560,550 20,050,997
Gross profit 9,515,292 14,146,889
Gross profit margin 70% 71%

(iii) Other costs

Increase/
31-Oct-21 31-Oct-19
(Decrease)
---------- Rupees ----------
Managers’ salary (738,607) (671,461) 10.00%
Staff costs (3,289,398) (4,609,012) –28.63%
Maintenance (150,000) (100,000) 50.00%
Depreciation (2,027,187) (1,912,441) 6.00%

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 Management Professional Competence
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Multi Subject Assessments – Winter 2021

(b) Objective of growth

Yasmin's opinion is that Uncle Azad needs to set an objective of growth in
revenues and profits. Whether this opinion is valid or not depends on the objectives
of the stakeholders of the company.

Omar, as the founder of the company, is happy that the restaurant provides a
comfortable income for the family in terms of a dividend and as Omar has said,
enables him to have fun. While this may not appear ambitious, this attitude may
reflect Omar's age and desire for an easier life. He may also not wish to take on the
risks that aiming for growth would require in terms of further investment.

A strategy of growth may be desired by other stakeholders. Yasmin herself is

clearly keen for the business to grow. This may be based on the fact that, as a
partner, growth of the business would increase her wealth. It may also be that, as a
partner, she wishes to enjoy the challenge of growing the business.

Growth would also be potentially beneficial for the staff of Uncle Azad. Opening
new restaurants may offer opportunities for promotion as new restaurants will need
managers and chefs. A larger business will also require a larger central head office,
providing new employment opportunities.

It is clear that Omar and Yasmin have different objectives, and it is important that
they work together to agree the objectives of the business now, since
misunderstandings may lead to resentment. A compromise may be possible – such
as allowing the business to aim for growth, but limiting Omar's role to managing
the original restaurant.

(c) (i) More focused approach to marketing

A more targeted approach to marketing would involve identifying the
different market segments and deciding which segment(s) to target. Having
identified the appropriate target segments, Uncle Azad would then focus on
meeting the needs of these segments.

The customer reviews of Uncle Azad, shown in Exhibit 2, demonstrate the

views of three different types of customer: a tourist, a business customer and a
local, visiting the restaurant for a birthday party. It can be seen from the
comments that the restaurants do not entirely meet the needs of any of these
three groups. Laura from Manchester regrets the lack of vegan options; Arish
from Dubai is very dissatisfied with several aspects; while Rhana from
Karachi is happy with everything except the price.

The main advantage of a more focused approach is that Uncle Azad

restaurants would be able to learn about the needs of its target segments and
how to meet them. This would lead to greater satisfaction from customers
within that segment, improving the reputation of the restaurants and therefore
the revenues.

Advertising and promotion campaigns will be more successful if they are

focused. People are more likely to read or respond to promotions (e.g. emails)
that are relevant to them, and are more likely to ignore promotions that are
aimed at the market as a whole. If Uncle Azad is clear about what its target
segments are, and what they want, then the promotion campaigns will have a
clearer focus.

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 Management Professional Competence
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Multi Subject Assessments – Winter 2021

Having a more focused approach may help to drive cost efficiencies at the
restaurants. Rather than buying in a wide variety of foods to suit all tastes for
example, the restaurants may be able to narrow the selection, leading to lower
food waste costs.

A disadvantage of such a strategy is that it would involve additional costs.

Market research would need to be performed to identify the potential market
segments and what the preferences of each segment are. It may be necessary
to change the décor of the restaurants to fit in with the targets. There will be
more promotions and therefore promotion costs. It would be necessary to
consider whether the benefits of this approach would outweigh the costs.

The focused approach may also mean that customers who are not within the
target segments would not like the changes to the offering. However, these
segments may already be unhappy with the offering as Arish from Dubai
demonstrates. Hopefully, the loss of customers outside the targets is likely to
be less than the increase in customers from the target.

(ii) Potential market segments

The market for dining out could be segmented based on the following
dimensions:
 Incomes and social class
 Reason for dining out
 Location of visitors

Individuals from higher social classes will generally expect a high quality of
food and a high level of customer service, and will be happy to pay higher
prices. As income levels fall, customers will expect lower prices and more
value for money, but may be less conservative in their tastes for décor and
ambience.

The reason for dining out will also impact on what customers want. If people
primarily visit the restaurant for social gatherings, they will expect a different
experience from people visiting for business purposes. Factors such as the
music (live or recorded), the volume of the music, the décor of the restaurant
and the nature of service would need to be considered. Uncle Azad would
need to be aware which of these factors would appeal most to their target
segments.

Finally, the location of visitors will affect Uncle Azad strategy. The
restaurants may want to aim for people living in the local area only for
example, as opposed to attracting visitors from a wider area and possibly
tourists visiting Pakistan.

In selecting appropriate segments for Uncle Azad, the following factors

should be considered:
 Does the segment offer good potential in terms of revenue and profits?
 Does Uncle Azad have the capabilities to serve this segment well?

Based on the comments received on Traveller's Choice, the food is good

quality so the company may be able to attract individuals with higher incomes
who are prepared to pay higher prices for good quality food.

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In terms of reasons for dining out, the restaurant did not appeal to the
business traveller. Trying to change the restaurants to focus on this segment
may not be feasible, so business visitors may well be eliminated. The
restaurants could therefore focus on visitors who wish to come for social
gatherings or family celebrations.

In order to gain sufficient customers to pay higher prices for the quality food,
the restaurants should also focus on visitors from a wider geographical area,
who are prepared to travel for a good meal. It could also continue to aim for
wealthy tourists, who wish to experience genuine local food.

In summary, it is recommended that Uncle Azad focus on customers with

high disposable income, who would visit the restaurant for social purposes
and who may or may not necessarily be located locally to the restaurants.

(d) Proposal to apply for venture capital

Venture capital is a source of finance, often equity finance, that is provided to
small, often risky businesses, that have potential to grow. Venture capitalists are
interested in businesses that have a good track record and a large untapped market.

The advantage of venture capital is that being a source of equity, there is no legal
requirement to pay interest charges which might be the case for other types of
finance. There is, therefore, less financial risk to the business.

Venture capital also complies with Sharia law as it is consistent with the Mudaraba
model whereby the risks and rewards are shared by the investor and the
entrepreneur, and it does not involve the payment of interest, unlike debt finance.

Another advantage is that the venture capitalist would have experience of working
with many other small companies. It would therefore be able to provide expertise
and advice that could help Uncle Azad in a number of areas, such as marketing.

The venture capital organisation would typically become a shareholder, and this
would dilute the shareholdings of the Chaudury family. The venture capital
company would also usually require representation on the Board of Directors of
Uncle Azad which would mean that they would have a potentially significant
influence over the strategic and operational decisions made by the company. The
existing directors and shareholders may not like having to gain consensus for
decisions that previously they would have been able to make independently.

The venture capital company would also be looking to sell their investment,
typically within five to seven years. One common way of achieving this is by listing
the company on a stock market. This would mean that over the longer term, Uncle
Azad would become a listed company and would be required to comply with all
the additional regulations that apply to such companies, such as additional
financial reporting disclosures and compliance with corporate governance
regulations. Even if the Chaudury family maintain control over the business, there
will be much more information about the company disclosed to the public.

It should be noted that there is no guarantee that a venture capitalist can be found
who would be willing to invest in Uncle Azad. It would be necessary to persuade
potential investors of the strengths of the current business and, in particular, the
potential for growth. It will be necessary to persuade them that Uncle Azad has
some competitive advantage that would enable it to succeed in new locations.

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(e) Action in respect of the theft

Omar is facing a difficult dilemma in that Asif, one of the managers who he
considers a friend, has been stealing from the business. The business's policy is that
the manager should be dismissed immediately and reported to the police, but Omar
is unsure of whether or not to do this as Asif has a family to support and a wedding
to pay for.

From an ethical perspective, Omar must be transparent about this and inform the
other partners, including Yasmin, as this is a serious issue. If Omar tries to disguise
this, that would be unfair on the other partners, who have also been affected by the
theft.

In terms of the decision as to how to deal with Asif, it is important to consider the
impact of the decision on the other staff. Omar mentioned in his discussion with
Asif that business policy is immediate dismissal and prosecution for all acts of theft.
It is probable that the staff are aware of Asif's actions and may be aware that he has
been caught. If Omar does not dismiss and prosecute Asif, it would send the
message that the business is not serious about the policy. Potentially, this could
cause other staff to believe that theft will go unpunished.

On the issue of fairness, staff may also consider it unfair if Asif is not punished in
accordance with policy for his acts. Many of the staff are likely to be honest, and
probably dislike the actions of their boss, but feel they cannot do anything about it.
Now that he has been caught, they would expect him to be punished. If he is not,
they may consider that to be unfair. This could be seriously demotivating and
damaging to the business culture.

Keeping Asif employed as a manager would be a big risk in terms of trust. He has
already breached the trust placed in him by the directors of Uncle Azad and there is
no guarantee that he would not do so again, were he to be kept employed.

While Asif does have a family to support, he himself is to blame for risking the
consequences of his actions, and Omar should not feel he has any duty to protect
Asif from losing his job or from prosecution. If he really is a friend of Omar, Asif
could have approached Omar for financial help, rather than stealing from him.

(f) Tax implications for Uncle Azad

If Uncle Azad converts the business by disposing assets to a wholly-owned resident
company, no taxable gain or loss would arise from that disposal. However, the
following conditions would need to be satisfied:
 The consideration received by Uncle Azad is in the form of share(s) other
than redeemable share(s).
 The association must own all the issued shares in the company immediately
after the disposal.
 Each member (i.e. Omar, Daulat and Yasmin) must have an interest in the
shares proportionate to the members' interest in the business assets
immediately before the disposal.
 The new company must undertake to discharge all the liabilities related to the
assets disposed of to the company.
 Any liability in respect of the assets disposed of to the company must not
exceed the cost of the assets at the time of the disposal.
 The fair market value of the share(s) should be equivalent to the fair market
value of the assets (less any liability that the new company agrees to bear), on
the date of disposal.
 The company to which the assets are transferred should not be exempt from
tax in the tax year in which disposal takes place.
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Assets acquired by the company shall be treated as having the same character as
before the transfer. When a transfer of assets takes place, the cost in the hands of the
company will be:
 In the case of depreciable assets or intangible assets that are amortised, the
written down value immediately before the disposal
 In the case of stock-in-trade, at the value taken for tax purpose under section
35(4)
 In other cases, the transferor's cost at the time of disposal

Further, where an AOP disposes of assets subject to depreciation (u/s 22),

amortization (u/s 24) or pre-commencement expenditure (u/s 25) in a tax year,
these deductions from its income will not be allowed in that tax year.

In the hands of the transferor, the cost of share(s) received will be calculated as the
transferor's cost (reduced by any liability that the company may undertake) divided
by the number of share(s).

The tax rate would be applicable that of a company as per ITO, 2001.

Tax implications for members of Uncle Azad

If Uncle Azad converts into a company, its shareholders will now only require to
pay tax on the dividend at the rate of 15% to be received from the company. They
will not be liable to any tax payable by the company.

All the other income of the shareholders will be charged in accordance with the
relevant provisions of the Income Tax Ordinance, 2001.

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 Management Professional Competence
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Multi Subject Assessments – Winter 2021

Ans.2 Shikapur Gas Supplies Ltd

(a) SGS Bond: Coupon rate

The SGS bond issue yield will be based on the comparable company bond already
in issue for KHE.

The yield on KHE debt

Redemption value:
Cash: Rs. 10,000
Shares: 15 × [325 × (1.1)8] = Rs. 10,450

Note: The KHE bond was issued two years ago, hence eight years left to run.

Therefore, conversion would take place, with a value of Rs. 10,450

10% DF 10% PV 5% DF 5% PV
T0 Market price (9460.00) 1.000 (9460.00) 1.000 (9460.00)
T1-8 Interest 800.00 5.335 4268.00 6.463 5170.40
T8 Redemption 10450.00 0.467 4880.15 0.677 7074.65
(311.85) 2785.05

The IRR of the bond (using linear interpolation)

= 5% + [{(10%−5%) × 2785.05} / (2785.05 + 311.85)] = 9.5%

Therefore the required yield on SGS debt, adjusting for the credit spread difference
of 150 points = 9.5% − 1.5% = 8%

SGS coupon rate:

Issue value = PV of future cashflows

10,000 = (I × AF1-88%) + (9,000* × DF88%)

10,000 = (I × 5.747) + (9,000 × 0.540)
10,000 = (I × 5.747) + 4,860
5,140 = 5.747 × I
I = 5,140 / 5.747 = 894

*The debt is redeemable at a 10% discount; hence the redemption value is Rs.
10,000 × 90% = Rs. 9,000

This implies a coupon rate of 894 / 10,000 = 8.94%

(b) New organisational structure

The current structure is functional, which suited the business well given it was
essentially one strategic business unit. The functional structure allowed specialisms
to deliver efficiency and effectiveness in operations.

However, the move to gas extraction represents related diversification – it is

downstream vertical integration. Manufacturing operations will still continue,
albeit on a smaller scale.

Recommendation
A divisional structure is recommended, with a manufacturing and a gas extraction
divisions being the two main divisions.

Some functions may benefit from a shared service centre approach such as Finance,
IT and Human Resources.
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Justification – divisional approach

This reflects the fact that the business will be very different in several functional
respects – such as operations (manufacturing compared to gas extraction), product
development and marketing (different target markets). This divisionalised approach
will have the following advantages:
 Management and operational focus
These will be facilitated for the very different operations: manufacturing plant
and extracting natural gas are markedly different.

 Geographical focus
Manufacturing will remain in Shikarpur, with gas extraction taking place on
the land bank. A divisional structure will enable management to directly
monitor operations under their control.

 Motivation – managers
Divisional managers can be financially incentivised to optimise the
performance of their own divisions. This will be particularly important for the
extraction business as it is new, and reasonably speculative.

 Motivation – workers
Targets and bonuses can be set to reflect divisional rather than group
performance, incentivising a divisional orientation amongst staff.

 Speed of decisions
Decisions can be made locally with speed, that reflect local requirements.
This should hopefully minimise any bureaucracy within each business unit.

Justification – shared service centres:

Some functions may benefit from a shared service centre approach where the
differences between the needs of the two divisions are not so marked. This may
apply to Finance, Product design, IT and Human Resources.

This would have significant benefits:

 Control and consistency
Keeping some functions intact for the group as a whole will help ensure
group-wide consistency and will enable head office to enact policies and
consolidate information for the group as a whole more easily.
 Economies of scale and expertise
One large function as opposed to two smaller ones may allow economies of
scale (for example, with IT network infrastructure costs) and would make
employing niche experts (such as hedging experts in treasury) more likely to
be viable given their cost is being spread over two units.

 Less duplication of effort

There is a risk that decentralised functions duplicate effort, wasting time and
resources.

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(c) Main change management issues

Widescale transformational change:

The entire workforce is facing significant change, whether relocating, redundancy
or retraining for the downsized manufacturing operation. Each of these is
'paradigm shifting' - i.e. deeply unsettling for all. The fact that most workers are
affected makes controlling the change process and culture particularly challenging.

Inexperienced management:
Change management skills are lacking in the management team given the long,
stable history of the current manufacturing site. They may require training or
externally sourced support.

Relocation:
Many workers face relocation to a remote area, so are likely to need significant
assistance to find suitable premises and help settling in.

Changed reporting lines:

The organisational restructure will change reporting lines and break up old teams.
This will mean most of the workforce will need to work to form new teams and
new working relationships with managers. This will create stress and a learning
curve for most employees.

Lack of diversity:
Most workers come from a similar background. A diverse workforce tends to be
more resilient to change given that different perspectives are naturally shared
amongst change subjects. As this is not the case for SGS, any issues are likely to
become intensified.

Heavy local dependence on SGS as an employer:

SGS is the major employer locally and as such, there will be a significant social
impact on the local community as a high proportion will become unemployed or
forced to relocate. Community support may be needed during and after the
transition period.

Environmental concerns:
Extraction process could raise concerns in terms of pollute water supplies and can
cause serious tremors. Close monitoring would be needed to avoid any unwelcome
environmental side-effects arising from extraction process.

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(d) Corporate social responsibility issues and responses

Global warming is a high profile issue

The burning of fossil fuels such as extracted natural gas contributes to global
warming and climate change. This could impact on SGS's reputation as they move
into the more direct role of extraction. Offsetting policies (such as planting forests)
may help to redress this balance.

Fracking has environmental concerns

Fracking is noted as potentially causing local tremors and ground water pollution.
Detailed and proactive monitoring should take place, as well as siting operations as
far away from any local communities as possible. Alternative water supplies should
be made available at short notice should any groundwater contamination occur.

Significant disruption to the Shikarpur workforce community

SGS is the main employer in the current local community, so relocation and
redundancy on a large scale will disrupt the whole community. An outreach
programme should be funded to help with relocation from the community, and
retraining for those made redundant.

Impact on the current supply chain

SGS suppliers are also likely to be affected by the downsizing of manufacturing
operations. This could have consequential impacts on their communities and
employees. They should be kept informed in a timely manner to allow them to
plan.

Impact on new communities

Developing the new extraction site will have a local environmental and social
effect. The environmental impact should be minimised through site design and
consultation with environmental experts. The local community does not have skills
to be able to offer them significant employment opportunities, so a community
support function should be set up to manage the impact on any affected local
communities.

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Ans.3 Karachi Auto Manufacturers

(a) Range of valuations

Asset based valuation:

Rs. in million
Non-current assets − non vehicles 70.00
Replacement cost of vehicles 210.00
Net current assets 75.00
Calculated Intangible value (W1) 75.44
Asset value 430.44
Less loan (150.00)
Equity value 280.44

W-1: CIV working Rs. in million

Return based on MLL ROCE* 42.50
Return based on industry ROCE (21.25)
Additional returns due to brand 21.25
Less: Tax on additional returns (6.16)
Additional after tax returns due to brand 15.09

*ROCE × Capital employed = 10% × 425 = Rs. 42.5m

Valued into perpetuity at Ke = 15.09/0.2 = 75.45

Cash flow based: Free cash flows to equity:

T0 T1 T2 T3 T4
----------------- Rs. in million -----------------
PBIT 42.50
Interest (15.00)
27.50
Tax (7.98)
FCFE 19.52
Growth rate 0.17 0.17 0.17 0.14
FCFE 22.84 26.72 31.26 35.64
Perpetuity factor 16.67
Discount factor 0.833 0.694 0.579 0.482
Present value 19.02 18.54 18.10 286.37
Total present value = equity value 342.03

Working
The T4 cashflows onwards are a constantly growing perpetuity, growing at a rate of
14% per year at a cost of equity of 20% per year.

The perpetuity factor is therefore:

1/(r−g) = 1/ ((20%−14%) = 1/(6%) = 16.666667

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Earnings based valuation:

P/E × Earnings
 P/E = 15 (adjust downwards as target is unlisted, but back up to reflect higher
growth prospects than the listed company)
 Earnings per FCFE calculation = Rs. 19.52 million

So equity value = 19.52 × 15 = 292.8m

Summary values
Rs. in million
Assets based 280.44
Cash flow based 342.03
Earnings based 292.80

Bidding strategy:
The Malik family is unlikely to accept less than the asset based value of the
business, albeit this also includes a calculated intangible value.

Therefore, the recommended approach is to start bidding at Rs. 280 million

(which is marginally above the book value of equity of Rs 275m), with an upper
limit of Rs. 300 million.

The limit is a little below the cash-flow based ceiling because:

 The cash-flow based valuation represents the maximum value to KAM.
 There will be transaction costs associated with the purchase that have not
been factored into the valuations as noted.

(b) Real options

Option to delay:
The Malik family have granted a period of exclusivity to KAM, giving them time to
consider the acquisition without fear of losing it. This adds value as it gives time to
further consider the option, research alternatives, research MLL itself and
potentially, to wait until demand in the auto parts industry recovers. Changes to
industry tax incentives may also be clarified in this period.

Option to follow on:

The logistics business could be expanded to include new industries beyond vehicle
parts. The brand is recognised widely which will help this process.

Option to abandon:
The business is profitable and could be sold on or otherwise profitably divested in
the future.

These options all add to the value of the business, making the decision to purchase
firmer and/or presenting the possibility of increasing the purchase price if
necessary.

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 Management Professional Competence
Suggested Answers
Multi Subject Assessments – Winter 2021

(c) Recommended changes to corporate governance arrangements

Significant changes would be required in order for KAM to become listed. They
should apply the Pakistan Code of Corporate Governance 2019 on a mandatory
(for mandatory provisions) and 'comply or explain' basis (for voluntary provisions),
ideally adopting the following:

Split of Chair and CEO role

The executive operations of the business and the Board need to be separated. This
allows the board to assess operations objectively. To facilitate this, the Chair and
the CEO roles should be undertaken by two separate people. As the Chair should
be independent, the father of the Syed family should not take this role – Fahad
could take the CEO role, however. A new Chair, with experience in running a
listed business, should be appointed.

Introduction of independent NEDs

To further separate the Board from operations, independent Non-Executive
Directors (or NEDs) should be appointed. Two or one third of the members of the
board, whichever is higher, should be made up of independent NEDs. This means
board decisions cannot be dominated by those with operational/executive
responsibilities in the business. The current single non-executive director is not
independent given he worked recently for one of KAM's main customers and is a
personal friend of the Chair/CEO.

Introduction of audit, nomination and remuneration committees

Subcommittees of the main board, staffed by non-executive directors, should be put
in place to ensure sound governance, including:
 Management of internal and external audit, and financial statements review
(audit committee)
 Formalisation of remuneration schemes (remuneration committee)
 Formalisation of nominations, and appointments procedures / activities
(nominations committee)

Amendments to bonus scheme for executives

Ideally, executive bonus schemes should relate to personal targets rather than
simply an equal share of group profits. This is to incentivise individual effort
towards personal objectives.

Amendment to non-executive remuneration plans

Non-executives should not be heavily incentivised with short-term targets;
therefore, the payment of a fixed fee is recommended. This means your proposed
share option scheme with the current NED should not be put in place.

Introduction of formal shareholder communications

Once listed, shareholders from outside the family will be introduced. Their rights
are protected in law and through corporate governance provisions. For example,
their rights should not be unduly prejudiced in favour of family shareholders, and
they have a right to receive information and participate as appropriate in voting on
key matters of concern.

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 Management Professional Competence
Suggested Answers
Multi Subject Assessments – Winter 2021

(d) Hedging strategy

There is a net purchases exposure to foreign exchange transaction risk with KAM's
parts distribution business. As the Rupee spot rate has declined, the Rupee
equivalent of overseas purchases has increased. This is not being offset by foreign
exchange gains on sales as sales are invoiced in Rupees.

It should be noted that foreign exchange hedging can reduce short-term risk, but it
cannot reverse underlying trends in the market. The hedged rates will reflect the
continuing downwards trend, albeit this trend may well reverse at some point in the
future.

Purchases can be split into two elements:

The predictable amount – Rs. 5 million per month

As this is predictable with respect to timing and amount, a forwards contract could
be used to hedge against the regular amounts. Although this gives no upside
potential should rates increase, they are inflexible, and we will suffer the bank's
margin requirement, they are easy to arrange, can be arranged for up to one year or
so and can be tailored to our needs as to timing and amount. Time flexibility is less
of an issue given the predictability of these flows.

The fluctuating amount – Rs. 20 million per month

This is unpredictable in relation to both size and timing. The timing flexibility
could be created using futures as they can be closed out at any point up to the
futures expiry date. However, they will be an imprecise match for the required
amount given the wild fluctuations, and are still a binding obligation. KAM would
still be facing significant exposure due to being potentially massively under or over-
hedged.

A better alternative for these purchases may be to acquire rupee put options from
an exchange. Although premiums will be costly, KAM will maintain access to
upside potential and, importantly, KAM can let some options lapse if purchases are
lower than expected. American style options can be exercised over a period of time,
giving KAM the time flexibility it needs.

The options suggestion assumes that the exchange-traded options exist for the
currencies KAM needs. If not, they can often be synthesised by simultaneously
acquiring two options, but this is probably beyond KAM's current treasury
capability at the moment, and is also costly. Equally, an option 'collar' could be
used in the future to mitigate the put option premium, but this is for future
consideration.

Summary:

Predictable purchases: Forward contracts arranged with the bank

Unpredictable purchases: Exchange-traded Rupee put options

If the put option premiums are very high, KAM could consider approaching
suppliers again for Rupee invoices and accept a higher price, albeit this may have a
knock on effect on KAM's sales prices.

(THE END)

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