attached.
Chartered Professional Accountants of Canada, CPA Canada, CPA are trademarks and/or certification marks of the Chartered Professional Accountants of Canada. © 2020, Chartered Professional Accountants of Canada. All Rights Reserved. Les désignations « Comptables professionnels agréés du Canada », « CPA Canada » et « CPA » sont des marques de commerce ou de certification de Comptables professionnels agréés du Canada. © 2020 Comptables professionnels agréés du Canada. Tous droits réservés. 2019-09-27 Finance — Practice Case 6 Case (90 minutes) Today is March 16, 2020. Bob Johnson, CEO of Rock Mining Ltd. (RML), has been with RML for the past five years. Prior to this, he was the CEO of an integrated forest company that he successfully managed for seven years. RML is a publicly traded, small-cap, Canadian company with a zinc mine in Manitoba and a copper mine in Quebec. RML’s core competency lies in maximizing extraction of ore at its mines. As a result of this process, RML’s production and administration costs are consistently lower than the industry average. In 2019, RML reported a profit of $7 million on sales of $120 million. Bob has been investigating acquisition options and identified a number of possibilities. After further research, Bob narrowed the choices down to two opportunities that he considers a good fit for RML, which he has discussed with the board. Woods Forestry Inc. — Share purchase Woods Forestry Inc. (WFI) is a privately owned integrated forestry company. The shares are currently for sale for $40 million. Bob met with the shareholder and managers of WFI and prepared a summary of information, provided in Appendix I. Extracts of WFI’s financial statements and notes are provided in Appendixes II and III. Red Valley — Asset purchase The Red Valley gold mining property, currently owned by Sudbury Xtra Gold Inc. (SXG), is for sale for $11 million. This acquisition would be structured as an asset purchase. SXG is currently looking to sell the Red Valley property to finance further exploration. The Red Valley site has not yet been mined, nor has any infrastructure been built to access the gold reserve. Additional information and select financial details of Red Valley are provided in Appendixes IV and V. While forestry and mining both fall within the natural resources industry, the underlying risks of each sector differ. Betas for these two segments and additional pertinent financial information are set out in Appendix VI. In addition, while the board of RML is amenable to diversification outside of zinc and copper, it wants to proceed cautiously and is only willing to consider one acquisition at this time. Finance — Practice Case 6 Case 2 / 9 One of the significant issues in mining is the requirement to remediate the land base after the ore body is exhausted. RML is very experienced in estimating these costs for mining properties, as it is part of its normal business. However, accurately forecasting these types of obligations in the forestry sector falls outside RML’s area of expertise. You, CPA, work for Valuation Expertise Group (VEG). RML has hired VEG to value the two acquisition targets. Jen Brown, your team leader, has asked for your assistance and has specifically asked you to do the following: 1. Calculate the appropriate capitalization/discount rate for each acquisition target and explain the differences. Bob is uncertain what Beta represents and would like a brief explanation. 2. Prepare a preliminary valuation calculation for WFI using the capitalization of free cash flow method, using the five-year historical average, as at December 31, 2019. Then discuss qualitative considerations that may also impact the decision. 3. Prepare a preliminary valuation calculation for the Red Valley property using the discounted cash flow approach, assuming a valuation date of December 31, 2020, as the investment will not be made until then. Follow this with a qualitative discussion of considerations that may also impact the decision. 4. Recommend one of the alternatives based on your quantitative and qualitative analysis. Consider comparing based on profitability indices. Your response should be no longer than 2,700 words, excluding any Excel files. Finance — Practice Case 6 Case 3 / 9 Appendix I WFI information (As gathered by Bob Johnson in discussions with WFI management) WFI started operations in British Columbia in 1974. While no forecasts of the future prospects of WFI have been provided, revenue and costs have been stable for the past five years and are expected to remain as such for the foreseeable future. The executive team is very experienced, having been with the company for an average of 23 years. WFI’s current expectation would be to retain the existing workforce after the acquisition. However, RML would take a more hands-on approach. Other relevant information: • Sustaining capital expenditures, net of tax shield, are $5 million per annum. • The present value of the tax shield based on the current undepreciated capital cost (UCC) balance is $28 million. • The owner has historically been paid a salary of $1,000,000. The market value of his services is estimated to be $100,000 per year. • WFI’s combined federal and provincial income-tax rate is 30%. • Cash is considered redundant, and it is not required for ongoing operations. Finance — Practice Case 6 Case 4 / 9 Appendix II WFI Statement of financial position as at December 31 (Audited, prepared using IFRS) (in $’000s) 2019 2018 Assets Current assets Cash and cash equivalents $ 2,321 $ 1,220 Accounts receivable — trade 8,890 8,540 Inventories 11,780 12,080 Total current assets 22,991 21,840 Property, plant, and equipment, net 38,222 38,560 Timber licences 19,543 20,561 Other intangible assets 8,890 8,540 Total assets $89,646 $89,501 Liabilities Current liabilities Accounts payable and accrued liabilities $ 3,141 $ 3,444 Current portion of long-term debt (A) 7,512 7,488 Current portion of deferred reforestation obligations 3,744 3,165 Total current liabilities 14,397 14,097 Long-term debt (B) 27,278 30,350 Deferred reforestation obligations 7,731 7,919 Deferred income taxes 843 842 Total liabilities 50,249 53,208 Shareholders’ equity Share capital 12,000 12,000 Retained earnings 27,397 24,293 Total equity 39,397 36,293 Total liabilities and equity $89,646 $89,501 Total long-term debt (A + B) 34,790 37,838 Finance — Practice Case 6 Case 5 / 9 Appendix II (continued) WFI Statement of profit or loss for year ended December 31 (Audited, prepared using IFRS) (in $’000s) 2019 2018 2017 2016 2015 Sales $85,973 $84,287 $82,634 $81,014 $79,425 Expenses Manufacturing and product costs 54,163 54,365 54,125 51,849 50,435 Freight and other distribution costs 14,862 13,305 12,481 12,568 11,322 Depreciation and amortization 5,335 5,652 5,494 5,976 5,600 Selling and administration costs 3,944 3,884 3,747 3,180 3,423 78,304 77,206 75,847 73,573 70,780 Operating income 7,669 7,081 6,787 7,441 8,645 Finance expense, net 1,893 1,345 1,282 1,220 1,120 Net profit before income taxes 5,776 5,736 5,505 6,221 7,525 Income tax expense 1,733 1,721 1,652 1,866 2,258 Net profit $ 4,043 $ 4,015 $ 3,853 $ 4,355 $ 5,267 Finance — Practice Case 6 Case 6 / 9 Appendix III WFI Extracts of notes to the financial statements For the year ended December 31 (in $’000s) Long-term debt The fair value of total long-term debt at December 31, 2019, roughly approximates the book value of $34,790. Reforestation obligations WFI has reforestation obligations amounting to $11.475 million at December 31, 2019. The total undiscounted amount of the estimated cash flows required to settle the obligations at December 31, 2019, was $12.690 million. The estimated cash flows have been adjusted for inflation and discounted using pre-tax adjusted risk-free rates ranging from 1.1% to 2.3% at December 31, 2019. Finance — Practice Case 6 Case 7 / 9 Appendix IV SXG Red Valley information (As gathered by Bob Johnson in discussions with SXG management) The technique for extracting gold from the ore body is similar to that of removing copper and zinc. A geological survey performed by My Geological Consultants Inc. (MGC) indicated that the current market value of proven gold reserves at the Red Valley site is US$514 million, as detailed in Appendix V. However, RML recently learned that MGC is wholly owned by an investor who also owns 15% of SXG. RML’s management has provided estimated mining costs and other relevant data as detailed in Appendix V. Cash flows are expected to be earned evenly throughout the year. Development costs and special tax treatment The $11 million purchase price of the mining property includes the land and permits. It is expected that the mine will be ready to start production on January 1, 2021, after RML spends $10 million to build the necessary infrastructure and $20 million to purchase new equipment