CASE STUDY EXERCISES CASE 4 INTRODUCTION Farming Success Limited is an agricultural private limited liability company, engaged in the production of Special Palm Oil (SPO). The company was established 25 years ago by a group of private promoters. It purchased a total of 10,000 hectares of farmland from some families in a local community. The company has developed 60% of the land and the palm trees are fully matured. The remaining 40% of the land is not yet developed. The company had been doing well since the planted area matured. The financial statements for the past five years are contained in Appendices 1 and 2. The company had been able to get sufficient labour for its various operations from the local community. The gestation period for the type of palm trees planted is a minimum of five years and by the beginning of the sixth year of existence, the company had started to produce Fresh Fruit Bunches (FFB) for sale. The production schedule of FFB since the company's plantation matured is contained in Schedule 3. The company commenced the processing of its FFB in the seventh year of its existence. The company had devoted its resources mainly to the production of SPO, hence it did not acquire a palm kernel crushing plant along with the palm oil processing mill. The company's SPO had enjoyed a very good market, with a market share of about 30%. There are seven other companies in the industry, of which four are quoted. The buyers of the company's SPO usually pay (between four to six weeks) in advance before any supply is made. This system provides a good source of working capital for the company. Though the company is a private limited liability company, it compares favourably with quoted companies in the industry in terms of turnover and profitability. The average P/E ratio of a good quoted company with stable earnings and dividend for several years in the industry is 9.5 while that of Farming Success Limited is 9.8. The shareholders have not been willing to get the company quoted so as not to dilute the ownership structure. The company's operations are seasonal. The main season is usually from February to May and the light season runs from September to November. The company must take advantage of the main season in order to ensure that sufficient cash is realised to be able to operate during the off-season. The company, during its early years of operations, when the palm trees had not matured made use of casual labour, it was discovered when SPO processing started, that the system of using casual labour was inadequate. STARRY GOLD ACADEMY +2348023428420, +2347038174484, info@starrygoldacademy.com, www.starrygoldacademy.com Page 1
Since the peak period coincides with the land preparation for local farming activities, it becomes difficult for the company to get sufficient labour during the peak period. To retain its labour force throughout the year, the company makes effective use of its labour for plantation upkeep during the off-season. The company also has a policy of retaining any casual labourer who has worked conscientiously for a period of one year. In the early years of SPO processing, the company made it a policy to grant an annual scholarship award to indigenes of the community from which the land for the plantation was purchased. The company also assisted on some community development projects and strived to give indigenes preference in the recruitment of personnel. In view of the good relationship, the community seven years ago, indicated its intention to give more land to the company for its expansion programme when the 4,000 hectares are fully developed. The shareholders of the company had been declaring 80% of its distributable profits as dividends for the first five years and ploughing back the balance. The amount ploughed back had been invested on purchase of posh cars for the directors and top management of the company. Very little amount was invested in agricultural equipment which had been a limiting factor for the effective harvesting of the FFB needed for the production of the company's product. MARKET SITUATION Usually, the customers of the company had to pay four to six weeks in advance for any purchase. The company, being in a sellers' market, had always passed any increase which may be due to inefficiency in its operations to the customer. The demand for the company's product is fairly inelastic. Considering the present state of encouragement by the government for investment in palm plantation and the ever increasing foreign exchange rate which has made it unattractive to import SPO or its substitutes into the country, the company could still enjoy this fairly inelastic demand for the next few years. Currently, as a result of the problems listed below, the company's customers may have to pay three months in advance for any supplies: (a) Incessant breakdown of the mill which is now aging; (b) Low extraction ratio due to inefficiency of the mill; (c) Low staff productivity due to low morale; and (d) Inability to procure spare parts in time for the mill and other farm equipment due to liquidity problems. Recently, a customer, Faith Palm Products Limited (FPPL) paid for 150 tonnes of SPO at N50,000 per tonne. The supply had been delayed for four months. The company increased its price to N65.000 per tonne and Faith Palm Products Limited was requested to pay an additional N15.000 per tonne before supply could be made to it. STARRY GOLD ACADEMY +2348023428420, +2347038174484, info@starrygoldacademy.com, www.starrygoldacademy.com Page 2
The company had also offered to refund N7.5 million paid by FPPL if the latter could not afford to pay the additional N15,000 per tonne. FPPL had taken the company to court to press for the supply at the price demanded and for which it had paid. STAFF DEVELOPMENT The company has a total work force of 500, of which 150 are casuals. In the past, the usual labourers were converted to permanent staff after a year's service but at present there is no such opportunity, as casual labourers are laid off during the off season. Rather than making use of them for the usual farm upkeep, contractors are mow used for farm upkeep. These contractors are connected persons to top management. In most cases, the contracts were poorly executed but were paid for. These contractors, in most cases, made use of the laid off casual labourers. The remaining 350 permanent staff are in the following cadres: Top management 4 Senior management 21 Middle management 30 Supervisory 50 Junior 245 350 Most staff do not attend any staff improvement courses or training programmes except members of top management and a few favoured staff in the senior and middle management cadres. The junior staff cadre does not enjoy any training opportunity at all. MANAGEMENT STRUCTURE The management of the company is headed by a Managing Director who holds a first degree in physiotherapy. He-is a cousin of the Chairman, a major promoter of the company. The Executive Director (Finance) has an Ordinary Diploma in Accounting. He rose through the ranks to this position. He enjoys good rapport with the Managing Director. He is fond of telling the Managing -Director any adverse comments by any other management staff. The Executive Director (Operations) is a specialist in the field of agriculture. He has a good knowledge of the industry but his STARRY GOLD ACADEMY +2348023428420, +2347038174484, info@starrygoldacademy.com, www.starrygoldacademy.com Page 3
performance was impaired as the Managing Director and the Finance Director did not co-operate with him. Most equipment needed for effective operations are always not provided. The Executive Director (Technical) holds a Diploma in Automobile Engineering. He was recruited 15 years ago to take charge of the Mechanical Workshop. He rose to the present position a year ago through the assistance of his in-law, who is related to a Director and one of the promoters of the company. The former Technical Director who holds a degree in Production Engineering and Masters degree in Business Administration was frustrated out of the company. His problem started when he advised that the company be prudent by setting aside funds for the refurbishment or replacement of the mill rather than encouraging the shareholders to distribute almost all the profits. CURRENT PROBLEMS OF THE COMPANY The immediate problems of the company are as follows: ( a) The company is currently experiencing a liquidity crisis arising from low production of SPO. Delays in supplying customers had discouraged many from making advance payment which had been a good source of working capital in the past. Management had estimated that the company would need N5 million to buy essential spare parts for the mill. This amount would sustain the mill till a major refurbishment or replacement would take place which should not be later than a year if the company is to avoid a complete shutdown. It would take three months before any repayment can be made from the sales proceeds. The company could not raise the funds from its bankers as it could not service its present commitments. (b) (c) The agricultural loan of M25 million taken 5 years ago for the planting of undeveloped land was diverted to the construction of a sophisticated office complex in the plantation. The loan has a three-year moratorium. The principal has net been repaid at all and the loan has not been serviced effectively. The two options now available to get the funds required for the spare parts are: (i) To borrow from a local finance company at an annual interest rate of 42%. The repayment of capital will start after three months and will be spread equally over three months. (ii) The spare parts could be obtained at exhorbitant prices from a supplier who is ready to supply the parts needed on credit or for cash. The supplier is ready to allow six months credit. There is an urgent need to refurbish the mill within the next one year. The repairs to be carried out as a result of the problem listed above is only a temporary measure. The mill should be replaced as it has become technologically obsolete. The cost implications of refurbishing and replacing the mill are contained in Schedules 4 and 5. The company had been selling its uncracked kernel to local mini kernel crushers, but substantial revenue is lost in this process. In the light of these, the company planned to purchase a palm kernel crushing plant. The production of palm kernel will require three grades of labour. Grades 1 and 11 will have to be recruited at the inception of operating the palm kernel crushing plant. Grade 111 labour is available in the company and they are currently not engaged. They are being retained because their services will be required in a year's time when the STARRY GOLD ACADEMY +2348023428420, +2347038174484, info@starrygoldacademy.com, www.starrygoldacademy.com Page 4
company's planting programme is expected to have fully matured. It is reckoned that by this time the company will recruit Grade III labour for the palm kernel plant, if acquired. (d) (e) The cost implications of buying and running the palm kernel crushing plant are contained in Schedule 6. Due to the current financial crisis, the company had stopped granting scholarships to deserving indigenes and had not aided any communitybased project in recent times. This situation had generated a lot of bad feelings from the host community. The company is presently experiencing a serious encroachment problem on its undeveloped land. The local farmers have recently gone to the extent of planting permanent cash crops on the land. The recent inability of the company to aid the community on its development projects had reduced the support being given by the chiefs and leaders of the community who had been preventing their subjects from encroaching into the company's farmland. The company would need to plant 1,500 hectares within the next three years, in order to stop the community from encroaching on its property. Failure to plant may result in the community taking over the property completely. Any attempt to dislodge any trespassers could lead to crises. The cost implications of planting the 1,500 hectares are given in Schedule 7. The planting may be spread over three years at 500 hectares per annum. FUTURE PLAN Apart from solving the immediate problems, the company is proposing in the medium term to: a) Plant the remaining 2,500 hectares if it is able to plant the 1,500 hectares in an area prone to encroachment within the next three years; and b) Produce refined palm kernel oil which is enjoying increased demand and can be a good foreign exchange earner for the company. MANAGEMENT CONSULTANCY The company has commissioned its external auditors to look into its problems and recommendations for solving them. They had been auditing the company's financial statements for the past 15 years and the audit constitutes 50% of their see income. The firm has good rapport with the management. The top management had intimated the auditors that the shareholders would not like the company to go public in order to avoid dilution of the present ownership structure and that the current shareholders may not be able to inject further funds into the company. STARRY GOLD ACADEMY +2348023428420, +2347038174484, info@starrygoldacademy.com, www.starrygoldacademy.com Page 5
SCHEDULE 1 FIVE-YEAR BALANCE SHEETS AS AT 31 DECEMBER 2000 1999 1998 1997 1996 N 000 N 000 N 000 N 000 N 000 Paid up share capita! 25,000 25,000 25,000 25,000 25,000 Long term Loan 25,000 25,000 25,000 25,000 25,000 Profit and Loss Account 36.500 33.000 26.000 20,000 16.000 86.500 83.000 76.000 70.000 66.000 Represented by: Fixed assets 88.750 79.500 73.400 64,370 61.000 Current Assets: Stock of spare parts 2,000 4,000 3,500 6,500 7,000 Trade debtors 1,500 1,200 1,750 950 1,050 Pre payment 750 1,050 600 800 720 Cash and bank balances 4,500 3,750 2,860 3,450 2,770 Less: Current Liabilities (11.000) (6.500) (6.110) (6.070) (6,540) Net current assets (liabilities) (2,250) 3,500 2,600 5,630 5,000 86.500 83,000 76.000 70,000 66.000 STARRY GOLD ACADEMY +2348023428420, +2347038174484, info@starrygoldacademy.com, www.starrygoldacademy.com Page 6
SCHEDULE 2 FIVE-YEAR INCOME STATEMENTS FOR THE YEAR ENDED 31 DECEMBER 2000 1999 1998 1997 1996 N'000 N'000 N'000 N'000 N'000 Turnover 346,000 378,000 313,100 304,000 300,300 Cost of production (211,060) (215.460) (172.000) (158.080) (154.150) Gross profit 134,940 162,540 141,100 145,920 146,150 Administrative and Distribution expenses (109.940) (112.540) (98.243) (117.169) (123,150) Other income 2,000 Profit before tax 25,000 50,000 42,857 28,751 25,000 Tax (7,500) (15.000) (12.857) (8.751) (7.500) Profit after tax 17,500 35,000 30,000 20,000 17,500 Dividend (14.000) (28.000) (24.000) (16.000) (14.000) rretained profits 3,500 7,000 6,000 4,000 3.500 STARRY GOLD ACADEMY +2348023428420, +2347038174484, info@starrygoldacademy.com, www.starrygoldacademy.com Page 7
SCHEDULE 3 20 YEARS FRESH FRUIT BUNCHES (FFB) PRODUCTION SCHEDULE Year FFB Production (in tonnes) 2000 51,000 1999 54,000 1998 55,000 1997 59,000 1996 61,000 1995 72,180 1994 72,000 1993 72,850 1992 71,000 1991 60,000 1990 72,000 1989 72,500 1988 71,500 1987 71,190 1986 73,150 1985 70,500 1984 72,205 1983 72,000 1982 54,000 1981 36,000 Note: The palm trees were expected to achieve the standard production of 12 tonnes of FFB per hectare by year 1984 and the normal standard should be maintained for the next 20 years. STARRY GOLD ACADEMY +2348023428420, +2347038174484, info@starrygoldacademy.com, www.starrygoldacademy.com Page 8
SCHEDULE 4 COST DATA FOR MILL REFURBISHMENT Cost of refurbishment N150,000,000 Life span of refurbished Mill 5 years Salvage value N 30,000,000 Production capacity (SPO) p.a. 10,000 tonnes Production cost per tonne of SPO other than FFB: Labour N 1,200 Material other than FFB N 4,800 Fixed overheads of which depreciation comprises 40% N 4,000 Selling price per tonne N 65,000 Value of the Mill if sold now N 20,000,00 Notes: (i) (ii) (iii) (iv) (v) (vi) (v) Necessary farm upkeep operations would be carried out to bring production to normal standard of 12 tonnes of FFB per hectare. The total planted and mature area is 6000 hectares Production of FFB will increase every five years by 20% due to maturity of new planting. FFB not processed could be sold for N6,000 per tonne. The refurbishment could be carried out every five years at a cost of N150 million for each refurbishment. The refurbishment cannot be carried out for more than three times after which the mill has to be scrapped finally. The final salvage value of the mill is the same value of refurbished mill after 5 years of usage. The production capacity after every refurbishment remains constant at 10,000 tonnes of SPO per annum. The extraction ratio of SPO is 12.5% of FFB input. SCHEDULE 5 COST IMPLICATIONS OF A NEW MILL Cost of purchase, including installation costs Estimated life N2.4 billion Production capacity (SPO) p.a. 15 years Production cost per tonne of SPO other than FFB: 24,000 tonnes STARRY GOLD ACADEMY +2348023428420, +2347038174484, info@starrygoldacademy.com, www.starrygoldacademy.com Page 9
N Material other than FFB 2,400 Labour 800 Fixed overhead of which depreciation comprise 40% 3,000 Selling price per tonne 65,000 Salvage value 25,000,00 Notes: (i) (ii) (iii) The total estimated production of FFB is currently 72,000 tonnes annum. FFB that cannot be processed could be sold for N6,000 per tonne. Production of FFB will increase every five years by 20% as a result maturity of new planting. The extraction ratio of SPO is 20% of FFB input. SCHEDULE 6 COST OF ACQUISITION AND OPERATION OF PALM KERNEL CRUSHING PLANT Useful life 10 years N Cost of acquisition including installation 15,000,000 Salvage value 1,500,000 One Engineer (salary p.a.) 360,000 One technical supervisor (salary p.a.) 180,000 Other fixed overheads p.a. (excluding depreciation) 1,350,000 VARIABLE COSTS OF PRODUCTION OF ONE TONNE OF PALM KERNEL 10 hours of grade 1 labour STARRY GOLD ACADEMY +2348023428420, +2347038174484, info@starrygoldacademy.com, www.starrygoldacademy.com Page 10
20 hours of grade II labour 20 hours of grade III labour Other variable costs N500 (i) Grades 1,11 and 111 labour are paid N25, N15 and N10 respectively per hour. (ii) The expected production of FFB is 72,000 tonnes per annum. Uncracked kernel production is 75% of FFB input. (iii) Extraction ratio of palm kernel is 50% of uncracked kernel. (iv) One tonne of uncracked kernel can be sold for N2,500 (v) The plant is capable of processing all palm kernel produced. (vi) Selling price per tonne of palm kernel is N7,000. SCHEDULE 7 COST OF NEW PLANTING Notes: N Cost of initial land clearing per hectare 5,000 Cost of seedling per stand 180 Cost of planting per stand 70 Supervision cost per hectare p.a. 2,500 Plantation upkeep per hectare p.a 4,500 Cost of fertiliser per hectare p.a. 1,200 Notes: STARRY GOLD ACADEMY +2348023428420, +2347038174484, info@starrygoldacademy.com, www.starrygoldacademy.com Page 11
(i) Number of palm trees per hectare 150 stands (ii) The planting will be spread over three years. 500 hectares new planting will be done annually. QUESTION 4.1 (a) (b) Highlight some of the personnel problems farming Success Limited and make suggestions on what the company can do to revitalise the management of the company. Community relationship is very important for land-based agricultural companies, what are the ways to improve the social relationship of the QUESTION 2 (a) (b) Using the financial statements in Appendices 1 and 2, you are required to compute the following ratios for Farming Success Limited for the five years and comment on the trend. (i) (ii) (iii) Earning Per Share Quick ratio Current ratio (iv) Cost of production/turnover ratio. - The dividend payout ratio for the past five years had been 80% per annum. You are required to comment on this payout ratio having regard to the current problems of the company. QUESTION 4.3 (a) What is your advice to Farming Success Limited on the litigation instituted against it by Faith Palm Products Limited? STARRY GOLD ACADEMY +2348023428420, +2347038174484, info@starrygoldacademy.com, www.starrygoldacademy.com Page 12
(b) What will be the implication on the pricing of the company's product B government introduced a special tax on SPO. QUESTION 4.4 (a) (b) Calculate the Net Present value of the refurbishment and replacement options* of the mill. Which option would you recommend? Assume the cost of capital to be 15% and ignore inflation. There are two options to solve the immediate problem of spare parts procurement. You are required to advise on the more appropriate option. Supporting your recommendation with necessary calculations. " QUESTION 5 Compute the estimated full standard cost of a tonne of palm kernel in the first year of operation. A prospective customer had offered to pay N6.200 per tonne for the supply of 500 tonnes of palm kernel. Would you recommend the acceptance of this offer? The supply will not affect supplies to other anticipated customers. QUESTION 4.6 The company is desirous of planting 1.500 hectares in areas prone to local farmers' encroachment. You are required to prepare a three-year budget to show the cost implication of the new planting, assuming 500 hectares will be planted every year. QUESTION 4.7 (a) What are the ethical issues the company's external auditors should consider in its appointment as management consultant by the company? (b) As the Management Consultant highlight the various ways of solving the problems of the company. QUESTION 4.8 Extract the FFB production variances for the years 1989-2000 and comment briefly on possible causes of the variances. STARRY GOLD ACADEMY +2348023428420, +2347038174484, info@starrygoldacademy.com, www.starrygoldacademy.com Page 13