Reference no: EM13488990

All amounts exclude value added tax.

Tip Top Transport Ltd ('TTT') is a logistics group listed on the Johannesburg Securities Exchange. TTT has the following operating divisions:
Division

Focus area
Commercial Goods
This division services the retail industry and is responsible for the transport of fast moving consumable goods.
Fuel Logistics
This division transports petrol and diesel from refineries and oil depots to forecourts of fuel retailers.
Agricultural Logistics
This division services the agricultural industry by transporting wheat, maize, rice, sunflower seeds, sugar and flour.
FastLiner
This division operates a fleet of luxury buses which transports paying customers between major cities in South Africa.
Servicing and Maintenance
This division is responsible for all servicing and maintenance of TTT's trucks and buses.

Return on investment (ROI) is one of the group's key performance measures and divisional management is incentivised on the basis of divisional ROI. TTT's overall ROI has declined in recent years mainly as a result of the challenging economic conditions and operating cost increases. The operating divisions have been asked to propose initiatives to improve ROI as part of the group's efforts to enhance shareholder value and returns.

TTT expects each operating division to generate a ROI in excess of 25% on a before tax basis. TTT's operating divisions are also expected to generate returns in excess of the group's adjusted weighted average cost of capital (WACC) of 20% when making capital investments. TTT's actual WACC is lower than 20%. The operating divisions do not have control over the payment of income tax and therefore tax cash flows are ignored when evaluating returns. As a result, operating divisions are given a higher hurdle rate to compensate for ignoring income tax in capital investment decision making.

Commercial Goods Division: Replacement of truck fleet and budgeted performance

The Commercial Goods Division ('CGD') is planning to replace its entire fleet of 70 trucks in the financial year commencing on 1 January 2014. The fleet is standardised and each new truck is forecast to cost R900 000. CGD has purchased all its trucks from the VIS Transport Group ('VIS') in the past and has been negotiating with VIS about the replacement of the fleet in 2014. VIS has agreed to sell the trucks to CGD and arrange financing for CGD as set out below:

- VIS will deliver all 70 trucks to CGD on 1 January 2014.
- CGD is to pay an upfront deposit of R180 000 for each truck and the balance of the purchase consideration, namely R720 000 per truck, is to be financed on the following basis:
- CGD is to pay 60 equal monthly payments of R15 297,87 per truck commencing on 31 January 2014; and
- VIS undertakes to purchase the trucks for a consideration of R225 000 each on 31 December 2018. However, the trucks will need to be maintained and serviced on a regular basis and have travelled no more than 600 000 km in order for CGD to
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exercise this guaranteed buyback option. In the event that CGD does not meet these criteria for any truck or chooses not to return the trucks, the balance of the capital outstanding must be settled on 31 December 2018.
The proposed acquisition of the 70 trucks is a significant capital investment for CGD and the TTT group. CGD has prepared an analysis of the proposed capital expenditure and the average operating performance of each truck, which is summarised in the table below, for consideration and approval by TTT's Board of Directors.
You may assume that the mathematical calculations in the average profitability analysis table below are correct.
Year ending 31 December
2014
2015
2016
2017
2018
Average profitability analysis per truck
Notes
R
R
R
R
R
Total revenue
1 404 000
1 466 600
1 609 200
1 701 000
1 792 800
Revenue
1
1 080 000
1 115 600
1 231 200
1 296 000
1 360 800
Fuel recovery charges
2
324 000
351 000
378 000
405 000
432 000
Operating costs
(1 312 741)
(1 380 207)
(1 446 172)
(1 511 807)
(1 579 084)
Fuel costs
3
(360 000)
(390 000)
(420 000)
(450 000)
(480 000)
Insurance - vehicles
4
(45 000)
(47 250)
(49 615)
(52 095)
(54 700)
Other insurance costs
4
(65 000)
(68 250)
(71 665)
(75 250)
(79 015)
Driver costs
5
(120 000)
(128 400)
(137 400)
(147 000)
(157 200)
Back-up driver costs
5
(60 000)
(64 200)
(68 700)
(73 500)
(78 500)
Servicing and maintenance
6
(180 000)
(192 000)
(203 000)
(213 000)
(223 000)
Allocated overheads
7
(125 000)
(135 000)
(145 800)
(157 500)
(170 100)
Other operating costs
8
(156 000)
(165 600)
(174 000)
(182 400)
(192 000)
Depreciation
9
(135 000)
(135 000)
(135 000)
(135 000)
(135 000)
Financing costs
10
(66 741)
(54 507)
(40 992)
(26 062)
(9 569)
Operating profit per truck
11
91 259
86 393
163 028
189 193
213 716
Notes
1 Each truck travels on average 108 000 km per annum transporting customer goods ('productive km'). It is budgeted that customers will pay a fixed fee of R10 per km, excluding fuel costs, to CGD in the 2014 financial year for the transportation of goods. Although the fee per km will escalate in future years, the average productive km per truck travelled is assumed to be 108 000 km in each year of the budgeted period.
2 Fuel costs incurred are billed separately to customers. All routes have been mapped and standard distances agreed with customers. The average fuel consumed per km travelled by trucks on each route is also agreed with customers. CGD invoices customers the prevailing fuel cost per litre, multiplied by the pre-agreed number of litres consumed per km on routes. CGD does not mark up fuel costs when invoicing customers.
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3 For a variety of reasons, fuel costs are forecast to be higher than that invoiced to customers. The most common reason is that drivers deviate from pre-agreed routes or take detours. In addition trucks have to travel from CGD depots to the TTT Servicing and Maintenance Division's workshops on a regular basis for servicing, repairs and maintenance. Each truck is forecast to travel an average of 120 000 km annually, which is consistent with distances travelled during prior years.
4 CGD insures trucks against theft and accident damage which is budgeted to cost R45 000 per truck in the 2014 financial year. In line with customer requirements, CGD also insures itself against potential liability in the event of environmental damage as well as third party claims for injury and consequential losses suffered as a result of negligence of truck drivers, mechanical breakdown or truck malfunction. This insurance is estimated to amount to R65 000 per truck in the 2014 financial year.
5 Drivers are budgeted to be paid R120 000 per annum on a cost to company basis in the 2014 financial year. Their salaries are expected to increase by approximately 7% per annum thereafter. There is a pool of back-up drivers on standby, in the event that any of the primary drivers become ill or to accompany drivers on long-distance trips. Back-up drivers are full-time employees of CGD.
6 Each truck is required to be serviced after every 10 000 km travelled. The Servicing and Maintenance Division marks up the costs of servicing and maintaining the CGD trucks by 50% in order to generate a reasonable return on its assets and efforts.
7 CGD analyses costs and allocates these to trucks using activity based costing principles. The allocated costs in the budget represent divisional expenses incurred in dealing with customers (e.g. scheduling deliveries, customer service, complaints and queries), invoicing and collecting amounts from customers, human resource management, and general management and control of operations.
8 Other operating costs relating to the operation of trucks are variable in nature.
9 The acquisition costs of trucks less estimated residual values are depreciated evenly over five years.
10 Financing costs have been correctly calculated on a monthly basis for the period 2014 to 2018 based on the proposed agreement with VIS.
11 Operating profit is analysed before taxation as CGD has no control over group tax planning.
CGD: Owner driver proposal
The CGD management is considering whether an 'owner driver' scheme be implemented instead of acquiring the 70 new trucks in 2014. The key rationale for the scheme is to empower drivers to become entrepreneurs and generate wealth.
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CGD's management has researched the owner driver scheme implications and has made the following proposals:
(a) Drivers would acquire the new trucks directly from VIS on 1 January 2014 on the same terms and conditions negotiated between CGD and VIS. In addition the Azania Development Bank has agreed to guarantee the obligations of each driver to VIS and will stand surety in favour of VIS in the event that drivers default on obligations to VIS.
(b) Drivers will cease to be employees of TTT on 31 December 2013 and instead enter into a contractual relationship with CGD to perform transport services on behalf of CGD.
(c) Drivers will be paid a fixed fee (excluding fuel costs) per km travelled as per agreed transport routes and distances. Fuel costs will be recovered and invoiced separately by drivers to CGD on the same basis as agreed between CGD and its customers. The proposed fixed fees are as follows:
Fees payable by CGD to owner drivers
2014
2015
2016
2017
2018
Fee per km travelled in transporting customer goods
R8,00
R8,35
R8,70
R9,05
R9,40

(d) Drivers will contractually agree to have their trucks serviced and maintained by the Servicing and Maintenance Division of TTT on the same basis as previously undertaken by CGD. During the period 2014 to 2018 the Servicing and Maintenance Division will invoice drivers for services rendered on the same basis as set out in the average profitability analysis per truck.

(e) Drivers will take full responsibility for all operating costs of trucks except for other insurance costs and allocated overheads set out in the average profitability analysis per truck.

If the owner driver scheme is introduced, drivers are expected to travel an average total of 113 400 km per annum per truck instead of the 120 000 km assumed in the average profitability analysis per truck. This is because there is likely to be an increased focus by drivers on efficiency and improving operating performance. The average productive km travelled per truck in the transport of CGD customers' goods will, however, remain at 108 000 km per annum for the period 2014 to 2018.

Drivers will need the services of accountants on an outsourced basis to handle the invoicing and administration of their businesses. It is estimated that this will cost drivers R12 000 per annum in 2014, escalating by 5% per annum thereafter.

CGD estimates that its allocated overheads will drop by 80% following the introduction of the owner driver scheme.