QUESTION 100 marks

This question has been written with the assistance of OpenAI ChatGPT-4

1 Background

Valuevest (Pty) Ltd ('Valuevest') was founded in 2010. It is a private equity company based in
South Africa, specialising in investments in various sectors. The company strives to comply
with sound corporate governance principles and accordingly has adopted the King IV Report
on Corporate Governance, which it applies as far as practically possible. The Board of
Directors consists of three independent directors as well as a chief executive officer (CEO),
chief financial officer (CFO) (a CA(SA)) and chief investment officer (CIO). The board has also
established an Investment and Audit Committee.

Valuevest typically aims for a high rate of return on its investments that significantly exceeds
its cost of capital. The specific return expectations for each company may vary depending on
various factors such as the risk profile, sector or industry and stage of the investment (early-
stage, growth, or buyout). Valuevest also employs various strategies to enhance the value of
its investments, such as operational improvements, strategic initiatives and financial
restructuring.

The company follows a structured investment process to identify, evaluate and execute
investment opportunities. This includes the following:
• Deal sourcing: Valuevest has a dedicated investment team that actively researches
sectors and considers investment proposals from companies seeking capital.
• Initial screening: Upon finding a potential investment opportunity, Valuevest’s
investment analysts conduct an initial screening process in which they assess the
company's sector, business model, financial performance, management team and
growth prospects. If the opportunity aligns with Valuevest's investment criteria, the
analysts will complete an investment proposal, which is presented to the CIO, who
reviews it and, if it is considered viable, will move it to the next stage.
• Due diligence: Valuevest’s investment team will then conduct a thorough due diligence
on the target company. This process involves a comprehensive assessment of the
company's financial statements, operations, and legal, regulatory and competitive
landscape. In the due diligence process, Valuevest makes use of external experts such
as legal advisors, consultants and industry specialists. The goal is to identify risks,
opportunities and potential areas for value creation.
• Investment proposal and valuation: Based on the findings from the due diligence
process, the investment team will then develop an investment case and perform a
valuation. In the valuation the team considers factors such as financial performance,
growth prospects, industry benchmarks and comparable transactions.
• Structuring the deal: Once the valuation has been determined and the investment
proposal finalised, the investment team will negotiate the terms of the investment,
including any equity stake, funding, governance rights and exit mechanisms.
• Final approval and execution: Once all details of the transaction have been agreed
upon, the investment case will be presented to the Investment Committee for
consideration and approval. Transactions which exceed the Investment Committee
approval mandate must go to the Board, based on the recommendation of the
Investment Committee. After approval of the transaction, Valuevest will proceed with the
execution of the investment, which involves finalising the legal documentation,
coordinating with the target company’s management team and securing any required
regulatory approvals.

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• Post-investment value creation and monitoring: After the investment agreement has
been completed, Valuevest will use its industry expertise, operational know-how, and
network of contacts to help the investee company achieve its growth objectives. The
Valuevest team also regularly monitors the performance of its portfolio of companies,
participates in board meetings of the investee, and maintains open communication with
the investee’s management team.

Throughout the investment process, Valuevest aims to generate attractive risk-adjusted

returns for its investors while actively supporting the growth and success of the companies in
its portfolio.

2 Artificial intelligence technology

At a recent investment strategy session, the Investment Committee discussed the possibility
of using artificial intelligence (AI) for the entire investment process. The information technology
(IT) manager explained that AI would enable Valuevest to evaluate and execute investment
opportunities more accurately and efficiently. He suggested that Valuevest should consider
fully automating the whole investment decision-making process. Bank statements, financial
statements and management accounts could be uploaded, and the system would then
automatically value the business. The IT manager believes that, by using AI, Valuevest could
gain a competitive edge in evaluating investment opportunities in a more data-driven and
efficient manner.

The IT manager has identified an advanced AI model, ChatGPT, for this purpose. ChatGPT
uses historical financial data, market trends and industry benchmarks and works as follows:
One enters a question or request and ChatGPT will attempt to understand the prompt and
provide a response based on the data. Some of the features of ChatGPT include that it
remembers what you have asked previously and can continue interacting. Furthermore, it can
be asked to re-generate an answer, perform recalculations and corrections and it will refer to
information that was presented earlier in the interaction.

ChatGPT provides full, written responses in a conversational way based on the enormous
amount of data with which it has been programmed. The version of ChatGPT that Valuevest
is considering does not have access to real-time data or specific company data later than
September 2021. ChatGPT does not always fully understand context in the same way a
human does. At times it lacks the ability to understand nuances, intentions or the strategic
implications behind certain numbers or trends.

Valuevest's IT team and a team of financial specialists tested ChatGPT by prompting it to

perform earnings-based valuations on existing companies in Valuevest’s portfolio. The results
of the valuations performed by ChatGPT were compared to manual valuations performed by
the team of financial experts. The team reported that most of the valuations were up to 90%
accurate after a process of providing information and requesting recalculations and
corrections. The team concluded that ChatGPT could be used to perform earnings-based
valuations and research potential events affecting a company’s valuation.

Some of Valuevest’s executives were very excited by the possible use of ChatGPT and were
of the opinion that this could give Valuevest a competitive advantage in the market. In view of
this, they discussed the possibility of retrenching a large component of the team of financial
analysts and investment specialists.

One of the concerns raised by the CFO on the use of ChatGPT related to cyber security and
the risk it holds for Valuevest’s business. The IT manager responded that the company
continuously invests in systems and technology but that the risk is always prevalent and real.

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 3 Investment in ACL

Valuevest is evaluating a potential investment opportunity in a frozen food warehouse logistics

operator, Arctic Cold Logistics (Pty) Ltd ('ACL'). ACL is an emerging company that specialises
in multi-temperature wholesale, warehousing and distribution services for food. It has a strong
presence in South Africa and neighbouring countries.

JGL Inc. (‘JGL’), a medium-size firm of registered auditors, have been the auditors of ACL
since inception. JGL is currently planning the audit for FY2023.

Valuevest sees significant growth potential in the company due to the expanding market for
frozen food products in view of improvements in technology. Temperature-controlled logistics
infrastructure is imperative for improving food security in Africa, to enable fresh food suppliers
to deliver food of quality. As a result, investments in cold-chain retail, logistics and
warehousing have been gaining momentum in Africa.

Based on the discussion of using AI in the investment process at the strategy session,
Valuevest decided to test the process by using ChatGPT for the valuation of an 80%
shareholding in ACL.

Information to be used in ChatGPT

The financial team consists of experienced and inexperienced staff members and prepared
the following information to copy into ChatGPT:

Arctic Cold Logistics: Management report

Income statement for the year ended / ending 31 December
Actual Forecast
Notes 2022 2023 2024 2025 2026
R'000 R'000 R'000 R'000 R'000
Operating revenue 1 473 808 522 081 576 900 640 358 697 991
Operating expenses 2 (450 904) (502 572) (553 824) (610 902) (668 675)
Operating profit 22 904 19 509 23 076 29 456 29 316
Finance cost (15 111) (13 768) (12 927) (11 691) (11 043)
Finance income 3 321 432 375 401 424
Profit before tax 8 114 6 173 10 524 18 166 18 697
Income tax expense (1 597) (1 682) (2 887) (4 841) (4 983)
Profit for the year 6 517 4 491 7 637 13 325 13 714

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 Arctic Cold Logistics: Management report
Balance sheet as at 31 December
Actual Forecast
Notes 2022 2023 2024 2025 2026
R'000 R'000 R'000 R'000 R'000
ASSETS
Non-current assets 182 519 141 563 139 914 135 695 127 606
Right-of-use assets 4 37 650 33 137 26 922 23 358 18 689
Property, plant and
equipment 139 349 103 670 109 490 108 463 104 926
Deferred tax asset 2 801 1 384 0 0 0
Investments and other
financial assets 2 719 3 372 3 502 3 874 3 991

Current assets 136 415 163 458 171 587 176 967 198 471
Inventories 26 761 29 731 32 532 35 521 38 263
Taxation receivable 1 114 893 0 0 0
Trade and other receivables 73 696 78 533 84 365 92 650 99 502
Cash and cash equivalents 5 34 844 54 301 54 690 48 796 60 706

Total assets 318 934 305 021 311 501 312 662 326 077

EQUITY AND LIABILITIES

Shareholders' equity 64 123 67 806 74 068 84 995 96 240
Ordinary share capital 7 300 7 300 7 300 7 300 7 300
Retained earnings 6 56 823 60 506 66 768 77 695 88 940

Non-current liabilities 149 649 129 758 109 428 89 445 76 978
Long-term borrowings 109 529 92 553 87 287 61 917 53 348
Lease liability 40 120 37 205 20 789 25 445 19 987
Deferred tax liabilities 0 0 1 352 2 083 3 643

Current liabilities 105 162 107 457 128 005 138 222 152 859
Provisions and other liabilities 9 039 7 032 7 000 6 235 6 521
Trade and other payables 70 682 75 624 82 025 88 650 98 210
Current tax liabilities 3 759 1 168 582 1 231 1 952
Current portion of long-term
borrowings 21 682 23 633 38 398 42 106 46 176

Total equity and liabilities 318 934 305 021 311 501 312 662 326 077

Notes

1 Revenue for the financial year ended 31 December 2023 (FY2023) includes revenue of
R5 million (FY2022: R10 million) received by ACL from a contract with Phisor (Pty) Ltd
for cold storage of vaccines. This contract was not renewed due to the decrease in
demand for the vaccines and thus not included in the forecast revenue. The profit before
tax on the contract amounted to R3,2 million in FY2023 (FY2022: R4 million).

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 ACL is in the process of signing a contract with a well-known food manufacturing
company, Brand Tiger (Pty) Ltd, for four years. The contract will commence in FY2024
and the revenue from the contract for FY2024 is forecast to be R12 million. The annual
revenue is expected to increase by 5% per annum and the net profit margin from the
contract is expected to be 18%. The contract has not been incorporated in the forecast
figures.

2 The operating expenses include the following item:

2022 2023 2024 2025 2026

R'000 R'000 R'000 R'000 R'000
Depreciation (26 392) (24 942) (25 759) (25 699) (27 697)

ACL's cash flow position was negatively affected during the periods of lockdown caused
by the Covid-19 pandemic. As a result, it decided to suspend the payment of bonuses
to management as from FY2020. The management team of ACL is however confident
that business has returned to normal and will even surpass expectations in future and
the decision was therefore taken to resume bonus payments from FY2024. Annual
bonus payments of R3 million for the investment team will be paid in FY2024 and will
not be increased in the foreseeable future.

At a recent Board meeting, at which all the directors were present, the directors
unanimously agreed to reinstate the executive management share option scheme. In
terms of this scheme the CEO, CFO and chief operating officer of ACL will receive share
options as incentives amounting to 20% of the profit after tax, if the profit grows year on
year by the Consumer Price Index plus three percentage points (3%). This decision has
not yet been incorporated into the forecast figures.

3 Finance income represents interest income on cash and investments.

4 Right-of-use assets as at 31 December 2023 were as follows:

Equipment
Land and
and Vehicles Total
buildings
machinery
R'000 R'000 R'000 R'000
Carrying value at the
beginning of the year 22 118 9 721 5 811 37 650
New leases entered into 5 173 1 076 853 7 102
Derecognition on lease
termination (2 057) - - (2 057)
Depreciation (3 042) (1 981) (1 171) (6 194)
Impairment charge (3 364) - - (3 364)
Carrying value at end of year 18 828 8 816 5 493 33 137

At inception, ACL assesses whether a contract contains a lease. ACL recognises a right-
of-use asset and a corresponding lease obligation with respect to all lease arrangements
in which it is the lessee, except for short-term leases and leases of low-value assets
(less than R100 000). The lease obligation is initially measured at the present value of
the lease payments outstanding at the commencement date, discounted by using the
rate implicit in the lease.

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 The right-of-use assets comprise the initial measurement of the corresponding lease
obligation, lease payments made at or before the commencement date, any initial direct
costs incurred by the lessee, less any lease incentives received. They are subsequently
measured at cost less accumulated depreciation and impairment losses. All right-of-use
assets are encumbered as security for the respective lease obligations.

The impairment charge was recognised on the land and buildings as the carrying
amounts exceeded the recoverable amounts.

The right-of-use assets are located throughout South Africa.

5 The entire cash balance is considered to be excess cash.

6 ACL has a constant dividend pay-out ratio of 18% and this dividend policy is not
expected to change in the foreseeable future.

7 Details of similar listed companies in the same industry as ACL are as follows:

Company PE ratio Description

FoodC 11,2 Leading South African food manufacturer, producing
a wide range of branded and private-label food
products.
VLogistics 7,5 African-focused provider of integrated market access
and logistics solutions focusing on the healthcare,
consumer, automotive, chemicals and food industries.
DittoT 9,8 International company that provides and manages
supply chain solutions for companies across the
globe.

The corporate tax rate in South Africa is 27%.

All the above information was loaded into ChatGPT. ChatGPT responded with a price/earnings
(P/E) valuation of ACL. However, one of the members of the financial team noted that the AI
did not take the non-recurring items as indicated in the information above into account. He
reminded the AI of this and the following response with an adjusted valuation was provided by
ChatGPT:

You’re correct. The valuation should take into account significant changes in business
contract and employee compensation.

First, let’s adjust the 2023 net profit:

1. We subtract the non-renewed contract profit of R3.2 million.

2. The resumption of bonus payments will reduce the net profit starting 2024. However,
since it does not affect the 2023 profits, we don’t need to make adjustments for this in
the current calculation.

Adjusted 2023 Net Profit = Actual 2023 net profit – profit from Phisor contract
= R4 491 000 – R3 200 000
= R1 291 000

Next, let’s use the average P/E ratio of comparable companies to estimate ACL’s value.

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 The P/E ratio for FoodC, VLogistics, and DittoT are 11,2, 7,5 and 9,8 respectively. The average of
these gives us a P/E ratio of 9,5 ((11,2 + 7,5 + 9,5)/3).

Now we can estimate the company’s value:

Company value: Adjusted net profit * average P/E ratio

Company value: R1 291 000 * 9,5 = R12 265 500

So, the estimated value of ACL as of 31 December 2023, based on an earnings-based valuation
method and considering the non-renewed contracts and management bonuses, is
approximately R12,27 million.

Keep in mind that this is a simplified calculation and actual valuation methods may consider
various other factors and future prospects. Also, note that P/E ratios can vary widely between
industries and companies, and an average of three companies may not be a comprehensive
indicator. We would advise further in-depth analysis or consultation with a financial advisor.

As part of performing valuations of companies that are potential investment opportunities,

Valuevest usually performs an analysis on the financial statements and the forecast financial
information that is provided to it. As a further test of the AI's abilities, it requested ChatGPT to
analyse the forecast income statement provided by ACL as part of its management reports.

ChatGPT gave the following response:

Certainly, I’ll take a look at the forecast income statement of ACL provided. The goal of this
analysis is to understand the predicted future performance of the company based on the
provided financial forecasts.

Here is a high-level analysis:

1. Revenue growth: ACL’s revenue is forecast to consistently grow each year from 2023
to 2026. This is a positive sign as it indicates the company anticipates increasing its
sales. However, one needs to understand the source of this growth – is it due to
increasing market share, expansion into new markets, or process increases?
2. Operating expenses: The company’s operating expenses are also expected to increase
in the forecast period. This is not surprising considering the revenue growth.
However, it’s crucial to assess whether these costs are scaling proportionally with
revenues or whether there might be inefficiencies.
3. Profit before finance cost: Profit before finance cost is also expected to increase over
the forecast period, suggesting improvements in operational efficiency or perhaps
benefits from economies of scale.
4. Finance costs: Finance costs are projected to decrease. This could mean the company
plans to pay down its debt or has refinanced to a lower interest rate. However, if
finance costs are decreasing and the company still has a considerable debt burden,
this could indicate an optimistic assumption about interest rates or repayments that
might not be realistic.
5. Net profit: The net profit is projected to grow significantly, almost tripling from 2023
to 2026. This is a positive indication of the company’s future profitability but should be
assessed in conjunction with other financial statements to check for balance and
consistency.

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The financial team was happy with the valuation and proposed that Valuevest go ahead with
making a bid for the shares of ACL, based on the valuation provided by ChatGPT. Some
members of the management team were however hesitant and requested that a free cash flow
valuation be performed as a reasonability test. It was decided that a risk premium of 3% should
be added to the normal required rate of return of Valuevest, which is currently at 14%. The
continuous annual growth rate of ACL after 2026 is expected to be 6%.

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 INITIAL TEST OF COMPETENCE, JUNE 2024

PROFESSIONAL PAPER 3

This paper consists of two parts. Answer each part in a separate answer book.

Marks
PAPER 3 PART I – REQUIRED Sub-
Total
total
(a) Critically evaluate the tasks performed by ChatGPT as part of
Valuevest’s process of identifying and evaluating the suitability of the
potential investment in ACL, based on –
(i) the earnings-based valuation of ACL performed by ChatGPT; 8
and
(ii) the additional work required to assess the reasonability of the
forecast income statements (apart from the work already
performed by ChatGPT). 4

• Do not perform any calculations or re-perform any of the

calculations provided by ChatGPT.

Communication skills – clarity of expression 1 13

(b) Perform a valuation of ACL using the free cash flow valuation
methodology. 20

• Start with the movement in cash. 20

(c) Discuss the risks and other relevant strategic factors that Valuevest
should consider regarding the decision to make use of an AI such as
ChatGPT in performing the valuation of companies that are potential
investment opportunities. 13

Communication skills – logical argument 1 14

Total for part I 47

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 INITIAL TEST OF COMPETENCE, JUNE 2024

PROFESSIONAL PAPER 3

This paper consists of two parts. Answer each part in a separate answer book.

Marks
PAPER 3 PART II – REQUIRED Sub-
Total
total
(d) Discuss and conclude on the ethical considerations surrounding the
proposal by Valuevest executives to use ChatGPT to replace the
team of financial analysts and investment specialists. 4 4
(e) Describe the controls that Valuevest’s management should have
implemented with regard to –
(i) the investment process as described in section 1, excluding
the payment process and human resources department
controls, in addition to those already described in the scenario. 8
• Limit your answer to four additional controls; and
(ii) protecting the company against cyber attacks. 6
Communication skills – appropriate style 1 15
(f) Discuss the governance concerns surrounding the bonus and share
option schemes in note 2 of section 3. 8

• Include appropriate and applicable considerations in terms of

the SAICA Code of Professional Conduct.
• Do not include aspects to be considered in evaluating or
addressing the threats identified.

Communication skills – layout and structure 1 9

(g) Describe the procedures that Valuevest’s consultants should
perform as part of their due diligence to identify possible unrecorded
liabilities and contingent liabilities not accounted for in the financial
statements of target companies. 6 6
(h) Describe, with reference to the external audit of ACL for FY2023 –
(i) the risk of material misstatement related to the right-of-use
assets; and 8
(ii) the substantive procedures to verify the right-of-use assets
that JGL should perform. 10

• Do not address presentation and disclosure in your answer.

Communication skills – appropriate style 1 19

Total for part II 53
TOTAL FOR THE QUESTION 100

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