1 CPA MOCK Evaluation Finance Elective Page 1 ELECTIVE (FINANCE)- Elective examinations will be 3 hours in length. Candidates will be given 4 hours to complete the examination, providing an extra hour to formulate their responses. The intention is to reduce the time constraint. Elective examinations may use a mix of objective format, single-competency and multicompetency area questions, but greater than 50% of assessment opportunities will be related to the Elective area being examined. The split and length of questions may vary across the Electives to adapt to the learning outcomes required. Elective examinations use more complex cases than those used for Core 1 and Core 2, requiring a minimum of 60 and a maximum of 120 minutes to complete. The assessment of professional skill will continue in a multi-competency environment, always building on prior learnings. Elective cases require candidates to simulate the roles they will play in real life, and therefore access will be provided to the reference tools they would use, where practical to do so. Below is an example of a short case that focuses heavily on the Finance competencies, but also includes Core Management Accounting and Strategy and Governance competencies. SIZZLE BEEF Suggested Time: 70 minutes (represents the time judged necessary to complete the question) You, CPA, work for Virtue and Moir Chartered Professional Accountants. You have been approached by Larry Welldone, a local entrepreneur you met while attending a food industry trade show. Larry is a very successful businessman and has been involved in a number of different types of operations during his career including real estate development, manufacturing and information technology. One industry Larry has little experience in though is the food service industry, and he is now considering an investment in that industry. Sizzle Beef is a very successful restaurant chain that has been operating for over twenty-five years. The restaurant specializes in roadhouse style cooking. Originating in Calgary, Alberta, the chain had a single store for twenty years before it began expanding. Using the franchise model, the company enjoyed tremendous growth and now has 50 locations across Canada. Larry wants to acquire two existing locations, one in Montreal, and the other in Halifax. The same family owns both, and by all accounts, the locations have been quite successful. Larry has had preliminary discussions with the family and he firmly believes they are motivated to conclude a deal. Further notes from your discussion with Larry are contained in Appendix I.
2 CPA MOCK Evaluation Finance Elective Page 2 Larry also provides you with summary financial information (Appendix II), excerpts from the Halifax franchise agreements (Appendix III), as well as excerpts from two financing arrangements that he is considering (Appendix IV). Larry would like you to prepare the cash flow forecast requested by the bank. He would also like your assessment of the value of the opportunity, an assessment of whether he has enough financing to purchase both restaurants and any other advice that you believe is appropriate.
3 CPA MOCK Evaluation Finance Elective Page 3 APPENDIX I NOTES FROM MEETINGS WITH LARRY WELLDONE The ownership of the restaurants is split between two members of the same family. The father owns the Montreal location, and his daughter owns the Halifax location. Each of the restaurants is separately incorporated. Both father and daughter have enjoyed the experience of opening a new restaurant but are now ready to move on to something new together. The father and the daughter have both used their enhanced capital gains exemption. They are only interested in selling the assets of the business (as opposed to the shares). The Montreal location was the first to open. The length of time each restaurant has been opened is as follows: Montreal Halifax 4 years 1 year Each restaurant leases the premises and owns the equipment and furnishings. The equipment and furnishings were purchased from the franchiser, pursuant to the franchise agreement. Each location has a lease agreement for the premises that matches the franchise agreement term. And each lease has a rent step-up of $10,000 in year 5. Larry is very concerned about food cost and labour cost because he has friends who have warned him this is where most restaurants either make it or break it. He has contacted five existing locations and they were willing to share information with him on their costs as a percentage of revenue as follows: Location Food Costs Labour Costs % 40.0% % 30.0% % 35.0% % 37.5% % 32.5% Average 30.0% 35.0%
4 CPA MOCK Evaluation Finance Elective Page 4 APPENDIX I (continued) NOTES FROM MEETINGS WITH LARRY WELLDONE Larry also learned from his discussion with other restaurant owners that they all experienced their best results in the first year of operation and experienced a leveling off after the third year very similar to the Montreal location. In his review of information, Larry has discovered there are family wages of $25,000 annually for the owner s children in each restaurant. Larry pressed for information about what the company gets for the $25,000. The response was they get not much really. Larry has learned that an adjacent business owner has sued the Halifax restaurant. The lawsuit claims loss of business income as a consequence of the restaurants signage that has impacted their visual exposure from the street. The amount of the claim is $100,000. Lawyers representing the restaurant believe there is a 50% chance of a loss, and estimate a cost of $25,000 to defend the case. A few years ago, Larry borrowed $250,000 and invested the cash in a private company that one of his friends owned. His friend recently sold the company, and Larry now has $1,000,000 in cash after having just paid the tax on the investment earnings. This represents the vast majority of Larry s net worth. Larry plans to use the cash to finance a portion of the investment in the restaurants. Larry believes that if he invested the money in similar risk investments, he could earn a return of 25% on his money.
5 CPA MOCK Evaluation Finance Elective Page 5 APPENDIX II SUMMARY FINANCIAL INFORMATION Montreal Revenue $ 5,000,000 $ 4,750,000 $ 4,500,000 $ 4,500,000 Labour costs 1,650,000 1,610,000 1,565,000 1,610,000 Food costs 1,350,000 1,335,000 1,315,000 1,360,000 Other costs 1,250,000 1,200,000 1,200,000 1,200,000 Profit before tax $ 750,000 $ 605,000 $ 420,000 $ 330,000 Halifax Revenue $ 4,000,000 Labour costs 1,300,000 Food costs 1,100,000 Other costs 1,100,000 Profit before tax $ 500,000
6 CPA MOCK Evaluation Finance Elective Page 6 APPENDIX III EXCERPTS FROM HALIFAX FRANCHISE AGREEMENT The initial term of this franchise agreement shall be from January 1, 2013 until December 31, The total price for the franchise is $400,000. This amount represents all equipment, furnishings and fixtures required to open the restaurant (valued at $300,000) and a one-time franchise fee ($100,000). The franchisee shall have the option to extend the franchise agreement for five additional terms of ten years each subject to meeting all conditions annually as set out by this agreement. In addition, it will be the obligation of the franchisee to upgrade all furnishings, menus and marketing and promotional materials to be consistent with other Sizzle Beef restaurants every ten years at a minimum. The franchisee may not sell, transfer or assign their interest in this franchise agreement to a third party without the prior written consent of the franchisor. Such consent will not be unreasonably withheld.
7 CPA MOCK Evaluation Finance Elective Page 7 APPENDIX IV EXCERPTS FROM BANK DISCUSSION PAPER The purpose of the loan is to assist in the financing of the purchase of the equipment, furnishings and fixtures, and goodwill of two Sizzle Beef restaurants located in Montreal and Halifax. Under either option a three-year cash flow forecast will be required. Option #1 Term loan Term loan for $1,000,000. The loan is repayable in equal principal instalments over a period of 36 months plus interest at the rate of 8%. The loan shall be secured as follows: First fixed charge over all equipment and furnishings Assignment of the franchise agreement Personal guarantee for 100% of the loan amount In the event of default, the rate shall increase to 9%, and a default penalty fee of $10,000 will become payable. Option #2 Loan secured by equipment and working capital There are two parts to this loan: Loan secured by the equipment furnishings and fixtures of the restaurants to a maximum of 75% of the value of these assets or $300,000 (whichever is less). The loan is repayable in equal principal instalments over a period of 36 months plus interest at the rate of prime plus 3%. Revolving operating line of credit to a maximum of $200,000 secured by the inventory and receivables of the company. The loan would be capped at 50% of the eligible inventory (defined as inventory that is not obsolete and is less than six months old) and 75% of the eligible accounts receivable (defined as regular trade receivables less than 90 days old). The interest rate would be at a rate of prime plus 2%. The loan amount would be adjusted based on monthly reports to be filed by the 15 th day of the following month. No personal guarantees are required under this loan arrangement. However, a standard monthly fee equal to 0.25% of the loan balance not utilized would be paid in addition to the payments noted above.
8 CPA MOCK Evaluation Finance Elective Page 8 MARKING GUIDE SIZZLE BEEF Assessment Opportunity #1 (NOTE: The Board of Examiners will be the one to define what each assessment opportunity will be. This is an example for illustration purposes.) The candidate provides a cash flow forecast for the restaurants. The candidate demonstrates competence in Management Accounting. CPA Mapping: Prepares, analyzes or evaluates operational plans, budgets and forecasts (Core Level A) Evaluates cost classifications and costing methods for management of ongoing operations (Core Level A) (Candidates are expected to prepare a cash flow forecast. They are expected to explain their assumptions and any adjustments made, clearly providing the why to support their reasoning. Candidates should also conclude on the results of their analysis.) The bank requires a cash flow forecast for the next three years as a condition of its proposed financing. Below, we have discussed some of the significant items and adjustments which we believe are necessary to the financial information provided by the vendor. Revenue and Earnings Trends The historical results show a trend of decreasing revenue and earnings at the Montreal location. Its highest revenue and earnings levels were in its first year of operations. Both revenues and earnings decreased in year 2 and year 3 before leveling off in year 4. In our meeting with you, you indicated that other franchise owners also experienced results similar to the Montreal location. As a result, we feel the Halifax location must be projected over the next two years to show decreasing revenues and earnings levels, as Montreal did in its first three years. We will use consistent decreases as Montreal experienced on a percentage basis. Montreal s decreases were as follows: Revenue % Decrease Year 1 $ 5,000, % Year 2 $ 4,750, % Year 3 $ 4,500, % Year 4 $ 4,500, %
9 CPA MOCK Evaluation Finance Elective Page 9 Rent increases The rent in the Montreal location will increase in 2014 (its fifth year of operations). Earnings have been adjusted accordingly. Note that the Halifax lease also has a rent escalation in Year 5 but this is after the three-year forecast. Food and Labour Cost The food and labour cost as a percentage of revenue in each of the locations should be compared to the information you received from other locations and appropriate adjustments made. We will use the average amounts from the information you were able to obtain, which is 30% for food costs, and 35% for labour costs. Family salaries There is $25,000 of excess salaries being paid to family members in each restaurant. This should be adjusted out. Lawsuit There is a $100,000 lawsuit that has been initiated against the Halifax location. The lawyer suggests a 50% probability of losing the lawsuit, and an estimate of $25,000 to defend it. Therefore, a $75,000 adjustment has been made. Interest and Principal Payments Interest and principal payments will be required on the financing from the bank. Note that the interest payments are deductible for tax purposes while the principal payments are not. In order to determine the required interest and principal payments, we have prepared a loan amortization schedule (see Appendix 1). Taxation We have used a tax rate of 38% in our analysis. This is an estimate of the taxation rate for the forecast period. Note that this tax rate would depend, to some extent, on the form of ownership that you anticipate. More details on this are provided below. Depreciation Depreciation is a non-cash item and therefore needs to be added back to the net income to determine cash flows. Depreciation is estimated at $30,000 per restaurant based on the fact that the original cost of the equipment, furnishings and fixtures was $300,000 and are expected to have a useful life of 10 years. Note that we have assumed depreciation and capital costs allowance are equivalent as well.
10 CPA MOCK Evaluation Finance Elective Page 10 Cash Flow Forecast The resulting cash flow forecast is provided below. Note that the restaurants are anticipated to be slightly cash flow negative for the first two years followed by a small positive cash flow in the third year. Forecast Forecast Forecast Montreal Montreal Revenue 4,500,000 4,500,000 4,500,000 Food cost (30%) (1,350,000) (1,350,000) (1,350,000) Labour cost (35%) (1,575,000) (1,575,000) (1,575,000) Other cost (1,250,000) (1,250,000) (1,250,000) Rent adjustment-montreal (10,000) (10,000) (10,000) Family Salary adjustment 25,000 25,000 25,000 Sub-total-cash outflow (Montreal) 340, , ,000 Halifax Halifax Revenue 3,800,000 3,600,000 3,600,000 Food cost (30%) (1,140,000) (1,080,000) (1,080,000) Labour cost (35%) (1,330,000) (1,260,000) (1,260,000) Other cost (1,150,000) (1,150,000) (1,150,000) Family Salary adjustment 25,000 25,000 25,000 Lawsuit (75,000) - - Sub-total-cash outflow 130, , ,000 Interest (see amortization schedule) (67,778) (41,111) (14,444) Income before tax 402, , ,556 38% (152,844) (164,878) (175,011) Income after tax 249, , ,545 Depreciation (non-cash) 60,000 60,000 60,000 Loan Principal Repayments (333,333) (333,333) (333,334) Total cash flow (23,955) (4,322) 12,211
11 CPA MOCK Evaluation Finance Elective Page 11 Assessment Opportunity #2 The candidate calculates the weighted average cost of capital for the new business. The candidate demonstrates competence in Finance. CPA Mapping: Evaluates the entity s cost of capital (Level B at Core- moves to A in Finance Elective) (Candidates are expected to attempt a valuation of the business as part of their solution. To do so, they need to first determine the weighted average cost of capital, explaining any assumptions they had to make in arriving at a reasonable figure. Stronger candidates will comment on difficulty of determining the equity amount.) In order to perform a valuation for the restaurants, we first need to determine an appropriate discount rate to utilize. As such, we need to determine the weighted average cost of capital (WACC) for the business. The WACC for this business will have two components: the cost of debt and the cost of equity. The cost of debt is the after-tax cost of the interest component of the debt. Since the interest rate on the loan (option #1) is 8% and we have estimated the tax rate of the business to be 38%, the after-tax cost of the debt is 4.96% (8% * (1-38%)). The cost of equity is the opportunity cost of the returns that could be earned through investments with similar risk profiles. We are told that the opportunity cost for Larry is 25%. As a result, we will use this as the cost of equity. The WACC is the weighted average cost of these two components. Since we expect that the new business will use equal parts of equity and debt to finance the business, the WACC will be 14.98% (50% * 4.96% + 50% * 25%). Note that the cost of equity for a business such as this is very difficult to determine. While we have assumed that the cost of 25%, as presented in the case is accurate, we should perform further research on similar businesses to ensure that it is reasonable. We should also discuss the concepts of the weighted average cost of equity with Larry. Our concern stems from the fact that Larry has recently quadrupled his money from an investment that he had made a few years ago and this may be tainting his risk appetite at this point to be more optimistic than normal. Assessment Opportunity #3 The candidate estimates the value of the two restaurants. The candidate demonstrates competence in Finance.
12 CPA MOCK Evaluation Finance Elective Page 12 CPA Mapping: Applies appropriate methods to estimate the value of a business (Level B at Core, moves to A in Finance Elective) (Candidates are expected to attempt a valuation of the two restaurants, choosing the most appropriate method. Candidates should explain why they chose the method they are using. Valuation adjustments are required and should be well explained by the candidate.) You have asked us to provide an estimate of value for the two restaurants you are considering acquiring. Our value will be based on the limited financial information that you have made available to us, as well as some additional information that we have gathered from our review of the franchise agreement and from our meetings with you. At a very high level, there are two ways to value an on-going business, the balance sheet approach and the income approach. In this situation, the restaurants have very few tangible assets and given the restaurants are part of a franchise, the main asset is goodwill. As a consequence, an asset-based approach is not appropriate and therefore we will use an incomebased approach. There are essentially two different income approaches you can take as well: a capitalized earnings approach or a discounted cash flow approach. A capitalized earnings approach is appropriate when you expect a business to generate relatively stable earnings stream over time. A discounted cash flow approach is more appropriate when you have earnings levels that fluctuate from year-to-year, such as in a start-up. A discounted cash flow approach also makes sense if you have a limited time frame for an earnings stream. Given the Halifax restaurant is quite new, a discounted cash flow approach makes the most sense.
13 CPA MOCK Evaluation Finance Elective Page 13 Valuation calculations are provided below: Terminal Value Income before tax $ 402,222 $ 433,889 $ 460,556 $ 460,556 Addback: interest expense 67,778 41,111 14,444 14,444 Addback: estmated depreciation 30,000 30,000 30,000 30,000 Less: Increased Rent - Halifax (10,000) EBITDA 500, , , ,000 Less: 38% (190,000) (191,900) (191,900) (188,100) Less: Capex (30,000) Less: Net working capital Free Cash Flows 310, , , ,900 Terminal Value Annuity 1,848,465 Discount Rate 86.97% 75.64% 65.79% 65.79% Present Value $ 269,612 $ 236,831 $ 205,976 $ 1,216,030 Total Valuation $ 1,928,449
14 CPA MOCK Evaluation Finance Elective Page 14 Additional notes: While technically the terminal value should be at the end of the lease, which is over 50 years into the future due to the multiple extensions available, we have assumed that the franchise exists in perpetuity. The resulting difference in terminal value would be insignificant if calculated based on a 50 year finite lease. Depreciation has been estimated based on the fact that $300,000 was initially required for the equipment, furnishings and fixtures and it is anticipated that these will require replacement every ten years. The increased rent for the Halifax location begins in 2017 and is therefore applicable to the entire terminal period. For simplicity we have assumed ongoing Capex (Capital expenditures) equal to depreciation is applicable for the terminal period. A more accurate representation would be to estimate the exact years when the expenditures are required (i.e. every 10 years), discount these cash flows and remove them from the terminal value. However, this has not been performed as the difference would not be significant. The discount rate used in the above valuation is the WACC as calculated above. Given the value calculated above, I suggest that you approach the vendors with an offer of $1.5 million for the restaurants, subject to a number of conditions as discussed further below. While this offer is significantly less than the valuation provided above, it is a good point to start the negotiations. It also provides the current owners with a healthy return on their original investment ($400,000 for each restaurant). Assessment Opportunity #4 The candidate provides an assessment of the financing options proposed by the bank and assesses the amount of financing required. The candidate demonstrates competence in Finance. CPA Mapping: Evaluates sources of financing (Level B at Core, moves to A in Finance Elective) Evaluates the entity s cash flow and working capital (Level A at Core) (Candidates are expected to discuss the financing options available and then make a recommendation as to how to proceed based on their analysis. Stronger candidates will discuss the more sensitive components of their analysis to the client.)
15 CPA MOCK Evaluation Finance Elective Page 15 Financing Options The two options are analyzed below: Option #1 Term loan The term loan is a standard loan repayable over 36 months. The loan is for $1,000,000 and is secured by a fixed charge over the assets, an assignment of the franchise agreement and the personal guarantee of Larry. The loan carries an interest rate of 8%. These terms all appear quite reasonable. One problem with this loan is the short repayment period of only three years. This is very aggressive and is leading to slightly negative cash flows in the early years of business forecast. Normally, the repayment or maturity profile of a company should align with the assets that the financing relates to. As such, we would recommend that you approach the bank in an effort to amortize the loan principal over a period of ten years. This would better reflect the value of the underlying assets (equipment, fixtures and goodwill associated with the franchise) and would ease the cash flow position in the first few years. Option #2 Loan secured by equipment and working capital While the interest rates and fees associated with this loan appear reasonable, the loan would not provide a significant amount of financing. The loan is based on a percentage of tangible assets held by the new business. Since this is a restaurant business (and the premises are leased) it is unlikely that the tangible assets would provide the security that the bank is looking for to provide enough financing. For example, we know that the equipment, furnishings and fixtures are worth (at cost) $300,000 and if this also represents the fair market value of the equipment, then the total loan proceeds available secured by these assets would be $225,000 (75%). As well, the restaurant business does not typically have a great deal of inventory and usually almost no receivables. If we assume that the inventory at any one time can be valued at $50,000 (which may be high) then the total loan proceeds that could be raised the revolving line of credit would be $25,000 (50%). Therefore, in total, this facility would generate at most $250,000 in financing. While we see the lack of a personal guarantee as a positive aspect of this option, this loan facility is just not realistic in terms of the amount of funds generated. Financing Requirement If we assume that our valuation above is reasonably accurate then Larry will need a total of approximately $1.9 million to purchase the two restaurants. This does not include fees and expenses.
16 CPA MOCK Evaluation Finance Elective Page 16 Larry has $1.0 million of personal money to invest in the restaurants and the bank has committed to providing a further $1.0 million. Therefore, Larry appears to have enough money to purchase the two restaurants. However, we would like to point out some potential concerns that we have regarding the financing available: As noted above, the restaurants generate negative cash flows in the first two years of operations as estimated by our cash flows. This is a concern as Larry will have used up all of his personal resources to fund the purchase and therefore there does not appear to be much of a cushion for unanticipated shortfalls. There is a good chance that the restaurants will underperform our estimates and if this is the case funding could be an issue as there is very little room for error as noted above. We would suggest that some significant sensitivity analysis be performed to determine if the financing outlined above is adequate. Assessment Opportunity # 5 The candidate discusses additional concerns with respect to the potential acquisition. The candidate demonstrates competence in Finance and in Enabling Competencies. CPA Mapping: Evaluates the purchase, expansion, or sale of a business 2.1 Demonstrates a cohesive process for using professional judgment to solve problems and make decisions (Enabling) (Candidates were not directed to these issues specifically (non-directed indicator), where candidates need to evaluate the other decision factors related to the potential expansion transaction.) There are a number of other considerations that you should take into consideration before finalizing the purchase of the restaurants: Risky Venture As eluded to above, you are considering placing all of your personal savings of $1.0 million into this venture. The restaurant industry, by nature, is a very risky business and far more restaurants fail than succeed. As well, both of these restaurants have a limited history and the risk is further increased.
17 CPA MOCK Evaluation Finance Elective Page 17 Purchase One Restaurant One option for you to consider to reduce your risk, and the amount of financing required, would be to purchase only one of the two restaurants. This would also allow you gain experience in this industry with an eye to expansion in the future. As Montreal and Halifax are also a significant distance apart, owning and managing both operations may be difficult and owning only one operation may allow you to better focus your attention. Incorporation Given the nature of the industry (food) I would highly suggest that you incorporate a company for this business. While you may be subject to personal guarantees by the bank, the limited liability of an incorporated entity would still be beneficial in this industry. You may even consider having two separate legal companies (if you decide to go ahead with the purchase of both restaurants) providing greater protection in the event that something should happen in the future that results in either a lawsuit or one of the restaurants falters and has to be closed. There is a lawsuit right now that has been initiated against the Halifax restaurant. If this were a much larger lawsuit, and the company forced to pay damages in excess of what the Halifax location alone could afford, then the assets of the Montreal location would also be at risk, if the same company owned both restaurants. However, if the restaurants were owned in separate legal companies, the assets of the Montreal restaurant would not be exposed to any risk. Due Diligence Before closing any deal, you should perform a variety of due diligence procedures to ensure you completely understand what you are receiving. These would include a complete and thorough review of the financial statements and other information of the existing businesses. Legal Advice As well, you should seek the advice of a lawyer to help you consummate any transaction. The lawyer will provide many additional checks, such as searching for additional lawsuits or liens, which have been filed against the existing companies. Terms of the Agreement Part of the legal agreements should specify certain terms and conditions such as: Any lawsuits (such as the existing lawsuit at the Halifax location) should be the responsibility of the existing owners and not yourself. You could include a clause in the agreement that places a certain amount of purchase funds in escrow for a period of time and any lawsuits or other liabilities could be paid directly from the escrow funds. In that way you will ensure the funds are available to pay for these unforeseen events.
18 CPA MOCK Evaluation Finance Elective Page 18 Standard clauses should also be included in the agreements regarding such things as severance for any employees that you may not wish to retain and a non-compete clause for the existing owners for a period of time within a certain radius of the existing operations. Start Your Own Franchise Finally, I would like to suggest that you look at the possibility of beginning a Sizzle Beef franchise from scratch instead of purchasing the existing restaurants in question. This could prove to be significantly less expensive ($400,000 for the rights and all the equipment and furnishings) vs. the existing restaurants (estimated to cost close to $1.0 million each). You should consider whether that much goodwill has been built up in the restaurants since they opened only a short period of time ago.
19 CPA MOCK Evaluation Finance Elective Page 19 APPENDIX 1 LOAN AMORTIZATION SCHEDULE Opening Principal Closing Balance Interest Payment Balance Loan Proceeds 1,000, Month 1 1,000, , , , Month 2 972, , , , Month 3 944, , , , Month 4 916, , , , Month 5 888, , , , Month 6 861, , , , Month 7 833, , , , Month 8 805, , , , Month 9 777, , , , Month , , , , Month , , , , Month , , , , Month , , , , Month , , , , Month , , , , Month , , , , Month , , , , Month , , , , Month , , , , Month , , , , Month , , , , Month , , , , Month , , , , Month , , , , Month , , , , Month , , , , Month , , , , Month , , , , Month , , , , Month , , , , Month , , , , Month , , , Month , , , Month 34 83, , , Month 35 55, , , Month 36 27, , Interest - Year 1 67, Interest - Year 1 41, Interest - Year 1 14, Principal Repayments - Year 1 333, Principal Repayments - Year 2 333, Principal Repayments - Year 3 333,333.33