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Comprehensive Cases (Chapters 1220)

COMPREHENSIVE CASE ONE Seacourt Restaurants Ltd.


Charles Court owns and operates the Seacourt Restaurant as a proprietorship. The
restaurant has gained a reputation for offering quality food, good service, and moderate
prices in a cozy, relaxed setting. It is a distinctive restaurant well known to the people of
Winnipeg. Court often brags about the competence of his bar and restaurant staff and
about the efficiency of his kitchen.
Profits in the past year amounted to $120,000 before draws by Court, who lives mod-
estly and requires only about $50,000 before tax for living expenses. Over the years, he
has invested excess profits in public securities, so he has substantial investment income,
which in itself puts him in the maximum tax bracket.
Court has asked you whether he should incorporate. He is aware that incorporation
has some advantages but has also read in the newspapers that double taxation occurs
when a corporation structure is used.
Required:
Outline the benefits that may be achieved by incorporation of this business, and provide
Court with information that will help him to understand the relationship between cor-
porations and their shareholders.
Some time later . . .
After incorporation, Courts business continues to prosper, and he hires Charles Spud to
work as an assistant manager. Spud is young and aggressive. He has good marketing skills
but his real strength lies in cost control and staff efficiency. With Spuds help, the restau-
rants pre-tax profits increase to $240,000 after both Spud and Court have been paid fair
salaries.
Court begins to spend less time at the restaurant. In his place, Spud efficiently manages
the whole operation. Court continues to take a $50,000 salary.
Spud approaches Court and asks if he can acquire part ownership. Spud feels that he
contributes substantially to the generating of profits and that a 20% equity interest would
be reasonable.
Court approaches you for advice. He feels that he might be able to satisfy Spud by
establishing some bonus arrangement but that he will likely have to let Spud own 20% of
the operations. He also mentions that the land and building have increased greatly in
value.Their current value of $800,000 is $300,000 higher than the original value. Usually,
in the restaurant industry, land and building can be leased at 12% of their original value on
a net-net basis (that is, the tenant pays all of the costs associated with the building). Cur-
rently, the company deducts about $30,000 annually for amortization on the existing
building. If Court shares ownership, he does not want Spud to share in any continued
appreciation of the building, as Court regards this as a fortuitous gain.
It is common in the restaurant business to value the business at six times normal after-
tax profits.
Court has also indicated that Spud has no money with which to make a purchase of
equity.
Required:
1. Outline alternatives that will permit Spud to acquire a 20% interest in the business,and
briefly evaluate each alternative. Recommend a course of action.
2. What value should be used for the transfer of 20% ownership?
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Some time later . . .
After suffering a heart attack, Court asks Spud to purchase his remaining 80% interest.
Spud agrees. Court will keep the building as an investment. They agree on a price of
$600,000, to be paid in cash on closing, for the remaining 80% of the shares. By now the
company has built up $200,000 of cash reserves. The bank has agreed to loan Spud
$400,000 for the balance (the $400,000 to be repaid over an eight-year period).
Retained earnings at the time of sale amount to $300,000.
Required:
Advise both Court and Spud on how the transfer of 80% of the shares can best be struc-
tured to maximize cash flows.
Some time later . . .
Seacourt continues to prosper, and good profits are maintained, although most of the cash
generated goes to reduce the bank debt.
A local businessman approaches Spud to see if Spud would purchase his failing restau-
rant, the Butcherchop. While Spud feels he could turn the business around, he wisely backs
away because of the amount of cash that would be needed to redecorate the restaurant.
The Butcherchop Ltd. has accumulated losses of $300,000, which the present owner
can use if the company combines its operations with those of a successful venture. He
therefore returns to Spud and proposes the following:
1. A new entity would be set up that would share profits or losses 50/50.
2. The new entity would rent the building and equipment from the Butcherchop Ltd.
3. Spud would develop a new concept and oversee renovations costing $150,000.
4. Spud would contribute $25,000 equity. The Butcherchop Ltd. would provide the
remaining $125,000 required to meet the cash needs in 3 above.
5. Spud would not be liable except to the extent of $25,000.
Spud realizes that losses may result in the early years, but is reasonably certain that his
ideas will be successful.
Required:
Outline alternative methods of organizing the new entity, and evaluate each.
Some time later . . .
Finally, the bank loan is paid off. Spud realizes that the Seacourt concept is distinctive
enough to market in other locations. He has two young managers who are aggressive and
want an opportunity to help expand the business. They envision Seacourts across the
country.
Spud realizes that expansion would require extensive resources. It would take about
$1,000,000 to erect a building comparable to the one in Winnipeg; an additional $200,000
would be needed for fixtures. In addition, a new restaurant might incur several years of
losses before profits begin to come in.
Of course, each location could be financed in some manner, but equity requirements
still appear high.
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Spud realizes he must address two fundamental problems:
1. How to reduce the equity cash requirements.
2. How to raise sufficient capital and minimize risk to the existing successful operation.
With regard to 2, Spud lists the following alternatives:
1. Expand slowly by developing one restaurant and not expanding further until the first
is generating positive cash flows. (This way, Spud would retain 100% control.)
2. Raise a large amount of capital from many local investors to open several restaurants
at once.These investors would be equity holders but not active in management.
3. Find one wealthy investor to provide most of the cash, with Spud providing manage-
ment and development expertise.
4. Seek out separate capable managers, each of whom has the resources to be part
owner, for the individual new restaurants.
Required:
1. What can be done to reduce the equity requirements of each new restaurant?
2. For each of the preceding alternatives, outline a form of organization that may be suit-
able, and briefly comment on why it appears suitable.
COMPREHENSIVE CASE TWO Cambell Enterprises Ltd.
Cy Cambell is chairman of the board of Cambell Enterprises Ltd.The company originally
operated a successful car dealership, which was sold in 20X4.When it was sold, Cambell
talked several of the key employees into staying on and assisting in the management of
new ventures in the auto industry. The employees acquired shares in Cambell Enterprises;
shortly thereafter, the company purchased the shares of Borex Distributors Ltd., a com-
pany that distributes specialty parts to retail auto-accessory stores. Borex last year
earned profits of $500,000 before tax but after salaries had been paid to each manager.
The profits of Borex have been funnelled to Cambell Enterprises and reinvested in other
business ventures, one of which is not related to the auto industry. An organizational
chart for the current year (20X9) is shown on the last page.
The shareholders have some major decisions to make with respect to their holdings,
and the vice-president (finance) has prepared the following summary:
Winnipeg Moon Publishers Ltd. Winnipeg Moon operates a daily tabloid news-
paper in Winnipeg.The company was acquired in 20X5 and had accumulated business
losses of $100,000 at that time. Since acquisition, the Moon has lost an additional
$500,000, mainly because it cant find enough readers. Management is convinced that sub-
stantial losses will continue for another three to five years before circulation reaches a
break-even level.They are prepared to sustain losses for two more years, but if they find
no alternative solutions, they will take no further risks. During this time, they will consider
the following:
1. Selling the company.
2. Finding new additional equity investors to share the risk until profits are attained.
3. Winding up the operations.
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The second alternative is the most desirable, but given the risks and losses, it may be
difficult to attract participants.
KroninTire and Rim Ltd. Kronin operates a tire retreading plant that converts old
used tires into like new tires.The process is capital-intensive, and the plant has recently
been retooled with modern equipment. Profits of Kronin amount to about $350,000
annually.
Patricks Jack and Jump Ltd. The shares of Patricks were acquired in 20X6 at a
cost of $1,200,000. Even after dividends have been paid, the company has accumulated
retained earnings of $1,400,000. An offer of $2,800,000 for the shares was received last
week, and Cambell feels this offer reflects the proper fair value.The details of the trans-
action have yet to be worked out, and a meeting is planned for early next week to com-
plete the sale.
Borex Distributors Ltd. Borex has been successful in distributing accessories in
Manitoba and Ontario for the past several years. Last year two salespeople were sent into
North Dakota and Minnesota for a three-month selling tour. They then completed a sim-
ilar tour of western Canada. The number of orders generated convinced the executives
that these markets could be exploited. The expansion plans could be carried out by divid-
ing the new territories among the Winnipeg-based sales representatives, or by establish-
ing sales offices in both Alberta and Minnesota serviced by salespeople living in those
territories. Ultimately, a more formal organization may be required.
QuickStart Co. One of the biggest selling items for Borex is a remote-control car
starter, which is supplied by an American company. Borex has learned that a local busi-
nessman plans to establish a business named QuickStart to manufacture the product in
Winnipeg but is short of funds for establishing and starting up the plant. Borex has offered
to put up half the money ($600,000) to start the venture in return for a 50% equity own-
ership. Borex is convinced the operation will eventually be profitable, though it will likely
suffer losses for at least the first four years.
Julio Car Stereo Systems Ltd. Cambell Enterprises is attempting to purchase this
company, and has completed a series of meetings with Julio, which has agreed to sell its
net assets for $1,200,000, or its shares for $l,150,000. Julio is a profitable company and
either of these prices would be satisfactory as a purchase price. (Last year Julio earned a
pre-tax profit of $500,000.) Julios most recent balance sheet is as shown in the following
table:
Assets Liabilities and Equity
Current assets $600,000 Bank loan $200,000
Share capital and
Goodwill (at cost) 0 retained earnings 400,000
$600,000 $600,000
The fair market value of Julios current assets is the same as stated on the balance
sheet. A decision must be made regarding which offer to choose. The decision to buy has
already been made. The cash received from the sale of Patricks Jack and Jump will pro-
vide more cash than is required for the above acquisitions.
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Cambell has proposed a new investment in the book-publishing industry, but the other
shareholders have strongly argued against it because of their problems with the Moon.
Cambell has decided to make the investment on his own, and intends to propose that a
large cash distribution be made to shareholders so that he will have the funds to finance
the venture on his own.
Required:
Review the above financial structure and business plans of Cambell Enterprises. How
might Cambell and the other shareholders maximize their wealth?
Exhibit I
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