It is almost the end of June of 2003 and you are preparing to meet
with your banker with your final proposal for the purchase of a fast
food franchise.  The total investment will be $500,000. It breaks down
as follows:

$200,000 for equipment with an expected life of 10 years 
$100,000 for the cost of the franchise which can be resold at a later date 
$100,000 for pre-opening legal, hiring, training, and interest expenses 
$100,000 for the initial base stock of cash, food and paper products 
 

  You have $50,000 of your own money that you will be using as part of
this investment. You seek to borrow the rest. You expect an interest
rate of 6% and a loan duration of five years. For calculation ease,
you expect to make principal and interest payments annually at the end
of each calendar year. You will pay off 20% of the initial principal
each year. Between now and the start of business you pay interest only
and that is included in the bulleted numbers above.

 

The corporation selling you the franchise tells you that you can be
ready to open in 6 months.  You are told to expect revenues of
$2,000,000 in the first year rising at a rate of 5% per year.  You
will have fixed operating expenses of $500,000 which rise at 2% per
year with inflation and variable costs of good sold expenses of 60% of
the revenue.  You also have to pay a franchise fee of 2% of gross
revenue.  Your tax rate is expected to be a flat 35%.

 

The banker has asked you to come with the following items of information:

 

a)      Statements of expected cash flows for years 2004 - 2008

b)      Statements of income for years 2004-2008

c)      Balance Sheets for years 2004-2008

 

You also know that the banker responds well to financial measures but
wonders about the forecast provided by the franchise vendor.  To
address those issues you decide to bring:

 

d)      The expected internal rate of return and NPV

e)      The expected internal rate of  return if sales rise by only 2% per year

f)        The expected internal rate of return if sales are flat

 

Include the financial measures above and financial statements (The
financial statements can be an Excel spreadsheet.)

 

Lastly, you are wondering if you should put up another $50,000
yourself and reduce your loan to $400,000. You have money invested in
an instrument that you expect to pay you 9% per year over the five
year period.

 

What analysis should I use in determining whether to put more of my
own money into this investment?


 

Statement of Income, 2003

 

Sales Revenue                                                    0

 

 Less: Cost of Goods Sold                                                        0

 

Gross Income                                                          
                0

 

Less: Operating Expenses

 

            General and Administrative       $93,000

            Depreciation                           0

 

            Total Operating Expenses         $93,000

 

Operating Income                    
     -$93,000

 

Less: Interest Expense                                            
         $7,000

 

Net Income before taxes                                                  -$100,000

 

Less: Taxes (rate = 35%)                                                   -$35,000

 

Net Income                                                            
           -$65,000

 

 

Balance Sheet as of 12/31/03

Assets

Current Assets 

            Cash                                                      $25,000

            Tax refund receivable                              $35,000
(This will reduce cash payments for taxes in 2004)

            Inventory                                                $75,000

                        Total Current Assets                 $135,000

 

Gross Fixed Assets (at cost)

            Equipment                                            $200,000

            Franchise                                              $100,000

                        Total Gross Fixed Assets          $300,000

 

Less: Accumulated depreciation                                    0

 

Net Fixed Assets                                              $300,000

 

Total Assets                                                     $435,000

 

Liabilities and Owner?s Equity

 

Current Liabilities                                                          0

 

Long Term Debt                                               $450,000

 

Total Liabilities                         $450,000

 

Owner?s Equity

 

Paid In Capital                                                    $50,000

 

Retained Earnings                                             -$65,000

 

            Total Owner?s Equity                            -$15,000

 

Total Liabilities and owner?s equity                    $435,000

 

Statement of Cash Flows for 2003

 

Cash Flow from Operating Activities

 

Net income after taxes              -$65,000

Increase in inventories               -$75,000

Increase in tax receivable                      -$35,000

 

Add depreciation                                                 0

 

                        Cash Flow from Operations                     
        -$175,000

 

Cash Flow from Investment Activities

 

            Increase in Gross Fixed Assets -$300,000

 

                        Cash Flow from Investment Activities    -$300,000

 

Cash Flow from Financing Activities                  

 

            Change in Long Term Debt                      $450,000

            Change in owners equity                            $50,000

            Dividends to owner                                               0

            

                        Cash Flow from Financing Activities           
      $500,000

 

Net increase in Cash                                                  
                $25,000



Can someone help me make the right decisions in this case, and kindly
furnish the appropriate financial measures and financial statements?
So sorry
for the crazy format.  Hopefully, you can read the case without
difficulty.   

Regards, Delialah....

Sorry ... 

But this does not look like a very exciting investment proposition to
me and, if I were a banker (which I'm not), I would be looking for you
to put up a much bigger stake than $50,000.

Are you really confident about this project?

If not, then please look for something else.

probonopublico,

I appreciate your response.  Thank you for taking the time to read
this.  How would you respond to the questions posed if you had to
present this as a proposal to your boss?  I want to answer the
questions first, the make suggestions and recommendations after.  If
you have the time, please reply.  Thanks.

Hi, Delialah

When I first read your question, I didn't realise that it was only an
academic exercise ...

But, of course, your references to '2003' were a giveaway.

In the real world of finance, the bank would spell out how much it
would expect the borrower to contribute from his own money and what
other security it would require, so the calculations that you are
seeking would be largely irrelevant.

Indeed, I could argue that the concepts that you are being taught (??)
are outmoded anyway. IRR and NPV are Sixties stuff when some crackpot
managers truly believed that these things could be worked out with
accuracy.

In fact, many of the companies that used these techniques with great
enthusiasm have now gone bottom up.

I am afraid therefore that I am unable to help you 'make the right
decisions in this case' but that's not the end of the world ...

There are lots of other folks around who may be able to help you.

Sorry!

And Good Luck in your Quest.

Bryan

Bryan, and others.  Surely someone has some idea how I can present
this proposal.  I've seen you guys answer the strangest questions. 
How would you respond if you absolutely had to? Thanks...