Restaurant Case Study Question Introduction This example is an illustration of the capitalization of after-tax cash flow method of valuation

as it might apply to a restaurant operation. In choosing an applicable capitalization rate the business valuator typically considers a number of different elements, including existing risk-free rates of return, prevailing stock market multiples, and comparable transactional information. The final selection of an appropriate rate is ultimately a matter of professional judgement, however, and unlike real estate appraisals, the selection isn't necessarily heavily influenced by only the comparable analysis.1 This example also considers the effects of unused borrowing capacity (as a redundant asset) and its incorporation into the final value calculation. Students are cautioned to note that this example is for illustrative purposes only and does not necessarily reflect all of the steps undertaken in an actual valuation engagement or a precise valuation conclusion. Some of the information contained in this question (in terms of format and type of analysis completed) has been adopted from similar questions contained in prior CICBV Membership Entrance Exams ______________________________________________________________________ Background Green Grapes Restaurants Ltd. (Green Grapes) is a busy restaurant operation with two outlets one in Vancouver, B.C. and another newer one in Kelowna, B.C. Both locations have similar revenues and expenses, but neither is formally separated for financial reporting purposes. Green Grapes serves primarily Italian style food, but also offers a number of other "home style" dishes. Both locations are somewhat "upscale" and its primary clientele group is the 30-50 age bracket. The company was initially established in 1990 by the husband and wife team of Mr. and Mrs. Pasta, who have been the sole shareholders since inception. Both are beginning to find the strain of operating the restaurants unbearable and are considering selling both locations (buildings which are leased). They have come to you for assistance in determining what an appropriate sales price might be as at December 31, 2004. Food-service Industry In Canada, there are approximately 63,000 commercial food-service units consisting of full-service restaurants, limited service restaurants, contract and social caterers, and taverns, bars, and night-clubs. Nearly two-thirds of all the restaurants in Canada are independent brands with chain restaurants accounting for the remainder. It is estimated that the average Canadian household visits a restaurant 508 times a year and spends 30% of its total food dollar on food-service. The percentage of restaurant meals and snacks eaten off-premise has increased from 53% in 1994 to 60% in 2003
Students may want to refer back to pages 2.5 and 2.6 of the lesson notes for additional discussion on this topic.
1

Restaurant Case Study Page 1

due in large part to the increased popularity of drive-through service, which is part of what is referred to as the quick service restaurant market. The quick service restaurant market is the largest segment of the food services industry in Canada with over $12 billion in total revenue in 2002. The five primary segments of the quick service market are: - Hamburgers - Pizza - Chicken - Coffee/Donut - Other Sandwich Both the overall restaurant industry and the quick service market have experienced strong growth in Canada during the most recent years as both the number of dualincome households and increasing time constraints are triggering families to replace home cooked meals with purchased meals. The demand for restaurants is largely driven by consumer income, since a restaurant meal is more expensive than one home cooked. In B.C., total food-service industry sales in 2003 were approximately $6.9 billion and represented approximately 5.3% of the provinces Gross Domestic Product, the highest percentage of any Canadian province. There are in excess of 157,000 employees that work in the industry, which also provides a major source of entry-level and part-time jobs to the youth of the province. It is estimated that every dollar spent by consumers in restaurants generates an additional $1.98 spent in other industries allied with the restaurant industry.

Restaurant operations Restaurants buy food in bulk and prepare it for sale to retail customers. The underlying business is very simple in concept, which is largely why there are usually several restaurants competing in the same markets and why small restaurants and chains can effectively compete with larger ones. The highly competitive nature of the industry, however, makes success difficult resulting in a higher failure rate than most other businesses. The average profit margin for the food-service industry is just 4.6%, with food costs (37.5%) and labour costs (30.3%) being the two largest expenses of operations. In 2003, the average food-service operation earned annual sales of approximately $600,000 and an annual pre-tax profit of $20,000. According to industry data, it is estimated that new entrants into the industry have a 60% chance of surviving beyond their second year, and only a 22% chance of surviving beyond eight years. Competition faced by restaurants naturally includes other restaurants, but also those establishments often referred to as non-commercial food-service businesses. These are establishments whose primary business is something other than food and beverage service and includes: - Accommodation food-service hotels, motels and resorts - Institution food-service factories, residential care facilities - Retail food-service department store cafeterias and restaurants - Other food-service vending machines, sports clubs, movie theatres, etc.

Restaurant Case Study Page 2

Eating and drinking places are mostly small businesses, with seven out of ten having fewer than 20 employees. Restaurant operations are considered labour intensive, however, with the typical employee being: - female (55%) - under 30 years of age (52%) - single (68%) - working part-time and averaging 25 hours a week - living in a household with two or more wage earners (79%)

Strategy Green Grapes has succeeded in surviving the critical first several years of restaurant operations and has established a fairly loyal customer base. In the most recent years, Mr. And Mrs. Pasta have started using various sales promotions in an effort to increase sales, such as publishing 2 for 1 coupons in some of the local community newspapers, which has succeeded to some extent. Both Mr. and Mrs. Pasta are somewhat risk adverse and have therefore operated the business of Green Grapes on a conservative basis. There is the potential, however, that the business could be expanded more quickly with the benefit of some new management and ideas.

Management Green Grapes has a management team of four individuals who have a combined 75 years of restaurant experience. Both Mr. and Mrs. Pasta had worked in the food services industry prior to opening Green Grapes, and the financial affairs are handled primarily by two restaurant managers - one at each of the Vancouver and Kelowna locations. All of the individuals in the management team have discussed the idea of possibly selling Green Grapes and agreed that they would stay on if asked by the new ownership in order to facilitate a smooth transition.

Financial Statements Figures I and II contains historical financial statements (income statement and balance sheet respectively) of Green Grapes for the fiscal years ending December 31, 2000 to 2004 inclusive. Other Information 1. A review of the tax returns for the year ended December 31, 2004 provided the following information: Class 8 10 13 UCC Balance (000s) $50 $50 $50

Restaurant Case Study Page 3

2. Rates of return on fixed income investments: (Illustrative only) 90 day Treasury Bill Government of Canada 5 year Bonds Long-term Corporate Bonds Chartered Bank Prime Lending Rate 4% 5% 6% 4%

(Source: Bank of Canada website at www.bankofcanada.ca)

3. Stock Market Data: (Illustrative only) TSE 300 composite multiples TSE small-cap subindex multiple P/E Multiple 10x 8x CFPS Multiple 7x 5x

(Source: Bank of Canada website at www.bankofcanada.ca)

4. Transaction Data: In a well-publicized transaction, a privately-owned restaurant operation similar to that of Green Grapes (known as "Pasta and More") operating in Kamloops, B.C. was sold to a foreign investor. Pasta and More had revenue of $900,000 and generated net annual income of $40,000. The purchase price paid was $250,000 in cash.

5. Summary of Restaurant Industry Financial Ratios: (Illustrative only) 2004 1:1 2.5:1 2003 1:1 2.0:1

Current ratio Total Debt: Equity

(Services such as Standards and Poors generally provide a variety of industry ratios. Dedicated business valuation websites also offer this kind of analysis for sale, such as The Financial Valuation Group at www.fvginternational.com. In some instances the valuator could calculate some comparable ratios himself using publicly available financial statements. The Industry Canada website at www.strategis.ic.gc.ca is another reference source to consider.)

Restaurant Case Study Page 4

FIGURE I GREEN GRAPES INC. INCOME STATEMENT FOR THE YEARS ENDED DECEMBER 31 (000s)
2000 Revenue Cost of sales Gross profit 1,000 500 500 2001 1,100 550 550 2002 950 450 500 2003 1,200 750 450 2004 1,250 700 550

Direct store Expenses Store contribution

100 400 (40%)

105 445 (40%)

110 390 (41%)

90 360 (30%)

95 455 (36%)

Indirect Expenses Salary Information systems Distribution Other Depreciation

280 10 5 5 5 305 95

300 10 6 5 5 326 119

275 22 4 1 7 309 81

260 8 5 4 4 281 79

290 10 5 5 5 315 140

EBIT Interest Operating line

12

Earnings before tax Income tax Net income % of revenue

90 40 50 (5.0%)

112 44 68 (6.2%)

75 32 43 (4.5%)

73 30 43 (3.6%)

128 66 62 (5.0%)

[Please note that operating results are for illustrative purposes only and are not necessarily intended to be representative of a typical restaurant operation]

Restaurant Case Study Page 5

FIGURE II GREEN GRAPES INC. BALANCE SHEET FOR THE YEARS ENDED DECEMBER 31
2000 ASSETS Current Assets Cash 90 Accounts receivable 100 Inventory & Prepaids 110 300 2001 2002 2003 2004

95 100 100 295

90 110 97 297

100 100 88 288

100 110 100 310

Capital Assets

190 490

185 480

188 485

192 480

190 500

LIABILITIES AND S/H EQUITY Current Liabilities Bank indebtedness Accounts payable

200 110 310

185 100 285

190 120 310

200 90 290

200 100 300

Shareholders Equity Capital stock Retained earnings

10 170 490

10 185 480

10 175 485

10 180 480

10 190 500

[Please note that the sample balance sheets are for illustrative purposes only and are not necessarily intended to be representative of a typical restaurant operation]

Restaurant Case Study Page 6

Valuation Analysis Valuation Approach On the basis of my review, I considered a going concern approach most appropriate given Green Grapes history of profitable operations. I have further concluded that using the capitalized cash flow approach is the most appropriate methodology to use in valuing all of the issued and outstanding shares of Green Grapes. I believe that this is an appropriate approach to adopt since the companys reported operating results vary from its cash flow due to depreciation expense exceeding required capital expenditures. The capitalized cash flow approach considers the following aspects: pre-tax pre-interest cash flow: The maintainable pre-tax, pre-interest cash flow from the operations of Green Grapes are estimated to be in a range of $90,000 to $120,000, based on the results of my analysis on Schedule A-1 Interest expense, income taxes and sustaining capital expenditures are then deducted in order to arrive at a range of maintainable cash flows. Capitalization rates: the maintainable cash flow is capitalized using an appropriate rate of return. This rate represents an investors required rate of return in consideration of, among other factors, the following: o rates of return for alternative investments including risk free rates of return available; and o a risk adjustment factor reflecting the particular industry in question and the degree of uncertainty in achieving the maintainable cash flow

Capitalized Cash Flow Value My calculation of the capitalized cash flow value of Green Grapes is contained on Schedules A-1 through A-5 and is discussed under the following headings: Adjusted cash flow Leverage Review Maintainable cash flow Estimate of fair market value Schedule A-1 Schedule A-2 Schedule A-3 Schedule A-4

Restaurant Case Study Page 7

Adjusted cash flow (Schedule A-1) The results of operations for the five years ended December 31st are summarized on Schedule A-1. The major adjustments reflected in the Schedule are summarized below: depreciation expense has been eliminated to reflect its non-cash nature; interest expense, if applicable, has been eliminated as debt financing is considered separately; and the gain/(loss) on sale of assets, if applicable, has been eliminated as this is nonrecurring.

After giving effect to the adjustments and considerations noted above, the resulting cash flow, expressed on a pre-debt service, pre-tax basis, is considered to be a reasonable estimate of the cash available to Green Grapes on an annual basis before considering debt service and income tax costs. Leverage review (Schedule A-2) In my view, it is appropriate to consider the ability of Green Grapes to service a reasonable level of debt in arriving at my overall conclusion. In my view, a potential investor would seek a debt/equity structure in Green Grapes such that the return on equity would be enhanced by appropriately leveraging the operations. Accordingly, on Schedule A-2, I have calculated the borrowing capacity of Green Grapes using several measurements. The availability of debt is a function of the underlying assets of Green Grapes which could be pledged as security and the pre-tax cash flow available to service debt. Based on my review and as noted on Schedule A-2, I have concluded that Green Grapes had unused borrowing capacity of $60,000 as at December 31, 2004. This calculation assumes that the financing, as at the valuation date, would be obtained at a rate of approximately 5%. My estimate of the cost of debt financing is based upon the prime interest rate charged by the major Canadian chartered banks as at December 31, 2004 and expectations that the interest rates would not experience significant fluctuations in the near term. Maintainable cash flow (Schedule A-3) On Schedule A-3, I have determined that the maintainable cash flow is in the range of $55,000 to $70,000 based on a pre-interest, pre-tax cash flow of $90,000 to $120,000, from which I have deducted interest, based on my leverage review and existing bank indebtedness, income taxes at the rate of 35%, and sustaining capital expenditures, net of the tax shield. Capitalization rate

Restaurant Case Study Page 8

As noted, the selection of a capitalization rate is generally based on a review of empirical data including rates of return available from alternative investments as well as a review of transactions involving comparable companies.

Transactional Information: In selecting the capitalization rate, I gave consideration to the sales transaction of Pasta and More which was completed at a price/multiple of approximately 6.25x net income. Risk Free Rates of Return: Risk free rates of return on various government and corporate instruments ranging from 4% to 6%. Stock market multiples: Public market multiples range from 10X (earnings) and 7X (cash flow) for the TSE composite index to 8X (earnings) and 5X (cash flow) for the small-cap subindex. However, various factors must be considered when reviewing these multiples, including: - the price used in determining the multiple could reflect a minority interest discount; - the multiples could be based on depressed earnings; and, - the stocks used could be thinly traded. Based on my review of available information and as noted on Schedule A-4, I have concluded on a range of capitalization rates of 25% to 28.6% or 4 times and 3.5 times cash flow respectively. My conclusion considered available data as well as the following positive factors specific to Green Grapes: - history of profitable growth - strong management team In addition, I considered the following negative factors specific to Green Grapes: - moderate to weak tangible asset backing - Green Grapes business is likely susceptible to economic downturns; - business is based on a strong and growing disposable income; and - mall based retailing is on the decline.

Estimate of fair market value (Schedule A-4) Based on the previous discussion, I have calculated the fair market value of the ongoing operations of Green Grapes as falling within a range of $220,000 to $245,000 as at the valuation date. I have added the net present value of tax benefits available in future due to existing undepreciated capital cost balances and the unused leverage. The final fair market value for all the issued and outstanding shares of Green Grapes is therefore in the range of $290,000 to $315,000 as at the valuation date. It is also my opinion that the approximate mid-point of $300,000 is a reasonable estimation of value.

Restaurant Case Study Page 9

Appendix A Schedule A-1 Green Grapes Calculations of Cash flow December 31 (000s)
Income before tax Add/(Deduct): Depreciation Adjusted cash flow Before interest and Income taxes 2000 90 2001 112 2002 75 2003 73 2004 128

95

118

79

78

133

(1) Simple Average (2) Weighted average 2000 1 95 2001 2 236 2002 3 237 2003 4 312 665 2004 5 15 $1545 / 15 = $103 (3) Most recent year

101

133

Restaurant Case Study Page 10

Appendix A Schedule A-2 Green Grapes Leverage Review December 31, 2004 (000s)
1. Margin Analysis Book Value Accounts receivable Inventory Fixed assets $110 $ 50 $100 Margin 75% 50% 60% Margin Value $83 $25 $60

2. Interest Coverage Earnings before interest and taxes Assumed interest rate Assumed times interest earned Indicated servicing capacity $100 5% 5x $400

3. Financial Ratios - Current ratio: Industry average: Green Grapes Indicated Debt Actual debt Additional debt

1:1 1:1

n/a

- Total Debt to Equity ratio: Industry average: Green Grapes Indicated Debt Actual debt Additional debt 2:1 300/200 = 1.5:1 400 300 100

4. Conclusion Maximum debt indicated Less: Existing long-term debt Leverage adjustment $60 0 $60

Restaurant Case Study Page 11

Appendix A Schedule A-3 Green Grapes Calculation of Maintainable Cash flow December 31, 2004 (000s)
Low Cash flow before LTD interest & income taxes Interest Income taxes (@35%) $ 90 (3) (30) High $ 120 (3) (41)

Sustaining capital expenditures, net of tax shield* Maintainable cash flow Rounded

(3) $ 54 $ 55

(3) $ 72 $ 70

* Assumed detailed calculation not shown for simplicity

Restaurant Case Study Page 12

Appendix A Schedule A-4 Green Grapes Calculation of Estimated fair market value December 31, 2004 (000s)
Low Maintainable cash flow after tax - Appendix A-3 Multiples (Capitalization rates of 25% / 28.6%) Capitalized cash flow Add: Net present value of tax shield on UCC balance Add: Leverage adjustment (Appendix A-2) Estimated en bloc fair market value $ 55 x 4.0 $ 220 10 60 $ 290 High $ 70 x 3.5 $ 245 10 60 $ 315

UCC Tax shield calculation UCC class Class 8 Class 10 Class 13 Rate 20% 30% 20% UCC balance $50 $50 $50 Tax shield* $3 $4 $3 $10

* Assumed: Detailed calculation not shown for simplicity

Restaurant Case Study Page 13