Reference no: EM13510630

QUESTION

Your client, Mr Abrahams, is keen to purchase the business of Delight Coffee Shop and has requested your assistance in evaluating the business and negotiating his purchase thereof. Delight Coffee Shop commenced trading on 1 March 2001 in a suburban shopping centre in
Morningside, Sandton. DCS (Pty) Ltd was incorporated on 27 February 2001 to own the operations of Delight Coffee Shop. A five-year lease agreement was entered into with the owner of the shopping centre. The business has traded profitably since inception, and has developed a reputation for serving fine food and coffee. The sole shareholder of DCS (Pty) Ltd, Mrs Strand, wishes to sell the business as she intends relocating to Cape Town in the near future.

The initial cost of all equipment as well as the furniture and fittings for the coffee shop totalled R450 000. This was financed by means of a four-year term loan obtained from MSD Bank and secured by a personal suretyship from Mrs Strand. DCS (Pty) Ltd was also required to pay a twomonth rent deposit of R30 000 to the landlord, refundable at the termination of the lease agreement. Mrs Strand paid the rent deposit personally and was refunded by DCS (Pty) Ltd in July 2001.

Mrs Strand has managed Delight Coffee Shop since its inception. She is confident that the business will continue to thrive as it has many regular customers. In addition, the shopping centre in which the coffee shop is located attracts significant passing trade on a daily basis. The employees are competent and have been with the business since inception. Delight Coffee Shop currently has five permanent employees who deal with food preparation as well as four waiters to serve customers.

While the waiters receive only minimal monthly wages, they may keep tips received from customers. These tips are usually generous and waiters perceive that they earn adequate compensation for their efforts.

Mrs Strand is satisfied with the internal controls in place over ordering and purchasing, food preparation and daily banking. Her only concern relates to the operation of the till and completeness of revenue. Waiters take customer orders and record these in duplicate on pre-printed order pads, which are not pre-numbered. One copy of each order is passed to the kitchen and the duplicate slip is retained by the waiter. Beverages and meals are then collected from the kitchen by waiters and delivered to customers. Upon completion of meals, waiters manually calculate and enter individual amounts on the cash register. Till slips, which record individual amounts of food and beverage items and the total due by the customer, are then presented to the customer for payment. Till slips do not state the actual food and beverage items, but simply the individual amounts, the total and the VAT.

Customers can pay in cash or by credit card. Waiters have full access to the cash register to deposit cash and obtain change for customers. Waiters can also operate the credit card machine to process electronic payments. At the end of each day, waiters place their copies of customer orders in a filing tray next to the cash register, while kitchen employees destroy their copies of customer orders. Mrs Strand computes the theoretical cash balance per the cash register at the close of business on a daily basis. The theoretical cash balance is determined as follows:

R'000
Opening cash float xxx
Add: Daily sales per printout obtained from cash register xxx
Less: Purchases paid for using cash in till -xxx
Less: Sales paid for by credit cards -xxx
Theoretical closing cash balance xxx

There are rarely any material differences between the actual and the theoretical cash. Mrs Strand manages the daily operation of Delight Coffee Shop and is physically present most of the day. Mr Abrahams has decided that he will need to employ somebody to manage the operations of Delight Coffee Shop at a cost of R5 000 per month, as he himself will not be physically present in the coffee shop for more than two hours each day.

DCS (Pty) Ltd has outsourced the accounting functions of the business and the preparation of monthly and annual financial statements to its auditors. The audited annual financial statements of DCS (Pty) Ltd for the year ended 28 February 2002 and the draft annual financial statements for the year ended 28 February 2003 are available for review. These financial statements have not yet been signed off, because of unresolved queries from the audit partner regarding the provisions for taxation. Financial information per the draft annual financial statements of DCS (Pty) Ltd:

ABRIDGED INCOME STATEMENTS FOR THE YEARS ENDED 28 FEBRUARY
2003 2002
R R
Turnover 1 120 882 1 014 504
Cost of sales 460 729 385 324
Opening inventory 15 843 -
Purchases 461 334 401 167
Closing inventory (16 448) (15 843)
Gross profit 660 153 629 180
Operating expenses 488 587 454 489
Accounting fees 19 260 18 000
Bank charges 24 659 21 305
Depreciation 77 018 83 250
Petrol 14 405 12 857
Rent 201 600 180 000
Wages 137 820 127 167
Other expenses 13 825 11 910
Operating profit 171 566 174 691
Net interest expense 39 054 56 775
Profit before taxation 132 512 117 916
Taxation 39 754 35 375
Profit after taxation 92 758 82 541
ABRIDGED BALANCE SHEETS AS AT 28 FEBRUARY
2003
R
2002
R
ASSETS
Non-current assets
Furniture and fittings, equipment
Current assets
289 732
189 539
366 750
124 056
Inventory
Trade and other receivables
Bank balances and cash
16 448
43 450
129 641
15 843
38 451
69 762
Total assets 479 271 490 806
EQUITY AND LIABILITIES
Capital and reserves
Non-current liabilities
Interest bearing borrowings
Current liabilities
175 300
138 755
165 216
82 542
258 294
149 970
Trade and other payables
Taxation
Current portion of interest bearing borrowings
13 840
31 837
119 539
11 611
35 375
102 984
Total equity and liabilities 479 271 490 806

Mrs Strand wishes to sell the business of DCS (Pty) Ltd as a going concern (as opposed to selling the shares in the company) for R581 350 with effect from 1 March 2003. The business of Delight Coffee Shop is to be sold excluding interest bearing liabilities, cash resources and the rent deposit. The tangible assets of the business to be sold comprise fixed assets, inventory and trade receivables. Trade payables are to be for the account of Mr Abrahams. Mrs Strand's calculation of the purchase price was determined as follows:

Operating profit for the year ended February 2003 171 566
Add back: Personal expenditure charged through the business
Purchases of groceries charged to cost of sales 28 883
Other personal expenditure charged to operating expenses 29 280
Petrol expenses 8 880
Wages paid to Mrs Strand's domestic worker 20 400
Restated operating profit 229 729
Restated operating profit multiplied by 2,4 551 350
Rent deposit 30 000
Purchase price for the business 581 350

Mrs Strand has not earned a salary from DCS (Pty) Ltd since the business started. She did not charge any personal expenditure through the business in the 2002 financial year. Depreciation charged to the income statement is equivalent to wear and tear allowances that may be claimed in terms of the Income Tax Act.

Mr Abrahams has confirmed that the average purchase price of coffee shops in the northern suburbs of Johannesburg is usually determined as between 2,3 and 2,5 times the historical operating profit. He reached this conclusion from his dealings with various business brokers over the past six months. The other common method for determining the purchase price for a coffee shop is to discount the net cash flow generated in a normal trading year, before financing activities, at 40%.

REQUIRED

(a) Advise Mr Abrahams regarding what purchase price he should offer for the business of Delight Coffee Shop. Support your advice with detailed workings and consider the various methods for determining a fair purchase price.

(b) List and discuss the key issues to be clarified and resolved by Mr Abrahams in concluding the purchase arrangement between DCS (Pty) Ltd and himself.

(c) Advise Mr Abrahams of any apparent weaknesses in internal controls in the operation of Delight Coffee Shop. Describe what procedures could be implemented to address these weaknesses.