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8 Jun 2019

You are working on a part of a repeat audit of a client with aJanuary 31 fiscal year end. The client company is a retailsupermarket chain, which means that it operates stores from whichit sells products to consumers. It earns a profit by sellingproducts for more than they cost to buy.

One of the peculiarities about this business is that it tends tobe both seasonal and cyclical. By seasonal, I mean that people willbuy at some times of the year but not others. (For example, patiofurniture does not sell well as Christmas presents, so the chaindoes not stock patio furniture at that time of year.) By cyclical,I mean that certain classes of products do better when the economyis booming than when times are tight and people are getting laidoff left and right. (For example, kitchen accessories forrecreational vehicles do better in good economic times than in badeconomic times.) You notice that revenue is down about fifteenpercent for the year compared to the preceding year. When you talkwith B. Castaneda, the controller, Castaneda reminds you thatCastaneda used to work for your accounting firm. Then Castanedatells you that the drop in revenue was caused by the FederalReserve, which stopped lowering interest rates at its most recentmeeting in February of 2002. If it hadn't been for that, Castanedasaid, the year's revenue probably would have been up, not down.

Required:

a. Evaluate the explanation provided by Castaneda. Showcalculations, if any, to support your conclusions.

b. How should you obtain sufficient competent evidential matterrelated to Castaneda's explanation in order to evaluate it further?What procedures and audit tests should you perform? c. Whichspecific aspects of the client's financial statements requireintensive investigation in this audit?

Thanks

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Casey Durgan
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9 Jun 2019

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You will do this by developing a cash proforma budget for hisbusiness venture (note: a cash proforma is a spreadsheet that helpsforecast income and expenses over a period of time). If donecorrectly, it can be used to plan for and manage the business.

He is planning to open his coffee house on the 1st ofMarch 2016.

Assignment

Using Microsoft Excel, construct a monthly proforma cash budgetfor your client for the first year of operations.

Use the file called “Starlucks Coffee HouseTemplate” for your starting point. This is the filethat must be downloaded and used as the basis for your assignment.Do not make any changes to this pre-designed template other thaninstructed.

Place the cash proforma analysis on a worksheet labeled“Cash Flow".

Place all your case assumptions data on a separate worksheet andlabel the worksheet "Assumptions” (note:each piece of data must appear in its own cell on the Assumptionsheet).

Place your startup costs on a third worksheet labeled"Startup Costs"

Create an additional worksheet for your scenario onerecommendation. Label the worksheet“Recommendation”.

Charts (graphs)

You will be creating two appropriate charts so create and label twoadditional worksheets for the charts (each chart will be in its ownworksheet).

Chart One – “Monthly Product Revenue” – thischart should show the total monthly

revenue of each product for the entire year.

Chart Two: – “Total Product Net Income” – thischart should show the total net income, by month, for the entireyear. This will be used to determine any trends or projections inproduct sales.

Make sure both charts are formatted correctly (i.e. appropriatetitle, legend where appropriate, data series properly labeled,etc.) and they are appropriate for business use.

Assumptions – provided by yourclient:

Product Selling Prices:

Frappuccino beverages will sell for $5.75 each
Espresso beverages will sell for $4.75 each
Hot chocolate beverages will sell for $3.25 each
Brewed coffee will sell for $2.10 each
Smoothies sell for $4.50 each
Pastries will sell for $3.25 each

Cost of Goods Sold (COGS):

Frappuccino ingredients cost $2.15 per unit

Espresso ingredients cost $2.05 per unit
Hot chocolate ingredients cost $1.23 per unit
Brewed coffee ingredients cost $.95 per unit

Smoothie ingredients cost $1.05 per unit

Pastries ingredients cost $1.35 per unit

The building rent is $2,500 per month.

Phone, Internet and Wi-Fi will cost about $600 per month.

Electricity should average about $800 a month.

Insurance will be $1200 a month.

Advertising and promotion will be $500 a month.

Assume that each month contains 4.2 weeks.

Operating Hours

The coffee house will be open six days a week (closed onMonday).

During the week (Tuesday – Friday), the coffee house will beopen from 7am – 11 pm. It will need three hourly employees and amanager during these hours.

On the weekends (Saturday and Sunday), the coffee house will beopen 10am – 10 pm and will need five hourly employees and amanger.

Your client will be the manager and draw a salary of $40,000 peryear. He will also work during the busiest times, and fill in forthe assistant manager on days off and sick days. The assistantmanager will receive an annual salary of $30K. The hourly workerswill be paid $7.25 an hour.

During the week, your client expects an average of 25 customersan hour. During the weekend, he expects an average of 45 customersan hour.

Demand Rate

Your client believes that on average 1/4 of customers will buy aFrappuccino, half will buy an espresso, a quarter of them will buya Hot chocolate, 25% will purchase brewed coffee, one out of 5 willbuy a smoothie, and 3 out of 4 customer will purchase a pastryitem.

Startup costs for the coffee house include:

Kitchen equipment: $26,275

Sales equipment: $3,500
Coffee house fixtures (chairs, tables etc.): $8,500

Start-up inventory: $1,875

Pre-opening marketing: $2,000

Licenses: $1,900

Security deposit: $5,000

First Insurance Payment: $1200

Your client has $5,000 and plans to borrow the rest from thebank with a five-year loan at 7.1% interest.

(Use the appropriate financial function to calculate the monthlytax payment)

Assume a tax rate of 15% if Income Before Taxes (IBT) is equalto or is greater than $9,000. Assume a tax rate of 10% if IBT isless than $9,000.

(Use the appropriate logical function to calculate the monthlytax payment)

Your client feels that starting with April, monthly revenue forall products, will grow an average of 1.25% per month.

Scenario One: “What if” Analysis

A former school friend of your client is an amateursinger/guitarist and has planted the idea in your client’s head ofhiring him to provide live entertainment on the weekends (Saturdayand Sunday evenings 6 - 11). The friend states he can guarantee 7more customers per hour if your client will hire him at $1,000 amonth.

What is your recommendation: Would it be a profitable idea tohire the musician?


Recommendation:

Show your client how your recommendation would affect his bottomline by recreating the proforma for this scenario, and applying thedata analysis to determine profitability.

(hint) you do not have to start this new proforma from scratch,but note, it is a completely independent proforma. The new proforma(worksheet) must update accordingly from the data worksheets.


Plan on showing your analysis and discussing the proforma changesthat occur under both scenarios and how it affectsprofitability.

Use a formatted text box (not a comment) to explain yourrecommendations. This will be approximately a 2-3 paragraphwrite-up. The recommendation should be complete, concise, andcorrect (use spell check).

Month 1

Month 2

Month 3

Month 4

Month 5

Month 6

Month 7

Month 8

Month 9

Month 10

Month 11

Month 12

Revenue:

Frappuccino

Espresso

Hot chocolate

Brewed coffee

Smoothies

Pastries

Monthly Revenue:

Expenses:

Cost of Goods Sold (COGS)

Rent

Phone

Electricity

Insurance

Advertising

Hourly Wages

Salaries

Loan Payment

Total Monthly Expenses:

Income Before Taxes (IBT)

Tax

Net Income

Cash Flow

Joe’s Peanuts

This case concerns the restaurant owner who has the good idea ofputting a rack of peanuts atone end of his counter. The idea beingthat customers would make impulse purchases of these peanuts whenthey are standing at the counter paying their bill, ordering adrink ... at least, he thought it was a good idea!

EFFICIENCY EXPERT: Joe, you said you put in these peanutsbecause some people ask for them, but do you realize what this rackof peanuts is costing you?

JOE: It ain't gonna cost. 'sgonna be a profit. Sure, I paid $50for a fancy rack to hold bags, but the peanuts cost 35 cents a bagand I sell 'em for 50 cents. If I sell 50 bags a week to startit'll take a few weeks to cover the cost of the rack. After that Igotta clear profit of 15 cents a bag. The more I sell, the more Imake.

EFFICIENCY EXPERT: That is an antiquated and completelyunrealistic approach, Joe. Fortunately, modern accountingprocedures permit a more accurate picture which reveals thecomplexities involved.

JOE: Huh?

EFFICIENCY EXPERT: To be precise, those peanuts must beintegrated into your entire operation and be allocated theirappropriate share of business overhead. They must shareaproportionate part of your expenditure for rent heat, light,equipment deprecation, decorating, salaries for your waitresses,cook......

JOE: The cook? What's he gotta do with peanuts? He don't evenknow I got 'em.

EFFICIENCY EXPERT: Look Joe the cook is in the kitchen, thekitchen prepares the food, the food is what brings people in here,and the peopleask to buy peanuts. That's why you must charge aportion of the cook's wages, as well as part of your own salary topeanut sales. Thissheet contains a carefully calculated costanalysiswhich indicates the peanut operation should pay exactly$2,550 per year toward these general overhead costs.

JOE:The peanuts? $2,550 a year for overhead? The nuts?

EFFICIENCY EXPERT: It's really a little more than that. You alsospend money each week to have the windows washed, to have thewindows washed, to have the place swept out in the mornings, keepsoap in the washroom, and provide free cokes to the police. Thatraises the totalto $2,780 per year.

JOE: [Thoughtfully] But the peanut salesman said I'd make money..... put 'em on the end of the counter, he said ... and get 15cents a bag profit.

EFFICIENCY EXPERT: [With a sniff] He's not an accountant. Do youactually know what the portion of the counter occupied by thepeanut rack is worth to you?

JOE: Ain't worth nothing - no stool there ... Just a dead spotat the end.

EFFICIENCY EXPERT : The modern cost picture permits no deadspots. Your counter contains 60 square feet and your counterbusiness grosses $45,000 a year. Consequently, the cost of a squarefoot of space occupied by the peanut rack is $750 per year. Sinceyou have taken that area away the general counter use, you mustcharge the value of the space to the occupant.

JOE: You mean I gotta add $750 a year more to the peanuts?

EFFICIENCY EXPERT: Right. That raises their share of the generaloperating costs to a grand total of $3,530 per year. Now then, ifyou sell 50 bags of peanuts per week, these allocated costswillamount to $1.36 per bag.

JOE: What?

EFFICIENCY EXPERT : Obviously, to that must be added yourpurchase price of 35 cents per bag, which brings the total to$1.71. So you see by selling peanuts at 50 cents per bag, you arelosing $1.21 on every sale.

JOE: Somethin's crazy!

EFFICIENCY EXPERT : Not at all! Here are the figures. They proveyour peanuts operation cannot stand on its own feet.

JOE: [Brightening] Suppose I sell lotsa peanuts ... thousandsbags a week instead of fifty.

EFFICIENCY EXPERT: [Tolerantly] Joe, you don't understand theproblem. If the volume of peanuts sales increases, our operatingcosts will go up... you'll have to handle more bags with more time,more depreciation, more everything. The basic principal ofaccounting is firm on that subject: "The Bigger the Operation, theMore General Overhead Costs That Must be Allocated." No, increasingthe volume of sales won't help.

JOE Okay, you're so smart, you tell me what I gotta do

.

EFFICIENCY EXPERT: [Condescendingly] Well .... you could firstreduceoperating expenses.

JOE: How?

EFFICIENCY EXPERT: Move to a building with cheaper rent. Cutsalaries. Wash the windows bi weekly. have the floor swept only onThursday. Remove the soap from the washrooms.Decrease thesquare-foot value of your counter. For example, if you can cut yourexpenses 50%, that will reduce the amount allocated to peanut from$3,530 to $1,765 per year, reducing the cost to $1.03 cents perbag.

JOE: [Slowly] That's better?

EFFICIENCY EXPERT: Much, much better. However,even then youwould lose 53 cents per bag if you only charge 50 cents. Therefore,you must raise your selling price. If you want a net profit of 15cents per bag you would have a charge $1.18.

JOE:[Flabbergasted] You mean even after I cut operating costs50% I still gotta charge $1.18 for a 50 cent bag of peanuts?Nobody's that nuts about nuts! who'd buy 'em?

EFFICIENCY EXPERT: That's a secondary consideration. The pointis, at $1.18 you'd be selling at a price based upon a true and fairevaluation of your then reduced costs.

JOE: [Eagerly] Look! I gotta better idea. Why don't I just throwthe nuts out ... put 'em in the garbage.

EFFICIENCY EXPERT: Can you afford it?

JOE : Sure. All I got is about 50 bags of peanuts ... cost about$17.... so I lose $50 on the rack, but I get outta this nuttybusiness and no so more grief.

EFFICIENCY EXPERT: [Shaking head] Joe it isn't that simple. Youare in peanut business! The minute you throw those peanuts out youare adding $3,530 of annual overhead to the rest of your operation.Joe ... be realistic... can you afford to do that?

JOE : [Completely crushed] It's unbelievable! last week I wasmaking money. Now I'm in trouble... just because I believe 50 bagsof peanuts a week is easy.

EFFICIENCY EXPERT: [With raised eyebrow] that is the object ofmodern cost studies, Joe ...to dispel those false illusions.

REQUIRED

1. Is Joe losing $1.21 on every sale of peanuts?Explain.

2. Do you agree that if the volume of peanut salesisincreased, operating losses will increase? Explain.

3. Do you agree with the "Efficiency Expert" that, inorder to make peanut operation profitable, the operating costs inthe restaurant should be decreased and selling price of the peanutsshould be increased? Give reasons.

4. Do you think that Joe should eliminate his peanutoperations? Why or why not?

PLEASE DO NOT ANSWER IF CANNOT GIVE 200 WORDS

First, spend a couple of sentences summarizing the textbelow.Then, answer the following In the text below , the speakermentioned several challenges which led to his company's capitalstructure policy being different from what's discussed intraditional textbooks. Which of these challenges do you think isthe strongest reason why their capital structure policy isdifferent and why do you think so?

Capital Structure Policy Amit Singh: A big part of Pfizer’svalue chain is to identify the drug in the labs and then take themall the way to science, all the way to the market, to benefit thepatients. It can take over ten years to develop a drug all the wayfrom pre-clinical stages in the labs all the way to the market, andit can take, based on some studies, over a billion dollars of moneyin order to make this transition. Hi, my name is Amit Singh, and Iwork at capital market group in Pfizer treasury. My mainresponsibilities involve, as you can imagine by the name capitalmarkets, maintaining and ascertaining the optimal capital structurefor the company, which basically means how much debt, cash, andequity the company should maintain. That’s one of my primeresponsibilities. The other things I look at are also supportingbusiness development groups, so, you know, Pfizer’s often involvedin mergers and acquisitions— divestitures, more recently. Wesupport evaluations of more day-to-day smaller projects, morefinance-related projects, where the evaluation and discountrate-type inputs are needed from Treasury. So Pfizer’s capitalstructure policy, unlike what you would read in traditionaltextbooks, is more practical, and it has to do with minimizing abunch of capital structure related costs, which have to do with taxrates, um, it could be related to your foster financial distressand other funding costs. If a product is two-thirds of the waythrough to the market and then some toxicity is developed in theproduct and the product fails, you have pretty much lost thosehundreds of billions of dollars that you invested in the product todate. However, as a corporate finance person, I find several otheraspects that are quite interesting and challenging. One of them isthe fact that Pfizer and several companies the size of Pfizer holdwhat is called excess liquidity or excess cash on their balancesheets. What that means is when you try to do an optimal capitalstructure analysis for a company like Pfizer, you can’t…cannot justfocus on the mix of the debt and the equity. In fact, you have tofocus on the fact that you have a lot of cash on the balance sheet,which means your net debt, which is the debt net of the cash, isless than what you think it is. A couple of other items that I alsofind very fascinating, one is the fact that many of thepharmaceutical projects have real options embedded in them. What Imean by that is, if you have a long-term Pfizer project that isgoing from the drug…going from pre-clinical stages and research allthe way to the market, somewhere along the line you have options inthe process, where, for example, you can abandon the project. Youhave the option to accelerate the project, and all of theseoptionalities, so to speak, embedded in the projects, end upincreasing the value project. And it is very difficult to capturethis using a traditional discounted cash flow approach, which iswhat people try to do, given that real option analysis is quitedifficult. The third big challenge which I find fairly unique tothe pharmaceutical industry, is what I would refer to as thestair-step nature of the discount rates—and I’ll explain that in asecond—of a project that is an early stage drug development projectversus a later stage. So, what do I mean by that? So let’s assumeyou have two projects, one is a drug that is in phase one ofdevelopment, the other one is the same drug, all else equal, is inthe second phase of development. Now if you want to do a discountedcash flow analysis on both these drugs, do you use the samediscount rate for both of those projects? And a lot of people,including myself, believe that the answer is ‘no.’ In fact, webelieve that the discount rate for the drug—all else equalagain—that is in the earlier stage of the project should be higherthan the product that is in the later stage. And that’s not justbecause of the probability of success being lower in the earlystages, but it is more so because of some unique systematic risksthat are given rise to for the products that are more early stagethan later stage. So I find that, again an area of research that’sfar from resolved and fascinating and unique to pharmaceuticals.The last and the fourth item that I find also…again very unique andfascinating for the pharmaceutical industry, is the fact that it isvery difficult to calculate the return on invested capital for apharmaceutical company in any given year. And again, what do I meanby that? If you wanted to know whether a company was performingwell or not, one metric that people often try to use is what is thereturn that the company is making on the invested capital that isinvested in the company in any given year, as compared to thecompany’s cost of capital? To the extent here that your returns areexceeding the cost of capital, your company’s creating value and,if not, you’re not creating value, or maybe you’re destroyingvalue. However, for a pharmaceutical company, given the long-termnature of the investment, a dollar invested today can potentiallyhave a halo effect for several years to come, and it is verydifficult to ascertain what the return of that dollar is in anygiven year. And that makes it very challenging to analyze thereturns of a pharmaceutical company. Pfizer’s market capitalizationis close to $140 billion. So how does Pfizer fund its R & D?Pfizer looks at R & D spend, or investment in R & D, as anexpenditure or investment that is separate from its financing. Sowe do not look at each project as a project that needs to beseparately funded. In fact we rank order the projects based oncertain metrics, and are in a unique position to be able to fundall good projects that come our way. So we do not use projectfinance, and we do not go to try to raise debt or equity forindividual R & D projects. The cash flows in the pharmaceuticalindustry, while the returns may be good for a successful product,are fairly uncertain. In a business that is this uncertain, it isvery difficult to maintain a very high debt balance, because debtpayments are certain and you have to make them. In orderto…therefore, in order to maintain and keep in mind theavailability of the cash flows and the fact that you may go throughseveral years of low productivity, and low cash generation, youneed to acknowledge the fact, and you need to keep your debtbalance accordingly low. In many ways that is very comparable torunning a household because, just like in a good budget-makingprocess in a household, you want to see how stable your jobprospects are in the near term and even in the longer term, beforeyou make a big purchase, especially if you take a big loan out,where the payments…you will have to make the payments and if youwere to not make the payments, the repercussions would be dire andit would relate to bankruptcy. It is, in my mind, good financialpolicy is the same, whether it is in the household or a bigsuccessful company. In 2009, Pfizer acquired another research-basedpharmaceutical company, Wyeth, for $68 billion. To the question ofwhether our capital policy has changed because of the Wyethacquisition, the answer is ‘yes.’ But, has the…to the question “hasthe policy changed permanently?” I think the answer is ‘no.’ Tofinance the Wyeth acquisition, which cost us $68 billion, we had totake on $23 billion of new debt. In order to be able to take onthat much debt, we had to depart from our historical policy of verylow debt, but that doesn’t mean that we assume that that is thepermanent debt level that we would stay at. In fact we havesince…since the Wyeth acquisition in 2009, we’ve been paying downdebt, and we plan to settle down at a much lower debt level. One ofthe things that can cause us to re-look at and continuouslyreevaluate our capital structure is the availability, or our senseof the future availability in our cash flows. So anything in ourbusiness that fundamentally changes our cash flow availability, oris projected to change the cash flow availability in the futurewould make us re-look at our capital structure. What I mean by thatis, for example, if we take on a business, or the proportion of ourstable cash flow business increases in the future, as compared tothe entire cash flow for the company, that would mean that we cantake on more debt. And the reverse of that is if our proportion ofour pharmaceutical business in the company grows, which is the moreuncertain part of the business, then we would end up taking on lessand less debt in the future and holding more and more cash.

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