QUESTIONS
Incremental Profit Analysis
1. Realizing that the key to the expansion decision is the projection of incremental income, calculate the projected sales revenue and profit from operations for June 1996 (x=37), using the trend lines in Exhibit 3. Do the same for the next 11 months (hint: spreadsheets could prove to be useful). Estimate operating expenses (difference in above figures) and administrative expenses (10% of operating expenses) to arrive at profit before gains/losses for fiscal 1997. Don't forget to adjust income for the first year of operations, number of rooms, and Don Foster's Dive share of the profits. Based on projected performance for the first year, do you think the business should undertake the expansion which Andy Crowe has proposed?
2. Expand the analysis to include income projections for 1998 and 1999. Given the superior location for the new dive shop and the more active clientele at the Holiday Inn, does the longer term perspective have any impact on your decision to expand?
3. Students are often misled by looking only at dollars of profit. Divide the profit before gains/losses (in parts 1 and 2 above) by the incremental investment in assets required by Don Foster's Dive, to get a return on investment measure for each year. How do these returns stack up against other opportunities available to Don Foster's Dive (e.g., investment in common stocks)? What is the outlook for returns beyond 1999? Does this additional analysis have an impact on your decision to expand?
Financial Statement Preparation and Analysis
4. Generate the proforma (projected) financial statements for the entire Don Foster's Dive business for 1997, 1998, and 1999, assuming the expansion is undertaken. Assume that 1996 was a normal year for Don Foster's Dive, and that expansion income each year will be added to 1996 results. Assume assets (with the exception of the additional investment in fixed assets and inventory) will remain the same in future years. Also assume that current liabilities will be the same except for short-term bank loans, which will be used to make the balance sheet balance.
5. Calculate the debt ratio (total debt/total assets) and the current ratio (current assets/current liabilities) for each year. Comment on the strength of the proforma financial statements from the perspective of a banker considering whether to make the bank loan to the business for the expansion. Analysis of International Differences
6. To take the analysis one step further, assume Don Foster's Dive is considering Key West, Florida as an alternative location for the new dive shop because of high import duties on purchases and high work permit fees in the Cayman Islands. Assume a partner can be found in Florida with similar contractual arrangements as that obtained from the Holiday Inn owners. Assume that Don Foster's Dive share of profit before gains/losses will be 5 percent higher and the investment required would be 5 percent lower (prior to considering conversion to US dollar equivalents). Compute the incremental income (ignoring taxes and goodwill amortization) and ROI from the expansion to Key West. Should the expansion to Key West be undertaken?
7. Now consider the additional factors arising from international differences as they relate to taxes and goodwill (assume one half of the goodwill could be associated with the U.S. segment, that goodwill is amortized equally over 10 years in the U.S., and that goodwill amortization must be deducted after computing Don Foster's Dive share of the profits, but before taxes). Recompute the return on investment and decide if the expansion makes as much sense in the U.S. as it does in the Cayman Islands. Assume current federal, state and local tax rates are 40 percent in the U.S. location.
Accounting Disclosures and Behavioral Implications
8. Businesses in the Cayman Islands can choose among various internationally accepted accounting standards as the basis for preparing financial statements. In addition, there is no requirement for financial statements to be provided to the public. For a business operating in this environment, examine the ability of accounting information to assist the banker and the Holiday Inn owners in drawing performance comparisons with other business segments and in monitoring the performance of Don Foster's Dive. What differences might arise in the behavior of Don Foster's Dive management under such disclosure requirements? Be sure to address attitudes toward risk and ethical considerations.
9. Note that the financial statements (Exhibits 1 and 2) indicate that they are unaudited. In addition, in an environment without taxes, no tax returns are required to be filed and no threat exists to be audited by a tax authority in the Cayman Islands. Address the need for auditing in this financial reporting environment. In other words, is it more important for the banker and the Holiday Inn owners to have audited financial statements since Don Foster's Dive is located in the Cayman Islands?