A Hong Kong based businessman, Mr Li, is considering whether to buy a franchise. He has spent some time looking at different franchise opportunities and is most interested in The Coffee Company franchise. The Coffee Company has been established for three years and is based in the UK. It currently has 65 franchisees operating under The Coffee Company name in the UK, compared to 72 franchisees operating in the UK 12 months ago. During the last twelve months The Coffee Company has been offering franchise opportunities overseas as the company is keen to expand this aspect of their business. This would be the first franchise agreement in Hong Kong.

The Coffee Company was set up by a wife and husband who had had no previous business experience in coffee shops, although they have both had some prior business experience in the car industry. The wife has a background in accounting and the husband has a background in sales. The wife and husband do not run any Coffee Company shops; instead they are focused upon building up the number of franchisees. To differentiate themselves from other coffee shops, Coffee Company shops only sell coffee and biscuits.

Mr Li has no business experience in coffee shops either. His current business is manufacturing bricks for the construction industry. The Coffee Company provides initial training in how to run a coffee shop. Normally, they would provide a weeks training shortly prior to the opening of the franchise. However, The Coffee Company has stated that in this case they can only offer three days training because of the travel time required to visit Hong Kong. The Coffee Company has said that it will be able answer any queries by email or telephone. The Coffee Company will provide advertising literature to Mr Li that is currently used by its UK franchisees.

The franchise agreement between Mr Li and The Coffee Company states:

1. An amount of 40,000 must be paid by Mr Li at the outset to The Coffee Company. This fee is to cover for use of The Coffee Company logo and to purchase fixtures and fittings that are standard in all Coffee Company outlets.

2. A fee amounting to 5% of turnover of the franchise must be paid by Mr Li to The Coffee Company each year. The fee must be paid at the end of each year and it must be paid in pounds sterling.

3. Mr Li must purchase all coffee and biscuits from The Coffee Company. The cost of purchasing the coffee is 10 pence per cup and the cost of purchasing each biscuit 20 pence. The payment for these purchases is to be made at the end of each year in pounds sterling.

4. The advertising literature that the Coffee Company will provide must be paid for by Mr Li. This will cost 5,000 per year. This amount is payable at the start of each year in pounds sterling. 5. Mr Li is responsible for finding suitable premises.

Mr Li has found premises that he considers suitable for a coffee shop. These premises would cost HK$500,000 per year to rent. The rent would be payable at the end of each year. The shop would sell different types of coffee and different types of biscuit. The average selling price for a cup of coffee would be HK$15 and the average selling price for a biscuit would be HK$10. Mr Li had hoped that he would be given assistance in projecting the likely level of future sales by The Coffee Company. However, they have not provided any assistance and Mr Li has estimated that sales over the next four years would be as follows:

Mr Li has estimated that staff costs each year will total HK$1,150,000 and other costs will total HK$8,000 per year.

Assume that corporation tax is payable in Hong Kong at a rate of 15% and based on the net cashflow for each year. Corporation tax is payable one year in arrears. If the net cashflow for any year is negative then you should assume that zero tax is to be paid on this cashflow, and that the negative cashflow can be carried forward and deducted from future positive cashflows when calculating corporation tax.

Mr Li estimates that the value of the coffee shop at the end of year 4 would be equivalent to the pre-tax net cashflow in year 4 multiplied by a factor of 6.

The current spot rate is HK$12.82 to the . The exchange rate is expected to change in the future, and it has been estimated that the inflation rate in the UK will be 2.5% per year and the inflation rate in Hong Kong will be 2% per year.

If Mr Li decides to buy the franchise then he will need to obtain a bank loan to finance the venture. He is aware that the bank will require him to have prepared a business plan. As a part of this business plan Mr Li will need to have considered any risks that might be associated with the venture.

Required:

Mr Li is aware that he really needs some further advice and you have been asked to:

Prepare a report for Mr Li advising him of any potential risks he should be aware of before approaching the bank for a loan.

Number of biscuits sold Year 1 Year 2 Year 3 Year 4 Number of cups of coffee sold 90,000 100,000 120,000 120,000 60,000 75,000 80,000 80,000 Number of biscuits sold Year 1 Year 2 Year 3 Year 4 Number of cups of coffee sold 90,000 100,000 120,000 120,000 60,000 75,000 80,000 80,000