Can someone please help me answer Question1 from this case study? Case 35 OT snack company Valuation . Thanks

CASE 35 OT SNACK COMPANY VALUATION James Fussell had a lifelong dream of owning and running his own business, After losing his job as controller of a medium-sized corporation for the second time in three years, he began giving it even more thought. In both cases the firm Fussell was working for had been purchased by another firm and most of the acquired firm's top managers had been let go. Owning his own firm was one way to avoid being subjected to the decisions of others that could change his life so quickly. With this goal firmly in mind, Fussell simultaneously started looking for a job to pay his present bills and for a company to own that would give him the sense of control and satisfaction he had dreamed about. James Fussell James Fusseil was born and raised in Florida. He graduated with a degree in management from the University of South Florida in 1971. After college he ac- cepted a job with the accounting firm D. E. Gatewood, certified public accoun- tant. To improve his accounting skills he completed 36 additional hours of ac- counting courses. After taking these courses, Fussell took and passed the certified public accountant (CPA) exam. "I felt an accounting background was needed for running my own business in the future, and that by working with a certified public accounting firm I would strengthen that skill and learn about many different types of firms." After five years, Fussell took a job with Blue Bell, Inc. in Greensboro, North Carolina. Blue Bell, Inc. was a publicly owned corpo ration in the very competitive textile business, and although profitable, its re- turn on investment was not as high as some stockholders of the company de- sired. The decision was made to take the company private, and a group of Blue Bell executives made an offer that was accepted by a majority of the stockhold- ers. To reduce expenses and help pay off the debt incurred in purchasing Blue Bell, the new owners drastically reduced the scope of operations and eliminated many middle and upper-level management positions. Pussell was among those who were forced out. 213 his accounting skills and past background, he quickly found a position with Old Fussell was fortunate and quickly found a job with Thomasville Furniture chased by Weyerhauser, Inc., a much larger multidivision corporation, and Company. He started in March, but by October, that company had been pur- Fussell was once again looking for a job. This time he was determined to locate a job that would be temporary until he could find a firm to own and run. With CASE 35 OT SNACK COMPANY 231 contacted several business brokers about helping him locate a firm for sale. He also enlisted the help of literally dozens of friends and acquaintances. Fusseln considered several businesses but rejected them as not the type he wanted. In October 1993, his broker asked him to look at OT Snack Company, which he de scribed as a bakery. Fussell thought it was a bakery in a shopping center and was not enthusiastic, but after visiting the business he became very excited. OT SNACK COMPANY OT Snack Company was formed by Alton Bodenheimer and Grady Griffin, Jr.. in 1949. The fried pie has been the firm's only basic product; although at one time it produced a honeybun, production of that item was discontinued in 1977. The company slowly built up its business by selling to vending machine com- panies and through distributors who sold the pies as a desert to the lunch counter trade. The owners concentrated on quality and service and expanded sales throughout the Carolinas, Virginia, Tennessee, and Georgia. By the end of 1993, OT Snack employed 52 people and produced between 400,000 and 500,000 dozen pies a year. These pies were produced with six different fillings-apple, cherry, peach, raisin, chocolate, and lemon. Production A fried pie is as simple a bakery product as can be imagined. A fruit or pie fill- ing is wrapped in pie dough, and it is deep-fried in fat. The actual production at OT was in four basic steps. First, the pie filling was cooked and then cooled. The fruit fillings were made from dried fruit, water, and sugar plus ingredients to re- tard spoilage. The mixture was stirred and cooked for about an hour and then cooled for 48 hours. In the second step, the dough was prepared and cut into sections. These sec- tions contained enough dough to make six dozen pies. Women, who worked on a piece rate, rolled out the individual pie shells with a metal rolling pin, placed the filling in the shell, and formed the shell around the filling. This finished product was then placed on a screen to be deep-fried in fat. Next the pies were deep-fried in fat for three minutes, put on cooling racks, and moved into a holding room. In the final step, the pie was wrapped in a glas- sine wrapper and placed into a tray for shipping. There was virtually no excess inventory kept at the plant as all production was made to fill current orders. 214 PART VII VALUATION The trays were stacked according to customer orders and were usually picked up the same day they were produced. Personnel OT employed 46 people in production and the average pay was about $5.50 per hour. Turnover was very low, and 31 of the employees had been given gifts of stock in the firm. This stock amounted to 10 percent of all the outstanding shares. OT also had a very good benefit program. The production operation was man- aged by John Davis, who had worked for OT since mid-1964. John had worked in all phases of plant operations and knew the production operation and the cy- cle of the business as well as anyone. Although turnover was very low, produc- tion efficiency was also low. Sales had been declining since 1987 (see Exhibit 1), and on days when orders were low, employees not on piecework were in the habit of staying at work and on the payroll, although not doing any work. Part of this casual attitude was due to the fact that the city of Winston-Salem had not issued any building permits since 1984 in the South Marshall Street Redevelopment area where OT was located. The city planned on redeveloping the area with upscale condominiums. OT's current sole owner, Alton Bodenheimer, was too near retirement to plan for a move to a new location. With the future of the present location in limbo, he had allowed the business to de- cline. All of the production equipment was old and outdated, for there certainly was no incentive to replace equipment if the plant was going to be relocated in the near future. The equipment, however, had no salvage value and was in dire need of immediate replacement. In addition, no new customers had been added in several years and the busi- ness served a static customer base. Evidence of the lack of current marketing was that none of OT's products were sold in local grocery stores. An indication of Bodenheimer's attitude was shown in early 1992 when he asked if he was look- ing forward to retirement. His reply was: "Hell, I've been retired for 10 years!" One employee said that a typical day for Bodenheimer was to come into the plant in the morning and see what orders they had; go to a local coffee shop for about an hour and a half; come back to the plant until lunchtime; and then, shortly af- ter lunch, go play golf. The redevelopment project and the thought of having to move had simply taken away his desire to plan for the future of the company. Financial Information In late 1993 OT Snack Company was a profitable firm producing a good prod- uct with a loyal customer base. Production was about 400 dozen pies per hour. Rather than move the business, the owner, Alton Bodenheimer, had decided to sell the company. What James Fussell saw when a business broker showed him the financial statements (see Exhibit 2) and when he subsequently toured the plant was a product with tremendous potential. The owner was asking $1.2 mil- lion for a business that had $450,000 in cash and marketable securities and al- 215 dent appraiser at $297,000, would be purchased by the city of Winston-Salem in most no liabilities. The property, which Fussell had appraised by an indepen- CASE 35 OT SNACK COMPANY 233 early 1994 at the appraised priced. Although the plant's capacity was 12,000 dozen pies per week, its currena dozen. (The pies were sold in vending machines for 45 to 50 cents each.) Fussell believed that the market for these pies could easily be doubled without having to hire another salesperson. With that in mind, and knowing that the plant had to be moved, Fussell began looking for a new home for OT Snack and for ways to both produce and sell more pies. Automated Equipment Through a friend Fussell learned about an automated equipment line that would produce fried pies. He flew to Duluth, Minnesota, to see the equipment in oper- ation. The production line was produced by the Moline Corporation and cost $497,000 to purchase and install. The equipment produced pies on a continuous conveyor. At one end, the dough was produced and extruded onto a sheet and rolled to the appropriate thickness, trimmed, and cut into strips. The filling was deposited into the stirps, which were folded, and the pie was cut out, with the scrap dough recycled back to the beginning. The pie was then fed into the fryer, which was maintained at a constant temperature, and the pies were cooked for exactly three minutes. The pies were then moved onto a cooling conveyor. This equipment would reduce the number of people required for production by almost 65 percent. In fact, only 17 people would be needed to operate the en- tire process, and the equipment was capable of producing 24,000 dozen pies per week (double the present capacity). For planning purposes, Fussell assumed that the economic life of the equipment and its depreciable life would be the same. A building suitable for production was located on the north side of Winston- Salem in Northridge Business Park. The annual lease on this building was $75,000. At about the same time, Fussell found that he could lease the automated equipment for $8,000 per month from the leasing department of a local bank, Central Carolina Bank, if OT would put down a deposit of $200,000. Marketing Before finally deciding on whether to purchase OT Snack Company, Fussell did a quick marketing survey. The firm had about 15 current customers who or- dered once or twice a week. In addition, he found that several potential cus- tomers had contacted OT in the recent past. These customers included Vendors Supply of North Carolina, Waldensian Bakeries, and Fox Bakeries, all located in North Carolina; Palmetto Bakeries in South Carolina; and Vending Services of America, located in Georgia. Several of these firms were primarily bread and bakery goods distributors who were looking for additional products to sell to their customers-supermarkets, convenience stores, service stations, etc. 216 PART VII VALUATION DECISION TIME Fussell went over all the facts to make sure that he had thoroughly investigated the firm and its potential. He then made two income projections for 1994 sales based on the assumption that OT would operate in its new location in 1994. The salaries, shown in Exhibit 3, were based on what Fussell expected to pay the two managers who were presently on salary; the management fee was what he hoped to earn. The first income projection was based on sales of $1.2 million and assumed that the pie operation would operate with the automated pro- duction line. The second projection assumed a sales level of about $2.7 million. (See Exhibit 4.) James Fussell thinks he has done a very exhaustive study of OT Snack and the potential of the fried pies market in the region presently served by OT. Although sales have declined in the last few years, Fussell believes that the com- pany still produces a quality product and gives excellent service to its current group of customers. The potential for the firm seems outstanding. After check- ing with his banker, Fussell knows he can purchase the business based on a loan on the assets of the firm, cash from his savings and investments, and a mortgage on his home and all his personal assets. Fussell faces two very important decisions. Should he take the plunge and buy this firm? Given an affirmative answer to the first decision, he must then de- termine what price he would be willing to pay for OT Snack Company. He ac- tually would be purchasing 90 percent of the stock, since the employees own 10 percent). The second decision is based on the first; that is, if he buys OT Snack Company, should he automate the production process? QUESTIONS 1. Assuming Fussell wishes to buy the firm, what should he pay for it? 2. How should Fussell pay for the firm? 3. If Fussell buys the firm, should he automate? (Calculate both the net present value and the internal rate of return.) 4. What is the dollar break-even point before and after automation? 5. Assuming an average rate of inflation of 7 percent between 1987 and 1993, what was the actual sales decline in constant dollars? 6. Given your answers above, would you advise Fussell to buy OT Snack Company? Why or why not? 217 CASE 35 OT SNACK COMPA EXHIBIT 1 OT Snack Company Sales: 19841993 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 $801,828 1,043,478 1,387,024 1,553,755 1,506,317 1,488,852 1,246,352 1,039,402 1,116,108 1,098,236 1120 CT STEET T BE HIS VIVER 2 SOARER 213 CASE 35 OT SNACK COMPANY VALUATION James Fussell had a lifelong dream of owning and running his own business, After losing his job as controller of a medium-sized corporation for the second time in three years, he began giving it even more thought. In both cases the firm Fussell was working for had been purchased by another firm and most of the acquired firm's top managers had been let go. Owning his own firm was one way to avoid being subjected to the decisions of others that could change his life so quickly. With this goal firmly in mind, Fussell simultaneously started looking for a job to pay his present bills and for a company to own that would give him the sense of control and satisfaction he had dreamed about. James Fussell James Fusseil was born and raised in Florida. He graduated with a degree in management from the University of South Florida in 1971. After college he ac- cepted a job with the accounting firm D. E. Gatewood, certified public accoun- tant. To improve his accounting skills he completed 36 additional hours of ac- counting courses. After taking these courses, Fussell took and passed the certified public accountant (CPA) exam. "I felt an accounting background was needed for running my own business in the future, and that by working with a certified public accounting firm I would strengthen that skill and learn about many different types of firms." After five years, Fussell took a job with Blue Bell, Inc. in Greensboro, North Carolina. Blue Bell, Inc. was a publicly owned corpo ration in the very competitive textile business, and although profitable, its re- turn on investment was not as high as some stockholders of the company de- sired. The decision was made to take the company private, and a group of Blue Bell executives made an offer that was accepted by a majority of the stockhold- ers. To reduce expenses and help pay off the debt incurred in purchasing Blue Bell, the new owners drastically reduced the scope of operations and eliminated many middle and upper-level management positions. Pussell was among those who were forced out. 213 his accounting skills and past background, he quickly found a position with Old Fussell was fortunate and quickly found a job with Thomasville Furniture chased by Weyerhauser, Inc., a much larger multidivision corporation, and Company. He started in March, but by October, that company had been pur- Fussell was once again looking for a job. This time he was determined to locate a job that would be temporary until he could find a firm to own and run. With CASE 35 OT SNACK COMPANY 231 contacted several business brokers about helping him locate a firm for sale. He also enlisted the help of literally dozens of friends and acquaintances. Fusseln considered several businesses but rejected them as not the type he wanted. In October 1993, his broker asked him to look at OT Snack Company, which he de scribed as a bakery. Fussell thought it was a bakery in a shopping center and was not enthusiastic, but after visiting the business he became very excited. OT SNACK COMPANY OT Snack Company was formed by Alton Bodenheimer and Grady Griffin, Jr.. in 1949. The fried pie has been the firm's only basic product; although at one time it produced a honeybun, production of that item was discontinued in 1977. The company slowly built up its business by selling to vending machine com- panies and through distributors who sold the pies as a desert to the lunch counter trade. The owners concentrated on quality and service and expanded sales throughout the Carolinas, Virginia, Tennessee, and Georgia. By the end of 1993, OT Snack employed 52 people and produced between 400,000 and 500,000 dozen pies a year. These pies were produced with six different fillings-apple, cherry, peach, raisin, chocolate, and lemon. Production A fried pie is as simple a bakery product as can be imagined. A fruit or pie fill- ing is wrapped in pie dough, and it is deep-fried in fat. The actual production at OT was in four basic steps. First, the pie filling was cooked and then cooled. The fruit fillings were made from dried fruit, water, and sugar plus ingredients to re- tard spoilage. The mixture was stirred and cooked for about an hour and then cooled for 48 hours. In the second step, the dough was prepared and cut into sections. These sec- tions contained enough dough to make six dozen pies. Women, who worked on a piece rate, rolled out the individual pie shells with a metal rolling pin, placed the filling in the shell, and formed the shell around the filling. This finished product was then placed on a screen to be deep-fried in fat. Next the pies were deep-fried in fat for three minutes, put on cooling racks, and moved into a holding room. In the final step, the pie was wrapped in a glas- sine wrapper and placed into a tray for shipping. There was virtually no excess inventory kept at the plant as all production was made to fill current orders. 214 PART VII VALUATION The trays were stacked according to customer orders and were usually picked up the same day they were produced. Personnel OT employed 46 people in production and the average pay was about $5.50 per hour. Turnover was very low, and 31 of the employees had been given gifts of stock in the firm. This stock amounted to 10 percent of all the outstanding shares. OT also had a very good benefit program. The production operation was man- aged by John Davis, who had worked for OT since mid-1964. John had worked in all phases of plant operations and knew the production operation and the cy- cle of the business as well as anyone. Although turnover was very low, produc- tion efficiency was also low. Sales had been declining since 1987 (see Exhibit 1), and on days when orders were low, employees not on piecework were in the habit of staying at work and on the payroll, although not doing any work. Part of this casual attitude was due to the fact that the city of Winston-Salem had not issued any building permits since 1984 in the South Marshall Street Redevelopment area where OT was located. The city planned on redeveloping the area with upscale condominiums. OT's current sole owner, Alton Bodenheimer, was too near retirement to plan for a move to a new location. With the future of the present location in limbo, he had allowed the business to de- cline. All of the production equipment was old and outdated, for there certainly was no incentive to replace equipment if the plant was going to be relocated in the near future. The equipment, however, had no salvage value and was in dire need of immediate replacement. In addition, no new customers had been added in several years and the busi- ness served a static customer base. Evidence of the lack of current marketing was that none of OT's products were sold in local grocery stores. An indication of Bodenheimer's attitude was shown in early 1992 when he asked if he was look- ing forward to retirement. His reply was: "Hell, I've been retired for 10 years!" One employee said that a typical day for Bodenheimer was to come into the plant in the morning and see what orders they had; go to a local coffee shop for about an hour and a half; come back to the plant until lunchtime; and then, shortly af- ter lunch, go play golf. The redevelopment project and the thought of having to move had simply taken away his desire to plan for the future of the company. Financial Information In late 1993 OT Snack Company was a profitable firm producing a good prod- uct with a loyal customer base. Production was about 400 dozen pies per hour. Rather than move the business, the owner, Alton Bodenheimer, had decided to sell the company. What James Fussell saw when a business broker showed him the financial statements (see Exhibit 2) and when he subsequently toured the plant was a product with tremendous potential. The owner was asking $1.2 mil- lion for a business that had $450,000 in cash and marketable securities and al- 215 dent appraiser at $297,000, would be purchased by the city of Winston-Salem in most no liabilities. The property, which Fussell had appraised by an indepen- CASE 35 OT SNACK COMPANY 233 early 1994 at the appraised priced. Although the plant's capacity was 12,000 dozen pies per week, its currena dozen. (The pies were sold in vending machines for 45 to 50 cents each.) Fussell believed that the market for these pies could easily be doubled without having to hire another salesperson. With that in mind, and knowing that the plant had to be moved, Fussell began looking for a new home for OT Snack and for ways to both produce and sell more pies. Automated Equipment Through a friend Fussell learned about an automated equipment line that would produce fried pies. He flew to Duluth, Minnesota, to see the equipment in oper- ation. The production line was produced by the Moline Corporation and cost $497,000 to purchase and install. The equipment produced pies on a continuous conveyor. At one end, the dough was produced and extruded onto a sheet and rolled to the appropriate thickness, trimmed, and cut into strips. The filling was deposited into the stirps, which were folded, and the pie was cut out, with the scrap dough recycled back to the beginning. The pie was then fed into the fryer, which was maintained at a constant temperature, and the pies were cooked for exactly three minutes. The pies were then moved onto a cooling conveyor. This equipment would reduce the number of people required for production by almost 65 percent. In fact, only 17 people would be needed to operate the en- tire process, and the equipment was capable of producing 24,000 dozen pies per week (double the present capacity). For planning purposes, Fussell assumed that the economic life of the equipment and its depreciable life would be the same. A building suitable for production was located on the north side of Winston- Salem in Northridge Business Park. The annual lease on this building was $75,000. At about the same time, Fussell found that he could lease the automated equipment for $8,000 per month from the leasing department of a local bank, Central Carolina Bank, if OT would put down a deposit of $200,000. Marketing Before finally deciding on whether to purchase OT Snack Company, Fussell did a quick marketing survey. The firm had about 15 current customers who or- dered once or twice a week. In addition, he found that several potential cus- tomers had contacted OT in the recent past. These customers included Vendors Supply of North Carolina, Waldensian Bakeries, and Fox Bakeries, all located in North Carolina; Palmetto Bakeries in South Carolina; and Vending Services of America, located in Georgia. Several of these firms were primarily bread and bakery goods distributors who were looking for additional products to sell to their customers-supermarkets, convenience stores, service stations, etc. 216 PART VII VALUATION DECISION TIME Fussell went over all the facts to make sure that he had thoroughly investigated the firm and its potential. He then made two income projections for 1994 sales based on the assumption that OT would operate in its new location in 1994. The salaries, shown in Exhibit 3, were based on what Fussell expected to pay the two managers who were presently on salary; the management fee was what he hoped to earn. The first income projection was based on sales of $1.2 million and assumed that the pie operation would operate with the automated pro- duction line. The second projection assumed a sales level of about $2.7 million. (See Exhibit 4.) James Fussell thinks he has done a very exhaustive study of OT Snack and the potential of the fried pies market in the region presently served by OT. Although sales have declined in the last few years, Fussell believes that the com- pany still produces a quality product and gives excellent service to its current group of customers. The potential for the firm seems outstanding. After check- ing with his banker, Fussell knows he can purchase the business based on a loan on the assets of the firm, cash from his savings and investments, and a mortgage on his home and all his personal assets. Fussell faces two very important decisions. Should he take the plunge and buy this firm? Given an affirmative answer to the first decision, he must then de- termine what price he would be willing to pay for OT Snack Company. He ac- tually would be purchasing 90 percent of the stock, since the employees own 10 percent). The second decision is based on the first; that is, if he buys OT Snack Company, should he automate the production process? QUESTIONS 1. Assuming Fussell wishes to buy the firm, what should he pay for it? 2. How should Fussell pay for the firm? 3. If Fussell buys the firm, should he automate? (Calculate both the net present value and the internal rate of return.) 4. What is the dollar break-even point before and after automation? 5. Assuming an average rate of inflation of 7 percent between 1987 and 1993, what was the actual sales decline in constant dollars? 6. Given your answers above, would you advise Fussell to buy OT Snack Company? Why or why not? 217 CASE 35 OT SNACK COMPA EXHIBIT 1 OT Snack Company Sales: 19841993 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 $801,828 1,043,478 1,387,024 1,553,755 1,506,317 1,488,852 1,246,352 1,039,402 1,116,108 1,098,236 1120 CT STEET T BE HIS VIVER 2 SOARER 213