Can someone please help me answer the four questions on the first two pages?

NA0274 Cavendish Cove Cottages Sean Hennessey, University of Prince Edward Island \"I just don't know if the asking price is fair,\" Sherry Noonan exclaimed to Martin Heaney, one of her business professors at the University of Prince Edward Island (UPEI) located in eastern Canada. It was February 18, 2009, the middle of the second semester's reading week, and Sherry was only a few weeks away from graduating with a bachelor of business administration degree. Sherry was considering making an offer on a cottage rental business located in the heart of Cavendish, the very popular tourist destination on Prince Edward Island (PEI). While Sherry would have some financial support from her family if she bought the cottages, she knew that a key was to determine the \"true\" value of the business and to not overpay. The future success of the business was dependent on paying a fair price. As Sherry left Martin Heaney's office, she reflected on the conversation with her professor and mentor. At this point in her university career, Sherry had completed courses in all of the functional areas of business: marketing, operations management, corporate finance, organizational behaviour, and accounting. As such, she felt that she should be able to analyze the information she had regarding the family run cottage business, arrive at a value for the business, and then make an offer. This work would have to be completed over the next week which would allow both Professor Heaney and her parents time to review her work. It would also give Sherry the time to negotiate with the business's owners, Fran and Ted Baker. It was important to get all of this done well before final exams started in six weeks. It would also ensure that she would have plenty of time to prepare for the opening of the cottages in May, if she decided to make an offer, and if it was successful. The Bakers were asking $800,000 for the cottage business, and Martin Heaney wondered whether Sherry thought that was a fair price. Heaney had focused on some of the key questions that had to be answered: What was the cottage business worth; what was its \"true\" value? How should this value be estimated? Would she have to invest additional funds in the cottages after the purchase? If so, how much would be Copyright 2013 by the Case Research Journal and by Sean Hennessey. The author acknowledges the invaluable assistance and cooperation provided by the individuals that are the subject of this case. He is also grateful for the many insightful comments and suggestions provided by three anonymous referees, Steve Dawson, an Associate Editor of the Journal, and Deborah Ettington, the Editor of the Journal that greatly helped in the development of the case. Previous versions of this case were presented at or accepted for presentation at the Administrative Sciences Association of Canada Conference, the Atlantic Schools of Business Conference, the North American Case Research Association's Annual Conference, and the Academy of Economics and Finance Annual Conference. Cavendish Cove Cottages 1 This document is authorized for use only by Erika Herrera (ekherrera@gmail.com). Copying or posting is an infringement of copyright. Please contact customerservice@harvardbusiness.org or 8009880886 for additional copies. Q UESTION 1 1. Using the financ ia l data of the Cavendish Cove Cottages case study, calculate the Return on Equity (ROE) for 2008. A. 31.49% B. 39.39% C. 10.18% D. 39.89% 5 points QUESTION 2 1. Is return on sales or return on equity a better basis on which to compare the performance of Cavendish Cover Cottages? A. Although all financial ratios are imperfect, return on equity is best suited for this case study. B. Although all financial ratios are imperfect, return on sales is best suited for this case study. C. Neither, since all financ ia l rations are imperfect, a firm should not incorporate the use of financial ratios as a leading indicator. D. Both are equally important and can be interchanged with this case study. 5 points QUESTION 3 1. Using the financ ia l informa tio n from the case study and the infor matio n listed below, calculate the net margin: 2006 sales $158,375 2007 sales increased 24.31% 2008 sales increased 6.92% A. 16.8% B. 17.01% C. .023% D. 20.88% 5 points QUESTION 4 1. Return on Invested Capital (ROIC) measures the return on the capital invested in the business. When calculating this ratio, which of the following should be placed in the numerator position of the formula? A. Shareholders' equity B. Fixed Assets C. Operating profit D. Operating profit before interest after tax required, and how would it affect the amount to offer the Bakers? If a deal was tiated, how would she finance the purchase? Finally, would the economic meltd currently affecting the world affect her plans? Now all Sherry had to do was an these questions using the business concepts she had learned at university, an working life. The economic environmenT Beginning in December 2007, and accelerating throughout 2008 and into 2009 world experienced a major recession, a significant economic contraction. This downturn was the result of many bad policy decisions and actions by governm corporations, and individuals. The fallout of all of these bad decisions coalesce 2007 and 2008, and resulted in a crisis in the U.S. financial system that quickly throughout the world. This event was being referred to as \"the Great Recession was being unfavourably compared to the Great Depression of the 1930s. In September 2008, the world's financial system was brought to its knees. S markets around the world crashed, and credit markets froze. Commercial and i ment banks could no longer raise financing in the inter-bank loan markets. Lar industrial corporations, that a few days before could raise billions, could no lon access either short or long-term financing. Small businesses could not raise fu to make payments to creditors or invest in the company. And individuals could arrange loans to buy houses, cars, or other assets. A virus had spread through world's financial system in a surprisingly short period of time, one that threate economic collapse. The upheaval caused by this shock to the system fuelled the recession that in 2007, and by the end of 2008, economies around the world were shrinking. growth was apparent in still-developing economies like China and India, almos of the developed countries were in recession, and unemployment rates soared December 2008, it was reported that much of the developed world had been in sion since December 2007, and, in 2008, in the U.S. alone over 3.6 million peo lost their jobs. In January 2009, Canada's unemployment rate peaked at 7.3 pe increasing from a low of 5.9 percent in 2008. In the U.S., the unemployment ra increased from a low of 4.9 percent in 2008 to 7.8 percent in January 2009. In tion, it was predicted that global recovery may not occur until 2011. While Canada was not spared the economic downturn, the worst outcomes w felt in the U.S. and many parts of Europe. Canada's better relative position was strong domestic economy, a wealth of commodities required by the developing a sound fiscal policy with manageable government deficits and debt, political s ity, a pro-business government, and a prudent and well-capitalized financial se During the crisis, the Canadian banking system did not experience the same s others due to stricter regulations. The credit markets in Canada remained open financial panic so obvious in other countries was relatively absent in Canada. C banks were considered to be well managed and regulated, and among the bes ized in the world. In 2008, both the World Economic Forum and Moody's ranked Canada's banking system as the world's most financially sound. 2 Case Research Journal Volume 34 This document is authorized for use only by Erika Herrera (ekherrera@gmail.com). Copying or posting is an infringement of copyright. Please contact customerservice@harvardbusiness.org or 8009880886 for additional copies. I Prince edward island Prince Edward Island (PEI) was Canada's smallest province, with just 5,684 square kilometers (1.4 million acres) of land and a population of 140,000. PEI, in the Gulf of St. Lawrence, was located on the east coast of Canada, separated from its sister provinces of Nova Scotia and New Brunswick by the Northumberland Strait. The three provinces were jointly referred to as the Maritime Provinces. In 1997, the Confederation Bridge opened providing PEI with a permanent link to New Brunswick. A ferry service also ran between PEI and Nova Scotia for about eight months of the year. About 55 percent of the Province's population lived in the rural areas of the province, outside the two cities of Charlottetown (population 35,500) and Summerside (population 16,000). Exhibit 1 provides two maps, one of PEI and another showing its location in eastern North America. Exhibit 1A: Map of PEI Department of Natural Resources Canada. All rights reserved. Cavendish Cove Cottages 3 This document is authorized for use only by Erika Herrera (ekherrera@gmail.com). Copying or posting is an infringement of copyright. Please contact customerservice@harvardbusiness.org or 8009880886 for additional copies. PEI, or \"The Island\" as locals referred to it, was known, in part, for the natur products from its land and water. Agriculture and the fisheries were the first an largest industries, but non-primary manufacturing shipments had grown to be over $500 million, diversifying the economy. PEI was called \"the million-acre fa and fields with rows of potato plants set in the red soil of the Island were a com sight. The combination of the red and green of the fields and the blue of the w sky made for striking scenery. This island landscape was one of the reasons wh one million people visited PEI each year, which made tourism a vital export-ori industry. Exhibit 1B: Location of PEI in Eastern North America Source: Tourism PEI The PEI economy relied heavily on agriculture, tourism, and fishing, with all subject to the vagaries of weather and commodity prices. Tourism, in particula highly unpredictable and dependent on factors such as weather, gas prices, th uling of special events such as concerts and festivals, terrorist threats, the ma actions of other destinations, and changes in economic growth, unemploymen interest rates. For individual tourist operators, the difference between a good a year could be as simple as two weeks of bad weather in the high season, or a major events in a neighboring destination that reduced visitations to your area factors could lead to lost customers, or the need to discount rates to generate Peiand The Tourism indusTry For the year July 1, 2007 to June 30, 2008, PEI attracted a little over one millio visitors in 366,326 travel parties. These visitors stayed at least one night in PE 4 Case Research Journal Volume 34 This document is authorized for use only by Erika Herrera (ekherrera@gmail.com). Copying or posting is an infringement of copyright. Please contact customerservice@harvardbusiness.org or 8009880886 for additional copies. I spent $314.6 million. These numbers had remained very static over the last three years. About 79 percent were repeat visitors. Key characteristics of visitors to PEI in general, and of the four primary markets are provided in Exhibits 2 and 3. Tourism on PEI was very seasonal with July and August accounting for over 50 percent of all visitors and spending. The September and October fall season was starting to become popular after many years of marketing by Tourism PEI, the Provincial Government Tourism Department, and individual operators. This period accounted for almost 19 percent of visitors and 21 percent of spending. Exhibit 2: Key Tourism Statistics for Overnight Pleasure Visitors to PEIBy Tourism Season Source: \"Overall Results for the 2007-2008 Exit Survey: Results For the Year From July 1, 2007 to June 30, 2008,\" Tourism Research Centre, School of Business, University of PEI. Report available at: http://trc.upei.ca/exitsurvey. Note: Total direct expenditures per season were calculated as follows: Number of travel parties average spending pe trip. All information refers to overnight pleasure travellers. Only about 30 percent of visitors arrived in PEI in the eight months from November to June. May and June were quite slow in many areas of PEI, and in the six-month off-season from November to April, tourism was concentrated in the weekends and when special events were held. The vast majority of visitors during these two periods were from the two other Maritime Provinces of Nova Scotia and New Brunswick. These were the core tourism markets for PEI, and accounted for 65 percent of visitors and 52 percent of expenditures. Though obviously valuable and loyal, these visitors spent fewer nights and engaged in fewer activities, resulting in lower yields for industry Cavendish Cove Cottages 5 This document is authorized for use only by Erika Herrera (ekherrera@gmail.com). Copying or posting is an infringement of copyright. Please contact customerservice@harvardbusiness.org or 8009880886 for additional copies. stakeholders (see Exhibits 2 and 3). Average spending per tourist party per vis highest in the peak season of July and August. Exhibit 3: Key Tourism Statistics for Overnight Pleasure Visitors to PEIBy Primary Markets of Origin Source: \"Overall Results for the 20072008 Exit Survey: Results For the Year From July 1, 2007 to June 30, 2008,\" Tourism Research Centre, School of Business, University of PEI. Report available at: http://trc.upei.ca/exitsurvey. Note: Total direct expenditures per season were calculated as follows: Number of travel parties average per party per trip. All information refers to overnight pleasure travellers. About 89 percent of visitors were from other parts of Canada. PEI's four key markets, Nova Scotia, New Brunswick, Ontario, and Quebec, accounted for 86 cent of visitors and 82 percent of direct spending (see Exhibit 3). Only 7 perce visitors were from the United States, quite low given the proximity of the north ern part of the U.S. to PEI. This was a concern to many stakeholders, however, 6 Case Research Journal Volume 34 This document is authorized for use only by Erika Herrera (ekherrera@gmail.com). Copying or posting is an infringement of copyright. Please contact customerservice@harvardbusiness.org or 8009880886 for additional copies. I the years this percentage had been fairly consistent and limited budgets precluded large marketing campaigns in the U.S. In late 2008, Tourism PEI released preliminary numbers for the four-month peak and fall seasons in 2008 that indicated both visitor numbers and spending were down about 3 percent from 2007 levels. The cavendish area Cavendish was located on the north shore of PEI, on the Gulf of St. Lawrence, in the center of the Province. The tourist area that included Cavendish was known as Anne's Land and was a thirty minute, very scenic, drive from Charlottetown, the capital city. \"Anne's Land\" referred to the book Anne of Green Gables written by the well-known Island author Lucy Maud Montgomery. Montgomery was born, raised, and spent much of her life in the Cavendish area. Anne of Green Gables, published in 1908, was based in Cavendish. The story imparted an image of PEI that each year drew thousands of visitors to Cavendish from around the world. As a result, Anne was a major focus of the tourism industry in Cavendish with many attractions and names of businesses based on characters and locations in the book. Cavendish was a favourite destination for many visitors due to its wealth of tourist attractions. In the area there were national parks, beaches, amusement parks, many types of tourist attractions, eight golf courses within a fifteen minute drive and eight more within thirty minutes, numerous restaurants, shopping, a nightclub and pubs, miniature golf, as well as beautiful scenery. In addition, within the National Park there was a trail system that offered many kilometers of hiking and biking opportunities. All of these attractions were easily accessible from Route 6, the main road that transversed the north coastline of central PEI. In the area there were all types of accommodations from campgrounds to selfcatering cottages, to hotels and resorts, to four-star B & Bs and country inns. There were hundreds of cottage rental properties in the greater Cavendish area. In Cavendish itself, there were over fifty cottage rental properties. A major draw was the famous Cavendish Beach, within the PEI National Park, with its rolling dunes and beautiful sandstone rock facings. The beach attracted many visitors either to swim in its warm waters, or walk the long stretches of red sandy shoreline. Market research indicated that in 2007/2008, 112,300 travel parties (30.7 percent of the total that visited PEI) spent at least one night in Anne's Land, or about 501,900 nights in total. Anne's Land was the second most popular destination for visitors after Charlottetown where 36.2 percent of travel parties spent at least one night. However, Anne's Land accounted for 33 percent of the total number of nights spent in PEI, easily surpassing Charlottetown's 27.2 percent of total nights. Unsurprisingly, overnight stays in Anne's Land peaked in July and August, accounting for 40.7 percent of the total number of nights spent in PEI. In the six month off-season from November to April, Anne's Land only accounted for 4.8 percent of the total number of nights spent. c avendish cove coTTages Cavendish Cove Cottages (CCC) was owned and operated by an older couple, Fran and Ted Baker. As they told Sherry in one of their meetings: \"We started the business in the late 1950s and have been operating in the same location, under the same name ever since. Back then, you could buy land for almost nothing out here. I only wish we had been able to buy more land then, but who had the money? It was hard enough to Cavendish Cove Cottages 7 This document is authorized for use only by Erika Herrera (ekherrera@gmail.com). Copying or posting is an infringement of copyright. Please contact customerservice@harvardbusiness.org or 8009880886 for additional copies. come up with the few thousand dollars it did cost. While we have loved growin business and meeting the people who have stayed here over the fifty plus yea owned the place, we think it might be almost time for a break! We have a grea tion, and hope to turn it over to someone who has a passion for people and bu We are interested in selling, but at the right price. This is a great location for a business, with a loyal clientele.\" CCC consisted of nineteen rental units and one owner's unit on 2.4 acres of (see Exhibit 4). In addition to the cottages, the complex had an in-ground hea swimming pool, old-fashioned wooden swing benches, and a playground for ch All cottages had cable television, refrigerator, stove, microwave, barbeque, pic as well as the other standard amenities normally expected with a rental unit. T erty was located in the heart of the community of Cavendish on the main Cave road, Route 6, a few hundred yards inland from the shoreline. Route 6 was eas reached from all parts of PEI. All of the main tourist attractions in Cavendish an neighboring communities were on, or just off, this road. The main entrance to endish Beach, a significant attraction in its own right, was a four minute drive CCC. Those with more time could easily walk to the beach in less than fifteen m Exhibit 4: Cavendish Cove CottagesCategories and Pricing of Cottages Number of Cottage Type Cottages Daily Rental Rate for 2008 High Season 2 1, 3 Low Season 1bedroom Deluxe 7 $131 $76 2bedroom Standard 1 $131 $76 2bedroom Deluxe 1 $151 $81 2bedroom Executive 2 $176 $96 3bedroom Standard 5 $131 $76 3bedroom Deluxe 3 $146 $81 Total 19 2 Notes: 1. The stated rate for each cottage was for up to four people. An extra charge of $8.00 per pe day was made for parties with more than four people. 2. CCC was open for about nineteen weeks, from about May 17 (the date changed every year since the actual opening date was the Friday of the Victoria Day holiday that fell on the Mo day preceding May 25 in Canada) to September 30. Victoria Day was always one week prio Memorial Day in the U.S. High season was from June 25 to Labour Day (the first Monday in September). Low season was before June 25 and after Labour Day. 3. The Bakers were taking bookings and quoting the 2008 rates for the 2009 season. This was to the need to set rental rates up to a year in advance, and the current low rate of inflation Also within 200 yards of the business were grocery stores, restaurants, a lau mat, shopping, and numerous family-oriented attractions. These included wate land-based amusement parks, and an interactive recreation of a PEI village fro Also close by was the Green Gables heritage site which included the famous G Gables House. The house and farm site were once owned by relatives of Lucy M Montgomery and were the inspiration for her book. Also on the site were nume other family-oriented attractions. Finally, within a ten minute drive from the co 8 Case Research Journal Volume 34 This document is authorized for use only by Erika Herrera (ekherrera@gmail.com). Copying or posting is an infringement of copyright. Please contact customerservice@harvardbusiness.org or 8009880886 for additional copies. I were four championship golf courses, two within walking distance. One was a new five star, twenty-seven-hole, championship course which bordered the cottage complex. The other was the historic and very scenic ocean-side Green Gables golf course. The complex was zoned as \"resort commercial\" and, for property tax purposes, was assessed a value of $417,250 with property taxes of $5,340. On the income statement, this was included as part of the licences expense. Exhibits 5, 6, and 7 provide the income statements, balance sheets, and notes to the statements, respectively, for CCC for the 2006-2008 fiscal years. Exhibit 5: Cavendish Cove CottagesIncome Statements For the Years Ended December 31 2006 Rental income 2007 2008* $158,375 $196,881 $210,499 Advertising 4,483 4,221 6,527 Amortization 20,258 25,965 27,573 Cable 1,284 1,095 2,088 Electric 8,753 9,281 10,270 Heat 1,146 1,436 1,182 Insurance 6,729 7,988 10,471 Interest & bank charges 2,216 4,131 3,149 10,321 14,966 11,700 6,963 7,159 6,706 less: Operating Expenses Interest on longterm debt Licenses Office 879 1,919 1,489 3,582 4,649 3,460 Repairs & maintenance 15,935 20,541 18,955 Supplies Professional fees 11,586 6,844 8,479 Telephone 3,995 2,914 3,801 Vehicle and travel 4,965 2,911 3,035 Wages and benefits 63,424 49,460 47,387 Total fixed expenses 166,519 165,480 166,271 -8,144 31,401 44,228 $0 6,305 $567 -8,144 37,706 44,795 Earnings before taxes & other Net other income Earnings before taxes Taxes Net income after tax 1,340 8,174 9,436 -$6,804 $29,532 $35,359 * Note: The results for the 2008 fiscal year have not yet been certified by the company's accountant. Fran and Ted listed CCC in the PEI Visitors Guide, the official tourist publication produced and distributed by Tourism PEI. The vast majority of PEI tourism operations of all types (accommodations, food and beverage, attractions, golf courses, and so on) maintained a listing in the Visitors Guide. CCC also had brochures that were available onsite and in the eight Visitor Information Centres, run by Tourism PEI, that Cavendish Cove Cottages 9 This document is authorized for use only by Erika Herrera (ekherrera@gmail.com). Copying or posting is an infringement of copyright. Please contact customerservice@harvardbusiness.org or 8009880886 for additional copies. were located across PEI, and maintained a website. As with many PEI tourism o tors, these were the only forms of advertising used or even considered. The co website could be best described as \"lean,\" providing limited information and fe tures. To make reservations, potential customers had to use either a toll-free n or e-mail; it was not possible to make reservations on the website. Exhibit 6: Cavendish Cove CottagesBalance Sheets As at December 31 Assets Cash Marketable securities 2006 2007 2008* $0 $8,113 $4,084 0 18,750 6,250 Accounts receivable 2,944 189 1,605 Income taxes receivable 1,340 0 0 Total current assets 4,284 27,051 11,939 16,655 16,495 16,495 Gross fixed assets (Note 1) 518,700 580,604 612,986 less: Accum amortization 242,210 268,175 295,748 Net value 276,490 312,429 317,238 Total fixed assets 293,145 328,924 333,733 1 1,919 1,493 $297,430 $357,894 $347,164 $2,784 $0 $0 7,223 4,300 4,818 0 8,209 8,405 7,500 10,000 10,000 Demand loan (Note 4) 31,250 31,250 37,500 Curr portion of longterm debt 21,796 22,271 22,271 Total current liabilities 70,553 76,030 82,994 116,040 149,544 127,273 38,440 30,390 24,610 225,033 255,964 234,876 Land Other assets (Note 2) Total assets Liabilities and Equity Line of credit (Note 3) Accounts payable Income taxes payable Bonus payable Longterm debt (Note 5) Payable to shareholder (Note 6) Total liabalities Common shares (Note 7) 3,125 3,125 3,125 Retained earnings 69,273 98,805 109,163 Net equity 72,398 101,930 112,288 $297,430 $357,894 $347,164 Total liabilities & equity * Note: The results for the 2008 fiscal year have not yet been certified by the company's acco 10 Case Research Journal Volume 34 This document is authorized for use only by Erika Herrera (ekherrera@gmail.com). Copying or posting is an infringement of copyright. Please contact customerservice@harvardbusiness.org or 8009880886 for additional copies. I Exhibit 7: Cavendish Cove Cottages, Inc Notes to the Financial Statements (unaudited) The company is incorporated under the Companies' Act of Prince Edward Island, and is pri marily engaged in the cottage rental industry. The financial statements have been prepared in accordance with Canadian generally accepted accounting principles and include the following significant accounting policies: 1. Capital Assets Capital assets are recorded at cost, net of government assistance. Amortization is computed using the decliningbalance method at the following annual rates, which were the same as the Capital Cost Allowance (CCA)1 rates for the applicable asset classes. Building 5% Equipment 20% Vehicle 30% Pool 8% Pavement 8% 2008 Accumulated Amortization Cost Buildings Equipment 2007 Net Book Value Net Book Value $350,804 $104,636 $246,168 $237,478 189,985 128,202 61,783 63,648 Vehicle 43,181 40,281 2,900 4,350 Pool 22,323 19,709 2,614 3,261 6,693 2,920 3,773 3,693 $612,986 $295,748 $317,238 $312,429 Pavement Totals Government assistance of $27,953 has been deducted from the cost of the buildings while $10,655 has been deducted from the cost of the equipment. 2. Other Assets 2007 Website development Goodwill Totals 2008 $2,131 $639 $1,492 $1,918 1 0 1 1 $2,132 $639 $1,493 $1,919 Website development costs are being amortized on a straightline basis over a five year period. 3. Line of Credit: The line of credit is authorized to a maximum of $20,000 and is payable on demand. The interest rate is based on prime plus 1.5 percent. The line is secured by land and cottages, and the personal guarantee and postponement of claims by shareholders. 4. Demand Loan: The demand loan is payable on demand and bears interest at prime plus 2 percent. The average prime rate during 2008 was 5 percent (2007-5%, 2006-6.5%). The demand loan is secured by a collateral first mortgage on the cottages, and personal guarantees of the shareholders. Cavendish Cove Cottages 11 This document is authorized for use only by Erika Herrera (ekherrera@gmail.com). Copying or posting is an infringement of copyright. Please contact customerservice@harvardbusiness.org or 8009880886 for additional copies. Exhibit 7: continued 5. LongTerm Debt: The longterm debt is secured by a mortgage on the land and cottages, personal guarantees of the shareholders, and life insurance on the shareholders. Loan at 8.5%, payable to 2010 in annual 2008 2007 2006 $30,000 $35,000 $40,000 $80,000 $90,000 $43,750 $4,544 $6,815 $9,086 $35,000 $40,000 $45,000 $149,544 $171,815 $137,836 22,271 22,271 21,796 $127,273 $149,544 $116,040 amounts of $5,000 plus interest Loan at prime + 1.5%, payable to 2012 in annual amounts of $10,000 plus interest Loan at prime + 1.5%, payable to 2006 in annual amounts of $2,271 plus interest Loan at prime + 1.5%, payable to 2011 in annual amounts of $5,000 plus interest Totals less: Current portion Principal repayments required in each of the next four years are: 2009 2010 2011 2012 $22,271 $22,272 $20,000 $20,000 6. Due to Shareholders: This amount is due on demand without interest. However, the share holders have indicated they will not request material repayment within the next fiscal year and consequently, the amount has not been classified as current. 7. Common Shares: There are 20,000 common shares at no par value authorized to be issued, 5,000 common shares are issued for a total value of $3,125. No dividends were paid during the 2006 fiscal year. Note: 1. Capital cost allowance (CCA) is the Canadian tax term for depreciation. It is calculated on a declin balance basis as a percent of the undepreciated capital cost (UCC) of the asset. In the year the as acquired, only one-half of the allowable CCA can be claimed for tax purposes. c oTTage uniTs Of the nineteen rental cottages available, seven were one-bedroom, four were bedroom, and eight were three-bedroom units. The units were further divided i standard, deluxe, and executive categories. The rental units ranged in size from to 784 square feet. There were five smaller (226 to 270 square feet) units with remainder generally between 435 and 784 square feet. Exhibit 4 provides a lis the cottage complex with rental rates for the 2008 tourism season. Given the n set rental rates up to a year in advance and the current low rate of inflation, th were quoting and taking bookings for the 2009 season based on the 2008 rent While the Bakers had operated the business for over fifty years, none of the were that old. As Ted told Sherry, \"seventeen of the units were built in the 197 replacing the five original cottages, plus adding one or two new cottages every so to meet the demand from the increasing number of tourists coming to PEI. I 12 Case Research Journal Volume 34 This document is authorized for use only by Erika Herrera (ekherrera@gmail.com). Copying or posting is an infringement of copyright. Please contact customerservice@harvardbusiness.org or 8009880886 for additional copies. I last few years, we have upgraded eleven of the cottages. They are now as good as any in the area.\" In discussions with the real estate agent listing the property, Sherry learned that the upgrades included new interiors, windows, and flooring. Dishwashers and whirlpool tubs were also installed in some units. These upgrades began in 2005, and were in addition to the yearly outlays for repairs and maintenance. Sherry noted that six of the units still required work. Of these, three were the onebedroom, two were three-bedroom standard, while one was a three-bedroom deluxe. The real estate agent assured Sherry that, \"the six cottages are fine, they are structurally sound and can be rented as is.\" In an earlier conversation, Ted had mentioned to Sherry that, \"those six units are looking tired and if I was a younger man, I would renovate them. But, I guess I will leave that decision to the new owner.\" The two executive two-bedroom cottages were new additions to the property and were very popular. Commenting on these, Ted said, \"building them was one of our better decisions. These are usually the first to rent, regardless of the season. People drive in, see them, and, if they are empty, take a look. When they compare them to our other options, they usually choose the executives.\" Construction of these 784 square foot units had started in the fall of 2006, and were first rented in the spring of 2007. The owner's unit was 1,170 square feet with three-bedrooms, an office, and laundry. This unit too was rather \"tired.\" There was also a 480 square foot garage on the property. CCC was rated by Canada Select, the only country-wide accommodations rating program in the country. Canada Select's ratings ranged from one to five stars (see Exhibit 8). CCC's five smaller units were rated 2.5stars, while the remaining fourteen units were rated three-stars. The competition in the accommodations sector in the Cavendish area was fierce. There were at least seventy-five other accommodation providers within a fifteen-minute drive of CCC. These included over fifty cottage operations that ranged in size from a single rental unit to those with over fifty units. In 2008, of the forty-eight cottage properties rated, four were two-star, seventeen were 2.5-star, eight were three-star, eleven were 3.5-star, and eight were four-star. In 2008, there were no five-star cottage properties on PEI. All accommodation operators offered low and high season rates. To encourage visitor bookings, the low season rates were often 50 percent or less than the high season rates. Rental rates for cottages were often set six months to one year in advance since many repeat guests booked for the following year when checking out in the current year. Many cottage operators were fully booked for the high season six to twelve months ahead of time. CCC's long history meant that many of its clients were repeat visitors. Recently, however, some long-time clients had been lost to competitors who had newer and additional amenities such as ocean-view rooms, Jacuzzis (hot tubs), fireplaces, and fitness centres. Cavendish Cove Cottages 13 This document is authorized for use only by Erika Herrera (ekherrera@gmail.com). Copying or posting is an infringement of copyright. Please contact customerservice@harvardbusiness.org or 8009880886 for additional copies. Exhibit 8: Information on the Canada Select Rating System Canada Select is an industry led rating program, developed to provide a national con sistent standard of quality within categories of accommodation. Canada Select inspects and rates all participating properties to ensure they meet consumer expectations. Ratings are based on extent and quality of facilities, guest services, and amenities. Six catego ries of roofed accommodations are rated: hotel/motel, cottages, bed and breakfast/tourist homes, inns, resorts, hunting/fishing lodges. Where the quality of facilities is superior, a property may be awarded a halfstar above its criteria rating, i.e., a two star property may warrant a 2.5 star rating, depending on the overall quality assessment. Each category and star level has distinct criteria that must be achieved. A star rating from (one to five, in half star increments), is awarded based on the results of an evaluation. Each star level reflects specific consumer expectations. The following are the star rating descriptions: One star: At this level, guests should expect clean and wellmaintained accommodations providing the necessary facilities for an enjoyable stay. Criteria includes standards such as room size, window screens and coverings, clothes storage, linens, door lock, smoke detector, and parking facilities. Two star: This level equates to what is popularly considered \"midrange\" accommodation. It exceeds the one star level in quality of mattress, bed linen, floors/window/wall cover ings, and in provision of bedside and seating area lighting, additional room furniture, and parking space. Three star: These properties will offer larger units with additional room furniture, coordi nated furnishings, better quality mattresses and linens, and will be equipped with clock/ alarm, extra amenities in washrooms, etc. Private baths for all BB rooms is a requirement for a three star and higher rating. Three star properties offer above average facilities and services. Four star: This rating indicates exceptional quality in all areas of facilities and services of fering superior quality throughout the property in areas of guestrooms, bath, and common areas. The property typically provides laundry/valet service as well as many additional amenities. Five star: A fivestar property is luxurious at a world standard, offering outstanding facili ties, guest service, and amenities. See: www.canadaselect.com, www.hotelassociation.ca/site/programs/canada_select.h emPloyee and oTher daTa In the high season CCC employed four workers, three full-time and one part-tim the low season, this was reduced to one full-time and one part-time employee. worked as housekeepers and on the front desk. Two of the employees had bee staff for over twenty years. They provided a consistent vision and level of serv repeat guests. In the Cavendish area, it was relatively easy to hire low-skilled w Pay rates were the mandated minimum wage of $8.00 per hour, which include efits. Long-term employees usually received $2.00 more per hour. Fran and Ted actively worked and managed the business and drew a salary. had mentioned to Sherry that: \"to keep costs down, Ted and I work long hours, cially during the peak season. We get up early in the morning, and go to bed la that is just the way this business is. But, we are getting older and slowing dow We can't quite put in the time and effort we once did, we need more help.\" Sin Bakers lived on the property, they were never really \"off-duty\" and late night c 14 Case Research Journal Volume 34 This document is authorized for use only by Erika Herrera (ekherrera@gmail.com). Copying or posting is an infringement of copyright. Please contact customerservice@harvardbusiness.org or 8009880886 for additional copies. I and early morning check-outs were common occurrences, especially when guests were travelling long distances. It was a business that required patience and dedication, as well as interpersonal and \"handyman\" skills. The cottages were open from about May 17 (the date changed every year since the actual opening date was the Friday of the Victoria Day holiday that fell on the Monday preceding May 25) to September 30. Many tourism operators in the region stayed opened until Canadian Thanksgiving, the second Monday of October. Fran, who looked after the bookings, claimed that CCC's occupancy rates for both the 2007 and 2008 seasons were 93 percent in the high season and 30 percent in the low. The asking price for CCC was $800,000, and the real estate agent listing the property suggested: \"that is a very reasonable price, Sherry. Consider the property is essentially a turn-key operation, it is located in the heart of Cavendish, the Bakers have created a huge amount of goodwill over their many years of dedicated ownership, and, as shown on the financial statements, the value of the assets are very high. This is a wonderful opportunity for someone like you just starting out in business.\" Regarding a possible sale, Ted had told Sherry that, \"the accountants set it up so Fran and I each own 50 percent of the common shares of the business. If you buy, I guess you will end-up with those shares, plus the business. I wonder if we will have to pay taxes on the money we get? If it comes to that, I am sure the accountants will be quick to tell us.\" When Sherry mentioned this to Martin Heaney, he had replied, \"Sherry, you should remember from your finance course that the first $750,000 of capital gains from the sale of the common shares of a small businesses are exempt from tax. Both Fran and Ted would qualify for that, but 50 percent of any remaining gain would be taxed at about 45 percent. So, what do you think, should that be considered in your analysis of the value of the business?\" Finally, Sherry had inquired with the main building contractor who worked with her family's business and had learned that the cost of renovating cottages was about $50 per square foot. c onclusion Sherry Noonan considered all of the information she had collected and knew she had better get to work on trying to determine whether to make an offer for Cavendish Cove Cottages and, if so, the amount. If she bought the business, Sherry planned to be the manager and draw a salary. Her family had run some very successful businesses in Charlottetown for many years. One of these was a hotel operation, and Sherry had worked in the business on a regular basis since she was twelve. Over the years she had done everything from cleaning and changing beds, to making minor repairs, to working the front desk, to night auditor, to manager. But still, there were many questions she had to consider: Was this a business worth buying and, if so, what was its \"true\" value? Was the $800,000 asking price fair? How should she determine a fair price? With a fair price calculated, how should she finance the purchase? Her parents indicated that they would \"help out\" and provide a portion of the purchase price as common equity. Sherry wondered how large an investment she should request from her parents and what rate of return her parents would require on this investment. Sherry knew her parents had done well over the years and had access to cash, some of which was currently invested in short-term investments that were currently yielding less than 1 percent. In February 2009, the yields on Canadian Cavendish Cove Cottages 15 This document is authorized for use only by Erika Herrera (ekherrera@gmail.com). Copying or posting is an infringement of copyright. Please contact customerservice@harvardbusiness.org or 8009880886 for additional copies. Government securities were: 0.7 percent on three-month treasury bills, 2.04 p for five-year bonds, and 2.96 percent for ten-year bonds. Guaranteed Investment Certificates, issued by large Canadian banks, were y ing 0.8 percent for one year, 1.8 percent for three years, and 2.1 percent for fi From her corporate finance course, Sherry knew that the market risk premium Canadian common shares over the period 1938 to 2007 was 6.7 percent. Sher wondered where she could raise the remainder of the money required. Borrow a bank was a possibility. But, after all the courses she had taken, Sherry knew bank would not lend her the full purchase price. All lenders required some sign the owners were committed to the business. After phoning the bank, Sherry knew that the prime rate was currently 2.75 cent, while commercial mortgage rates were 5.1 percent for a one-year term, 5 percent for a three-year term, and 5.9 percent for a five-year term, though the rate offered by the lender was dependent on the particulars of the deal and th rower's credit history and score. Sherry felt she should develop a monthly amo schedule for the loan for a few years of the planned amortization period so she know the cash flow required to service the loan. But first she had to decide on amortization period, the number of years she would take to repay the full amo borrowed. Finally, Martin Heaney had provided Sherry with the Real Estate Res Corporation (RERC) estimate for required returns on commercial real estate. H noted that in the hospitality industry returns ranged from 8 percent to 15 perc depending on the characteristics and location of the property. Sherry only had a few days to finalize any offer she might make to Fran and Baker. They were a lovely couple, and she wanted to be fair to them and ensur enjoyed their well deserved retirement. But this was a business decision; she h ensure the amount she offered was fair to both her and the Bakers. Martin Hea had volunteered to review her analysis and Sherry planned to take advantage expert advice. Also, her parents had told her that, \"while we fully support you this is family money and we need to agree with the offer you plan to make, an analysis behind it. There is a large amount of money involved and a poor decis this point will impact the business for many years. Paying a fair price is one of to success.\" As she headed home after a long day of study at the University, Sherry knew had better get to work on determining the value of CCC. The analysis she com would have to be comprehensive and convince her parents, Professor Heaney, most importantlyherself that she had correctly dealt with all of the pertinent 16 Case Research Journal Volume 34 This document is authorized for use only by Erika Herrera (ekherrera@gmail.com). Copying or posting is an infringement of copyright. Please contact customerservice@harvardbusiness.org or 8009880886 for additional copies