Introduction

On a bright and sunny morning in 2011, Jim Miller, Co-Owner and Sue Thompson, Manager of Operations of Java For You, were enjoying their morning java as they reviewed the past quarter's financials. Jim Miller and Kathy Smith opened the coffee shop in 2005 as joint partners, and Sue joined the staff midway through 2006. Generally speaking, the coffee business had been good to them since they opened their doors six years previous. Through the expansion of the business to another location and subsequent closing, they had maintained a solid level of solvency. At that moment, Kathy brought her cup of coffee over to the table with an obvious look of concern on her face. As she approached the table, Jim suspected that he was about to hear what was troubling her. Before Kathy could even get settled in her chair, she blurted out "I will need to sell off my part of the business". At that point, Jim and Sue had absolutely no idea of what was going on. Kathy proceeded to describe a particularly unsettling trip to the doctor with her husband. The diagnosis was that her husband would no longer able to work in the occupation in which he was trained. It was for these reasons that Kathy felt the need to sell off her portion of the business as soon as possible. As Jim listened to Kathy's explanation, he felt a strong sense of urgency as Kathy and he had built this business together from the ground up.

Background

In 2005 Jim and Kathy had pondered whether a small coffee shop would be sustainable against the industry giants such as Starbucks, Panera and now McDonalds. They wondered what they could offer that would differentiate them from these powerhouses. After all, the United States was the largest coffee consumer in the world (Hoovers, 2012). Was there room in this industry for everyone? They found the answer in Java For You, with a quality product, supreme location and a competitive pricing structure.Locating themselves near two college campuses seemed a good fit with the ongoing caffeine need of college students. According to the St. Louis University official website, they boast a student population of 13,200 with 8,100 being undergraduates and 5,100 being at the graduate level (2012). Washington University had a student population of 11,967 students with 6,000 being undergraduates and 5,967 being at the graduate level (Washington University official website, 2012). The location of their shop was adjacent to St. Louis University on Lindell Blvd. and a short walk or short drive from Washington University. Java For You served up a variety of coffee blends which included brewed coffee, Espresso beverages, Frappucino beverages, chocolate beverages, teas and smoothies with unique recipes not shared with their competitors. Additionally, light lunch or dinner items such as salads, wraps, soups and sandwiches were offered. Their entire menu was derived from market research conducted on the two campuses, in which they looked at components including preferred menu choices and pricing based upon the student's perceived value.

The atmosphere in the Lindell Blvd. shop was that of a comfortable home-setting. The shop was split into three sections: one with tables and chairs that resembled your kitchen, another with several couches and a fireplace that resembled your living room, and another with larger tables typically used by students working on group projects. The overall decorating scheme represented both St. Louis University and Washington University with displays from each scattered throughout.

The pricing structure was established at a below-the-market level that appealed to the cost-conscious target market, college students. While the use of organic materials was appealing to this market, the price levels were found to be of greater importance.

The last component of success was in the area of efficient and pleasant service. Both Jim and Kathy agreed that students were looking for efficiency in the level of service. The drive-through and pre-mixing recipes decreased the wait time for students who always seemed to be running late. The ample meeting facilities equipped with wi-fi and ample plug-ins were an added necessity for students who were interested in meeting at their shop. The hours of operation were from 7:00 am until midnight with the greatest volume of traffic in the shop in the latter part of the day and the drive through type of business earlier in the day.

Brookings Drive Expansion Washington University

Riding high on their 2006 profits of over $7,000 at the Lindell Blvd. location (see Figure 1), the decision was made to open an additional shop located closer to Washington University on Brookings Drive. Unfortunately, they found a solid evening traffic crowd with lukewarm reception for the balance of the day. Due to financial reasons as demonstrated in Figure 1 and Figure 2, this shop was closed in July 2009. After the closing of the Brookings Drive shop, the profit margins once again turned upward with focus ultimately on the original shop on Lindell Blvd.

Competition

This industry was complex as consumer taste and population growth drove demand in the consumer sector and economic growth of businesses drove demand in the commercial sector (Hoovers, 2012). As in many industries, large companies had scale advantages in purchasing, distribution, manufacturing and marketing and small companies had advantages in specialized products and/or serving a local market. Additionally, there was intense competition in the coffee industry from alternate beverage companies such as soft drink, bottled water and juice manufacturers. The main competition for Java For Me in St. Louis, Missouri with respect to the college student target market was Starbucks, Panera and McDonalds. According to Fortune 500's annual ranking, Starbucks ranked #229 based upon annual revenues (2012). With 17,000 coffee shops in 40 countries offering coffee drinks, food items, roasted beans, coffee accessories and teas, their predominance in the coffee industry was obvious. In 2011, their annual sales peaked at $11,700.4 million (Hoovers, 2012). Panera Bread took a slightly different approach preferring to focus on the quick casual restaurant business with about 1,550 bakery-cafes in 40 states and Canada (Hoover, 2012). Their main product line was made-to-order sandwiches using a variety of artisan breads. Additionally, they offered soups, salads and gourmet coffees as well as offering its products to-go. Their business model included 660 of its locations being company-operated and the balance run by franchisees.

McDonalds holds the record as the #1 fast-food company based upon sales with more than 33,500 restaurants in 119 countries (Hoovers, 2012). While its popularity began with its Big Macs, Quarter Pounders, Chicken McNuggets and quick service, it had extended its focus to healthier food alternatives and the coffee business. As a matter of fact, before specialty coffee shops, McDonalds was the "best coffee in town". According to Fortune 500 rankings, based upon annual revenues, McDonalds ranked #111 (2012).

Financial Details

The Dilemna

As Kathy continued to explain her husband's illness, it seemed apparent to Sue and Jim that there was no convincing her otherwise. Jim suggested that Kathy think about her decision for a week but she was not receptive to this idea, continuing to push the discussion towards how they would value the business in order for her to break free from the responsibility of the business.

While Jim didn't necessarily want to see Kathy depart from their partnership, he knew that he wanted to maintain his 50% ownership. Sue had indicated that she would be interested in buying Kathy's half of the business, which would make a nice segway into a new business arrangement.

As they continued to discuss the task at hand, Jim reminded the group that there were a variety of methods that could be used to value the business and deciding on the most appropriate would need careful thought. Using her background as a Financial Analyst, Sue directed the group towards the discounted cash flow analysis (DCF) as a widely accepted method within the industry in respect to valuation of a firm. As a result, Sue knew that cash flow and the weighted average cost of capital were important pieces to the valuation puzzle. Kathy suggested that they also review the valuations of the main competitors to see how their firm stacked up against the industry.

Conclusion

With Kathy's impending financial concerns, the obvious first step seemed to be determining the value of the business. As Jim, Kathy and Sue had become steadfast friends through the building of this business, they all agreed that the value needed to be fair to all parties and should only be focused on store #1, as store #2 was simply not successful. Additionally, understanding how the value was calculated was important to all three. The annual cash flows generated as well as the weighted average cost of capital were crucial metrics that played an integral part in determining the firm's valuation. Kathy was also concerned that the value of their business be compared against their competitors. Specifically, when comparing the price/earnings ratio of Java For You with its closest competitors, how "cheap" or "expensive" was Java For You relative to its competition? With the state of the economy, this seemed a particularly important consideration as market values were significantly inconsistent.

Financial Details Figure 1. Profit & Loss Statement Summary (Years 2005-2010) 2005 2006 2007 2007 2008 #1 only #1 only #1 #2 #1 Total Income 290,353 399,421 444,062 152,437 460,564 Cost of Goods 102,718 148,331 157,805 56,434 166,361 Gross Profit 187,635 251,090 286,257 96,003 294,203 Total Advert 5,829 9,135 8,382 4,843 36,797 Amortization 1,148 1,148 1,148 1,148 Assoc.Relation 753 148 402 36 1,670 Bank Svc 5,391 6,622 6,384 3,585 7,769 Christmas Bon 2,100 500 Computer 293 420 2,264 Credit Card Depreciation 21,992 25,296 12,827 12,873 11,136 Donations 220 100 Dues/Subscript 1,373 310 819 395 772 Expense 288 Insurance 5,796 1,855 4,298 1,937 4,140 Interest Exp 3,544 233 Janitorial 980 939 1,199 748 1,046 Legal/Acct 1,360 1,955 2,338 538 1,766 License/Permit 380 1,099 459 1,050 732 Misc. 16,656 272 -2966 2,125 3,051 Office Supp 1,663 956 581 727 1,184 Postage/Del 199 58 72 Printing/Repro 335 155 Promotion 684 61 103 Rent 18,079 22,376 24,121 24,857 25,806 Repairs 2,401 6,389 3,628 2,065 6,521 Rest. Supplies 3,296 11,202 2,936 8,352 3,234 Shipping 107 95 391 Store Display 260 Total Taxes 1,898 27,241 2,933 4,833 Telephone 1,031 1,085 535 177 Training/Educ. 1,261 470 49 16 Travel 1,013 2,438 1,456 1,413 251 Utilities 9,534 11,274 14,854 6,664 15,913 Water filter 605 Payroll Exp 96,481 134,055 137,486 84,064 113,647 TOTAL EXP 196,811 243,944 244,292 166,083 242,864 Net Ordinary -9,176 7,146 41,965 -70,080 51,339 Income Net Other -743 146 278 147 -862 Income/Exp. NET INCOME -9,919 7,292 42,243 -69,933 50,477 2008 2009 2009 2010 #2 #1 #2 #1 only Total Income 227,418 426,613 111,821 442,116 Cost of Goods 90,867 156,028 41,767 148,297 Gross Profit 136,551 270,585 70,054 293,819 Total Advert 16,126 29,175 5,001 22,904 Amortization Assoc.Relation 659 1,963 228 Bank Svc 2,882 6,996 357 7,652 Christmas Bon Computer 870 200 Credit Card 2,071 Depreciation 21,594 16,326 Donations 1,025 375 Dues/Subscript 12 1,625 181 1,779 Expense Insurance 3,258 4,248 2,649 2,793 Interest Exp 3,176 2,793 328 Janitorial 783 1,467 388 1,631 Legal/Acct 1,766 1,549 1,070 3,947 License/Permit 412 747 522 852 Misc. 40 -4262 Office Supp 1,115 480 240 250 Postage/Del 15 Printing/Repro Promotion 1,000 1,396 103 Rent 35,664 27,547 28,395 21,439 Repairs 1,074 4,986 1.291 3,285 Rest. Supplies 3,210 886 743 184 Shipping 145 66 41 33 Store Display Total Taxes 2,081 1,804 2,290 1,603 Telephone 441 259 Training/Educ. 8 1,125 10 124 Travel 710 831 349 844 Utilities 10,085 13,528 6,001 14,788 Water filter 552 957 644 1,034 Payroll Exp 106,776 138,762 35,508 147,578 TOTAL EXP 215,424 242,824 84,588 249,602 Net Ordinary -78,873 27,761 -14,534 44,217 Income Net Other -1,364 -563 4,352 -5,872 Income/Exp. NET INCOME -80,237 27,198 -10,182 38,345 Notes: All figures rounded to nearest dollar Fiscal year = calendar year Source: Java For You Financial Reports (2011) #1: Original shop on Lindell Blvd. located adjacent to St. Louis University #2: Second shop on Brookings Drive located close to Washington University Figure 2. Balance Sheet Summary (Years 2005-2010) 2005 2006 2007 #1 only #1 only #1 and #2 Current Assets 36,688 67,806 47,449 Fixed Assets 115,107 100,917 221,574 Other Assets 120 TOTAL ASSETS 151,795 168,723 269,143 Current Liabilities 16,654 26,020 7,732 Long Term Liabilities 100,000 TOTAL LIAB 16,654 26,020 107,732 Equity 135,141 142,703 161,411 TOTAL LIAB & EQUITY 151,795 168,723 269,143 2008 2009 2010 #1 and #2 #1 and #2 #1 only Current Assets 40,907 30,320 39,213 Fixed Assets 190,452 98,067 92,120 Other Assets 120 120 120 TOTAL ASSETS 231,479 128,507 131,453 Current Liabilities 10,058 6,501 4,446 Long Term Liabilities 88,500 71,071 34,550 TOTAL LIAB 98,558 77,572 38,996 Equity 132,921 50,935 92,457 TOTAL LIAB & EQUITY 231,479 128,507 131,453 Note: all figures rounded to dollar Interest rate = 4% for long term liabilities Internal cost of equity assumed to be 21% and found using the CAPM equation and assuming a risk-free rate of 1%, a market return of 12%, and a beta of 1.8 Applicable tax rate is 35% * Includes initial partner investments: $75,000 from each of two partners #1: Original shop on Lindell Blvd. located adjacent to St. Louis University #2: Second shop on Brookings Drive located close to Washington University Source: Java For You Financial Reports (2011). 

The question is

Based on the financial data provided, assess the financial situation of the business

a. Use financial ratios of profitability and liquidity to determine the health of the business

b. make a simple trend analysis to determine how the financial progress of the business

c. Estimate their cash position based on the balance sheet and income statement.

What are Jim's alternatives to Kathy's decision to retire and sell her ownership in the business