It's been almost two years since you, a CPA at a medium-sized CPA firm, started working on various engagements for Over The Edge Ltd. (OTE), a company that manufactures snowboards. During this time, your passion for accounting and snowboarding has reached new heights. At the same time, the company has grown from a small custom snowboard manufacturer servicing the local market to a multinational success. Recently, OTE's snowboards were used by a gold medallist in the Winter Olympics! It's Monday morning, and you are meeting with the company's owner and sole shareholder, Wutang Pan. Also in attendance is Misty Phung, OTE's VP of finance.

Wutang: I am glad you are here. I have some fairly big news! Fun Consolidators Inc. (FCI), the largest competitor in our industry, has expressed an interest in acquiring OTE. They have been purchasing smaller companies like mine over the past two years. I hadn't been thinking about selling the company right now, but things have progressed very quickly with FCI. They have confirmed that they are going to put in a formal offer to buy OTE.

You: Congratulations. I guess you are going to have to make some big decisions. Is there a particular reason why you want to sell the business?

Wutang: There is a lot to consider in selling my business. It is a large part of my life. Over the next few weeks, I am going to have to think about whether I am ready to make such a change. I'm getting older and I have worked hard for a long time building the business. While my children are still quite young, I don't see any of them becoming involved with the business. So, this might be the right time to sell. As you know, the snowboard industry is cyclical, but it is at its peak right now. It might be a nice change not to have the stress of running a business and, who knows, maybe I will be able to keep working at OTE for a while or maybe I will try a new venture along similar lines.

I'm very proud to say that OTE has been named one of the "Top 10 Small Businesses to Work For" for the past three years. The award is based on financial performance, customer surveys, and employee satisfaction. I have a very dedicated and loyal staff, and it's not just the management team. Many of the staff members are like family. In the past seven years, we have not had to lay off any of our employees. Any employees who have left the company have done so of their own free will and under very favourable circumstances. My management team are great motivators. They have been very successful in empowering the employees and making them feel proud of their accountability to the company; in return, members of management are able to participate in the company's profits. Community support is very important to me. Toronto has been very kind to my family and me, providing us with many opportunities. That's why we have an informal apprenticeship program; each summer, we hire five local students to work around the shop. We don't need the extra manpower, but that's not the point. At a total cost of about $20,000 per year, it's more than worth it.

You: What can you tell us about FCI?

Wutang: The company is publicly owned and is listed on the Toronto Stock Exchange. Over the past two years, they have bought three of my competitors. In two of the three acquisitions, they closed the existing plants and moved the manufacturing to the U.S. During our discussions, the representative from FCI asked about the salary levels for senior management. He said that FCI normally pays the top executives of its subsidiaries $150,000 per year.

You: By the way, do you have any plans for early retirement or to pursue other goals?

Wutang: I haven't given it a lot of thought yet. While I would have the cash from the sale of the business, I'd want to be prudent and invest it wisely and conservatively for my kids' future. It might be a while before we could take the kind of vacations with my friends and family that we have taken in the past. Before I receive the offer, I would like you to give me a baseline on what OTE is really worth. I have a pretty good idea of the value of the tangibleassets used in the business, but I don't know whether they are going to make an offer for the shares or the assets.

You: I can definitely help you with that; I'll prepare a valuation of OTE's shares this week.

Wutang: Great, we should use the December 31 current year-end financial statements, which have now been finalized. Misty can provide you with anything else you need.

Wutang thanks you and departs, leaving you and Misty to discuss the information that you will need.

Misty: OTE is a good candidate for applying the capitalized cash flow approach of business valuation. In your valuation spreadsheets, be sure to make notes explaining each of your adjustments. Wutang will want to understand exactly what adjustments we are making and why. Often, when estimating future cash flows, we look at the past five years' results. OTE operates in a stable industry and, according to my discussions with Wutang, the results for the company three, four, and five years ago were relatively consistent with those for the prior and current years. Therefore, we'll rely on the prior year-end and current year-end amounts to set our value range. I will email you the December 31 current year-end statements (Exhibit I). In this case, I want you to assume that the present value of the tax shield associated with capital reinvestments is about 10% of the amount spent.

You: What capitalization rate shall I use for the valuation?

Misty: I would like you to do your first draft of the valuation using a weighted average capitalization rate of 12%. Once you have prepared the valuation, you will need to check it for reasonableness. One of the simplest ways to check the reasonableness of the valuation is to compare the value determined in the capitalized cash flow approach to the adjusted net asset value. The adjusted net asset value will provide the "floor value" of the company in other words, the lowest value Wutang should accept in a transaction. The difference between the two is typically the amount assigned to goodwill. I also put together a memo for you with some information on non-recurring or unusual items incurred by OTE. I will email it to you. (Exhibit II) Since FCI is public, it would not be able to claim a small business deduction for OTE. I would say that FCI could expect to pay corporate tax at the rate of 30%.

Required:

Part 1 In Excel, prepare a capitalized cash flow valuation for OTE, using the information provided in the exhibits.

Part 2 In Excel, prepare an adjusted net asset valuation for OTE using the financial statements and information attached.

Part 3 In Word, prepare a memo comparing the two valuation approaches. Summarize your results from the calculations and explain why there is a difference in the two valuations.

Exhibit I

Over The Edge Inc.

Balance sheet

As at December 31

Current year | Prior year

Cash $ 4,560 |$ 12,720

Investments | 29,850

Accounts receivable 1,370,150 | 1,112,457

Income taxes receivable 36,160 |

Inventory 1,196,190 | 938,945

Prepaids 4,920 | 4,920

TOTAL CURRENT ASSETS 2,611,980 | 2,098,892

Property, plant, and equipment 4,244,413 | 2,998,749

Intangible assets 13,883 |

Due from shareholder 21,500 | 21,500

Total Assets $ 6,891,776 | $ 5,119,141

Demand bank loan $ 375,422 | $ 96,800

Accounts payable and accruals 1,409,932 | 1,175,915

Warranty accrual 315,231 | 259,412

Deferred revenue 156,500 |

Current portion of term loan 141,000 | 141,000

Income taxes payable | 11,700

2,398,085 | 1,684,827

Term loan 572,000 | 713,000

Other long-term liabilities 1,128,570 |

Share capital 150,100 | 150,100

Retained earnings 2,643,021 | 2,571,214

TOTAL Liabilities and shareholder's equity $ 6,891,776 | $ 5,119,141

Over The Edge Inc. Statement of income and retained earnings For the year ended December 31

Current Year | Prior Year Sales

$ 8,959,800 | $ 8,834,000

Cost of sales 5,949,648 | 6,129,709

Gross profit 3,010,152 | 2,704,291

Expenses:

Advertising and promotion 357,900 | 266,500

Amortization 219,163 | 166,584

Automobile 140,800 | 102,600

Bad debts 17,250 | 19,110

Donations 1,200 | 1,000

Dues and fees 7,500 |

Insurance 69,600 | 57,200

Interest and bank charges 119,203 | 46,600

Office 101,200 | 108,700

Professional fees 67,700 | 34,800

Property taxes 44,700 | 40,900

Rent expense 84,654 |

Repairs and maintenance 207,100 | 155,100

Salaries and wages 1,160,460 | 1,175,600

Travel 117,666 | 103,900

Utilities 67,600 | 60,200

Warranty 72,059 | 69,482

Income before taxes 154,397 | 296,015

Income taxes 33,840 | 76,754

Net income 120,557 | 219,261

Retained earnings, opening 2,571,214 | 2,360,953

Dividends 48,750 | 9,000

Retained earnings, closing $ 2,643,021 | $ 2,571,214