Katie Chatwick runs a home-based business called Pregnant Paws (PP), which breeds Persian cats. Katie has been able to find a ready market for the limited number of kittens produced annually by breeding female Persians, called queens, each year. Although each four-month-old pedigreed Persian kitten sells for $700, Katie has operated PP as a break-even hobby.

Katie's husband, Tom, is retiring from his local government career next month. Tom wants to keep busy after retirement and supplement his government pension. The Chatwicks are considering a business expansion and have approached you, CPA, for advice.

The Chatwicks are interested in purchasing land that has become available near a new mixed-use residential/commercial development complex. One expansion option would be for the Chatwicks to move the existing cats from their personal residence to this new property, and then purchase additional Persian breeding cats. The other expansion option would be to switch to a new breed of cats, Himalayans. Information on breeding is included in Appendix I. Due to the nature of the breeding operations, only one type of cat can be bred at any given time. If the Chatwicks proceed with breeding Himalayans, the Persian queens will be rehomed.

The Chatwicks would like to start by understanding which breed is more profitable. They need you to prepare analysis of both breeds and conclude on the return on investment for each. Next, they would like you to provide a recommendation on their plans for purchasing land. Include the breeding option you recommended in your analysis. The time horizon should be limited to six years, which is the length of the breeding life of one queen. Information necessary for your analysis is included in Appendix II. Be sure to include a qualitative discussion of the opportunities before recommending a course of action.

Lastly, PP is currently a sole proprietorship owned by Katie. Katie was planning to incorporate because a friend told her this would save money. Recently, at a local business event, an acquaintance told her that corporations are only for the big guys and that, because she is a family-run business, it isn't logical for her to incorporate her business. Katie is very confused and needs more information about her ownership structure options

Persian breeding option

Persian cats aren't ready for breeding until two years old, at which point the queens can be fully evaluated for health and genetic problems. PP currently has 10 Persian queens that have just turned two years old. Once a queen reaches eight years of age and is past her breeding prime, she is spayed and rehomed as a family pet for free to a suitable home.

Queens are bred only once each year and, on average, produce a litter of five kittens. The Chatwicks are very diligent about health issues, and their kittens in the past have had a very low mortality rate. Kittens are spayed or neutered before they are sold so that they cannot be used for breeding purposes by the buyer, which protects that breed of cat from being tainted by unqualified breeders and reduces competition. There are still a high number of quality breeders of Persian cats, and this is a very competitive market.

The Chatwicks estimate with the expansion and increased marketing efforts they could sell up to 240 Persian kittens per year given market conditions. The annual cost to reach this larger market would be $7,000. The Chatwicks are confident that they can purchase 38 quality Persian breeding queens immediately to facilitate the expansion, at a cost of $1,800 per queen.

Himalayan breeding option

The Chatwicks are also considering breeding Himalayan queens. Himalayan kittens are typically less popular than Persians due to their less desirable temperament, but are currently quite trendy due to publicity they receive by having celebrity owners. As Himalayan kittens currently sell for $1,600, their profitability is attractive. There are fewer breeders, so the market is less competitive.

The Chatwicks estimate that up to 120 Himalayan kittens could be sold each year, with annual marketing costs to reach this market of $5,000. This number may increase as the breed gains popularity. A two-year-old Himalayan queen ready for breeding currently costs $4,000. PP could obtain enough breeding-age queens to meet any reasonable number required in an expansion. The Chatwicks consider a Himalayan queen ready for breeding at age two and expect a litter of six kittens, on average, once a year until the queen reaches eight years of age. Historically, Himalayans do have more health issues than Persians, but the Chatwicks are confident they can address this in their breeding protocols. As with the Persians, Himalayans who are past breeding age will be rehomed as family pets for no fee.

The Chatwicks stressed that they only have about $80,000 put aside for the purchase of queens, and are firm on adhering to their budget.

Appendix I (continued)

Information on breeding

Costs related to breeding

The average costs directly associated with the care and breeding of either Persians or Himalayans are:

Breeding fee for use of male cat (once per litter) $1,000

Food per adult cat per year 75

Food per kitten per month 5*

Veterinary bills per adult cat per year 200

One-time veterinary bill per kitten 250

Other supplies per adult cat per year 90

* Kittens are fed by their mothers for the first two months. Purchased food is only required from that point until the kitten is sold, usually at the age of four months. After the age of four months, a kitten is considered to be an adult cat.

Appendix II

Expansion opportunity

Building and land purchase

The purchase price for the land near the development complex is $50,000. A prefabricated building measuring 1,500 square feet would be purchased, erected, and connected to all necessary utilities at a total cost of $120,000. Assume a capital cost allowance rate of 4% on the building. The building is specific to the Chatwicks' needs and is expected to have a nominal value at the end of the six years.

Overhead costs of new building

The estimated annual overhead costs of the new building are:

Property taxes $3,000

Insurance 2,000

Electricity, heat, and water 1,500

Maintenance 500

A tax rate of 25% is anticipated for PP.

Expected return

Although the Chatwicks are not particularly risk-averse, they do expect an appropriate return on their investments. They consider a 10% after-tax return to be the minimum acceptable amount with respect to the expansion of PP.

Question

Which cat breed is more profitable?

What is the return on investment for each breed?

Provide a recommendation for purchasing land. (Include the breeding option you recommend)

Katie is thinking about incorporating, a friend told her it would save money but she is confused on whether its the logical choice. Provide an explanation as to whether Katie should incorporate or not.