Nickerson who are seeking business advice. Richard is an engineering professor at the local college and Nancy is a substitute teacher. Nancy has always wanted to run her own business and has approached Sassy Shoes Ltd. (Sassy) to investigate the possibility of obtaining a Sassy franchise.

The Nickersons advised you that they have no prior business experience and that they need guidance. The only thing they know for sure is that they plan to incorporate the new business. A friend, who is a CPA, has explained the tax implications of a corporate structure. They are confident in her advice and do not need you to advise them on any tax matters.

They provided you with extracts of the draft franchise agreement with Sassy (Appendix I) and a five-year discounted earnings projection prepared by Sassy (Appendix II). They also met with two other Sassy franchisees to gain some further insight and provided you with notes on their meetings as well as other information in Appendix III.

Richard's current salary is $125,000 a year; Nancy has been earning $20,000 a year from substitute teaching. They are concerned that they will not be able to replace Nancy's earnings with income from Sassy, so they would like you to calculate break-even sales for the first year (excluding any start-up costs).

Nancy has also considered starting an independent shoe store as opposed to the franchise. She has included some information on this in Appendix IV. Nancy asks if you can provide a discounted five-year earnings before interest and taxes (EBIT) projection if she and Richard decide to open an independent shoe store.

Nancy and Richard would also like your advice on other factors they should consider in opening a franchise shoe store or an independent shoe store. Nancy is set on opening a shoe store, so for any risks, they want to understand ways to mitigate them. As well, they would like a recommendation on which route to take. Their required rate of return on both options is 15%.

Finally, they would like to know the total financing required for start-up if they open a franchise, and are seeking suggestions on possible sources of financing.

Appendix I

Extracts of draft franchise agreement

1. Parties Sassy Shoes Ltd., the franchisor, and Richard and Nancy Nickerson, the

franchisee.

2. Duration September 1, 2020, to August 31, 2025, renewable for a further five

years at the option of the franchisee. Upon renewal, no further "initial" franchise fee

is required; only the ongoing franchise fee would be payable.

3. Premises To be subleased by the franchisor to the franchisee. The rent for 800

square feet is a minimum of $50,000 per annum ($40 per square foot plus a service

charge of $22.50 per square foot); if annual total sales are higher than $400,000,

another 2% on the portion of sales over $400,000 is due at year end.

4. Territory The franchisor agrees not to open Sassy franchise stores within a 10-

square-kilometre radius of the premises.

5. Initial franchise fee $60,000 payable upon signing the contract. The fee entitles

the franchisee to use the Sassy logo for the term of the contract.

6. Initial investment An amount of $150,000 is to be paid by September 1, 2020, for

initial inventory ($110,000) and leasehold improvements ($40,000).

7. Royalty (ongoing franchise fee) A monthly fee of 5% of gross sales.

8. Franchise services The franchisor will design and supervise the construction of

the leasehold improvements and will provide initial training in the store operation,

administration, and inventory management. Purchasing advice (for example, styles

and sizes) for the first operating year will be provided, as well as a detailed operating

manual.

9. Accounting The franchisee is responsible for maintaining an accounting system

and for providing financial information on which the lease and royalty payments will

be based. Audited financial statements must be provided to the franchisor no later

than two months after year end.

10. Franchise The franchisee is restricted to selling only women's shoes and related

products in the Sassy store. All inventory purchases must be made through Sassy.

The franchisee agrees to spend approximately 1% of sales on local advertising.

11. Resale The franchisee is not permitted to sell the franchise to a third party during

the term of the agreement.

12. Breach of contract The franchisor may terminate the franchise agreement if the

franchisee fails to comply with the terms of the contract.

Appendix III

Other information

The franchisor (Sassy) has signed a five-year lease, renewable at its option. The store is located just outside Penticton, British Columbia, in a large new mall scheduled to open on September 1, 2020. Penticton is a city covering almost 50 square kilometres, and the mall is located on the western edge of the city. All 75 locations in the mall are leased, and the mall is expected to draw customers from the western half of the city and the adjacent farming towns.

Sassy's shoes are in the medium price range. Shoe purchases average $40 per pair and retail for $80. There is only one other shoe store in town, at the moment, that will compete directly with Sassy by selling women's shoes in the same price range.

The Nickersons thought that the five-year earnings projection provided by Sassy was reasonable. They concluded that the shopping centre developer must have done a comprehensive customer survey to justify the mall in the first place, and that such a mall ought to be able to support a women's shoe store. Even if earnings were low for the first year or two, they would still have Richard's salary to support them.

Sassy has already established 12 franchises. The Nickersons visited two franchisees located in shopping malls, serving markets comparable in size to Penticton, and both franchisees were very positive about their businesses. One of the franchisees told them that sales in her first year were slightly under $400,000 but were now, in her third year, over $700,000. The other franchisee had sales of $400,000 in the first year but had only achieved $660,000 in his fourth year. He felt the slower growth was due to the opening of a nearby competing store. Both were enthusiastic about the purchasing/inventory advice provided by the franchisor and felt good about the limited risk given that they were not left to guess which styles to order. When asked about financing arrangements for their initial start-up costs for the franchise, they mentioned that their banks were willing to provide a line of credit secured by 50% of inventory, which is standard for the industry.

Financing options

After paying the initial franchise fee of $60,000, the Nickersons will still have $70,000 of non-registered savings. The Nickersons have a very good credit rating and own a home that has an assessed value of $400,000. The remaining mortgage on their home is $210,000. Nancy mentioned that their bank has previously stated it will only lend up to 80% of the assessed value of the home, less the outstanding mortgage balance.

Appendix IV

Independent shoe store

Nancy has considered starting an independent shoe store as opposed to the franchise. If she and Richard choose this route, the store would be located in an existing Penticton shopping mall.

Nancy has not had the time to get figures on what it would cost to run an independent shoe store, but she expects that the purchasing terms and cost structures would be similar to Sassy's.

However, she does expect the minimum lease costs and sales to be 10% less due to being in an older shopping mall and to lower brand recognition.

Question

1. What other factors should Nancy and Richard consider in opening a franchise store vs independent store. If there are any risks, how can they mitigate them?
2. What is the total financing required for start up if they open a franchise ?