Should the Scuba Business Dive into the Expansion?

1. What are the advantages of the proposed dive shop?
2. What are the disadvantages of the proposed dive shop?
3. Project a pro-forma income statement, balance sheet, and statement of cash inflows and outflows for fiscal 1997 and 1998 for ONLY the new location, using the information presented in the case. Present the financials in Cayman Island dollars; do not translate into US dollars. The fiscal year starts June 1 and ends May 31.
   1. Clearly show how your projected your revenues. Hint: use the regression equation shown in exhibit 3 to project revenues, but not profits, and adjust for the circumstances of the new shop.
   2. State clearly any assumptions that you make to complete the financial statements.
4. In your opinion, should Don Foster open the new shop? Why or why not?

Ignore any foreign currency effects and income taxes.

Please round to the nearest dollar.

AICPA Case Development Program Case No. 97-01: Should the Scuba Business Dive Into the Expansion 1 SHOULD THE SCUBA BUSINESS DIVE INTO THE EXPANSION? Michael H. Moms, Professor of Accountancy University of Notre Dame, Notre Dame, Indiana Andrew M. Crowe, Controller Don Foster's Dive Cayman, Ltd., Cayman Islands As controller and general manager of Don Foster's Dive Cayman, Ltd., Andy Crowe knew that something had to be done to improve the profit performance of the company. Although profits increased for several years after incorporating in July of 1991, sales revenue declined during the last two years, with the company reporting a loss for fiscal 1996. Andy knew that the current fleet of dive boats were being underutilized, so the timing was right to examine ways to expand sales revenue. ENVIRONMENT Don Foster's Dive is located in the Cayman Islands, a self-governing British crown colony, situated 480 miles south of Miami. To vacationers, the Cayman Islands mean calm clear waters and a carefree world of outdoor pleasures. To scuba divers and snorkelers, the Caymans are synonymous with the world's best diving. Not only are the quality and variety of the dive sites spectacular, but the Cayman Islands also possess a unique dive site called Stingray City. At this location, divers and snorkelers swim with 30 to 40 wild stingrays that feed from human hands. To investors, the Cayman Islands are a reliable tax haven. There are no corporate, capital gains, payroll, property or withholding taxes on the islands. The absence of taxes on income together with political and racial stability, has attracted the attention of investors seeking a tax free base for their operations. Currently there are approximately 32,000 companies, 550 banks, 900 mutual funds and 400 insurance companies of various categories registered or licensed in the Cayman Islands. Those companies operate from an environment in which there are no excessive restrictions on their freedom to trade or their ability to transact business in any part of the world. In addition, disclosure of information by government officials, professional agents, attorneys and accountants and their staffs is forbidden by law under severe penalties. BUSINESS Don Foster's Dive specializes in providing vacationers with a wide variety of exciting watersports activities including the rental of snorkeling equipment, wave runners, sail boats, wind surfers, floating mats, and plastic kayaks. Parasailing and other local excursions are also offered through Don Foster's Dive, but its primary line of business is providing scuba diving trips and instruction. Copyright 1998 by the American Institute of Certified Public Accountants (AICPA). Cases developed and distributed under the AICPA Case Development Program are intended for use in higher education for instructional purposes only, and are not for application in practice. Permission is granted to photocopy any case(s) for classroom teaching purposes only. All other rights are reserved The AICPA neither approves nor endorses this case or any solution provided herein or subsequently developed. AICPA Case Development Program Case No. 97-01: Should the Scuba Business Dive Into the Expansion 2 Scuba is an acronym for Self-Contained Underwater Breathing Apparatus. The breathing apparatus consists of a tank containing pressurized air and a regulator that delivers the air to the diver on each inhalation. Other basic equipment includes a soft rubber face mask to improve visibility, swimming fins to enhance mobility, and a vest, called a buoyancy compensator device, to help regulate divers' depth while submerged and to keep divers afloat when they are on the surface of the water. Don Foster's Dive maintains twenty employees to staff the dive shops and dive boats, provide various levels of instruction, and guide divers while underwater. It maintains six dive boats in various locations around the island in addition to the wide variety of watersports equipment. Don Foster's Dive provides two dives in the morning, starting about 9:00 a.m., one dive in the afternoon, and a final dive at night. Customers are either transported by Don Foster's Dive vans to the dive boat or picked up at the beach in front of their hotel. Divers can explore wrecks, walls (huge underwater cliffs), and reefs. Dive instruction, equipment, and information about the 200 different dive locations in the Caymans are provided by their experienced, professional instructors on the way to the dive site. OVERVIEW OF THE PROBLEM Increased competition in the dive industry in the Cayman Islands has caused revenues to stagnate and even decline in recent years (see Exhibit 1). With a huge investment in boats and diving equipment, (see fixed assets in Exhibit 2) Don Foster's Dive must find a way to utilize excess capacity. Since about 40 percent of its $2.4 million dollars of revenue arise out of a single dive and watersports rental shop located on the beach just outside a resort hotel, Andy thought about expanding to a second dive shop, located near the other end of the famous 7 Mile Beach. After considering several locations, he settled on the Holiday Inn because of its superior beach location and the fact that it attracts a younger more family oriented clientele, who are more likely to participate in watersports activities. He approached the Holiday Inn owners with a proposal to have Don Foster's Dive open a full service dive and watersports facility at the resort. The owners were interested in offering their guests a wide variety of watersports activities and dive services. They agreed to provide a small building on their premises and the exclusive license to provide diving and other watersports services at their hotel in return for the minority interest in a 60/40 split of any profits generated by the proposed dive shop. Don Foster's Dive would renovate the shop and provide vessels and staff for the new venture. Although the proposal sounded exciting for Don Foster's Dive, Andy wasn't sure of the viability of the venture given the additional investment it would require and its unknown impact on assets, debt, cash flow and income. Andy knew the first step was to determine the impact of the expansion on profits and to obtain proforma (projected) financial statements that he could carry to the bank to justify the necessary financing. Don Foster's Dive just completed its 1996 fiscal year on May 31, and could have the new facility open on a limited basis in a matter of days after signing the contract. OPERATIONAL ISSUES Although there is some uncertainty in the incremental business the new dive shop would generate, Andy has obtained data that can help with the projections. He contacted the local Department of Tourism and obtained statistical data for a dive shop on the beach outside the Radisson Resort, which is similar to the proposed site. Using those statistics, he estimated monthly sales and profit from operations (provided in Exhibit 3 along with a trend line) for the dive and watersports facility during the last three years. Given Andy's experience with the business, he feels confident that the trend established from the data at the Radisson dive shop would be representative of business at the new Holiday Inn location. Adjustments for the difference in size of the hotels (Radisson Resort has 330 rooms and the Holiday Inn has 230 rooms) would, of course, have to be made in order to get accurate annualized projections of sales revenue and profit from operations. In addition, Andy knows that it takes approximately one year for a new shop to reach its full sales potential. From recent experience in opening new dive shops for Don Foster's Dive and in talking to competitors along 7 Mile Beach, Andy believes that revenue and profit from operations at the proposed site for the first year will be 50 percent of subsequent figures and operating expenses (mostly variable) will be ten times as large as adminiistrative expenses on the new facility for the Case No. 97-01: Should the Scuba Business Dive Into the Expansion 3 AICPA Case Development Program foreseeable future. All other previously existing facilities at Don Foster's Dive are expected to yield about the same revenue, expenses and income as in 1996. The additional investment required by Don Foster's Dive to open the new shop includes $31,000 for building improvements and signs; $ 17,500 for waverunners, aqua trikes, sailboats, kayaks, and floating chair mats; $10,000 for additional scuba equipment; $20,000 for increased retail inventory and $5,000 for additional computer equipment. All of the investments are anticipated to be financed by a long-term bank loan which together with existing long-term bank loans will be repaid in equal installments of $4,008 per month (exclusive of interest). The existing note payable is also reduced by monthly payments of $9,070 (exclusive of interest). The interest cost on both debt instruments is part of the administrative expense component on the income statement. If the purchases are made, the total depreciation expense (included with operating expenses) using a straight line method is expected to increase by $15,000 to about $65,000 per year on all fixed assets (all figures are stated in CI dollars). EXHIBIT 1 DON FOSTER'S DIVE CAYMAN, LTD. INCOME STATEMENTS (UNAUDITED) FOR THE YEAR ENDED MAY 31 1996 1995 1994 Sales Revenue $ 2,376,874 $ 2,479,367 $ 2,556,897 Operating Expenses $(2,204,865) $(2,162,768) $(2,010,180) Profit from Operations $ $ $ Administrative Expenses $ (257,132) $ (295,043) $ (331,470) Profit Before Gains/Losses $ (85,123) $ 21,556 $ 215,247 Gain on Sale of Fixed Assets Gain on Currency Exchange $ $ 1,824 16,018 $ $ (3,799) 18,186 $ $ 0 10,437 Profit (Loss) for the year $ (67,281) $ 35,943 $ 225,684 172,009 316,599 546,717 Note: Statements are reported in Cayman Island (CI) Dollars (Fixed Rate of US $1.00 = CI $.82) Case No. 97-01: Should the Scuba Business Dive Into the Expansion 4 AICPA Case Development Program EXHIBIT 2 DON FOSTER'S DIVE CAYMAN LTD. BALANCE SHEETS (UNAUDITED) MAY 31 Current Assets: Cash Accounts Receivable Inventory Total Current Assets Non-Current Assets: Investments Fixed Assets Goodwill Total Non-Current Assets Total Assets Current Liabilities: Short-term Bank Loan Customer Deposits Accounts Payable Total Current Liabilities Long-term Liabilities: Long-term Bank Loan Note Payable Total Long-term Liabilities Shareholders' Equity: Capital Stock Paid-In Capital Retained Earnings Total Equity Total Liabilities and Equity 1996 1995 $ $ $ $ 1,038 54,744 38,103 93,885 $ 1,004 $ 67,547 $ 43,860 $ 112,411 $ $ $ $ $ 3,000 $1,220,097 $ 384,950 $1,608,047 $1,701,932 $ 167,000 $1,270,631 $ 384,950 $1,822,581 $1,934,992 $ 167,000 $1,341,818 $ 384,950 $1,893,768 $1,991,312 $ 93,608 $ 46,913 $ 158,437 $ 298,958 $ 140,293 $ 69,349 $ 113,293 $ 322,935 $ 122,941 $ 36,984 $ 141,415 $ 301,340 $ 156,958 $ 870,741 $1,027,699 $ 189,910 $ 979,591 $1,169,501 $ 264,953 $1,078,123 $1,343,076 $ 82 $ 223,094 $ 152,099 $ 375,275 $1,701,932 $ 82 $ 223,094 $ 219,380 $ 442,556 $1,934,992 $ 82 $ 163,377 $ 183,437 $ 346,896 $1,991,312 Note: Statements are reported in Cayman Island (CI) Dollars (Fixed Rate of US $1.00 = CI $.82) 1994 1,701 49,502 46,341 97,544 AICPA Case Development Program Case No. 97-01: Should the Scuba Business Dive Into the Expansion 5 AICPA Case Development Program Case No. 97-01: Should the Scuba Business Dive Into the Expansion 6 QUESTIONS Incremental Profit Analysis 1. Realizing that the key to the expansion decision is the projection of incremental income, calculate the projected sales revenue and profit from operations for June 1996 (x=37), using the trend lines in Exhibit 3. Do the same for the next 11 months (hint: spreadsheets could prove to be useful). Estimate operating expenses (difference in above figures) and administrative expenses (10% of operating expenses) to arrive at profit before gains/losses for fiscal 1997. Don't forget to adjust income for the first year of operations, number of rooms, and Don Foster's Dive share of the profits. Based on projected performance for the first year, do you think the business should undertake the expansion which Andy Crowe has proposed? 2. Expand the analysis to include income projections for 1998 and 1999. Given the superior location for the new dive shop and the more active clientele at the Holiday Inn, does the longer term perspective have any impact on your decision to expand? 3. Students are often misled by looking only at dollars of profit. Divide the profit before gains/losses (in parts 1 and 2 above) by the incremental investment in assets required by Don Foster's Dive, to get a return on investment measure for each year. How do these returns stack up against other opportunities available to Don Foster's Dive (e.g., investment in common stocks)? What is the outlook for returns beyond 1999? Does this additional analysis have an impact on your decision to expand? Financial Statement Preparation and Analysis 4. Generate the proforma (projected) financial statements for the entire Don Foster's Dive business for 1997, 1998, and 1999, assuming the expansion is undertaken. Assume that 1996 was a normal year for Don Foster's Dive, and that expansion income each year will be added to 1996 results. Assume assets (with the exception of the additional investment in fixed assets and inventory) will remain the same in future years. Also assume that current liabilities will be the same except for short-term bank loans, which will be used to make the balance sheet balance. 5. Calculate the debt ratio (total debt/total assets) and the current ratio (current assets/current liabilities) for each year. Comment on the strength of the proforma financial statements from the perspective of a banker considering whether to make the bank loan to the business for the expansion. Analysis of International Differences 6. To take the analysis one step further, assume Don Foster's Dive is considering Key West, Florida as an alternative location for the new dive shop because of high import duties on purchases and high work permit fees in the Cayman Islands. Assume a partner can be found in Florida with similar contractual arrangements as that obtained from the Holiday Inn owners. Assume that Don Foster's Dive share of profit before gains/losses will be 5 percent higher and the investment required would be 5 percent lower (prior to considering conversion to US dollar equivalents). Compute the incremental income (ignoring taxes and goodwill amortization) and ROI from the expansion to Key West. Should the expansion to Key West be undertaken? 7. Now consider the additional factors arising from international differences as they relate to taxes and goodwill (assume one half of the goodwill could be associated with the U.S. segment, that goodwill is amortized equally over 10 years in the U.S., and that goodwill amortization must be deducted after computing Don Foster's Dive share of the profits, but before taxes). Recompute the return on investment and decide if the expansion makes as much sense in the U.S. as it does in the Cayman Islands. Assume current federal, state and local tax rates are 40 percent in the U.S. location. AICPA Case Development Program Case No. 97-01: Should the Scuba Business Dive Into the Expansion 7 Accounting Disclosures and Behavioral Implications 8. Businesses in the Cayman Islands can choose among various internationally accepted accounting standards as the basis for preparing financial statements. In addition, there is no requirement for financial statements to be provided to the public. For a business operating in this environment, examine the ability of accounting information to assist the banker and the Holiday Inn owners in drawing performance comparisons with other business segments and in monitoring the performance of Don Foster's Dive. What differences might arise in the behavior of Don Foster's Dive management under such disclosure requirements? Be sure to address attitudes toward risk and ethical considerations. 9. Note that the financial statements (Exhibits 1 and 2) indicate that they are unaudited. In addition, in an environment without taxes, no tax returns are required to be filed and no threat exists to be audited by a tax authority in the Cayman Islands. Address the need for auditing in this financial reporting environment. In other words, is it more important for the banker and the Holiday Inn owners to have audited financial statements since Don Foster's Dive is located in the Cayman Islands? SUGGESTED REFERENCE MATERIAL Holt, Paul E. and Hein, Cheryl D. International Accounting (Dame Publications, Inc. 1996). James, Canute, "A Tax Haven with Great Attractions," The Financial Times, March 18, 1997, p. l6. Keegan, Mary and King, Hannah, "Together but Different," Accountancy (October, 1996) .64-65. Price Waterhouse. Doing Business in the Cayman Islands (Price Waterhouse 1993). Wolf, K. Buck, "Seeking Shelter from Taxes, Firms Flock to Caymans," Journal of Commerce and Commercial (September 22, 1994), p.64