W16042

5 FORTUNE: ONE OF MANY CHINESE RESTAURANTS

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In early May 2014, Wenbei Li, a new immigrant from China, was anxious about her decision to open a Chinese restaurant in downtown London, Ontario. She was hesitant because the financial viability of this potential investment was uncertain, and she could not afford any mistakes. However, Li, like many first- generation immigrants, was prepared to work hard, take risks, and make tough decisions.

PERSONAL EXPERIENCE

In 1998, Li established the 5 Fortune company in Yunnan Province, China. The investment projects she carried out through this company included 5 Fortune Herbal Cuisine (two herbal cuisine restaurants), 5 Fortune Very Ethnic (an adjacent store selling ethnic embroideries and clothing), 5 Fortune Arts (an exhibition room for Chinese paintings, oil paintings, modern decorative paintings, and painting frames), and 5 Fortune Clothing (a self-owned brand of ramie cotton clothing design and production). Li sold all these investment projects before she immigrated to Canada in May 2012. Li settled down in London, Ontario and looked for business opportunities. Because she lacked English language skills, Li thought the restaurant business might be a good starting point for her ambition to be an established entrepreneur in Canada. In the future, Li planned to establish a restaurant franchise that focused on cultural cuisine and to build a culinary school dedicated to Yunnan cuisine.

5 FORTUNE CULTURE RESTAURANT

The purpose of a "culture restaurant" in Li's mind was to use cultural cuisine to promote the cultures of ethnic minoritiesin this case, from Chinaand at the same time to provide a platform to facilitate the exchange of Eastern and Western cultural values. As an artist and entrepreneur, Li was passionate about this plan.

Li found that lots of people in London loved Chinese food. However, she could only find a few Chinese cuisines in town, most of which had been modified to fit the preferences of Western customers. Li was eager to make unique and authentic Chinese hometown food and promote the cultures of the 26 ethnic minorities in Yunnan province.

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Li chose the downtown area in London for her business because she heard about the municipal government's plan to revitalize that area. Moreover, Li thought that because convenient but stereotyped chain stores were dominant in the region, a small and distinctive business was more suited to the concentrated downtown.

Li thought it would be best to target college students and white collar employees who were interested in foreign culture, liked trying new food, and enjoyed art and live performances that could be offered in her restaurant. She estimated that the average customer would spend $20-30 per person.1 Considering the restaurant's unique characteristics, Li believed there was no direct competition in this niche market although there were already at least 10 Chinese or Asian restaurants in downtown London.

FINANCING

Li understood that the project was a huge investment for her, and any mistake could be devastating. After considering the types/ sizes of restaurant that would be desirable, Li believed that the investment for the first stage would be $840,000, made up of land and building ($570,000), renovations and equipment ($170,000), working capital ($50,000), furniture ($40,000), and other start-up costs ($10,000).

Li and her family had half of the money needed; she had two options to fund the other half. Li had a family friend in Toronto with restaurant experience who was willing to invest in the project and become an equal partner of the restaurant. Li's family was more inclined to this partnership because they trusted this person and felt the person could provide valuable advice. Alternatively, Li could take on a bank loan through a mortgage. The mortgage would be for $420,000, 20-year term, at 4.25 per cent per annum, paid annually. The Bank of Canada was keeping its low-interest rate policy in place which enticed Canadians to take on debt (see Exhibit 1).

In addition to ensuring she could realize her objective of maximizing value, Li believed she should investigate the impact of the timing of the investment, uncertainty of the returns, control of the business, tax benefits, potential conflicts between investors, and future flexibility for raising capital. In particular, Li needed to consider the following factors that could significantly affect decisions about capital structure in a company:

1. Taxes: With typical tax rules (where interest was tax deductible but dividends were paid after tax),

adding debt could increase the value of the company.

2. Bankruptcy risk: The capital structure would affect the risks the company and its stakeholders were

exposed to.

Direct costs of bankruptcy

Lawyers fees, court costs, etc.

Higher interest rate

Foregone opportunities

Average costs were about 5-10 percent of asset book value b) Indirect costs

Impaired relations with customers, suppliers, creditors, employees, etc.

Management time The chance of default and the cost of default, if default occurred, would be lower for companies with stable cash flows and tangible assets.

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3. Impact of financing on investments:

a) If investors were well informed and invested a large enough stake, they would be more involved in corporate decision making, which would improve business performance. Therefore, financial vehicles should have been chosen to attract the right investors.

b) Conflicts of interest could affect investments ("agency costs"). Shareholders avoided good projects if the benefit accrued mainly to debt holders. However, shareholders might have taken on poor projects (such as high risk projects in a company approaching bankruptcy) if the shareholders would benefit. In cases where conflicts of interest could be significant and difficult to control (e.g., high growth companies), companies would finance with equity.

c) Control effects: Key decision makers in the company typically owned the company's equity, creating an incentive to take on value-enhancing projects. If key decision makers did not own enough of the equity, the decision makers might not have been motivated to enhance shareholder value. In cases where decision-maker control was important, companies were less likely to issue more voting equity.

d) Direct debt constraints: Debt covenants could directly restrict management action. In cases where manager flexibility to pursue opportunities was important (e.g., tech companies), firms were less likely to raise debt.

4. Signals: Insiders (managers and controlling shareholders) knew more about the value of their company than outside (potential) investors. Selling common stock sent a negative signal to outsiders. Outside investors might have believed that insiders were selling the stock because they know the stock was overvalued. Selling debt, on the other hand, sent a positive signal. If decision makers were confident about future performance, they would be willing to make a commitment to repay the debt plus interest, knowing that taking on the debt would enhance their returns. A desire to send the correct signals led to a preferred order of financing (the pecking order theory): internal financing first, then debt, then equity.

5. Access to fairly priced capital:

a) Availability of capital: There were periods (e.g., after the subprime crisis) when capital was either not available or was very costly. If the company expected to have high need for future capital, the company should have financed itself in order to have more financial flexibility and financing options in the future. Thus, companies would build strong cash reserves and lean toward less debt financing in the beginning, reserving debt as an option for the future.

b) Market valuation: There were periods when debt or equity might be mispriced by potential

investors. Therefore, equity would be issued when it was perceived to be overpriced.

PROJECTION

After surveying the restaurants nearby, Li projected the best, medium, and worst revenue predictions. She estimated the revenue would be $68,000 per month in the best case scenario (100 per cent capacity), $51,000 in the medium case (75 per cent capacity), and $34,000 in the worst case (50 per cent capacity). The monthly operating costs for 100 per cent capacity are projected in Exhibit 2. The business might be seasonal because a significant portion of the customers would be university students who go home for vacation and holidays. The population of the London area was 366,000; Western University had about 35,000 students and employees. Li felt that in forecasting the profitability of the restaurant, an estimate of 75 per cent average capacity over a year was realistic and 50 per cent capacity would be the lowest possibility. Li also assumed the effective tax rates would be 40 per cent.

Li was nervous and, because of a lack of financial knowledge and experience, did not know how to evaluate the situation. One night, she dreamt of buying the restaurant, losing all the money, and in the end, begging for food and money outside her own restaurant.

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EXHIBIT 1: ONE-MONTH TREASURY BILL YIELDS

EXHIBIT 2:

1.) If Li requires a rate of return of 6% on equity investment; what is the cost of

capital of the project if she decides to keep a capital structure of 50-50?

2.) What are the following financial ratios on both financing options, considering the

three case scenarios, and no growth?

a.Net Income

b.Total Cash Flows

c.ROE

d.Accounting and Financial Break-even Points

e.Payback Period

f.NPV

3.) Why should Li's decision be on this project?