3. December 17, 2014
Page 3
Executive Summary
This report provides an analysis and evaluation of two prospective acquisitions for Humble Pie’s Inc.
The first analysis provides detailed financial information regarding Pete’s Steakhouse, an
underperforming chain of restaurants with five locations in the Mid-Atlantic area. The second
prospective opportunity is a manufacturing facility in Knoxville, Tennessee. It has an optimal location
near distribution routes and would double current production.
Our financial results found both the steakhouse acquisition and Knoxville facility to be profitable with
comparable payback periods. Our methods for financial analysis include the following:
Cash flow valuation
Net present value
Return on investment
Payback period
Residual income
Industry comparison
Because of similar financial analysis results, qualitative factors were weighed heavily in the decision
making process. Strategic, behavioral, risk, and technical factors were evaluated for both the steakhouse
and factory options.
Pete’s Steakhouse provides a slightly higher rate of return than the Knoxville plant and allows you to
secure vertical distribution channels. However, this comes at the expense of a higher degree of risk in
the other critical success factors.
The Knoxville facility doesn’t match the financial performance nor provides the same degree of
distribution security. However, the plant is more strategically aligned with your current objectives and
provides sustainable competitive advantages.
Our recommendation, as conservative financial consultants, is to purchase the Knoxville facility and
double current production.
7. December 17, 2014
Page 7
Option 1: Pete’s Steakhouse
Acquiring Pete’s Steakhouse chain consists of obtaining five restaurants in the mid-Atlantic region for
an initial cost of $10 million and includes $7.5 million in operating assets. The steakhouse acquisition
will add $5.2 million to the value of your company, assuming a 10% expected return and perpetuity of
the business. Although an 8% return was originally discussed for your investments, we applied a 10%
return to this analysis due to the riskier nature of venturing into a service industry, given your
company’s manufacturing background.
The steakhouse provides a 15% return on your investment, requires 6 ½ years to recover from your
initial outlay in terms of profit, and earns $518,000 in net income above the minimum rate of return:
This is your residual income.
From the financial information provided by Pete’s Steakhouse, they experienced a $5,000 decrease in
operating income between 2012 and 2013. This decrease was related to four slightly offsetting factors
including decreases in sales volume and food costs and increases in price per meal and other operating
expenses. Although a decrease in operating income can be worrisome, the 0.5% decrease from 2012 is
minimal. Details for this analysis are included in your packet.
For the analysis of Pete’s Steakhouse, we project sales at a constant rate using the weighted average
from the two years of financial information provided. We determine our projection to be conservative
since the National Restaurant Association forecasted record high sales in 2014 with a 3.6% increase
from 2013 sales.
Investment Valuation and Return Measures
Average Net Cash Flow $ 1,518,410
Initial Cost $ 10,000,000
Expected Earnings (10%) 1,000,000
Residual Income 518,410
Return on Investment 15.18%
Payback Period (in years) 6.59
NPV (assuming perpetuity) $ 5,184,101
8. December 17, 2014
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Pete’s Steakhouse:
Key Assumptions
Other Assumptions and Further Explanation
Only actual operating costs are reflected in the financial data provided (e.g. owner salary as a
portion of excess income)
According to industry average, 80% of total operating assets are attributed to fixed assets. From
applying an estimated average life of 10 years to all fixed assets, an annual depreciation of
$600,000 was used in determining maintainable earnings.
From previous conversations, an 8% cost of capital was set for investments; however, a 10% was
used to value the steakhouse based on the riskier nature of entering into an unfamiliar industry.
Average Operating Assets $ 7,500,000
Fixed Assets (80% of Total Operating Assets) $ 6,000,000
Average Estimated Useful Life of Fixed Assets 10
Annual Depreciation Expense $ 600,000
Initial Acquisition Cost $ 10,000,000
Less: Tangible Assets $ (7,500,000)
Goodwill (straight-line amortization over 15 years) $ 2,500,000
Price Per Meal Increase 12%
Related Variable Food Cost Increase 12%
Tax Rate (Federal and State) 40%
Cost of Capital (expected return) 10%
9. December 17, 2014
Page 9
Pete’s Steakhouse:
Cash Flow Valuation
Pete's Steakhouse
Cash Flow Valuation
Actual 2012 Actual 2013
Weighted
Average
Projected
Customer Volume 1,105,000 1,066,000 1,079,000 1,079,000
Net Sales $ 10,508,520 $ 10,523,440 $ 10,518,467 $ 11,780,683
Variable Expenses:
Food 6,362,772 6,340,206 6,347,728 7,109,455
Labor 700,336 696,612 697,853 697,853
Other Operating Expenses 1,333,701 1,362,399 1,352,833 1,352,833
Total Variable Expenses 8,396,809 8,399,217 8,398,414 9,160,142
Contribution Margin 2,111,711 2,124,223 2,120,052 2,620,541
Fixed Expenses:
Labor 300,144 298,548 299,080 299,080
Other Operating Expenses 889,134 908,266 901,889 301,889
Depreciation Expense (included above) (included above) (included above) 600,000
Amortization of Goodwill NA NA NA 166,667
Total Fixed Expenses 1,189,278 1,206,814 1,200,969 1,367,635
Operating Income 922,433 917,409 919,084 1,252,906
Tax 368,973 366,964 367,633 501,162
Net Operating Income After Tax $ 550,445 $ 550,445 $ 551,450 $ 751,743
Net Cash Flow $ 1,518,410
10. December 17, 2014
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Pete’s Steakhouse:
Projected Operating Expenses as a Percentage of Net Sales
78%
12%
4%
6%
Overview of Operating Expenses
as a Percentage of Sales
Total Variable Expenses
Total Fixed Expenses
Tax
Net Operating Income
60%
6%
12%
3%
5%
3%
1%
4%
6%
Detailed Operating Expenses
as a Percentage of Sales
Variable Food
Variable Labor
Other Variable Operating
Fixed Labor
Depreciation
Other Fixed Operating
Amortization of Goodwill
Tax
Net Operating Income
12. December 17, 2014
Page 12
Option 2: Knoxville Production Facility
Investing in the Knoxville production facility will cost a total of $10 million, $7.5 million in building and $2.5
in equipment. This investment will add $6.2 million to the value of your business. An 8.5% rate of return,
instead of 8%, was applied to this analysis due to the similar risk nature of your current operations but in a new
location. The facility will provide an expected return on investment of 13.8%, a payback period of just over 7 ¼
years, and residual income of $528,000.
Investment Valuation and Return Measures
Average Net Cash Flow $1,377,504
Initial Cost $10,000,000
Expected Earnings (8.5%) $ 850,000
Residual Income $ 527,504
Return on Investment 13.78%
Payback Period (in year) 7.26
NPV (assuming perpetuity) $ 6,205,928
Key Assumptions
Average Estimated Useful Life of Building 39.5 years
Average Estimated Useful Life of Equipment 7 years
Estimated Sales Price Increase 5%
Inflation Rate 1.5%
Tax Rate (Federal and State) 40%
Cost of Capital (expected return) 8.5%
Other Assumptions and Further Explanation
An 8.5% cost of capital was applied instead of 8% due to the similar risk nature of your current
operations, but in a new location
A 5% estimated increase in sales was used to estimate total sales revenue after the third year of
$10,000,000 in revenue.
Fixed costs will not increase directly and proportionately with sales: average inflation is 1.5%.
Fixed costs will decrease relative to overall sales percentage.
13. December 17, 2014
Knoxville Facility:
Cash Flow Valuation
Year Sales Total Cost EBIT
Cash Paid
for Taxes
(Note A)
Net Income
Net Op. Cash
Flow
Year 1 $ 4,000,000 $ 3,765,794 $ 234,206 $ 37,151 $ 197,055 $ 611,928
Year 2 6,000,000 5,238,481 761,519 136,236 625,283 1,040,157
Year 3 10,000,000 8,697,596 1,302,404 396,791 905,613 1,320,486
Year 4 10,500,000 9,083,560 1,416,440 483,782 932,659 1,347,532
Year 5 11,025,000 9,488,088 1,536,912 560,120 976,792 1,391,665
Year 6 11,576,250 9,912,098 1,664,152 606,435 1,057,717 1,472,590
Year 7 12,155,063 10,356,553 1,798,509 655,341 1,143,168 1,558,042
Year 8 12,762,816 10,822,463 1,940,352 747,580 1,192,772 1,607,646
Year 9 13,400,956 11,310,890 2,090,066 842,684 1,247,382 1,662,256
Year 10 14,071,004 11,822,948 2,248,056 900,193 1,347,864 1,762,737
Average Cash Flow $ 1,377,504
Cash Paid For Taxes Determination
A B C A+B-C G F-G (Note A)
Book Annual Tax DPA 9% of F 40%
EBIT Depreciation Depreciation Income DPAD* Taxable Tax
Year 1 $ 234,206 $ 414,873 $ 547,016 $ 102,063 $ 9,186 $ 92,877 $ 37,151
Year 2 761,519 414,873 802,118 374,274 33,685 340,590 136,236
Year 3 1,302,404 414,873 627,191 1,090,086 98,108 991,978 396,791
Year 4 1,416,440 414,873 502,243 1,329,070 119,616 1,209,454 483,782
Year 5 1,536,912 414,873 412,995 1,538,790 138,491 1,400,299 560,120
Year 6 1,664,152 414,873 412,995 1,666,030 149,943 1,516,088 606,435
Year 7 1,798,509 414,873 412,995 1,800,388 162,035 1,638,353 655,341
Year 8 1,940,352 414,873 301,434 2,053,792 184,841 1,868,950 747,580
Year 9 2,090,066 414,873 189,873 2,315,066 208,356 2,106,710 842,684
Year 10 2,248,056 414,873 189,873 2,473,056 222,575 2,250,481 900,193
*DPAD = Domestic Production Activities Deduction
14. December 17, 2014
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Knoxville Facility:
Annual Depreciation Calculation
Equipment Depreciation (Double-Declining)
Depreciation
Expense
Total
Accumulated
Depreciation
Ending value
Annual
Depreciation
(Equip. + Build.)
Year 0 $2,500,000
Year 1 $ 357,143 $ 357,143 $2,142,857 $ 547,016
Year 2 612,245 969,388 1,530,612 802,118
Year 3 437,318 1,406,706 1,093,294 627,191
Year 4 312,370 1,719,075 780,925 502,243
Year 5 223,121 1,942,197 557,803 412,995
Year 6 223,121 2,165,318 334,682 412,995
Year 7 223,121 2,388,439 111,561 412,995
Year 8 111,561 2,500,000 - 301,434
Year 9 2,500,000 - 189,873
Year 10 2,500,000 - 189,873
Building Depreciation (Straight-Line) $ 189,873
16. December 17, 2014
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Portfolio Management
Has movement into the restaurant industry always been your passion? If so, you should reconsider your
current objective of only producing high-quality, customized pies. Pete’s Steakhouse allows you to
diversify into a new industry with a broad scope of customers. Expanding the scope of your operations
will be challenging and is ultimately changing the scope of your company.
If you wish to continue to grow your current operations and expand market share within the pie industry,
we recommend investing in the new production facility. This facility allows you to concentrate
organizational resources in your primary line of business, share existing resources, and exploit
synergies.
Integration Patterns, Industry Differentiation, and Growth Strategies
Pete’s Steakhouse
Purchasing a restaurant creates a minor vertical move for you into the service industry. In the service
industry, you will have direct exposure to customers, both their loyalty and caprices; and will also need
a strong emphasis on human resources and expertise to address the customer service component. You
will have to train your employees to pay attention to detail and establish an overall understanding of
how to compete in this industry. Therefore, developing market knowledge is critical to success. In
addition, you should understand the connection between customers’ desires, competitors’ offerings, and
how to obtain customers with effective marketing and advertising techniques.
In order to remain profitable in the restaurant industry, it is essential to maintain risks of overhead
fluctuations regarding labor costs, retain high-quality employees, and sustain adequate working capital.
We believe acquiring a line of credit for $3,000,000 is sufficient for 90 days of expenses for Pete’s
Steakhouse.
Knoxville Facility
On the other hand, you have already experienced success in the pie manufacturing industry. If you
purchase the Knoxville facility through horizontal integration, you will be able to better define your
business in the production industry. Another facility would double current production capacity. From
having the ability to mass produce products, you will see the creation of a sustainable competitive
advantage. Also with the additional space, you will have the future capabilities to start new product lines
for healthier products, thus targeting more health-conscientious consumers.
Since the Knoxville facility is well-positioned along distribution routes, you can focus on increasing
sales volume and market share with existing products. You will either benefit from penetrating the
market with additional marketing and promotional programs or could pursue more assertive sales efforts
to obtain a larger market share.
An important risk factor to consider when analyzing new markets, however, is that at some point the
market may become saturated, meaning that all of the customers interested in your product have been
satisfied by you or an existing competitor.
17. December 17, 2014
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Life Cycle Stage
Behavioral factors may also affect the future performance of a company, so it is important to determine
where your organization exists in the product life cycle. This will help you further understand the
dynamic nature of the strategy you choose because as your company evolves, your strategies must also
adapt to changes in the environment.
Pete’s steakhouse has evolved into the maturity stage of the life cycle and will face increasingly high
levels of competition. Pete’s becomes the restaurant for competitors to beat. By purchasing the chain,
you will be pressured to innovate and adapt to changes to outperform competitors in meeting
consumers’ expectations.
Your current operations are still in the growth stages of the life cycle. The primary focus in this stage is
to concentrate resources in a manner that will sustain sales growth and enhance your reputation. Once
again, the risk here is that new competitors will continue to enter the market, and you will have to
modify practices to compete with them.
Agency Costs
Agency costs are another behavioral factor to consider. By pursuing the steakhouse acquisition, your
business will be divided between five restaurants and the original Charlotte plant. With facilities
scattered, it will be difficult to adequately train and manage employees and staff the restaurants to
achieve organizational goals while controlling costs. Example agency costs would be establishing
incentives for management and company employees to align their performance with company values.
The Knoxville facility allows you to focus on two factories, which may even decrease agency costs.
Monitoring and motivating employees will be less difficult with the concentration of company
operations.
Supply Patterns
Supply chains are perhaps the biggest technical factor to consider in choosing between these options.
Purchasing a new factory will allow you to continue to utilize your established relationships with
suppliers. By increasing production volume and using economies of scale, you will have more leverage
with suppliers to renegotiate lower prices and see an increase in contribution margin percentages.
Pursuing the steakhouse will give you the option to utilize the previous owner’s supply channels or to
choose different methods. Some risk factors are inherent with this decision. A lack of current prior
industry experience may make it difficult to assess the best suppliers for items such as steaks and
potatoes. In addition, products prone to price fluctuation such as steaks could lower profit margins down
the road.
18. December 17, 2014
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Critical Success Factors
Recommendation
As you can see through the Financial Analysis, Pete’s Steakhouse provides a higher rate of return than
the Knoxville plant, but with a higher degree of risk. As your conservative financial consultants we
advise you to choose the Knoxville plant option. The plant is more strategically aligned with your
current objectives and provides sustainable competitive advantages.
Given the similarities in potential, what is your passion? If your passion is to provide outstanding
desserts to your customers, purchase the Knoxville plant, and continue to expand your current
operations. However, if your passion is to cook and serve customers in the restaurant industry, acquire
Pete’s Steakhouse.
Follow your dreams and success will follow you!
