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ELECTIVE (PERFORMANCE MANAGEMENT): Elective examinations will be 3 hours in length. Candidates will be given 4 hours to complete the examination, providing an extra hour to formulate their responses. The intention is to reduce the time constraint. The Elective examinations will be made up of a mix of objective-format questions and cases. The split and length may vary somewhat across the Electives to adapt to learning outcomes required. Elective examinations use larger and more complex cases than those used for Core 1 and Core 2, requiring a minimum of 60 and a maximum of 120 minutes to complete. The assessment of professional skill will continue in a multi-competency environment, always building on prior learnings, however, greater than 50% of assessment opportunities will be related to the Elective area being examined. Elective cases require candidates to simulate the “roles” they will play in real life, and therefore access will be provided to the reference tools they would use, where practical to do so. Below is an example of a longer case that is focused on the Performance Management competencies, drawing heavily on Core Finance competencies.
ROMACORRAL FOODS LTD. Suggested Time: 120 minutes (represents the time judged necessary to complete the question) Overview RomaCorral Foods Ltd. (RCFL) is a Canadian public company listed on the Toronto Stock Exchange (TSX) but controlled by its parent company – Entertainment, Food, and Leisure PLC (EFL), a British public company listed on the London Stock Exchange (LSE). The parent company reports under International Financial Reporting Standards (IFRS). RCFL owns and operates two chains of restaurants in Canada. One chain specializes in Italian cuisine (Roma Italian) and the other in mid-level steak house cuisine (Corral Steak House). History Parent Company – Entertainment, Food, and Leisure PLC (EFL) EFL is one of the largest companies in the hospitality business worldwide. The company’s European operations include a few hotel chains, several restaurant chains, and a chain of coffee shops. In Canada, EFL owns 75% of the common shares and all of the preferred shares of RCFL. RomaCorral Foods Ltd. (RCFL) RCFL operates under the following mission statement:
RomaCorral Foods Ltd. provides Canadian consumers with excellent food and refreshments at good value and in comfortable, relaxing surroundings while providing its investors with above-average returns through operational efficiency and selective, aggressive growth. In addition, RCFL adopted the following vision statement: RomaCorral restaurants are the preferred choice of North American consumers seeking high-quality food and refreshments at affordable prices. As of June 30, 2014, there were 70 Roma Italian (Roma) restaurants and 24 Corral Steak Houses (Corral) restaurants in mid- to large-sized cities throughout Canada.
In late 2014, Raymonde Plante became CEO of RCFL. Plante felt it would be wise to revisit RCFL’s operating strategies and, together with the board of directors, developed a high-level environmental scan (see Appendix 1). The Canadian Food Service Industry The food service industry is a large, dynamic, and innovative sector of the Canadian economy. The main segments in the food service industry and their market shares (shown as percentages) are as follows: 1. Full-service restaurants (35%) – Licensed and unlicensed fine-dining, mid-level, casual, and
family restaurants as well as restaurant/bar combinations. 2. Limited service restaurants (34%) – Quick-service (fast-food) restaurants, coffee shops,
cafeterias, food courts, and takeout and delivery outlets. 3. Social and contract caterers (6%) – Caterers supplying food services to institutions, airlines,
railways, recreational facilities, and special events. 4. Other food service providers (25%) – Bars, hotels, motels, resorts, hospitals, schools, prisons
and other institutions, department store cafeterias, vending machines, stadiums, movie theatres, street vendors, private clubs, seasonal entertainment operations, etc.
The following are considered the main reasons for a restaurant’s success: appropriate location and offerings for the target market, consistent quality of food and service, and effective capitalization. Supply chain management is essential to ensure high-quality food while controlling costs. Scheduling is another important factor in cost control, given that labour must correspond to demand. Individual restaurants have a wide range of operating results, as shown in the following table: Restaurant Financial Data as a Percentage of Sales – Industry Ranges
Food, beverages, and other direct materials 25% to 40%
Wages and benefits 25% to 40%
Operating expenses 7% to 13%
Occupancy expenses (rent, insurance, utilities, etc.) 4% to 14%
General and administrative expenses 1% to 5%
Income (loss) before interest, amortization, and taxes (1.5%) to 19%
Average net profit margin in the Canadian food service industry slowly improved from a low of 3.2% in 2007 to 4.5% in 2010 before declining to 4.3% in 2011.
RCFL Operations The organizational chart of the management team is contained in Appendix 2. Restaurant Operations – General Most of the Roma and all of the Corral restaurants are located near, or within, suburban shopping areas in mid- to large-sized Canadian cities. Most RCFL restaurants are served by public transportation and have sufficient no-charge parking nearby. RCFL restaurants are open six days per week for both lunch and dinner and on Sundays for dinner only. As is typical of full-service restaurants, RCFL outlets tend to be quiet on Mondays and become busier as the week progresses, with Sunday business being somewhat unpredictable. Each restaurant has a manager who is responsible for his/her restaurant’s operation. The RCFL head office is responsible for implementing and maintaining information and accounting systems, developing the corporate-wide supply chain, providing training support as needed, processing payroll, building new outlets, evaluating manager and restaurant performance, facilitating major repairs or renovations, maintaining insurance, developing chain-wide advertising and promotions, conducting internal audits, arranging for external audits, and managing corporate banking. Head office is also responsible for setting menus and prices. Both Roma and Corral outlets are considered busy restaurants. Most outlets operate at about 80% of their practical maximum capacity which is considered good in the industry. For purposes of evaluating the performance of the individual outlets in each chain, a benchmark is set at the average monthly sales per seat achieved by the restaurant with the highest annual sales in that division. Each outlet is expected to achieve at least 85% of this benchmark, as well as a target net profit margin set by head office each year. Compensation and Staffing At the restaurant level, RCFL pays competitive wages for managers, assistant managers, and kitchen workers and slightly more than minimum wage for bartenders, servers, and hosts/hostesses. Annual management bonuses for each restaurant are based on achieving the target average monthly sales per seat (i.e. at least 85% of the benchmark) and the target net profit margin. It is not difficult to hire staff for RCFL restaurants, but many of the better servers leave after a few years. This is puzzling because their restaurants are among the busiest in the industry, and servers’ tips tend to be higher at RCFL outlets than at most other restaurants.
Banking RCFL has used the Capital Bank of Canada (CBC) and they have built a good working relationship. CBC provides RCFL with 75% mortgage financing on each land and building purchase for a new restaurant, as well as a line of credit to a maximum of 50% of the total of accounts receivable and inventory. The line of credit is offered at the prime rate, and the mortgages at 0.5% below the bank’s basic long-term mortgage interest rate. As a company listed on the TSX, RCFL must submit annual, audited financial statements. (See Appendix 3) Current Situation As a result of the economic recession that began at the end of 2014, Canadian consumers continued to reduce discretionary spending in the first six months of 2015. Sales at Canadian restaurants fell, and experts predict that 2016 revenues will drop by 2.5%. Sales at full-service restaurants are expected to show the largest decline (3%) as cost-conscious consumers switch to limited-service restaurants, where sales are expected to decline less severely (1.5%). Many full-service restaurants with prime costs (direct materials and labour) greater than 65% of sales recorded losses in the first half of 2015. Some steak houses in Canada, which generally have higher prime costs than Italian restaurants, went out of business. In contrast, sales at coffee shop chains, which have higher prime costs (68%-72%) increased in the first half of 2015 and are predicted to remain relatively strong, resulting in an average increase in sales of 2% per year over the next two years. In fiscal 2015, RomaCorral Foods Ltd. (RCFL) experienced a 1.5% decrease in average annual sales per restaurant but an increase in overall sales as a result of opening six new restaurants. Overall profits increased, and RCFL paid a dividend of $2 per share on both the common and preferred shares. The EFL board of directors reduced its expectations for RCFL’s growth in net income after taxes. Instead of a growth rate of 20% per year, the board indicated it required RCFL to achieve an after-tax net profit growth rate target of 5% over the next two years (i.e. net income of $42,901,583 in fiscal 2017) and to pay a dividend of $2 per share annually on both common and preferred shares. The board also indicated that EFL would not be able to provide RCFL with any financing for at least the next three years. Senior Staff Meeting – July 2015 Plante assembled the senior staff to discuss possible Roma expansion onto the parcels of land that RCFL has options on.
Singh informed the group that RCFL currently holds options on parcels of land in locations that would be very suitable for opening 7 Roma outlets. Each option, which cost $50,000 at the end of 2013 (shown separately on the statement of financial position), gives RCFL the right to purchase the designated parcel of land for an additional $550,000 before January 1, 2016, at which time the options will lapse. The 2015 average income per restaurant in operation for more than one year and the performance targets for each division are highlighted in Appendix 4. During 2015, all restaurants met the sales target and most met the net profit margin target. Plante indicated that he expects the economy to stabilize soon and that the average sales per restaurant will remain at the fiscal 2015 levels in the foreseeable future. He also indicated that January 1, 2016, is the earliest any new restaurant could be ready to open. He expressed his concern in opening new restaurants without EFL’s financial support and provided the following summary of the required capital investments for each new restaurant:
Roma Outlet
Land (including cost of option) $ 600,000 Building $ 4,500,000 Furniture and equipment $ 1,000,000
The seven locations for proposed Roma outlets would not be suitable for steak houses. Initial promotional campaigns for the new Roma restaurants would cost approximately $50,000 per outlet. 1. In addition to providing RCFL with 75% mortgage financing for new land and buildings, CBC
is willing to refinance the existing mortgages (without a penalty) for up to 75% of the fair value of the land and buildings of existing restaurants, provided that the ratio of long-term debt (including the current portion) to equity does not exceed 2 to 1. As of June 30, 2015, the net fair value of RCFL’s land and buildings was approximately $405 million. The bank will charge RCFL 4% annual interest on its line of credit and issue new or refinanced mortgages (5-year term, amortized over 25 years) at 3.5%.
2. RCFL uses a discount rate of 10% after taxes and a 20-year time horizon for evaluating
investments in restaurants. Land values are expected to double in 20 years and the fair values of other assets are expected to equal their book values.
Required: As Alicia King, CPA, analyze the current situation of RomaCorral Foods Ltd., update the environmental scan, analyze the expansion alternative facing RCFL, and prepare a report for the senior management team advising them on the strategies to follow in order to meet the targets imposed by the parent company, EFL.
SELECTED FINANCIAL DATA FOR A ROMA RESTAURANT For the year ended June 30, 2015
(in thousands of dollars-except target average monthly sales per seat)
Roma1 Sales $ 3,197
Food and beverages 902 Salaries, wages and benefits 869 Other variable costs 8
5
Total variable costs 1,856
Contribution margin 1,341
Facilities (excluding amortization) 140 Selling, local advertising and promotion 21 General and administration 54 Depreciation – building 81 Depreciation – furniture and equipment 98 Head office allocation2 291
685
Income before taxes 656 Income taxes (40%) 26
2
Net income $ 394
Number of seats 200 Target average monthly sales per seat3 $ 1,231 Target net profit margin 12%
1 Amounts represent the average sales and expenses for restaurants that have been
operating for more than one year. 2 Head office costs (including regional office costs) are allocated evenly to the individual
outlets. Total head office costs were $27,456,000 in fiscal 2014 and $29,071,000 in fiscal 2015. These costs are expected to be $31,200,000 in fiscal 2016 and $32,600,000 in fiscal 2017.
3 The target average monthly sales per seat for performance evaluation purposes is set at 85% of the benchmark. The benchmark is set at the average sales per seat achieved by the restaurant with the highest annual sales in that division.
This case focuses on candidates’ ability to analyze a situation and then to analyze the strategic options presented and suggest a course of action that is consistent with their analysis. This particular case also draws heavily on candidates Core Finance skills for their quantitative analysis. Candidates are expected to use their judgment in assessing which issues are the most relevant and to what extent these issues should be analyzed.
SITUATIONAL ANALYSIS
Assessment Opportunity #1 The candidate performs a detailed environmental analysis.
CPA Mapping Core PM-Elective
2.3.1 Evaluates the entity’s strategic objectives and related performance measures
B A
2.3.2 Evaluates the entity’s internal and external environment and its impact on strategy development
B A
The following tables list the points candidates are expected to present.
Mission: RomaCorral Foods Ltd. provides Canadian consumers with excellent food and refreshments at good value and in comfortable, relaxing surroundings while providing its investors with above-average returns through operational efficiency and selective aggressive growth.
Vision: RomaCorral restaurants are the preferred choice of North American consumers seeking high-quality food and refreshments at affordable prices.
Strategic Goals:
Achieve an after-tax net income growth rate target of 5% over the next two years (i.e. net income of $42,901,583 in fiscal 2017). Pay a dividend of $2 per share annually. Obtain an average return on investment of 10%.
Stakeholders’ Preferences:
Singh Indicated that options on parcels of land that would be suitable for opening Roma outlets.
Plante Questioned the feasibility of opening new restaurants without any financing from EFL.
Key success factors Location Menu Food and service quality Capitalization Supply chain management Scheduling of labour
Constraints The bank is willing to refinance the existing mortgages for up to 75% of fair value of land and buildings of existing restaurants, provided that the ratio of long-term debt to equity does not exceed 2 to 1.
Environmental Scan/SWOT Analysis: The following are some additional SWOT points that candidates may provide in their responses.
Strengths Weaknesses
Overall profits increased for RCFL and all restaurants met the sales target and most met the net profit margin target.
RCFL holds options on 12 parcels of land. Bank will refinance the existing mortgages
for up to 75% of the fair value of the land and buildings.
Many full-service restaurants with prime costs (direct materials and labour) greater than 65% of sales recorded losses. RCFL prime costs are less than 65%.
EFL would not be able to provide financing for three years.
Head office costs are allocated evenly to the individual outlets.
RCFL experienced a 1.5% decrease in average annual sales per restaurant.
Annual management bonuses are based on achieving the target average sales per seat and the target net profit margin; weakness is that there are no qualitative measures for performance evaluation.
RCFL outlets tend to be quiet on Mondays
Opportunities Threats
Plante indicated that she expects the economy to stabilize soon.
Restaurant revenues will drop by 2.5% in 2016.
Sales at full-service restaurants are expected to show the largest decline (3%).
Cost conscious consumers are expected to switch to limited-service restaurants.
Sales at limited-service restaurants are only expected to decline 1.5%.
Mission/Vision Consistent with the mission/vision?
Goals Meets goals?
Stakeholder Needs/Preferences
Stating if an alternative does or does not meet a specific stakeholder’s need or preference.
Constraint E.g. Calculating the debt: equity and comparing it to the bank’s constraint of 2:1.
KSFs In order to link to a KSF, it must be valid and considered in the analyses of the alternatives.
Strengths Option/issue strengthens or uses a strength.
Weaknesses Option/issue must:
1. address how the alternative/ action will solve the weakness, or
2. use the weakness for justification of not doing something, or
3. discuss how the alternative/option will worsen an existing weakness.
Opportunities Must indicate how alternative/option takes advantage of the opportunity.
Threats Must use the threat as a justification for not doing something or must indicate how the option/action would address a threat.
Financial Assessment:
Assessment Opportunity #2 The candidate performs a financial analysis of the company (part of environmental scan).
Also draws on Core competencies in Finance:
5.1.1 Evaluates the entity’s financial state (i.e. ratio analysis, benchmarking, etc.)
B NA
The following are some points that may be made in discussing the current financial situation of the company (either in the SWOT analysis or in a separate financial assessment section or in the analysis of the issues). Ratio Analysis: Liquidity is low (although not completely unexpected given that the majority of restaurant
sales would be cash/credit card leaving the receivables lower than in a traditional business which impacts the current assets).
Coverage appears to be adequate, below the bank’s benchmark of 2:1. Inventory turnover has been declining which is a concern in the restaurant industry where
good-quality food is of importance. Accounts receivable turnover is low, staying steady at just over 3.32 days which is expected
due to the cash nature of the business. Revenues are growing, and profitability ratios remain steady.
Benchmarks – See Appendix 1: Food and beverage cost of sales, restaurant salaries, wages and benefits, facilities
expenses, general and administrative expenses and operating expenses are all well in line with the industry benchmarks.
Income before interest, depreciation and tax, and net margin are both well above the industry benchmarks.
Prime costs are lower than the benchmark. Net income and revenue growth both exceed the benchmarks. Overall, RCFL appears very efficient operationally as compared to industry benchmarks and is growing faster and more profitably than its peers. Analysis of Strategic Alternatives
Assessment Opportunity #3 The candidate assesses the strategic alternatives.
CPA Mapping Core Elective
2.3.3 Evaluates strategic alternatives B A
Also draws on Core knowledge in Finance:
3.5.1 Performs sensitivity analysis A N/A
5.1.2 Develops or evaluates financial proposals and financing plans
B N/A
5.2.3 Evaluates sources of financing B N/A
5.2.5 Evaluates the entity’s cost of capital B N/A
Net income shortfall calculation – See Appendix 1 RCFL will need to overcome a $6,106K shortfall to meet its goal of $42,902K net income in
2017. The following are some relevant decision analysis concepts and tools that could be applied in the quantitative analyses of the strategic alternatives: Cost and revenue analysis
Relevant revenues, costs, contribution margins, opportunity costs, cash flows, break even, and/or net income are appropriately calculated and interpreted for the alternatives or for the recommended strategy. Assumptions are clearly indicated and are reasonable.
After-tax net income for 2016 The incremental or total after-tax net income is calculated for the alternatives or for the recommended strategy and compared to the target (i.e. $41,863,800 for RCFL overall). The increase in head office costs is included in the calculation of the required incremental income for 2016 or in the calculation of total 2016 net income for each alternative or for the recommended strategy. Capital budgeting / discounted cash flow analysis Appropriate capital budgeting or discounted cash flow analysis methods (e.g. net present value, internal rate of return, capital rationing) are applied correctly in analyzing the alternatives. For example, the following are included in the analysis: (i) appropriate operating cash inflows and outflows for each year, capital costs and other one-
time cash flows (non-cash items and interest are not included); (ii) consideration of the time value of money using the 10% after-tax rate over 20 years; (iii) after-tax cash flows; and (iv) calculation of CCA tax shields on capital cost using a reasonable CCA rate (e.g. 4% for
buildings and 20% for furniture and equipment). Note that candidates’ quantitative analyses may be very different, given the different assumptions they will make in preparing them (e.g. assumptions regarding prices, sales volumes, etc.). Their assumptions should be clearly stated and generally consistent with the case information. Other Quantitative Issues Other quantitative tools are applied appropriately in the response, such as the following: Financing required and available The financing required for the strategic alternatives and dividends ($16M) and the financing available [e.g. remortgage current properties (75% x current value – current mortgage outstanding), mortgage of new properties (75% x building and land costs for new outlets), line of credit (50% of accounts receivable and inventory), cash flows generated from future operations] are calculated and compared for each alternative and/or for the recommended strategy. Financial forecast A financial forecast for one or more years that incorporates the expected effects of the major recommendations is prepared. This can be in the form of a pro forma income or cash flow statement, or a pro forma balance sheet.
Assessment Opportunity #4 The candidate recommends an appropriate course of action (consistent with analysis).
2.2.1 Assesses whether management decisions align with the entity’s mission, vision, and values
B A
2.4.1 Analyzes the key operational issues and alignment with strategy
B A
For this case, support should include quantitative analysis that proves that the recommended actions would provide the following (i.e. integration of the constraints and goals, etc): 1. EFL’s target of a 5% growth in after-tax net income over the next two years (i.e.
$42,901,583 in fiscal 2017) will be met.
2. The bank’s constraint that the long-term debt (including the current portion) to equity ratio does not exceed 2 to 1 will be met.
3. RCFL will be able to acquire the financing required to implement the recommended strategy. 4. A 10% after-tax rate of return over 20 years will be achieved for the recommended capital
investments.
5. Sufficient cash flows will be generated to enable an annual dividend payout of $2 per share (i.e. $16 million).
Sample Analysis The following appendices provide sample analyses to assist the markers in recognizing valid points and calculations made by candidates.
This would let RCFL exercise its options on 12 parcels of land in suitable locations (S).
This would let RCFL spread its growing head office overhead over more locations (W).
Has a positive net present value over the next twenty years (see Appendix 2, Figure 1) – the expected NPV is $5,988K.
Additional net profit exceeds net income goal by $872K (see Appendix 2, Figure 3) (G).
1.70:1 D:E would not exceed requirement from the bank (Appendix 2, Figure 4) (C).
RCFL has strength in experience and expertise in management and operation of Roma and Corral outlets (S).
Expanding outlets would build upon a recognized strength for a good reputation for quality food at reasonable prices (S/KSF/M).
Expansion could also take advantage of increasing consumer away from fine-dining (O).
High wheat prices increase the cost of pasta, which squeezes margins at Roma outlets (T – for Roma).
Sales at full-service restaurants are expected to show the largest decline (3%) which would impact success (T).
There is a continuing threat of high competition in all food service markets, which is exacerbated by the overall decrease in sales at Canadian restaurants in first half of 2015 and forecast decline in sales at full-service restaurants (T).
RCFL would not be able to immediately undertake a full expansion (12 stores), owing to financing constraints (see Appendix 2, Figure 2).
M: Mission V: Vision G: Goals C: Constraint K: Key success factor S: Strength W: Weakness O: Opportunity T: Threat A1: Alternative 1 A2: Alternative 2 TG: Target SP: Stakeholder’s preference APPENDIX 3 DIVIDEND CONSIDERATIONS Candidates should also consider the payment of the dividend in their recommended strategy. A basic calculation showing the cash flow/income generated and comparing it to the $16M dividend required is sufficient. If pro forma statements are prepared, this dividend payment may/should also be reflected here for reference.