Expert Answer :11 PAPER 1 QUESTION 4 50 marks Your client, Mr Abr

Solved by verified expert :11PAPER 1QUESTION 4 50 marksYour client, Mr Abrahams, is keen to purchase the business of Delight Coffee Shop and hasrequested your assistance in evaluating the business and negotiating his purchase thereof.Delight Coffee Shop commenced trading on 1 March 2001 in a suburban shopping centre inMorningside, Sandton. DCS (Pty) Ltd was incorporated on 27 February 2001 to own the operations ofDelight Coffee Shop. A five-year lease agreement was entered into with the owner of the shoppingcentre. The business has traded profitably since inception, and has developed a reputation for servingfine food and coffee. The sole shareholder of DCS (Pty) Ltd, Mrs Strand, wishes to sell the businessas she intends relocating to Cape Town in the near future.The initial cost of all equipment as well as the furniture and fittings for the coffee shop totalledR450 000. This was financed by means of a four-year term loan obtained from MSD Bank andsecured by a personal suretyship from Mrs Strand. DCS (Pty) Ltd was also required to pay a twomonthrent deposit of R30 000 to the landlord, refundable at the termination of the lease agreement.Mrs Strand paid the rent deposit personally and was refunded by DCS (Pty) Ltd in July 2001.Mrs Strand has managed Delight Coffee Shop since its inception. She is confident that the businesswill continue to thrive as it has many regular customers. In addition, the shopping centre in which thecoffee shop is located attracts significant passing trade on a daily basis. The employees arecompetent and have been with the business since inception. Delight Coffee Shop currently has fivepermanent employees who deal with food preparation as well as four waiters to serve customers.While the waiters receive only minimal monthly wages, they may keep tips received from customers.These tips are usually generous and waiters perceive that they earn adequate compensation for theirefforts.Mrs Strand is satisfied with the internal controls in place over ordering and purchasing, foodpreparation and daily banking. Her only concern relates to the operation of the till and completenessof revenue. Waiters take customer orders and record these in duplicate on pre-printed order pads,which are not pre-numbered. One copy of each order is passed to the kitchen and the duplicate slip isretained by the waiter. Beverages and meals are then collected from the kitchen by waiters anddelivered to customers. Upon completion of meals, waiters manually calculate and enter individualamounts on the cash register. Till slips, which record individual amounts of food and beverage itemsand the total due by the customer, are then presented to the customer for payment. Till slips do notstate the actual food and beverage items, but simply the individual amounts, the total and the VAT.Customers can pay in cash or by credit card. Waiters have full access to the cash register to depositcash and obtain change for customers. Waiters can also operate the credit card machine to processelectronic payments. At the end of each day, waiters place their copies of customer orders in a filingtray next to the cash register, while kitchen employees destroy their copies of customer orders.Mrs Strand computes the theoretical cash balance per the cash register at the close of business on adaily basis. The theoretical cash balance is determined as follows:R’000Opening cash float xxxAdd: Daily sales per printout obtained from cash register xxxLess: Purchases paid for using cash in till -xxxLess: Sales paid for by credit cards -xxxTheoretical closing cash balance xxxThere are rarely any material differences between the actual and the theoretical cash. Mrs Strandmanages the daily operation of Delight Coffee Shop and is physically present most of the day. MrAbrahams has decided that he will need to employ somebody to manage the operations of DelightCoffee Shop at a cost of R5 000 per month, as he himself will not be physically present in the coffeeshop for more than two hours each day.12DCS (Pty) Ltd has outsourced the accounting functions of the business and the preparation ofmonthly and annual financial statements to its auditors. The audited annual financial statements ofDCS (Pty) Ltd for the year ended 28 February 2002 and the draft annual financial statements for theyear ended 28 February 2003 are available for review. These financial statements have not yet beensigned off, because of unresolved queries from the audit partner regarding the provisions for taxation.Financial information per the draft annual financial statements of DCS (Pty) Ltd:ABRIDGED INCOME STATEMENTS FOR THE YEARS ENDED 28 FEBRUARY2003 2002R RTurnover 1 120 882 1 014 504Cost of sales 460 729 385 324Opening inventory 15 843 –Purchases 461 334 401 167Closing inventory (16 448) (15 843)Gross profit 660 153 629 180Operating expenses 488 587 454 489Accounting fees 19 260 18 000Bank charges 24 659 21 305Depreciation 77 018 83 250Petrol 14 405 12 857Rent 201 600 180 000Wages 137 820 127 167Other expenses 13 825 11 910Operating profit 171 566 174 691Net interest expense 39 054 56 775Profit before taxation 132 512 117 916Taxation 39 754 35 375Profit after taxation 92 758 82 541ABRIDGED BALANCE SHEETS AS AT 28 FEBRUARY2003R2002RASSETSNon-current assetsFurniture and fittings, equipmentCurrent assets289 732189 539366 750124 056InventoryTrade and other receivablesBank balances and cash16 44843 450129 64115 84338 45169 762Total assets 479 271 490 806EQUITY AND LIABILITIESCapital and reservesNon-current liabilitiesInterest bearing borrowingsCurrent liabilities175 300138 755165 21682 542258 294149 970Trade and other payablesTaxationCurrent portion of interest bearing borrowings13 84031 837119 53911 61135 375102 984Total equity and liabilities 479 271 490 80613Mrs Strand wishes to sell the business of DCS (Pty) Ltd as a going concern (as opposed to selling theshares in the company) for R581 350 with effect from 1 March 2003. The business of Delight CoffeeShop is to be sold excluding interest bearing liabilities, cash resources and the rent deposit. Thetangible assets of the business to be sold comprise fixed assets, inventory and trade receivables.Trade payables are to be for the account of Mr Abrahams. Mrs Strand’s calculation of the purchaseprice was determined as follows:ROperating profit for the year ended February 2003 171 566Add back: Personal expenditure charged through the businessPurchases of groceries charged to cost of sales 28 883Other personal expenditure charged to operating expenses 29 280Petrol expenses 8 880Wages paid to Mrs Strand’s domestic worker 20 400Restated operating profit 229 729Restated operating profit multiplied by 2,4 551 350Rent deposit 30 000Purchase price for the business 581 350Mrs Strand has not earned a salary from DCS (Pty) Ltd since the business started. She did notcharge any personal expenditure through the business in the 2002 financial year. Depreciationcharged to the income statement is equivalent to wear and tear allowances that may be claimed interms of the Income Tax Act.Mr Abrahams has confirmed that the average purchase price of coffee shops in the northern suburbsof Johannesburg is usually determined as between 2,3 and 2,5 times the historical operating profit.He reached this conclusion from his dealings with various business brokers over the past six months.The other common method for determining the purchase price for a coffee shop is to discount the netcash flow generated in a normal trading year, before financing activities, at 40%.REQUIRED(a) Advise Mr Abrahams regarding what purchase price he should offer for the business of DelightCoffee Shop. Support your advice with detailed workings and consider the various methods fordetermining a fair purchase price. (22)(b) List and discuss the key issues to be clarified and resolved by Mr Abrahams in concluding thepurchase arrangement between DCS (Pty) Ltd and himself. (18)(c) Advise Mr Abrahams of any apparent weaknesses in internal controls in the operation ofDelight Coffee Shop. Describe what procedures could be implemented to address theseweaknesses. (10)