Core Fitness plc, a London based health and fitness chain is an associate undertaking of Core Wellbeing Plc, a leading international health & leisure corporation. The London chain has plans for expansion and are seeking shareholder approval for the significant investment.
The MD of Core Fitness plc has sent over to the Chief Executive of Core Wellbeing plc relevant information on the proposed capital investment. The MD is of the opinion that the company is in a strong financial position to justify the construction of a new leisure facility. He has also supplied summarised financial information of Core Fitness plc for the past 4 years.
The CEO of Core Wellbeing Plc requests a meeting with his finance team.
"As you know, we're a major investor in Core Fitness plc’s equity, and it appears that they are seeking shareholder support for a new leisure facility that they are planning to build.”
“Could your team study the accompanying financial information and make a report to our Board, critically analysing and commenting upon the MD's statements about Core Fitness plc’s financial performance, policies and strategies. If you think there are any areas of weakness, I shall expect clear reasoning and explanations, and even suggestions for improvements. Consider Core Fitness plc’s current capital structure and provide me with recommendations on its financing policies.”
“I would also like you to prepare an investment appraisal of the proposed project on the basis of the information provided by the MD. In particular I would like to know whether the planned expansion is worthwhile and whether he is justified in not worrying about any adverse variance in membership rate."
“As a major shareholder, we can always press for changes in Core Fitness plc’s operating and financing strategies, where necessary.”
Core Fitness plc’s summarised financial statements for the last four years are enclosed along with details of the proposed new investment (Appendix A&B).
Appendix A
Core Fitness Plc Summarised Financial Information
MD’s summary:- The performance and financial position of our group show a picture of great strength. The last four years have seen our company's operations become increasingly diversified, and our turnover has more than doubled - a clear indication of successful management. Our share price has also doubled over the same period.
Market information
2015 2016 2017 2018Core Fitness Plc share price 64p 83p 96p £1.06
FT-SE 100 share index 3940 4470 4814 5618
Leisure industry share index 2300 3257 4214 5009
Leisure industry P/E ratio 8:1 14:1 18:1 23:1
Income Statement summaries for the years ending 30th September (£million)
2015 2016 2017 2018
£'m £'m £'m £'mTurnover 26 29.6 39.2 54.4
Operating profit 5.1 5.4 6 7.3
Interest payable 1.1 1.3 1.8 2.9
Earnings before tax 4 4.1 4.2 4.4
Taxation 1.2 1.2 1.2 1.3
Net Income 2.8 2.9 3 3.1
Dividends 0.9 1 1 1
Retained Earnings 1.9 1.9 2 2.1
Statement of Financial Position summaries as at 30th September
2015 2016 2017 2018
£'m £'m £'m £'mNon-Current Assets
Tangible assets 37.2 42.7 58 78
Accumulated depreciation 14.4 16.5 22.4 30
22.8 26.2 35.6 48
Current Assets
Stock 3.2 3.3 4.4 5
Debtors 4.5 4.5 7.2 11.4
Cash 0.2 0.2 0.3 0.4
7.9 8 11.9 16.8
Total Assets 30.7 34.2 47.5 64.8
Current Liabilities
Trade Creditors 6.8 7.7 10.6 14.3
Taxation 1.2 1.2 1.2 1.3
Overdraft 0 0 3.4 5.4
Other 1.2 1.9 2.2 3.4
Total current liabilities 9.2 10.8 17.4 24.4
Total Net Assets 21.5 23.4 30.1 40.4
Equity £'m £'m £'m £'m
Ordinary shares (10p per value) 4 4 4 4
Share premium account 1.8 1.8 1.8 1.8
Retained Earnings 5.9 7.8 9.8 11.9
11.7 13.6 15.6 17.7
Non-Current Liabilities
6% irredeemable debentures 9.8 9.8 14.5 22.7
21.5 23.4 30.1 40.4
Appendix BDetails of Proposed New Leisure Complex
Since the end of the last financial year, we have drawn up plans for building a new “luxury” leisure complex in Whitechapel. The new facility will certainly result in a substantial increase in shareholder value, further boosting the company's share price. It will be one more step towards the achievement of our corporate objective of becoming the largest leisure group in the UK within five years.
A clear need for such a leisure facility has been established by our comprehensive market research survey, which has just been completed at a cost of £125,000. The impact of this project on our existing portfolio of gyms and leisure facilities in London has also been studied. Since the proposed new complex is targeted at the ‘high-end’ market segment, the adverse impact on our existing provision is expected to be not more than £500,000 in contribution per year, a price worth paying for the increase in overall market share and brand visibility.
The capital cost of the new complex would be £16 million, an expenditure that would attract accelerated capital allowances on a reducing balance basis at the rate of 3% per year, commencing from the first year of operation. Of course, since depreciation is not really a cash flow, this is not relevant for appraisal of the project. Construction will be completed, and the leisure complex will become operational, one year after investment of the amount of £16 million.
Working capital of £2,000,000 will need to be invested before commencing operations, and it is expected that the requirement will drop to £1,000,000 from year 4 and this level will remain sufficient for the duration of the project. All working capital is recovered at the termination of the project, at the end of year 10.
The new facility will accommodate a maximum of 1500 members and the membership rate has been estimated at 85%. Although seemingly high, we are confident that we have the experience and expertise to achieve this. Besides, the project’s viability is unlikely to be affected even if the membership rate were to fall to 75%.
In keeping with the class of the complex and in addition to our high-tech gym, leisure and health facilities, the complex will house a 5-star restaurant, cafe/bistro, bar and banqueting/meeting rooms.
The membership fee will be £400 per month. In addition to the revenue from annual membership, each member is expected to spend an average of £200 per month on food and drink, and £1000 per year on other leisure facilities. On the basis of our past experience, the profit margin on food and drink has been estimated at 60% and on other leisure facilities at 35%. For calculating the contribution from food and drink and the other leisure facilities we have assumed the 85% membership rate. Additionally, non-members are expected to provide an annual revenue of £1,800,000 per year.
The main operating costs would be the annual staff costs of £3,000,000. The other significant operating costs would be services such as gas, electricity, water, etc. amounting to £900,000 per year, and maintenance and other costs are estimated to be £750,000 per year.
All the above revenues, costs and values are estimated at current prices, and take no account of inflation. Although the current level of inflation is 3.25% per year and is expected to continue at this level for the foreseeable future, it has been treated as irrelevant for appraisal of this project because any inflation would affect both sides equally - revenues as well as costs.
The project will be financed by a mix of equity and debt finance and we believe that our current after-tax weighted average cost of capital would be an appropriate discount rate for appraisal purposes. The current share price is £1.06, and the cost of equity is 22%. Our existing debt consists of 227,000 6% £100 irredeemable bonds trading at par. We will continue to pay corporation tax at the rate of 30% in arrears for the foreseeable future.
We will have a licence to operate this complex for a period of 10 operating years. Although it may be possible to extend the licence thereafter, no financial forecasts have been made beyond this time horizon, and we are conservatively assuming that the facility will have zero residual value at the end of the ten-year period. We would not undertake the investment if we did not expect it to be fully viable over ten years, ignoring any residual value at the end of that period.
As the finance team, prepare and submit the written report on Core Fitness Plc, as required by the Chief Executive of Core Wellbeing plc.
The report should include the following :-
Financial Performance Analysis (50 marks)
• 14 ratio calculations (14 marks)
• Interpretations of results and recommendations (24 marks)
• Consideration of the MD’s claims about the company’s turnover and share price - include an analysis of share price, industry and market (10 marks)
• Recommendations on the company’s future financing policies (2 marks)
Investment Appraisal (40 marks)
• Narrative of how cash flows were dealt with, with reference to MDs comments on depreciation and inflation (9 marks)
• Excel spreadsheet of relevant cash flows (16 marks)
• WACC calculation for appropriate discount rate (2 marks)
• Appraisal using NPV and IRR techniques and recommendation (6 marks)
• Consideration of the MD’s comments on the membership rate – include a sensitivity analysis (re-work appraisal at 75% membership rate) (7 marks)
Sample Solution