Ted agreed to purchase the assets of the recently closed Italian restaurant for $53,000 from its previous owner, subject to bank financing. The purchase cost included the restaurant's fixtures and equipment, in particular, a pizza oven, a food preparation table, a walk‐in freezer, refrigerators, and miscellaneous kitchen equipment. Mary received the equipment list from the seller. The table contains the list of purchased fixtures and equipment. The financial statements compiled by the owner's bookkeeper were the source of cost and accumulated depreciation figures. The market values of the long‐lived assets were estimated by a commercial appraiser.

Equipment purchased from the previous restaurant

Item	Cost	Accumulated depreciation	Remaining useful life	Market value
Existing leasehold improvements	$110,000	$55,000	Five‐year lease	$17,500
Pizza oven	$34,500	$34,500	Nil	$2,000
Other production equipment	$31,000	$21,800	Six years	$12,300
Prep tables, refrigerators, etc.	$15,000	$5,200	Five years	$8,500
Cooking equipment	$12,500	$8,400	Five years	$3,600
Fixtures	$37,500	$26,250	Five years	$9,100
Total				$53,000

As the previous tenant had operated an Italian restaurant and had complied with health regulations, leasehold improvements were minimal. Ted Di Lollo provided Mary with $20,000 in quotes from local businesses for signage and leasehold improvements. The suppliers estimated that work would be completed by the end of May 20X7 and that payment would be due on May 31.

The pizza oven, included in the purchase cost, was in poor condition and would soon require replacement. The oven had been the top of the line when originally purchased but now was fully depreciated. The old pizza oven could be sold for $2,000 in June 20X7. The remaining equipment and fixtures were in good working order and usable in the new venture.

Two equipment purchases were planned: a point of sale (POS) system and a new pizza oven. The $15,000 POS system had a useful life of five years and would be installed in June 20X7 with payment due in June. Regarding the pizza oven purchase, Ted and Mary researched the different models and technologies of ovens and based on the needs of the pizzeria, narrowed down the options to two alternatives.

Convection oven

The first option was a convection oven with a capacity of 30 pizzas per hour. Such an oven would cost $10,000. The model would have a useful life of 10 years and no salvage value. Convection ovens are relatively small, requiring 60 cubic feet of space in the restaurant. Due to its simplicity of design, convection ovens are easier to maintain and clean than conveyor ovens. A lower skill level is required to operate the oven. The downside of the technology is its longer cooking time—five to six minutes per pizza. The estimated sales figures, along with budgeted wage and benefits costs, in subsequent sections were based on the purchase of a convection oven.

Conveyor oven

The second alternative was a conveyor oven with a capacity of 80 pizzas per hour, requiring 300 cubic feet of space. The cost of a conveyor oven was $25,000[ 1] and the oven had an estimated useful life of 10 years, at which time, it would have no salvage value.

Conveyor ovens can cook a pizza in four to five minutes with great consistency. Cooking speed and throughput may be an issue as most pizzas were sold during lunch or dinner (Henkel and Brown, [ 2]). The reduced cook time of the conveyor oven would improve the restaurant's response time to pizza orders. Although a faster response time was expected to increase sales by five sales transactions per day relative to the original sales forecast, either model would provide sufficient peak capacity to meet the pizzeria's needs for the foreseeable future.

The downside of the conveyor oven was its complexity. The additional training costs, daily cleanings by staff, and frequent maintenance would add $300 a month to employee wages and benefits expenses relative to the convection oven.

Ted Di Lollo asked his cousin to recommend whether he should purchase the convection or conveyor oven. Mary replied that her class in capital budgeting could be useful, in particular, decision rules such as net present value and payback period. She asked him "If you pay for the conveyor oven, how fast would you want to recover this additional investment". Ted responded that he would pay the extra $15,000 if cash flows from the oven recovered this amount in a maximum of two years. Whichever pizza oven is chosen, it would be installed and paid for during June 20X7.

She said that four cash flows related to the ovens were relevant to the decision, the difference in oven purchase cost, additional revenues and costs related to the more expensive option, and Capital Cost Allowance (CCA). The pizza ovens were deemed as Class eight assets under the Income Tax Act with a 20 percent annual CCA rate. The oven selected had no effect on the restaurant's net working capital.

The remaining start‐up costs for the new business were estimated as shown in Table.

Miscellaneous start‐up costs

Start‐up costs	Cost	When paid
Security deposits, including a one‐month lease deposit	$4,000	May 20X7
Purchased opening inventory and supplies	$12,000	June 20X7
Advertising for grand opening	$2,500	June 20X7
Employee wages during the start‐up phase	$6,500	June 20X7
Commercial lease—two months	$2,770 / month	May and June 20X7
Common area maintenance	$462 / month	May and June 20X7
Miscellaneous costs	$3,000	June 20X7
Utilities (May and June)	$1,000	May 20X7
Total	$35,464

After Mary talked to suppliers, she realized that trade credit was seldom extended to new restaurants. She assumed that all start‐up costs, including equipment, leasehold improvements, lease payments, and grand opening costs would have to be paid in cash. The grand opening celebration was scheduled in early July 20X7. The food and supplies inventory would be maintained at its beginning level of $12,000. As the business consumed food and supplies, they would be replaced and then expensed as cost of food sold.

Restaurant Financing

With help from his family, Ted planned to invest $120,000 cash in the pizzeria after the bank loan was approved. One night with his parents, he discussed what return they expected on their investment. They agreed that a 10 percent annual return on their equity investment in the company was reasonable.

He applied to the bank for a 5.7 percent, five‐year term loan guaranteed by the Canada Small Business Finance Program. The federal program reimbursed financial institutions for 85 percent of eligible losses on property, plant, and equipment loans

Mary estimated that the restaurant would average five sales transactions per hour during July 20X7. The number of sales transactions per hour was predicted to increase at the rate of one percent per month until the end of the first fiscal year. During the second year, the number of hourly sales transactions was forecasted to increase by one half of one percent per month.

Mary based her monthly sales transactions on the pizzeria's hours of operation. During the first four months of business, Ted planned to open the pizzeria for eight hours a day, seven days a week. Beginning in month five, the pizzeria's hours of operation would be extended to 12 hours per day, seven days a week. Mary estimated the number of pizzas sold per day by multiplying the average number of pizzas sold per hour by the hours of operation per day and rounded this number up to the nearest whole number of pizzas.

Mary ate at Whitehorse pizza restaurants to study the competition to evaluate their customer flow, quality of product, customer service, and take‐out menus. Based on observation, she estimated the average revenue per customer transaction was $23.00, a figure she used in the sales forecast. She noticed that customers paid using cash, debit cards, or credit cards. In the cash budget, Mary assumed that half of the customers paid by credit card (fee: 3.5 percent of gross sales), 30 percent paid by debit card (fee: 0.5 percent of gross sales), and the remainder paid in cash. Mary assumed that credit card companies would immediately pay the pizzeria for customer sales.

Projected Operating Expenses

After completing the sales forecast, Mary estimated the pizzeria's three largest operating costs: food, employee wages and benefits, and the cost of occupancy.

Cost of food

Mary found her answers to food‐related questions in a Canadian Pizza article. According to Diana Cline, who regularly wrote the Pizza Chef column for the industry magazine, "That means your food cost needs to be below 30%—ideally in the 20–25% range" (Cline, [ 1]). Based on her research, Mary estimated food costs at 28 percent of sales, with purchases of food and supplies being made in cash. Talking to restaurant suppliers, she learned that trade credit was not available for new restaurants. Suppliers either insisted prepayments upon order or payment on delivery.

Wage expense

The pizzeria would be staffed by its owner, a full‐time line cook, a kitchen helper, and front counter staff. Mary searched Yukon job postings websites and discovered that restaurant wages were higher in Whitehorse than in other Canadian cities.

Mary prepared a staffing schedule for the restaurant and confirmed her numbers with Ted. She adjusted her kitchen staff figures upward after learning that her cousin planned to use fewer pre‐made ingredients in the pizzas in favor of more onsite preparation. Ted believed that freshly made pizzas would give him a competitive advantage, although his labor costs would be higher.

During the first four months of operation, Mary projected wages and benefits expenses at $9,750 per month, a figure that included the employer's portion of Employment Insurance, Canada Pension Plan, and accrued vacation pay. In Month 5, the pizzeria's hours of operations would lengthen to 12 hours per day, increasing wages and benefits costs to $14,625 per month. Ted planned to live on his savings until the end of October. As of November 20X7, he would start drawing a monthly salary of $6,000 from the company.

Occupancy cost

A draft lease agreement was negotiated with owner of the building. The premises of 1,108 square feet, situated near several government offices along a busy downtown street, provided ample room for a take‐out pizzeria. Ted negotiated a five‐year lease of $2,770 per month, plus five dollars per square foot per year for common area maintenance costs,[ 2] payable monthly, and added to the monthly lease payments.

Other operating costs

Mary estimated other operating expenses based on figures from the Fort St. John venture. She planned to refine these numbers by contacting local vendors such as Yukon Energy, Northwestel, and restaurant suppliers. Monthly utility costs were budgeted at $500 from May to October 20X7, rising to $750 in November 20X7, once the hours of operation are expanded to 12 hours per day. She received a quote from The Co‐operators for commercial liability insurance. The cost of the coverage was $6,000 per year, payable on May 1 of each year.

Starting in the month of July 20X7, Mary budgeted monthly costs of $800 for advertising, $750 for miscellaneous and $250 for repairs and maintenance expenses in the financial model. She quickly realized that few vendors extended trade credit to new restaurants. Thirty‐day credit terms were only available for advertising, miscellaneous, utilities, and repairs and maintenance costs. All other costs were paid when incurred.

The combined federal and Yukon territorial income tax rate was 15 percent for a Canadian Controlled Private Corporation. The company would have six months after its 20X8 year end to file its first corporate tax return and to pay its federal and territorial income taxes to Canada Revenue Agency. On April 30, at the end of each fiscal year, the company's directors planned to declare a cash dividend based on a 50 percent dividend payout ratio. The payment date for the year‐end dividend would be in June of the following fiscal year. No dividend would be paid if the company operated at a loss during a fiscal year.

According to the bank, Accounting Standards for Private Enterprises were acceptable, so these standards were used throughout the pro forma financial statements. She recommended that the new pizza oven, fixtures, leasehold improvements, and other long‐lived assets should be depreciated using the straight‐line method. The residual value of $0 would be used for depreciation purposes.

Property, Plant, and Equipment were considered ready for use on July 1, 20X7. Leasehold improvement would be depreciated over the duration of the lease. Other long‐lived assets were to be depreciated over their useful lives. Use the taxes payable method when calculating income tax expense and payable.

1. Calculate the NPV and payback period for the pizza oven decision and assess each oven from a qualitative perspective. Which oven should be purchased? Why did you select that oven?
2. Research a different oven choice by doing internet research on pizza ovens. Are there better options available than the two listed in the case? Justify your recommendation.

Answer rating: 100% (QA)

Here is my analysis of the pizza oven options for Teds new pizzeria 1 Net Present Value Calculation ... View the full answer