Question

Rob and Joan Russell started baking pies from their home eight years ago. Their business idea was simple: There were no top-quality pies sold commercially in their mid-sized New England town. They produced no plan, no budget, and gave no thought to how much capital this venture would require. Their pies were indeed great and with little effort they built a customer base of individuals and restaurants that wanted the best and were willing to pay $12-15 per pie. Rob and Joan rented a kitchen from a catering firm that they could use during the caterer’s off hours. With the new facility they could bake 100 pies per day. Their revenue was soon running at a pace of $500,000 per year with monthly sales of 3,000 pies at an average price of $14. The success they were enjoying and the encouragement they received from customers and friends made them think of expanding their distribution regionally, creating a brand name, and adding other products. But these expansions required taking on significant new expenses. It was time to make a haphazard venture into an expansive venture with a bankable business plan. With revenues of $500,000 per year and renting the kitchen from the caterer, they had profits of about $200,000 per year (they paid themselves no salaries.) The Variable Costs per pie were $4, and their Fixed Costs including staff, kitchen rental, and two delivery vehicles were approximately $160,000 per year. BEP=$160,000/10=16,000; current volume is 36,000. Over a few months Rob and Joan developed the outline of a business plan:

• There was a closed restaurant that they could buy and equip as a commercial bakery. The parking lot could accommodate delivery trucks and employees’ vehicles. The total cost of buying and equipping this new facility was $1 million. bankable business plans for entrepreneurial ventures 220

• A bank agreed to lend them $500,000 at 7% per annum and the owner of the building offered to give them a second mortgage for the other $500,000 at 10% per annum. The total yearly interest cost would be $85,000 with principal payments of $50,000 beginning in the third year.

• The new location would allow them to triple production and keep Variable Costs at the same $4 per pie.

• The fixed costs after the move to the new facility would increase to $700,000 per year not including interest or principle payments, covering advertising, a full-time salesperson, and the operation of the bakery. Rob or Joan would still not be salaried. Rob and Joan need to do some financial analysis of this deal. They want to know what impact this deal will have on their profits.

Question 1: Will it change their Break-Even Point?

Question 2:Is this new deal riskier? Is the upside much greater?

Question 3: How could they change the proposed deal to make it work better for them?

Question 4: In sum, would moving to this new facility give Rob and Joan a bigger piece of the pie?

Answer 1

Answer 1: Yes, it will change their Break-Even Point, because they are not sure how much sale will be increased with this plan, but the fixed cost is going to increase from $160,000 to $700,000. This is a major increase in the fixed cost. This will impact the break even and it will push the break even later, if we do not see the sale increase in the similar patter to manage this high cost of $700000.

Answer 2:

Yes, this new deal is riskier because it is needs large investments and banking fund is based on annual interest pattern. The interest will be running continuously and it will add cost for the business. High revenue model and profit is needed for managing this large investment business. Hence this is more risky than initial time. No, the upside is not much greater and it could have significant adverse impact as well. Hence we are not sure that the upside will be better than the current one. It will depend upon the success and growth of the business.

Answer 3:

They could change the proposed deal to make it work better for them by exploring alternate way of managing the budget and funding the business ideas. They can explore the other funding options like explore share option and invite investors for investing in the business, so that they can be saved from the interest penalties. They can explore the limited liability corporations, so that they will have lower liabilities in the business. They can explore small expansion of their business so that they can manage the business cost and can generate revenue for managing the expenses and achieve break even as early as possible. They can think of leasing the facility instead of buying the facility. They need to explore cheaper financial alternatives.

Answer 4:

In sum, moving to this new facility will not give Rob and Joan a bigger piece of the pie. The Pie cost for consumer will likely to be remain similar and if they increase the pie cost, then they will lose the sale and business opportunity. Hence they cannot go for price increase for the pie. The pie price will going to be remain similar and they can go for minor change or adjustment, but they cannot go for large price increment for the pie. The pie pricing will have severe impact on the ale and business opportunity in the target market.