CBV INSTITUTE PROGRAM OF STUDIES
Level I – Introductory Business Valuation
Winter 2021 Term
Administered by: York University, School of Continuing Studies
Date: March 8, 2021
150 minutes, 100 marks
Question One (50 marks, 75 minutes)
Today is February 28, 2021. You are a senior associate at Dean & Wright LLP (“DW”), a
boutique valuation firm located in Toronto, Ontario. This morning, you received an email from a
client, Don Martin:
“Hello DW, I have been in talks about acquiring Pharma High Inc. (“Pharma High”), a company
that holds a cannabis cultivation and sales license here in Ontario. Both myself and the seller
have come to an estimated purchase price of $10.0 million for the company. I want to obtain
comfort that $10.0 million is a reasonable price. Pharma High’s background and expectations
going forward are in Appendix I and the historical financial statements are in Appendix II.
This acquisition will bring significant synergies to my company Cloud 9 Inc. (“Cloud 9”). Cloud 9
currently operates five cannabis retail stores here in Ontario. By integrating Pharma High’s
operations, we can expect Cloud 9’s gross profit margins to improve by at least 5% going
forward and keep fixed costs in-line with those seen in fiscal years ended 2020 and 2021.
Assuming that Cloud 9 acquires Pharma High today, what would the combined value be? The
relevant business information for Cloud 9 is in Appendix III and the historical financial
statements are in Appendix IV.”
Based on your research, you summarized some general economic and industry data relevant to
this engagement on Appendix V.
Required:
a) Determine the fair market value (“FMV”) of Pharma High as at February 28, 2021 and
advise Don whether he should acquire the company for $10.0 million. In point form,
indicate the selected valuation approach and methodology used and determine whether
the resulting goodwill is reasonable. A report is not required at this time (35 marks).
b) Based on your conclusions in Part a) above, advise Don what would be the FMV of the
combined entity (i.e. Cloud 9 and Pharma High) (15 marks).
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Appendix I: Pharma High Inc. Business Background
Pharma High obtained its cultivation and sales license on February 8, 2020 and began
operations on February 28, 2020. To date, business has been slow given Pharma High’s slow
development of a viable cannabis strain. However, near the end of fiscal 2021, Pharma High
successfully developed a strain that provides all the benefits of THC without the side effects and
entered into a relationship with Cloud 9. Management believes it would be able to sell 80% of its
annual production directly to Cloud 9 on an almost guaranteed basis. Management estimates
the remaining 20% of annual production can be achieved through sales to other local
dispensaries with a 70% success rate. Inventory that cannot be sold during the year will have to
be destroyed in accordance with regulations.
Pharma High’s existing production facility currently has 10 grow rooms. Management expects
each grow room to produce:
● 55,000 grams of harvest in 2022
● 65,000 grams of harvest in 2023
● 75,000 grams of harvest in 2024
● 90,000 grams of harvest in 2025
● 105,000 grams of harvest in 2026
Management has noted that by 2026, the production yield will be at capacity. Based on market
prices, the cannabis harvest can be sold for $10 per gram in 2022 and 2023. With expectations
that the product will be a market success, future yields in 2024 and thereafter can be sold for
$10.50 per gram. Pharma High expects their costs of production to be about $5.50 per gram.
Most research and development costs have already been incurred during 2021 and
Management does not expect any other significant costs to be needed. Fixed general and
administrative costs are projected to be approximately $1.1 million in 2022 and 2023 and $1.5
million in 2024 and thereafter. Included in the projected general and administrative costs are
amortization expense of approximately $250,000 each year and interest expense of
approximately $325,000.
Capital expenditures are not expected to be significant going forward as most costs related to
building out the warehouse and grow rooms have already been incurred. Annual capital
reinvestment is expected to be approximately $50,000 and would be eligible for the accelerated
investment incentive for capital cost allowance (“CCA”) purposes. Working capital requirements
are expected to be approximately 10% of annual revenues going forward.
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Appendix II: Pharma High Inc. Historical Balance Sheet
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Appendix II (continued): Historical Income Statement
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Appendix III: Cloud 9 Business Background, per Don Martin
Cloud 9 was incorporated on February 28, 2018 and successfully obtained a cannabis retail
operator license from the Alcohol and Gaming Commission of Ontario on January 11, 2019.
Shortly thereafter, Cloud 9 was able to secure the necessary retail store authorizations for the 5
cannabis retail stores it currently operates.
Cloud 9 does not own any of its premises and leases each of the retail locations it operates out
of. As luck would have it, a childhood friend of mine owns several large retail spaces and was
able to provide me his retail lots at a significantly reduced price. To help me out in establishing
my dispensary business, he offered a significant reduction in rent for 2019 and 2020. However,
seeing as how my business sales have established a stabilized level in 2020 and 2021, he
charged me the full amount starting in fiscal 2021 at the same rates he would charge his other
lessees. To repay him for his kindness, I gifted him and his family about $35,000 worth of
inventory in fiscal 2021. My accountant recorded this into the cost of goods sold for the 2021
year-end financial statements.
While Cloud 9 has a relatively short operating history, each of my dispensaries opened with
much fanfare and the prime locations of each of my retail stores don’t hurt either! I would say I
don’t expect future sales to deviate much from what we’ve experienced in 2020 and 2021.
Annual capital expenditures are expected to be approximately $15,000 and would be eligible
for the accelerated investment incentive. The working capital, excluding cash, as at the 2021
year-end is at an optimal level.
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Appendix IV: Cloud 9 Historical Balance Sheet
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Appendix IV (continued): Cloud 9 Historical Income Statement
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Appendix V: General Economic and Industry Information
● Combined federal and provincial tax rate is 26.5%
● Average CCA rate is 10.0%
● Long-term treasury bill interest rate – 1.3%
● Equity risk premium – 6.0%
● Industry risk premium – 5.5%
● Size premium – 7.0%
● Forecast GDP growth rate – 2.0%
● Cost of debt – 5.0%
● Industry optimal capital structure is comprised of 90.0% equity and 10.0% debt
● The UCC of Pharma High and Cloud 9’s fixed assets approximates their net book values
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Question Two (50 marks, 75 minutes)
You recently co-hosted a valuations webinar with your firm’s partner, Ms. Yani Swami on the
basics of valuations. After the webinar, you received the following email from Mr. Goku, owner of
One Punch Inc. (One Punch):
Dear Sir,
My partner Vegeta and I attended the webinar conducted and found it to be very useful. We
would like to hire you to provide a valuation of our company One Punch. We require the
valuation for tax planning and it might be submitted to the CRA. One Punch owns and operates
a martial arts gym (the Gym) under the same name. The Gym hosts a variety of martial arts
programs under highly trained instructors. We will send more information once we receive your
information request and terms of engagement.
Sincerely,
Goku.
A follow up call with the two owners sheds more light on the operations of the Gym, which are
detailed in Appendix I. During the call, Goku mentions to you that they are old school in the way
they operate a business and think that a handshake deal will suffice instead of signing an
engagement letter.
Historical audited financial statements of the Gym for the last 5 years are not available.
Management prepared financial statements are set out in Appendix II. Financial statements for
the two month period ended February 28, 2021 are not available and Management has asked
you to consider a Valuation Date of December 31, 2020 - the date of the last available financial
statements. Vegeta has also provided you with budgets for 2021, which have been personally
prepared by him.
Required:
a) Provide Ms. Yani with your opinion as to:
I. Whether an oral agreement would constitute a valid contract; and (1 mark)
II. What are the benefits of having a signed engagement letter (2 marks).
b) Ms. Yani thinks that this engagement will require a representation letter from the clients.
I. What is a management representation letter? (1 mark).
II. What are some of the items that would be appropriate to include in a
management representation letter in this case? (6 marks).
c) Prepare the valuation calculations. A report is not required at this time, but you must
explain the selected valuation approach and methodology used. (35 marks).
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d) Ms Yani thinks the enterprise value should be closer to 1.5x to 2.0x of membership base.
This is based on an industry rule of thumb quoted by Mr. John Wick, an investment
banking partner at your firm.
I. What is the rule of thumb method? Explain some drawbacks of this method of
valuation. (3 marks).
II. Analyse how your valuation conclusions under Part C above compare to the rule
of thumb method. (2 marks).
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Appendix I - Background
The following background information was received from Management.
Operating since 2000, the Gym provides martial arts instructions to students. It is one of the
three martial arts gyms in the city and according to Vegeta they are the best in the business.
The gym offers Muay thai, Jiu-Jitsu, Wrestling and Krav maga lessons. The other two gyms in
the city only offer one or two different programs. The Gym has won multiple accolades with
many of its students going on to becoming professional competitors.
The Gym currently has 2,000 members and this number has remained more or less stable over
the last 5 years. Vegeta represented that the number of members leaving and those joining
each year were very similar. As such he expected membership to remain constant in the
foreseeable future. Members usually subscribe to monthly plans and payments are received in
advance at the start of each month.
According to Goku, Vegeta is an astute salesman and it was his idea to start selling gym
branded merchandise. The merchandise plan was rolled out in July 2019. Merchandise sales
are recorded in the income statement at net of all costs. Merchandise sales are expected to be
at similar levels in the future.
The Gym is not working capital intensive and Goku is confident that they will not need any
working capital infusions. The Gym needs $102,000 of cash to meet any contingencies and
Vegeta is considering investing the remaining cash in marketable securities. Capital
expenditures have been for replacement of training equipment and are estimated at $40,000 a
year. Goku and Vegeta are involved full time in the business. Market salaries for owner
operators of comparable gyms average $65,000 a year, each.
Vegeta mentions that the Gym had been sued by Mr. Saitama, who was injured during one of
the training classes. Mr. Saitama is suing for $1 million. Vegeta is confident that Mr. Saitama has
no case since he signed the required waivers. He does not think you should consider the lawsuit
when determining the fair market value of the company. A one time lawyer fee of $12,000 is
expected to be incurred for this case in 2021.
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Appendix II: Financial Statements
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Appendix III: Other Information
● Vegeta mentioned that in 2018, there was a one time advertising spend of $175,000 for
a taekwondo program which did not take off.
● The company is currently debt free.
● Vegeta said that the 2021 budget does not include costs for hiring a new secretary at
$20,000 a year. This cost did not exist historically but is expected to be a part of costs
going forward.
● Outside instructors are guest instructors brought in for special sessions for the students.
● Rent is paid to a non-related third party and management claims that it is at arm’s length.
The lease agreement specifies for rent to be increased to $100,000 a year starting 2022
and grow by inflation thereafter.
● Travel in 2020 included a vacation trip by Vegeta to the Bahamas that cost $10,000.
● COVID 19 led to the cancellation of in-person classes in 2020. In an effort to save
memberships, the Gym offered online classes for half the cost. This move helped save
the member base from being lost. However, revenues were affected. Management is
confident of returning to normal operations in 2021.
● A one time grant of $200,000 was approved by the city as a COVID 19 measure on
December 31, 2020. This amount is not reflected in the balance sheet or income
statement. This is an interest free grant and would be treatable as revenues in the hands
of the company for tax purposes.
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Appendix IV: General Economic and Industry Information
● Combined federal and provincial tax rate is 25.0%
● Average CCA rate is 10.0 %
● Risk free rate is 2.0%
● Equity risk premium – 6.0%
● Comparable company beta is 0.6x
● Size premium – 7.0%
● Forecast GDP growth rate – 2.0%
● Cost of debt – 5.0%
● Industry optimal capital structure is comprised 70.0% equity and 30.0% debt
● The UCC approximates net book values
● Historical inflation was 2.0% every year.
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