CASE SIMULATION WEEK 3

Century Auto Service Ltd. (CASL) provides auto repair services for cars and small trucks. Jim Dunstin
started the company in 1980, and it grew at an explosive rate over the next 20 years. In 2000, Jim Dunstin
died suddenly. Ownership of CASL passed to his son, Devin and his daughter, Madison. Each sibling
received 50% of the outstanding shares in the company.

Madison handled the administrative side of the business until 2010, when she and her family moved to
another province. CASL employed a part-time bookkeeper to take over Madison’s duties. Madison
continued to hold her shares in CASL, but she became inactive in the operations, leaving all CASL
decision making to Devin. Devin has always kept Madison informed of the company’s activities and has
helped her to understand some of the regulatory documents she has had to sign over the years. She has
not bothered to review CASL’s financial statements in recent years because she is satisfied that Devin is
operating the business effectively and has trusted him to provide her with a fair return.

Today, Devin continues to work very hard at expanding CASL’s customer base. CASL’s customers are
mostly individuals. Over the past few years, Devin has made significant inroads into servicing corporate
businesses and has signed service contracts with several such customers.

It is now August 2017. Madison has contacted Devin and announced her desire to sell her shares in
CASL. She wants to pay down her mortgage, and her children are planning to attend university away
from home and she will require extra funds for that purpose. Since she does not think that she will ever
become active in the business again, she wishes to sell her shares now.

The shareholder agreement requires that a valuation of the business be undertaken in the event that one of
the shareholders wishes to sell. CASL’s financial statements are Notice to Reader statements prepared by
a local accountant. The accountant is planning to retire and is not interested in undertaking the valuation.

Devin has approached your firm, Gooding and Company, and would like to appoint you as CASL’s new
accountants. A meeting between Devin and Brian Gooding, who will be the partner responsible for the
client, was arranged. Brian has asked you, CPA, to attend the meeting as well . Devin is a casual
acquaintance of Brian’s, so he knows that Devin is married and has a 26-year-old daughter.

Brian started the meeting by asking Devin about the shareholder agreement.

Devin: “Madison and I had our lawyer draw up a shareholder agreement after we inherited the
company from our father. It basically says that the remaining shareholder gets the first
opportunity to purchase the shares from the other shareholder and that a valuation of the
company’s worth will be the basis for the selling price of the shares. The agreement does not
prescribe any specific valuation method. I talked to Madison and she is amenable to using
your firm to do the valuation work. After the valuation is completed, though, she will be
getting tax and financial advice from her own advisor.

“Frankly, I’m a little surprised that Madison wants to sell. Ever since she left the company,
we have been paying her a dividend, providing her with a steady cash flow stream. I guess
she really needs the extra cash.”

Reprinted from the 2003 UFE Report, with permission Chartered Professional Accountants of Canada,
Toronto, Canada. Any changes to the original material are the sole responsibility of the author and have
not been reviewed or endorsed by the Chartered Professional Accountants of Canada.
CASE SIMULATION WEEK 3 (continued)

Brian: “How is the business doing?”

Devin: “Terrific. Our customer list has doubled in the last ten years to over 2,500 customers. We
have really loyal customers and we’ve been expanding our corporate business. As a matter
of fact, we just signed a new contract that we think can add $25,000 per year to our gross
margin. It started on July 1, 2017, and it’s a two-year deal. We’re really excited about it!”

Brian: “What is it that makes CASL so successful?”

Devin: “I think our customers trust us to give them quality work at a reasonable price. As an
independent, we’re always looking for ways to create a cost advantage. For example, I just
recently struck an agreement with one of our suppliers, Auto Parts Distributors (APD). I
guaranteed that I would give them 80% of our parts business as long as they could guarantee
same-day delivery on most parts. In return, APD agreed to reduce their prices to us by 10%.
So I will get better prices, great service, and I will be able to reduce my inventory. APD
must be pretty happy with the deal too. They just sent me a brand new set of golf clubs. I
think those clubs would cost over $2,000 if I had to pay for them!”

Brian: “How about your staff?”

Devin: “Good auto mechanics are difficult to find so I try to hang on to them. As a result, I tend to
pay a little better than other companies. I promoted one of my mechanics, my son-in-law
Steve Hennesy, to assistant general manager. Steve has been with me for about ten years and
I consider him to be like my own child. I’ve been giving him more of my administrative
tasks to do so that when I’m away, he can cover for me.

“I am worried that Steve might be getting offers from competitors to go work for them. So I
will sell him 10% of the shares in CASL once I buy Madison’s shares. I think I should move
on this sooner than later. I will need some advice on different ways to go about structuring
all of this from a tax perspective. I’d really like to slow down a little bit, play more golf, and
travel. I think I could do that if Steve becomes more involved in the decision making.”

Brian: “I guess you don’t have much time for golf, do you?”

Devin: “No. But in April 2017 I joined a private golf club. CASL paid the $20,000 initiation fee and
my annual dues of $3,600. It’s a bit expensive but CASL wrote it off. Sometimes, I take
customers or suppliers to the club. My daughter is a member as well, so I get to play golf
with her every now and then. I’d truly like to play more golf in the summer and watch
hockey in the winter.”

Brian: “Do you drive a company car?”

Devin: “Minivan actually. It has our company logo on the side, which I think is a great way to
advertise. CASL paid about $40,000 for it last year, but I hardly put any kilometres on it.
I’m so busy at the shop, I really just use it for going to work and back.”
CASE SIMULATION WEEK 3 (continued)

Brian: “How is your compensation package structured?”

Devin: “Each year, my accountant and I try to figure out the best way to pay me. We established a
kind of standardized method a few years ago. First of all, I receive a salary equivalent to
what a manager, who is not an owner, would be paid. We figure that’s about $80,000 per
year. Then, in December, we take a look at the company’s cash position, and, based on that,
I declare a bonus. Things have been pretty good lately, and I have been able to take out a
bonus of $70,000 each of the last two years. We also declare dividends each year so that we
can give Madison a return on her investment. Our dividends have been $20,000 each for the
past five years.”

Brian: “What services do you want our firm to provide to CASL?”

Devin: “First of all, I would like you to complete the valuation of the business for Madison and I.
Second, I need you to advise me on how I should finance the purchase. I’m eager to buy
Madison’s shares and make Steve a shareholder, while minimizing taxes. I have some assets
that I am prepared to sell, but I don’t know how much cash I’ll have left after I pay the taxes.
CAnd, as I mentioned to you before, I want you to do our accounting and tax work going
forward. I’m thinking of getting a line of credit for the business. I’ve heard that the bank
doesn’t like Notice to Reader statements. Does that mean I need an expensive audit?”

After the meeting, Brian went back to his office and phoned Madison to confirm some of the details. He
then called you into his office.

Brian: “I just looked at the 2017 and 2016 financial statements. Here is a copy (Exhibit I). I also
looked at Devin’s personal tax return, including his T-4 for 2016. It showed employment
income of $150,000. Finally, here is a copy of a list of personal assets that Devin is prepared
to sell (Exhibit II).

“I’d like you to start working on Devin’s requests today. I’ve included some information in
the file that you will need to start the valuation (Exhibit III).”
CASE SIMULATION WEEK 3 (continued)

EXHIBIT I

CENTURY AUTO SERVICE LTD. BALANCE SHEET

Assets
Current assets

Cash $ 65,000
Accounts receivable 45,000
Inventory 52,000
162,000
Property, plant and equipment (net) 280,000
$ 442,000
Liabilities
Current liabilities $ 25,000
Long-term debt 50,000
75,000
Shareholders’ equity
Share capital 10,000
Retained earnings 357,000
367,000
$ 442,000
CASE SIMULATION WEEK 3 (continued)

EXHIBIT I (continued)

CENTURY AUTO SERVICE LTD.

2017 2016

Revenue $ 980,000 $ 925,000

Cost of sales
Parts 300,000 273,000
Labour 222,000 210,000
Gross margin 458,000 442,000
Operating expenses 265,000 255,000
Income before income taxes 193,000 187,000
Income taxes 57,900 56,100
Net income $ 135,100 $ 130,900
CASE SIMULATION WEEK 3 (continued)

EXHIBIT II

ASSETS THAT DEVIN DUNSTIN IS PREPARED TO SELL

1. I own a speedboat that has a double inboard motor that is worth about $60,000. I paid $80,000.

2. I also own artwork worth $25,000 today. It was worth about $500 when I inherited it from my
grandfather many years ago. My grandfather always said the painting would be worth something
someday!

3. I have an RRSP currently worth about $700,000 with a cost of $170,000 based on statements from
my advisor. The RRSP contains mostly guaranteed investment certificates and bonds since I sold
most of my stocks before the market crashed.

4. Investments in public company shares, held outside of my RRSP, worth around $15,000 (cost
$40,000). I’m tired of the ups and downs of the stock market anyway. I would rather invest the
money in something that I control.

5. My cottage. I bought it in 2000 for $125,000. I figure it’s worth about $500,000 based on what my
neighbours just sold their cottage for.

6. My investment in some condominium partnership. I’ll actually be glad to get rid of this one! My
neighbour convinced me to buy into it on the basis that it would save me some tax. It cost me
$60,000 when I bought it three years ago and I’ve had a loss for income tax purposes of $10,000 per
year since. I haven’t received a single penny from it. I think I can sell my partnership unit today
for about $50,000.
CASE SIMULATION WEEK 3 (continued)

EXHIBIT III

INFORMATION FOR VALUATION

1. The auto repair business is constantly evolving. Fifty years ago, most repair work was done at
independent gas stations and car dealerships. Slowly, independent auto repair shops set up
business, distinct from gas stations. In the 1970s, national chains (both corporate stores and
franchises) entered the industry. Today, the industry is almost fully segmented between the national
chains and independent repair shops. Most gas stations no longer have repair facilities.

2. The independent segment of the business is considered to have more risk. Thus, the earnings
multiplier in this segment is approximately 5, while the earnings multiplier for a national chain
franchise is 6.