Background Information

Eileen Timmons was a Registered Nurse living in Salmon River, Newfoundland. A single parent with two children in their late teens, she found that in 1990 her income was significantly reduced when Provincial Government attempts to cut costs in the health care sector resulted in her employment status changing from full-time to part-time. As a result, she found it increasingly difficult to meet her living expenses. In order to supplement her income, Eileen had been considering the use of the proceeds of her late husband's insurance policy, $25,000, to start a small business, and had actively searched for the right opportunity. This opportunity seemed to present itself when, in early 1991, she learned that the local convent was for sale.

The Presentation Sisters of the Blessed Virgin Mary had been involved in the religious and educational aspects of life in Salmon River for over one hundred years. For most of this time approximately 15 members of the Order resided in the town, working as teachers in the local community school. With the introduction of regional schools, however, this service had been discontinued several years ago. As a result, the number of Presentation Sisters living in the community gradually decreased, until only three remained. The governing body of the Order decided that it was no longer feasible to operate the convent, which had been built about sixty years ago, so it was advertised locally for sale.
When Eileen learned of the former convent's availability, she immediately felt that it would be ideal for use as a tourist home. She also thought that, because of the building's age, it would need substantial upgrading and renovations. Accordingly, she contacted her brother Fred. After some discussion, they decided to form a limited company as equal shareholders to purchase the building. As a resident of the community, Eileen's role would be to supervise the day-to-day operations of the Inn. She would also continue her employment as a nurse. Fred's role would be to supervise one of his employees who would carry out an extensive examination of the building to determine the necessary improvements and modifications. He would also be responsible for raising the money to finance the purchase and renovations. Fred felt the Inn would qualify for funding under the Fisheries Alternative Program. This program, administered through the Atlantic Canada Opportunities Agency, would provide contributions toward approved capital costs of up to 65%. An equity contribution of 20% would normally be required from the project's owners, and the balance could then be financed through conventional lenders.
Fred was disappointed by the results of his survey of the property Although the building was sound structurally, he found that extensive external repairs were needed. Virtually all of the windows needed replacement and much of the siding had to be replaced. Inside, the building needed to be completely redecorated and improvements made to prepare it for this business. In addition, new furniture for the rooms and equipment for the restaurant would be required. At this point, Fred began to wonder whether the Inn would support the level of investment required. However, Eileen felt strongly that she could make it pay, and the Fisheries Alternative Program would contribute a major portion of the capital cost. The decision was made to proceed, and the funding was eventually approved; Exhibit I outlines the funding proposal.

By late October 1991, the company was ready to start the renovations. Almost immediately the project ran into problems. The local carpenters hired to complete the job seemed to take much longer than the original estimate, and many of the materials estimates were understated. Eileen also decided to hire an interior decorator to recommend draperies, wallpapers, and color schemes which would preserve the original character of the building. As a result, the company incurred large cost overruns, and temporary financing had to be obtained from the bank. This was subsequently repaid from an additional investment by the shareholders and an additional term loan from the bank.
In May of 1992, the Inn was ready for business. Over the course of the summer there were several occasions when the company was unable to meet its obligations in a normal manner. Eileen found that she had to use part of her income from the hospital to pay some of the pressing bills. She felt that this was reasonable, however, because both of her children were now employed at the Inn, so the overall family income was higher. She was completely taken by surprise when the bank refused to honor the payroll check. As she commented to Fred during the telephone call, "I don't know what the bank expects of me. I'm already paying many of these bills personally What more can I do?"

The Problem

Fred arrived at Salmon River early on Sunday, October 11, and immediately met with Eileen. -Me first thing we must do is to determine our financial position," he told her. "I guess we can begin by reviewing the financial statements," she replied. I just received them on Friday." Fred examined the financial statements, which are attached as Exhibits 2 and 3.

The following additional information came to light during the conversation:

1. The capital improvement phase of the project was complete.

2. The bank overdraft position was essentially unchanged since the financial statement date. However, the bank manager had recently asked Eileen to present a plan to retire this amount in an orderly manner Eileen felt she would need to have this plan ready within a week.

3. The accounts payable amount included $28,625 due to the contractor. Eileen admitted that this should have been paid from the proceeds of the second term loan, but there were several pressing operating accounts which took precedence.

4. Payroll deductions had not been remitted for two months and now totaled $5,137. Provincial sales tax was also unpaid and totaled $3,240. These were similar to the amounts included in the accounts payable figure on the Balance Sheet.

5. After the Inn had opened for business, Eileen felt that she did riot have the time to supervise all of the day-to-day operations. Within the community, she was able to locate a lady who had had several years of experience in the hospitality industry. Eileen thought that the $7,000 salary paid this person was worthwhile, unfortunately, the lady had recently moved out of the community as her husband had been transferred.

6. The revenues for both room rentals and restaurant sales were well below projections. There were eight rooms which rented at an average of $40 per night. Fred calculated that there had been 100 days between the Inn's opening and the end of August, a potential rental revenue of $32,000. On that basis, the occupancy rate appeared rather low Eileen felt, however, that the occupancy rate should have averaged about 60%, although she did not have any actual statistics to confirm this. She was also very disappointed by the restaurant sales. When the menu had been drawn up originally, all food purchases had been marked up by 150% to arrive at selling prices. She felt that about $5,000 of the amount disclosed as "purchases of food and supplies" related to non-food items. Even at that, however, the margin appeared too low.

7. Wages and benefits were also a cause for concern. Fred felt that, even with the manager's salary deducted, this amount was excessive. Eileen became a little defensive, pointing out that her two children had been paid about $6,000 between them during the Inn's operating period. After further discussion, Eileen admitted that she had realized that there were too many employees. However, she felt that because of the poor fishery in the area a number of people in the community had not worked sufficient time to qualify for unemployment insurance benefits. In her opinion, employing these people for "a few weeks" was a good public relations gesture.

8. Most of the other item on the list reflected normal operating costs for the year.

Required:

Analyze the company's operations, results and future. Discuss the three options available to Fred and Eileen. Which one would be in the best interest of the business? Which one would be in the best interest of Fred and Eileen?

                                                             Exhibit 1
                                                       Approved Funding Proposal