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Head office loans bear interest and repayment is dependent on operational cash flows

QUESTION 4 45 marks
Health Zone (Pty) Ltd operates ten health clubs in the Western Cape region. The company was
established three years ago by its executive directors, and has become a competitive force in the
region. Before setting up their own business, the executive directors had worked for another health
club group. Health Zone (Pty) Ltd attempts to distinguish itself in the market through its friendly staff
and competitive pricing.
Health Zone (Pty) Ltd clubs have similar layouts and facilities that include cardiovascular equipment,
free weight areas, circuit training, swimming pools and squash courts. The company would like to
expand to other provinces and open another 30 clubs within the next five years.
The company plans to open its first Health Zone (Pty) Ltd club in the Gauteng province on 1 July
2004. A suitable site has been secured in Sandton in an established shopping centre, and Health
Zone (Pty) Ltd has entered into a ten-year lease agreement with the landlord for rental of these
premises. The financial director of Health Zone (Pty) Ltd has prepared cash flow forecasts for the new
Sandton club, which are summarised below:
Years ending 30 June 2005 2006 2007 2008 2009
Notes R’000 R’000 R’000 R’000 R’000
Revenue 2 940 4 686 6 723 7 359 8 119
Advertising in clubs 300 330 363 399 439
Membership fees 2 2 640 4 356 6 360 6 960 7 680
Operating costs (3 225) (3 516) (3 660) (3 989) (4 350)
Personnel expenses 3 (1 440) (1 555) (1 680) (1 814) (1 960)
Rental of premises 4 (450) (504) (565) (632) (708)
Water and electricity 3 (330) (363) (399) (439) (483)
Head office charges 5 (300) (324) (350) (378) (408)
Cleaning and security expenses 3 (270) (292) (315) (340) (367)
Sales commission 6 (145) (159) 0 0 0
Maintenance of equipment 7 (40) (44) (48) (53) (58)
Other expenses 3 (250) (275) (303) (333) (366)
Financing costs 8 (823) (846) (674) (262) 0
Interest income 8 0 0 0 0 38
Working capital 9 313 28 30 33 36
Net cash (utilised)/generated (795) 352 2 419 3 141 3 843
1 Capital expenditure and expenses incurred to date and payable on 1 July 2004:
Refurbishment of premises 2 200
Purchase of gym equipment 3 000
Market research costs 250
Pre-opening operating costs 250
Sales commission 264
5 964
2 The forecast of membership fees are based on the following assumptions:
2005 2006 2007 2008 2009
Number of members 1 000 1 500 2 000 2 000 2 000
Annual fee per member (rand) 2 640 2 904 3 180 3 480 3 840
Members must pay fees monthly in advance. The new club has already signed up 1 000
members largely due to the aggressive marketing drive by the company’s sales personnel.
These 1 000 members have contractually agreed to pay R220 a month with effect from 1 July
2004. Membership is only granted for a 12-month period and is renewable annually subject to
price escalations.
The financial year of Health Zone (Pty) Ltd ends on 30 June.
3 Personnel expenses, water and electricity, cleaning and security costs and other expenses are
fixed costs in nature.
4 Rentals are paid monthly in arrear. Health Zone (Pty) Ltd will also have to pay a rental deposit
of R250 000 by 1 July 2004, the start of the rental period. The rental deposit will be refunded at
the expiry of the ten-year lease period. The landlord will allow Health Zone (Pty) Ltd to
refurbish the premises before 1 July 2004 as the premises are currently vacant.
5 Health Zone (Pty) Ltd has established a head office infrastructure sufficient for support of 40
health clubs on a national basis. The head office responsibilities include identifying suitable
sites for new clubs, negotiating leases, opening new clubs, consolidating the financial reporting
of individual clubs and overall review of financial performance of clubs. Head office costs are
allocated to individual clubs on a discretionary basis.
6 Each Health Zone (Pty) Ltd club employs sales personnel to attract new members and renew
memberships annually. Sales personnel are incentivised to sign up new members. Sales
commission is set at 10% of the annual membership fees of new members and is paid upfront.
The cash flow forecasts take into account that sales commission is paid annually in advance.
7 Gym equipment is purchased from GymQuip (Pty) Ltd, and a one-year warranty is included in
the purchase agreement. GymQuip (Pty) Ltd also maintains the equipment in all of Health Zone
(Pty) Ltd’s clubs and charges a fixed monthly maintenance fee for doing so. Gym equipment
generally has a useful life of five years, and has negligible value at the end of that period.
8 Health Zone (Pty) Ltd funds the establishment and operation of new clubs. Head office loans
bear interest and repayment is dependent on operational cash flows. Surplus cash generated
by individual clubs is deposited with head office and attracts interest at market related rates.
9 Health Zone (Pty) Ltd clubs generate positive working capital.
10 Tax has not been included in the cash flow forecasts of new clubs since individual clubs have
no control over this aspect.
11 Cash flows per the above forecasts are assumed to occur at the end of the financial year.
Although this assumption is conservative, it is consistent with head office capital budgeting
Health Zone (Pty) Ltd requires that new clubs achieve a 20% pre-tax rate of return. For capital
budgeting purposes Health Zone (Pty) Ltd requires that new clubs generate positive cash flows, in net
present value terms, over the initial five-year period after opening of the club in question.
Leasing option
The major constraint facing Health Zone (Pty) Ltd is access to funding in order to open new clubs.
The company has a limited capital base and at present new clubs are funded by means of cash flows
generated by existing clubs.
GymQuip (Pty) Ltd has offered to lease gym equipment to Health Zone (Pty) Ltd. While the terms of
such lease agreements have not yet been negotiated, GymQuip (Pty) Ltd has indicated that –
• lease terms would be five years;
• lease payments would be monthly in advance;
• maintenance charges would be incorporated into monthly lease payments; and
• Health Zone (Pty) Ltd would not be entitled to purchase the equipment at the end of the lease
Membership fees
Health Zone (Pty) Ltd is considering offering members the option of paying membership fees annually
in advance. Members currently only have the option of paying monthly in advance. The company has
not yet decided what discounts should be offered to members who elect to pay annually in advance.
(a) Determine the net present value of the projected cash flows at 1 July 2004 of the new Health
Zone (Pty) Ltd club in Sandton for the period 1 July 2004 to 30 June 2009. Show all your
workings. (20)
(b) Calculate the average number of members that the Sandton Health Zone club would require to
break even, from an accounting perspective, in the 2007 financial year. (8)
(c) List the potential advantages to Health Zone (Pty) Ltd of leasing gym equipment from GymQuip
(Pty) Ltd as opposed to purchasing the equipment. (6)
(d) List factors to be considered by Health Zone (Pty) Ltd in determining the discount that should
be offered to members who elect to pay membership fees annually in advance. (6)
(e) List procedures that should be followed when assessing the creditworthiness of new members
of Health Zone (Pty) Ltd clubs. (5)
See the present value tables at the end of the paper.

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