Strategic decision making

Flabberdegaz Ltd operates 12 theaters in major cities in New Zealand. The company was established by a group of entrepreneurs with significant experience in the music industry. The first Flabberdegaz theatre was opened in Wellington in 2013 and immediately became popular amongst music lovers. The success of the first venue led to Flabberdegaz Ltd opening a further 11 theaters over the next three years.

Flabberdegaz Ltd theaters offer patrons the opportunity to enjoy high quality musical shows. The company has flourished at a time when theatre attendance generally has been on the decline. Flabberdegaz's musical theme shows have entranced audiences due to the quality of productions and the brilliance of cast members. Patrons are permitted to purchase alcoholic and other beverages on the premises to consume before and during shows. However, Flabberdegaz does not serve food or meals.

The company commissions independent contractors to write and produce musical shows on an annual basis. All rights to such shows are owned by Flabberdegaz Ltd and these shows may only be staged at its theaters. Independent contractors are paid a fixed amount per new show for their creative work. The company has its own casting directors, musical directors and choreographers who select cast members and direct and rehearse their performances. The company offers musicians and artists contract employment for the duration of shows, and hence does not offer them permanent employment.

Flabberdegaz Ltd has approximately six different shows running at its 12 theaters nationally, at any point in time. These shows are rotated amongst the different theaters and care is taken to ensure that the same shows are not featured at theaters in close proximity to each other. The company commissions four new musical shows per year to continually provide patrons with opportunities to see new musicals.

Each theatre can accommodate 350 patrons and has standardised décor. The company has historically leased premises and lease agreements are generally for ten-year periods with five- year renewal options. Flabberdegaz Ltd is planning to build and own its theaters in future. This change in strategy resulted from the high cost of leasing premises and will enable the company to effectively utilise its free cash flow annually. Historically, surplus cash has been distributed annually to shareholders in the form of dividends.

Flabberdegaz Ltd plans to build and open two new theaters (350 seats in each) during the 2018 financial year. The cost of erecting such theaters is estimated at $15 million each. Sound equipment and furniture and fittings for each theatre are expected to cost a further $2,5 million per venue. The new theaters are to be financed by means of long-term loans from a commercial bank repayable annually, over a ten-year period. Commercial banks have adopted the view that theatre buildings provide limited security for loans due to their specialised nature and use. Accordingly, loans are to be secured by a pledge (floating charge) over movable and immovable assets of Flabberdegaz Ltd, as well as personal suretyships from individual shareholders. Loans will bear interest at 1.5% above the prevailing medium risk lending rate, which is currently 11% per annum. The medium risk lending rate is tied to and move with the prime bank rate.

There are four individual shareholders who collectively own 100% of the shares in issue of Flabberdegaz Ltd. These individuals are all executive directors and are actively involved in the business.

The shareholders and executive directors of Flabberdegaz Ltd are concerned about the following issues facing the business:

- The financial results of Flabberdegaz Ltd for the year ended 30 June 2017 were lower than the budgeted results approved by the board in July 2016.
- Attendance levels at Flabberdegaz theatres have been declining over the past year. The shareholders are considering different strategies to boost attendance, including lowering ticket prices.

The budget and actual financial results of Flabberdegaz Ltd for the year ended 30 June 2017 as well as the draft budget for the 2018 financial year are summarised below:

Notes

1 Although Flabberdegaz does sell tickets directly, the majority of sales are through an independent ticketing agent who has a national call centre infrastructure. Commission of 10% of the face value of tickets is paid to the independent ticketing agent. The company operated 12 theatres throughout the 2017 financial year, each with a capacity of 350 seats. The two new theatres are scheduled to open on 1 October 2017 and 1 March 2018. The budgeted and actual attendance statistics and ticket sales for the year ended 30 June 2017, and budget assumptions for the year ending 30 June 2018 are summarised below:

2 Construction costs of stage props for new shows are expensed in the year they are incurred.

3 Leasehold improvements, sound equipment and furniture and fittings are depreciated over a ten-year period. Depreciation is budgeted to increase significantly in the second half of 2017 and first half of 2018 because of the new theatres being opened. Buildings are to be depreciated over 20 years.

4 Budgeted rental escalations are 9% based on the terms of lease agreements.

5 Musicians and artists sometimes follow particular shows from theatre to theatre. The majority of traveling and accommodation costs per the income statements relate to expenses incurred by cast members traveling to different cities and their accommodation costs.

6 Other overheads are fixed in nature.

The balance sheet of Flabberdegaz Ltd at 30 June 2017 is summarised below:

FLABBERDEGAZ LTD BALANCE SHEET AT 30 June 2017

REQUIRED

(a) Critically analyse the actual results of Flabberdegaz Ltd for the year ended 30 June 2017 and compare the results against the 2017 budget. Your answer should include -
(i) computations of key ratios and variances;
(ii) commentary on the major variances between actual and budgeted performance; and
(iii) highlight any major issues that the executive directors of Flabberdegaz Ltd should address which is evident from your analysis.
Hint: "Variances" does not refer to standard cost variances, but to the differences between the two sets of figures.

(b) Calculate the number of tickets that need to be sold in the 2018 financial year in order to break even. Assume that the utility, marketing and traveling and accommodation costs are fixed in nature. In addition, you should assume that 65% of all ticket sales occur through the independent ticketing agent.

(c) Review and evaluate the draft budget income statement for the year ending 30 June 2018 and identify any issues and assumptions that may require revision before the board of directors of Flabberdegaz Ltd approve the budget. Show all your workings.

(d) Critically evaluate the decision of Flabberdegaz Ltd to build and own its theatres as opposed to leasing premises in future, and consider the potential financial impacts of this decision and the risks inherent in pursuing this strategy. Indicate whether you agree with their decision and provide detailed reasons for your conclusion.