AFM231 Chapter Notes - Chapter 27: Personal Bankruptcy, Secured Creditor, Meet Bill

Case 13–6: Butler Lumber Company*

After a rapid growth in its business during recent years, the Butler Lumber Company in the spring of 2011 anticipated a further substantial increase in sales. Despite good profits, the company had experienced a shortage of cash and had found it necessary to increase its borrowing from the Suburban National Bank to $247,000 in the spring of 2011. The maximum loan that Suburban National would make to any one borrower was $250,000, and Butler had been able to stay within this limit only by relying very heavily on trade credit. In addition, Suburban was now asking that Butler secure the loan with its real property. Mark Butler, sole owner and president of the Butler Lumber Company, was therefore looking elsewhere for a new banking relationship where he would be able to negotiate a larger and unsecured loan.

Butler had recently been introduced by a friend to George Dodge, an officer of a much larger bank, the Northrop National Bank. The two men had tentatively discussed the possibility that the Northrop Bank might extend a line of credit to Butler Lumber up to a maximum amount of $465,000. Butler thought that a loan of this size would more than meet his foreseeable needs, but he was eager for the flexibility that a line of credit of this size would provide. After this discussion, Dodge had arranged for the credit department of the Northrop National Bank to investigate Mark Butler and his company.

The Butler Lumber Company had been founded in 2001 as a partnership by Mark Butler and his brother-in-law, Henry Stark. In 2008 Butler bought out Stark’s interest for $105,000 and incorporated the business. Stark had taken a note for $105,000, to be paid off in 2009; to give Butler time to arrange for the financing necessary to make the payment of $105,000 to him. The major portion of the funds needed for this payment was raised by a loan of $70,000, negotiated in late 2008. This loan was secured by land and buildings, carried an interest rate of 11%, and was repayable in quarterly installments at the rate of $7,000 a year over the next 10 years.

The business was located in a growing suburb of a large city in the Pacific Northwest. The company owned land with access to a railroad siding, and two large storage buildings had been erected on this land. The company’s operations were limited to the retail distribution of lumber products in the local area. Typical products included plywood, moldings, and sash and door products. Quantity discounts and credit terms of net 30 days on open account were usually offered to customers.

Sales volume had been built up largely on the basis of successful price competition, made possible by careful control of operating expenses and by quantity purchases of materials at substantial discounts. Much of the moldings and sash and door products, which constituted significant items of sales, were used for repair work. About 55% of total sales were made in the six months from April through September. No sales representatives were employed, orders being taken exclusively over the telephone. Annual sales of $1,697,000 in 2008, $2,013,000 in 2009, and $2,694,000 in 2010 yielded after-tax profits of $31,000 in 2008, $34,000 in 2009, and $44,000 in 2010.¹ Operating statements for

^{theyears2008–2010andfor thethreemonthsendingMarch31,2011,aregiveninExhibit1.}EXHIBIT 1: Operating Statements for Years Ending December 31,⁴¹¹ 2008–2010, and for First Quarter 2011 (thousands of dollars)

^a ln the first quarter of 2010 sales were $698,000 and net income was $7,000.

^b Operating expenses include a cash salary for Mr. Butler of $75,000 in 2008, $85,000 in 2009, $95,000 in 2010, and $22,000 in the first quarter of 2011. Mr. Butler also received some of the perquisites commonly taken by owners of privately held businesses.

Mark Butler was an energetic man, 39 years of age, who worked long hours on the job. He was helped by an assistant who, in the words of the investigator of the Northrop National Bank, “has been doing and can do about everything that Butler does in the organization.” Other employees numbered 10 in early 2011, 5 of whom worked in the yard and drove trucks and 5 of whom assisted in the office and in sales

As part of its customary investigation of prospective borrowers, the Northrop National Bank sent inquiries concerning Mark Butler to a number of firms that had business dealings with him. The manager of one of his large suppliers, the Barker Company, wrote in answer:

The conservative operation of his business appeals to us. He has not wasted his money in disproportionate plant investment. His operating expenses are as low as they could possibly be. He has personal control over every feature of his business, and he possesses sound judgment and a willingness to work harder than anyone I have ever known. This, with a good personality, gives him a good turnover; and from my personal experience in watching him work, I know that he keeps close check on his own credits.

All the other trade letters received by the bank bore out this opinion.

In addition to owning the lumber business, which was his major source of income, Butler held jointly with his wife an equity in their home. The house had cost $72,000 to build in 1989 and was mortgaged for $38,000. He also held a $70,000 life insurance policy, payable to his wife. She owned independently a half interest in a house worth about $55,000. Otherwise, they had no sizeable personal investments.

The bank gave particular attention to the debt position and current ratio of the business. It noted the ready market for the company’s products at all times and the fact that sales prospects were favorable. The bank’s investigator reported: “Sales are expected to reach $3.6 million in 2011 and may exceed this level if prices of lumber should rise substantially in the near future.” On the other hand, it was recognized that continuation of the current general economic downturn might slow down the rate of increase in sales. Butler Lumber’s sales, however, were protected to a considerable degree from

_{fluctuationsinnewhousingconstructionbecauseoftherelativelyhighproportionofitsrepairbusiness.Projectionsbeyond2011weredifficulttomake,buttheprospectsappearedgoodfora} continued growth in the volume of Butler Lumber’s business over the foreseeable future.

The bank also noted the rapid increase in Butler Lumber’s accounts and notes payable in the recent past, especially in the spring of 2011. The usual terms of purchase in the trade provided for a discount of 2% for payments made within 10 days of the invoice date. Accounts were due in 30 days at the invoice price, but suppliers ordinarily did not object if payments lagged somewhat behind the due date. During the last two years, Butler had taken very few purchase discounts because of the shortage of funds arising from his purchase of Stark’s interest in the business and the additional investments in working capital associated with the company’s increasing sales volume. Trade credit was seriously extended in the spring of 2011 as Butler strove to hold his bank borrowing within the $250,000 ceiling imposed by the Suburban National Bank. Balance sheets at December 31, 2008–2010 and March 31, 2011, are presented in Exhibit 2.

The tentative discussions between George Dodge and Mark Butler had been about a revolving, secured 90-day note not to exceed $465,000. The specific details of the loan had not been worked out, but Dodge had explained that the agreement would involve the standard covenants applying to such a loan. He cited as illustrative provisions the requirement that restrictions on additional borrowing would be imposed, that net working capital would have to be maintained at an agreed level, that additional investments in fixed assets could be made only with prior approval of the bank, and that limitations would be placed on withdrawals of funds from the business by Butler. Interest would be set on a floating-rate basis at 2 percentage points above the prime rate (the rate paid by the bank’s most creditworthy customers). Dodge indicated that the initial rate to be paid would be about 10.5% under conditions in effect in early 2011. Both men also understood that Butler would sever his relationship with the Suburban National Bank if he entered into a loan agreement with the Northrop

^{NationalBank.}412 Questions ⁴¹³

What has been the company’s financial strategy? Why does Mr. Butler have to borrow so much money to support this seemingly profitable business? Has he been managing his company’s cash flow wisely?

1

Sales in 2006 and 2007 amounted to $728,000 and $1,103,000, respectively; profit data for these years are not comparable with those of 2008 and later years because of the shift from a partnership to a corporate form of organization. As a corporation, Butler was taxed at the rate of 15% on its first $50,000 of income, 25% on the next $25,000 of income, and 34% on all additional income above $75,000.

1

This statement is not necessarily consistent with the profit maximization assumption often made in economics. The techniques in this chapter are equally applicable under a profit maximization assumption, however, so there is no point in arguing here whether the profit maximization assumption is valid and useful. Discussion of this point is deferred until Chapter 26.

2

As described later, net income may be subject to an adjustment for interest expense when calculating ROI.

3

In this context, the companies are using net assets to mean assets less current liabilities, whereas the formal accounting meaning is assets minus all liabilities.

4

Diagrams analogous to Illustration 13–1 can be drawn to show return on invested capital or return on assets, as alternative ROI measures.

5

Major newspapers such as The Wall Street journal print firms’ P/E ratios along with the firm’s daily stock quotations. These data are also available in many sites on the Internet.

6

Financial analysts often exclude one-time items from income when calculating profitability ratios. In addition to extraordinary items, one-time items often include restructuring changes, inventory writedowns, asset impairments, contingency losses and gains, and gains and losses on asset dispositions.

7

A company’s implied growth rate is often used in dividend and net income-based equity valuation models to normalize dividend and net income growth for future periods beyond five years.

Summer is approaching and Steven and Sue Mahan have finally decided that their idea of a successful Southwestern furniture, art, and jewelry trading company has come of age. They know that summer is a popular tourist time in New Mexico and could be the best time to start this new business. The Mahans have had a long-time interest in Southwestern art and furniture. Steven graduated from college with an economics degree about 15 years ago and received his MBA in finance a few years later. He has been working in Dallas, TX, as the controller of a major wholesale distributor company for many years. His wife, Sue, who will be a full partner in the business, spent the first 10 years of her career in retail sales. Over the last several years, she has assumed more administrative duties for the group she works with.

Steven and Sue know they bring the expertise and skill to run a successful business, but to ensure success they have been researching the market for over five year's. They also know that they must be very careful and thoroughly research the business and industry they are pursuing. They have traveled extensively to New Mexico and have spent a good deal of time getting to know the local artists (primarily ski bums). They have found that there is a great demand for Southwestern furniture in Texas and the Southwest,

The Mahans have decided to open a shop called Southwest Trading Company in Taos, NM, and act as both a retailer and supplier to furniture and art outlets in Texas. Steven's extensive contacts with businesses in Dallas and Houston have given him the orders needed to make the business a success as soon as they begin shipping the goods. Sue has already begun marketing the Southwestern products. Southwest Trading Company's arrangements with the local craftspeople will allow very aggressive pricing of the goods to retail establishments in Texas. This aggressive pricing has been well received and tentative orders are already in place.

Steven has found an ideal location in Taos that is currently available. The owner is ask­ing $275,000 for the space but Southwest Trading has a contract, contingent on financing, for $250,000. Steven and Sue have gotten bids on remodeling and should be able to reno­vate the space for about $45,000. Although they will purchase the building, the land is leased on a transferable lease with 65 years remaining. The Mahans have decided to invest $235,000, which represents most of their savings, into the venture. Sue's sister is also interested in the possibilities that the company exhibits and is lending Southwest $90,000. Repayment on the note to Sue's sister is not expected to begin for five years. They have estimated that they will need $130,000 in inventory to start the business and they will buy the inventory in cash to build goodwill with the local craftspeople. They also estimate that they will need $20,000 in cash to conduct day-to-day operations and bill payment.

Wanting to use a local bank, Steven has approached Cary Farmer, the senior loan officer at Santa Fe National Bank in Santa Fe, NM, for financing. Steven's background in finance has allowed him to put together the following assumptions for their preliminary business plan. Steven believes that all renovations to the building and inventory can be in place by the end of June 2008.

Sales are expected to be a bit lower the first year (July through December, 2008), since only six months will be included in the first fiscal year. Sales are expected to gtow significantly in the first full year, 2009, with growth leveling oft in the third and fourth years. Sales are expected to be $275,000, $675,000, $800,000, and $900,000 in 2008, 2009, 2010 and 2011, respectively. Sales are expected to level off after 2011.

Based on tentative agreements and orders, it is expected that cost of goods sold will average about 63 percent of sales.

General and administrative expenses are expected to be $70,000 for the six months in 2008, increase to $100,000 in 2009, and level off at $120,000 from 2010 forward. The land lease expenses and interest expenses are included in operational expenses.

Selling expenses are expected to be about 12 percent of sales and Sue is expecting to undertake extensive marketing and promotion efforts throughout Texas after the busi­ness is opened. It is expected that these additional promotional expenses will be about $30,000 in 2008 only.

The company will use 10-year straight-line depreciation of the building and improvements.

Southwest's effective tax rate is expected to be 34 percent.

Since they expect a good deal of business to be paid by credit card and to ship goods to Texas on credit, they expect to carry about 48 days of accounts receivable. They also expect that, because of the type of business they are entering, they will turn their inventory over about three times a year.

On the basis of the negotiations they have had with their craftspeople, suppliers, and other wholesale distributors, they estimate that they can count on about 28 days of accounts payable to help finance the business.

In preparing to go to the bank for the necessary loan, the Mahans want to prepare pro­jected financial statements showing that Southwest Trading Company can make a profit and pay back the loan. They also want to know more precisely how much they will need to borrow from the bank to open the doors for business. The Mahans plan to prepare five years of balance sheet, income statement, and cash budget data for the bank. They must also develop an opening balance sheet as of the day they plan to open the doors, June 30, 2008. These pro forma financial statements will aid them, and the hank officer, in answer­ing many questions including the following:

How much financing will be needed to open the doors of the business in July 2008?

Five years of pro forma balance sheet and income statement data must be prepared to determine if additional financing is needed, and if so, how much. Steven's finance background tells him that the estimated financing needed each year will be an account­ing plug figure to ensure that the balance sheet balances. If projected assets exceed liabilities and equity, the difference will be the bank's borrowing needs. If liabilities and equity exceed projected assets purchases, these funds will be used to pay off debt or increase cash or marketable securities.

Because this is a start-up business, it is even more important to identify what the loan proceeds will be used for, what the primary source of repayment is, and when the total loan proceeds will be repaid. Using the pro forma projections, the primary source of repayment and when the loan will be repaid can be determined.

A cash budget or cash-based income statement needs to be prepared because Steven knows the only thing that matters to the bank is cash.

Finally, Steven needs to prepare a collateral schedule. He knows that the banker does not want the collateral but will need all he can get if the business is not as successful as expected.

Prepare a list of questions to which you would need the answers. Be sure to explain the specifics of the questions as they relate to this case.

What types of loan covenants would you require?

Identify the bank's largest risks in making this loan.

How would you structure the loan to protect the bank?

What is your recommendation concerning the loan request?

Conduct the analysis suggested by the above questions. What is your recommendation concerning the loan request?