Port a Cabin, Inc.

Page 1 of 5

Port-a-Cabin, Inc.
Sandra Adam had a great idea. During her master's program in civil engineering, she had
designed for use with a standard home toilet a com pact filtration system that was able to
reduce by over 70% the volume of effl uent requiring disposal by secondary or tertiary treatment
facilities. After graduation she continued to refine the system and finally, in mid-2005, she
received a patent on her filtration process.

Jeff Adam, Sandra's younger brother, completed his MBA in the spring of 2006 and started
to help Sandra explore the commercial possibilities of the filtration system. He had held
various summer jobs in the construction industry and with a plastics molding company, and he
helped Sandra build the prototype filtration system. Being quite familiar with the capabilities of
the system he had some ideas about at least one potential application of the system—portable
toilets.

Both of the Adams saw portable toilets as a natural use for the compact filtration system, and
one where they might have a competitive advantage over standard holding tank models. One
of the major costs associated with portable toilets is pumping the effl uent collected in the
holding tank into a truck for disposal at an approved treatment center. With heavy use the
toilets require pumping at least once, and sometimes twice, each week. With the compact
filtration system, though, primary filtration would be done at the toilet, so only 30 percent of
the total effl uent would need pumping and further treatment (the rest is discharged into a
standard storm drain) Thus, the pumper truck would make two-thirds fewer service calls for
each toilet. This would result in a considerable savings in time and labor. Jeff Adam believed that
construction companies, rental firms, sports organizers and other users of portable toilets
would be most interested in such a product, assuming it could be priced competitively.

Through contacts at the plastics molding company for whom he had worked Jeff was able to
obtain estimates of the cost of necessary equipment and manufacturing costs to produce one-
piece plastic composite toilet housings. Sandra had been researching production costs for
manufacturing the filtration and holding tank system required for each toilet. It was soon apparent
that the Adams would be able to build state-of-the-art portable toilets and sell them at a good profit
for only slightly more than standard systems cost. Hence, they decided to form a company to produce
and market what they called "Port a Cabin, Inc; Portable Relief Stations." It was agreed that Jeff would
oversee the actual production process and handle all financial arrangements while Sandra would
supervise quality control and be in charge of sales and distribution. Because of the construction boom
in the Sunbelt area where the firm would be located, local banks and insurance companies indicated a
willingness to supply the Adams with debt capital. Equity could be raised through a stock sale to
local investors at a price of $10 per share.

A local attorney advised the Adams that now, before any value was created and before raising any
outside capital, the business should be incorporated. He further suggested that there be ten million
authorized shares with a $10 par value. It would not be necessary to issue the full ten million shares
initially—only as many as were actually needed could be issued. The Adams decided that the best
course of action was to issue a yet-to-be-determined number of shares to themselves at a share
price of $0.10 each, or $X in total, to assign a value of $1 to the patent, and to use the cash account as
the offsetting entry. These actions would produce the initial balance sheet shown in Table 1.

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The information in this case is disguised. However, the financial data of this company / industry represents an accurate approximation. December 29, 2019
Port a Cabin, Inc. Page 2 of 5

Table 1 Pro Forma Balance Sheet

Cash $ X-1 Accounts payable

Accounts receivable 1 Notes payable $0
Inventory 0 Other current liabiliti es 0
Plant and 0 Long-term debt 0
Equipment 0 Common stock ($0.10 par) 0
Patents 1 Total liabiliti es and net worth X
Total assets $X Total liabilities and net worth $X

Before the corporate charter can be filed, it is necessary to determine the number of shares Sandra
and Jeff can issue to themselves at $0.10 each; if they sell themselves too many, outside investors will
not be willing to buy sufficient stock at $10 per share to meet the firm's financial require ments. Thus, a
realistic business plan is required to set forth information about the production processes, the market,
and financing arrangements for additional capital.

The Adams are planning to sell the toilets directly to large con struction companies; equipment rental
firms; and other potential users such as school districts for athletic fields and special events. They
project a selling price of $900 per unit, which is only slightly more than the cost of a standard holding
tank system. The much lower servicing cost attributable to the in-tank filtration system is expected to
make the toilets highly competitive in the regional market.

Although some sales will be made to organizations such as schools and churches, it is clear that the
primary demand will be from the construction industry and service firms who cater to that industry.
Due to the cyclical nature of the construction industry, as well as uncertainty in the economy as a
whole, Sandra and Jeff have estimated full-operation sales for three scenarios—optimistic, most
likely, and pessimistic. These estimates are given in Table 2. Jeff interprets the most likely value as
the mathematical expected value of a normal probability distribution, and the pessimistic and
optimistic values as being two standard deviations below and above the expected value.

Table 2 Distribution of Sales

Scenario Sales in Units Sales in Dollars
Pessimistic 13,025 $11,722,500
Most likely 17,025 15,322,500
Optimistic 21,025 18,922,500

After an in-depth study, two alternative production processes were identified that could be employed
in manufacturing the toilet shells. Plan A holds down the initial investment somewhat and has
significantly lower fixed operating costs; it involves the use of a minimum amount of highly
automated equipment, combined with purchasing tank-age subassemblies locally rather than
manufacturing them. Under this plan, annual fixed costs are estimated to be $2,567,000, while
variable costs would be $700 per unit produced.

The second alternative, Plan B, involves more operating leverage: fixed costs would be $6,035,500 per
year, and variable costs $490 per unit. The selling price will be set at $900 regardless of the production
process, and neither of the estimated fixed costs includes any interest charges. Total capital
requirements for current and fixed assets, plus operating funds during the start-up period, are

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The information in this case is disguised. However, the financial data of this company / industry represents an accurate approximation. December 29, 2019
Port a Cabin, Inc. Page 3 of 5

estimated to be $4.125 million under Plan A and $4.628 million under Plan B. At the moment, these
investment requirements are known with certainty.

QUESTIONS

1. Which production plan should the Adams choose? To answer this question, calculate the breakeven
point and the expected EBIT under each plan, as well as the level of EBIT at the different sales levels.
Then use this information to help analyze the riskiness and relative rates of return of Plans A and B.
Also, calculate the return on investment (ROI) for each project, and the sales level at which ROI A =
ROIB. It should be noted that the information given to this point in the case will not be sufficient to
enable you to reach a definite conclusion regarding Plans A and B. You can, however, think about
the issues.

2. Regardless of your conclusion in Question 1, assume that the Adams decided to go with Plan B,
and that the total capital required by John Pottery is $4.628 million to put this plan into effect. 1 Jeff
contacted various commercial banks, investment bankers, and other potential sources of outside
capital. Based on his notes from these meetings, he constructed the schedule for the cost-of-
debt given in Table 3 (these rates apply to all debt raised to finance Plan B).

Table 3 Debt Schedule

Amount Borrowed Interest Rate on All Debt
up to $ O.650 million 10.00 %
$0.650 to 1.300 million 10.25
1.300 to 1.950 million 10.70
1.950 to 2.640 million 11.50
2.640 to 3.305 million 12.95
3.305 to 3.965 million 15.75
3-965 to 4.628 million 20.15

It is clear to Jeff that some equity will be required; all of the capital requirements cannot be
financed by debt. The investment banker had suggested that an initial price of $10 per share
should maximize the appeal and thus the marketability of the stock. Most of the issue would likely
be subscribed locally, and the consensus is that for Plan B, the cost-of-equity schedule given in
Table 4, stated as a function of the amount of debt employed, is a reasonable estimate.

1
Before the asset decision can be finalized, Jeff would need to perform the same analysis for Plan A as he is
going through here for Plan B. Only with information on both the operating cost structure of the
production process and the associated optimum financial structure for each alternative can a rational
decision be made.
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The information in this case is disguised. However, the financial data of this company / industry represents an accurate approximation. December 29, 2019
Port a Cabin, Inc. Page 4 of 5

Table 4 Cost-of-Equity Schedule

Debt (Millions of Dollars) Cost-of-Equity

$ 0.000 10.50%
0.650 11.20
1.300 12.25
1.950 13.75
2.640 15.95
3.305 18.90
3.965 22.50
4.628 27.00

3. The investment banker indicated that if no debt is used, and the Adams finance only with
common stock, 462,800 shares can be sold at the $10 per share to raise the $4.628 million of
capital required for Plan B. If debt financing is used, stock will be sold at $10 per share, but
fewer shares will have to be issued to raise the required $4.628 million.

4. Jeff is interested in choosing the financing plan that will create the greatest personal net worth
for him and Sandra, where net worth is defined as follows:

5. Net worth = Value of stock x Number of shares for the Adams.

6. The price is to be set at $10, so you need to fi nd the maximum number of shares that
the founders can issue to themselves and still have investors be willing to pay $10 per share
while raising the required equity. To simplify the calculations, assume that the capital
requirements are net of any cash received on the sale of the stock at $0.10 per share to the
Adams. Thus, you may ignore this amount and presume for calculation purposes that the Adams
pay nothing for their stock. Use a tax rate of 48 percent, and complete Table 5.

Table 5 Value Calculations

Interest Cost-of- Number of Self-
Debt Firm Value
Rate Equity Insured Shares
$0 10.00% 10.50% $4,678,762 ?
650,000 10.00 11.20 $4,734,554 ?
1,300,000 10.25 12.25
1,950,000 10.70 13.75
2,640,000 11.50 15.95
3,305,000 12.95 18.90
3,965,000 15.75 22.50 $4,705,162 7,716
4,628,000 20.15 27.00 $4,651,512 2,351

7. [Hints: (1) you can base your analysis on expected EBIT, calculated at the expected level of sales.
This requires fewer calculations than if you calculated values at each of the three sales levels.
(2) If the Adams use no debt, they will sell 462,800 shares at a price of $10 each (disregarding
any shares they themselves will receive). If they do use debt, they will sell fewer shares. In
setting up your analysis, first analyze the situation at zero debt, then analyze the leverage

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Port a Cabin, Inc. Page 5 of 5

situations. The value of the firm, and the shares the Adams can keep, will change at each debt
level.]

8. From the standpoint of the times-interest-earned (TIE) ratio, how safe does the company look?
Explain. (Note: the average manufacturing firm has a TIE ratio to about 6X.)

9. Suppose the debt is in the form of a 20-year term loan. What will the annual amortization payment
be (interest plus principal)? Use this to calculate WC Inc.'s debt service coverage ratio. (For
simplification, the debt service coverage ratio here is defined as EBIT / [Interest charges + Before-
tax principal repayment].) Does this ratio indicate that the company is in a safe position? Explain.
(Note: the average manufacturing firm has a coverage ratio of about 4 X)

10. Suppose this were your company. What level of debt would you choose? Would your choice be
influenced by your other assets; that is, would it matter whether your entire net worth was
invested in the company as opposed to a situation where you owned about $1 million of other
securities?

_____________________________________________________________________________________________________________________________________
The information in this case is disguised. However, the financial data of this company / industry represents an accurate approximation. December 29, 2019