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Case 10 81.......................................................2
Quang Company : Financial Analysis and Loan
Structure ................................................................2
CASE 1*....................................................................3
Going Public..............................................................3
Sun Coast Savings Bank............................................3
CASE 2 *....................................................................7
Lease Analysis..........................................................7
Environmental Sciences, Inc......................................7
CASE 3*...................................................................11
Working Capital.......................................................11
Policy and Financing................................................11
Office Mates, Inc.....................................................11
CASE 4....................................................................16
Cash Budgeting.......................................................16
Alpine Wear, Inc. ....................................................16
Question ................................................................17
CASE 5....................................................................23
Entrepreneurship: ..................................................23
Financing and Valuing ............................................23
A New Venture .......................................................23
CASE 6....................................................................31
Project Risks...........................................................31
Cogeneration Corporation........................................31
CASE 7....................................................................41
Profitability and Loan Policy....................................41
Key Bank.................................................................41
Assets................................................................................................ 43
Liabilities & Equity.............................................................................43
Gap Strategies..................................................................................51
Cash flow from operating activities.........................................56
Cash flow from investing activities.........................................56
Cash flow from financing activities.........................................56
CASE 8....................................................................58
Strategic and Industry Analysis................................58
NetGear Industries..................................................58
Years ended December 31................................................................63
CASE 9....................................................................68
Risk Acceptance Criteria & SME Distress Indicators...68
Ho Hung Imports.....................................................68
Liabilities and equity ..............................................73
Pro Forma Income Statements.................................73
Ho Hung Imports – Part 2.........................................74
SME Distress Indicators...........................................74
Liabilities and equity ..............................................78
Liabilities and equity ..............................................80
Statement Date Sales before taxes*.....................81
Quang Company......................................................82
Liquidity............................................................................................. 88
Activity.............................................................................................. 88
Profitability........................................................................................ 88

Case 10
Quang Company : Financial Analysis and Loan Structure


Going Public
Sun Coast Savings Bank

Sun Coat Saving Bank was founded in 1971 in Safety Harbor, Florida, which is just
across the bay from Tampa. Safety Harbor is very popular with people who work in Tampa
but do not wish to live within the city itself. Per-capita income in Safety Harbor is
substantially above the national average; in fact, the town has a reputation for having the
greatest population, of BMWs and Mercedes Benzes per capita in the United States. The
combination of an increasing population, high per capita income, and a huge demand for
funds to finance new home construction has made Sun Coast the fastest-growing association
in the state in terms of both assets and earnings.
Although Sun Coast is very profitable and has experienced rapid growth in earnings,
the company’s quick expansion has put it under severe financial strain. Even though all
earnings have been retained, the net-worth-to-assets ratio has been declining to the extent that,
by 1993, it was just above the minimum required by federal regulations (see Table 1).
Sun Coast now has the opportunity to open a branch office in a new shopping center.
If the office is opened, it will bring in profitable new loans and deposits, further increasing the
company’s growth. However, an inflow of deposits at the present time would cause the net-
worth-to-assets ratio to fall below the minimum requirements. Consequently, Sun Coast must
raise additional equity funds of approximately $3 million if it is to open the new branch.

Table 1
Sun Coast savings Bank
Balance Sheet for Year Ended
Cash and marketable securities $ 83,441,700
Mortgage loans 815,235,000
Fixed assets 60.423.300
Total assets $959,100,000
Savings accounts
Other liabilities $817,153,200
Capital stock ($100 par value) 83,077,000
Retained earnings 900,000
Total claims 57,969,800
Note: Federal law requires the ratio of capital plus retained earnings-to-assets to be at least 6
Even though Sun Coast has a ten-man board of directors, the company is completely
dominated by the three founders and major stockholders: Jim Evans, chairman of the board
add owner of 35 percent of the stock; Tony McCoy, president and owner of 35 percent of the
stock; and Vincent Culverhouse, a builder serving as a director of the company and owner of
20 percent of the stock. The remaining 10 percent of the stock is owned by the other seven
directors. Evans and Culverhouse both have substantial outside financial interests. Most of
McCoy’s net worth is represented by his stock in Sun Coast.
Evans, McCoy, and Culverhouse agree that Sun Coast should obtain the additional
equity funds to make the branch expansion possible. They are not in complete agreement,
however, as to how the additional funds should be raised. They could raise the additional
capital by having Sun Coast sell newly issued shares to a few of their friends and associates.
The other alternative is to sell shares to the general public. The three men themselves cannot
put additional funds into the company at the present times.
Evans favors the private sale. He points out that he, McCoy, and Culverhouse have all
been receiving substantial amounts of ancillary, or indirect, income from the savings bank
operation. The three men jointly own a holding company, which operates an insurance agency
that writes insurance for many of the homes financed by Sun Coast and a title insurance
corporation that deal with the association. Also, Culverhouse owns a construction company
that obtains loans from the association. Evans maintains that these arrangements could be
continued without serious problems if the new capital were raised by selling shares to a few
individuals, but questions of conflict of interest would probably arise if the stock were sold to
the general public. He also opposes a public offering on the grounds that the flotation cost
would be high for a public sale, but would be virtually zero if the new stock were sold to a
few individual investors.
McCoy disagrees with Evans. He feels that it would be preferable to sell the stock to
the general public rather than to a limited number of investors. Acknowledging that flotation
cost on the public offering are a consideration, and that conflict-of-interest problems may
occur if shares of the company are sold to the general public, he argues that there would be
several offsetting advantages if the stock were publicly traded: (1) the existence of a market-
determined price would make it easier for the present stockholders to borrow money, using
their shares in Sun Coast as collateral for loans; (2) the existence of a public market would
make it possible for current shareholders to sell some of their shares on the market if they
needed cash for any reason; (3) having the stock publicly traded would make executive stock-
option plans more attractive to key employees of the company; (4) establishing a market price
for the shares would simplify problems of estate tax valuation in the even of the death of one
of the current stockholders; and (5) selling stock to the public at the present time would
facilitate acquiring additional equity capital in the future.
Culverhouse, whole 20 percent ownership of the company gives him the power to cast
the deciding vote, it unsure whether he should back the public sale or the private offering. He
thinks that additional information is needed to help clarify the issues.
The board therefore instructed Madeline Brown, Sun Coast’s chief financial officer, to
study the issue and to report back in two weeks. As a first step, Brown obtained the data on
Sun Coast’s earnings given in Table 2. Brown then collected information on four publicly
traded financial institutions; this data is shown in Table 3. She then set about the task of
coming up with a recommendation for the board of directors.
Table 2
Sun Coast Savings Bank (Selected Information)
Year Net Profit Earnings per Share
1992 $8,562,780 $951.42
1991 7,476,390 830.71
1990 6,521,490 724.61
1989 5,231,610 581.29
1988 4,712,220 523.58
1987 3,905,550 433.95


Table 3
Data on Publicly – Traded
Financial Institutions

Assets Net Book Price EPS EPS

(Million) Worth Value per 1992 1987
(Millions) share
Virginia Federal $14,000 $ 950 $30.30 $32.00 $5.25 $2.50
Soithland Financial 30,500 2,020 16.15 17.00 2.00 0.83
Texas Federal 24,000 1,130 38.95 25.00 5.40 1.59
Great Southern Financial 27,000 1,400 56.50 28.00 6.25 3.94

1. Table 1 presents Sun Coast’s balance sheet at the end of 1992. Using information
contained in the balance sheet, calculate Sun Coast’s net-worth-to-assets ratio, the
number of shares of stock outstanding, and the book value per share of common stock.
2. Using the data in Table 2, calculate Sun Coast’s average annual growth rate in
earnings per share from 1987 to 1992. (Hint: In your calculations, use only the data for
1987 and 1992).
3. For the four S&L’s listed in Table 3, calculate the following.
a. The net worth/assets ratios for 1992
b. Compound annual growth rates in earnings per share for the five-year period
c. The price/earnings ratios in 1992.
d. The market value/book value ratios for 1992.
4. Considering your answers to Question 1 through 3, develop a range of values that you
think would be reasonable for Sun Coast’s market/book ratio if it were a publicly held
5. Regardless of your answer to Question 4, assume that 0.8x is an appropriate market
value/book value ratio for Sun Coast. What would be the market value per share of the
6. Investment bankers generally like to offer the initial stock of companies that are going
public at a price ranging from $10 to $30 per share. If Sun Coast stock were to be
offered to the public at a price of $20 per share, how large a stock split would be
required prior to the sale?
7. Assume that Sun Coast chooses to raise $3 million through the sale of stock to the
public at $20 per share.
a. Approximately how large would have to be sold in order for Sun Coast to pay
the flotation cost and receive $3 million net proceeds from the offering?
b. How many shares of stock would have to be sold in order for Sun Coast to pay
the flotation cost and receive $3 million net proceeds from the offering?
8. Assume that each of the three major stockholders decided to sell half of his stock.
a. How many shares of stock and what total amount of money (assuming that the
stock split occurred and that these shares were sold at a price of $20 per share)
would be involved in this secondary offering is defined as the sale of stock that
is already issued and outstanding. The proceeds of such offerings accrue to the
individual owners of the stock, not to the company.)
b. Approximately what percentage flotation cost would be involved if the
investment bankers were to combine the major stockholders’ secondary
offering with the sale by the company of sufficient stock to provide it with $3
9. Assume that the major stockholder decide that Sun Coast should go public. Outline in
detail the sequence of events from the first negotiations with an investment banker to
Sun Coast’s receipt of the proceeds from the offering.
10. Can you see why Evans and McCoy might personal differences of opinion on the
question of public ownership?
11. The analysis was based on the comparability of Sun Coast with four other savings
institutions. What factors might tend to invalidate the comparison?
12. All things considered, do you feel that Sun Coast should go public? Fully justify your


CASE 2 *
Lease Analysis

Environmental Sciences, Inc.

Over the past few years, official in Florida and other states that rely primarily on deep wells
for the drinking water have become aware of a potential serious problem – the pollution of
aquifers by the unrestrained use of fertilizers and pesticides. The result of a study conducted
by the United States Geological Survey showed that while the primary aquifer underlying
Florida is not yet contaminated, one chemical commonly found in agricultural pesticides has
caused extensive contamination of wells that tap water-bearing strata near the surface. To
combat this potentially widespread problem, officials in Florida and elsewhere are lobbying
for strict environmental regulation of commercial fertilizers and pesticides. As a result,
companies specializing in agricultural chemical have been working furiously to supply new
products that will not be banned under the proposed regulations.
Environmental Sciences, Inc., a regional producer of agricultural chemicals based in
Orlando, recently developed a pesticide that meets the new regulations. Now the firm must
acquire the necessary equipment to begin production. The estimated internal rate of return
(IRR) of this project is 24 percent and the project is judged to have low risk. Environmental
Sciences uses an after-tax cost of capital of 11 percent for relatively low-risk projects, 13
percent for those of average risk, and 15 percent for high-risk projects; so this low-risk project
passed the hurdle rate with flying colors.
The production-line equipment has an invoice price of $1,375,000, including delivery
and installation charges. It falls into the modified accelerated cost recovery system (MACRS)
five-year class, with current allowances of 0.20, 0.32, 0.19, 0.12, 0.11 and 0.06 in Years 1-6
respectively. Environmental’s effective tax rate is 40 percent. The manufacturer of the
equipment will provide a contract for maintenance and service for $75,000 per year, payable
at the beginning of each year, if Environmental Sciences buys the equipment.
Regardless of whether the equipment is purchased or leased, Susan Baker, the firm’s
financial manager, does not think it will be used for more than four years, at which time
Environmental’s current building lease will expire. Land on which to construct a larger
facility has already been acquired, and the building should be ready for occupancy at that
time. The new facility will be designed to enable Environmental to use several new
production processes that are currently unavailable to it, including one that will duplicate all
processes of the equipment now being considered. Hence, the current project is viewed as a
“bridge” to serve only until the permanent equipment can become operational in the new
facility four years from now. The expected useful life of the equipment is eight years, at
which time it should have a zero market value, but the residual value at the end of the fourth
year should be well above zero. Susan generally assumes that assets salvage values will be
equal to their tax book values at any point in time, but she is concerned about that assumption
in this instance.
Currently, the company has sufficient, capital, in the form of temporary investments in
marketable securities, to pay cash for the equipment and the first year’s maintenance. Susan
estimates that the interest rate on a 4-year secured loan to buy the equipment would be 11
percent, but she has decided to draw down the securities portfolio and pay cash for the
equipment if it is purchased.
Oceanside Capital, Inc. (OSC), the leasing subsidiary of a major regional bank, has


offered to lease the equipment to Environmental for annual payments of $435,000, with the
first payment due upon delivery and installation and additional payments due at the beginning
of each succeeding year of the 4-year lease term. This price includes a service contract under
which the equipment would be maintained in good working order. OSC would buy the
equipment from the manufacturer under the same terms that were offered to Environmental,
including the maintenance and service contract. Like Environmental, OSC executives think,
however, that the nature of the business. OSC is not expected to because of the expanding
nature of the business. OSC is not expected to pay annual taxes over the next 4 years, because
the firm has an abundance of tax credits to carry forward. Finally, OSC views lease
investments such as this as an alternative to lending, so if it does not write the lease, it will
lend the $1,375,000 that would have been invested in the lease to some other party in the form
of a term loan that would earn 11 percent before taxes.
Susan Baker has always had the final say on all of Environmental’s lease-versus-
purchase decisions, but the actual analysis of the relevant data is conducted by
Environmental’s method of evaluating lease decisions has been to calculate the “present value
cost” of the lease payments versus the present value of the total charges if the equipment it
purchased. However, in a recent evaluation. Susan and Tom got into a heated discussion
about the appropriate discount rate to use in determining the present value costs of leasing and
of purchasing. The following points of View were expressed.
(1) Susan argued that the discount rate should be the firm’s weighted average cost of
capital. She believes that a lease-versus-purchase decision is in effect a capital
budgeting decision, and such it should be evaluated at the company’s cost of
capital. In other words, one method or the other will provide a net cash savings in
any year, and the dollars saved using the most advantageous method will be
invested to yield the firm’s cost of capital. Therefore, the weighted average cost of
capital is the appropriate opportunity rate to use in evaluating lease-versus-
purchase decisions.
(2) Tom, on the other hand, believes that the cash flows generated in a lease-versus-
purchase situation and more certain than are the cash flows generated by the firm’s
average project. Consequently, these cash flows should be discounted at a lower
rate because of their low risk. At the present time, the firm’s cost of secured debt
reflects the lowest risk rate to Environmental Sciences. Therefore, 11 percent
should be used as the discount rate in the lease-versus-purchase decision.
To settle to the debate, Susan and Tom asked Environmental’s CPA firm to review the
situation and to advice them on which discount rate was appropriate. This led to even more
confusion because the firm’s accountants. Michelle Nobelitt and Bill Orr were also unable to
reach agreement on which rate to use. Michelle agree with Susan that the discount rate should
be based on the firm’s cost of capital, but on the grounds that leasing is simply an alternative
to other means of financing. Leasing is a substitute for “financing.” Which is a mix of debt
and equity, and it saves the cost of raising capital; this cost is the firm’s weighted average cost
of capital. Bill, however, thought that none of the discount rates mentioned so far adequately
accounted for the tax effects inherent in any capital budgeting decision, and he suggested
using the after-tax-cost of secured debt.
In the last lease-versus-purchase decision, the firm’s weighted average cost of capital
(13 per cent) was used, but now Susan is uncertain about the validity of this procedure. She is
beginning to learn toward Bill’s alternative, but she wonders if it would be appropriate to use
a low-risk discount rate for evaluating all the cash flows in the analysis. Susan is particularly
concerned about the risk of the expected residual value. While the company is almost certain
of the other cash flows and the tax shelters, the salvage value at the end of the fourth year is
relatively uncertain, having a distribution of possible outcomes that makes its risk comparable
to that of the average capital budgeting project undertaken by the firm. She is also concerned
that using a discount rate based on the after-tax cost of a secured loan might be inappropriate
when the funds used to purchase the equipment would come from internal sources. Perhaps
the cost of equity capital also deserves consideration, because the funds could be used to
increase the next quarterly dividend payment.
To settle all the disputes, the parties to the lease-versus-buy analysis agreed that
outside consultant should be hired to conduct the analysis. Assume you are that consultant
and the firm has provided you with the following list of questions.
Part A: Lessee’s Analysis.
1. The conventional format for analyzing lease-versus-purchase decisions assumes that
the money to buy the equipment will be obtained by borrowing. In this case, however,
Environmental has sufficient internally generated capital, held in the form of
marketable securities, to buy the equipment outright. What impact does this fact have
on the analysis?
2. Should Environmental lease or purchase the equipment? Assume that if the decision is
made to purchase the equipment, it will be sold for its book value on the first day of
Year 5, hence the full Year 4 depreciation can be taken. Further, use the 11.0 percent
before tax (6.6 percent after-tax) cost of debt as the residual value discount rate. (Hint:
Use Part A of Table 1 as a guide).
3. Justify the discount rate you used in the calculation process. Now assume that Susan
wants you to adjust the analysis to reflect differential residual value risk. What impact
does this have on Environmental’s lease-versus-purchase decision? (Hind: The 13
percent weighted average cost of capital used to evaluate average risk projects is an
4. a. Based on the information given in the case, would you classify this lease as a
financial lease or as an operating lease? For accounting purposes, a lease is classified
as a financial lease, hence must be capitalized and shown directly on the balance sheet,
if the lease contract meets any one of the following conditions:
(1) The lease can buy the asset at the end of the lease term for bargain price.
(2) The lease transfers ownership to the lease before the lease expires.
(3) The lease lasts for 75 percent or more of the asset’s estimated useful life.
(4) The present value of the lease payments is 90 percent or more of the asset’s
b. Does the differential accounting of operating versus financial, lease make
comparative financial statement analysis more difficult for outside financial analysts?
If so, how might analysts overcome the problem?
5. In some instances, a company might be able to lease asset at a cost less than the cost
the firm would incur if it financed the purchase with a loan. If the equipment
represented a significant addition to the lessee’s assets, could this affect its overall cost
of capital, hence the capital budgeting decision that preceded the lease analysis?
Would this affect capital budgeting decision related to other assets? Explain.
6. Now assume that Susan estimates the residual value could be as low as $0 or as high
as $467,500. Further, she subjectively assigns a probability of occurrence of 0.25 to
the extreme values and 0.50 to the base case value, $233,750. Describe how Susan’s
estimates could be incorporated into the analysis. If you are using the Lotus model,
calculate Environmental’s net advantage to leasing (NAL) at each residual value.
What is the expected NAL? (For this analysis, assume a 6.6 percent after-tax discount
rate on all cash flows.)
PART B: Lessor’s Analysis
7. Now evaluate the proposed lease from the point of view of the lessor. Oceanside
Capital, Inc. Assume that the residual value is equal to the book value at the end of the
fourth year, and use an 11 percent after-tax discount rate for call cash flows. Is the
current term favorable to OSC? (Hint: Use Part B of Table 1 as a guide).
PART C: Combined Analysis.
8. Based on a 4-year use of the asset, a 6.6 percent after-tax discount rate on the cash
flows of the lessor, and an 11 percent after-tax discount rate on the cash flows of the
lessor that is, the original conditions), you should have found that the lease is
advantageous to both Environmental Sciences and OSC. Is there a range of lease
payments that would be acceptable to both the lessor and the lessee? At which end of
the range do you think the actual payment would be set? If you are using the Lotus
model, specify the actual range of payments.
9. There is a possibility that Environmental will move to its new production facility
earlier than anticipated, hence prior to the expiration of the lease. Thus, Susan is
considering asking OSC to include a cancellation clause in the lessee contract. What
impact would a cancellation clause have on the risk ness of the lease to
Environmental? How would it affect the risk to OSC? If you were a cancellation
clause were added? If so, what changes might be made?
10. Leases are sometimes written so that the lessee makes payments at the end of each
year rather than in advance. If the lessor structured the analysis with deferred
payments, how would this affect (a) the NAL from the lessee’s standpoint and (b) the
rate of return earned by the lessor? Could the lease payments be adjusted, if they were
made on a deferred basis, to produce the same NAL as existed when the payment were
in advance?
11. Assume now that OSC has no tax credits to carry forward hence is in the 40-percent
tax bracket. Also assume that both parties to the lease estimate a $233,750 residual
value and discount it at a 6.6 percent after-tax discount rate. What do you think would
happen to OSC’s NPV under these conditions? If you are using the Lotus model, do
the calculation.
12. What effect do you think environmental’s tax rate has on it lease-versus-purchase
decision? If you are using the Lotus model, find Environmental’s NAL at tax rates of
0, 10, 20, 30, 40, 50 and 60 percent. Explain your results.


Working Capital
Policy and Financing

Office Mates, Inc.

Office Mates, Inc. is a medium-sized manufacturer of metal file cabinets for home and office
use. The company sells its office furniture through regular channels, but its home products are
sold under the trade name “Office Friends” through mass merchandisers such as Wal-Mart.
Sales of both lines have grown substantially over the past 20 years because of the ever
increasing demand for storage containers. Because the demand for paper storage appears to be
slowing, Office Mates has recently moved into the manufacture and distribution of computer,
CDs and diskette storage systems, which it believes to be the “hot” growth area of the future.
Although the firm has always been up to date in manufacturing and marketing,
financial management has tended to take a back seat. In fact, the recently retired financial
manager joined the company right out of high school and worked his way up from an initial
position of mail clerk. To revitalize the finance function, the company brought in Bob Knight,
who has an MBA and who had worked as treasure for several years at a competing company,
as chief financial officer (CFO).
After spending several weeks familiarizing him with Office mates’ operation, Knight
concluded that one of his first tasks should be the development of a rational working capital
policy. With this in mind, he decided to examine three alternative policies: (1) an aggressive
policy, which calls for minimizing the amount of cash and inventories held and for using only
short-term debt, (2) a conservative policy, which calls for holding relatively large amounts of
cash and inventories and for using only long-term debt, and (3) a moderate policy, which falls
between the two extremes. The aggressive policy would result in the smallest.
Tentatively, Knight plans to hold the level of accounts receivable constant, i.e., it
would be the same under each of the three policies. Brian King, the company’s president,
suggested that as a part of the aggressive policy, under which cash and inventories are
minimized, the company could also minimize accounts receivable, and vice versa under the
conservative policy. However, Knight is bothered by labeling a policy, which allows accounts
receivables to rise (while holding sales constant) would include lengthening credit terms and
selling on credit to weaker customers, and neither of those actions seems “conservative”. Still,
Knight knows that King will bring this point up when they discuss the merits of the three
policies, and in the board of directors’ meeting, when the directors are asked to approve one
of the policies.
Knight also concluded that the company’s $5 million of net fixed assets is sufficient to
accommodate a relatively wide range of sales, so fixed assets can remain constant regardless
of what is done in the working capital area. As for current assets, Table 1 contains Knight’s
estimates of the firm’s balance sheet under the three alternative working capital policies.
Office Mates’ stock sells at about its book value, and the company’s target capital structure
calls for debt ratio in the range of 45 to 55 percent, so all three working capital policies are
consistent with Office Mate’s target debt/equity mix. In fact, all three alternatives have a
50/50 debt/equity mix; hence the decision does not affect the mix of debt and equity, but
rather, the level of the current assets and maturity structure of the debt. Knight’s best estimate
of debt costs is 10 percent for short-term debt and 13 percent for long-term debt.
The choice of working capital policy will affect some of the company’s costs. Thus,
while variable costs are expected to be 50 percent of sales regardless of which working capital
policy is adopted, fixed costs are likely to be a function of the level of current assets held- the
greater the level of current assets, the greater are fixed costs. This situation results primarily
because of the need to hold the larger inventories in high-cost. Dehumidified warehouses, and
because of higher insurance costs. Knight estimates annual fixed costs to be $4,000,000 under
the aggressive policy, $4,500,00 under a moderate policy, and $5,000,000 with the
conservative policy. Office Mates’ federal-plus-state tax rate is 40 percent.
Table 1
Estimated Balance Sheets

Alternative Working Capital Policies

Aggressive Moderate Conservative
Current assets $4,000,000 $5,000,000 $6,000,000
Net fixed assets 5,000,000 5,000,000 5,000,000
Total assets $9,000,000 $10,000,000 $11,000,000
Short-term debt $4,500,000 $2,500,000 $ 0
Long-term debt 0 2,500,000 $5,500,000
Total equity 4,500,000 5,000,000 5,500,000
Total Claims $9,000,000 $10,000,000 $11,000,000
Working capital policy will also affect the firm’s ability to respond to varying
economic conditions. In an average economy, Office Mate’s sales would be highest if the firm
used a conservative policy. Here the firm’s inventories would be the highest, so it could
respond immediately to incoming orders and not risk losing sales because of stock outs.
Office Mate’s cash and marketable securities would also be highest under a conservative
policy. Furthermore, if higher sales occurred because of the conservative policy, then
accounts receivable would also be higher, even if credit standards and credit terms were not
changed. Conversely, expected sales are lowest under an aggressive policy. Here the firm
would have low cash and inventory levels, hence some sales would be lost, which would
depress the level of receivables.
The different policies would also cause sales to react differently to changing economic
conditions. In a string economy, the conservative approach with its higher inventories would
be best for generating increased sales. On the other hand, an aggressive policy would inhibit
the firm from responding to increased demand. Table 2 contains Knight’s best estimates of
the sales levels under the alternative polices for three different states of the economy.

Table 2
Estimated Sales Under Working Capital Policy

Working Capital Policies

Economy Aggressive Moderate Conservative
Weak $9,000,000 $11,000,000 $13,000,000


Average 12,000,000 13,000,000 14,000,000
Strong 13,000,000 14,500,000 14,000,000
With these estimates in mind, Knight must draft a report to present to Brian King and
Office Mate’s board of directors. Assume that you are Knight’s assistant, and he has asked
you to help him prepare the report. To help you get started, Knight has generated the
following list of questions. Your task now is to answer them, after which your must help
Knight prepare the final report. Since you were hired by the previous CFO, you know that
Knight does not have much confidence in your knowledge of ability. This assignment will
give you a chance to prove your worth-in effect, your performance will start you on the path
to the top, or out the door, and so you really need to get it right.
1. The two most basic decisions when establishing a working capital
police relate to the level of current assets and the manner in which current assets
are financed. Explain the differences between aggressive, moderate, and
conservative working capital policies.
2. Bob Knight expresses some doubts at to how to characterize accounts
receivable in terms of conservative, moderate, of aggressive working capital
policies. Obviously, the higher the level of sales, the higher the level of accounts
receivable. On the other hand, if the firm takes deliberate actions, which raise the
level of receivables as a percentage of sales, would you characterize action as
“aggressive” of “conservative”? Clearly, if the company takes the action of
keeping more cash or inventories on hand, that is a conservative action, but is an
action, which raises receivables “conservative”? Explain.
3. Construct pro forma income statements for each working capital policy,
assuming an average economy, a weak economy, and a strong economy. Then, use
these data to calculate ROEs and basic earning power ratios (EBIT/Total assets).
(Hint: Use Table 3 as a guide). How could this date be used to help decide on the
optimal working capital policy? Could you choose a working capital policy on the
basis of the information generated thus far?
4. Assume that there is a 50 percent chance of an average economy, a 25
percent chance of a weak economy, and a 25 percent chance of a strong economy.
What is the expected ROE under each policy? How do the policies compare in
term of relative riskiness? (Hint: Riskiness can be expressed in terms of standard
deviation and coefficient of variation).
5. Now assume that the Federal Reserve, reacting to increasing
inflationary pressures, tightens monetary policy shortly after Office Mates has
made its working capital policy decision. Any long-term debt outstanding would
be locked in at 13 percent, but Office Mates would have to roll over any short-term
debt outstanding at the new rate, which has skyrocketed to 15 percent. Assuming
an average economy, what would be the resulting ROE under each policy? Do
these results affect your previous conclusions about the relative riskiness of the
three alternatives?
6. Like most companies of its size, Office Mates has two primary sources
of short-term debt: trade credit and bank loans. One suppler, which furnishes
Office Mates with $500,000 (gross) of materials a year, offers terms of 3/10, net


a. What are Office Mates’ net daily purchases from this supplier?
(Use a 360-day year).
b. What is the average level of Office Mates’ accounts payable to
this supplier, assuming the discount is taken? What is the average payables
balance if the discount is not taken? What are the dollar amounts of free
credit and costly credit from this supplier?
c. What is the approximate percentage cost of the costly credit?
d. What is the effective annual percentage cost?
e. What conclusions do you reach from this analysis?
7. In discussing a possible loan with the firm’s banker, Knight learned
that the bank would be willing to lend Office Mates up to $5,000,000 for one year
at a 10 percent nominal, of stated rate. However, Knight failed to ask the banker
about the specific terms of the loan. Assume that Office Mates will borrow
a. What would the effective interest rate be on the loan if it were a
simple interest loan? If the banker offered to lend the money for 6 months,
but with a guaranteed renewal at the same 10 percent simple interest rate,
would this be as good, better, or worse than simple interest? Explain.
b. What would be the effective interest rate if the loan were a
discount loan? What face amount would be needed to provide Office Mates
with $2,500,000 of available funds?
c. Assume now that the loan terms call for an installment loan
with add-on interest and 12 equal monthly payments with the first payment
due at the end of the first month. What would be Office Mates’ monthly
payments? What would be the approximate percentage cost of this loan?
What would be its effective annual rate? Would this type of loan be
suitable if Office Mates needs all of the money for the entire year? What
type asset is most suitably financed by an installment-type loan?
d. Now assume that the bank charges simple interest, but it
requires a 20 percent compensating balance.
(1) Suppose Office Mates does not carry any cash balances
at that bank. How much would the firm have to borrow to obtain the
needed $2,500,000 while meeting its compensating balance
requirement? What is the effective annual percentage rate on this loan?
(2) Now suppose Office Mates currently carries an average
cash balance of $75,000 at the bank and that those funds can be used as
a part of the compensating balance requirement. What effect does this
have on the amount borrowed and on the cost of the loan?
(3) Return to the scenario in which Office Mates currently
maintains its working cash balance in another bank. Now assume that
the bank from which Office Mates would borrow pays 5 percent simple
interest on all checking account balances. What would the effective
percentage cost of the loan be in this situation?
e. Finally, assume that the bank charges discount interest and also
requires a 20 percent compensating balance. How much would Office
Mates have to borrow, and that would be the effective interest rate under
these conditions?
8. Assume now that you have had some additional discussions with Bob
Knight in which he told you that he would like more information on the ROE and
the riskiness of the alternative working capital policies under different sets
assumptions. He asked you, first, to assume that sales are independent of working
capital policy and then to determine the expected ROE and standard deviation of
ROE under each policy if the sales estimates are $11,000,000 for a weak economy,
$13,000,000 for an average economy, and $14,500,000 for a strong economy.
Similarly, he asked you to assume that a different manufacturing process is used,
causing the mix of fixed and variable costs to change. Using the original sales
estimate, he wants to know what the expected ROE and standard deviation of ROE
would be under the three policies if variable costs increased to 70 percent of sales
(in al cases), and fixed costs decreased to $1,000,000 under an aggressive policy,
to $1,500,000 under the moderate policy, and to $2,000,000 under the conservative
policy. How would your answers to these question, and similar question, be used
by top managers and they actually make the working capital policy decision?
Quantify your answer if you have access to the Lotus 1-2-3 model, but just discuss
the situation in words if you do not have access to the model.
9. What is your recommendation regarding a working capital policy for
Office Mates, and in what form should the company raise short-term debt? You
really do not have enough information to make a definitive statement when
answering this question, but assume that Knight wants you to at least make a
preliminary recommendation, which can be modified later if necessary.


Cash Budgeting

Alpine Wear, Inc.

Ann, Austin, the recently hired treasured of Alpine Wear, Inc., was summoned to the
office of Billy Joe Durango, the president and chief executive officer. When she got to Billy’s
office, Ann found him shuffling through a set of worksheets. He told her that because of a
recent tightening of credit by the Federal Reserve, hence an impending contraction of bank
loans, the firm’s bank has asked each of its major loan customers for an estimate of their
borrowing requirements for the remainder of 1993 and the first half of 1994.
Billy had a previously scheduled meeting with the firm’s bankers the following
Monday, so he asked Ann to come up with an estimate of the firm’s probable financing
requirements for him to submit at that time, Billy was going away on a white-water rafting
expedition, a trip that had already been delayed several times, and he would not be back until
just before his meeting with the bankers. Therefore, Billy asked Ann to prepare a cash budget
while he was away.
Due to the firm’s rapid growth over the last few years, no one had taken the time to
prepare cash budged recently; thus Ann was afraid she would have to start from scratch. From
information already available, Ann knew that no loans would be needed from the bank before
January, so she decided to restrict her budget to the period from January through June 1994.
As a first step, she obtained the following sales forecast from the marketing department:

1993 November $300,000

December 480,000

1994 January 600,000

February 720,000
March 840,000
April 980,000
May 780,000
June 600,000
July 300,000
August 240,000
(Note that the sales figures are before any discounts; that in, they are not net of
Alpine Wear’s credit policy is 1.5/10, net 30. Hence, a 1.5 percent discount is allowed
if payment is made within 10 days of the sale; otherwise, payment in full is due 30 days after
the date of sale. On the basis of a previous study, Ann estimates that, generally, 25 percent of
the firm’s customers take the discount, 65 percent pay within 30 days, and 10 percent pay
late, with the late payments averaging about 60 days after the invoice date. For monthly
budgeting purposes, discount sales are assumed to be collected in the month of the sale, net
sales in the month after the sale, and late sales two months after the sale.
Alpine Wear begins production of goods two months before the anticipated sale date.
Variable production costs are made up entirely of purchased materials and labor, which total
60 percent of forecasted sales-20 percent for materials and 40 percent for labor. All materials
are purchased just before production begins, or two months before the sales f the finished
goods. On average, Alpine Wear pays 50 percent of the materials cost in the month when it
receives the materials, and the remaining 50 percent the next month, or one month prior to the
sale. Labor expenses follow a similar pattern, but only 30 percent is paid two months prior to
the sale, while 70 percent is paid one month before the sale.
Alpine Wear pays fixed general and administrative expenses of approximately
$90,000 a month, while lease obligations amount $36,000 per month. Both expenditures are
expected to continue at the same level throughout the forecast period. The firm estimates
miscellaneous expenses to be $30,000 monthly, and fixed assets are currently being
depreciated by $48,000 per month. Alpine Wear has $1,200,000 (book value) of bonds
outstanding. They carry a 10 percent semiannual coupon, and interest is paid on January 15
and July 15. Also, the company is planning to replace an old machine in June with a new one
costing $400,000. The old machine has both a zero book and a zero market value. Federal and
state income taxes are expected to be $90,000 quarterly, and payments must be made on the
15th December, March, June, and September. Alpine Wear has a policy of maintaining a
minimum cash balance of $300,000 and this amount will be on hand on January 1, 1994.
Assume that you were recently hired as Ann Austin’s assistant, and she has turned the
job of preparing the cash budget over to you. You must meet with her and Billy Durango on
Sunday night to review the budget prior to Billy’s meeting with the bankers on Monday.
Answer the following question, which she provided to you for direction, but also think about
any other related issues that Ann or Billy, or the bankers, might rise concerning the
projections. In particular, be prepared to explain the sources of all the number and the effects
on the company’s funds requirements of any of the basic assumptions turn out to be incorrect.
Your predecessor was fired for not really understanding a report he submitted, and you don’t
want to suffer the same fate!
1. Construct a monthly cash budget for Alpine Wear for the period January through June
1994. For the purposes of this question, disregard both interest payments on short-term
bank loans and interest received from investing surplus funds. Also, assume that al cash
flows occur on the 15th of each month. Finally, note that collections from sales in
November and December of 1993 will not be completed until January and February of
1994, respectively. (Hint: Use Table 1 as a guide.) If you have access to Lotus model, use
it to generate the required numbers. What is the maximum cumulative funds shortfall
during the 6-month planning period?
2. Assume that the bank will agree to give Alpine Wear a $400,000 line of credit. Will this
be sufficient to cover any expected cash shortfalls? Suppose the bank refused to grant the
loan, and thus the company had to obtain short-term financing from other sources. What
other sources might be available?
3. The monthly cash budget you have prepared assumes that cash flows occur on the 15th of
each month. Suppose Alpine Wear’s outflows tend to cluster at the beginning of the
month, while collections tend to be heaviest toward the end of each month. How would
this affect the validity of the monthly budget? What could be done to correct any
inaccuracies that might result from the mismatch of inflows and outflows?
4. Now assume that you and Ann decide you need to develop a daily cash budged for the
month of January, based on the following assumptions. (Hint: Use Table 2 as a guide).


(1) Assume that Alpine Wear normally operates 7 days a week; therefore, use 31
days for your January cash budged.
(2) Sales are made at a constant rate throughout the month; that is, 1/31st of the
January sales are made each day.
(3) Daily sales follow the 25 percent, 65 percent, and 10 percent collection
(4) Discount purchasers take full advantage of the 10-day discount period before
paying, and “on time” purchasers wait the full 30 days to pay. Thus, collections during
the first 10 days of January will reflect discount sales from the last 10 days of
December, plus “regular” sales made in earlier months. Also, on January 31 st, Alpine
Wear will begin collecting January’s net sales and December’s late sales.
(5) The lease payment in the made on the first of the month.
(6) Fifty percent of both labor costs and general and administrative expenses are
paid on the 1st and 50 percent are paid on the 15th.
(7) Materials are delivered on the 1st and paid for on the 5th.
(8) Miscellaneous expenses are incurred and paid evenly throughout the month:
1/31 each day.
(9) Required interest payments are made on the 15th.
(10) The target cash balance is $300,000 and this amount must be in the bank on
each day. This minimum balance is required by the firm’s bank.
If you calculated it correctly, the monthly cash budget should have indicated that a bank
loan of $184,650 would be required in January. Does the daily cash budget support this
5. Think about the mechanics of the bank loan. During a typical month, the funds needed or
the cash surplus would be changing daily. Could the company increase of decrease its loan
on a daily basis? If not, would this have any effect on the amount of funds it needs?
6. You are aware that Billy is concerned about the efficient utilization of his firm’s cash
resources. Specifically, he has questioned whether or not seasonal variations should be
incorporated into the firm’s target balance. In other words, during months when cash
needs are greatest, the target balance would be somewhat higher, while the target would
be set at a lower during slack months. Would you recommend that Alpine Wear follow
this strategy? If the firm had any compensating balance requirements, would this affect
your answer? How would a variable target balance be incorporated into the monthly cash
budget? How would it be incorporated into the daily cash budget?
7. The only receipts shown in Alpine Wear’s cash budget are collections. What are some
other types of inflows that could occur? Also, the budget ignored short-term interest
expense and income. If the company paid interest at 7 percent annually on the short-term
bank loan and received interest at 5 percent annually on surplus cash, how could these
items be incorporated into the cash budget? Be specific; that is, indicate exactly how the
budget would be modified and give an example.
8. Because cash is a nonearning asset, Alpine Wear’s cash management policy is to invest
any surplus funds in marketable securities. Can you suggest an investment policy that will
provide liquidity and safety, yet offer the firm a reasonable return on its marketable
securities investment? Specifically, describe the types of securities, the desired maturities,
the expected returns, and the risks that would be involved. Would your suggestions be the
same for a company whose cash balances were projected to be in the millions of dollars as
opposed to Alpine Wear’s thousands? Would it matter if the forecasts showed cash
surpluses for future months, going out indefinitely, versus a situation in which surpluses
and deficits alternated from month to month due to seasonal factors?
9. The cash budget is a forecast, so many of the cash flows shown are expected values rather
than amounts known with certainty. If actual sales, hence collections, were different from
the forecasted levels, then the forecasted surpluses and deficits would be incorrect.
You know that Billy and Ann will be interested in knowing how various changes in the
key assumptions would affect the cumulative surplus or deficit. For example, if sales fell
below the forecasted level, what effect would that have? It would be particularly bad to
have a $400,000 line of credit and then find that due to incorrect assumptions the actual
cash requirement was $600,000.
With this in mind, quantify your answers. Otherwise, just discuss the likely effects of the
indicated changes. In either situation, indicate how the company should prepare for the
types of events noted. In this discussion, recognize that getting a line of credit is not
without cost. Banks typically charge a 1-point, or 1 percent of the maximum amount
requested, commitment fee up front. Thus a $400,000 line would require a $4,00
commitment fee, while a $600,000 line would cost $6,000.
a. What would be the impact on the monthly net cash flows from January to June 1994 if
actual sales were 20 percent below the forecasted amounts? (In your answer, assume
that actual sales for November and December 1993 are 20 percent below the
forecasted level. Also, assume that purchases and labor, as well as all other expenses,
are set by contract at the start of the 6-month forecast period on the basis of the
original expected sales; so the outflows cannot be adjusted downward during the
planning period even though sales decline below the forecasted levels.)
b. What if actual sales were on 50 percent of the forecasted level? To answer this
question, again assume that al expenses are based on the expected level of sales, not
the realized level.
c. Suppose customers changed their payment patterns and began paying as following
month, and 50 percent in the second month versus the old 25-65-10 patterns. Now
how large a credit line would the company require?
10. Based on all of your analysis, how large a credit line would you recommend that Billy
seek from the firm’s bankers? If you find it difficult to identify a defendable number, what
other information would you want, and how would you suggest the credit line be


Table 1
Monthly Cash Budget Worksheet

November Decembe January February March April May June July August
Gross Sales $300,000 480,000 x 600, 000 720,000 840,000 980,000 $780,00 $600,000 $300,00 $240,00
(expected) x x x x x 0 0 0
Gross Sales $300,000 480,000 x 600, 000 720,000 840,000 980,000 $780,00 $600,000 $300,00 $240,00
(realized) x x x x x 0 0 0

Month of $7., 875 $118,200 147,750 177,300 206,850 241,325 $192,07 $147,750
Sale x x x x 5
1. Month 195,000 x 312,000 390, 000 468,000 546,000 637,000 507,000
after Sale x x
2. Months 30,000 x 48,000 x 60, 000 72,000 84,000 98,000
after Sale
$489,75 $615,30 734,850 859,325 913,075 752, 750
0 0 x x x x
Purchases $120,000 144,000 x 168,000 196,000 $ $120,00 $60,000 $48,000
x x 156,000 0
1. Month 60,000 72,000 84,000 98,000 x 78,000 60,000 30,000 x 24,000 x
before Sale
2. Months 60,000 72,000 84,000 98,000 x 78,000 60,000 30,000 x
before Sale
$156,00 182,000 176,000 90,000 x $54,000
0 x x


November Decembe January February March April May June July August
1. Cash Gain
(Loss) for
Collections $489,750 615,300 734,845 859,325 913,075 752,750
x x x x x


Payments: 156,000 x 182,000 176,000 138,000 90,000 $54,0000
x x x
1. Month 100,800 x 176,600 93,600 x 72,000 36,000 28,000
before Sale x
2. Months 201,600 $325,200 $274,40 $218,40 $168,00 84,000
before Sale 0 0 0
Administrativ 90,000 90,000 x 90,000 x 90,000 x 90,000 x 90,000 x
e Expenses
Lease 36,000 36,000 x 36,000 x 36,000 x 36,000 x 36,000 x
Miscellaneous 30,000 30,000 x 30,000 x 30,000 x 30,000 x 30,000 x
Taxes 60,000 90,000
Interest (on 400,000
$674,400 690,800 790,000 584,400 450,000 812,800
x x x x x
($184,650) ($75,500) (55,150) 274,925 463,075 (120,050)
Net Cash Gain
X x x X


Table 1

November Decembe January February March April May June July August
1. Cash
Surplus of
Cash at $300,00075 $115,350 39,850 x (15.300) 259,62 722,70
Start 0 X 5x 0x
Cumulative $115,350 39,850 x (15,300) 259,625 722,70 602,65
Cash X x 0x 0x
Target Cash $300,000 300,000 300,000 300,000 300,00 300,00
Balance x x x 0x 0x
Cash or
g to
Cash ($184,650) (260,150) (315,300) (40,375) 422,70 302,65
Balance X X X 0x 0x


Financing and Valuing

A New Venture

Advanced Fuels Corporation

Advanced Fuels Corporation (AFC) was founded five year ago by Dr. Zachary Aplin,
who left his faculty position at Texas A&M to work full time developing a process to convert
waste products into fuel. He used a government grant, personal funds, and loans from friends
and relatives as seed money to finance his new company, and he was the sole stockholder.
Dr. Aplin and his two-member staff worked feverishly for three years, and at the
beginning of the fourth year, they made a major break-through that led to the development of
an efficient process for converting waste products into ethanol, a compound that can be
blended with gasoline to produce a cleaner automobile fuel. Ethanol-gasoline blends have bee
around for some time, and over a billion gallons of ethanol an ethanol is currently produced
from feed corn, and the ethanol is more expensive than the gasoline to which it is added. Only
a federal subsidy makes the ethanol-gasoline mixture economically feasible. However, hence
greatly increase the market potential of the blended fuel.
AFC has received a patent from the U.S. Patent Office for Dr. Aplin’s unique ethanol
production process. After considering licensing the process to major oil companies, Aplin
decided that AFC itself should produce the ethanol. However, this would require a substantial
amount of capital, and Dr. Aplin had exhausted his personal financial resources. Therefore, he
began a series of discussions with AFC’S accountants and bankers. Both sets of advisors
stated that the first step toward attaining outside capital is to develop a business plan.

The Business Plan

A business plan is a document that describes in detail the key aspects of a proposed
business venture. Everything from raw material sources customers is contained in the plan.
Business plans range from 10 to over 100 pages in length, but most are about 50 pages. The
10 key segments of a business plan for a typical manufacturing venture are listed below:
1. Summary. A summary of no more than three pages should (a) provide a clear and concise
overview of the business and (b) capture the reader’s interest.
2. Business Description. The business description should explain in detail what the new
company will do, the markets it will serve, and how it will operate. This section should
also provide industry background information. Additionally, any competitive advantages
or disadvantages, which the new venture will have, should be discussed.
3. Marketing. Sales projections, supported by market research data, should be delineated in
the marketing segment. This segment is a critical component of the plan for two main
reasons. First, potential capital providers must be convinced that there is a well-defined
customer base for the venture’s product. Unless they have a clear understanding of the
target market, potential investors will be reluctant to provide the necessary capital.
Second, the projected sales volume will affect the size of the enterprise, hence the amount
of capital it will requite.
4. Research, Design, and Development. This section should provide a description of all
research performed to date and give the extent and cost of future research required for the
venture. Also, all technical processes and equipment should be explained in detail.


5. Manufacturing. The manufacturing segment should first define plant location (s) and the
strategic reasoning behind location choices. Labor cost and availability, proximity to
suppliers and customers, and community support should all be discussed. Additionally,
detailed cost data for the manufacturing process should be spelled out.
6. Management. The management section presents the organizational, ownership, and
compensation structures of the company. All key personnel should be identified, and brief
resumes for these individuals should be provided.
7. Critical Risks Segment. In this section, existing and potential problems, including the
company’s major competition and any negative industry trends, should be discussed.
Alternative solutions and their costs should be offered for all current and potential
8. Financial Segment. The financial segment documents the projected profitability of the
venture and is absolutely crucial to the capital acquisition process. Projected income
statements, balance sheets, cash flow statements, and cash budgets are included. The most
important element is probably the cash flow statement. Potential lenders can use it to gain
insights into the amounts and timing of external capital requirements and repayments,
while potential equity investors use it to estimate future equity cash flows, which form the
primary basis for estimating the value of the enterprise.
9. Milestone Schedule. The milestone schedule gives projected dates for future significant
events in the life of the business. This schedule and end, equipment installation dates,
hiring dates, and dates of first shipments.
10. Critical Assumptions. In a well-developed business plan, most of the key assumptions
behind the projected financial statements are spelled out in detail throughout the
document. Still, it is useful to include a summary section, which lists the most important
assumptions. For example, if getting final approval for pending patents is vital to moving
forward, this fact should be noted here.
Generally, a start-up firm’s final business plan is developed jointly by its managers
and an investment-banking firm that specializes in start-up financing. The investment banker
must be familiar both with sources of capital and the legal requirements associated with
security offerings. Often and though, companies develop preliminary plans with the help of
commercial bankers and CPAs; Dr. Aplin and his staff followed this route. Working on the
preliminary plan is generally a useful exercise, and in this case it forced Aplin to think about
issues that he had not previously considered. For example, he knew that his production
process offered a cost advantage over the competition, but he was amazed to discover that his
projected production costs would be only 70 percent of those of his closest competitor. On the
other hand, the capital-intensive nature of the production process was revealed by the business
plan, and it was sobering it learn just how much capital his fledgling firm would need to
The cost of building one production facility was determined to be $10 million. Since
Aplin’s manufacturing strategy called for building plant in five major cities in the United
States, and since $1 million in working capital is needed to start up each plant, AFC’s total
capital requirement is $55 million. This was a lot more than Dr. Aplin had anticipated, so he
decided to hire an investment banking firm to help him finalize AFC’s business plan and to
identify and approach potential capital providers.
Venture Capital Sources
The investment bankers identified four main sources of start-up capital: venture
capital funds, individuals, and public offerings.


Venture Capital Funds, Some financial institutions such as insurance companies and
pension funds, and wealthy individuals, after allocate a certain portion of their capital to high-
risk investments. Much of this risk capital is placed into venture capital funds managed by
experienced professionals called “venture capitalists”. Venture capital fund manager generally
purchase either the common stock or convertible debentures of new businesses with the
potential for rapid growth. Because of the very high risk associated with investments, venture
capitalists require a high-expected rate of return, typically in the 20-40 percent range.
Bank. In the 1980s, banks would lend money to star-up companies if asset such as real
estate, plant, and equipment were available for collateral. However, since 1989, when
Congress approved new rules governing bank capital requirements, banks have not been
active in the start-up financing market. The banks entered the 1990s with many bad real estate
loans, and, after the savings-and-loan debacle, bank examiners are quick to force banks to
write down problem loans, which puts additional pressure on bank capital. As a result, start-
up companies now find it very difficult to obtain bank financing. Further, if bank loans are
available at all, the terms are normally short-term (less than one year), hence not suitable for
funding long-term investments or permanent working capital.
Individuals. Sometimes entrepreneurs are able to convince friends, relatives, or
wealthy individuals to provide the capital needed to start a company. Capital provided by
these individuals is termed “informal risk capital”, and a wealthy individual who invests
directly in a start-up venture is called an “angel”. If significant amounts of money are to be
obtained, it may be necessary to obtain it only from “informed, sophisticated” individuals
who are in a position to understand the risks they are taking and to afford a loss should the
venture fail. This qualification is generally met by having the individual sign an affidavit that
his or her net worth is in excess of $1 million.
Public Offerings. A public offering involves raising capital by selling equity or debt
securities to the public at large. An investment-banking firm is vital to a public offering, both
to assist in determining the value of the securities to be sold and to market the securities to
investors. While public offerings are a valuable source of capital for companies once they get
beyond the star0up stage and have established a track record, they are virtually impossible for
most start-ups.
Commonly Used Terms
Venture capital financing has a “lingo” of its own. Here are some of the more
commonly used terms:
Bridge Loan. It often takes some time to line up permanent investors for a start-up
venture. Often, a business will obtain short-term loans from individuals of, possibly, its
investment bank, to get operations started, with the intention of paying this loan off when
permanent financing is obtained. Such a loan “bridges the gap from here to permanent
financing: hence it is called a “bridge loan”.
Equity Kicker. With start-ups, there is generally a high probability of failure, but also
a small probability of success and rich rewards. For example, suppose three out of four
companies, charging a high 25 percent on each loan (in most states, usury laws would limit
the rate to 16-18 percent on this type of loan). The lender would lose 100 percent on three
loans, make 25 percent on the fourth, and end up with large losses on the entire operation. The
moral of the story is that portfolio theory works well only if investors can share fully in
upside results.
Now consider situation when the founder of a start-up firm, such as Dr. Aplin,
exhausts his personal funds and is forced to seek outside capital. Outsiders think (correctly)
that the founder has better information about the firm’s prospects than they do. Accordingly,
they want the most secure position they can get in an admittedly risky venture. That often
means that outsiders will insist on supplying their capital in the form of debt, so that they will
have first claims on assets and income in the event that founder’s projections fail to
materialize. However, as we have seen, lenders cannot achieve their desired results by
forming portfolios of risky debt securities, because they do not share in upside gains beyond
the stated interest rate.
How can lenders share in upside gains? The answer is to use convertibles or warrants,
which are called “equity kickers” and which have no upside limitation. Note also that U.S
banks are prohibited from taking equity kickers; this helps explain their participation in
venture financing is limited.
Mezzanine Capital. As companies progress beyond the start-up phase, their capital
often includes two or more layers of debt: senior debt, which is secured by assets, and
subordinated debt, which is unsecured but which often includes an equity kicker. This second
level of debt is called “mezzanine capital”.
Private Placement. A private placement is any debt of equity issue that is not offered
to the general public.
Seed Money. The initial capital required to start an entrepreneurial project is called
“seed money”. In AFC’s case, this is the capital supplied by Dr. Aplin and his friends and
Venture Capital Networks. Computerized databases have been developed that contain
profiles of ventures needing capital and profiles lf private investors who are interested in
providing venture capital. A computer program periodically compares all profiles of both
types to determine if there are matches. If a match exists, the entrepreneur and the potential
investor are introduced to see if a funding agreement can be reached.
Valuing Start-Up Firms
After explaining the different sources of start-up capital and some key terms, the
investment banker stated, the investment banker stated that the nest step should be to
determine AFC’s value, as this will be of interest to al potential investors. Five methods are
commonly used to value the equity of a start-up firm.
Discounted Cash Flow Approach. The discounted cash flow approach recognizes that
the value of a business is a function of the timing, riskiness, and amounts of cash flow that the
business generates. Three steps are involved: (1) Historical financial date and current trends
are used to forecast the firm’s future cash flows to equity holders. In a start-up situation, the
forecasting problem is complicated by a lack of historical data, which makes good judgment
and market research very important. (2) A discount rate based on the riskiness of the cash
flow must be determined. (3) The present value of the cash flows must be calculated to arrive
at the equity value.
The discounted cash flow approach is the most comprehensive valuation technique,
but for start-up firm it has obvious weaknesses. Anyone with Lotus 1-2-3 or some other
spreadsheet can make forecasts and determine a firm’s “value”, but that value is no better than
the forecasts. Therefore, investors also to consider less refined, but.
Liquidation Value. This method determines the value if the business ceases operations
and is liquidated. Liquidation value is calculated by first summing the estimated net selling
prices that would be realized if each asset were sold individually. From this sum we subtract
all existing liabilities, and the result is the liquidation value of the existing liabilities, and the
result is the liquidation value of the business to its equity investors. Included in liabilities are
costs associated to its equity investors. Included in liabilities are costs associated with
liquidation, such as severance pay for terminated employees. The liquidation value method
generally establish the minimum worth of a business’s equity. Additionally, lending
institutions sometimes use the liquidation value of an individual asset to determine the
amount that can be loaned using that asset as collateral.
Adjusted Tangible Book Value. This valuation method starts with the latest balance
sheet. The book value of each account is adjusted upwards or downward in order to arrive at
its fain-market value. Adjustments are made to account for land appreciation, uncollectible
account receivable, and obsolete inventories. Additionally, the values of intangible assets such
as patents or goodwill and other assets or liabilities that are not on the books must be added.
Once the adjusted book values have been established, total liabilities are subtracted from total
assets to arrive at the business’s adjusted tangible book value. This method is similar to the
liquidation value method except that fair-market values are determined within the context of a
continuing business.
Earnings Multiple Method. If historical income statements are available, if the past is
likely in the sense of not being relatively high or low because of temporary conditions, then
one can use the earnings multiple, public companies in the same industry and similar in size
to the firm being valued. Date on companies that recently went public are especially useful for
this purpose of such date are available. Based on comparisons of the company being valued
and the public companies, judgment is used to establish a P/E ration apply to the company’s
earnings. For example, suppose a company is relatively stable and has averaged $200,000 in
net income for the pat three years, and a P/E of 5 is deemed appropriate. The value of the
company’s equity would be 5 $(200,000) = $1,000,000.
Replacement Value. This method requires a determination of the total cost that would
be incurred if the business were to be reconstructed from scratch. The cost must include items
such as land, buildings, and equipment, as well as marketing and advertising expensed
associated with building a customer base. This method is most often user to value firms by
companies seeking merger partners as an alternative to de novo expansion and by insurance
companies to determine policy premiums. The firm’s liabilities could be subtracted from the
total replacement value firms by companies seeking merger partners as and alternative to de
novo expansion and by insurance companies to determine policy premiums. The firm’s
liabilities could be subtracted from the total replacement value.
Combination of Methods. Generally, more than one method is used to value a
company. For example, an analyst might use the discounted cash flow and earnings multiple
methods together with the replacement value method. These three values might be averaged,
or greater weight might be placed on one method. These values might be averaged, or greater
weight might be placed on one method because of the circumstances. If it were known be
placed on one method because of the circumstances. If it were known that a larger company
wanted to make an acquisition in the industry, and the replacement valuation produced a
relatively high value, then analyst might assume that the company could be sold at close to its
replacement value. Clearly, a great deal of judgment is required, and different experts will
reach very different conclusion.
At times, it is appropriate to analyze different groups of a firm’s assets differently. For
example, a steel company may have diversified outside of its core business (steel) into several
different industries such as oil and chemicals. Analysts may conclude that the company’s
“break-up value” exceeds its value as a conglomerate corporation, and they might use the
replacement value method to evaluate the chemical and oil divisions and the discounted cash
flow method to evaluate the core steel business.


A meeting has been scheduled next week wherein Dr. Aplin and AFC’s accountant will
discuss the company’s plans with several bank commercial loan officers and venture capital
fund representatives. He hopes to finalize AFC’s financing arrangements at that time. In
preparation for the meeting, Table 1 and 2 were extracted from the business plan.
For Question 1 through 3, assume you are a commercial-loan-officer with a large regional
1. What type of financing might your bank be willing to provide to AFC?
2. How would you as a banker go about preparing for your meeting with Dr. Aplin and
his consultants?
3. Assume that view AFG’s venture positively and have decided to make a financing
proposal for the equipment, land, and facilities. What valuation method would you use
to decide how much to lend to AFC’s Explain.
For Question 4 through 9, assume that you are the manager of a venture capital fund, and
that a bank is willing to lend $20 million of the $55 million financing requirement. The
debt service requirements are $5, $5, $5, $5 and $10 million in Years 1 through 5m
respectively. You are considering providing an equity investment for the remaining $35
million required by AFC.
4. List three questions which you might ask Dr. Aplin in your meeting with him.
5. You have decided to use the discounted cash flow approach to value AFC. Based on
the riskiness of the new business, you believe a 30 percent discount rate is appropriate,
along with a 10 percent growth rate in equity cash flow in Year 6 and beyond. What is
the forecasted value of AFC to its equity holders? (Hint: Use the cash flows in Table 2
as a starting point)
6. What percentage of the common stock would you require in exchange for the needed
$35 million? How likely is it that Dr. Aplin would be willing to offer you this
percentage ownership of AFC?
7. Now assume that the estimated terminal growth rate is only 5 percent, and the bank is
only willing to lend AFC $10 million? Under these conditions, what is the smallest
percentage of common stock you would require for your $45 million? It is likely that
Dr. Aplin be willing to give up this percentage ownership of AFC?
8. Use the earning multiple methods to estimate the value of AFC’s equity. As a first
pass, use the average projected earnings over the first five years as the best estimate of
AFC’s normalized earnings. Then assume the stocks of publicly traded firms with
somewhat similar technologies sell at an average of 8 times earnings.
9. If you used the adjust tangible book value method to value AFC, how would you
determine the market value of the patent?
General questions:
10. In your opinion, what are the two most important segment of a business plan? Why?
11. If you had a promising idea for a business venture and wanted to acquire start-up
capital. What steps would you take to attain the needed financial resources>


Table 1
Current: Balance Sheet and New Capital Requirement

Current Balance Sheet Capital Required

(In Millions)
Cash $ 1.000 Purchase of equipment $ 10
Patent 400,000 Purchase of land 5
Total assets $401,000 Construction 35
Working capital 5
Accounts payable $1,000 Total requirement $55
Loans from friends
And relative $250,000
Total liabilities $251,000
Common stock 100
Additional paid-in capital 149,900
Total liabilities and equity $401,000

Table 2
Projected Cash Flow Statements
(In Millions of Dollars)
Year 1 Year2 Year 3 Year 4 Year 5
Sales $20 $53 $102 $117 $129
Cost of goods sold 10 26 51 59 65
Gross margin $10 $27 $51 $58 $64
General/administrative expenses 5 10 19 23 25
Debt service 5 5 5 5 10
Pre-tax income $0 $12 $27 $30 $29
Taxes 0 5 12 13 14
Net income $0 $7 $15 $17 $15
Depreciation/amortization 2 6 6 6 6
Terminal value 116
Net cash flow $2 $13 $21 $23 $137

a) Depreciation/amortization expense is included in the cost of goods sold; yet it is a
noncash charge. Thus it must be added back to net income to obtain the net cash
flow in each year.
b) The terminal value is the present value, as of the end of Year 5, of the equity cash
flows that are expected to occur after Year 5. This value was obtained by assuming
10 percent annual growth in equity cash flows after Year 5 and cost of equity of 30
Terminal value = $21(1.1)/[0.30-0.10] = $116


Project Risks

Cogeneration Corporation

The Cogeneration Corporation was formed as a general partnership by Engineering Firm Ltd. and
Local Utility to undertake a cogeneration project. Cogeneration involves the production of steam,
which is used sequentially to generate electricity and to provide heat. The two forms of energy—
electricity and heat—are thus cogenerated. The owners of the cogeneration facility may use some of
the electricity for themselves and/or sell the rest to the local electric utility company. The leftover heat
from the steam has a number of possible commercial uses, such as process steam for a chemical
plant, for enhanced oil recovery, or for heating buildings.

The Project

Engineering Firm has proposed to Chemical Company that it design and build a Cogeneration Project
at Chemical Company's plant in the East Region.

The Project Sponsor

Engineering Firm has considerable experience in designing and managing the construction of energy
facilities. The market for engineering services is very competitive. Engineering Firm has found that its
willingness to make an equity investment, to assist in arranging the balance of financing, and to
assume some of the responsibility for operating the project following completion of construction, can
enhance its chances of winning the mandate to design and oversee construction of a cogeneration
project. Nevertheless, Engineering Firm's basic business is engineering, and its capital resources are
limited. Accordingly, it is anxious to keep its investments "small," and it is unwilling to accept any credit
exposure. However, it is willing to commit to construction of the facility under a fixed-price turnkey
contract, which would be backed up by a performance bond to ensure completion according to

The Industrial User

Chemical Company's plant began commercial operation in 1964. Two aged, gas-fired steam boilers
produce the process steam used in the chemical manufacturing process at the plant. Local Utility
currently supplies the plant's electricity.

Engineering Firm has suggested building a Cogeneration Project to replace the two boilers. The new
facility would consist of new gas-fired boilers and turbine-generator equipment to produce electricity.
The Cogeneration Project would use the steam produced by the gas-fired boilers to generate
electricity. It would sell to Local Utility whatever electricity the plant did not need. It would sell all the
waste steam to Chemical Company for use as process steam and would charge a price significantly
below Chemical Company's current cost of producing process steam at the plant.


Chemical Company is willing to enter into a steam purchase agreement. But it will not agree to a term
exceeding 15 years, nor will it invest any of its own funds or take any responsibility for arranging
financing for the facility. Chemical Company is insistent that the steam purchase contract must
obligate it to purchase only the steam that is actually supplied to its plant. Such a contract is called a
take-if-offered contract.

The Local Utility

Local Utility is an investor-owned utility company. It provides both gas and electricity to its customers,
including Chemical Company. Local Utility has stated publicly that it is willing to enter into long-term
electric power purchase agreements and long-term gas supply agreements with qualified
cogenerators. It has also formed an unregulated subsidiary for the express purpose of making equity
investments in government-approved independent power projects. The government has authorized
Local Utility to make such investments, provided Local Utility owns no more than 50% of any single

Local Utility has informed Engineering Firm that it is in support of the Cogeneration Project. It is willing
to enter into a 15-year electric power purchase agreement and a 15-year gas supply agreement. Local
Utility has committed to accepting a provision in the gas supply agreement that would tie the price of
gas to the price of electricity: The price of gas will escalate (or de-escalate) annually at the same rate
as the price Local Utility pays for electricity from the Cogeneration Project. Local Utility is willing to
invest up to 50% of the project entity's equity and to serve as the operator of the facility. However, it is
not willing to bear any direct responsibility for repaying project debt. Local Utility would include the
facility's electricity output in its base load generating capability. A 15-year inflation-indexed (but
otherwise fixed-price) operating contract is acceptable to Local Utility. The contract would specify the
operating charges for the first full year of operations. The operating charges would increase thereafter
to match changes in the producer price index (PPI). These charges would represent only a relatively
small percentage of the Cogeneration Project's total operating costs. Because such facilities are
simple to operate, the completed Cogeneration Project will require only a dozen full-time personnel to
operate and maintain it.

Outside Financing Sources

The balance of the equity and all of the long-term debt for the project will have to be arranged from
passive sources, principally institutional equity investors and institutional lenders. The equity funds will
have to be invested before the long-term lenders will fund their loans. The passive equity investors will
undoubtedly expect Local Utility to invest its equity before they invest their funds. The strength of the
electric power purchase and gas supply agreements will determine how much debt the Cogeneration
Project will be capable of supporting. The availability of the tax benefits of ownership, as well as the
anticipated profitability of the project, will determine how much outside equity can be raised for the

Estimating the Project's Total Cost


First, the project's total cost must be determined. Total cost includes 1) all direct costs, such as
engineering, labor, and materials; and 2) all indirect costs, such as financing-related charges
(including interest and commitment fees) and the cost of financial guarantees or other credit support

In the case of the Cogeneration Project, Engineering Firm and Local Utility have agreed to pay various
preconstruction costs—mainly, the fees for securing the many permits the Cogeneration Project will
need to have before lenders will advance any construction funds. Preconstruction costs amount to $3
million. Engineering Firm and Local Utility contributed these permits to the project in return for equity in
Cogeneration Company (see Exhibit 1).

The principal engineering firm usually supplies a construction drawdown schedule. The construction
period allows time for preliminary engineering and licensing in addition to the actual construction. For
the Cogeneration Project, funds needed during the construction period will be supplied by a
commercial bank. Bank debt will fund 100% of the cost during the construction period. Engineering
Firm and Local Utility have arranged a $120 million construction loan facility. In addition, Engineering
Firm and Local Utility committed to the bank that they would arrange permanent financing for
Cogeneration Company. They estimate that Cogeneration Company will incur approximately $2 million
of fees in connection with arranging the permanent financing. Construction-period loans are generally
made on a floating-rate basis.

Contingency for Cost Overruns

The construction loan should have sufficient capacity to provide funds for contingencies and for
fluctuations in interest rates. Because the construction loan entails loan fees that depend on the size
of the loan commitment, it is important not to oversize the construction loan. No provision is made for
foreign currency risk since the loan and the project revenues and costs are in dollars.

Capital Cost

Exhibit 2 indicates the total project cost of the Cogeneration Project, given a 24-month construction
schedule and an interest rate of 10%. Interest is paid on funds that are drawn down, and a
commitment fee is charged on the unused balance of the commitment. The loan commitment is
designed to accommodate higher interest rates during the construction period and higher construction
costs (for example, to cover design changes).

Construction is expected to cost $100 million. Commitment fees and interest will add $7.308 million,
bring the construction cost to $107.308 million. The unused balance of $12.692 million shown in
Exhibit 2 is available to cover cost overruns or higher interest charges. Including the $3 million of
preconstruction costs and $3.2 million cost of arranging the financing, total expected project cost is
$113.508 million.

However, the total project cost is sensitive to the interest rate applicable during the construction
period. If the interest rate is higher than expected, project cost increases accordingly.


Ownership Arrangements

The Cogeneration Project's target capital structure is 25% equity and 75% debt. The proportions of
equity and debt were determined by analyzing the profitability of the project. The greater the level of
operating income that can be contractually assured, the greater the amount of debt a project can
support. Cogeneration Company's debt will be nonrecourse to the equity investors. Long-term lenders
must look solely to the project's cash flow for their repayment. The equity investors will receive their
returns in the form of tax benefits, dividends paid out of excess cash flow from the project (i.e., after
payment of debt service), and any residual value of the cogeneration plant.

Exhibit 1 indicates the initial capitalization of Cogeneration Company following completion of

construction. Total capitalization equals $113.508 million, divided between long-term debt and equity:

Amount Percent
(millions of $)
Long-term debt $85.131 75.0
General partner 2.838 2.5
Limited partner 25.539 22.5
Total equity 28.377 25.0
Total capitalization $113.508 100.0

Engineering Firm and Local utility each own half of the general partner, Cogeneration Corporation.
Each will invest 25% of total project equity, and the passive investors will invest the other half of the
equity. Engineering Firm and Local Utility invest just enough funds in Cogeneration Corporation to
capitalize the general partner adequately for income tax purposes.

Initially, the general partner will receive 10% of the partnership's income, losses, and cash
distributions, and the limited partners will receive the remaining 90%. Once the limited partners have
received cumulative cash distributions equal to their original investment of $25.539 million, the 10/90
split will change to 50/50. The initial spilt is in proportion to the equity investors' respective investments
in the Cogeneration Project. Following reversion, the general partner shares equally with the limited
partners with respect to partnership income, losses, tax credits, and cash distributions. This shift in
distribution arrangements is designed to reward the general partner if the partnership performs well.

Cash Flow Projection Assumptions

The cash flow projection assumptions for the Cogeneration Project are shown in Table 1. The contract
volumes of electricity (as specified in the electric power purchase agreement) and steam (as specified
in the steam purchase agreement) establish the base output levels for 15 years. The electric power
purchase agreement specifies electricity prices. The steam purchase agreement provides a base
steam sales price, which can be escalated using a forecast of future changes in the PPI. (Such
forecasts are available from economic forecasting services.) The projected volumes and prices can be
used to forecast annual revenue amounts.

The design of the cogeneration facility will determine the annual levels of gas usage. The gas supply
agreements escalates the gas price to match future increases in electricity prices, which were used to
prepare the revenue projections. Management fees and other operating expenses will also increase
with the PPI, as provided for in the 15-year operating contract entered into with Local Utility.
Management fees are included in "Operating and other cash expenses" in Table 1.

Table 1
Cogeneration Project: Assumptions for the Cash Flow Projectionsa

1. Capacity utilization: 90%

2. Prices at the time the plant is placed in service, and contracted escalation factors:

Electricity $40.00/megawatt-hour; 6% annually

Steam $4.00/thousand pounds; PPIb
Natural gas $3.00/million BTU; 6% annually

3. Predicted volumes:
At Capacity Maximum Annual At 90% Utilization

Electricity production 250 MW 2,190,000 MWH 1,971,000 MWH

Steam production 150,000 PPH 1,314 M P 1,182.6 M P
Gas usage 1,950 M BTU/hour 17,082 B BTU 15,373.8 B BTU

4. Operating and other cash expensesc:

First year = $8 million/year; escalation factor = PPI.

5. Tax rate: 40%.

MW = megawatts; MWH = megawatt-hours; PPH = pounds per hour; M P = million pounds; BTU =
British thermal unit; M BTU = million BTUs; B BTU = billion BTUs.
The producer price index, which is assumed to escalate at the rate of 5% per annum.
Includes operating costs, maintenance expenditures, and management fees amounting to $6 million,
and insurance and local taxes amounting to $2 million.


1. Discuss the project's economics and risks.

2. How can the project sponsors eliminate interest rate risk exposure mentioned under "Capital


Exhibit 1
Cogeneration Project: Sources of Long-Term Financing and the Allocation of Income, Losses, and Cash Distributions

Passive Engineerin Local Engineerin Local

Equity g Utility g Utility
Investors Firm Firm

Contribute $14.189 Each contributes Each contributes $1.419

million for 55.56% $5.675 million for million for a 50% equity
of the limited a 22.22% limited ownership interest in
partnership partnership the general partnership
interests interest

Cogeneration Corporation
Limited Partners (General Partner)

Contribute Receive 10% of Contribute $2.838

$25.539 income, losses, and million for a 10%
Receive 90% of million for a distributions until equity interest
income, losses, 90% equity reversiona
and distributions interest
Contribute $85.131
million of nonrecourse
loans (75% of capital)
Cogeneration Long-Term
Company Lenders
Debt service payments

Reversion occurs when the limited partners have received cumulative cash distributions equal to their original investment of
$25.539 million. Thereafter, the general partner (Cogeneration Corporation) is entitled to receive 50% of all partnership income,
losses, and cash distributions.

Exhibit 2
Cogeneration Project: Total Project Cost and Construction Loan Drawdown
(millions of dollars)

Total direct costs $100 million Commitment fees .5 percent

per annum
Commitment amount $120 million Interest rate 10 percent
per annum

Total Cumulative Unused

End of Construction Commitment Interest Total Construction Funds Balance of
Month Drawdown Fees Financing and Used Commitment
Costs Financing
0 -- -- -- -- -- -- $120.000
1 $0.250 $0.050 -- $0.050 $0.300 $0.300 119.700
2 0.250 0.050 $0.003 0.053 0.303 0.603 119.397
3 0.375 0.050 0.005 0.055 0.430 1.033 118.967
4 0.375 0.050 0.009 0.059 0.434 1.467 118.533
5 0.500 0.049 0.012 0.061 0.561 2.028 117.972
6 0.500 0.049 0.017 0.066 0.566 2.594 117.406
7 1.000 0.049 0.022 0.071 1.071 3.665 116.335
8 1.500 0.048 0.031 0.079 1.579 5.244 114.756
9 2.000 0.048 0.044 0.092 2.092 7.336 112.664
10 2.000 0.047 0.061 0.108 2.108 9.444 110.556
11 3.000 0.046 0.079 0.125 3.125 12.569 107.431
12 4.000 0.045 0.105 0.150 4.150 16.719 103.281
13 5.000 0.043 0.139 0.182 5.182 21.901 98.099
14 6.000 0.041 0.183 0.224 6.224 28.125 91.875
15 7.000 0.038 0.234 0.272 7.272 35.397 84.603
16 8.000 0.035 0.295 0.330 8.330 43.727 76.273
17 10.000 0.032 0.364 0.396 10.396 54.123 65.877
18 11.000 0.027 0.451 0.478 11.478 65.601 54.399
19 10.000 0.023 0.547 0.570 10.570 76.171 43.829
20 8.750 0.018 0.635 0.653 9.403 85.574 34.426
21 7.000 0.014 0.713 0.727 7.727 93.301 26.699
22 6.000 0.011 0.778 0.789 6.789 100.090 19.910
23 3.500 0.008 0.834 0.842 4.342 104.432 15.568
24 2.000 0.006 0.870 0.876 2.876 107.308 12.692
Total $100.000 $0.877 $6.431 $7.308 $107.308


Cacluated on the unused balance of commitments.
Calculated on cumulative funds used.

Exhibit 3
Cogeneration Project: Projected Traditional Cash Flows
(millions of dollars)

Revenues Cash Expenses Income from Traditional

Operations Cash Flow
Natural Operating Noncash from
Year Electricity Steam Gas & Other Expenses a
Pretax After-tax Operationsb
1 $78.84 $4.73 $46.12 $8.00 $11.35 $18.10 $10.86 $22.21
2 83.57 4.97 48.89 8.40 11.35 19.90 11.94 23.29
3 88.58 5.22 51.82 8.82 11.35 21.81 13.08 24.44
4 93.90 5.48 54.93 9.26 11.35 23.83 14.30 25.65
5 99.53 5.75 58.23 9.72 11.35 25.98 15.59 26.94
6 105.51 6.04 61.72 10.21 11.35 28.26 16.96 28.31
7 111.84 6.34 65.42 10.72 11.35 30.68 18.41 29.76
8 118.55 6.66 69.35 11.26 11.35 33.25 19.95 31.30
9 125.66 6.99 73.51 11.82 11.35 35.97 21.58 32.93
10 133.20 7.34 77.92 12.41 11.35 38.85 23.31 34.66
11 141.19 7.71 82.60 13.03 -- 53.27 31.96 31.96
12 149.66 8.09 87.55 13.68 -- 56.52 33.91 33.91
13 158.64 8.50 92.81 14.37 -- 59.96 35.98 35.98
14 168.16 8.92 98.37 15.09 -- 63.62 38.17 38.17
15 178.25 9.37 104.28 15.84 -- 67.50 40.50 40.50

Deductible for tax purposes. Assumes the total project cost of $113.508 million can be deducted on
a straight-line basis over 10 years.
Before interest charges but after deduction of the equity investors' tax liabilities on their partnership


Exhibit 4
Cogeneration Project: Annual Interest and Debt Service Coverage Ratios


1. Principal amount: $85.131 million

2. Term: 10 years
3. Interest rate: 10 percent per annum
4. Principal repayment: years 1 - 3 = 5%
years 4 - 7 = 10%
years 8 - 10 = 15%

Interest Debt
a b
Year EBIT EBITDA Interest Principal Tax- Coverage Service
adjusted Ratio Coverage
Principal Ratioe
1 $18.10 $29.45 $8.51 $4.26 $7.09 2.13 1.89
2 19.90 31.25 8.09 4.26 7.09 2.46 2.06
3 21.81 33.16 7.66 4.26 7.09 2.85 2.25
4 23.83 35.18 7.24 8.51 14.19 3.29 1.64
5 25.98 37.33 6.38 8.51 14.19 4.07 1.81
6 28.26 39.61 5.53 8.51 14.19 5.11 2.01
7 30.68 42.03 4.68 8.51 14.19 6.55 2.23
8 33.25 44.60 3.83 12.77 21.28 8.68 1.78
9 35.97 47.32 2.55 12.77 21.28 14.08 1.99
10 38.85 50.21 1.28 12.77 21.28 30.43 2.23

Earnings before interest and taxes. (example: $78.84 + $4.73 - $46.12 - $8.00 - $11.35 = $18.10)
Earnings before interest, taxes, depreciation, and amortization. (example: $78.84 + $4.73 - $46.12 -
$8.00 = $29.45)
Principal repayments divided by (1 - tax rate).
EBIT divided by interest expense.
EBITDA divided by interest expense plus tax-adjusted principal.


Profitability and Loan Policy

Key Bank

At the end of 2008, Key Bank had total resources of $410 million. It served its market area with 16
offices and a staff of 295 full-time officers and employees.

Early 2009, Nguyen Hong Anh, executive vice-president of Key Bank, was reviewing the financial data
he had assembled for the asset and liability committee (ALCO). Hong Anh had joined the bank the
previous November, along with Ho Thi Kim, who was named chairman of the board and chief
executive officer. Shortly after the two men had assumed their new positions, Thi Kim instructed Hong
Anh to respond to the report of national bank examiners, dated 17 October 2008, which was highly
critical of the bank’s policies and procedures for monitoring and controlling its risk position. Hong Anh
was asked to review the bank’s performance and, as soon as he completed his evaluation, to present
his recommendations for corrective measures to the ALCO.

The examiners had found much to criticize. They specifically made note of three areas of concern.
First, the bank’s exposure to credit, interest rate, and liquidity risks was judged excessive in relation to
its capital strength and earnings performance. Second, the bank funded approximately 25% of its
assets through large Certificates of Deposit (CDs), more than twice the peer bank average of about
12%. Finally, the bank’s financial reports and written policy statements regarding interest rate and
liquidity risk management did not provide the data and specific guidelines needed to make well-
reasoned asset and liability management decisions.

During the past few weeks, Hong Anh had worked on evaluating Key Bank’s recent operating
performance and its financial condition. He was also occupied with designing an information system of
financial reports that would be useful in managing the bank’s resources and that would meet the
examiners’ criticism.

For his analysis of Key Bank’s performance, Hong Anh put together the financial data of eight banks
for the last two years, 2007 and 2008. While none of the eight banks competed with Key Bank, each
was about the same size, with total assets that ranged from about $300 million to just under $600
million. Also, the banks selected to form a suitable peer group were located in areas with economic
and demographic characteristics similar to those of Key Bank’s market. The balance sheet and
income statement data for Key Bank and the peer group banks are shown in Exhibits 1 and 2. Exhibit
3 contains key financial ratios for Key Bank and its peers.

The two primary financial reports designed by Hong Anh for management’s use in making asset and
liability management decisions were an interest rate sensitivity report (Exhibit 4) and a liquidity report
(Exhibit 5). Hong Anh felt that the reports would improve management’s ability to monitor and
understand Key Bank’s risk position.

In preparing for the ALCO meeting at which he would discuss his findings and present his
recommendations, Hong Anh talked to each member of the committee and obtained their views on
the outlook for the local and national economies in 2007. The consensus estimate of the ALCO
members was that interest rates would bottom out by the end of the second quarter and would
increase during the last half of the year. Hong Anh’s summary of this forecast appears in Exhibit 6.


1. Compare the relative earnings performance of Key Bank with its peers.

2. Evaluate the financial risks which Key Bank has taken to attain these returns. Use both the
DuPont Analysis and a Cash Flow Analysis to support your answer.

3. Analyze the interest-sensitivity report in Exhibit 4. Justify your findings with one of the four gap
strategies attached.

4. Using the data in Exhibit 5, determine Key Bank's liquidity needs over the first quarter of 2009.
How should the bank meet its liquidity requirements?

5. Given the outlook for 2009 suggested in Exhibit 6, what specific recommendations would you
make to the management of Key Bank for improving the bank's earnings performance and
financial strength?


Exhibit 1 Key Bank Average Balance Sheet (000 $)

2008 2007
Key Peers Key Peers
Assets % % % %
Cash and due from banks 27424 7.03 6.87 25869 7.16 6.97
Interest-bearing bank deposits 8348 2.14 3.10 7299 2.02 2.98
Excess reserves sold 10884 2.79 5.24 9683 2.68 4.95
Investment securities:
Central government 35226 9.03 12.17 35913 9.94 12.96
Local government 24654 6.32 7.93 26628 7.37 9.04
Other securities 5930 1.52 1.75 4805 1.33 1.21
Total investment securities 65810 16.87 21.85 67346 18.64 23.21
Loans and leases:
Commercial 96589 24.76 17.06 90867 25.15 17.03
Real estate 69516 17.82 23.51 56218 15.56 21.59
Consumer 82935 21.26 14.87 74247 20.55 14.89
Other loans 16306 4.18 4.29 17776 4.92 4.82
Lease financing 1053 0.27 0.35 831 0.23 0.31
Total loans and leases 266399 68.29 60.08 239939 66.41 58.64
Less: reserve for losses 3199 0.82 0.73 2746 0.76 0.66
Net loans and leases 263200 67.47 59.35 237193 65.65 57.98
Premises and equipment 7295 1.87 1.69 7045 1.95 1.84
Other assets 7139 1.83 1.90 6865 1.90 2.07
Total assets 390100 100.00 100.00 361300 100.00 100.00

Total earning assets 351441 90.09 90.27 324267 89.75 89.78

Liabilities & Equity
Noninterest bearing deposits 67058 17.19 17.14 63264 17.51 17.32
Interest bearing deposits 29375 7.53 8.24 29012 8.03 8.80
Regular savings accounts 21104 5.41 7.89 18860 5.22 8.07
Money market accounts 44159 11.32 18.39 38876 10.76 15.96
CDs < $100000 82857 21.24 23.86 77788 21.53 24.57
CDs > $100000 98032 25.13 11.49 88048 24.37 11.68
Total deposits 342585 87.82 87.01 315848 87.42 86.40
Excess reserves purchased 14551 3.73 4.77 15211 4.21 5.15
Other liabilities 7295 1.87 1.24 6937 1.92 1.37
Total liabilities 364431 93.42 93.02 337996 93.55 92.92
Equity 25669 6.58 6.98 23304 6.45 7.08
Total liabilities & equity 390100 100.00 100.00 361300 100.00 100.00

Exhibit 2 Key Bank Income Statement

Percent of Average Total Assets (000 $)

2008 2007
Key Peers Key Peers
% % % %
Interest income:
Loans and leases 30467 7.81 6.80 30156 8.35 7.27
Investment securities 7001 1.79 2.33 7677 2.12 2.64
Interest-bearing balances 689 0.18 0.27 718 0.20 0.29
Excess reserves sold 775 0.20 0.38 794 0.22 0.42
Total interest income 38932 9.98 9.78 39345 10.89 10.62

Interest expense:
Interest on deposits 18828 4.83 4.70 19835 5.49 5.40
Interest on borrowings 989 0.25 0.35 1156 0.32 0.39
Total interest expense 19817 5.08 5.04 20991 5.81 5.79

Net interest margin 19115 4.90 4.74 18354 5.08 4.83

Noninterest income 3511 0.90 0.94 3324 0.92 0.97

Provision for loan losses 2146 0.55 0.43 1770 0.49 0.41

Adjusted net interest margin 16969 4.35 4.31 16584 4.59 4.42

Overhead expenses:
Salaries 6671 1.71 1.61 6540 1.81 1.70
Premises and equipment 2302 0.59 0.52 2276 0.63 0.57
Other expenses 5110 1.31 1.24 4914 1.36 1.28
Total overhead expenses 14083 3.61 3.37 13730 3.80 3.55

Income before taxes 6397 1.64 1.88 6178 1.71 1.84

Income taxes 2849 0.73 0.84 2746 0.76 0.82

Net income 3548 0.91 1.04 3432 0.95 1.02


Exhibit 3 Key Bank Financial Ratios
Average Balances (%, except where noted)

2008 2007
Peers Peers
Key Key
Profitability measures:
1. Return on assets 0.91 1.04 0.95 1.02
2. Net profit margin 8.36 9.70 8.04 8.80
3. Asset yield or utilization 10.88 10.72 11.81 11.59
4. Return on equity 13.82 14.90 14.73 14.41
5. Leverage or equity multiplier (x) 15.2x 14.33x 15.50x 14.12x
Spread management (% of earning
6. Net interest margin 5.44 5.25 5.66 5.38
7. Adjusted net interest margin 4.83 4.77 5.11 4.92
8. Net overhead burden 3.01 2.69 3.21 2.87
Asset management (% of assets):
9. Excess reserves sold & interest-
bearing bank balances 4.93 8.34 4.70 7.93
10. Central government securities 9.03 12.17 9.94 12.96
11. Local government securities 6.32 7.93 7.37 9.04
12. Net loans and lease financing 67.47 59.35 65.65 57.98
13. Premises and equipment 1.87 1.69 1.95 1.84
Liability management (% assets):
14. Noninterest demand deposits 17.19 17.14 17.51 17.32
15. Interest-bearing deposits 7.53 8.24 8.03 8.80
16. Regular and money market savings 16.73 26.28 15.98 24.03
17. CDs <$100000 21.24 23.86 21.53 24.57
18. CDs >$100000 25.13 11.49 24.37 11.68
19. Short-term borrowings 3.73 4.77 4.21 5.15
Expense control:
20. Interest expense/assets 5.08 5.04 5.81 5.79
21. Interest expense/interest paying
liabilities 6.83 6.75 7.84 7.80
22. Assets per employee (000 $) 1322 1485 1216 1352
23. Salaries/assets 1.71 1.61 1.81 1.70
24. Other expenses 1.90 1.76 1.99 1.85
25. Provision for loan losses/assets 0.55 0.43 0.49 0.41
Asset yield enhancement:
26. Interest income/assets 9.98 9.78 10.89 10.62
27. Interest income/earning assets 11.08 10.83 12.13 11.83
28. Noninterest income/assets 0.90 0.94 0.92 0.97
29. Loan income/loans and leases 11.44 11.32 12.57 12.40
30. Yield on investment securities 10.64 10.66 11.40 11.37
Credit quality (% loans & leases):
31. Net charge-offs 0.64 0.52 0.60 0.47
32. Past-due & nonaccrual loans & 1.93 1.58 1.89 1.71
Liquidity measures:
33. Temporary investments/assets 10.64 15.07 11.02 16.15
34. Volatile liabilities/assets 28.86 16.26 28.58 16.83
35. Net loans & leases/core deposits 107.62 78.59 104.12 77.60
Interest sensitivity measures (% of
36. Assets repricing in one year 51.92 51.95 53.06 52.24
37. Liabilities repricing in one year 60.37 57.83 59.84 55.04
38. One-year GAP -8.45 -5.88 -6.78 -2.80
Capital adequacy and loan loss
39. Equity/assets 6.58 6.98 6.45 7.08
40. Net loans & leases/equity (x) 10.25x 8.50x 10.18x 8.19x
41. Loan loss reserve/loans &
leases 1.20 1.22 1.14 1.13
42. Cash dividends/net income 33.34 38.64 33.90 34.67
43. Internal capital generation rate 9.21 9.14 9.74 9.41

Glossary of Selected Terms

Adjusted net interest margin. The yield realized on earning assets less total interest expense and
the provision for loan losses divided by average earning assets.

Asset yield or utilization. Total operating income (interest income plus noninterest income) divided
by average total assets.

Core deposits. Interest-bearing and noninterest-bearing demand deposits, regular savings, money
market savings, and CDs under $100000.

Earning assets. Interest-bearing assets including total loans and leases, investment securities,
excess reserves sold, interest-bearing deposits with other banks, and other money market

Employees. Full-time employees.

GAP. The difference between rate-sensitive assets and rate-sensitive liabilities over a specified time


Internal capital generation rate. The annual rate of increase in common shareholders’ equity that
results from retained earnings. The rate is computed by multiplying the return on average common
shareholders’ equity by the earnings retention rate (percentage of earnings retained).

Leverage or equity multiplier. Average total assets divided by average common shareholders’

Net charge-offs. The difference between the yield realized on earning assets and total interest
expense divided by average earning assets.

Net loans and leases. Gross loans less unearned income and the loan loss reserve.

Net overhead. The difference between noninterest income and noninterest expense divided by
average earning assets.

Net profit margin. Net income after taxes divided by total operating income.

Nonaccrual loans and leases. Loans and leases on which interest accrual have been discontinued,
usually due to the borrower’s financial difficulties.

Noninterest expense. All operating expenses other than interest expense and the provision for loan
losses, including salaries, benefits, occupancy costs, etc.

Noninterest income. All income other than interest and fees on earning assets, including safe-
keeping income, deposit service charge income, other service charges, etc.

Salaries. Salaries, wages, and officers’ and employees’ benefits.

Return on assets. Net income after taxes divided by average total assets.

Return on equity. Net income after taxes divided by average common shareholders’ equity.

Temporary investments. Interest-bearing deposits with banks, excess reserves sold, trading account
securities, and investment securities with remaining maturities of one year or less.

Volatile liabilities. Large CDs and other time accounts in amounts of $100000 and more, excess
reserves purchased, and other short-term borrowings.


Exhibit 4.1 Key Bank Interest Rate Sensitivity Report, 31 December 2008 (000 $)

1-7 8-30 31-60 61-90 91-120

Days Days Days Days Days

Cash & due from banks

Interest-bearing bank balances 1557 832 3929 1662
Investment securities 2625 505 2148 3074
Excess reserves sold 11428
Commercial loans 59187 4180 3762 4026 3226
Real estate loans 10532 1284 1052 1708 1131
Consumer loans 296 3527 5104 7208 4710
Other loans 696 536 880 1048 1413
Other assets
Total assets 85064 11689 12778 20993 12142

Noninterest-bearing deposits
Interest-bearing demand deposits 18506
Regular savings 234 415 508 465
Money market deposit accounts 46367
CDs <$100000 714 2558 22575 4602 2445
CDs >$100000 1565 14267 10046 21842 18024
Excess reserves purchased 15279
Other liabilities
Shareholders’ equity
Loan loss reserve
Total liabilities and equity 17558 81932 33036 26952 20934

Periodic GAP 67506 -70243 -20258 -5959 -8792

Cumulative GAP 67506 -2737 -22995 -28954 -37746
Cumulative GAP (% of assets) 16.35 -0.66 -5.57 -7.01 -9.14
Cumulative GAP (% of equity) 250.47 -10.16 -85.32 -107.43 -140.05


Exhibit 4.2 Key Bank Interest Rate Sensitivity Report, 31 December 2008 (000 $)

121-150 151-180 181-365 > 365

Days Days Days Days Total

Cash & due from banks 28795 28795

Interest-bearing bank balances 785 8765
Investment securities 7586 7467 45696 69101
Excess reserves sold 11428
Commercial loans 2262 1978 8762 13635 101418
Real estate loans 1137 1125 6766 48257 72992
Consumer loans 4692 4753 17536 40256 87032
Other loans 1218 2094 3600 6742 18227
Other assets 15156 15156
Total assets 17680 9950 44131 198537 412964

Noninterest-bearing deposits 70411 70411

Interest-bearing demand deposits 12338 30844
Regular savings 509 281 3766 15981 22159
Money market deposit accounts 46367
CDs <$100000 6795 2661 19626 25024 87000
CDs >$100000 11734 6587 16943 1925 102933
Excess reserves purchased 15279
Other liabilities 7660 7660
Shareholders’ equity 26952 26952
Loan loss reserve 3359 3359
Total liabilities and equity 19038 9529 40335 163650 412964

Periodic GAP -1358 421 3796 34887 0

Cumulative GAP -39104 -38683 -34887
Cumulative GAP (% of assets) -9.47 -9.37 -8.45
Cumulative GAP (% of equity) -145.09 -143.53 -129.44


Exhibit 5 Key Bank Liquidity Report for Maturing and Volatile Funds
First Quarter 2009 (000 $)

Maturing Volatile Loan Demand/

Funds Funds Deposit Growth
Interest-bearing bank balances
Investment securities 8352
Excess reserves sold 11428
Principal payments:
Commercial loans 15172
Real estate loans 6606
Consumer loans 15135
Other loans 2658

Total 65669

Noninterest-bearing demand deposits
Interest-bearing demand deposits
Regular savings 1157
Money market deposits 3500
CDs <$100000 22837
CDs>$100000 47720
Excess reserves purchased 15279
Total 86993 13900
Estimated new loan demand 35000
Estimated new core deposits
(excluding large CDs) 21000


Exhibit 6 Key Bank Asset and Liability Management Committee
Consensus View of Local and National Economic

Loan Demand

Loan demand in 2009, especially in real estate and consumer credit card activity, will pick up in our
market area in response to increased population as three major national firms—an electronics
company, an automotive parts and accessories manufacturer, and a building materials supplier—will
open new facilities and hire about 2700 employees during the year. Nationally, we see a recession in
the first two quarters, followed by reasonable recovery in the latter half of 2009.

Interest Rates

In spite of a national economic slowdown, business activity is stronger than anticipated in our region.
Easy monetary policy suggests that the Central Bank will attempt to increase money growth during the
year to stem the recession. Short-term interest rates will fall about 200 basis points, then rise from 50
to 100 basis points above those levels. Big banks’ prime rate should move up to 8.50 to 9.00%, while
3-month Treasury bill and CD rates should move up to 6.50 to 7.00%. All rate bets are off if there is a
continuing recession into 2010. If the recession continues or the recovery is weak, all interest rates will
continue to fall.

Key Bank will pay competitive deposit rates at the high end to enlarge its base of core deposits. It will
not match rates offered by some of the savings banks in our market area but will pay rates above
those of our bank competitors.

Gap Strategies

Definition of Gap

The concept of gap analysis is relatively simple. Each asset and liability category is classified
according to the time that it will be repriced and is then placed in a grouping called a time bucket. Time
buckets refer to the time that assets and liabilities mature, generally grouped in three-month to one-
year intervals.

For most banks, the assets are frequently long-term (loans primarily) while the liabilities are frequently
short-term (customer deposits, for example). This results in a funds gap. A funds gap is defined as
assets minus liabilities within each time bucket. The gap ratio is assets divided by liabilities in each
time bucket. A funds gap or gap ratio of zero means that the bank has exactly matched the maturity of
its assets and that of its liabilities. This match, however, is difficult to achieve based on the balance
sheet structure of most banks.


Gap positions are measured for each time bucket using the following formula:

Assets maturing (or eligible for repricing)

within one year — liabilities maturing
Cumulative gap to = -------------------------------------------------------
total assets ratio Total Assets

an acceptable level for this ratio depends on the average loan terms, terms of the liabilities, and
expectations about the movement of interest rates. If the gap ratio is greater than one, it is referred to
as a positive gap or asset-sensitive position. This means that there are more interest rate sensitive
assets for a particular time period than liabilities. If a bank expects interest rates to rise, it will likely
maintain a positive short-term gap. However, if interest rates decline, both assets and liabilities will be
repriced at a lower rate when the time period ends. Because there are fewer repriced liabilities to fund
the repriced assets, the result is increased risk (that is, the lower repriced assets will be funded in part
with higher liabilities that have not yet been repriced.

On the other hand, if the gap ratio is less than one or if there is a negative gap, a liability-sensitive
position results. If interest rates decline, risk is reduced because the lower-priced liabilities will be
funding more assets that are still priced at the higher rate. If a bank anticipates declining interest rates,
it will maintain negative short-term gaps, which allow more liabilities to reprice relative to assets.


There are several strategies a bank can employ for an effective gap management. These include:

• Maintain a diversified asset portfolio in terms of rates, maturities, and industry sectors. Loans and
securities should be selected on the basis of their degree of marketability.

• Develop action plans for specific asset and liability categories for particular phases of the business

• Analyze carefully any given change in the direction of interest rates before concluding that a new
rate cycle has begun.

The interest rate cycle may be divided into four phases: 1) a period of low interest rates, 2) rising
interest rates, 3) high interest rates, and 4) declining interest rates. Strategies may be employed at
various stages of the cycle as follows:


1. First phase - low interest rates (rates are expected to rise):

a. lengthen maturity of borrowed funds;

b. reduce fixed rate loans;
c. shorten maturity of investment portfolio;
d. sell investment securities
e. raise long-term debt;
f. reduce or remove customer credit line commitments.

2. Second phase - rising interest rates (interest rates are expected to reach their top in the near

a. begin to shorten maturity of borrowed funds;

b. begin to lengthen investment maturities;
c. prepare to start increasing the number of fixed rate loans;
d. prepare to increase investments in securities;
e. focus on new credit lines for customers.

3. Third phase - high interest rates (rates are expected to decline in the foreseeable future):

a. shorten the maturity of borrowed funds;

b. increase fixed rate loans;
c. increase the maturity of the investment portfolio;
d. increase the size of the investment portfolio (fixed rate);
e. plan future asset sales;
f. consider prepaying fixed rate debt.

4. Fourth phase - declining interest rates (rates are expected to bottom out in the near future):

a. begin to lengthen the maturity of borrowed funds;

b. begin to shorten the maturities of investments;
c. begin to increase variable rate loans;
d. begin to reduce investments in securities;
e. selectively sell other assets (fixed rate in particular);
f. plan raising long-term debt (at fixed rates).

The above strategic steps to gap management are designed to improve the net interest margin within
a set of risk parameters as determined by the bank’s management. At the same time, the strategic
steps illustrate the risk attached to forecasting interest rates and adjusting assets and liabilities
accordingly. Interest rates and the degree of risk attached to assets and liabilities depend heavily on
external forces, over which a bank has little control and often great difficulty to forecast.

Moreover, it once was a given that lower interest rates were good for banks. When rates fall, the
thinking went, profits grow—since banks pay less for deposits yet still collect interest from existing


loans and investments. But in the current noninflationary environment, the conventional wisdom has
been turned on its head: falling interest rates may be bad for banks.

That is because banks are paying so little for deposits that it is hard to believe they can cut rates much
further. Although fees make up an increasing portion of bank income, most profits still come from
interest. Lower and lower short-term interest rates are not good for deposit-funded banks since it is
difficult to lower deposit rates in concert with the decline in market rates.

Nevertheless, management oftentimes takes a gamble about which way they think interest rates are
headed and the gap position shows it: a negative gap indicates a bet that interest rates are going to go
down, a positive gap is a bet that interest rates are going to go up. Only the careful managers strike a
balance that does not sink the bank in the process.


DuPont Chart

Total assets
Net interest
Total assets
Total assets

Net income Income tax

Total assets Total assets

Return on Exceptional
Equity items (net) Loan loss
Total assets provision
Total assets

Total assets
Net operating Operating
costs expenses
Total assets Total assets

Total assets


(Indirect Method)


Cash Flow Statement
A. Cash flows from operating activities:
Net income
Adjustments to reconcile net income
to net cash inflow (outflow):
. Provision for loan losses
. Depreciation and amortization
. Other noncash charges

∆ loans
∆ interest and fees receivable
∆ trading account assets

∆ deposits
∆ accruals

Cash flow from operating activities (A)

B. Cash flows from investing activities:

∆ investments
Capital expenditures
∆ other assets

Cash flow from investing activities (B)

C. Cash flows from financing activities:

∆ purchased funds
∆ long-term debt
∆ other liabilities
Dividend payments
∆ capital

Cash flow from financing activities (C)

D. Net increase (decrease) in cash (A+B+C)

Cash and banks at beginning of period

Cash and banks at end of period
∆ cash and banks

Profitability Ratios


Key Bank Peers

2007 2008 2008

Net interest income 4.74%%

Provision for loan losses 0.43%

Overhead expenses 3.37%

Return on assets 1.04%

Return on equity 14.61%


Strategic and Industry Analysis

NetGear Industries

NetGear Industries designs and sells ethernet network kits, pieces of electrical equipment that control
the flow of data among computers—largely for home network use. Your bank is interested in the home
network industry to further diversify its commercial loan portfolio and has identified NetGear as a
prospective client. A credit report is needed immediately.

Fortunately, your bank’s credit files contain considerable information on NetGear, as well as
condensed financial statements and ratios on the company and the home network industry (as shown
in NetGear Industries Analyst Notes). To prepare the report it will be necessary to answer the following
questions (in groups) based on the information in the Analyst Notes.

1. Identify the stage of the home network industry in the industry life cycle. Describe at least two of
the general features that characterize this stage and cite at least three items of evidence from the
Analyst Notes that justify your identification.

2. Identify the pricing strategy used by the leading companies in the home network industry. Cite at
least three items of evidence from the Analyst Notes that justify your identification.

3. State whether the home network industry is likely to sustain rapid growth in unit sales over the
period 2009-2010. Cite at least three items of evidence from the Analyst Notes that justify your

4. Evaluate the competitive structure of the home network industry based on an analysis of the five competitive
forces. For each of these forces, cite at least three items of evidence from the Analyst Notes that justify your

Sample: 6 port hub for PlayStation (5 in front, 1 in the rear); “I0Gear” is a trademark of NetGear.
(Other sample products at end of case.)


Analyst Notes

Industry Factors

1. Home network kits and USB hubs allow computers (particularly home personal computers or PCs)
to exchange data and communicate via Local Area Networks (LANs) and Wide Area Networks
(WANs). A LAN spans a short distance and connects a small number of computers. A WAN spans
a longer distance and connects a larger number of computers.

2. Starting around 1982, PCs were linked together by cable to share printers, software, and memory.
As time passed, PCs were increasingly connected to larger and more complex computers and
peripherals. However, different computers had different operating systems (“languages”) that
made it difficult for them to communicate with each other. Routers, now called network hubs, were
required to enable them to communicate. Most recently, network distances have increased,
transmission speeds have increased rapidly, and the complexity of computer applications has
increased as well. Each of these developments increases the need for routers, which are a
component of network kits.

3. NetGear specializes in external USB hubs and ethernet network kits. A two-PC starter kit, for
example, contains an installation CD-ROM, a manual, two 10/100-mbps network cards (to be
inserted in each PC), two 8-meter ethernet cables, and a 4-port hub (router).

4. NetGear and one other company have a combined 70% market share in USB hubs and home
network kits. NetGear has about a 57% market share.

5. USB hubs and home network kits have become easier to use, increasingly functional and efficient,
more reliable, and more widely accepted.

6. Prices of low-end (simple and commodity-like) routers are falling 20% per year.

7. Unit costs and prices of USB hub and home network kits are falling due to experience curve
learning. Kit components are being improved, however, so that while older ones fall sharply in
price, new (improved) kits maintain average selling prices.

8. An increasing percentage of PCs is connected in LANs, both at home and at the office.

9. At the office, an increasing percentage of LANs is further connected in WANs.

10. An increasing number of households have more than one PC which share peripherals (printers,
drives, DVD burners, PlayStations, and Internet connections) and require data exchange (file
copies and transfers, e-mail forwarding, etc.).

11. One reason for overall USB hub and home network kit growth is the fashion for home
entertainment centers—systems that combine TVs, disc players, speakers, and even PC


12. Despite the recession, home entertainment systems are expected to grow rapidly over the next
few years. “Staying in is the new going out,” a noted magazine said recently.

13. Network users are expected to continue to demand faster transmission speeds for larger and
larger quantities of data in increasingly complex formats. This requires constant upgrading and
product innovation.

14. Multimedia applications (that make the best use of audio, video, and computers) are increasing,
and their higher capacity, speed, precision, and complexity require more sophisticated USB hub
and network kits.

15. Management teams of home network companies expect strong industry growth to continue but
also expect more competition, placing downward pressure on selling prices.

16. Weaker companies in the home network industry have shown poor financial results. Their
profitability is under pressure and a shakeout is expected.

17. Stronger companies show increasing profitability.

Competitive Factors

18. Network kits are increasingly critical to the day-to-day operations of customers. A network failure
could be extremely costly.

19. Network environments are very complex due to hardware and software technology and the lack of
common standards. Network kits are needed to connect computers with diverse operating
systems (“languages”).

20. Home network kits come in three versions: ethernet, home phone-line, and wireless LANS.

21. Ethernet networks are traditional wired networks, which require cables and a hub (or router).

22. Phone-line networks use the home's existing telephone wiring—without interfering with phone
calls (they operate at a higher frequency than telephones do).

23. Wireless networks use radio waves and require no physical connection.

24. Phone-line and wireless network kits have been available for years, but they have been plagued
by slow speed, high cost, or both.

25. Ethernet kits are inexpensive and fast and allow the addition of PCs to the network wherever a
cable can go. A recent survey indicated that ethernet connections are the fastest at downloading,
transferring, and sending data to other PCs and peripherals.

26. The two leaders' ethernet network kits accommodate 25-30 “languages” whereas newcomers’
traditional wired network kits support five or fewer. Both leaders make available phone-line
network kits as well and are included in their high-end product range.


27. The two ethernet leaders have substantial research and development budgets, patents, and
technology and design expertise.

28. The two ethernet leaders have extensive direct sales and service organizations.

29. Theoretically, ethernet network kits would not be needed if all computers and peripherals had
compatible systems and could communicate easily with each other.

30. New research and development and the adoption of universal “languages” may eventually
eliminate the need for ethernet kits but that is not expected to happen for many years.

31. Other pieces of equipment frequently perform some functions of ethernet network kits, but this is
not yet significant nor is it anticipated that they will be able to duplicate all the functions of today’s
ethernet network kit.

32. The cost of an ethernet network kit is a small percentage of the total cost of a home computer

33. A high quality ethernet kit can significantly increase the efficiency of a home network system
relative to the home network’s cost.

34. Customers prefer a single supplier of network kits.

35. Customers who switch to another supplier’s kits face high costs related to the change.

36. Ethernet network kit industry leaders subcontract the manufacturing of their products to
companies whose services are plentiful and commodity-like.

37. Cables and hubs are assembled mostly from commonly available electrical components.

38. Some of the components used to assemble cables and hubs are proprietary to a single supplier
but these are currently insignificant.

39. 80% to 90% of sales of the two ethernet kit leaders are to repeat customers.

40. Competition in the home network industry is based on product features. Price is often secondary.
The two ethernet kit leaders have different sets of product features.

Company Factors

41. NetGear’s profit margins are smaller on lower end products.

42. About 34% of NetGear’s sales are of lower end products, i.e. non-kit hubs and routers.

43. NetGear offers a full range of wireless routers and adapters; currently these products account for
35% of sales and are growing rapidly.


44. NetGear pays no cash dividend and does not expect to pay one in the near future.

45. NetGear intends to have no long or short-term debt. “Excess” cash will be invested in long-term

46. NetGear expects its tax rate to remain similar to that of the last two years.


Selected Home Network Kit Industry Statistics

Years ended December 31

2004 2005 2006 2007 2008 2009E

A. Kit sales growth 200% 150% 130% 80% 70% 50%

B. Gross margins 54% 55% 55% 55% 56%

Operating margins 16% 16% 17% 20% 21%

Pre-tax margins 15% 17% 18% 21% 22%

C. Operating profit growth 101% 85% 90% 96% 90%

Pre-tax profit growth 120% 104% 96% 92% 91%

D. End-user markets for kits: Home entertainment centers (HEC), Personal

computers (PCs) and
Local area networks (LANs)

Unit growth (compound annual rates)

1993-1997 35% n/d
1998-2003 30% n/d
2004-2007 25% 150%
2008-2009E 25% 15-20%

E. The home network market is estimated to grow by 35% over the next three years.


Table I

NetGear Industries

Balance Sheet (000s $)

Assets 2004 2005 2006 2007 2008

Cash and Equivalents 65052 90002 87736 167495 192839

Short-Term Investments 76663 83654 109729 37848 10170
Accounts Receivable 82203 104269 119601 157765 138275
Inventory 53557 51873 77932 83023 112240
Prepaid and Deferred Items 18626 20911 29361 33458 35493
Current Assets 296101 350709 424359 479589 489017
Net Fixed Assets 3579 4702 6568 11205 20292
Intangibles 558 558 4775 58304 74711
Other Assets 328 2202 2011 1858
Total Assets 300238 356297 437904 551109 585878

Liabilities and Equity 2004 2005 2006 2007 2008

Accounts Payable 52742 38912 39818 55333 60073

Accruals 56500 74022 87712 105555 94924
Taxes Payable 3659 3055 7737
Other Current Liabilities 2143 4304 8215 7619 21508
Current Liabilities 115044 120293 143482 168507 176505
Other Term Debt 11079 18746
Total Liabilities 115044 120293 143482 179586 195251
Ordinary Shares 31 33 33 35 34
Premium 188900 204754 221487 252421 266070
Reserves -1889 -558 -5 101 67
Retained Earnings -1848 31775 72907 118966 124787
Total Equity 185194 236004 294422 371523 390627
Total Liabilities and Equity 300238 356297 437904 551109 585878


Table II

NetGear Industries

Income Statement (000s $) 2004 2005 2006 2007 2008

Sales 383139 449610 573570 727787 743344

Cost of Goods Sold 260155 297764 379481 484548 502320
Gross Profit 122984 151846 194089 243239 241024
Research and Development 9916 12544 20224 29779 35573
SG&A Expenses 76027 85280 109830 139303 142799
Amortization (Intangibles) 1688 1866 4505 9045 13261

Operating Profit 35353 52156 59530 65112 49391

Interest Expense
Interest Income 1593 4104 6974 8426 4336
Other Income 2495 3298 -8384
Other Expenses 560 1770
Profit Before Taxes 36386 54490 68999 76836 45343
Income Taxes 12921 20867 27867 30882 27293

Net Income 23465 33623 41132 45954 18050

Table III

NetGear Industries

Ratios 2004 2005 2006 2007 2008

Sales growth 28.01% 17.35% 27.57% 26.89% 2.14%
Net Income growth 79.16% 43.29% 22.33% 11.72% -60.72%
Total Assets growth 46.35% 18.67% 22.90% 25.85% 6.37%
Total Liabilities growth 63.86% 4.56% 19.28% 25.16% 8.72%
Net Worth (Equity) growth 37.24% 27.44% 24.75% 26.19% 5.23%

Gross Profit Margin 32.10% 33.77% 33.84% 33.42% 32.42%
Operating Profit Margin 9.23% 11.60% 10.38% 8.95% 6.64%
Net income Margin 6.12% 7.48% 7.17% 6.31% 2.43%

Return on Assets (ROA) 7.82% 9.44% 9.39% 8.34% 3.08%

Return on Equity (ROE) 12.67% 14.25% 13.97% 12.37% 4.62%



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Risk Acceptance Criteria & SME Distress Indicators
Ho Hung Imports

Ho Hung Imports – Part 1

Risk Acceptance Criteria

Ms. Nguyen Kieu Trang was gravely concerned. Not only was her reputation as an astute lending
officer and account manager on the line, she could also see the current situation casting a shadow
over her entire career—and she was very ambitious. She was also under pressure to attract new
business as interest rates were falling and banks were now very liquid. The highly competitive
consumer finance area was not a strategic option at the present time.

A little over ten months ago she had come across a new start-up company with what she considered
to have more potential and less risk than any she had ever seen before. It was at her urging that
Credit Bank of Hanoi, her employer, had agreed to provide a $300000 credit line to the new venture,
Ho Hong Imports. Now it appeared very likely that the bank could lose up to several thousand dollars
because she had been fooled by optimistic talk and had not done her homework. Otherwise, she
would have been alerted to several potentially serious problems before they became so large that the
continued viability of the firm was in jeopardy.

As it is, the problems have led to a deterioration of the company’s financial position to the point where
only a massive reorganization and an infusion of additional capital could possibly save it. She feared
that the bank would not be willing to go along with such a reorganization because there was a good
chance that it would be too little too late.

Ho Hong Imports is a classic example of a business operation that should have been a money
generator. The individuals involved in the company all had extensive experience and contacts in the
industry and had demonstrated an ability to make money. Ms. Nguyen thought back to that fatal day
when Ho Hung Cuong and the two Leo brothers first walked into her office.

Ho Hong was an innovative and established designer of housewares such as linens, towels,
tablecloths, and accessories. His reputation for creativity was well known, and many regional retailers
carried merchandise designed by him in preference to the products for export made by local
manufacturers. For the preceding six years he had worked for a design and merchandising company
that had given him almost total carte blanche in creating new patterns and colors for their line of
housewares. He was free to be innovative; his designs were then implemented by textile mills located
mainly in Southern Italy.

This arrangement had proven to be both artistically satisfying and monetarily rewarding for Ho Hong—
despite competition from locally-made and imported products, so he was able to lead the kind of life
about which most people can only read and dream. In March 2008, though, the company for which he
worked was sold to a large retailing conglomerate owned by the Pham family. The new owners wanted
Ho Hong to remain with the company and were willing to pay him even more handsomely than before,
but he would no longer have the total artistic freedom he had come to enjoy. Because of this
constraint, he left the company in June 2008 with no firm prospects for another job.


Ho Hong was not only a designer—he had also been deeply involved in both the manufacturing and
the merchandising of the products. Because of this broad involvement, he was able to sell his
specialty-designed products at a premium despite their being imports in direct competition with locally-
produced goods. In addition, he had acquired a good rapport with the buyers from many of the big
retail and specialty stores in the country, as well as a close working relationship with the two brothers
heading the Leo Textile Group, the principal firm involved in the manufacturing of products from his

Soon after he resigned from the company, Ho Hong was contacted by the two Leo brothers. They
proposed that he start his own firm and indicated a willingness to put up two-thirds of the capital
needed to commence operations. Also, they agreed to coordinate production in Naples (Italy) of all
merchandise based on Ho Hong’s designs. This would be handled through Leo Exports, a wholly-
owned subsidiary of Leo Holdings. For his part, Ho Hong would be required to put up one-third of the
capital, to provide the designs for the product line, and to be the primary contact with buyers from the
retail stores.

It seemed like the perfect combination—an experienced and highly visible designer teaming up with
one of the oldest textile firms in Southern Italy. Nothing could stand in their way, or so Ms. Nguyen
thought. When Ho Hong and the Leo brothers came into her office that November day and presented
their ideas, Ms. Nguyen was convinced that someone was looking out for her best interests by
providing such an opportunity to show the bank what a great loan officer and account manager he

Because the proposed company was a start-up with no track record, though, a business plan would
have to be prepared, and numerous restrictive provisions would be imposed on the firm. Neither Ho
Hong nor the Leo brothers thought these requirements unreasonable, so they promised to get back
together with Ms. Nguyen within ten days to review their business plan.

Early the next week Ho Hong and the Leo brothers returned to Credit Bank and presented to Ms.
Nguyen the projections given in Table 1 and the pro forma statements shown in Table 2. The ensuing
conversation convinced Ms. Nguyen that the projections were very realistic, if not somewhat
conservative. She knew that sales of household accessories such as those designed by Ho Hong
tended to fall off the last three or four months of the year and pick up again early spring.

She was very pleased to see this pattern built into the sales estimates. Also, the proposed equity
capital funding, $55000, could be used to support a line of credit of a bit over $300000 according to
the bank’s internal guidelines for new ventures. The maximum anticipated borrowing was within this
limit, so Ms. Nguyen felt good about the plan’s prospects. During the conversation, the Leo brothers
gave a rough estimate of their personal wealth which Ms. Nguyen noted for the files.

The proposed company, to be named Ho Hong Imports, would be equally owned (one-third each) by
Ho Hong and the two Leo brothers. The three men understood the risks associated with start-up
companies and proposed to minimize them for Ho Hong Imports through careful management and
attention to detail. It was their stated intention to import merchandise on a “pre-sold” basis; that is, Ho
Hong Imports would import only what was actually ordered by final customers. That policy would avoid
the need for carrying large inventory and would eliminate much of the commercial risk of the business.


Thus, a relatively small showroom/warehouse would be sufficient for the immediate future. Such a
facility had been located in Istanbul and could be leased from a company called Cotton Investors for
only $10000 per month.

Ho Hong’s customers would be mainly large retail chains and stores with whom Ho Hong had dealt in
the past. Their orders would be placed with the Leo Exports of Italy, Ho Hong’s agent. Leo Exports, in
turn, would obtain the merchandise for export from its own manufacturing facilities and from contract
producers all over Southern Italy. The Leo brothers guaranteed receipt of all orders in Istanbul within
28 days of placing an order, so Ho Hong would be able to guarantee a maximum 60-day ordering lead
time to the department stores. The Leo brothers also agreed to bear all of the exchange rate risk from
the transactions, so the goods would be invoiced in dollars.

Aside from open account terms with suppliers, the requested financing arrangements were also
standard in the industry. Credit Bank would be asked to provide irrevocable letters of credit for Ho
Hong Imports drawn in favor of the Leo Exports. The requested credit period for the letters of credit
would be 30 days, the maximum time required between placing an order and clearing the goods for
delivery to the various stores. At the end of the 30-day period the letters of credit would be turned into
bankers’ acceptances due in 90 days.

In other words, Ho Hong would receive 30 days of financing from the letters of credit and an additional
90 days from the acceptances, for a total of 120 days before payment would be due. Since the credit
terms extended by Ho Hong Imports to the retail stores were to be net 30, this gave sufficient slack to
ensure collection of the receivables before the bankers’ acceptances came due. The Leo brothers
suggested that the advising bank to the L/C transactions be the Napolitano Trade Bank, a wholly-
owned subsidiary of Leo Holdings.

Ms. Nguyen reviewed the plan and was very impressed with its thoroughness and conservatism.
However, bank regulations required that several restrictions be placed on Ho Hong before the credit
line could be extended. First, there had to be an official filing on all assets of Ho Hong Imports.
Second, it had to be certified that the company had paid-in capital of at least $55000 and that proper
insurance coverage was obtained. All three of the owners had to give their personal guarantees (and
other appropriate forms of collateral) for the credit, and all receipts from sales had to be deposited into
a controlled account in the same proportion to which the bankers’ acceptances related to invoice

Finally, at least quarterly financial statements had to be submitted to the bank and, if deemed
necessary by the bank, this could be changed to monthly statements. The interest rate to be charged
on the bankers’ acceptances is 1 percent per month or 3 percent per 90-day period, payable at the
time the acceptance is created.

These terms were acceptable to Ho Hong and the Leo brothers, so Ms. Nguyen agreed to take the
proposal to the senior loan committee when it met in three days. In the meantime, the three men
started work on registering Ho Hong Imports and getting ready to go into business. At Ms. Nguyen’s
urging, the bank agreed to provide a credit line of up to $300000 under the conditions described here.
On January 1, 2009 Ho Hong Imports opened its doors for business.


QUESTIONS for part 1

1. Critique the job performance of Ms. Nguyen. Can you find any errors of omission or commission
she made in evaluating the initial application for the line of credit or in setting up procedures to
monitor the operations of Ho Hong Imports?

2. Do you detect a “hidden agenda” by the Leo brothers in their investment and financing
arrangements with Ho Hong Imports? How much money would the Leo brothers lose if Ho Hong
Imports ran into difficulties?


Table 1: Projected Sales, Income, and Monthly Loan Requirements ($)

Month Sales Net Income Maximum


January 0 - 2000
February 0 - 3000
March 0 - 3000
April 49000 10770 30280
May 98000 14900 90850
June 147000 23390 181690

Six-month total 294000 41060 181690

July 196000 32390 272540

August 245000 41410 363380
September 245000 41410 423950
October 196000 32400 423950
November 147000 23390 363380
December 147000 23390 302820

Total for year 1470000 235450 302820


Table 2: Ho Hong Imports - Pro Forma Financial Statements

Pro Forma Balance Sheet ($)

January 1, 2008 June 30, 2008 December 31, 2008


Cash 55000 126749 324542

Accounts receivable (Debtors) 147000 147000

Current assets 55000 273749 471542

Furniture and fixtures 4000 4000

Total assets 55000 277749 475542

Liabilities and equity

Bankers’ acceptances payable 181692 302820

Total current liabilities 181692 302820

Capital stock (par value $1) 10000 10000 10000

Paid-in surplus 45000 45000 45000
Retained earnings 41057 117722

Total equity 55000 96057 172722

Total liabilities and equity 55000 277749 475542

Pro Forma Income Statements

June 30, 2008 December 31, 2008

Net sales 294000 1470000

Cost of goods sold 176400 882000

Gross profit 117600 588000

Commissions (2%) 2352 11760

General and administrative
(including depreciation) 31000 97000

Earnings before interest and tax 84248 479240

Interest 5292 26460

Earnings before tax 78956 452780

Tax (48%) 37898 217334

Net income 41057 235445

Cash dividend 117722


Ho Hung Imports – Part 2
SME Distress Indicators

Ho Hong Imports’ financial statements covering the first quarter of operations were right on target,
mainly because the company had only placed one order for merchandise and had just received it on
March 31. Ho Hong was very excited about the prospects for the future and told Ms. Nguyen that
everything was running smoothly. This message was repeated whenever she called to inquire about
how things were progressing.

It was not until May 30 that Ms. Nguyen learned of any difficulties experienced by Ho Hong Imports.
On that date Ho Hong came in to see her with the report shown in Table 3. As shown by the income
statements, sales were slightly less than had been anticipated, but not by a significant amount. The
difficulties became apparent, though, in the balance sheets. Ho Hong was in a serious liquidity bind
because none of the receivables had yet been collected, and a tax payment had to be made to the
government tax office the next day for $30623. There was not enough money in Ho Hong’s account to
make a payment of this size, so the company needed a minimum of $12666 just to pay the taxes. Ho
Hong requested that he be permitted to draw down the line of credit by $25000 as a direct loan
borrowing to cover the cash shortage. He explained that the difficulties with the receivables were his
fault—he had been so busy with the myriad details of establishing the company’s presence in the
market that he had failed to follow up on the collections. Ms. Nguyen was assured that it was only a
slip of the mind and that there were no real problems with any of the accounts. When she questioned
the presence of inventory in the balance sheet and noted that orders were not supposed to be placed
with Leo unless a firm commitment had been obtained from a retailer, Ho Hong explained that one
store had burned down after the order had been placed. The small amount of resulting inventory could
be stored in Ho Hong’s warehouse and could be liquidated easily in the coming month.

After verifying that the store had indeed burned to the ground in the middle of May, Ms. Nguyen took
the request for direct borrowing to the senior loan committee. The request was approved without much
dissent, but Ms. Nguyen was instructed to monitor the collection process weekly to ensure that Ho
Hong was not getting into trouble. The $25000 loan would carry an interest rate of 1 1/2 percent per
month and would be considered as a sub-limit of the total $300000 credit line.

The drawdown on the credit line was up to $272535 in outstanding bankers’ acceptances by July 1,
and the direct note borrowing was reduced to $25000. Some of the debtors had been collected in the
past 30 days, but many were overdue. Ms. Nguyen was not particularly alarmed by this development,
though, because some checking had indicated that the department stores were notorious for paying
late—it was one of the “costs” of being in business. However, on August 1 bankers’ acceptances had
increased to $363381 and Ho Hong needed an increase in direct borrowing to $30000 to avoid
liquidity problems. Ms. Nguyen decided it was time to crack down on Ho Hong and force him to take
the collection problems seriously. She agreed to extend the direct borrowing limit to $30000 (this was
still within the guidelines previously set down by the senior loan committee), but told him that direct
borrowings had to be “cleaned up” (reduced to zero) by September 1. Ho Hong assured her that he
would devote his entire attention to collections for the next few weeks and would reduce overdue
receivables to zero by the end of the month. He apologized for neglecting the collection problem in the
past and indicated he had learned his lesson about the importance of cash flows.


In less than a week Ho Hong called to inform Ms. Nguyen that he had already collected and deposited
in the controlled account over $50000 of overdue receivables and had obtained promises that most of
the remainder would be paid within two weeks. The total was up to $80000 by the middle of August, so
Ms. Nguyen started to relax. All Ho Hong had needed was a good shock to get him motivated—he
tended to focus on the creative aspects of the business and to neglect the more mundane tasks. Ms.
Nguyen decided that what Ho Hong really needed was to hire an accountant as a business manager
to take over these vital tasks. She shared her thoughts about hiring a manager with Ho Hong and he
readily agreed. By August 20 a young accountant had been hired and started to put the business
affairs in order.

On the morning of August 25, the accountant, Truong Vinh Trong, and Ho Hong came to the bank to
see Ms. Nguyen. Truong looked very serious and Ho Hong had a dazed look about him. After ten
minutes Ms. Nguyen understood why the other two looked as they did. Truong had been very
aggressive in trying to collect the overdue receivables. He soon discovered that for several reasons up
to half of them would probably never be collected. Furthermore, rather than follow the previously
established policy of importing on a “pre-sold” basis, Ho Hong had been ordering straight from the
projections given in Table 1 (given in case study Part 1). Sales were below expectations, so almost
$50000 in inventory had been piling up in the Ho Hong Imports warehouse.

To increase sales and clear out the warehouse, Ho Hong had been increasing sales commissions
from the normal 2 percent to a level of 4 percent (Ho Hong Imports used an independent sales agency
which provided sales services to small and medium sized businesses). Compounding the cash flow
problems was the policy of paying the commissions in cash when the merchandise was delivered to
the retailer instead of when the account was collected.

This encouraged the sales force to extend credit to stores that were very bad credit risks and gave no
incentive for them to monitor the collections. Several of these stores had already filed for bankruptcy,
and Truong was pessimistic about ever collecting from many of the others.

This finding was bad enough, but Truong had also uncovered a far more serious problem. When he
contacted several of the large retailers about their overdue accounts, they told him that they had no
intention of paying for the shoddy merchandise Ho Hong was trying to push, and he could take back
the whole lot and never do business with them again. Truong verified that much of the merchandise
was shoddily manufactured and was constructed of inferior materials—not at all like the samples used
by the sales force in soliciting orders.

Ho Hong was devastated to learn of this development and immediately called the Leo brothers in
Naples. They were very evasive on the telephone with Ho Hong but promised to look into the
“allegations.” After some quick calculations, Truong projected the August 31 balance sheet shown in
the Anticipated column of Table 4. To reflect the need to reduce direct loans to zero, he assumed that
the three owners would contribute additional equity of $25000 and that half of the receivables would
have to be written off. The resulting balance sheet is given in the Revised column of Table 4. If these
actions were taken, there would still be a loss carry forward of $93048 to be applied against future

Ms. Nguyen looked at the figures in Table 4 with disbelief. How could this have happened? What can
be done to keep the bank from losing its money? Is there a chance that Ho Hong Imports can remain


in business? Her head swimming, she went upstairs to notify the senior loan committee of the latest

Hoang Trung Anh, the chairman of the senior loan committee, directed that proceedings be started to
force Ho Hong Imports into involuntary bankruptcy, but that the papers not be filed with the court until
several unknowns were resolved. He did not enjoy taking actions such as this, although he realized
that protecting the bank had to be his first priority. Before the decision would actually be made to file
the bankruptcy papers, the committee would need more information about the value of the assets.
This includes the willingness of the owners to invest more equity capital in the business, and the value
of any collateral put up by the owners to guarantee the line of credit plus other personal assets the
bank might be able to get. He asked Ms. Nguyen to work with Ho Hong and Truong to obtain this
information by the next afternoon and report back to the senior loan committee.

Ho Hong was very cooperative. He was starting to think that the Leo brothers might have taken
advantage of his lack of business savvy for their own purposes, and, in doing so, had damaged his
reputation. Working much of that night and the next morning, Ms. Nguyen, Ho Hong and Truong were
able to gather the following information.

1. The maximum that could be collected from the receivables was approximately $250000. Also, the
inventory could be liquidated for roughly half of its book value, or $75000 in round numbers.
Furniture and fixtures could be sold for about $2500, so the total liquidation value of the company
is $327500. In addition to $423945 outstanding bankers’ acceptances and the $30000 direct loan,
Ho Hong owed Cotton Investors $10000 for the building lease. All other bills had been paid
(except for the $66496 in accrued taxes owed to the government tax office, but the company
would not have to pay this in any case and would be getting back $306230 already paid in taxes
for the year). With the tax refund and assuming that Cotton Investors is paid the $10000, the
bank’s net exposure would be $105822.

2. Ho Hong’s total net worth, not counting the shares in Ho Hong Imports, is $32500. The Leo
brothers are quite wealthy, but it appears unlikely that the bank will be able to recover from them
anything in excess of the value of the collateral they put up as a guarantee for the loans. This
collateral consists of stock in an investment company partially owned by the brothers. At the time it
was pledged it had a market value of $350000, but Ms. Nguyen discovered that the company filed
for bankruptcy in early August when its speculative position in silver collapsed.

3. The Leo brothers were phoned and told of the financial problems with Ho Hong Imports. They
explained that they were very sorry, but they would be unable to increase their stock holdings in
Ho Hong Imports at this time because of financial problems of their own stemming from the
bankruptcy of their investment company and other “financial reverses.” Ho Hong agreed to invest
all of his liquid capital in the company or $25000—if the bank would hold off and not throw the
company into bankruptcy.

As Ms. Nguyen rode up the elevator on her way to the senior loan committee meeting the next
afternoon, she was not entirely sure what her final recommendation would be. She liked Ho Hong and
believed that he was used by the Leo brothers, but she also thought of the implications of the affair on
her career. Maybe she could discover a way to resolve the problems that would be favorable to all


QUESTIONS for part 2

3. When Ms. Nguyen talked with the local office manager of Cotton Investors about the overdue
lease payment of $10000, she got a distinct impression that he knew the Leo brothers quite well.
Returning to the bank after lunch, she called the Company Registration Office to find out who
owned Cotton Investors. She found it listed under Leo Holdings as a Swiss-based corporation, and
by further digging she discovered that Leo Holdings is a wholly-owned subsidiary of the Leo
Exports of Naples.

a. How does this information fit with your observations in Question 2?

b. If the bank proceeds with the bankruptcy filing could the properties of Ahmadi Holdings be
seized? Remember, the Leo brothers had been required to guarantee loans, and the
investment company stock put up as collateral represented only a small part of their total

4. Should Credit Bank proceed with the bankruptcy filing, or should it attempt to salvage the
company? In your answer consider the magnitude of the loss the bank might realize under various
scenarios as well as the chances for full recovery and the maintenance of a profitable lending
relationship. Assume that the revised balance sheet given in Table 4 is realistic (it assumes that
Ho Hong invests the $25000 and obtains an additional 4,545 shares of Ho Hong stock). This will
give Ho Hong a majority ownership position of about 54 percent.

5. Regardless of your answer to Question 4, assume that the bank decides against forcing Ho Hong
into bankruptcy if Truong takes over all business decision making. He believes that the sales
performance given in Table 5 can be achieved with hard work. No orders will be placed with Leo
Exports or any other manufacturer until all inventory is sold, and orders will be placed in the future
only on a “pre-sold” basis.

a. Suggest ways Ms. Nguyen can make sure that no unpleasant “surprises” with inventory,
receivables, or product quality occur in the future. That is, what controls would you suggest be
placed on Ho Hong Imports if they are allowed to continue operations?

b. How would you suggest handling the relationship with the Leo brothers? If they decline to
invest any more capital in Ho Hong Imports under any circumstances, how should Truong and
Ho Hong react?

Table 3: Ho Hong Imports - Financial Statements

Balance Sheet ($)


June 30, 2008 June 30, 2008
Actual Result Pro Forma

Cash 0 126749
Accounts receivable (Debtors) 255333 147000
Inventory (Stocks) 48200

Current assets 303533 273749

Furniture and fixtures 4000 4000

Total assets 307533 277749

Liabilities and equity

Bankers’ acceptances payable 201310 181692

Notes payable - bank 25000

Total current liabilities 226310 181692

Capital stock 10000 10000

Paid-in surplus 45000 45000
Retained earnings 26223 41057

Total equity 81223 96057

Total liabilities and equity 307533 277749

Pro Forma Income Statements

June 30, 2008 June 30, 2008

Actual Result Pro Forma

Net sales 255333 294000

Cost of goods sold 165966 176400

Gross profit 89367 117600

Commissions (2%) 3042 2352

General and administrative
(including depreciation) 29855 31000

Earnings before interest and tax 56470 84248

Interest 6042 5292


Earnings before tax 50428 78956

Tax (48%) 24205 37898

Net income 26223 41057


Table 4: Ho Hong Imports - Balance Sheet ($)
August 30, 2008 August 30, 2008
Anticipated Revised

Cash 803 803

Accounts receivable (Debtors) 544676 272338
Inventory (Stocks) 144797 144797

Current assets 690276 417938

Furniture and fixtures 4000 4000

Total assets 694276 421938

Liabilities and equity

Bankers’ acceptances payable 423945 423945

Notes payable - bank 30000
Taxes payable 66496 66496
Accruals (due to Cotton Investors) 10000 10000

Total current liabilities 530441 500441

Capital stock 10000 14545

Paid-in surplus 45000
Retained earnings 108835 - 93048

Total equity 163835 - 78503

Total liabilities and equity 694276 421938

Table 5: Revised Sales and Operating Profit Estimates ($)


Statement Date Sales before taxes*

September 30 125000 34474

October 31 125000 38552
November 30 125000 37577
December 31 125670 36327
January 31 133340 38419
February 28 141670 43111

*Note: The figure for EBT is before the application of the loss carry-forward of $93048; the tax rate is
48 percent.


Quang Company
Financial Analysis and Loan Structure

Hồ Xuân Hương was president of Quang Company, a manufacturer of valves and pipe fittings in
Vietnam. In April 2007, she visited Nguyễn Trung, a loan officer for GoldWest Bank, with a loan
request. She gave Trung Quang's financial statements for the years 2005 through 2006 and for the
most recent three-month period ending March 31, 2007. Hồ Xuân Hương indicated that she wanted
GoldWest Bank to provide Quang's banking requirements, including Quang's needs for loan funds.

She complained that her present bank had become careless in serving Quang's banking
requirements and that the loan officers assigned to Quang's account were being changed
frequently, causing her great inconvenience. She was frustrated with having to explain
Quang's needs and business every time there was a change in loan officers. Recently,
Quang's line of credit agreement with its present bank had expired, and the bank seemed
to be delaying action on the firm's request for a much-needed moderate increase in the

Hồ Xuân Hương informed Nguyễn Trung that she would need as much as 10 000 million dongs during
the next 12 months. She wanted part of the credit in 90-day promissory notes and the rest on an
intermediate basis. "Our sales volume continues to grow and our profits are good," she commented to
Trung. "We have been in business for 15 years and we have been profitable every year. Our
equipment is in good condition, and we will not have to expand our plant for at least three more years."
Hồ Xuân Hương offered as references her current mortgage lender, Fair Mutual Bank, and several of
her major suppliers.

Later, Nguyễn Trung made credit checks with these suppliers, who reported a pattern of generally
prompt payment. The highest credit by a single supplier was 1 500 million dongs. However, Quang
was not always able to take trade discounts, which all of its suppliers offered on a 2/10, net 30 basis
(i.e., Quang gets a 2% discount on purchases if it pays within 10 days, otherwise the full amount is
due in 30 days).

Fair Mutual Bank reported a balance of 2 750 million dongs owed on an original 5 000 million dong
loan. Payments of 250 million dongs per quarter were being made promptly. The loan from Fair Mutual
Bank was secured by land and buildings owned by Quang.

Nguyễn Trung had not yet checked with Quang's present bank to discuss its experience with Quang.
GoldWest Bank was very anxious to establish a complete business relationship with Quang, but Trung
was uncertain how to approach Quang's present bank and how to interpret what officers from that
bank might tell him.

After Trung conducted his initial investigation, he called Hồ Xuân Hương to set up a meeting at the
bank. At the meeting, Hồ Xuân Hương made a specific request for a 10 000 million dong loan. In
addition to the financial statements she provided earlier (Exhibits 1 to 3), she provided a personal
financial statement (Exhibit 4). Trung had also received a ratio analysis on Quang from GoldWest
Bank's credit analysis department (Exhibit 5).

Hồ Xuân Hương indicated that Quang's inventory was composed of the following:

Raw materials 40%

Work-in-process 20%
Finished goods 40%

Trung was advised by another loan officer that the fractions of values that could be recovered on short
notice for inventories such as Quang's were about 50, 0, and 50 percent, respectively, for raw
materials, work-in-process, and finished goods.


On Quang's accounts receivable, Trung wondered if those outstanding for more than 60 days actually
could be collected. He was also worried because Quang continued currently to sell to customers with
receivables older than 60 days, and he wondered if he should assign any value at all to the
receivables of such customers. Finally, he decided to appraise accounts receivable that were on time
at only the cost of production (cost of goods), about 70% of their book value.


1. Purpose: Determine the purpose of the loan.

2. Amount of the loan: As a check against the 10 000 million dong loan amount
requested by Hồ Xuân Hương, determine how much Quang actually needs to borrow. (Estimate
Quang's balance sheet and income statement for December 31, 2006, based on continued growth and
industry average ratios for an average collection period and inventory turnover. Estimate December
31, 2006 accounts payables and turnover based on the company's taking a substantially higher
amount of trade discounts than are presently taken.) Challenge: Calculate cost of trade credit, i.e., the
cost of not taking discounts. See Exhibit 6 for discount formula (use industry average payables in the
denominator as "days taken").

3. Repayment terms: Establish a repayment schedule for each type of borrowing.

4. Repayment source: Identify the cash flow sources of repayment for each type of borrowing.

5. Rate: Establish the interest rate on each type of borrowing. (Specifically in terms of points or
spread above the base rate, currently 15%.)

6. Security (Collateral value and borrowing base): Assuming that the bank secures the loan with
Quang's accounts receivable and inventories, determine how much value can be recovered if
Quang fails to pay. (Alternatively, determine how much GoldWest Bank can safely lend
against Quang's accounts receivable and inventories.)

7. Security (Guarantees, covenants, and other restrictions): Specify the covenants to be placed
on Quang. Describe the guarantee or other restrictions.

Exhibit 1
Quang Company

Income Statement
For the period ended December 31 (except where indicated)
(000 000's of dongs)

2004 2005 2006 March 31,

Sales 54000 61010 64000 18780

Cost of goods sold 37800 42090 44800 13330


Gross profit 16200 18920 19200 5450

Operating expenses* 11270 13590 13620 4240

Profit before taxes and 4930 5330 5580 1210
Other expenses (including 1690 1600 1740 420
Income taxes 1130 1310 1340 280
Net profit 2110 2420 2500 510

*Including depreciation 320 460 410 160

**Interest expense 580 530 550 140

Exhibit 2

Quang Company

Balance Sheet
Year ended December 31 (except where indicated)
(000 000's of dongs)

March 31,
2004 2005 2006 2007
Cash 1310 1390 1130 680
Accounts receivable 7830 8590 9140 10100
Inventory 11120 13160 13580 17800
Current assets 20260 23140 23850 28580
Land 1000 1000 1000 1000
Plant and equipment 5980 6030 6100 6140
Less: accumulated -1900 -2300 -2700 -2800
Net plant and equipment 5080 4730 4400 3340
Total assets 25340 27870 28250 32920

Liabilities & equity

Notes payable (bank) 6500 6500 8000 8000
Accounts payable 3700 4670 1900 6410
Accrued expenses 510 650 800 700
Current liabilities 10710 11820 10700 15110
Long-term debt 5000 4000 3000 2750
Total liabilities 15710 15820 13700 17860
Capital 1000 1000 1000 1000
Retained earnings 8630 11050 13550 14060
Total equity 9630 12050 14550 15060
Total liabilities & equity 25340 27870 28250 32920

Exhibit 3

Quang Company

Accounts Receivable Aging

March 31, 2007
(000 000's of dongs)

Credit Extended During:

Credit Before
Customer Since Feb. 2007 Jan. 2007 Dec. 2006 Dec. 2006

Buso, JC 330 660

Carpenter Co. 440
Dalton Co. 200
David Co.* 150
Fred Co. 150 60
Gaston Co. 450
Hardy Sons 250
Ivor 60 50 100
Jeffries Co. 520 40
Kezel Sons* 540 300 600 60 20


Lamont Co. 100
Lawren Sons 350
Hồ Xuân Hương Co.** 1040
Massey Co.* 150 300 340
Nestor 120
Olympia 840
Pinocle Co.* 40 100 100 100
Trenton Co. 450 80
Trilogy 260 300 50
Other*** 400
Total 6050 1620 1350 370 710

Total all 10100

*These companies are also suppliers to Quang.

**Hồ Xuân Hương Co. is an affiliated company.
***Other represents a loan to Hồ Xuân Hương.

Exhibit 4

Hồ Xuân Hương and Hồ Văn (husband)

Personal Financial Statements
April 1, 2007
(000's of dongs)

Cash 240
Marketable securities 1080
Loan receivable from Hồ Xuân Hương Co. 800
Residence 5500
Automobiles 440
Personal property 600
Shares of Quang Co. (book value) 15060
Total assets 23720

Liabilities & equity

Notes payable (bank) 1500
Notes payable (Quang Co.) 650
Mortgage on home 3350
Total liabilities 5500
Equity 18220
Total liabilities & equity 23720

Salary (2003) 1500
Bonus (estimated) 300
Other 20
Total income 1820

Exhibit 5

Quang Company

Financial Ratios

2004 2005 2006 20071 2006
Current ratio 1.89 2.10
Quick ratio 0.71 1.00

Receivables-days 49 49
Inventory-days 120 101
Payables-days 43 40
WCN-days 126 110

Debt/equity 1.19 1.50
TIE3 8.99 3.50

Gross profit margin 29.00% 30.70%
ROA4 6.23% 5.07%
ROE5 13.62% 17.00%

2006 quarterly figures are annualized
Days are calculated using 365 days, except quarterly figures calculated using 90 days
TIE = Times interest earned (interest coverage)
ROA = Return on assets
ROE = Return on equity
Exhibit 6
Statement of Cash Flows 2005 2006

Operating activities:

Net income
Plus: Depreciation & amortization

∆ accounts receivable
∆ inventories
∆ accounts payable
∆ prepaids
∆ accruals
∆ taxes payable
∆ other current items

1. Cash flows from operations (CFO)

Investing activities:

Investment in fixed assets

∆ other noncurrent assets

2. Cash flow from investing activities (CFI)

Financing activities:

Dividend payments
Current portion of long-term debt (n-1)
∆ short-term bank debt
∆ long-term and other noncurrent debt
∆ capital

3. Cash flow from financing activities (CFF)

Net cash flow 1 + 2 + 3

∆ in cash


Exhibit 7

Cost of Trade Credit Formula

Discount % 365
% Cost = ----------------------- x -------------------------------------------------------------------
100 - Discount % Days taken - Discount period