Finance Assignment

FIN 242f Credit Risk Analysis, summer 2022

class discussion + extra credit assignment (individually or in teams of two)

CASE: Owen’s Precision Machining

Background

For the second time in 14 months, Chris Owen, the second-generation owner of Owen’s Precision Machining, finds himself running out of cash. He wonders what he is doing wrong. At the same time, he needs to know how much additional money he will need to get the firm through the next 12 to 24 months if he doesn’t accept a buy-out offer currently on the table.

Update to the case

Chris does not accept the buy-out offer nor the offer from the suppliers. He called Bob Benson to request another investment in OPM preferred stock. To Chris’s surprise, Bob said he would not increase his investment and, since Chris has no plans to sell the company, expects to receive a 10% dividend at every FYE. As a show of support, he said he’s willing to wait until next June for his first check.

Although OPM’s current bank is willing to increase its revolving line from $600,000 to $700,000, another local bank, NewBank of Massachusetts, enters the picture, through a referral by Chris’ accountant, and suggests they might be able to put together an attractive package in return for becoming the sole lender to the company.

After several meetings at the bank, a plant visit, customer and supplier checkings, and a conversation with Bob Benson, NewBank provides Chris on August 15 with a proposal, subject to internal bank approval, for $1.2 million of senior secured financing to meet the company’s needs through FYE14. The bank says it is prepared to close on August 31. Specifically, NewBank offers the following terms and conditions:

· The bank will provide an $800,000 revolving working capital line of credit, secured by A/R and inventory, and governed by a borrowing base of 75% of A/R and 50% of RM and FG inventory. The bank reserves the right to exclude chronically slow receivables from the borrowing base and to send in an investigator at least once per year to check the books and records of the company and to inspect the inventory. The revolver will mature on June 30, 2014.

· The bank will charge a 1% commitment fee each year on the $800,000 revolving line of credit.

· The bank will provide a $400,000 line for 3-year loans to finance new and existing PP&E (net). New equipment purchases will be financed at 75% of purchase price; existing equipment at 40% of the net BV of PP&E. The loans will amortize on a level basis, with annual payments of principal and interest at FYE.

· The loans cross-default and will be cross-collateralized. (Thus, a default in one loan creates a default in the other loan and any excess collateral beyond the amount needed to pay off one loan will be available to pay off the other loan.)

· The interest rate on all loans will be 8.75%.

· The preferred stock cannot be redeemed, nor can the dividend be increased, without the bank’s approval. Further, if the loan is in default, OPM will not be permitted to pay dividends.

· There will be 3 financial covenants on leverage, coverage and profitability, all tested at each FYE.

· Chris Owen must provide an unlimited personal guaranty; however, the guaranty will only be effective if OPM suffers two consecutive quarterly losses that in total exceed $50,000. Conversely, the bank will release the guaranty if D/W drops below 1.0 at any FYE.

· By September 30, Chris must hire a full-time controller, subject to the bank’s approval.

The bank states that it is happy to provide Chris with a list of suitable candidates though he will not be obligated to choose any of them. The idea of a controller doesn’t surprise Chris, as he has already built into his forecast an increase of $35,000 in G&A for this very reason.

Chris is delighted with the bank’s aggressive proposal and an interest rate below 9%. Still, he is uneasy and admits to himself that he is overwhelmed by the complexity of the terms and conditions.

On the recommendation of a leading businesswoman in Lawrence, he hires Ernesto Gomez on August 1 as a consultant until he can hire a full-time controller. Ernesto charges $10,000 per month, with a minimum of $20,000. Chris has never paid anyone that much for financial advice but realizes he needs first-rate advice immediately. He interviews Ernesto, respects and trusts him, and agrees to his terms.

Ernesto immediately “rolls up his sleeves” and delves into all aspects of the company, especially its working capital management. With Chris’s permission, he speaks with key suppliers and learns they will accept terms of net 30, even though Chris, like his father before him, has always paid them sooner. He convinces Chris that he can pay his other suppliers in 40-45 days such that his overall days payable will be 35. He also takes a hard look at inventory which, at first glance, seems excessive, though Chris maintains that he needs all of it to meet the needs of his demanding customers. Perhaps Chris is right, as the inventory mix is complicated to manage. Ernesto decides not to press the matter right away.

He prepares a three-year forecast through FYE15 (6/30/15) even though the bank is only offering a two-year revolver (as he wants Chris to see one year beyond the term of the loan), working with Chris every step along the way to be sure he understands every entry on his financial statements. To help Ernesto build a three-year Excel file, Chris states that he will need to purchase another $200,000 in equipment in FY15. After reviewing the model with Ernesto, Chris now understands the value of managing inventory tighter and commits to reducing days inventory by 5 days in FY13, 10 days in FY14 and 15 days in FY15 (i.e., a total improvement of 15 days from FY2012’s actual number). Ernesto is delighted to hear this. To forecast depreciation, Ernesto will use the three-year average of depreciation/gross PP&E.

Based on a review of the growing needs of OPM’s customers and the overall favorable market where new technology firms are being founded in the greater Lawrence area almost every month, Ernesto convinces Chris to increase his forecasted sales growth to 25% through 2015. He believes Chris can manage the growth in operating expenses, suggesting that indirect labor and G&A only grow at 20% each year. Chris quickly accepts the indirect labor adjustment but wonders if G&A should track sales growth. Ernesto explains giving an example. “Just because sales grow 25%, will you need to add another payables clerk?” “Aha,” says Chris. “You’re right.”

At the same time, Ernesto is not comfortable with Chris’s 34.0% projected gross margin. “Sure, Chris, it will be great if you can maintain that rate but you may need to negotiate lower prices with your customers and prospects in light of increased competition.” To Ernesto’s surprise, Chris digs in, so he says, “fine, we’ll leave it at 34.0%.” From experience, Ernesto knows that sometimes it is best to compromise, since everything in a forecast is only an educated guess and what’s critical in situations like this is to get the “buy-in” of his clients.

With the new forecast and plans to hire a controller, Ernesto builds into G&A the salary of a new controller who must start by October 1. Ernesto knows several good candidates and will review their backgrounds with the bank before recommending that Chris make a final offer. Total compensation, including benefits, will likely be $50,000/year, effective July 1 of each year. (Remember that the FYE is 6/30.) Chris is surprised by the compensation but agrees.

Next, Ernesto explains to Chris that he has seriously understated his borrowing need in the existing forecast, which underscores the limited value of the current bank’s offer to increase its line. Chris says, “wait, I had my accountant prepare those numbers. How could he have made such a mistake?” Ernesto replied, “look, I’m sure he’s very good but he thinks like an accountant, not a controller.” Suddenly, Chris realizes the problem. “How am I supposed to run a company with negative cash? In fact, I would want at least $40,000 at all times so I can sleep at night.” Ernesto suggests $45,000 for FY13, rising each year by $15,000 to reflect growing sales, and Chris quickly agrees.

He then explains to Chris how a borrowing base works; if all goes according to plan, the bank’s formula will meet the company’s needs for the next three years. Ideally, Ernesto wants to see in a forecast a minimum 10% cushion in the B/B. Anything less than 5% gives him little comfort that his client will be able to respond quickly to surprises (positive, e.g., a surge of new orders requiring the purchase of more inventory; negative, e.g., a write-off of a large receivable that removes the A/R from the B/B calculation which could force a company to immediately reduce its outstanding loan to remain in compliance).

To build in a cushion, Ernesto says he will ask the bank to raise its advance rate on A/R to better reflect the quality of Chris’s customers. Ernesto explains that the bank probably expected him, as part of a negotiation, to challenge the 75% advance rate on A/R and the advance rates on equipment. “I’m confident they’ll go to 80% on receivables, 50% on existing equipment, and 80% on new equipment. In fact, they’ll agree to a four-year amortization on new equipment loans, which is still conservative, as some banks in town are offering 5 years.” Chris was silent. “I’m also confident they will lower the interest rate across the board to 8.5%. By the way, they will loosen the leverage covenant, eliminate the coverage or the profitability test, and that crazy ‘springing’ personal guaranty.” Finally, I’ll say we can’t accept the 1% annual commitment fee on the full amount of the revolver since “it’s not market.” I know that after the first year of a revolver, many banks only charge a commitment fee on the unused balance, which will save you several thousand dollars each year. That’s what I’ll insist on.

Chris asked, “why would they agree to do all of this?” Ernesto replied, “your firm has been successful for over 25 years, you’ve shown that you are a very capable owner who has grown his father’s business without blowing up the balance sheet with debt, you have excellent customers, and you make a great product. Chris, you’re the ideal client for NewBank to add to its portfolio. They’ll act like their doing you a huge favor by agreeing to revise their offer but, trust me, they want your business. I know, I’ve dealt with them many times. As soon as you mention that I am your advisor, they’ll know it’s time to negotiate. I’ll ask for more than what I’ve outlined and then grudgingly agree to everything I really want.” “Hah,” Chris says. “I can see now how much I needed someone like you all along.”

In addition to the revolver, his forecast will show each equipment loan separately. The first of the four loans will look like this, as it is based on 50% of the net book value of PP&E as of FYE12:

2013 2014 2015

Equipment loan 1 213 142 71

To keep the forecast simple, all bank debt will be shown as long-term (i.e., no current maturity, even for the equipment loans). If OPM performs close to plan, the bank will most likely extend the term to 2015 (or 2016), increase the size of the revolver, and increase the equipment line -- well in advance of maturity.

Finally, knowing how banks operate, he will create a “bank case” with the following assumptions and then calculate B/B compliance. Also, using that forecast, he will guess at the covenant package that the bank and he (and Chris) will agree to in order to see how much cushion there will be in the management case.

· Sales growth of 20% in FY13, and 15% thereafter

· gross profit of 33%

· indirect labor and G&A growth of 20% in FY13 and 12.5% thereafter

· Days receivable at the same level as FY11

· No change in days inventory

· The bank’s covenants will track their forecast, not Chris’s more ambitious one

If OPM is still in compliance with its borrowing base through FYE14 (without a cushion) and the covenants seem reasonable, then Ernesto will know he has done well for his client. For example, he knows the bank will not agree to EBIT/interest below 2.0, leverage above 2.0, or to annual losses.

Assume the bank agrees to everything above and that its “bank case” is what Ernesto forecasted it would be.

Additional guidance for forecasting in both cases

1. To calculate A/R in 2015, use the same days as 2014

2. Allocate inventory using the 2012 breakdown by percentage

3. No change in other current assets.

4. Accrued expenses: use the 2012 accrued expense/sales ratio

5. To calculate G&A for 2013, use this formula: =2012*1.2+(10*2)+2.5. Thereafter, it is simply 2013*1.2, and so on in the management case; follow the instructions for the base case. The formula is complicated for 2013 because we need to account for Ernesto for two months at $10K/month plus the new controller for 9 months at $50K/year. In the assignment, I told you that Chris had built into his forecast for FY13 G&A $35K for a controller, which absorbs the 20% year-on-year increase. So, the only difference for the new controller in 2013 is $2.5K: ($50K x 9/12) - $35K = $2.5K.

EXTRA CREDIT (do both): up to an additional 2 points toward the participation grade:

(1) submit an excel forecast for both the management and the base case through FYE15, using the agreed-upon terms and conditions.

(2) Assume in March 2014 after receipt of the audited FYE13 financial statements, Chris will want to negotiate a one-year extension of the revolver to June 30, 2015. In a brief WORD document, answer the following:

· Will Chris need to request any changes in the size of the revolver and/or the borrowing base?

· If he does need to, do you think the bank will agree? Why? If the bank doesn’t agree, what changes would Chris have to make in the way he runs OPM to remain in compliance with the size of the revolver and/or the borrowing base?

Please post the excel file and WORD document (no PDFs please) on LATTE by the start of class.

This assignment may be done individually or in teams of two students.