financial case

Running head: THOMPKINS AUTO GROUP 1

THOMPKINS AUTO GROUP: CAPITAL IMPROVEMENT AND EQUIPMENT FINANCING DECISION

Introduction

It is 2020 and the auto dealership, Thompkins Auto Group, was thriving in a stable and

growing economy. Sales were averaging a strong $50 million annually, and cost management

was very effective. As a result, the dealership was producing above average profits of 3% on

sales. However, Jerry, the far-sighted managing stockholder, knew that to keep the sales

momentum in a competitive environment, it was time to make significant improvements to

physical facilities and key equipment. His education, training, and extensive experience in the

industry all contributed to his conclusion—the financial success of Thompkins was not

sustainable without the needed improvements.

Jerry and his two co-owners had purchased the dealership from the previous owners only

five years ago. The business, located in North Central Texas, included sales of new and used

vehicles as well as the parts and service. The geographical area from which Thompkins drew its

customers was primarily rural, with several small towns located nearby. Ft. Worth is the largest

city in the region with a population of about 800,000, and the dealership, only 60 miles away,

was able to attract many customers from that city.

The economy in this North Texas area was heavily dependent on the oil industry which

was the primary source of employment. Other major sources of employment were farming,

ranching, light industry, retailing, and the service sector (private and governmental). The oil

industry was currently experiencing a low price shock. Jerry, however, knew well the vagaries

of the oil industry and had worked to make Thompkins at least somewhat resilient to the frequent

ups and downs in that industry.

Management Philosophy

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Over the years, the financial success of Thompkins had been driven by the overriding

business philosophy of its three stockholders—to attain a consistently high level of customer

satisfaction. They felt it would lead to repeat business and, through word-of-mouth, would

contribute to growth in their customer base. Several other dealerships were active in the area; so

in addition to its development of strong repeat and referral business, Thompkins used targeted,

creative advertising to further differentiate itself from its competitors.

The partners believed that happy customers would tend to be repeat customers and would

tend to speak favorably about the company. The owners also believed that their success in

maintaining high levels of customer satisfaction was due to achieving two strategic goals. The

first was to provide excellent service. To that end, Thompkins provided first-rate, job-specific

employee training on a regular basis. In addition, the dealership provided its employees with the

most up-to-date equipment and technology to support employee productivity and quality

customer service.

Thompkins’ second goal was to build and sustain strong business relationships with

customers. Customers served by happy, competent, and helpful employees were more likely to

be highly satisfied customers. To that end, the dealership's employees enjoyed a more generous

package of wages, benefits, and other perks than peers working for other dealerships in the area.

In turn, employees had become fully engaged and highly productive. The benefits of adhering to

the two operational goals were apparent from the amount of repeat and referral business

experienced by Thompkins.

Current Situation

The dealership’s potential to continue to meet the two strategic goals, however, would be

seriously impaired without a major investment in new equipment in the service department,

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including lifts and hoists, balancers, alignment machines, tire changers, HVAC machines, brake

lathes, engine analyzers, and other specialized equipment to meet the demands of newly

redesigned vehicles. A major concern was the ability of the parts and service departments to

continue providing the excellent service customers had come to expect. Thompkins’ employees

were committed to their jobs, but improved technology, equipment, and facilities were essential.

The owners agreed that employees were in need of increased inventories of parts and better

“tools” with which to do their jobs. Also, the outside of the entire facility was due for a

franchise required facelift. It was time, therefore, for Thompkins to make these major repairs

and to provide equipment upgrades. Several cost estimates were requested and analyzed. The

owners computed the total cost of completing the repairs, expansion, upgrades, and external

building improvementsi to be $1,000,000 and shop equipment to be an additional $1,000,000.

As the owner most active in the management of the business, Jerry had always been very

open in his decision-making and responsive to the views of his co-owners, even though he

owned a majority of the firm. Jerry owned 80% and each other partner owned 10% each. His

collaborative, consensus-seeking management style had been well received by his co-owners.

To the benefit of the entire organization, the three of them had consistently agreed on all major

decisions. The financing decision would not affect sales or NWC requirements.

Although the current expenditures were mainly for the facility image upgrade and costly

equipment required by the service department, Jerry was also wary of the impact of the ups and

downs of the oil prices on the local economy. Thus, he wanted to minimize the negative effect

the current financing needs might have in the event of an economic downturn.

Jerry had thoroughly researched financing possibilities for these current needs and had

narrowed the options to three he considered feasible: borrowing the entire amount from a

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financial institution; issuing new shares of Thompkins stock; or financing through the sale of the

dealership’s subprime notes receivable. He planned to take the morning to analyze these

alternatives in order to present his suggestions at the meeting this afternoon.

Financing Alternatives

Debt Financing

Jerry first considered the alternative of borrowing the entire $2,000,000. The dealership

has no other debt other than a floating floor plan loan for new and used vehicles. He explored

two options that banks had presented to him, using an unsecured loan or using a secured loan.

For an unsecured loan, the terms would be a five-year loan at six percent interest and

would require a $200,000 deposit in a compensating accounting that would earn 1%.

A secured loan would mean pledging the dealership’s three million in notes receivable as

collateral for the loan. The terms and payback of a secured loan would also be for a five-year

time period at four percent interest.

The income tax rate for Thompkins Auto Group is 35%.

Equity Financing

With that in mind, Jerry turned his thoughts to the prospect that Thompkins could issue

new shares of its stock in order to yield the $2,000,000. The cost of issuing the new shares

would be minimal, and equity financing would have a positive impact on the debt/equity ratio

but would tend to dampen the return on equity. The dealership was earning approximately

$1,500,000 per year. Due to the nature of automobile dealer inventories, the target capital

structure is 30% equity and 70% debt. Targeted dividend payout ratio is 70%. The company

had been experiencing about 10% growth in sales per year; however, net income had remained

fairly constant. The company was set up utilizing 10,000 shares of stock. Jerry holds 8,000

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shares and each of the other two partners hold 1,000 shares each. Current market values of

untraded equity suffer from a liquidity risk premium and are valued at 5x EBITDA. Current 10

year U.S. Treasury bond yields are .63%. Betas of comparable publicly traded companies, such

as CarMax, are 1.4.

Financing through Sales of Receivables

Jerry then began to focus on the third financing option, that of selling the $3,000,000

subprime notes receivable portfolio at a discount. The notes consisted of subprime loans made to

customers who were typically unable to receive conventional auto loans and had been financed

by the dealership. Because of the relatively high risk and proportion of bad debt write-offs, the

market interest rate charged on the loans was 18%.

Selling these notes would mean that it would no longer benefit from their cash flows.

The impact on net cash flow may be more favorable if the dealership continued to hold the notes

and simply borrow against them.

Since first offering these sub-prime loans five years ago, the dealership has experienced

average annual write-offs of around 15 percent, but the notes were definitely subject to higher

risks. In fact, during the recent economic downturn, write-offs became as high as 18 percent.

The economy seemed to be slowly recovering, but an extended new downturn, especially

in the oil industry, would result in increased write-offs. If the notes were used as collateral for a

loan, the dealership would experience smaller amounts of cash inflow while making loan

payments.

The notes could be sold with or without recourse, and Jerry considered these two

possibilities. If the dealership sold the loans without recourse, it would not be liable for future

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defaults, but it would have to deeply discount the loans and would receive only 65% of their face

value.

On the other hand, if the dealership sold the loans with recourse, it would receive 85% of

the face value but would be liable for future defaults.

While the dealership would receive more by selling the notes with recourse, Jerry

considered the additional risk factor associated with selling with recourse. Loan losses from the

subprime portfolio had been relatively stable at 15% over the past few years, Jerry considered

this estimate to be very solid because it was determined through several years’ experience.

These three options, borrowing the entire amount from the bank, issuing new shares of

stock, or selling its notes and the alternatives within each option, seemed to provide ample

financing possibilities from which to make a selection. Since the impact on future cash flows

would be extremely important in the ultimate decision, Jerry had computed the annual cash flow

impact of the alternatives and had included the results in tables to present to his co-owners. He

turned his attention to those tables.

Depreciation

Jerry typically favors MACRS depreciation schedules for the building improvements;

however, the current Section 179 deduction is being considered for the equipment. Essentially,

Section 179 of the IRS tax code allows businesses to deduct the full purchase price of qualifying

equipment and/or software purchased or financed during the tax year. That means that if you buy

(or lease) a piece of qualifying equipment, you can deduct the full purchase price from your

gross income. It’s an incentive created by the U.S. government to encourage businesses to buy

equipment and invest in themselves.

Leasing

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Leasing the shop equipment is another alternative for acquiring the necessary shop

equipment. Jerry is interested in finding out the net advantage to leasing (NAL).

Cash flow impact

From his tables, however, Jerry noticed that the impact on future cash flow would vary

significantly among the alternatives. Stockholders would probably expect dividends as a return

on their investment of at least 15 percent. Although financing through the sale of notes

receivable would require little if any cash outflow, the proceeds from collecting those notes and

interest would be lost. The tables illustrated the future cash outflow requirements for both an

unsecured bank loan and a bank loan secured with notes receivable. They also pointed out the

amount of cash inflow lost by selling the notes receivable. Except for equity financing, the least

negative impact on future cash flow would be through a secured bank loan; the largest negative

impact would be through selling the notes without recourse to the first financial institution.

Estimate the cost of capital for each option and the impact of the decision and

recommendation for the company.

Summary

Jerry realized that the cash flow information would be useful in selecting one of the

alternatives. Thus, each financing option had strong points and weak points, and each owner’s

opinion was extremely important. Your task is to play the role of a consultant and provide

guidance along with quantitative evidence to support your recommendations. Based on the given

information what is the best financing option for Thompkins?

i The IRS requires you to depreciate a building improvement over the same time frame that you depreciate your

building. Commercial real estate buildings typically have a 39-year life.