Finc 495 Week 1

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Contents

The Lotto Case (or Hitting the Jackpot)

Allen B. Atkins, Roxanne Stell, & Larry Watkins 3 - 5

American Apparel, Inc. – Saved from Bankruptcy but can it sustain?

Dr Anupam Mehta 6 - 20

A Model for Running an Undergraduate Business-Focused Case Competition

Jill M. Bale, Jimmy Senteza, & Toby A. White 21 - 36

Midwest Bancshares, Inc.

Heather Muehling, & Edward C. Lawrence 37 - 53

Creating Equity Indices: A Case Exercise

Judson W. Russell, & Christopher Brockman 54 - 66

Netflix: DVD-by-Mail or Online Streaming?

Rick Long, Inchul Suh, & Toby White 67 - 82

Strategic Approach of Business Valuation

Dr. Rishma Vedd, & Nataliya Yassinski 83 - 95

Did Right Case Take a Wrong Turn?

Janet E. Mosebach, & Diana R. Franz 96 - 100

Quandary at National Health Company

N. Ahadiat, & D. Rice 101 - 107

Interest Charge Domestic International Sales Corporations – The remaining ex-

porter tax benefit

Matthew Yost, & Chris Bjornson 108 - 122

Generating Financial Statements using QuickBooks: A Group Project in Financial

Accounting

Christopher Aquino, & Lei Han 123 - 133

Investing in a Brewpub: A Capital Budgeting Analysis

Elizabeth Webb Cooper 134 - 137

New Mexico National Bank, a bank with growth in mind (A)

Dr. James F. Cotter 138 - 154

A Case Study: Ethical Implications of friendly takeovers: A Financial Manager’s

Story

Barbara Tarasovich 155 - 165

Drug Revolution/Grace Pharmaceuticals Joint Venture

Karen M. Hogan, & Gerard T. Olson 166 - 170

From Jail Time to Swagger, Romance and Machoism: Changing the Image of the

Minivan

Mary Catherine Colley 171 - 185

The Lotto Case (Hitting the Jackpot)

Allen B. Atkins, Roxanne Stell, & Larry Watkins

Bob, Chad and Dylan had been dream-

ing of this day for the past six years; ever

since they first met in an introductory

economics course in college. For several

years they had been pooling their money

and buying Arizona Lottery tickets

dreaming that one day they would win

big. They realized that the lottery was

considered by many to be a voluntary

tax on the statistically challenged. But

miraculously they now sat at their favor-

ite local “watering hole” holding the

winning ticket that meant they would

split “The Pick” jackpot of $6 million.

What a great feeling! Now they just

needed to decide if they wanted to take

their winnings as a lump sum now or to

be paid over the next twenty in install-

ments.

Bob had been a political science major in

college but things hadn’t worked out as

he anticipated when he was a student.

He had entered the job market at what

looked now to be the bottom of the eco-

nomic downturn following the housing

crisis in the U.S. Bob believes he did not

start his job search soon enough and

found suitable openings virtually nonex-

istent. He was currently working part-

time at an organic farm and still living at

home which cramped his style consider-

ably. He has $150,000 in college related

loans (7% interest rate) which he cannot

service based on his annual taxable in-

come of $15,000. His share of the jackpot

would allow him to be debt free and

change his life for the better without

doubt.

Chad had been more fortunate than Bob.

He had applied himself in college and

earned a master of accounting degree

with an emphasis in taxation. After

graduation he immediately went to

work for one of the international ac-

counting firms and was now earning a

taxable income of $100,000 in spite of the

economic issues facing his friend Bob

and the country as a whole. He too had

debt but not from student loans. Chad

had purchased a very nice home in An-

them, Arizona for approximately 50% of

what it had sold for three years earlier

when built. He had a $250,000 mortgage

on the home, at a 4% interest rate, which

he saw little reason to pay off since he

anticipated significant inflation in the

near future.

Of the three friends Dylan was by far the

most successful. Dylan had majored in

finance and had excelled. When he

graduated, although he had several at-

tractive offers in the financial services

industry, he decided to go into the fami-

ly business. The company which his fa-

ther and uncle had started nearly 50

years ago had done amazingly well in

the downturn and since he was the only

child/nephew they were rewarding him

handsomely. He had been reluctant to

tell Bob but he was on track to receive to-

tal compensation (including bonuses)

that yielded a taxable income of $300,000

this year. Unlike his friend Bob, Dylan

was frugal and had taken on zero debt.

He was pleased with the trio’s good for-

tune but he didn’t think the windfall

would change his life all that much.

A few days later when the euphoria of

winning was subsiding the three friends

met again at the same establishment. All

were obviously in good spirits and were

looking forward to presenting their win-

ning ticket to Arizona Lottery officials.

Chad started the conversation by telling

Bob and Dylan that he had taken the ini-

tiative of doing some basic research on

how “The Pick” worked and what the

payout options were. Bob, proud of his

forethought, produced an article he had

saved years earlier from the Arizona Dai-

ly Star with the headline “Lump-sum

Lotto Payout is Best, Experts Say.” Bob

excitedly told his buddies that the ex-

perts were local CPAs and that clearly

the lump-sum payout was “the way to

go.” Dylan said he wanted to hear what

Chad had found out since he had gone

to the effort of looking into the specifics.

Chad (being a tax accountant) had pre-

pared a summary of his research which

follows:

A percentage of the proceeds from the sale of

Lotto tickets are allocated to a prize pool.

The size of the Jackpot that is prominently

advertised, six million dollars in this in-

stance, is actually only an estimate. The ad-

vertised amount is the sum of the estimated

annuity1 payments, without consideration of

the time value of money, which Lotto officials

believe can be purchased from the prize pool.

If the winner chooses the annuity payout

multiple insurance companies submit bids.

Officials award the bid to the insurance

company that offers the largest annual pay-

ments in return for the prize pool amount.

The insurance company with the best bid

typically offers a rate that is near the long-

1 The term annuity is actually a misnomer. Since

the payments are made by the insurance compa-

ny at the beginning of each of twenty periods it

is an annuity due.

term U.S. Treasury Bonds rate (currently

3%). If the winner chooses the Lump Sum

payout they simply receive the prize pool

amount; the amount that would have been

used to buy the annuity.

After reading the summary Bob said he

didn’t see how this related to the deci-

sion that had to be made since he didn’t

see anything that changed the preferred

option being that the lump-sum payout

is best. Chad acknowledged that Bob

was probably correct but he still wanted

to “run the numbers” and suggested that

Bob and Dylan should do the same.

Chad reminded them that they needed

to consider the tax consequences of the

payout schema and then provided the

following schedule of federal income tax

rates and reminded them that the state

tax rate was an additional 5%.

Bob rolled his eyes but said he would get

right on it. Dylan thanked Chad for the

information and they agreed to meet

again tomorrow to decide on the best

course of action.

Questions:

1. Is there necessarily one best deci-

sion for the group regarding the

payout options? If so what is it

and why?

2. What might be the reason(s) that

Chad does not want to pay off his

debt? Do you concur?

3. Prepare a personal analysis of the

payout options for Bob, Chad and

Dylan. Designate the preferred

option for each individual and

explain why.

4. What non-financial factors might

enter into the decision for the

winners?

References

Atkins, Allen B. and Edward A. Dyl,

“The LOTTO Jackpot: Should You Take

the Lump Sum or the Annuity?” Finan-

cial Practice and Education, Vol. 5, No. 2,

Fall/Winter, 1995, 107-111.

Authors

Allen B. Atkins, Ph.D., Professor of Fi-

nance, Northern Arizona University, al-

[email protected]

Roxanne Stell, Ph.D., Professor of Mar-

keting, Northern Arizona University,

[email protected]

Larry Watkins, Ph.D., CPA, Professor of

Accounting, Northern Arizona Universi-

ty, [email protected]

Taxable Income Bracket* Federal Tax Rate

$0 to 8,500$ 10%

8,500 to 34,500 15%

34,500 to 83,600 25%

83,600 to 174,400 28%

174,400 to 379,150 33%

379,150 to and over 35%

* Assumes individual filing status

American Apparel, Inc. – Saved from Bankruptcy but can it sustain? Dr Anupam Mehta

Abstract

American Apparel, Inc, which was once the fastest growing retailer of America, is

now striving to save its bleeding bottom line. With the possible bankruptcy looming

on the American Apparel heads and huge pile of loans to pay, it is battling to get on

the operating profits necessary for its very existence. The present case depicts the

struggle of founder and CEO Dov Charney to revive the company with his recovery

mechanism, inventory management, strengthening online & offline sales and crush-

ing operating expenses to fight against the quarter by quarter losses, negative EPS

and decreasing margins. This case gives an opportunity to the students to analyze

and evaluate the financially troubled company’s performance along with applying

the Altman’s Z score. At the end of the case students need to decide: whether the

CEO Dov Charney’s recovery plan is able to improve the financial performance of

the company? What are the trends of growth and earnings? Does the company have

sufficient liquidity and profitability to meet the requirements of massive debt and

gather refinance options? Does the company survive bankruptcy?

Keywords: American Apparel, Bankruptcy, Z score, Profitability, Retails sector, fi-

nancial performance, Ratio analysis

Introduction

With a cumulative loss of $41 million for

the first three quarters in 2012, Ameri-

can Apparel, once the “Label of the Year:

American Apparel”, “The fashion sensa-

tion of 2008” (The Guardian, 2008) is

struggling to stay afloat, after going into

deep financial troubles in 2009 and was

on the verge of bankruptcy in 2011. The

company’s net profit slipped to $1 mil-

lion in 2009 from $15 million in 2007 and

down to annual net losses of $86 million

& $39 millions in 2010 and 2011 respec-

tively. Dov Charney, the CEO and

Founder of American Apparel, who built

the company from a small retailer to a

massive vertically integrated manufac-

turer, distributor and retailer, is now

burdened with massive debt load, falling

share prices and decreasing margins. Till

now, Dov Charney’s efforts have been

able to sustain the company in spite of

losses and pull up the investors for its

sinking company, while enhancing the

sales from $533 million in 2010 to $547

million in 2011 and further building up

to $444 million (first three quarters in

2012) with effective inventory manage-

ment and expansion plans. But, continu-

ous losses pressurized him to improve

the profitability and deliver the financial

results or it will run out of options soon.

Figure 1 Stock Performance for 2006-2011

(Source: American Apparel, Inc., 2011)

Company background

As of July 31, 2012, American Apparel

had approximately 10,000 employees

and operated 251 retail stores in 20 coun-

tries, including the United States, Cana-

da, Mexico, Brazil, United Kingdom, Ire-

land, Austria, Belgium, France,

Germany, Italy, Netherlands, Spain,

Sweden, Switzerland, Australia, Japan,

South Korea and China. American Ap-

parel operates a global e-commerce site

that serves over 60 countries worldwide

at http://www.americanapparel.net. In

addition, American Apparel also oper-

ates a leading wholesale business that

supplies high quality T-shirts and other

casual wear to distributors and screen

printers. It is also one of the few clothing

companies exporting "Made in the USA"

goods. The American Apparel is head-

quartered in Downtown, Los Angeles,

where, from a single building they con-

trol the dyeing, finishing, designing,

sewing, cutting, marketing and distribu-

tion of the company's product. CEO Dov

is very passionate about the company,

and involved in every stage of manufac-

turing. He is known for the sexual con-

troversies and various sexual lawsuits.

The CEO Dov is also, famous for his use

of provocative models for advertise-

ments. Apart from these controversies,

Dov is having a very strong fashion

sense. In 2004, he was named Ernst &

Young's Entrepreneur of the Year and

Apparel Magazine's Man of the Year

(www.americanapparel.net, 1997).

American Apparel’s Mission statement

Company’s Long-term goal: to become

the #1 destination for basics – be the first

name that fashion-conscious consumers

think of for t-shirts, sweatpants, under-

wear, socks, and other basic apparel.

(www.americanapparel.net., n.d.)

The rise of American Apparel

The CEO Dov Charney with his vertical

integration business model converted

the company to America’s fastest retailer

in 2008. During the year, the company

made wide spread expansion and

launched stores across the globe with

new launches in Australia, Belgium,

Brazil, China, and Spain. The company

expanded 78 net store openings and 3

store moves. The company got strong

comparable store sales results: 22%,

Achieved EBITDA of $70.1 million and

EPS of $0.33 by significantly expanding

the manufacturing operations. The com-

pany was basking on the glory of signifi-

cant store growth and strong compara-

ble store sales performance. By the end

of 2008, the company has 260 stores in 19

countries, nearly 10,000 employees and

$545 million in revenues and a five year

compound annual growth rate of 46%

(American Apparel, Inc., 2008). The

company has a biggest competitive ad-

vantage of bringing the fashion changes

quickly, as the entire process is governed

in one building right from, cloth, cutting,

and delivery of final product. By the end

of 2008, the company was able to build a

unique brand which was fashionable

and low on prices.

Major setback to the profitability

In 2009, despite the company’s ability to

build a unique brand and having built a

wide network of stores across the globe,

the company started struggling to sus-

tain. Although, year 2008 was good in

terms of revenues and over all expan-

sion, beginning 2009, the company faced

several difficulties. The long run probe

into the employment of illegal immi-

grants, and forced termination of bulk of

its employees, brutally affected the per-

formance of the company. Immigration

crackdown forced American Apparel to

fire 1,800 workers, most of whom are La-

tino immigrants (Daily 49ER, 2009). As a

result, the company’s profits reduced

from $14 million in 2008 to $1 million in

2009, with EPS reduced from 0.33$ to

0.02$ in just one year and the operating

margins decreased from 6.6% to 4.4%.

The forced terminations of several em-

ployees impacted the performance of

2010 as well.

"We suffered the after-effects of a major

labor disruption resulting from an im-

migration intervention in 2009. The dis-

ruption of our 2010 production schedule

resulted in significantly higher produc-

tion costs per unit and late deliveries of

products to our stores and to our whole-

sale clients," said acting president Tom

Casey. "In addition, we encountered ex-

traordinarily challenging world-wide

economic conditions. We also experi-

enced higher yarn and fabric costs in the

second half of 2010" (American Apparel,

Inc., 2011).

Liquidity crisis and production losses

A significant decrease in the net cash

flow from operating activities, was ob-

served from December 31, 2009 ($45.2

million) to December 31, 2010 (- $32 mil-

lion). Meanwhile, the revenue during the

period fell nearly 5% as compared to

previous year, with total retail sales fell

just over 10%, wholesales sales dropped

6%, while online consumer sales shrunk

by 4.4% (Proactive investors, 2009). In

2011 things became worse, when the

company, with a long term mission of

becoming the number one destination

for garments, started to feel the difficulty

even to stay afloat. In its annual report

company specified that its operations are

at risk and raised substantial doubt that

the company may able to continue as a

going concern. As the crisis grew, the

company desperately looked for new in-

vestors.

“If the company is not able to timely,

successfully or efficiently implement the

strategies that the company is pursuing

to improve its operating performance

and financial position, obtain alternative

sources of capital or otherwise meet its

liquidity needs, the company may need

to voluntarily seek protection under

Chapter 11 of the U.S. Bankruptcy

Code,” DealBook (2011).

Recovery plan

On the blink of bankruptcy, the CEO

Dov Charney secured $14.9 million in

additional financing and gave life line to

the company. Dov, in his upbeat spirits,

made an extensive plan for the recovery

of the company through improving the

operating performance, over hauling of

the entire process of inventory manage-

ment and severely trying to crush the

cost while focusing on getting the re-

quired EBIT quarter by quarter in order

to meet the requirements of heavy debt

that it has taken.

According to Dov Charney, "We contin-

ue to make meaningful progress in im-

proving inventory efficiency lower car-

rying costs and reduce working capital

requirements over the long-term. These

efforts, together with other operating

performance improvements will assist in

our near-term refinancing efforts" (Inves-

tors.americanapparel.net, 2012).

The expansion and renewed focus on

sales enhancements resulted into total

net sales increase by 15% to $56.3 million

in December 2011. For the same period,

comparable store sales increased 12%

and wholesale net sales increased 25%.

The Gross operating margin as well im-

proved.

“Our sales exceeded plan in all channels

and we saw good progress in our whole-

sale channel across a broad spectrum of

customers. Our retail sales increases

were also broad based with notably

large increases in the US, in all Asian

markets, and in Australia. Our product

is resonating well with our customers

both in stores and online. During the

quarter we opened three new stores in

the UK, including one in Westfield, Lon-

don and two store-in-store locations at

the venerable Selfridges department

store chain. We are excited about our

progress in 2011 and expect to build on

our recent successes in the coming year”

said Dov Charney (American Apparel,

Inc., 2012).

The strategy of building both online and

offline stores was continued in 2012 as

well. In April 2012, it launched a new

online store,

www.store.americanapparel.com.hk,

serving Hong Kong, while continued to

build brand offline and online.

Figure 2: Recent Stock Performance

(Source: Yahoo Finance, 2012)

Figure 3: Quarterly results

(Source: Google Finance, 2012)

Burdened under Debt

In spite of some improvements, the

overall financial figures were still nega-

tive, making CEO Dov Charney to fur-

ther increase debt or refinance, else it

would go bankrupt. This time again Dov

was able to arrange the investors and

managed to get the major loans extend-

ed/refinanced till 2015 During July 2012,

the company announced it has replaced

its existing $75 million senior credit facil-

ity that was due to expire in July 2012

with a three year $80 million Senior

Credit Facility also extended the maturi-

ty date of the Second Lien Loan by two

years to December 31, 2015

(Americanapparel.net.,2012).

“I’ve never seen a company get so many

lifelines. Dov must be very charming,”

said the retail analyst. (Retailgeeks.com,

2012)

The growing liabilities, the high interest

rates and inability to generate profits

and once again resorting to the lenders

for further loan, resulted into a total lia-

bilities increasing to $ 319 million at the

end of the third quarter of 2012 as com-

pared to $13,877 in equity. But it seems

Dov, is unshattered with the loans, all he

wants to somehow keep the company

floating. He believes that once the com-

pany is able to hit the numbers, the in-

terest payment can be made easily.

Concern and challenges

“There’s obviously a level of sexiness

and excitement that (Charney) portrays,

and passion for the brand” retail con-

sultant said. “If the numbers aren’t that

positive, as they’re not, investors are

probably buying a vision and a promise

that, things will get better”

(Retailgeeks.com, 2012). Although the ef-

forts of Dov Charney have managed to

get investors till now, some analysts be-

lieve that the company has done noth-

ing, except buying some time from its

latest financing. With huge liabilities, the

company has to show the results in

numbers otherwise it may have to face

the bankruptcy. No wonder, the compa-

ny is having tough time to save its bleed-

ing bottom line. With the sword of liabil-

ities dangling on Dov Charney’s head,

he fears, whether the recovery plan will

able to enhance the profitability of the

company? What are the key financial in-

dicators that need to be further empha-

sized, in order to pay back the liabilities,

and generate further refinance, if re-

quired? Having survived on the blink of

bankruptcy, would American Apparel

be able to pass through the crisis or is it a

sure short candidate of business failure?

Specific Assignment Questions

1. Has the recovery plan of Dov

Charney able to improve the financial

performance of the company?

2. Do you think company can sur-

vive? Apply the Atman Z –score to fur-

ther strengthen your conclusions.

3. How good are the operating mar-

gins and EBIT of the company?

Notes: 1 Altman’s Z score

“Z” Score Component Definitions

1. X1=Working capital/ total Assets

2. X2=Retained earnings / Total As-

sets

3. X3=EBIT/Total Assets

4. X4=Equity value/ total book debt

5. X5=Sales/Total Assets

Z score is calculated to find out the fu-

ture viability and chances of bankruptcy

Z = 1.2X1 + 1.4X2 + 3.3X3 + 0.6X4 + 1.0X5

Altman defined a “problematic area”

which is between 1.81 and 2.99. Firms,

with z-scores within this range, are con-

sidered uncertain about credit risk and

considered marginal cases to be watched

with attention. Firms with Z scores be-

low 1.81 indicate failed firms. Although,

the cut-off point was set at 2.675, Altman

advocates using the lower bound of the

zone-of-ignorance (1.81) as a more realis-

tic cutoff Z-Score. So if Z < 1.81, then the

company has a high probability of de-

fault. Altman, E., (1968)

When using this model Altman conclud-

ed:

Z-score < 1.81 = high probability of bank-

ruptcy.

Z-score > 3.0 = low probability of bank-

ruptcy.

Z-score 1.81- 3.0 = indeterminate. (Al-

Rawi, K. et al., 2008)

References

Al- Rawi, K. et al. (2008) The Use of Alt-

man Equation For Bankruptcy Predic-

tion In An Industrial Firm (Case

Study), International Business & Eco-

nomics Research Journal, Volume 7,

(Number 7), p.118.

Altman, E., (1968) Financial Ratios, Dis-

criminant Analysis and the Prediction

of Corporate Bankruptcy, Journal of

Finance, September.

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Unknown. (2012) (online) Available at:

http://www.wwd.com/retail-

news/financial/american-apparel-

losses-narrow-

5795784/print...(Accessed:12th July

2012).

Yahoo Finance (2012) American Apparel

Inc Common Stock (NYSE MKT). (im-

age online) Available at:

http://finance.yahoo.com/q/bc?s=APP

&t=1y&l=on&z=l&q=l&c= (Accessed:

11th Dec 2012)

Exhibit 1: Annual Cash Flow statement for year ending 2011

(Source: American Apparel, Inc. (2011) annual report on form 10-k for the year ended December 31, 2011)

American Apparel, Inc. and Subsidiaries

Consolidated Statements of Cash Flows

(Amounts in Thousands)

2011 2010 2009

CASH FLOWS FROM OPERATING ACTIVITIES

Cash received from customers 542,930$ 532,601$ 559,089$

Cash paid to suppliers, employees and others (534,497) (559,386) (488,858)

Income taxes (paid) refunded (866) 698 (16,901)

Interest paid (5,535) (6,456) (8,609)

Other 273 173 482

Net cash provided by (used in) operating activities 2,305 (32,370) 45,203

CASH FLOWS FROM INVESTING ACTIVITIES

Capital expenditures (11,070) (15,701) (20,889)

Proceeds from sale of fixed assets 311 39 -

Net cash used in investing activities (10,759) (15,662) (20,889)

CASH FLOWS FROM FINANCING ACTIVITIES

Cash overdraft (1,407) (404) 1,307

(Repayments) borrowing under revolving credit

facilities, net (6,874) 50,852 (43,590)

Net proceeds from issuance of common stock and

purchase rights 21,710 - -

Payment of debt issuance costs (1,881) - (5,003)

Proceeds from sale of treasury stock - 1,650 -

Payment of payroll statutory tax withholding on

stock-based compensation associated with issuance

of common stock (759) (2,051) -

Borrowings of subordinated notes payable to related

party - - 4,000

Repayments under subordinated notes payable to

related party - - (3,250)

Borrowings under term loans and notes payable, net

of $5,000 discount - - 75,074

Repayment of term loans and notes payable (13) (15) (51,183)

Proceeds from equipment lease financing 3,100 - -

Repayment of equipment lease obligations (1,294) (1,860) (2,826)

Net cash provided by (used in) financing activities 12,582 48,172 (25,471)

EFFECT OF FOREIGN EXCHANGE RATE CHANGES ON CASH (1,491) (1,530) (1,165)

NET INCREASE (DECREASE) IN CASH 2,637 (1,390) (2,322)

CASH, beginning of period 7,656 9,046 11,368

CASH, end of period 10,293$ 7,656$ 9,046$

For the Years ended December 31,

Exhibit 2: Annual Balance sheet as on 31st Dec, 2011

(Source: American Apparel, Inc. (2011) Annual Report on Form 10-K for the Year Ended December 31, 2011)

Consolidated Balance Sheets

(Amounts in thousands, except per share amounts)

December 31,

2011 2010

ASSETS

CURRENT ASSETS:

Cash 10,293$ 7,656$

Trade accounts receivable, net of allowances of $2,195 and

$2,630 at December 31, 2011 and 2010, respectively 20,939 16,688

Prepaid expenses and other current assets 7,631 9,401

Inventories, net 185,764 178,052

Income taxes receivable and prepaid income taxes 5,955 4,114

Deferred income taxes, net of valuation allowance of

$12,003 and $9,661 at December 31, 2011 and 2010,

respectively 148 626

Total current assets 230,730 216,537

PROPERTY AND EQUIPMENT, net 67,438 85,400

DEFERRED INCOME TAXES, net of valuation allowance of

$61,770 and $42,318 at December 31, 2011 and 2010,

respectively 1,529 1,695

OTHER ASSETS, net 25,024 24,318

TOTAL ASSETS 324,721$ 327,950$

LIABILITIES AND STOCKHOLDERS' EQUITY

CURRENT LIABILITIES:

Cash overdraft 1,921$ 3,328$

Revolving credit facilities and current portion of

long-term debt, net of unamortized discount of $16,012 at

December 31, 2010 50,375 138,478

Accounts payable 33,920 31,534

Accrued expenses and other current liabilities 43,725 39,028

Fair value of warrants 9,633 993

Income taxes payable 2,445 230

Deferred income tax liability, current 150 -

Current portion of capital lease obligations 1,181 560

Total current liabilities 143,350 214,151

LONG-TERM DEBT, net of unamortized discount of $20,183 at

December 31, 2011 97,142 444

SUBORDINATED NOTES PAYABLE TO RELATED PARTY - 4,611

CAPITAL LEASE OBLIGATIONS, net of current portion 1,726 542

DEFERRED TAX LIABILITY 96 260

DEFERRED RENT, net of current portion 22,231 24,924

OTHER LONG-TERM LIABILITIES 12,046 7,994

TOTAL LIABILITIES 276,591 252,926

Exhibit 3: Consolidated Statements of Operations and Comprehensive (Loss) Income

for year ending Dec, 2011.

(Source: American Apparel, Inc. (2011) Annual Report on Form 10-K for the Year Ended December 31, 2011)

Years Ended December 31,

2011 2010 2009

Net sales 547,336$ 532,989$ 558,775$

Cost of sales 252,436 253,080 238,863

Gross profit 294,900 279,909 319,912

Selling expenses 209,841 218,198 198,518

General and administrative expenses (including

related party charges of $919, $822 and $790 for

the years ended December 31, 2011, 2010 and

2009, respectively) 104,085 103,167 93,636

Retail store impairment 4,267 8,597 3,343

(Loss) income from operations (23,293) (50,053) 24,415

Interest expense (including related party

interest expense of $64, $266 and $271 for the

years ended December 31, 2011, 2010 and 2009,

respectively) 33,167 23,752 22,627

Foreign currency transaction loss (gain) 1,679 (686) (2,920)

Unrealized (gain) loss on change in fair value

of warrants and purchase rights (23,467) 993 -

Loss on extinguishment of debt 3,114 - -

Other (income) expense (193) 39 (220)

(Loss) income before income taxes (37,593) (74,151) 4,928

Income tax provision 1,721 12,164 3,816

Net (loss) income (39,314)$ (86,315)$ 1,112$

Basic (loss) earnings per share (0.42)$ (1.21)$ 0.02$

Diluted (loss) earnings per share (0.42)$ (1.21)$ 0.01$

Weighted average basic shares outstanding 92,599 71,626 71,026

Weighted average diluted shares outstanding 92,599 71,626 76,864

Net (loss) income (from above) (39,314)$ (86,315)$ 1,112$

Other comprehensive (loss) income item:

Foreign currency translation, net of tax (188) (1,085) 620

Other comprehensive (loss) income, net of tax (188) (1,085) 620

Comprehensive (loss) income (39,502)$ (87,400)$ 1,732$

American Apparel, Inc. and Subsidiaries

Consolidated Statements of Operations and Comprehensive (Loss) Income

(Amounts in thousands, except per share amounts)

Exhibit 4: Quarterly Reports - Balance Sheet

(Source: American Apparel, Inc. (2012) American Apparel, Inc. Reports Third Quarter 2012

September 30, 2012 December 31, 2011*

ASSETS

CURRENT ASSETS

Cash 7,186$ 10,293$

Trade accounts receivable 25,951 20,939

Prepaid expenses and other current assets 10,800 7,631

Inventories, net 180,879 185,764

Restricted cash 5,928 -

Income taxes receivable and prepaid income taxes 1,475 5,955

Deferred income taxes, net of valuation allowance

of $12,003 at both September 30, 2012 and December

31, 2011 639 148

Total current assets 232,858 230,730

PROPERTY AND EQUIPMENT, net 65,959 67,438

DEFERRED INCOME TAXES, net of valuation allowance

of $61,770 at both September 30, 2012 and December

31, 2011 1,559 1,529

OTHER ASSETS, net 33,269 25,024

TOTAL ASSETS 333,645$ 324,721$

LIABILITIES AND STOCKHOLDERS' EQUITY

CURRENT LIABILITIES

Cash overdraft 2,625$ 1,921$

Revolving credit facilities and current portion of

long-term debt 71,586 50,375

Accounts payable 37,247 33,920

Accrued expenses and other current liabilities 38,750 43,725

Fair value of warrant liability 28,455 9,633

Income taxes payable 389 2,445

Deferred income tax liability, current 697 150

Current portion of capital lease obligations 1,017 1,181

Total current liabilities 180,766 143,350

LONG-TERM DEBT, net of unamortized discount of

$29,959 and $20,183 at September 30, 2012 and

December 31, 2011, respectively 103,964 97,142

CAPITAL LEASE OBLIGATIONS, net of current portion 1,083 1,726

DEFERRED TAX LIABILITY 108 96

DEFERRED RENT, net of current portion 21,597 22,231

OTHER LONG-TERM LIABILITIES 12,250 12,046

TOTAL LIABILITIES 319,768 276,591

COMMITMENTS AND CONTINGENCIES

STOCKHOLDERS' EQUITY

shares outstanding at December 31, 2011 11 11

Additional paid-in capital 173,787 166,486

Accumulated other comprehensive loss (2,735) (3,356)

Accumulated deficit (155,029) (112,854)

Less: Treasury stock, 304 shares at cost (2,157) (2,157)

TOTAL STOCKHOLDERS' EQUITY 13,877 48,130

TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY 333,645$ 324,721$

American Apparel, Inc. and Subsidiaries

Condensed Consolidated Balance Sheets

(Amounts and shares in thousands, except per share amounts)

(unaudited)

Exhibit 5: Quarterly Reports - Income Statement

American Apparel, Inc. (2012) American Apparel, Inc. Reports Third Quarter 2012

2012 2011 2012 2011

Net sales 162,160$ 140,889$ 444,282$ 389,760$

Cost of sales 76,960 65,898 209,990 178,705

Gross profit 85,200 74,991 234,292 211,055

Selling expenses 58,017 52,283 168,258 152,536

General and administrative expenses

(including related party charges of $332

and $177 for the three months ended

September 30, 2012 and 2011,

respectively, and $883 and $628 for the

nine months ended September 30, 2012 and

2011, respectively) 22,566 24,552 71,792 77,025

Retail store impairment - 784 129 2,436

Income (loss) from operations 4,617 (2,628) (5,887) (20,942)

Interest expense 10,454 8,832 30,274 23,715

Foreign currency transaction (gain) loss (685) 1,855 141 780

Unrealized loss (gain) on change in fair

value of warrants and purchase rights 13,312 (6,101) 15,340 (21,201)

(Gain) loss on extinguishment of debt - - (11,588) 3,114

Other expense (income) 36 (186) 188 (240)

Loss before income taxes (18,500) (7,028) (40,242) (27,110)

Income tax provision 512 166 1,933 1,042

Net loss (19,012)$ (7,194)$ (42,175)$ (28,152)$

Basic and diluted loss per share (0.18)$ (0.07)$ (0.40)$ (0.32)$

Weighted average basic and diluted shares

outstanding 106,248 102,279 105,960 88,614

Net loss (from above) (19,012)$ (7,194)$ (42,175)$ (28,152)$

Other comprehensive income (loss) item:

Foreign currency translation, net of

tax 1,073 (1,279) 622 135

Other comprehensive income (loss),

net of tax 1,073 (1,279) 622 135

Comprehensive loss (17,939)$ (8,473)$ (41,553)$ (28,017)$

American Apparel, Inc. and Subsidiaries

Condensed Consolidated Statements of Operations and Comprehensive Loss

(Amounts and shares in thousands, except per share amounts)

(unaudited)

Three Months Ended September 30, Nine Months Ended September 30,

Exhibit 6: Quarterly Reports: Cash Flow Statement

American Apparel, Inc. (2012) American Apparel, Inc. Reports Third Quarter 2012

2012 2011 2012 2011

Net sales 162,160$ 140,889$ 444,282$ 389,760$

Cost of sales 76,960 65,898 209,990 178,705

Gross profit 85,200 74,991 234,292 211,055

Selling expenses 58,017 52,283 168,258 152,536

General and administrative expenses

(including related party charges of $332

and $177 for the three months ended

September 30, 2012 and 2011,

respectively, and $883 and $628 for the

nine months ended September 30, 2012 and

2011, respectively) 22,566 24,552 71,792 77,025

Retail store impairment - 784 129 2,436

Income (loss) from operations 4,617 (2,628) (5,887) (20,942)

Interest expense 10,454 8,832 30,274 23,715

Foreign currency transaction (gain) loss (685) 1,855 141 780

Unrealized loss (gain) on change in fair

value of warrants and purchase rights 13,312 (6,101) 15,340 (21,201)

(Gain) loss on extinguishment of debt - - (11,588) 3,114

Other expense (income) 36 (186) 188 (240)

Loss before income taxes (18,500) (7,028) (40,242) (27,110)

Income tax provision 512 166 1,933 1,042

Net loss (19,012)$ (7,194)$ (42,175)$ (28,152)$

Basic and diluted loss per share (0.18)$ (0.07)$ (0.40)$ (0.32)$

Weighted average basic and diluted shares

outstanding 106,248 102,279 105,960 88,614

Net loss (from above) (19,012)$ (7,194)$ (42,175)$ (28,152)$

Other comprehensive income (loss) item:

Foreign currency translation, net of

tax 1,073 (1,279) 622 135

Other comprehensive income (loss),

net of tax 1,073 (1,279) 622 135

Comprehensive loss (17,939)$ (8,473)$ (41,553)$ (28,017)$

American Apparel, Inc. and Subsidiaries

Condensed Consolidated Statements of Operations and Comprehensive Loss

(Amounts and shares in thousands, except per share amounts)

(unaudited)

Three Months Ended September 30, Nine Months Ended September 30,

Exhibit 6: Quarterly Reports - Total Debts

American Apparel, Inc. (2012) American Apparel, Inc. Reports Third Quarter 2012

Author

Dr Anupam Mehta, Assistant Professor, Institute of Management Technology, Du-

bai, UAE, [email protected]

* This case has been compiled from published sources. It is intended for class room discussion rather

than to illustrate either effective or ineffective handling of a management situation.

Lender

Description of Debt Name Interest Rate September 30, 2012

(a) 90-day LIBOR

of 0.47% plus

9.0% plus unused

facility fee

ranging (0.375%

-1.00%) and for

the brand name:

Crystal (b) 90-day LIBOR

Financial of 0.47% plus

Revolving credit facility LLC 19.75% 35,576$

90-day LIBOR of

0.47% plus 9.0%

plus unused

Crystal facility fee

Term loan from private Financial ranging (0.375%

investment firm LLC -1.00%) 30,000

Bank's prime

Revolving credit facility Bank of rate of 3% plus

(Canada) Montreal 4% 5,901

Term loan from private

investment firm, net of Lion

discount and including Capital From 15.0% to

interest paid-in-kind LLP 18.00% 103,614

Other 459

individual

leases

ranging

between From 5.0% to

Capital lease obligations $1-$511 18.00% 2,100

Cash overdraft 2,625

Total debt including cash

overdraft 180,275$

A Model for Running an Undergraduate Business-Focused

Case Competition

Jill M. Bale, Jimmy Senteza, & Toby A. White

Abstract

A case competition complements the curricular objectives of various programs in

this era of mission-driven business school accreditation. We provide a model for

conducting a case competition at a business school in a manner that integrates cur-

riculum objectives with learning outcomes, and without imposing greatly on time

constraints of faculty. Based on our experiences for running this competition for

three years at a small, mid-western university, we recommend a four-phase sequen-

tial description of the process: planning, execution, assessment, and feedback. Even

though the framework presented here is performed as an extra-curricular activity,

with minor modifications, it can be integrated into an ongoing standard undergrad-

uate-level course.

Introduction

There has been considerable attention

given to pedagogical studies that lead to

enhanced student learning in business

courses; however, these studies have

predominantly focused on methods and

tools to be used in the classroom (see

Rassuli and Manzer, 2005, Lam, 2007,

Santos, Vega, and Barkoulas, 2007).

While it is essential to develop basic

skills in the classroom, faculty should al-

so consider opportunities that are avail-

able outside the classroom. In this pa-

per, we provide a framework for a case

competition structure that intentionally

connects faculty and students in a way

that not only reinforces in-class learning

but also assists students in developing

skills essential for their future careers in

business. We present a structure for

conducting a business case competition

for undergraduates at a business school

that does not impose greatly on the

many academic activities faculty and

students choose to participate in during

a given term. The ideal case competition

integrates the undergraduate course cur-

riculum with real life experiences, while

achieving many positive outcomes.

In reviewing materials available in the

public domain on business case competi-

tions in the US, it is evident that they

have typically been a graduate school

phenomenon, pitting MBA students

against each other for prize money

and/or recognition. For example, several

highly ranked graduate schools such as

Boston University, George Washington

University, Columbia, NYU, Wake For-

est, and Wharton participate in intercol-

legiate case competitions. The competi-

tions are typically designed to encourage

contestants to provide workable solu-

tions to key business problems, to deal

with social enterprise or environmental

issues, or to develop a completely new

product or service.

There are also many national and re-

gional competitions organized by insti-

tutions such as Global Science Entrepre-

neurship, the Center for

Entrepreneurship, the Collegiate Entre-

preneur Organization, and the Neely En-

trepreneurship Center. These competi-

tions provide students the opportunity

to pitch their business concepts to a pan-

el of judges that are often veteran entre-

preneurs themselves.

At the undergraduate level, national and

international competitions like the IMA

Case Competition (Richtermeyer, 2007),

The Edward Jones Challenge (Umble,

Umble, and Artz, 2008) and The Travel-

ers’ Case Competition offer unique expe-

riences to undergraduate business stu-

dents. These competitions frequently

feature the elevator pitch concept, where

contestants must summarize the most

essential aspects of a business within the

time that it would take to ride up an ele-

vator. Student participants, often from

college entrepreneurship clubs, compete

for cash prizes and get an opportunity to

have their business ideas reviewed by

potential future employers.

The case competition described here

uniquely provides an opportunity for

undergraduate students to apply con-

cepts they have recently seen in their

coursework to ‘real world’ business

problems. While the competitions intro-

duced above are mostly a forum to de-

velop and present immediately usable

solutions for specifically identified prob-

lems, we make more of a deliberate at-

tempt to complement or harness tradi-

tional class pedagogy. Thus, our

objective is similar to that enacted by the

Northeastern University College of

Business Internal Business Case Compe-

tition (IBCC); that is, it “provides stu-

dents the opportunity to hone their ana-

lytical, critical thinking and presentation

skills by taking their course work from

the classroom to a competitive arena”

(Northeastern University, 2011). Fur-

thermore, the case competition intro-

duced here does provide undergraduate

students the needed preparation to par-

ticipate in the national, regional, and

graduate case competitions described

above.

I. Motivations and Learning Outcomes

There are several motivations for using

extracurricular case competitions. A key

motivation is increased interaction be-

tween faculty and students. In most

typical undergraduate academic envi-

ronments, faculty/student interaction

occurs primarily in the classroom or

during office hours, as relates to a par-

ticular class or perhaps with respect to

advising.

Frankel and Swanson (2002) tested the

impact of faculty-student interaction

outside the classroom and found that if

a professor had positive student encoun-

ters, then he/she was more likely to

show greater interest in student learning

by making additional effort to “encour-

age, strengthen, and praise students to

support appropriate behaviors” (p. 91).

In addition to greater faculty interest,

students benefit from team-based com-

petitions in several ways. Umble, Umble

and Artz (2008) noted that team-based

competitions achieve six student out-

comes through, “(1) providing an active

learning experience, (2) reinforcing im-

portant class concepts, (3) helping stu-

dents relate course concepts to the real

world, (4) enhancing critical thinking

skills, (5) providing an opportunity to

work in a team, and (6) enhancing the

overall learning experience (p.1).”

Another motivation of case competitions

relates to accreditation. The Association

to Advance Collegiate Schools of Busi-

ness (AACSB) accreditation standard

number 14 requires that students

demonstrate both general and manage-

ment-specific goals. General goals in-

clude “such learning areas as communi-

cation abilities, problem-solving abilities,

ethical reasoning skills, and language

abilities. . .[while management-specific

goals] relate to expectations for learning

accomplishment in areas that directly re-

late to management tasks and form the

business portion of degree require-

ments.” (p. 61). Furthermore, AACSB

requires that for each goal adopted by a

business school, the school must have

multiple assessment measures that

demonstrate achievement of those goals.

Case competitions may be valuable to

institutions that struggle with assessing

specific goals since such competitions

enhance the overall learning experience.

A final motivation for case competitions

relates to career placement for students.

Smith and Hanlon (2009) noted that

“perhaps the most important benefit

students earn by participating [in case

competitions] is the resume line. Stu-

dents report that this is the most dis-

cussed item in interviews for internships

and full-time positions, and is a great

opportunity to distinguish themselves

from other job applicants” (p. 1). Em-

ployers value the outcomes achieved

through case competitions. A 2010 sur-

vey conducted by the National Associa-

tion of Colleges and Employers (NACE)

concluded that “companies are seeking

evidence of communication and writing

skills, analytical ability and teamwork”

(Korkki, 2010). When examining what

skills are needed for success in business,

Coplin (2002) reported that employers

rank teamwork skills as one of the most

important skills learned in college.

There is little doubt that the extracur-

ricular case competition adds value to a

business program; however, resources

are limited and creating the competition

structure can be time consuming. In

choosing to participate in a case compe-

tition, faculty must weigh the imposing

needs of developing a case problem, so-

liciting student groups interested in

competing, committing office time to an-

swering questions, listening to and eval-

uating student presentations, and re-

viewing submitted reports against their

standard obligations of scholarship,

teaching, and service.

To minimize faculty time commitments

associated with a case competition, we

create a template for running a case

competition. The competition process is

separated into four task-based phases

(planning, execution, assessment and

feedback) that need to be implemented

in progression. The rest of the paper will

present a discussion of our template for

each phase, with examples from our own

experiences shown as necessary.

II. The Planning Phase

With good planning, the case competi-

tion will likely be a positive experience

for both faculty and student participants.

The planning phase includes scheduling,

advertising and student recruitment, and

case selection. Each process is discussed

in this section of the paper.

A. Timing and Scheduling

Limiting the competition to a single

weekend helps to mitigate the burden of

time commitment. The most optimal

timing for the case competition may be

early in the spring semester, perhaps af-

ter the second full week of classes. The

earlier part of a semester is convenient

for students as they have just settled into

their new classes and have a relatively

low academic work load; similarly, fac-

ulty have just rolled out their class work,

attended to all advisee issues relating to

course changes, and should not yet be

overly committed. We prefer holding

the competition in the spring semester,

instead of in the fall semester, because

we have time for attending to competi-

tion details during the winter break. We

also discovered that we can promote the

competition late in the fall semester, and

not incur a large gap in time between

when applications are solicited (in De-

cember) and when the competition

commences (in January).

To condense the event into a narrow

time frame, a single weekend, using Fri-

day (or Saturday) as a work day and

Saturday (or Sunday) as a reporting day,

works well. An example of a model

weekend schedule is included in Ap-

pendix 1. Before advertising and stu-

dent recruitment occur, the schedule

should be set so that all potential student

participants can plan accordingly.

(Refer Appendix 1)

B. Advertising and Student Recruitment

Student participation is critical, espe-

cially when the competition is financially

supported through a grant or benefactor.

To encourage student participation, the

competition should be announced in re-

lated courses and through electronic

platforms like student publications and

appropriate student e-mail lists. Stu-

dents should be asked to register as a

team on official application forms. As

for group size, we recommend 3-4 indi-

viduals for both student groups and for

the participating faculty panel. Faculty

teams should anticipate questions dur-

ing this time period since many students

will want clarification of processes.

Note that if a college has a robust, active

student population, the faculty team

may consider limiting the number of

teams that participate before beginning

its recruitment process.

C. Case Selection and/or Creation

The choice and preparation of the case

study to be used in the competition is

one of the biggest planning tasks for the

faculty team. The ideal case should re-

quire students to grapple with many

gray issues, much like they would as

business consultants. Pedagogically, the

case should have a limited number of

“correct answers”, and provide oppor-

tunities for students to think both criti-

cally and creatively, drawing upon their

myriad of business courses in providing

recommendations. The ideal case should

have the potential for many non-

traditional solutions which could poten-

tially be judged favorably, if appropri-

ately supported. In other words, the

case needs to be “messy” as defined by

Carrithers, Ling and Bean (2008). Given

the desired nature of the case, a faculty

team may opt to purchase a case, work

with a local business to create a case or

simply write a case that will be used in

the competition.

The easiest approach is to purchase a

case from an existing vendor and use it

as is. The primary advantage of this ap-

proach is the time saved by not writing a

case from scratch. However, a disad-

vantage of this option is that infor-

mation, whether free or at a cost, may be

available online. Availability of online

information should be thoroughly re-

searched by the faculty team and, in

turn, shared with all student competitors

at the onset of the competition to ensure

equal information for all student teams.

Another approach is to solicit case stud-

ies by asking business managers (or

guest speakers) from the local communi-

ty to provide an appropriate case based

on their internal work experiences. Yin

(1994) stated that case studies based on

contemporary real-life issues are particu-

larly appropriate for, and attractive to,

students. Other advantages to this ap-

proach are: (1) students may develop a

good understanding of the subject com-

pany (if its disclosure is allowed), (2) lo-

cal case studies enhance the relationship

between the University and the local

business community, and (3) the local

business may send some of its people to

participate on the panel of judges. The

disadvantage of this approach is the pos-

sibility that the case will need to be

adapted for the needs of the competition,

which will require faculty time.

The final approach, which is also the

most time consuming, is to create an

original case for the competition. To

date, we have been through three annual

cycles of our weekend case competition.

In our first year, we created a case based

on a Midwestern company that was con-

sidering two buildings for potential ex-

pansion, one of which would cost more

to the firm but would also serve as a

cornerstone for a downtown revitaliza-

tion effort. In our second year, we

adapted a case from the Harvard Busi-

ness Review, whereby a private label

manufacturer had to decide whether or

not to expand production facilities to

meet significantly increased demand

from a single customer. In our third

year, we adapted a case from Darden

Business Publishing that focused on

whether or not Boeing should go ahead

with the development and production of

a new mid-sized fleet of airplanes, espe-

cially in the context of keeping up with

its primary competitor Airbus.

Because the case was original in year 1

and purchased in both years 2 and 3, we

noted a large difference in average plan-

ning time. In year 1, the average plan-

ning time per faculty member was 15.7

hours, while in years 2 and 3, planning

averaged 5.0 and 6.2 hours per faculty

member, respectively. There is little

doubt that the choice of approach in case

selection was a primary factor in ex-

plaining the time difference after year 1.

III. The Execution Phase

The successful execution of a case com-

petition depends heavily on the preced-

ing planning phase. At the commence-

ment of the competition, the faculty

team should meet all contestants and

share the following information with the

student teams:

1. Time schedule: The faculty team

should review the timing of main

events, and answer any questions re-

lating to competition structure.

2. Guidelines and expectations: Each

student group should be given expec-

tations concerning both oral presen-

tations and written reports. Rubrics

for the oral presentation and written

reports should be shared with stu-

dents at this time.

3. Random draw for presentation order:

Each group draws their presentation

time at random out of a hat.

4. Case guidance: The faculty should

discuss the nature of the case and

may choose to give students some

specific direction on which tasks are

most important to address. The facul-

ty team may also announce limited

office hours during the competition,

for which students may visit if they

have further questions.

Note that in our first year, we gave no

general guidance on the case study in

the initial meeting. However, in our se-

cond and third years, more guidance

was given and results were slightly

higher in quality and much lower in var-

iability relative to the first year. Because

we used a published case in both the se-

cond and third year, there were teaching

notes online as well as a couple of relat-

ed web sources, all of which were shared

in the initial meeting with students.

Thus, the competition became more fo-

cused on presentation skills and writing

skills, rather than on problem-solving

skills (as in the first year).

When working on the case, students

were not restricted to a certain area, or

even required to work inside of the

business school. Also, we felt the easiest

way to communicate any key project

updates or clarifications, once the com-

petition had started, was via Black-

board©, to which all students had an op-

erating account. Blackboard© was also

utilized for each group’s final submis-

sions, which included their written re-

ports, presentation slides, and any

spreadsheets and appendices that sup-

ported their conclusions. This electronic

efficiency facilitated a smooth progres-

sion for assessment and review.

All student groups were required to

submit their written report, PowerPoint

presentation, and spreadsheet by a set

time. Presentations began 20 minutes af-

ter this deadline. A technology support

person was in the presentation room and

loaded each group’s submitted presenta-

tion slides before that group entered the

room. In addition, fellow faculty mem-

bers and administrators were invited to

watch some or all of the presentations.

Student teams were not allowed to

watch other presentations until they had

already presented.

IV. The Assessment Phase

Assessment occurs in two forms once the

competition has begun. First, the prod-

ucts created by each student team must

be assessed so that “winners” may be

determined. Second, the structure of the

competition itself must be assessed so

that improvements in processes can be

made in future years. In this section, we

will discuss both forms of assessment.

A. Student Team Assessment

It is difficult to measure student perfor-

mance consistently. However, rubrics

for both the oral presentation and writ-

ten report may assist in the process.

Griffin (2009) describes rubrics as fol-

lows. “[They are] the finest description

of what we think is important for our

students right now, in the service of their

learning.” (p. 13). The rubrics used in

the past three years can be found in Ap-

pendices 2A and 2B. The oral presenta-

tion rubric is a modification of a rubric

created by the University of Dayton (see

footnote on rubric). It is entirely likely

that these rubrics may need modification

as the case or the competition changes

over time.

(Refer Appendices 2A and 2B)

The adapted rubrics were shared with

students at the beginning of the competi-

tion. At this time, students were in-

formed of how the rubric scores would

be weighted. For the most recent com-

petition, we chose weights of 50% for the

oral presentation and 50% for the written

report. After each portion of the compe-

tition was completed, the faculty team

computed an average rubric score for

each team. From the two rubrics used,

the group rankings were then deter-

mined. The top six teams were recog-

nized at an awards ceremony, with the

top three teams winning various cash

prizes.

B. Assessment of Competition Structure

In addition to assessing student perfor-

mance, it is important to review the ef-

fectiveness of the competition process,

seeking opportunities for improvement.

In the three years of competition, we

identified several action steps that im-

proved the competition structure.

First, we changed our approach as to the

level of guidance provided to students

about the case study. Initially, the case

study was sent to students and little

guidance was provided, giving students

great flexibility in setting assumptions.

Although the lack of guidance may be

viewed as a positive, from an evaluation

standpoint, it was very difficult to figure

out which groups had made the most

optimal decision and why, especially

when referring directly to their support-

ing spreadsheets. Moreover, based on

the content of both their reports and

presentations, we learned the value of

stressing the need for contestants to fo-

cus on their thought processes and prob-

lem solving approaches, rather than

simply whether they got the “right an-

swer” in the end. These observations

helped us in formulating expectations

and guidelines that were communicated

succinctly in subsequent competitions.

Second, we discovered that sharing key

information concerning the oral and

written reports helped students to better

understand expectations. We created

and shared a document with students

called Points of Emphasis (see Appendix

3) that effectively summarized all the

general feedback we gave students after

the prior year’s competition and provid-

ed guidance to students concerning

presentation management and written

report structure. While such guidance

was beneficial for students, caution was

taken to avoid being overly prescriptive

to the point that team creativity may be

stifled.

(Refer Appendix 3)

Third, we extended the time given for

each student presentation and increased

the allowed length of their written re-

port. Because there were so many

groups (13 in total) participating in itera-

tion 1, the presentation times were re-

stricted to 8-10 minutes and the written

report’s maximum length was three

double-spaced pages. We discovered

that the time allowances and report re-

strictions stifled the effectiveness of stu-

dent performance. When we extended

presentation times to 15 minutes and al-

lowed five single-spaced pages on the

written reports, we observed, on aver-

age, more-relaxed, higher-quality

presentations and reports that contained

stronger analysis, relative to iteration 1.

Finally, we have struggled with the bal-

ance between encouraging students to

participate vs. suggesting (or requiring)

certain prerequisites, which will effec-

tively limit participation. In our first

two years of competition, advertised

prerequisite for our competition has

been a single semester of an introductory

corporate finance class (for which all

business students must take, usually

during their junior year). However, it

has become apparent that the selected

cases gave students with upper-level

business courses students a significant

advantage over students who had not.

We also discovered that since students

were allowed to self-select their own

groups, this potential gap in knowledge

from prerequisite classes could be quite

large. Although we have discussed im-

posing constraints on group formation,

we ultimately decided against it, think-

ing that such constraints would serve as

a significant disincentive for students to

participate. In general, we have ob-

served that the broader the background

of contestants in a team in terms of busi-

ness disciplines, the richer the final out-

put of that team.

From the faculty’s point of view, as-

sessment of the case competition re-

quires a significant time commitment.

Finding ways to minimize this commit-

ment is achieved through assessment of

the competition structure. We estimate

the time spent on assessment was 6.7

hours per faculty member in year 1, but

only 4.7 hours in years 2 and 5.0 hours in

year 3. This reduction in faculty time

was achieved through offering greater

guidance to students at the outset of the

competition, thus eliminating some of

the deviation in output and analyses

submitted by student teams. Further-

more, faculty who are judging for the 2nd

or 3rd times can rely on their past experi-

ences to expedite the assessment process.

For a complete breakdown of faculty

time spent per phase per iteration, see

Appendix 5.

(Refer Appendix 4 and 5)

V. The Feedback Phase

The feedback phase consists of feedback

from the faculty team to student compet-

itors as well as feedback from student

teams to participating faculty members.

In this section, we will discuss each type

of feedback flow in turn, and also men-

tion some limitations of our competition

structure.

A. Feedback from Faculty to Students

In all three years, the competition con-

cluded with an awards ceremony. Hav-

ing a formal ceremony elevated the exer-

cise and added prominence both at the

institution and potentially with the local

business community. However, before

the winners were announced, the faculty

team provided general overall feedback

to all participants. Such feedback in-

cluded the primary strengths and weak-

nesses observed from both the oral

presentations and written report, and fo-

cused on elements that separated the

winning teams from those who did not

place. We also provided information on

the specific nature of the case just com-

pleted. Since there were multiple solu-

tions possible, we noted that decisions

made by the groups needed to be well

supported. We also mentioned that the

winning groups achieved success based

largely on how they communicated their

results, and not just based on what their

results actually were. At the conclusion

of the faculty comments, participating

groups were encouraged to visit with

faculty members to obtain more detailed

feedback, which many groups did.

B. Feedback from Students to Faculty

Students also played a role in providing

feedback about the case competition, as

their responses contributed to the ongo-

ing assessment of process. In general,

student competitors enjoyed the compe-

tition. In all three years, faculty team

members heard from students who re-

quested more competitions since they

found the event to be a valuable oppor-

tunity to enhance their business skills.

After the initial competition, we admin-

istered an exit survey, but it focused

more on the competition’s structure and

guidelines along with the specific as-

pects of the given case. For the 2nd and

3rd years of our competition, we adminis-

tered an expanded exit survey to our

students, focusing on any improvement

in skills used during the competition

that would supplement the more typical

skills taught in the classroom. This sur-

vey can be found in Appendix 4, and

representative results are discussed be-

low.

When asked about their experience, the

most frequently observed response re-

volved around the team building aspects

of the competition. Many students com-

mented that working under time pres-

sure was a valuable experience, especial-

ly in the context of preparing them for

their future careers as potential business

consultants. Others noted their enjoy-

ment of the earlier stages of the project,

where group members had to brain-

storm for different ideas, discuss each

idea in turn, and ultimately come to a

consensus. By-products of this process,

mentioned by several students, were

conflict resolution and task allocation.

Still, other groups admitted to learning

about professionalism, both when speak-

ing in a more formal setting and when

writing a proper business memo, where

clarity, succinctness, and structure were

highly emphasized.

When asked about case content, student

responses focused mostly on broad skills

needed to be successful on the project,

such as demonstrating and enhancing

their spreadsheet skills or incorporating

qualitative and contextual factors into

their decisions. In addition, some stu-

dents commented about the research

skills that were required for success.

C. Limitations of our Competition Struc-

ture

There are three primary limitations with

respect to our model structure. First, we

did not provide feedback that is individ-

ually tailored to groups (or to the indi-

viduals within those groups). The large

number of groups and the compressed

timeframe for which the competition cy-

cle runs made it challenging for faculty

to find additional time for group feed-

back, although we acknowledge that this

would be quite beneficial. Second, there

is a potential ‘free rider’ problem; that is,

some students may do well just from be-

ing in a strong group, and subsequently

get both prize money and a resume

builder that does not necessarily reflect

their own individual effort and accom-

plishment. Third, partly because we

suggested a course prerequisite that is

not typically taken until one’s junior

year, there are very few students who

can participate in our competition more

than twice. Thus, it is difficult for us to

measure the extent to which their busi-

ness skills improve from their experienc-

es from prior competitions.

VI. Conclusion

In its career advice area, Monster.com

reports 100 possible interview questions,

many of which relate to team work, time

management, and problem solving. It is

clear from these questions that today’s

employers are seeking graduates who

have more than just a rudimentary

knowledge of core academic concepts.

The ability to deal with ever-changing

business situations, and find or provide

meaningful solutions is viewed quite fa-

vorably among employers, especially if

the prospective hire has satisfactorily

completed all the related, required

coursework.

Case competitions provide an oppor-

tunity to make business education mean-

ingful to business students, especially if

the competition is well organized, while

providing students an opportunity to

prepare for upcoming career challenges.

For example, competitions enable stu-

dents to deal with the challenge of deliv-

ering results under pressure, given an

enigmatic real-world business problem.

In this paper, we have provided a dis-

course of recommendations that aid

running a short undergraduate business

case competition that can seamlessly fit

into both student and faculty schedules,

while also achieving desirable business

learning outcomes. For the majority of

students and faculty who participate, the

experience is not just rewarding from an

intellectual perspective, but also an op-

portunity to develop and nurture com-

mon interests with one’s peers.

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on Teaching Behavior: An Investiga-

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and Interactive Practice, Journal of

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Marketing Themselves. The New

York Times, May 23, BU10.

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http://career-advice.monster.com/job-

interview/interview-questions/100-

potential- interview-

questions/article.aspx

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Competition (2011):

http://www.cba.neu.edu/nuhmc/ibcc/

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University of Dayton Oral Presentation

Rubric (2010):

http://assessment.udayton.edu/howto%2

0tips/Rubrics/presentation%20rubric

%- %20teach-nology.htm

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CA: Sage.

Appendix 1 : OUTLINE OF SCHEDULE FOR COMPETITION

Friday

10:00 am - 10:15 am – Copies of the competition guidelines and schedule will be distributed to each

group of students. This will be followed by a brief introductory presentation that reviews both the

schedule and guidelines. A random draw for Saturday’s presentation times will be conducted. Final-

ly, an announcement will be made as to which faculty members will be responsible for answering cer-

tain questions. LOCATION: XXX

10:15 am - 12:00 pm – Each team meets alone (at the location of their choosing) to read over the pro-

ject, and to develop their ‘plan of attack.’ Ideally this time could also be used to start doing some re-

search; this could consist of a review of both Principles of Finance I or Theory of Interest (in Actuarial

Science major) textbooks (where applicable) and/or an Internet search (relating to tax/accounting as-

pects of the problem). No faculty panel members will be present during this time.

12:00 pm - 12:30 pm – Lunch is provided to all teams. Faculty members may be present for lunch, but

will refrain from answering project-related questions until after lunch. LOCATION: XXXX

Saturday

10:00 am - 10:15 am – Details about both the written report and oral presentation will be announced.

In addition, there will be an overview of the Saturday schedule, including the stipulation that all pro-

ject-related work must be completed and submitted by 2:00p. It is now that we can be available to an-

swer any questions that teams feel comfortable asking in front of all the other teams. LOCATION:

XXXX

10:15 am - 12:00 pm – Ideally, this is the time during which teams will prepare their written report.

This is to be no more than three pages (plus any supporting tables and graphs), double-spaced, and is

to be written in the form of a memorandum to corporate management. Faculty members will be

available (again in their offices) to answer questions about the format/style of either the written report

or the presentation slides.

12:00 pm - 12:30 pm – Lunch is provided to all teams. Faculty members may be present for lunch, but

will refrain from answering project-related questions until after lunch. LOCATION: XXXX

12:30 pm - 2:00 pm – Each team returns to their separate locations; this is when the presentation slides

are developed (some team members may wish to use this time to also finish the written report if nec-

essary). Although 90 minutes does not seem like a lot of time to prepare slides, recall that this presen-

tation is to be short and succinct. Time management (under pressure) is key. If a team has adequate-

ly completed the project by lunch, there should be ample time to summarize their findings and

recommendations. Note that none of the faculty panel members will be present during this time.

ALL WRITTEN REPORTS AND SLIDE PRESENTATIONS ARE DUE AT 2:00P, REGARDLESS

OF WHEN A TEAM IS SCHEDULED TO PRESENT. SUBMISSION OF BOTH THE WRITTEN RE-

PORT AND SLIDE PRESENTATION IS TO BE DONE ELECTRONICALLY AT/BEFORE 2:00P (SO

TEAMS WILL NOT NEED TO PRINT THEIR SUBMISSION).

2:20 pm - 5:00 pm – In succession, all teams will present their findings and recommendations. Each

team will have 8 minutes to complete their talk, and depending on timing, we’ll have an additional 1-

2 minutes to ask a question or two. The talks will be scheduled exactly 10 minutes apart, so that we

can finish by 5:00p. Staying on schedule is paramount (and in extreme circumstances, talks may be

cut short if continuing on for too long). Presentations are open to the public, but other teams may

only sit in after they have given their own presentation. In the event that the room becomes too

crowded, teams that have been around the longest will be asked to leave. XXXX

5:00 pm - 5:30 pm – After all students have been dismissed, the panel of faculty judges will meet to

rank the group presentations. Ideally, individual preliminary rankings/ratings will be already done,

so this time will be used to simply pool results and discuss some of the stronger team presentations in

more detail.

Sunday

The faculty judges will individually review the written reports.

Monday

The faculty judges will meet briefly on Monday (perhaps during the lunch hour) to compile individu-

al ratings/rankings for the written reports. Finally, these results can be combined with those for the

oral presentations to form our overall winners.

5:00p-5:30 pm - The top 5 teams overall will be recognized, based on a 50/50 split between points as-

signed to the written report and oral presentation. However, only the top 3 teams will receive cash

awards (4th and 5th place get honorable mention). Dean (or other selected personality) will announce

all the winners at this official ceremony. LOCATION: XXXX

5:30 pm - 6:00 pm – A brief reception (with drinks and appetizers) to follow the awards ceremony.

LOCATION: XXXX

Appendix 2A: Written Rubric2

Level 1 Level 2 Level 3 Level 4

Content

Grade _____

Poor; paper does

not convey stu-

dent under-

standing of all

subtleties in the

case.

Marginal; paper

conveys some

understanding of

case, but several

issues are not ad-

dressed adequate-

Good; paper con-

veys an adequate

understanding of

case, but could be

stronger.

Excellent; paper

conveys case un-

derstanding in an

interesting and

complete way.

Recommendation

Grade _____

Recommendation

is not clear or is

not supported

Recommendation

is clear but sup-

port is not well

developed.

Recommendation

is clear and sup-

ported

Recommendation

is clear and com-

pletely support-

ed.

Organization

Grade _____

Writing is disor-

ganized with

poor flow

Writing is some-

what organized

but contains some

weak areas.

Writing is orga-

nized

Writing is orga-

nized, interest-

ing, and easy to

read

Mechanics

(structure, gram-

mar & spelling)

Grade_____

Careless; paper

contains many

structural,

grammatical, or

spelling errors

Marginal; paper

contains 3-5 struc-

tural, grammati-

cal or spelling er-

rors.

Good; paper con-

tains 1-2 struc-

tural, grammati-

cal or spelling

errors.

Excellent; paper

contains no struc-

tural, grammati-

cal or spelling er-

rors

2 Rubric modified from one found at: Jill M. Bale and Donna Dudney, “Assessing and Developing

Writing Skills in Finance,” Regional Business Review, Summer 2002.

Appendix 2B: Oral Presentation Rubric3

Level 1 Level 2 Level 3 Level 4

Organization

Grade _____

Audience can-

not understand

presentation be-

cause there is no

sequence of in-

formation.

Audience has

difficulty fol-

lowing presen-

tation because

student jumps

around; loses

“big picture”

results.

Students present

information in

logical sequence

which audience

can follow.

Students present

information in

logical, interest-

ing or innova-

tive sequence

which audience

can easily fol-

low.

Mechanics

(Including presen-

tation aids)

Grade_____

Student's

presentation

had four or

more spelling

errors and/or

grammatical er-

rors.

Presentation

had three mis-

spellings and/or

grammatical er-

rors.

Presentation has

no more than

two misspellings

and/or gram-

matical errors.

Presentation has

no misspellings

or grammatical

errors.

Time Management

Grade _____

Poor time allo-

cation; group

was unable to

cover several

key points in

time allotment.

Marginal time

allocation –

group did not

cover one or two

key points in

time allotment.

Good time allo-

cation – group

covered all main

points but some

addressed hasti-

ly.

Excellent time

allocation – cov-

ered all main

points effective-

ly.

Delivery

Grade_____

Students are dif-

ficult to hear,

use excessive

filler, and/or use

non-verbal dis-

tractions.

Students use ex-

cessive filler

and/or non-

verbal distrac-

tions.

Students' voices

are clear. Very

few fillers/ non-

verbal distrac-

tions are pre-

sent.

Students use a

clear voice with

no fillers. No

non-verbal dis-

tractions occur.

Content

Knowledge

Grade_____

Students do not

communicate a

complete under-

standing of the

case.

Students com-

municate some

understanding,

but miss several

aspects of the

case.

Students com-

municate an un-

derstanding of

the case with

explanations.

Students

demonstrate full

knowledge of

case with well-

supported ex-

planations.

Appendix 3: Points of Emphasis Information Shared With Students at Initial Meet-

ing

Written Report:

1) You only have 3 pages to get your point across, so don’t spent much time re-

stating the problem; assume the judges already have familiarity.

2) Let us know your recommendation right away, preferably in the opening

paragraph. You could even have a ‘thesis statement’ at the conclusion of this

paragraph that summarizes your rationale (that will be developed).

3 Rubric modified from one found at:

http://assessment.udayton.edu/howto%20tips/Rubrics/presentation%20rubric%20-%20teach-

nology.htm

3) The remainder of your paper should address how your overall conclusion (al-

ready mentioned) was formed; that is, you should provide a high-level over-

view of the main points from your analysis.

4) Remember that you are a professional (e.g. a consultant or mid-level manag-

er) so that you should use a professional tone in your writing. That is, you

should avoid flower, informal language and clichés.

5) Any information that is only tangential to your main train of thought should

be relegated to appendices or attachments, rather than in your core report.

Oral Presentation:

1) Rehearse beforehand, and focus on sounding and appearing professional; that

said, business casual attire should be sufficient.

2) Although we do not require all group members to speak equally (or at all), it

might work better to have everyone participate at least in some capacity.

3) Face your audience, know the content on your slides without having to al-

ways look directly at the slides, and sound confident in what you say.

4) Don’t fill each slide with too much information; each slide should contain one

or two main ideas. You can fill in the gaps with extra spoken words.

5) The presentation should be similarly structured to the report; state your con-

clusion early on, and spend the majority of your time offering support.

Appendix 4: Exit Survey given to Students at Conclusion of Competition

1) Comment on the structure of the competition. Specifically, did you feel

that the group size was about right? Also, do you feel that the 60/40 split

between the report (+ analysis) and the presentation is about right? If not,

what would you change?

2) Comment on the timing of the competition. Was it scheduled during the

appropriate time of the semester/year? Was the length of time your group

had to spend to complete the given tasks about right? Too much? Too lit-

tle?

3) Important: What, if anything, did you learn about group work, business

writing, and public speaking?

4) Important: What, if anything, did you learn about corporate finance and

time value of money, specifically with respect to capital budgeting analy-

sis or tax/accounting considerations?

5) Was the case itself clear? Was enough information provided for you to

adequately address the recommended tasks? Would you recommend this

case, or a version of it, be used again?

Appendix 5: Faculty Time Spent in Each Phase by Year

Phase

Average time per faculty

member

2010 2011 2012

Planning 15.7 hours 5.0 hours 6.2 hours

Execution 12.3 hours 12.3 hours 10.0 hours

Assessment 6.7 hours 4.7 hours 5.0 hours

Feedback 3.0 hours 2.3 hours 2.2 hours

TOTAL

37.7 hours

24.3 hours

23.4 hours

Additional notes:

• Three faculty members participated in each year

• 35.4% reduction in time spent in 2011 v.2010, 3.7% reduction 2012 v.2011

• Planning differences due to choices made in case selection (published in 2011

and 2012 vs. written by faculty team in 2010)

• Assessment differences due to greater initial guidance provided to students.

Authors

Jill M. Bale, School of Accountancy, University of Nebraska–Lincoln,

[email protected]

Jimmy Senteza, Associate Professor, Department of Finance, College of Business

and Public Administration, Drake University, [email protected]

Toby A. White, Assistant Professor, Department of Finance/Actuarial Science, Col-

lege of Business and Public Administration, Drake University, to-

[email protected]

Acknowledgments

This paper was presented at the FEA (Financial Education Association) Annual Conference in Octo-

ber 2010 (@San Antonio, Texas). The authors would like to thank Roger Brooks for his generous fi-

nancial support of the Brooks Weekend Case Competition (2010-2012).

Midwest Bancshares, Inc.

Heather Muehling, & Edward C. Lawrence

Midwest Bancshares, Inc. (MBI) is a large multibank holding company located in Lit-

tle Rock, Arkansas. In 2013, MBI is considering acquiring a small bank in St. Louis,

Missouri by the name of Quality Bancshares. This is a very detailed case study based

on real institutions that allows students to experience the difficulty of making bank

merger or holding company acquisition decisions with missing and conflicting data.

The case introduces three of major valuation methods for determining an appropri-

ate price for acquisition. While the case does require some number crunching for

valuation purposes, students should also be encouraged to go beyond the numbers

and draw on their knowledge of organizational behavior and other functional areas

of business in their analyses and recommendations. The case is intended for an ad-

vanced undergraduate or graduate course in Commercial Bank Management.

History

Midwest Bancshares, Inc. (MBI) can trace

its roots back to 1935 when a well-

known financier, Alexander Banks, came

to Little Rock, Arkansas with $20,000 in

his pocket for the purpose of starting his

own bank. Mr. Banks was brought up in

an upper-middle class family, where the

majority of the children chose occupa-

tions within various financial sectors.

Alexander’s passion had always been

banking, which is what drove him to

strike out on his own at the age of 32 to

start a bank with a “different” kind of

philosophy.

Alexander strongly believed that many

of his fellow banking colleagues had lost

sight of the real reason why banks suc-

ceeded at this time, the customer. His

stated philosophy was as follows, “pro-

vide value-added service to our custom-

ers, whereby we eliminate any reason for

competition”. Mr. Banks promoted this

philosophy, which we call “community

banking” today, and has watched it

flourish well into the 21st century.

Where are they now?

Today, MBI operates as the parent hold-

ing company for Central Bank Midwest,

N.A., located in the Midwest. Currently,

Central Bank Midwest has over 275 loca-

tions in Missouri, Kansas, and Arkansas.

It employs approximately 3,500 people

with their headquarters located in Little

Rock, Arkansas. In addition, MBI owns

several non-banking subsidiaries that are

involved in real estate, mortgage bank-

ing, and brokerage services.

Strategic Management Plan

Midwest Bancshares is faced with both

short-term and long-term strategic is-

sues. Immediate concerns for the bank-

ing industry center on slower revenue

and deposit growth and credit quality

issues. But in longer terms, all financial

service institutions should be focused on

increased use of technology, a motivated

and well-trained employee base, and a

consistent business philosophy of part-

nering with customers. As always, bank

management is strongly focused on cre-

ating shareholder value. In order to

achieve this goal, Midwest Bancshares is

focusing on the following key compo-

nents of high asset quality, revenue

growth through a growing customer

base, and continual reinvestment in

people, technology, and products.

Financial Status of MBI – Year 2012

Overview

According to MBI’s most recent calendar

year-end, December 31, 2012, the com-

pany reported a slight decline in its fi-

nancial performance as compared to

previous years with combined total as-

sets of approximately $22,038M (See Ex-

hibit 1-3). However, the Company

achieved its 10th consecutive year of rec-

ord earnings in 2012, with net income of

$357 million, a 7.4% increase over net in-

come in 2011. In addition, the return on

average assets was 1.62%, and the return

on equity was 16.22%.

Balance Sheet Analysis

Overall asset quality has remained

strong for MBI throughout 2012. Net

loan charge-offs totaled 0.38%, com-

pared with 0.41% (See Exhibit 4) in the

prior year. Allowance for loan loss in-

creased by $11 million to $257 million, or

1.62% of total loans. In addition, non-

accrual loans totaled $39 million (See

Exhibit 5), higher than in the previous

year, but still only 0.27% of total loans

and a very low level compared to MBI’s

peers.

Loan Portfolio Analysis. This brings

us to the discussion of MBI’s loan

portfolio (See Exhibit 6). A bank’s

loan portfolio combined with its, de-

posit base are the keys to its contin-

ued success. Total loans grew $660

million, or 4.4%, during 2012 com-

pared to growth of $1.1 billion, or

7.5%, during 2011. The growth in 2012

came principally from personal bank-

ing, business real estate, and business

loans, which grew 8.7%, 4.6%, and

3.7%, respectively. Additionally, other

banking consolidations in a number of

the Company’s markets provided the

Company an opportunity to establish

new customer relationships.

The Company currently generates

approximately 43% of its loan portfo-

lio in Arkansas, 22% in the St. Louis

regional market, and 35% in the Kan-

sas City regional market. The portfo-

lio is diversified from a business and

real estate standpoint, with 55% in

loans to businesses and 45% in loans

to individual customers. A balanced

approach to loan portfolio manage-

ment and an aversion toward credit

concentration have enabled the Com-

pany to sustain low levels of problem

loans and loan losses.

Deposit Base Analysis. Deposits are

the primary funding source for the

Company’s loans, and are acquired

from a broad base of local markets,

including both individual and corpo-

rate customers. On a yearly average

basis, deposits decreased $634 million

(See Exhibit 7), or (3.4%), during 2012

compared to 2011. This has caused

some banks within the Company to

incur higher incremental borrowing

costs to fund asset growth. The Com-

pany has resisted raising deposit rates

in order to attract higher deposits. A

strong liquidity position has enabled

it to keep funding costs lower without

deposit growth, and still profitably

fund its loan growth.

Income Statement Analysis – Year 2012

As stated previously, MBI experienced a

record year in terms of earnings for 2012

(see Exhibit 2). The increase in net in-

come was a result of a 3.1% growth in

net interest income (before provision for

loan losses), a 7.0% growth in non-

interest income, and flat credit costs.

This was partially offset by non-interest

expense, which was controlled to a 2.7%

increase.

Net Interest Income. Net interest in-

come increased $30 million over last

year mainly due to annual loan

growth of $1.2 billion coupled with

increased earning assets rates. Also

loan growth was mainly funded by

maturities of investment securities,

which generally yield lower rates than

loans, thus creating a more profitable

asset mix.

Non-Interest Income. Non-interest in-

come raised to $33 million, mainly in

the areas of credit card fees, and trust

revenues.

Non-Interest Expense. Non-interest

expense was $860.8 million in 2012,

which represented a 2.7% increase

over 2011. Salaries and employee ben-

efits, the largest components of non-

interest expense, were well controlled

during 2012. Salary increases were

held to a 3.1% increase in 2012 com-

pared to a 7.5% increase in 2011, and

employee benefits decreased slightly

in 2012, compared to a 16.2% increase

in 2011. The rise in salary expense was

due to additional employee incentive

payments and merit increases. This

rise was partly offset by a reduction in

full-time equivalent employees. The

benefits decrease occurred because of

a reduction in pension plan expense,

resulting from lower service cost ben-

efits earned and increases in the value

of plan assets.

MBI’s Peer Group Evaluation

Peer Evaluation Benchmarks

Each quarter MBI receives a banking

publication distributed by a local in-

vestment firm. Within this publication,

MBI is compared to other banks with

similar asset sizes, which is called in the

industry a “Peer Group”. In most cases,

the five most commonly evaluated

benchmarks are: Return on Assets

(ROA), Return on Equity (ROE), Net In-

terest Margin (NIM), Total Equity/Total

Assets, and Average Loans/Average De-

posits (Loan-to-Deposit) (See Exhibit 8).

The ratios most commonly evaluated in

terms of a bank’s profitability levels are

ROA, ROE, and Net Interest Margin.

First, a bank’s ROA is defined as net in-

come divided by average or total assets.

This ratio measures a bank’s profits per

dollar of assets. Therefore, a bank is con-

sidered a good-performer the greater the

ROA percentage. The same is also true

for the second profitability benchmark,

ROE. ROE is the amount earned on a

company’s stock investment for a given

period, and is defined as net income di-

vided by average equity.

The last important profitability bench-

mark, NIM, is defined as net interest in-

come divided by average total assets,

where net interest income (NII) equals

interest income minus interest expense.

NIM is viewed as the “spread” on earn-

ing assets (loans and securities). Once

again, typically, the greater the spread,

the greater the bank’s profitability.

In terms of a bank’s balance sheet, both

Total Equity/Total Assets and Average

Loans/Average Deposits ratios are most

commonly analyzed. Total Equity/Total

Assets ratio measures a bank’s capital

adequacy. Typically, a bank with an eq-

uity ratio in the range of 8.0% -10.0% is

considered average. However, anything

substantially greater than this may be

considered over-capitalized, and any-

thing significantly lower may be consid-

ered under-capitalized.

Lastly, the Loan-to-Deposit ratio is a

measure of bank’s liquidity, indicating

the extent to which deposits are used to

meet loan demands. The lower the ratio,

the more liquidity a bank has and vice-

versa.

Peer Group Analysis – Deposit Market

As of December 31, 2012:

• The Company’s deposit market share

ranks 2nd in the St. Louis Metropolitan

Statistical Area (MSA).

• The Company ranks 2nd in deposit

market share in St. Louis County,

Missouri with a 24.5% market share.

• The Company ranks 1st in deposit

market share in St. Charles County,

Missouri with a 29.5% market share.

MBI Approached by Local Investment

Firm

MBI’s business philosophy is one that

centers on its continuing need for

growth. Conner Ashton, MBI’s Chief Fi-

nancial Officer, is the man responsible

for evaluating potential acquisitions.

Approximately once a week, Mr. Ashton

is notified of a bank in some part of the

country that is putting itself up for sale

or evaluating its strategic alternatives.

Part of Mr. Ashton’s job is to analyze

these sale notices to see whether or not

they would be a good addition to MBI.

In June 2013, Quality Bancshares Com-

pany (Quality Bancshares), a one-bank

holding company located in St. Louis,

Missouri, retained a local investment

firm, Stanley, Nolls, and Company, Inc.

(Stanley), for the purpose of locating an

interested buyer for their subsidiary,

Quality Bank (Quality). On July 5, 2013,

Mr. Ashton received a formal letter from

Stanley stating Quality Bancshares inten-

tions of placing Quality onto the auction

block (See Exhibit 9) and a Confidentiali-

ty Agreement (See Exhibit 10) to sign

prior to receiving any information re-

garding Quality.

Mr. Ashton reviewed the investment

firm’s letter with MBI’s Chief Executive

Officer, Michael Easel. Mr. Easel and Mr.

Ashton agreed that Quality initially ap-

peared to be an acquisition that might fit

nicely into MBI’s current strategic man-

agement plan. Therefore, on July 6, 2013

Mr. Ashton responded by signing the

Confidentiality Agreement and return-

ing it to Stanley.

The Target – Quality Bancshares Com-

pany History

Quality was organized as a de novo in-

stitution in 1992 by a group of local

businessmen to provide personalized

banking services to small businesses

with annual sales of $10 million or less

and to individuals 55 year of age and

older (primarily as a funding source). As

Quality grew, it maintained a core de-

posit-funding base provided by its

commercial borrowers and local retail

customers. Management has kept a fo-

cus on excellence in customer service to

both of the Company’s market segments.

Loan growth has remained constant and

steady throughout the Company’s histo-

ry.

Ownership/Key Personnel

Al Conway, age 62, was one of the origi-

nal founders of Quality Bancshares back

in 1992. Prior to this, his career in bank-

ing was when he took his first position

with Boatmen’s Bank. For the next 18

years, Mr. Conway held several posi-

tions with Boatmen’s while also graduat-

ing from the Stonier School of Banking.

From 1992 to the present, Mr. Conway

has held the positions of President and

Chief Executive Officer for Quality

Bancshares.

In terms of ownership, Quality

Bancshares currently has 246 sharehold-

ers with 1,948,626 outstanding shares of

common stock as of April 30, 2013. Of

these shareholders, Senior Management

and Directors own approximately 75

percent. The largest shareholder among

these individuals is Mr. Conway, who

owns approximately 53 percent. The re-

maining 25 percent stock interest is dis-

tributed among individual investors.

As majority stockholder, Mr. Conway –

age 62, has decided that he is ready to

venture out and start-up his own bank.

After approximately 40 years in the

banking business, Mr. Conway has affil-

iated himself with several high-powered

local banking contacts that have agreed

to invest the necessary capital that

would be required for the initial start-

up. Even though Mr. Conway is still in

the initial planning phase, he has target-

ed Crestwood, Missouri (southern sub-

urbs of St. Louis) as the bank’s first loca-

tion site.

In terms of personnel, the bank also em-

ployed four people in key roles for their

lending, compliance, accounting, and

operation divisions. Each one of these

division manager’s had worked for

Quality for at least five years, and were

considered by Quality to be inherent to

the bank’s continued success. However,

together they only had 25 years of com-

bined banking experience.

Strategy

As stated previously, Quality Bancshares

strategy is to provide full-range banking

services coupled with outstanding cus-

tomer service to two primary targets: in-

dividuals 55 years of age and older (gen-

erally as depositors) and small

businesses with sales of $10 million or

less (loan and deposit customers). Quali-

ty’s target market is defined as business-

es and individuals within a three-mile

radius of its locations. These locations

are in the cities of St. John (northern

suburbs), Afton (southern suburbs), and

St. Charles (western suburbs).

The Bank utilizes customer calling, local

newspapers, and direct mail to attract

deposits and loans. Their current busi-

ness plan identifies a 20% annual growth

rate for loans and deposits. Manage-

ment and the board of directors have

targeted profit levels of a 4% spread be-

tween yields on loans and cost of funds,

a 1.00% ROA, and 14% ROE.

Management believes the Bank is able to

compete effectively in its market due to:

(a) personalized, expert customer ser-

vice, (b) lending officers and senior

management maintaining strong rela-

tionships with commercial customers, (c)

quick reaction to loan requests, (d) the

extensive experience of management,

and (e) industry consolidation, which

has resulted in fewer independent banks

addressing the Bank’s target market

niche. The Bank employs dedicated per-

sonnel at each location with experience

in the target market areas.

The Bank has always operated as a loan

driven company and increased deposits

as required by its loan portfolio. The

Bank has expanded its deposit base to

meet loan growth demands with promo-

tional activities, an infinity group target-

ed towards senior citizens, and favorable

public relations.

Financial Status of Quality Bancshares

As of April 30, 2013, Quality Bancshares

held $476 million in assets, $448M in de-

posits, and $28 million in common equi-

ty (Exhibits 11). Historical profitability

has been impacted by growth as assets

have grown from $300 million in 1999 to

$476 million in April 2013. In 2012, man-

agement focused on improving profits,

reporting net income of $3.4 million with

an ROE of 11.94% (Exhibit 12). For the

four months-ended April 30, 2013, the

Company earned $1.3 million (annual-

ized represents earnings of $3.9 million),

a ROE of 14.78% (Exhibit 13).

Over the past five years (2008-2012), the

Company has experienced the following

compound growth rates: Assets- 29.9%,

Loans- 31.4%, Deposits- 29.0%, Equity-

16.8%, Net Interest Income- 24.2%, and

Net Income- 23.0%. While the Company

has been experiencing these strong

growth rates, management has contin-

ued to focus on asset quality.

Balance Sheet Analysis

As of 4/30/13, the Company appears to

have a relatively strong balance sheet.

According to Exhibit 11, total assets have

continued to rise for the last three years

with an all-time high in the first 4

months of 2013. The Company has no

long-term debt and no intangible assets.

Loan Portfolio Analysis. Quality’s

lending strategy is primarily a small

business focus with borrowers in a

variety of industries and generally

within a three-mile radius from each

branch (Exhibit 14). Their loan portfo-

lio is composed of real estate secured

loans, as well as unsecured lines of

credit and working capital lines to

private owner-operated businesses in

St. Louis.

Traditionally, a majority of Quality’s

loan portfolio has used real estate as

an integral component of a credit’s

underlying source of collateral. Man-

agement expects real estate to contin-

ue to be a major factor in future loan

relationships, but is also trying to re-

spond to the marketplace’s competi-

tive pressures to develop a wider ar-

ray of customers and further

diversification in the portfolio.

In terms of Quality’s lending person-

nel, it is currently made up of experi-

enced lenders and loan referrals from

the Company’s board members. The

Company has also increased its focus

on customer retention to avoid having

to continually seek new lending rela-

tionships.

Taking a look at Quality’s loan portfo-

lio, the Company has been able to

grow consistently over the last five

years (2008-2012). According to

4/30/13 financial statements (Exhibit

11) the Company has reached an all

time high of $338 million in loans. In

terms of the Company’s loan/deposit

mix, the commercial mortgage loan

balance carries the most weight at

45%, while residential mortgage loans

are the next in line with only 19.3% of

total loans (Exhibit 14).

Non-performing assets totaled $4.0

million (Exhibit 15), or 0.84% of total

assets at December 31, 2012 compared

to $4.1 million, or 1.03% at December

31, 2011 and $800,000, or 0.27% at De-

cember 31, 2010. What was the cause

for the large dollar increase? In 2011,

Quality took actions to “call” a loan in

the amount of $3 million dollars for

one of its largest commercial custom-

ers. Subsequently, the bank seized a

commercial strip mall that had been

placed as collateral for the loan. The

asset was placed on the books as a

foreclosed non-performing asset, also

known as other real estate owned

(OREO), while Quality continues to

look for an interested buyer.

Deposit Analysis. Quality’s retail de-

posit customers are the primary fund-

ing source and tend to be long stand-

ing depositors living in the Bank’s

branch market area, which are gener-

ally the West and Northwest county

areas of St. Louis. Due to its relatively

young franchise and strong loan

growth, Quality has been fairly ag-

gressive in attracting funding.

Quality had total deposits of $429 mil-

lion at April 30, 2013 (Exhibit 16). Of

this amount, $284 million, or 66.3%,

consisted of certificates of deposits.

This large percentage is due to Quali-

ty’s typical customer being 55 years or

older in age. In addition, a concern of

the Bank has been its level of CDs

over $100,000 – which consists of ap-

proximately 6% of total deposits and

tend to be made up of city, county,

and local government depositors

within the Company’s primary mar-

kets, which prefer to conduct business

with banks headquartered in their ar-

eas.

A deposit base consisting primarily of

time deposits tends to be highly inter-

est rate sensitive. Likewise, the more

interest sensitive a specific pool of

customer funds are, the more difficult

it is to minimize deposit interest ex-

pense. Consequently, management

has made a point to try and limit the-

se types of deposits in the future.

Income Statement Analysis

Quality has experienced inconsistent

earnings for the last three years. As of

fiscal year-end (FYE) December 31, 2012,

Quality reported a net income of $3.4

million compared to $986 million in FYE

2011 and $1.6 million in FYE 2010.

Net Interest Income. Net interest in-

come prior to provisions has sus-

tained its largest increase as of De-

cember 31, 2009 with a reported total

of $15.2 million, or a 35.6% increase

over 2008. This significant increase is

due to a 23.96% growth rate in interest

income, while maintaining level inter-

est expenses.

Non-Interest Income. Non-interest in-

come has consistently increased over

the last three fiscal year-ends. As of

December 31, 2012, it reached an all-

time high of $970 thousand. At this

same time period, the ratio for non-

interest income to total revenues was

6.0%, down from 2011 of 6.86%.

Non-Interest Expense. Like non-

interest income, non-interest expense

has also continued to rise for the last

three fiscal year-ends. As of December

31, 2012, non-interest expense was re-

ported as $9.5 million, a 8.9% increase

from 2011.

Financial Projections

In preparation for Mr. Ashton’s presen-

tation to Mr. Easel concerning his final

recommendation, projected financial

statements were performed on Quality

Bancshares for 2013-2016 (Exhibits 17

and 18). These statements incorporated

key assumptions about the growth po-

tential for loans and deposits (Exhibit

19). In particular, the assumptions antic-

ipated strong growth in commercial

loans combined with large increases in

the demand deposits of commercial cus-

tomers.

Bank Valuation

Prior to making a purchase decision, Mr.

Ashton requested that the Corporate Fi-

nance Department compile a list of

banks that had acquired institutions sim-

ilar to Quality’s asset size (Exhibit 20).

By requesting this information, Connor

was hoping to see what other banks

were paying for a transaction of this size.

In order to gauge this, two forms of bank

valuations are generally analyzed:

Price/Earnings Approach (P/E) and Mar-

ket-to-Book Approach (Price/Book).

A bank’s P/E ratio reflects the value that

the bank’s earnings (EPS) command in

the marketplace. Therefore, a high P/E

ratio is preferred since the higher a

firm’s P/E ratio, the more highly its earn-

ings are valued by investors.

The second valuation approach,

Price/Book, compares the stock market

value of the bank to its book value as a

percentage. Alternatively, one can com-

pare the stock price per share to the book

value per share to get a ratio (e.g. 2 to 1).

A market-to-book relationship greater

than 100% implies that the firm is creat-

ing value, while a ratio less than 100%

suggests the firm is destroying value. At

the time of this merger proposal, the av-

erage range for these types of ratios was

typically between 150 to 200 percent

with some very attractive transactions

approaching 250%.

Market Competition and

Demographics

Expansion in St. Louis Market

Quality Bancshares operates in two sep-

arate areas of the greater St. Louis Met-

ropolitan Area through its two branches

in St. Louis County and its one branch in

St. Charles County. The Greater St. Louis

area is a bi-state region comprising 12

counties, five in Illinois and seven in

Missouri. A number of Fortune 500

companies are headquartered in St. Lou-

is, where affordable housing, good uni-

versities, a strong job market, and high

quality of life make it an attractive place

to live.

St. Louis Metropolitan Statistical Area

(MSA) Highlights:

• The St. Louis MSA has a population of

2.6 million and is expected to grow

2.45% until 2020 and be ranked 20th

among all U.S. MSA’s with 2.9 million

residents

• 77% of the St. Louis MSA lives in Mis-

souri and the balance in Illinois

• Labor force of nearly 1.4 million peo-

ple

• Median household income of $46,262

ranking 88th of 315 U.S. MSA’s.

• Households with annual incomes in

excess of $150,000 make up 3.9% of all

St. Louis County households. That

percentage is expected to grow to

4.3% of households over the next five

years.

• 53rd in 2012 per capita income, ex-

pected to improve to number 43 by

2035.

• 97% of firms have less than 100 em-

ployees.

• Seven Fortune 500 companies are

headquarters in St. Louis, which ranks

fourth among all U.S. metropolitan

areas. The 7 companies are Anheuser-

Busch-In-Bev, Express Scripts, Boeing

Defense Systems, BJC Health Systems,

Emerson Electric, Monsanto, and

Nestlé Purina PetCare Company.

• In addition, St. Louis is home to near-

ly 150,000 business firms.

• 23.9% of population has at least a

bachelor degree. The U.S. average is

23.0%.

St. Charles County Highlights

• St. Charles County has a population

of 278,000, and is expected to grow

14.6% to 2016.

• Median household income of $53,734.

• St. Charles has grown from a bed-

room community of St. Louis to hav-

ing its own business base, and experi-

enced a very high rate of growth.

Sources: The Regional Commerce and

Growth Association, Missouri Works

Labor Market Information, U.S. Census

Bureau, and SNL Securities.

Future Outlook

In the 4th quarter of 2012, Quality’s man-

agement set out on a three-year strategic

plan aimed at continuing the Bank’s

strong loan and asset growth record,

while improving profitability through a

combination of operating efficiency,

margin improvement, and fee income

growth.

Quality Bancshares improvement in

earnings is the result of a focus on net in-

terest margins between approximately

3.8% and 4.0%. These margins are above

those of the recent past and this im-

provement is the result of the Compa-

ny’s elimination of the holding company

debt, improved pricing of loans, and its

continued core deposit growth. The

Bank is also expecting an increase in its

efficiency ratio, driven primarily by the

fact that it should be able to grow its

earnings asset base without adding addi-

tional employees.

These levels of growth are in part the re-

sult of continued consolidation in the St.

Louis marketplace, growing reputation

of the Bank as a customer-oriented busi-

ness lender, additional lending capacity

resulting from this year’s preferred stock

offering, and the cumulative effect of re-

tained earnings.

Financing the Acquisition

One of the last steps that Mr. Ashton

was contemplating was how MBI would

finance the acquisition. As Mr. Ashton

looked over the specifics of the acquisi-

tion he said to him “The asking price

they have requested is 200% of book

value or a 2 to 1 ratio. Is that price rea-

sonable? And if so, how should we go

about financing this transaction? In the

past we have usually issued 100% stock

to avoid the reduction in potential earn-

ings. However, maybe this time since the

acquisition is so small we could pay

100% cash? Or what about borrowing a

portion of the amount needed? The

Federal Home Loan Bank has assured

me that they would lend us the money at

an 8% interest rate amortized over a ten-

year period. Or I guess I could even do a

combination of all three? Of course, I

need to figure out what would be in the

best interest of MBI, plus allow for some

sort of increased shareholder value for

Quality.”

Weighing the Facts – Yes or No?

Once due diligence was performed by

Midwest Bancshares audit staff, it was

now time for Mr. Ashton to make a deci-

sion. Before doing so, he sat down with

his Assistant Treasurer, Kate Long, as he

had done a hundred times in the past to

lay out a pro versus con checklist for the

potential acquisition (Exhibit 21). With

all of the variables to be considered such

as asset quality, customer base, retail lo-

cations, etc., this last step acted as a final

guide in determining Mr. Ashton’s final

decision.

Finally, Mr. Ashton asked his secretary,

Judy, to hold his calls for the rest of the

afternoon. It was now time for him to

make his decision. While sitting in his

elegant leather chair, he remembered

that Heather Lowrey, a financial analyst

down the hall, was currently taking a

Bank Management course at a leading

university in the state. “What the heck!”

he said to himself. “Why not bring

Heather in here and see what she thinks.

It sure couldn’t hurt to hear someone

else’s opinion.”

Typing rampantly on her computer,

Heather was working on her latest pro-

ject for MBI. All of a sudden, from

around the corner, Mr. Ashton appeared.

“Heather, how is that Bank Management

course that you are taking coming

along?”

Heather, pleasantly surprised that she

was sharing a casual conversation with

Mr. Ashton replied, “Mr. Ashton it is

quite interesting. I never knew all that

went into your job until I took this

course. It has been fascinating!”

Mr. Ashton responded, “Well Heather

for once you are going to put your

schoolwork to the test. You are just the

person I would like to use today as a

sounding board for our most recent po-

tential acquisition. Why don’t you come

into my office and let’s have a chat.”

Student Assignment

You are to take the role of a financial an-

alyst advising Mr. Ashton and the Board

of Directors. What decision would you

recommend that MBI make? Would you

vote yes or no for the acquisition? If yes,

at what price? Any buying conditions? If

you recommend against the acquisition,

why? Support your recommendation

with a sound written analysis, including

spreadsheet calculations that you feel are

appropriate. In determining a possible

value for Quality Bancshares, you must

use at least 3 valuation methods with

one of those being a NPV type of analy-

sis based on future cash flows.

Exhibit 9

Stanley, Nolls

& Company, Incorporated 802 West Capitol

Little Rock,

Arkansas 72201,

(501) 895-5000

July 5, 2013

Mr. Conner Ashton

Chief Financial Officer

Midwest Bancshares, Inc.

205 West Capitol

Little Rock, Arkansas 72201

Re: Opportunity to Purchase Quality Bancshares Company

Dear Mr. Ashton:

Quality Bancshares Company has initiated a process to solicit interest in the potential sale of its sub-

sidiary, Quality Bank. Specifics regarding the branch locations will be disclosed as part of the offer-

ing package. The sale will include the transfer of certain deposits, certain loans, and other assets at-

tributable to each branch office.

Since you may have a potential interest in making an offer for this bank, please find enclosed two

copies of our standard Confidentiality Agreement form for your consideration and signature. Please

keep one original for your records and return the other to me as directed below. Upon our receipt of

such agreement, we will send you financial and other materials pertaining to the branch for your re-

view.

Once you have received and reviewed the offering package, if you have any additional requests or

questions, please direct them to me at (501) 555-5511. No contact is to be made by you to the bank.

Stanley, Nolls, and Company, Inc. reserves the right to discuss with potential purchasers at any time

the terms of any proposal submitted by such party for the purpose of clarifying such terms. Until a

Purchase and Assumption Agreement is executed by Quality Bancshares Company, Quality shall

have no obligation to any prospective purchaser with respect to the sale of its branches.

Quality Bancshares Company shall have no obligation to accept any proposal, and expressly reserves

the right, in its sole and absolute discretion, to evaluate the terms and conditions of any proposal and

reject any and all proposals in its sole discretion, without giving reasons therefore, at any time and in

any respect.

Thank you for your interest. Please send the Confidentiality Agreement by mail to my attention at

the above address or fax to (501) 555-5512.

Sincerely,

John K. Foster

First Vice President

JKF: sk

Enclosure

Exhibit 10 Confidentiality Agreement

This CONFIDENTIALITY AGREEMENT, (the "Agreement") is made and agreed to by

Quality Bancshares Company, Inc., a Missouri corporation ("Quality"), with offices at

1485 Grand Avenue, St. Louis, Missouri 63102, and Midwest Bancshares, Inc. ("Com-

pany"), with offices at 205 West Capitol, Little Rock, Arkansas 72201 this _______day of

____________________, 2013.

In connection with consideration of a possible transaction between Quality

and Company involving the possible sale of all assets by Quality or its wholly-

owned subsidiary, Quality has prepared financial and other information concerning

the business and affairs which is proprietary and confidential (the "Evaluation Mate-

rials"). By entering into this Agreement, without our prior written consent, except as

required by law as advised by your counsel, you and your agents and employees

will not disclose to any person that discussions or negotiations are taking place or

have taken place concerning a possible transaction involving Quality or any of the

terms, conditions or other facts with respect to any such possible transaction, includ-

ing the status thereof. By entering into this Agreement and accepting the Evaluation

Material from Quality, Company agrees that any of the Evaluation Material that may

be furnished to it by officers, directors, employees, agents or advisors ("representa-

tives") of Quality and all analyses, compilations, studies and other material prepared

by Company or its representatives containing or based in whole or in part on any of

the Evaluation Material will be kept confidential and will be used solely to evaluate

the transaction described above and subject to the following:

1. Company recognizes and acknowledges the competitive value and

confidential nature of the Evaluation Material and the damage that could result to

Quality if information contained therein were disclosed to any third party and

agrees that in no event will it use the Evaluation Material to the detriment of Quali-

ty.

2. Company agrees that it will not disclose any of the Evaluation Material

to any third party without the prior written consent of Quality; provided, however,

that any such information may be disclosed to its employees, officers, and directors

(including those of affiliates), its agents and representatives including attorneys and

accountants and state and federal financial institution regulators who need to know

such information for the purpose of evaluating the transaction described above and

who agree to keep such information confidential and to be bound by this Agreement

to the same extent as if they were parties hereto.

3. Company agrees that without the prior written consent of Quality it

will not disclose to any person the fact that discussions or negotiations are taking

place concerning a possible transaction between the parties, or any of the terms,

conditions or facts with respect to any such possible transaction including the status

thereof; provided, that Company may make such disclosure if it has received the

written opinion of its counsel that such disclosure must be made by it in order that it

not commit a violation of law (in which case it shall notify the other party and its

counsel within a reasonable time prior to any disclosure it proposes to make con-

cerning the reasons for, and nature of, the proposed disclosure).

4. In the event that Company or its representatives are requested in any pro-

ceedings to disclose any of the Evaluation Material, it will give Quality prompt

notice of such request so that Quality may seek an appropriate protective order. If,

in the absence of a protective order, Company or any of its representatives is

nonetheless compelled to disclose any of the Evaluation Material, Company or its

representatives may disclose such information in the proceeding without liability

hereunder; provided, however, that Company or any of its representatives gives

Quality written notice of the information to be disclosed as far in advance of its

disclosure as is practicable and, upon the request and at the expense of Quality,

uses its best efforts to obtain assurances that confidential treatment will be ac-

corded to such information.

5. The foregoing restrictions with respect to information in the Evaluation

Material shall not apply to any information which a party can demonstrate (i) is or

becomes generally available to the public other than as a result of a disclosure by

Quality or its representatives, (ii) was available to Company on a non-confidential

basis prior to its disclosure by Quality, or (iii) becomes available to Company on a

non-confidential basis from a source other than Quality or its representatives, which

source was not itself bound by a confidentiality agreement.

6. In the event that a written agreement to proceed with the transaction

which is the subject of this letter is not entered into within a reasonable time or, up-

on the request of Quality, Company agrees promptly to deliver to Quality, all copies

of all Evaluation Material and any other written documents or memoranda contain-

ing or reflecting any information in the Evaluation Material (regardless by whom

prepared); not to retain any copies, extracts, or other reproductions in whole or in

part of any such material, and to destroy all other notes and other writings whatso-

ever prepared by it or its representatives based on the information in the Evaluation

Material, such destruction to be certified in writing to Quality by the authorized of-

ficer of Company supervising such destruction.

7. Company agrees not to communicate with any debtor, guarantor,

debtors or guarantor's accountant or attorney relative to any asset or liability of

Quality without Quality’s prior consent.

8. Both acknowledges that (i) the Evaluation Material is subject to the

confidentiality provisions of 12 C.F.R. Part 309 and may contain customer infor-

mation subject to the Right to Financial Privacy Act, and (ii) any unauthorized use of

the Evaluation Material may result in the imposition of criminal penalties under 18

U.S.C. Section 641.

9. Each agrees to indemnify and hold the other party and its representa-

tives harmless from all actions, liability and damages (including attorneys' fees and

expenses of defense) resulting from the breach of the obligations set forth in this

Agreement by it or its representatives.

10. Each party agrees that money damages would not be a sufficient rem-

edy for any breach of this Agreement by Company or its representatives and that, in

addition to all other remedies, Quality shall be entitled to specific performance and

injunctive or other equitable relief as a remedy for any such breach; and Company

further agrees to waive, and to use its best efforts to cause its representatives to

waive, any requirement for the securing or posting of any bond in connection with

such remedy. Company agrees to be responsible for any breach of this Agreement by

any of its representatives.

11. No failure or delay by a party or any of its representatives in exercising any

right, power or privilege under this Agreement shall operate as a waiver thereof,

nor shall any single or partial exercise thereof preclude any other or further exer-

cise of any right, power or privilege hereunder.

12. In case any provision of this Agreement shall be held to be invalid, il-

legal or unenforceable, the validity, legality and enforceability of the remaining pro-

visions of the Agreement shall not in any way be affected or impaired thereby. This

Agreement shall be governed by and construed in accordance with the internal laws

of the State of Missouri, without regard to conflict of laws principals.

IN WITNESS WHEREOF, the parties have executed this Agreement as of the

date first set forth above.

QUALITY BANCSHARES COMPANY,

INC.

By: _____________________________

Al Conway

President and Chief Executive Officer

MIDWEST BANCSHARES, INC.

By: ______________________________

Conner Ashton

Chief Financial Officer

Exhibit 19 - Midwest Bancshares, Inc. Assumptions for Projection Model for Qual-

ity Bancshares Company

Balance Sheet Growth

Assets:

Loans:

MBI Loans YR1 (10%) YR2 (5%) YR3 (5%)

Commercial R/E YR1 (15%) YR2 (10%) YR3 (5%)

Personal R/E YR1 (5%) YR2 (5%) YR3 (5%)

Const. & Land Dev. YR1 (15%) YR2 (10%) YR3 (5%)

Consumer YR1 (5%) YR2 (5%) YR3 (5%)

Participation YR1 (15%) YR2 (10%) YR3 (5%)

Allowance for Loan Loss Maintain existing level. 1.45% of loans at end of

year three.

Bond Portfolio Run-off per GAAP report (a report written using

GAAP principles)

Earning Assets Net funds provided

Non-Earning Assets Cash & Due From is same % as MBI

Fixed assets reduced by depreciation

OREO and Other no change

Liabilities:

Deposits:

Demand Initial reduction of $4 million in Year 1, off

set by growth YR1 (5%) YR2 (8%) YR3 (10%)

Int. Bearing Demand Run-off YR1 (7%) YR2 (8%) YR3 (3%)

Money Market Savings. $2 million run-off per year, offset by growth

YR1 ($1.8 million) YR2 ($2.2 million) YR3

($3.2 million)

Time Dep < $100,000 No net change year 1. YR2 and YR3 $2.5

million growth

Time Dep > $100,000 No change

Other Borrowings $4 million Trust Preferred Capitalization

Other Liabilities No change

Equity Grows by annual earnings

Income statement

Provision for Loan Loss 40 bps of loans for all three years

Non-Interest Income:

Deposit Charges Initially down, but growing with DDA

Other Fees Grow each year – Credit Card, ATM, Brokerage,

etc.

Misc. Income No change

Non-Interest Expense:

Salaries & Benefits Backroom reduction of 35 FTE’s at $25M, Branch

reduction of 9 FTE’s at $25M, and Sr. Mgmt. and

Secretary reduction of $155M. 5% annual growth

Occupancy & Equip. Close MBI St. Charles branch ($175M reduc-

tion)

Other Non-Interest 20%-75% reduction in existing expenses, resulting

in $750M YR1 and 5% annual growth each year af-

ter

Taxes 35%

Exhibit 21 - Midwest Bancshares, Inc.

Corporate Finance Department

*** Inter-Office Memorandum ***

_______________________________________________________________________

DATE: July 20, 2013 FROM: Conner Ashton

TO: John Easel RE: Pros/Cons –Quality Bancshares Co.

_______________________________________________________________________

Pros

1. Quality Bancshares does not presently offer a free checking product. Current-

ly, we are growing our free checking product at approximately 15% in the

St. Louis market alone.

2. The opportunity to double the non-interest income side of the income state-

ment due to our ability to sell multiple products to this customer base.

3. The ability to tap into Quality’s niche “55 and up” customer base, which is a

loyal customer base that we think we will be able to retain.

4. Low present book value of fixed assets on balance sheet. In order to build or

replicate existing site locations, we would have to purchase real estate that

costs $1.5 million +. Increased opportunity costs. (Additionally, we are to

receive $2.5 million for our present St. Charles location that we are selling –

our location is right up the street from Quality’s).

5. The bond portfolio is short and of high quality.

6. A customer base that fits our product offerings.

7. The holding company has a very low equity base (just under 6% of assets).

8. No evidence of brokered funding.

9. Tenure of Commercial Real Estate Portfolio is structure similar to Missouri

(three to five year balloons). We would have flexibility in dealing with the

portfolio over the next three years.

10. Lending is uncomplicated. Lack of exotic deals and/or structures.

Cons

1. Loss of service charges on the non-interest bearing transactional demand ac-

counts.

2. Bank has twice the size business banking loans as compared to MBI. Do not

believe all such loan relationships will be pushed out. However, in most

cases we would not have approved these types of borrowers under our un-

derwriting guidelines.

3. Locations are twice the size compared to our basic branch model. Increased

unused

space and decreased efficiency.

4. Consumer CD base is higher than what we are accustomed to managing.

5. Locked into $4 million dollars of expensive funding (in regards to $4 million

preferred stock offering in 2012).

6. Lack of credit card business.

7. Lack of diversification, whereby the bank does not have any fee based lines of

business.

8. Allowance for loan loss is low compared to Midwest Bancshares standards.

9. Lack of underwriting talent.

10. Ground zero on sales and marketing techniques – not receiving any human

resource value.

11. Compliance Department is problematic. Foreseen money penalties/lender lia-

bility issues to contend with.

12. While not bad quality, loan customer base is not “typical” Midwest

Bancshares. There could be a sizeable run-off as balloons mature over the

next three years.

13. HEAVY insider involvement, not only as customers, but as a sales referral

source. Loss of this base could impact operating conditions, on both sides of

the balance sheet.

Authors

Heather Muehling , Senior Financial Analyst

Edward C. Lawrence, Professor , Finance and Banking, University of Missouri – St.

Louis

Creating Equity Indices: A Case Exercise

Judson W. Russell, & Christopher Brockman

Abstract

Brooks Hamilton is a recent college graduate who joins a regional money manage-

ment firm. His first assignment is to create a stock index based on local firms for his

manager to include in her presentation to clients. Eager to make a good first impres-

sion, Brooks reviews his college notes on price-weighted and market-weighted indi-

ces and then begins his work. Along the way, he encounters stock splits and constit-

uent changes and makes appropriate adjustments to his indices. He provides a

report to his manager and makes his recommendation on which index to use.

Introduction

Brooks Hamilton arrived early for his

first day of work at Rising Tide Limited,

a Charlotte, North Carolina-based re-

gional money management firm for high

net worth individuals. He was eager to

get started and make a good impression

with the portfolio manager that he

would be supporting. He found that his

portfolio manager was already in her of-

fice and she motioned for him to come in

and have a seat while she wrapped up a

call. Brooks noticed that her office was

very orderly, unlike most of the profes-

sors’ offices from his college. His man-

ager had photos on the wall which

showed her with local celebrities, busi-

ness executives, and politicians. He

could tell that she was well-connected

and accustomed to spending her day

building her business. As she completed

her call she welcomed Brooks to the

firm. She told him that many of her cli-

ents are executives’ at large firms in the

area. Much of their net worth is concen-

trated in shares of their own firm. Over

the past several months she had been

working with her clients to diversify

their holdings, but several were reluctant

to take on shares in other firms since

they were so familiar with their own

company. She wanted to create a re-

gional index that would allow her clients

to compare their less diversified holding

with an index of large companies in the

area, but she didn’t have enough time to

gather the data and create the index.

Now that Brooks was on-board, this

would be his first task. She also men-

tioned that although some analysts came

into the office a little later in the day, she

expected him to be ready to start at 7:00

AM. Brooks thought he was off to a

poor start and wanted to get back on

track to let his manager know he was a

hard worker and capable of doing the

work. Brooks asked her to provide a bit

more information about the index as he

was eager to get started. She told Brooks

to get a list of firms in the Charlotte re-

gion that were included in the Fortune

500 and to create an index of the shares

of these firms so that her clients could

see the benefit of holding a more diversi-

fied portfolio. She explained that ideally

she would like to have an index with

more firms to gain a greater level of di-

versification, but that by focusing on lo-

cal firms the benefits would be more im-

pactful for her clients. Brooks recalled

from his college investments class that

there were a few ways to create an index

so he asked if she wanted a price-

weighted index or a market-

capitalization weighted index. He re-

called that there was another method

called, equally-weighted index, but

wanted to stick to just the first two to get

her response. She turned the question

around and asked him to do what he

thought would be the most appropriate.

He decided to do both and let her see the

strengths and weaknesses of both ap-

proaches. She asked Brooks to have the

material ready to review the following

morning so that she could use the infor-

mation in an important client meeting

later in the week. Brooks had brought

his college investments text and notes to

work thinking that they might come in

handy. He was happy that he had as he

flipped to the section on stock indices. It

looked like it would a late night for

Brooks.

Why index?

Why do we use indices? One of the key

methods for gauging performance in the

investments field is relative value. A

portfolio manager’s skill is often meas-

ured relative to a benchmark. The ques-

tion being addressed is, did the manager

produce risk-adjusted returns in excess

of the benchmark portfolio? For in-

stance, if the Standard & Poor’s 500 in-

dex had a 12% return for the year, did

the manager’s results beat this on a risk-

adjusted basis. The term ‘risk-adjusted’

refers to a method to express the portfo-

lio return in excess of the risk-free in-

vestment adjusted by the risk of the

portfolio. A standard term for this is the

Sharpe ratio, named after William

Sharpe. The Sharpe ratio is written:

[E(rp) – rf] / σp (1)

where: E(rp) = the expected return

on the investment portfolio

rf = the risk-free rate of return

σp = the standard deviation, or

variation, in the excess returns on

the investment portfolio

Using equation (1), a portfolio manager’s

relative performance, adjusted for the

risk of the portfolio, can be determined.

The expected return on the investment

portfolio is typically the simple arithme-

tic average of returns over a period of

time. The risk-free rate of return is often

the 10-year Treasury yield. The standard

deviation of the portfolio returns is the

variability in excess returns over the ob-

servation period, or risk. This risk pro-

vides a gauge of the likelihood of actual-

ly earning the expected excess return on

the portfolio. For instance, a high stand-

ard deviation suggests that the returns of

the portfolio fluctuate a great deal and

implies that the actual return could be

significantly greater or less than the ex-

pected excess return. A low standard

deviation suggests that returns are fairly

constant and increases the likelihood of

actually receiving the expected excess re-

turn. This risk-adjustment is crucial in

creating a relative performance bench-

mark.

For example, suppose the Standard &

Poor’s 500 index had a 12% annual re-

turn and a standard deviation of excess

returns of 25%. A portfolio manager

produced a return of 15% on her portfo-

lio over the same period, but with 45%

standard deviation. If the 10-year

Treasury yield is 4%, did the portfolio

manager beat the market on a risk-

adjusted basis?

S&P 500:[12% - 4%] / 25% = 0.32

Portfolio Manager: [15% - 4%] / 45% = 0.24

Although the portfolio manager had a

superior return than the market, the in-

creased variability of her portfolio pro-

duced a lower Sharpe ratio, which is

roughly translated as the excess return of

the portfolio per unit of risk. Having a

benchmark for comparison is important

and Brooks knows that his manager has

her performance measured relative to

others4. Therefore, indices are important

as a gauge of relative performance and

as a standard, or benchmark, for under-

standing the performance of the market.

Before getting started on the data gather-

ing, Brooks decided to refresh his

memory of index creation and opened

his text to review global stock indices.

Global Indices

There are many indices around the

world. This case highlights a few of the

larger, more relevant, indices. One ques-

tion that is often asked at financial firms

throughout the day is “how’s the market

doing today?” We can use the perfor-

mance of an index to provide a view of

market performance. There are a few

global standards for ‘the market’. The

most common equity index in the U.S. is

the Dow Jones Industrial Average, or the

DJIA for short. The first appearance of a

Dow Jones average was on July 3, 1884.

4 Performance attribution analysis is a preferred

method of gauging the performance of a portfo-

lio manager. This technique analyzes the portfo-

lio to determine investment style, asset alloca-

tion, and security selection. The example used in

this mini-case focuses on a single measure,

Sharpe ratio, since performance attribution is be-

yond the scope of this study—which is intended

to illustrate index creation.

It consisted of the closing prices of 11

companies trading on the New York

Stock Exchange, nine railroads and two

industrials. This index was created by a

relatively small news-distributing busi-

ness that opened in a small, unpainted

room at 15 Wall Street. The business

was founded by Charles Dow, Eddie

Jones, and Charles Milford Bergstrasser

and was known as Dow, Jones & Co5.

Currently there are three main Dow in-

dices, with the DJIA being the most

widely known. The other two are the

Dow Jones Utility Index and the Dow

Jones Transportation Index. The DJIA is

comprised of 30 companies. The stocks

comprising the DJIA have changed

through time due to acquisitions and

alignment of the constituents with the

current economy.6 The DJIA is a price-

weighted index which means that the

prices of the 30 constituent firms are

summed and then this figure adjusted

by a divisor to arrive at the index value.

The divisor would normally start at 30

for a 30 stock index and then adjust to

ensure that the index is consistent

through time.

5 For a wonderful history of Wall Street the read-

er should refer to Capital Ideas, by Peter Bern-

stein. 6 The most recent constituent changes were: Sep-

tember 14, 2012, Kraft Foods, Inc. was replaced

by UnitedHealth Group. On June 8, 2009,

Citigroup, Inc. and General Motors Corp. were

replaced by Cisco Systems Inc. and The Travelers

Companies, Inc. , September 22, 2008, American

International Group, Inc. was replaced by Kraft

Foods, Inc. February 19, 2008, Altria Group, Inc.

and Honeywell International were replaced by

Bank of America Corporation and Chevron Cor-

poration.

Figure 1. Creating a Three-Stock Price-Weighted Index

Stock Price at Close of Day

1 2 3 4 5

Stock A 112 113 114 113 111

Stock B 34 35 33 33 36

Stock C 10 11 12 13 15

Sum 156 159 159 159 162

Divisor 3 3 3 3 3

Index Val-

ue 52 53 53 53 54

Calculation (112+34+10)/3 (113+35+11)/3 (114+33+12)/3 (113+33+13)/3 (111+36+15)/3

Source: Authors

An illustration of a price-weighted index

is shown in Figure 1. In this example,

there are three firms in the initial index

(A, B, and C). At the inception of the in-

dex the prices of the three stocks are

summed and the result is divided by

three to get the initial index value of 52.

Each day, the prices are summed and

divided by three to produce a series of

index values. The figure shows that the

index increased in value from 52 to 54, or

3.85% [(54/52) -1], over the five-day peri-

od. It is interesting to note that Stock C

increased in value by 50% over this time,

from 10 to 15. The price-weighted index

is biased towards higher priced stocks.

Therefore, Stock A has the most impact

of the three stocks in this index, followed

by Stock B and then Stock C. As the

name implies, a price-weighted index is

based on stock prices and higher prices

have the most influence over the value of

the index.

Figure 2 shows the series value over the

time period. This figure plots the index

values of 52, 53, 53, 53, and 54 over the

five-day period. With more data the

time series plot will more closely resem-

ble the line charts that we see each day

in financial periodicals.

Suppose that on day 5, after the market

closes, firm C is acquired by firm D. The

index now needs to be adjusted to ac-

commodate the higher stock price of D,

which is trading at $50 per share versus

stock C’s $15 per share. If we simply

sum A, B, and D and divide by three, the

index increases from 54 to 65.67, or more

than 21%, however this is due to a con-

stituent change rather than performance.

We see this illustrated in Panel B of Fig-

ure 3. In order to create a consistent in-

dex we need to adjust the divisor to

maintain the index value. Panel C of

Figure 3 shows the mechanics behind

this adjustment and presents the new

divisor. We sum the three stocks (A, B,

and D), then divide by the prior index

value of 54 to attain the new divisor of

3.65. We will then use 3.65 for each sub-

sequent day unless there is a change in

the index.

Figure 3 depicts that constituent changes

require an adjustment in the divisor in

order to keep the index consistent

through time for comparison purposes.

Another instance when a divisor ad-

justment is required is when a company

issues a stock split. A stock split adjusts

the current price either down (stock

split) or up (reverse stock split) and ad-

justs the shares either up (stock split) or

down (reverse stock split). For instance,

suppose an investor owns 200 shares of a

stock trading at $80 per share. The in-

vestor’s holding is worth $16,000 = (200 x

$80). If the company initiates a 2 for 1

(2:1) stock split, then the investor will

now have 400 shares each worth $40 per

share. That is, the number of shares

doubled and the price was halved. The

net result though is that the investor’s

holding is still worth $16,000 = (400 x

$40).

Suppose the investor owns 2,000 shares

of a stock trading at $8 per share. The

investor’s holding is worth $16,000 =

(2,000 x $8). If the firm initiates a 1 for 2

(1:2) reverse stock split, then the investor

will now have 1,000 shares each worth

$16 per share. That is, the number of

shares was halved while the price dou-

bled. The net result is that the investor’s

holding is still worth $16,000 = (1,000 x

$16). Stock splits have no initial impact

on the investor’s holding, but will have a

material impact to a price-weighted in-

dex unless the divisor is adjusted. As

you recall, when we created the three-

stock index we did not include the num-

ber of shares anywhere in our calcula-

tions. Therefore, a stock split will impact

the price per share without any corre-

sponding adjusting to shares. To ac-

commodate stock splits in an index, the

divisor is adjusted.

Going back to our original three-stock

index example, we see that on day 5,

stock A had a price of $111. If the man-

agement of stock A decided to initiate a

6 for 1 (6:1) stock split, then the price

would fall to $18.50 ($111/6). Investors

will have their number of shares increase

by a factor of six and see not change in

their holding value. However, if we re-

duce the price of A from $111 to $18.50,

the index will have a material decline in

value. Figure 4 highlights the change in

index value without the necessary divi-

sor adjustment. Panel A represents the

starting value of the index with the in-

clusion of Stock D and the adjustment

process we followed from Figure 3.

Panel B of Figure 4 shows the price ad-

justment to Stock A for the 6:1 stock

split. The price of Stock A declined from

$111 per share to one-sixth of that

amount, $18.50 per share. As Panel B

shows, when we sum Stocks A, B, and D

we see the lower value of 104.50. Divid-

ing this value by the reported divisor of

3.65 results in an index of 28.63, a 46%

decline from the prior day. We know the

stock split had no net effect on the inves-

tor’s holding so why would we accept

this disruption in an index value? To

make the index more consistent, we ad-

just the divisor. Panel C of Figure 4

shows that by creating a new divisor of

1.94 the index retains its prior value be-

fore the stock split. To attain 1.94, we

sum of the prices of A, B, and D and di-

vide by the original index value of 54 on

day 5. We continue using this new divi-

sor of 1.94 for our index until there is

another change in constituents or stock

splits.7 The most common method for

7 In addition to stock splits, adjustments need to

be made for stock dividends as these are simply

modified versions of stock splits. A stock divi-

creating stock indices involves the mar-

ket capitalization of the firm, share price

times shares outstanding, rather than

just the price.8 While the DJIA or Nikkei

225 are well-known examples of price-

weighted indices, the S&P 500, Nasdaq,

FTSE 100, CAC 40, Euro Stoxx 50, Hang

Seng Index, and S&P/ASX 200 all utilize

some form of market capitalization in

their construction. Just as the price-

weighted indices are biased by high

price stocks, the market capitalization

weighted indices are biased by high

market capitalization firms. Let’s refer

back to our original example which in-

cluded Stocks A, B, and C and calculate

a market capitalization index. As the

name implies, market capitalization in-

dices include both share price and shares

outstanding. The primary variable is

still share price since shares outstanding

are relatively static over short time in-

tervals. Table 5 shows the index values

from stocks A, B, and C. In this example,

Stock A has 1 share outstanding, Stock B

has 8 shares, and Stock C has 150 shares.9

To attain the index value, Figure 5 shows

dend is a payment to investors in new shares

versus a cash dividend which obviously pays in-

vestors a cash amount. For instance, a 20% stock

dividend means that an investor with 100 shares

will receive an additional 20 shares. This is in

essence a 1.2:1 stock split. 8 Some capitalization-weighted indices use free-

float rather than shares outstanding in the

weighting process while others include the total

shares outstanding. There are differences among

indices in the capitalization-weighted category to

consider. In this study, we focus on total capital-

ization. 9 The reader can make these values in millions of

shares, if desired . The values were abbreviated

to 1, 8, and 150 for tractability, but can be 1 mil-

lion, 8 million, and 150 million with no change in

index value.

that you simply sum the products of

share price and shares outstanding. For

instance, at day 1 the value is deter-

mined as follows: (112 x 1 + 34 x 8 + 10 x

150) = 1884. Just as with the price-

weighted index, we use a divisor to

bring the sum of the market capitaliza-

tions into a less unwieldy value. In this

case we could apply a divisor of 18.84 to

get an index value of 100. The divisor

was initially selected to provide a stand-

ardized starting value. After establish-

ing this initial index value at day 1, we

can determine the index value each sub-

sequent day using the divisor of 18.84 as

shown in the second calculation line of

Figure 5. For instance, to get the index

value of 108.44 in day 2, we sum the

market capitalization of the three stocks

(113 x 1 + 35 x 8 + 11 x 150) and then di-

vide by 18.84 to get 108.44. Following

this approach we see the index value in-

creasing each day over the time period

and ultimately reach a value of 140.61 at

the close of day 5. This is an index in-

crease of 40.61% over the five-day peri-

od. In contrast to the price-weighted in-

dex, which increased by 3.85%, the

market-capitalization index reflects the

bias towards the high market capitaliza-

tion of Stock C and its rapid increase in

value. Although this example is extreme

it highlights the biases between these

two indices and shows that the index re-

turns can vary widely depending on the

index method chosen. As in our prior

example, we want to see how to adjust

for changes in the constituents in the

market capitalization-weighted index. It

follows the same approach as the price-

weighted index—we adjust the divisor

in order to keep the index value con-

stant. In Figure 6 we show Stock C be-

ing acquired by Stock D. We’ve added

the number of shares of D to our exam-

ple and see that the divisor, which we in-

itially set at 18.84 needs to be adjusted at

the close of day 5, the acquisition day, so

that the index value remains at 140.61.

The new market capitalization for close

of day 5 is: (111 x 1 + 36 x 8 + 50 x 65) =

3649. If we divide this figure by 140.61,

we get a new divisor value of 25.95121

which we round to 25.95 in Figure 6.

This is our new divisor for day 6 and all

subsequent days until another material

change occurs to the index.10 Again, as in

our price weighted example, what

would happen if Stock A had a 6:1 stock

split at the close of day 5? The price

would fall from $111 per share to $111/6

or $18.50 per share and the number of

shares outstanding would increase from

1 to 6. In other words the market capi-

talization would remain $111 and no ad-

justment would be needed for the mar-

ket capitalization-weighted index.

Data

Having refreshed his memory of index

creation including the impact of constit-

uent change and stock splits, Brooks was

ready to get the data to complete his as-

signment. He knew that there would be

a lot work involved to present both the

market-weighted and price-weighted

indices for his manager. Knowing that

there would be a lot of manual adjust-

ments he needed to make to create the

indices, and the fact that there were only

so many hours in the evening, he decid-

10 Material events would include a share issu-

ance, share repurchase, cash dividend, company

change, rights offering, spinoffs, and mergers.

For the market capitalization-weighted index a

stock split or stock dividend is immaterial.

ed that he would do a sample of just one

month’s data and perform the calcula-

tions for both indices. By seeing both

indices over a short period of time, his

manager could see the benefits and bias-

es of both and select the method that she

thought was best. Brooks could then

work on that one approach and complete

his work on time for his manager’s

presentation. He decided to take a sam-

ple of all Fortune 500 companies in the

Charlotte, North Carolina region for July

2012. He would gather daily prices and

perform the appropriate calculations to

create the indices. As Brooks starting

gathering data he found that there were

nine Fortune 500 companies for his indi-

ces. The list of companies and their re-

spective ticker symbols are found in Fig-

ure 7.

Brooks gathered the stock information

for each of these companies and down-

loaded the data which is presented in

Figure 8. He noticed that Duke Energy

had a 1:3 reverse stock split after the

market close on July 2. He also noted

that July 4 was a U.S. holiday and the

stock market was closed. The final unu-

sual item during the month of July 2012

was that Goodrich Corporation was pur-

chased by United Technologies after the

market close on July 26. He was ready to

get busy. Exercise 1 Using the infor-

mation provided in Figure 8. Calculate

the price-weighted index for the month

of July for these companies. What ad-

justment is required for the Duke Energy

1:3 reverse stock split? How did you ac-

count for the removal of Goodrich from

the index?

Exercise 2 What is the overall change in

index value for the month of July using

the price-weighted index? Which stock

increased in value the most? Which de-

clined the most? Which company(ies)

appear to be influencing the price-

weighted index the most?

Exercise 3 Using the information pro-

vided in Figure 8. Calculate the market-

weighted index for the month of July for

these companies. What adjustment is

required for the Duke Energy 1:3 reverse

stock split? How did you account for the

removal of Goodrich from the index?

Exercise 4 What is the overall change in

index value for the month of July using

the market-weighted index? Which

market capitalization increased in value

the most? Which declined the most?

Which company(ies) appear to be influ-

encing the price-weighted index the

most?

Exercise 5 Given the information from

Exercises 1-4, which method should

Brooks suggest that his manager use in

her presentation to clients? Why?

Figure 2. Time Series Plot of Three-Stock, Price-Weighted Index

Source: Authors

51.5

52.5

53.5

54.5

1 2 3 4 5

Figure 3. Changing Constituents in a Three-Stock, Price-Weighted Index

Panel A Stock Price at Close of Day

1 2 3 4 5

Stock A 112 113 114 113 111

Stock B 34 35 33 33 36

Stock C 10 11 12 13 15

Sum 156 159 159 159 162

Divisor 3 3 3 3 3

Index Val-

ue 52 53 53 53 54

Calculation (112+34+10)/3 (113+35+11)/3 (114+33+12)/3 (113+33+13)/3 (111+36+15)/3

Panel B Stock Price at Close of Day

1 2 3 4 5

Stock A 112 113 114 113 111

Stock B 34 35 33 33 36

Stock C 10 11 12 13

Stock D 50

Sum 156 159 159 159 197

Divisor 3 3 3 3 3

Index Val-

ue 52 53 53 53 65.67

Calculation (112+34+10)/3 (113+35+11)/3 (114+33+12)/3 (113+33+13)/3 (111+36+50)/3

Panel C Stock Price at Close of Day

1 2 3 4 5

Stock A 112 113 114 113 111

Stock B 34 35 33 33 36

Stock C 10 11 12 13

Stock D 50

Sum 156 159 159 159 197

Divisor 3 3 3 3 3.65

Index Val-

ue 52 53 53 53 54

Calculation (112+34+10)/3 (113+35+11)/3 (114+33+12)/3 (113+33+13)/3 (111+36+50)/3.65

Source: Authors

Figure 4. Stock Split Adjustment for Price-Weighted Index

Panel A Stock Price at Close of Day

1 2 3 4 5

Stock A 112 113 114 113 111

Stock B 34 35 33 33 36

Stock C 10 11 12 13

Stock D 50

Sum 156 159 159 159 197

Divisor 3 3 3 3 3.65

Index Val-

ue 52 53 53 53 54

Calculation (112+34+10)/3 (113+35+11)/3 (114+33+12)/3 (113+33+13)/3 (111+36+50)/3.65

Panel B Stock Price at Close of Day

1 2 3 4 5

Stock A 112 113 114 113 18.50

Stock B 34 35 33 33 36

Stock C 10 11 12 13

Stock D 50

Sum 156 159 159 159 104.50

Divisor 3 3 3 3 3.65

Index Val-

ue 52 53 53 53 28.63

Calculation (112+34+10)/3 (113+35+11)/3 (114+33+12)/3 (113+33+13)/3 (18.50+36+50)/3.65

Panel C Stock Price at Close of Day

1 2 3 4 5

Stock A 112 113 114 113 18.50

Stock B 34 35 33 33 36

Stock C 10 11 12 13

Stock D 50

Sum 156 159 159 159 104.50

Divisor 3 3 3 3 1.94

Index Val-

ue 52 53 53 53 54

Calculation (112+34+10)/3 (113+35+11)/3 (114+33+12)/3 (113+33+13)/3 (18.50+36+50)/1.94

Source: Authors

Figure 5. Creating a Three-Stock Market Capitalization-Weighted Index

Source: Authors

Figure 6. Changing Constituents in a Three-Stock Market Capitalization-

Weighted Index

Source: Authors

Shares 1 2 3 4 5

Stock A 1 112 113 114 113 111

Stock B 8 34 35 33 33 36

Stock C 150 10 11 12 13 15

Value 1884 2043 2178 2327 2649

Calculation

(112x1) + (34x8) +

(10x150)

(113x1) + (35x8) +

(11x150)

(114x1) + (33x8) +

(12x150)

(113x1) + (33x8) +

(13x150)

(111x1) + (36x8) +

(15x150)

Index Value 100.00 108.44 115.61 123.51 140.61

divisor 18.84 18.84 18.84 18.84 18.84

Calculation 1884 = 100 (2043 / 18.84) (2178 / 18.84) (2327 / 18.84) (2649 / 18.84)

initial value = 100

Stock Price at Close of Day

Shares 1 2 3 4 5

Stock A 1 112 113 114 113 111

Stock B 8 34 35 33 33 36

Stock C 150 10 11 12 13

Stock D 65 50

Value 1884 2043 2178 2327 3649

Calculation

(112x1) + (34x8) +

(10x150)

(113x1) + (35x8) +

(11x150)

(114x1) + (33x8) +

(12x150)

(113x1) + (33x8) +

(13x150)

(111x1) + (36x8) +

(50x45)

Index Value 100.00 108.44 115.61 123.51 140.61

divisor 18.84 18.84 18.84 18.84 25.95

Calculation 1884 = 100 (2043 / 18.84) (2178 / 18.84) (2327 / 18.84) (3649 / 25.95)

initial value = 100

Stock Price at Close of Day

Figure 7. Fortune 500 Companies in the Charlotte, NC Region

Sources: Bloomberg, Yahoo Finance

Figure 8. Daily Stock Prices for Fortune 500 Companies in Charlotte, NC Region –

July 2012

Source: Bloomberg

Authors

Judson W. Russell, Ph.D., CFA, Clinical Associate Professor of Finance, University

of North Carolina Charlotte, Department of Finance, Charlotte, NC 28223,

[email protected] (Corresponding Author)

Christopher Brockman, Ph.D., UBS Associate Professor of Finance, University of

Tennessee Chattanooga, College of Business, Chattanooga, TN

Netflix: DVD-by-Mail or Online Streaming?

Rick Long, Inchul Suh, & Toby White

Abstract

This case study requires students to analyze the issues surrounding the decision of

Netflix to split its business into two different parts: Qwikster for its DVD-by-mail

business and Netflix for its streaming business. The case offers students a chance to

evaluate the strategic choices of top managers, as they respond to rapid changes in

technology that impact how consumers access their entertainment content. The case

focuses on various aspects of equity valuation using the free cash flow model. Specif-

ically, the case provides students an opportunity to explore the challenges of Netflix

analysts when estimating the company’s cost of capital, subscriber growth rates, and

content acquisition costs in the context of intensifying competition in the online

streaming market.

Introduction

The Situation

On Monday, September 19, 2011, Rachel

Adams, Senior Equity Analyst for

Brooks Associates, Inc., an investment

and wealth management firm, was asked

to reassess the stock of Netflix by Ken-

neth Brooks, the firm’s Managing Part-

ner. Adams was a junior analyst when

she made a buy recommendation for

Netflix in 2005. Since then, the firm’s $6

million dollar investment in Netflix in-

creased to over $77 million, making it

one of the best performing stocks under

their management. However, it still rep-

resented a drop of more than $70 million

in value from its peak position in July

2011, only two months ago. Brooks was

concerned that the recent drop had more

to do with the shift in the business mod-

el of Netflix, rather than the short-term

market correction following the recent

price hike and huge customer backlash.

He was also concerned that a further de-

cline in the stock price of Netflix could

seriously damage Brooks’ overall portfo-

lio performance this year.

I. Company Background and In-

dustry Information

A. Brief History

Founded on August 29, 1997 by Reed

Hastings and Marc Randolph, Netflix

enjoyed unprecedented growth by pri-

marily providing a subscription-based

digital video disc (DVD) movie rental

business. Through the Netflix website,

consumers were able to browse the ex-

tensive list of movies, select films they

wanted to watch, and put each movie on

their personal queue. Customers would

receive DVDs via mail, watch them, and

ship them back to receive new DVDs

without worrying about late fees.

Netflix typically allowed customers to

maintain one to four DVDs in their pos-

session at any given time depending on

their subscription package. The love af-

fair consumers had with the Netflix

DVD-by-mail business helped push the

video rental giant Blockbuster into bank-

ruptcy. However, by 2007, DVD-by-mail

sales started to recede, and Netflix began

to deliver movie-streaming services over

the Internet (Grover, Edwards, and

Fixmer (2011)).

As of December 31, 2010, Netflix had

over 20 million subscribers globally.

Subscribers were able to access an un-

limited amount of movies and television

programs streamed over the Internet to

their selected viewing devices including

computers, mobile devices, and televi-

sions. Subscribers in the U.S. could also

have DVDs delivered to their homes.

Netflix continued to grow and change

quickly. Revenues more than doubled in

the last five years, growing from $997

million in 2006 to $2.16 billion in 2010

(see Exhibit 1). Net income grew even

faster, from $49 million in 2006 to $161

million in 2010. Total assets grew as

well, albeit at a slower rate, from $609

million in 2006 to $982 million (Exhibit

2). However, uncertainties regarding

rapid changes in technology coupled

with the viewership shift from DVDs to

streaming caused the price of Netflix

stock to fluctuate wildly, going from

$25.03 at the beginning of 2006 to $298.73

in July 2007 before falling back to $155.19

in September 2011 (Exhibits 3 & 4).

Furthermore, 2010 was the first year

when more subscribers watched movies

and television programs through stream-

ing video than through DVDs. Netflix

expected the streaming of entertainment

video over the Internet to be the main

driver for future growth. However, in

spite of the solid growth in subscribers

and declining acquisition cost per sub-

scriber, Netflix struggled to improve the

average monthly revenue and average

gross profit per paying customer (Exhib-

its 5 & 6).

B. Company Strategy

The main strategy of Netflix (as of Sep-

tember 19, 2011) was to continue the ex-

pansion of the video streaming business,

both in the United States and globally

(Wingfield-a (2011)). The company iden-

tified four main goals for future growth.

Netflix wanted to (i) continue to im-

prove customer service, (ii) expand con-

tent offered via streaming, (iii) expand

streaming services to more types of In-

ternet devices, and (iv) continue to meet

established targets for operating mar-

gins.

Netflix executives expected the DVD

business to decline over the next 5 years

(Edwards and Grover (2011)), and only

remain viable for about 15 more years

(Smith (2011)). Netflix’s CEO Hastings

was convinced that video streaming was

becoming increasingly popular due to its

faster speed and lower overhead (Anon-

ymous (2011)). According to the Interna-

tional Telecommunications Union, the

broadband Internet subscriptions would

reach 90 million in 2011 (Exhibit 7). Us-

ing broadband connections, Netflix cus-

tomers could easily order and watch

movies instantaneously without the loss

of picture quality (Ebert (2011)).

To meet the increasing demand for

streaming services, Netflix began invest-

ing heavily toward building its stream-

ing content library while reducing its ac-

quisition of DVD content. Overall, its

content subscription costs grew from

$532 million in 2006 to $1,154 million in

2010 (Exhibit 8). Netflix was able to limit

the growth in marketing costs including

free trials, but other costs, including ful-

fillment expenses, technology and de-

velopment expenses, and administrative

costs, were increasing in line with sales

(Exhibit 9).

C. Competition

The entertainment video market was ex-

tremely competitive and continued to

evolve quickly. Barriers to entry had

been reduced as the industry moved to

streaming video delivery over broad-

band connections (Sherman (2011)).

Therefore, new companies were able to

enter the market without incurring huge

startup costs.

Netflix had a large number of competi-

tors, each, delivering video content to

viewers through varying forms of tech-

nology: (i) DVD rental via kiosks/stores,

(ii) DVD via mail, (iii) pay-for-play

streaming, and (iv) streaming through

monthly subscription. The competition

in the DVD rental market included

Blockbuster, Redbox, Hollywood Movies

and many other local businesses. Com-

petitors in the streaming market includ-

ed Apple (iTunes), Google (YouTube),

Hulu (Multiple owners), and Amazon

(Prime Instant Videos), plus other multi-

channel video programming distribut-

ers, such as HBO, Cinemax, Direct TV,

Time Warner, and Comcast (Exhibit 10)

(Sherman (2011), Sherr (2011), Sherr and

Murphy (2011)).

II. DVD and Streaming Services

A. Strategy

Recognizing the failure of other former

‘technology highfliers’, including AOL

and MySpace, to adapt to rapidly chang-

ing industry conditions, Netflix felt the

need to move fast, especially since Hol-

lywood studios were demanding signifi-

cantly higher fees for online rights to

movies and TV shows (Grover, Ed-

wards, and Fixner (2011)). Thus, Netflix

was forced to seek out more revenue and

put more emphasis on building their

streaming library (Sherr (2011)).

At a Board meeting in April 2011, Netflix

made the key strategic decision to sepa-

rate their DVD-by-mail and online-

streaming businesses from both pricing

and product implementation perspec-

tives (Edwards and Grover, 2011). This

decision becomes public on July 12, 2011

(Weise, 2011) with the new pricing struc-

ture taking effect on September 1, 2011

(Boudway, 2011).

The old pricing structure included a

$9.99/month option whereby customers

could access movies via either DVD or

streaming. The new pricing structure

would unbundle these two methods of

access. There would be a $7.99 monthly

fee for DVDs and an additional $7.99

monthly fee for online streaming. Thus,

customers who wanted to maintain both

outlets would face roughly a 60% price

increase, since $7.99*2 = $15.98/month,

which is $5.99 higher than the old com-

bined fee of $9.99 (Weise (2011), Wing-

field-a (2011)).

The price increase was primarily aimed

at improving the financial health of the

company amid the declining DVD rental

business (Wingfield-b (2011)). Thus, Net-

flix was trying to push customers into

online delivery, whereby its costs had

been historically lower and its profit

margins higher (Grover, Edwards, and

Fixner (2011)). In conjunction with an

investment plan to upgrade its content

available over the Internet, Netflix was

betting that in the long-run, the number

of subscribers would grow or remain

relatively stable (Smith (2011), Wing-

field-b, 2011). They also expected that

revenues would grow from the price in-

crease and costs would decline due to

the increasing number of subscribers

choosing the more cost-effective stream-

ing option (Sherr, 2011).

B. Rationale

From a delivery cost perspective, stream-

ing was much cheaper to Netflix. DVD

warehouses were expensive, as were

postal fees to ship and return DVDs

(Sherr, 2011). The cost of new deals to

acquire content for streaming had in-

creased from $64 million in 2009 to over

$400 million in 2010 (Exhibit 8) (Smith,

2011). While the gross profit margin on

their DVD business stood at a healthy

37%, the corresponding margin for the

streaming business easily exceeded that

at 65% (Grover, Edwards, and Fixmer,

2011). Initially, Netflix expected 10 mil-

lion (40%) out of its expected 25 million

subscribers in 2011 to be on a streaming-

only plan, with 3 million (12%) on a

DVD-only plan, and the remaining 12

million (48%) to have a combination

DVD/streaming plan (Wingfield-b,

2011).

C. Response

Some analysts cautioned that a hasty

move or refocus toward the streaming-

only business could be a mistake (Wing-

field-a, 2011). Studios would continue to

charge Netflix more for digital licensing

deals, especially since competition

among streaming content suppliers was

increasing rapidly (Sherman, 2011). The

Hollywood studios had leverage on the

streaming side, but had no ability to

raise prices on the DVD side. Streamed

movies were subject to deals the studios

struck with TV cable networks like HBO

and Showtime and could not be a part of

the Netflix catalog until they had run

their course on these networks. In con-

trast, Netflix owned the rights to the

DVDs and rented them out earlier, since

they were not subject to any timing or

broadcast restrictions (Smith, 2011).

The Netflix streaming content consisted

mostly of mainstream films, and was

relative weaker on smaller, independent

films (Ebert (2011)). It also did not have

many newer titles (Smith, 2011), since

these were often blocked for a proba-

tionary period so as to not cannibalize

the studio’s DVD sales or viewership on

premium cable TV networks (Wingfield-

a, 2011). Customers complained that the

streaming service of Netflix did not pro-

vide enough watchable content when

compared to their DVD library (Ebert,

2011). Netflix anticipated that increased

investment in upgrading their streaming

content would ultimately lure more sub-

scribers (Sherr, 2011), Wingfield-b, 2011).

Renegotiations, however, with content

providers Sony, Disney, and others

turned out to be increasingly challenging

(Edwards and Grover, 2011). Netflix

previously had a deal with cable net-

work Starz, but talks to renew the deal

had broken off due to Starz demanding a

price that was 10 times higher than what

was agreed upon three years earlier

(Sherr (2011), Sherr and Murphy, 2011)).

Thus, Starz would no longer allow Net-

flix to stream films it licensed from Sony

and Disney (Sherman, 2011). To replace

this expiring deal, Netflix sought out a

licensing deal with Discovery Commu-

nications, which owned programming

rights for the Discovery Channel, TLC,

and the Science Channel, and was in ne-

gotiation for a new deal with Dream-

Works studio (Sherr and Murphy, 2011).

III. Decision to Form Qwikster

In July 2011, Netflix was one of the hot-

test U.S. stocks, and was widely ex-

pected to continue its ascent, especially

due to its aggressive plans to expand in-

to international markets (U.K./Ireland

and Latin America), and its increased fo-

cus on streaming (relative to DVDs-by-

mail). In fact, one analyst predicted the

stock would hit $1,000 within the next 5

to 7 years (Constable (2011)). By Sun-

day, September 18, 2011, only 17 days af-

ter their new pricing structure had gone

into effect, Netflix stock was down 55-

60% from its peak price achieved two

months earlier (Grover, Edwards, and

Fixmer (2011), Sherr (2011)). One reason

for the decline was that Netflix had un-

derestimated the number of subscribers

that would lapse due to the price and

administrative changes (Sherman (2011),

Sherr (2011)). As a result, Netflix CEO

Reed Hastings issued a public letter (Ex-

hibit 11) that was part-apology (for the

price increase, and the manner in which

it was communicated to customers), but

also part-rationalization (i.e., so as to

sway public opinion) (Edwards and

Grover (2011)). In addition, the letter in-

cluded the announcement that Netflix

was officially separating their DVD

business from their streaming business,

and renaming the DVD business

‘Qwikster’ (Smith (2011)).

IV. Subsequent Analyses

Rachel Adams understood the challenge

that Netflix was facing. Although she

agreed with CEO Reed Hasting’s push

toward the streaming business, she real-

ized that a thorough analysis of the risks

and returns for both its streaming and

DVD services was necessary in order to

make a strategic decision on Netflix

stock within the next two days. Recog-

nizing that she did not have much time,

due to the Netflix stock price being so

volatile the past few weeks, Adams be-

gan collecting data and reading recent

industry reports. She also wondered

whether Netflix should be viewed as a

media company or as a technology com-

pany, given the diverse set of firms that

it encountered in the marketplace. Feel-

ing a great sense of urgency, Adams de-

cided to begin her analysis by estimating

the future subscriber growth and content

acquisition costs. For a more complete

list of questions and issues that Ms. Ad-

ams and Brooks Associates needs to ad-

dress before making a recommendation,

see Section V on the next page.

V. Case Questions

The following list of questions covers the

majority of issues that Rachel Adams

would seek to address in her analysis of

Netflix, during the week of September

19, 2011, before she could offer her rec-

ommendation regarding Netflix stock.

The same list of questions can be ad-

dressed by students and faculty who de-

cide to adapt this case. Questions 1 and

2 have been identified as the most essen-

tial, if one wishes to adapt an abbreviat-

ed list, and for each of these, a brief list

of possible answers is provided. Ques-

tions 3-6 focus on additional quantitative

applications, whereas Questions 7-10 fo-

cus on more qualitative issues. Note that

Exhibits 1-11 are needed to help answer

many of these questions, and appear on

p.11-20.

1. What is the right mix of investment

and strategic focus for Netflix when

allocating fixed resources to either

the legacy DVD-by-mail business or

the relatively more trendy online

streaming business?

Possible answers include: Focus ex-

clusively on the DVD-by-mail busi-

ness, focus exclusively on the online

streaming business, or specify a per-

centage of investment into each of the

two businesses.

2. Recommend whether Brooks should

buy more, sell, or continue to hold

Netflix stock.

Possible answers include: Sell your

full holding immediately, sell a por-

tion of your holding now and wait

until the end of the year to decide

whether or not to sell the rest, con-

tinue to hold the same amount as be-

fore, or invest even more heavily in

the company.

3. Analyze trends in both the history of

Netflix stock performance and

growth rates in subscriber counts.

4. Evaluate the revenue and expense

streams for Netflix, and any interac-

tion between these two measures, in

the context of the recent shift in cor-

porate strategy.

5. Perform a prospective FCF-based

valuation analysis. Do you agree

with the strategy of Netflix to split

the company’s business into two sep-

arate segments?

6. Discuss whether the overall compa-

ny-level estimate for ‘cost of capital’

will vary from the estimates for each

of the two business types separately.

7. What motivated Netflix to split its

business into Qwikster for DVDs and

Netflix for streaming?

8. Discuss how Netflix might improve

the processes of both communicating

key product changes to consumers,

and/or networking with cable TV

channels, TV providers, and Holly-

wood studios.

9. Assess the impact of key competitors

on the future outlook of Netflix, and

the changing cost structure of these

companies when paying for up-

grades in the quality and quantity of

content offered online.

10. What other qualitative issues may

have a substantial impact on the fu-

ture viability of Netflix and both the

DVD and streaming access models?

References

Anonymous, 2011, July 13, Overheard:

Divide and Conquer, Wall Street

Journal, p.C.16.

Boudway, I, 2011, August 29, Seven

Days: Netflix price change, Bloom-

berg Business week 4243, 18.

Constable, S, 2011, July 17, Five Stocks

You’ll Wish You’d Bought in January,

Wall Street Journal, p.A.1.

Ebert, R, 2011, October 3, Don’t Bash My

Netflix, Bloomberg Business week

4248, 113.

Edwards, C., & Grover, R, 2011, October

24, Companies & Industries: Netflix -

CEO Reed Hastings’ abrupt turna-

bouts have alienated customers and

Wall Street, Bloomberg Businessweek

4251, 21-22.

Grover, R., Edwards, C., & Fixmer, A,

2011, September 26, Can Netflix Find

its Future by Abandoning Its Past?

Bloomberg Business week 4247, 29-30.

Sherman, A, 2011, October 17, Media:

Netflix Keeps Missing the Bull’s-Eye,

Bloomberg Businessweek 4250, 30.

Sherr, I, 2011, September 16, New Netflix

Pricing Gets Thumbs Down – Stock

Calls 19% As Customers Leave, Wall

Street Journal, p.B.1.

Sherr, I., & Murphy, M, 2011, September

22, Netflix Expands Its Discovery

Pact, Wall Street Journal, p.B.10.

Smith, E, 2011, September 20, Netflix

CEO Unbowed – Ignoring Customers’

Anger, Company Says Separating

DVD Business Is Essential, Wall Street

Journal, p.B.1.

Weise, K, 2011, July 18, Briefs: Netflix

Debuting new prices, Bloomberg

Business week 4238, 24.

Wingfield, N, 2011, July 13, Corporate

News: Netflix Plays Down DVDs –

Price of Basic Streaming-Disc Service

to Increase 60%, Angering Customers,

Wall Street Journal, p.B.2.

Wingfield, N, 2011, July 26, Earnings:

Netflix Warns Price Rise Will Clip

Growth, Wall Street Journal, p.B.9.

Exhibit 1. NetFlix Inc. – Income Statement (in millions of dollars)

Fiscal Year Ends in December

2006 2007 2008 2009 2010

Sales 996.7 1,205.3 1,371.2 1,670.3 2,162.6

Cost of Sales 469.8 561.2 668.0 821.7 1,018.7

Gross Profit 526.8 644.1 703.1 848.5 1,144.0

SG&A Expenses 306.8 342.2 339.2 403.6 527.7

EBITDA 220.1 301.9 363.9 444.9 616.2

Depreciation 157.1 225.0 242.2 257.5 338.7

EBIT 62.9 77.0 121.7 187.4 277.5

Interest Expense - - 2.5 6.5 19.6

Non-operating Expense 15.9 27.5 18.8 11.3 9.8

Special Items 1.5 7.0 (6.5) - -

Pretax Income 80.3 111.5 131.5 192.2 267.7

Total Taxes 31.2 44.5 48.5 76.3 106.8

Net Income 49.1 67.0 83.0 115.9 160.9

Source: Company Reports.

Exhibit 2. NetFlix Inc.– Balance Sheet (in millions of dollars, except for share values)

Fiscal Year Ends in December

2006 2007 2008 2009 2010

Cash 400.4 387.4 297.3 320.2 350.4

Current Content Library - - 18.7 37.3 181.0

Other Current Assets 10.6 16.0 13.3 23.8 47.4

Total Current Assets 428.4 416.5 361.4 411.0 641.0

Property and Equipment 160.4 209.8 223.5 240.5 309.5

Intangibles 1.0 1.4 1.8 1.6 1.6

Deferred Charges - - - 6.0 5.5

Other Investments - - 5.7 - -

Total Assets 608.8 647.0 617.9 679.7 982.1

Debt - Current Portion - - 1.2 1.4 2.1

Accrued Expense 29.9 36.5 31.4 33.4 36.5

Accounts Payable 93.9 104.4 100.3 91.5 222.8

Deferred Revenue 69.7 71.7 83.1 100.1 127.2

Total Current Liabilities 193.4 212.6 216.0 226.4 388.6

Long-term Debt - - 38.0 236.6 234.1

Other Non-current Liabilities - 3.7 16.8 17.7 69.2

Total Liabilities 194.6 216.3 270.8 480.6 691.9

Preferred Stock - Total - - - - -

Common Equity 414.2 430.7 347.2 199.1 290.2

Total Stockholders' Equity 414.2 430.7 347.2 199.1 290.2

Shares Outstanding 68.6 64.9 58.9 53.4 52.8

Stock Price - FY Close 25.9 26.6 29.9 55.1 175.7

Source: Company Reports.

Exhibit 3. NetFlix Inc. Stock Performance, Jan. 2005 – Sep. 2011

Data Source: Bloomberg

Exhibit 4. NetFlix Inc. Subscriber Growth and Fiscal Year-End Stock Price

Data Source: Company Reports

Exhibit 5. NetFlix Inc. – Subscriber Data (in thousands, except for subscriber acquisition cost)

2006

2007

2008

2009

2010

Total subscribers

6,316

7,479

9,390

12,268

20,010

Free subscribers

162

153

226

376

1,742

Paid subscribers

6,154

7326

9,164

11,892

18,268

Gross subscriber additions

5,250

5,340

6,859

9,332

16,301

Net subscriber additions

2,137

1,163

1,911

2,878

7,742

Acquisition cost per subscriber

$ 42.94

$ 40.86

$ 29.12

$ 25.48

$ 18.03

Source: Company Reports

Exhibit 6. NetFlix Inc. – Average Monthly Subscriber Revenue and Gross Profit

Data Source: Company Reports

Exhibit 7. Broadband Internet Subscriptions vs. Cable TV Subscriptions in the U.S. (in millions)

*Expected

Data Source: International Telecommunications Union (Broadband) / National Cable &

Telecommunications Association (Cable TV)

Exhibit 8. NetFlix Inc. – Acquisition of Content Library and Capital Expenditures (in millions of

dollars)

2006 2007 2008 2009 2010

Acquisition of streaming

content library

- - 48.3 64.2 406.2

Acquisition of DVD content

library

169.5 223.4 162.8 193.0 123.9

Purchases of property and

equipment

27.3 44.3 43.8 45.9 33.8

Amortization of content li-

brary

141.2 203.4 209.8 219.5 300.6

Depreciation and amortiza-

tion of PPE

15.9 21.4 32.5 38.0 38.1

Source: Company Reports

Exhibit 9. NetFlix Inc. – Other Operating Data (in millions of dollars)

2006

2007 2008 2009 2010

Cost of subscription 532.6 664.4 761.1 909.5 1,154.1

Fulfillment expenses 94.4 121.8 149.1 169.8 203.2

Marketing costs including

free trials

225.5 218.3 199.7 237.7 293.8

Technology and develop-

ment expense

48.4 71.4 89.9 114.5 163.3

General and administrative

costs

36.2 52.5 49.7 51.3 70.6

Interest expenses 15.9 20.3 2.5 6.5 19.6

Proceeds from sale of DVDs 12.9 21.6 18.4 11.2 12.9

Gain on disposal of DVDs 4.8 7.2 6.3 4.6 6.1

Source: Company Reports

Exhibit 10. NetFlix Inc. – Competitor Data (in millions of dollars)

Company Time Warner Cable Dish Network Coinstar Inc.

Income Statement

2009 2010 2009 2010 2009 2010

Sales 17,868.0 18,868.0 11,664.2 12,640.7 1,144.8 1,436.4

Cost of Sales 8,555.0 8,941.0 7,022.8 7,386.9 793.4 1,000.9

Gross Profit 9,313.0 9,927.0 4,641.4 5,253.8 351.3 435.5

SG&A 2,830.0 3,057.0 1,953.4 2,103.6 155.1 159.9

EBITDA 6,483.0 6,870.0 2,688.0 3,150.2 196.2 275.6

Depreciation 3,085.0 3,129.0 940.0 984.0 99.8 117.5

EBIT 3,398.0 3,741.0 1,748.0 2,166.3 96.5 158.1

Interest Expense 1,311.0 1,397.0 408.1 471.9 34.3 34.9

Special Items (127.0) (52.0) (361.0) (225.5) (13.2) (14.9)

Pretax Income 1,912.0 2,196.0 1,012.8 1,542.2 48.2 108.9

Total Taxes 820.0 883.0 377.4 557.5 19.0 43.0

Net Income 1,070.0 1,308.0 635.5 984.7 53.6 51.0

Balance Sheet

2009 2010 2009 2010 2009 2010

Cash 1,048.0 3,047.0 2,139.3 2,940.4 192.3 183.4

Receivables 663.0 718.0 779.9 786.1 61.4 26.0

Inventory 0.0 0.0 296.0 487.6 104.4 140.3

Total Current Assets 2,102.0 4,340.0 3,476.0 4,573.4 390.7 488.4

PP&E 13,919.0 13,873.0 3,042.3 3,232.3 400.3 444.7

Intangibles 26,477.0 26,314.0 1,391.4 1,391.4 315.4 277.3

Total Assets 43,694.0 45,822.0 8,295.3 9,632.2 1,222.8 1,282.7

Debt - Current Portion 0.0 0.0 26.5 1,030.9 33.2 197.9

Accounts Payable 478.0 529.0 520.3 400.8 118.9 161.6

Taxes Payable 0.0 0.0 0.0 0.0 20.6 2.3

Total Current Liabili-

ties

2,958.0 3,086.0 3,287.3 4,499.3 374.6 633.3

Total Long Term Debt 22,631.0 23,421.0 6,470.0 5,484.0 429.2 165.4

Deferred LT Taxes 8,957.0 9,637.0 312.8 567.7 0.0 0.0

Total Liabilities 35,005.0 36,605.0 10,387.0 10,765.6 810.4 812.7

Preferred Stock - Total 0.0 0.0 0.0 0.0 0.0 26.9

Common Equity 8,685.0 9,210.0 (2,092.2) (1,133.9) 412.4 443.1

Total Stockholders'

Equity

8,685.0 9,210.0 (2,092.2) (1,133.9) 412.4 470.0

Shares Outstanding 352.5 348.3 447.2 443.2 31.1 31.8

Stock Price - FY Close 41.39 66.03 20.77 19.66 27.78 56.44

Source: Company Reports

Exhibit 10. NetFlix Inc. – Competitor Data (in millions of dollars), continued

Company Apple Inc. Amazon.com Google

Income Statement

2009 2010 2009 2010 2009 2010

Sales 42,905.0 65,225.0 24,509.0 34,204.0 23,650.6 29,321.0

Cost of Sales 24,999.0 38,609.0 18,594.0 26,009.0 7,337.9 9,036.0

Gross Profit 17,906.0 26,616.0 5,915.0 8,195.0 16,312.7 20,285.0

SG&A 5,482.0 7,299.0 4,300.0 6,131.0 6,468.0 8,523.0

EBITDA 12,424.0 19,317.0 1,615.0 2,064.0 9,844.7 11,762.0

Depreciation 684.0 932.0 432.0 657.0 1,506.2 1,381.0

EBIT 11,740.0 18,385.0 1,183.0 1,407.0 8,338.5 10,381.0

Interest Expense 0.0 0.0 34.0 39.0 0.0 0.0

Special Items 0.0 0.0 (51.0) 0.0 (26.3) 0.0

Pretax Income 12,066.0 18,540.0 1,155.0 1,504.0 8,381.2 10,796.0

Total Taxes 3,831.0 4,527.0 253.0 352.0 1,860.7 2,291.0

Net Income 8,235.0 14,013.0 902.0 1,152.0 6,520.4 8,505.0

Balance Sheet

2009 2010 2009 2010 2009 2010

Cash 23,464.0 25,620.0 6,366.0 8,762.0 24,484.8 34,975.0

Receivables 5,057.0 9,924.0 836.0 1,324.0 3,201.7 5,002.0

Inventory 455.0 1,051.0 2,171.0 3,202.0 0.0 0.0

Total Current Assets 31,555.0 41,678.0 9,797.0 13,747.0 29,167.0 41,562.0

PP&E 2,954.0 4,768.0 1,290.0 2,414.0 4,844.6 7,759.0

Intangibles 559.0 1,083.0 1,801.0 1,912.0 5,677.5 7,300.0

Total Assets 47,501.0 75,183.0 13,813.0 18,797.0 40,496.8 57,851.0

Debt - Current Portion 0.0 0.0 141.0 224.0 0.0 0.0

Accounts Payable 5,601.0 12,015.0 5,605.0 8,051.0 215.9 483.0

Taxes Payable 430.0 210.0 0.0 0.0 0.0 37.0

Total Current Liabili-

ties

11,506.0 20,722.0 7,364.0 10,372.0 2,747.5 9,996.0

Total Long Term Debt 0.0 0.0 252.0 641.0 0.0 0.0

Deferred LT Taxes 2,216.0 4,300.0 0.0 0.0 0.0 0.0

Total Liabilities 15,861.0 27,392.0 8,556.0 11,933.0 4,492.6 11,610.0

Preferred Stock - Total 0.0 0.0 0.0 0.0 0.0 0.0

Common Equity 31,640.0 47,791.0 5,257.0 6,864.0 36,004.2 46,241.0

Total Stockholders'

Equity

31,640.0 47,791.0 5,257.0 6,864.0 36,004.2 46,241.0

Shares Outstanding 899.8 916.0 444.0 451.0 317.8 321.3

Stock Price - FY Close 185.35 283.75 134.52 180.00 619.98 593.97

Source: Company Reports

Exhibit 11. NetFlix Inc. – CEO’s Announcement to Split DVD & Streaming Services

An Explanation and Some Reflections, Sunday, September 18, 2011

I messed up. I owe everyone an explanation.

It is clear from the feedback over the past two months that many members felt we lacked respect and

humility in the way we announced the separation of DVD and streaming, and the price changes. That

was certainly not our intent, and I offer my sincere apology. I’ll try to explain how this happened.

For the past five years, my greatest fear at Netflix has been that we wouldn't make the leap from suc-

cess in DVDs to success in streaming. Most companies that are great at something – like AOL dialup

or Borders bookstores – do not become great at new things people want (streaming for us) because

they are afraid to hurt their initial business. Eventually these companies realize their error of not fo-

cusing enough on the new thing, and then the company fights desperately and hopelessly to recover.

Companies rarely die from moving too fast, and they frequently die from moving too slowly.

When Netflix is evolving rapidly, however, I need to be extra-communicative. This is the key thing I

got wrong.

In hindsight, I slid into arrogance based upon past success. We have done very well for a long time by

steadily improving our service, without doing much CEO communication. Inside Netflix I say, “Ac-

tions speak louder than words,” and we should just keep improving our service.

But now I see that given the huge changes we have been recently making, I should have personally

given a full justification to our members of why we are separating DVD and streaming, and charging

for both. It wouldn’t have changed the price increase, but it would have been the right thing to do.

So here is what we are doing and why:

Many members love our DVD service, as I do, because nearly every movie ever made is published on

DVD, plus lots of TV series. We want to advertise the breadth of our incredible DVD offering so that

as many people as possible know it still exists, and it is a great option for those who want the huge

and comprehensive selection on DVD. DVD by mail may not last forever, but we want it to last as

long as possible.

I also love our streaming service because it is integrated into my TV, and I can watch anytime I want.

The benefits of our streaming service are really quite different from the benefits of DVD by mail. We

feel we need to focus on rapid improvement as streaming technology and the market evolve, without

having to maintain compatibility with our DVD by mail service.

So we realized that streaming and DVD by mail are becoming two quite different businesses, with

very different cost structures, different benefits that need to be marketed differently, and we need to

let each grow and operate independently. It’s hard for me to write this after over 10 years of mailing

DVDs with pride, but we think it is necessary and best: In a few weeks, we will rename our DVD by

mail service to “Qwikster”. We chose the name Qwikster because it refers to quick delivery. We will

keep the name “Netflix” for streaming.

Qwikster will be the same website and DVD service that everyone is used to. It is just a new name,

and DVD members will go to qwikster.com to access their DVD queues and choose movies. One im-

provement we will make at launch is to add a video games upgrade option, similar to our upgrade

option for Blu-ray, for those who want to rent Wii, PS3 and Xbox 360 games. Members have been ask-

ing for video games for many years, and now that DVD by mail has its own team, we are finally get-

ting it done. Other improvements will follow. Another advantage of separate websites is simplicity

for our members. Each website will be focused on just one thing (DVDs or streaming) and will be

even easier to use. A negative of the renaming and separation is that the Qwikster.com and Net-

flix.com websites will not be integrated. So if you subscribe to both services, and if you need to

change your credit card or email address, you would need to do it in two places. Similarly, if you rate

or review a movie on Qwikster, it doesn’t show up on Netflix, and vice-versa.

There are no pricing changes (we’re done with that!). Members who subscribe to both services will

have two entries on their credit card statements, one for Qwikster and one for Netflix. The total will

be the same as the current charges.

Andy Rendich, who has been working on our DVD service for 12 years, and leading it for the last 4

years, will be the CEO of Qwikster. Andy and I made a short welcome video. (You’ll probably say we

should avoid going into movie making after watching it.) We will let you know in a few weeks when

the Qwikster.com website is up and ready. It is merely a renamed version of the Netflix DVD website,

but with the addition of video games. You won’t have to do anything special if you subscribe to our

DVD by mail service.

For me the Netflix red envelope has always been a source of joy. The new envelope is still that distinc-

tive red, but now it will have a Qwikster logo. I know that logo will grow on me over time, but still, it

is hard. I imagine it will be the same for many of you. We’ll also return to marketing our DVD by mail

service, with its amazing selection, now with the Qwikster brand.

Some members will likely feel that we shouldn’t split the businesses, and that we shouldn’t rename

our DVD by mail service. Our view is with this split of the businesses, we will be better at streaming,

and we will be better at DVD by mail. It is possible we are moving too fast – it is hard to say. But go-

ing forward, Qwikster will continue to run the best DVD by mail service ever, throughout the United

States. Netflix will offer the best streaming service for TV shows and movies, hopefully on a global

basis. The additional streaming content we have coming in the next few months is substantial, and we

are always working to improve our service further.

I want to acknowledge and thank our many members that stuck with us, and to apologize again to

those members, both current and former, who felt we treated them thoughtlessly. Both the Qwikster

and Netflix teams will work hard to regain your trust. We know it will not be overnight. Actions

speak louder than words. But words help people to understand actions.

Respectfully yours, -Reed Hastings, Co-Founder and CEO, Netflix

Source: Netflix US & Canada Blog (http://blog.netflix.com/2011/09/explanation-and-some-

reflections.html)

Authors

Rick Long, College of Business and Public Administration, Drake University,

[email protected]

Inchul Suh, College of Business and Public Administration, Drake University,

[email protected]

Toby White, College of Business and Public Administration, Drake University, Des

Moines, IA 50311, [email protected] (Corresponding Author)

Acknowledgment

The authors constructed this case solely to provide the basis for class discussion rather than to illus-

trate either effective or ineffective handling of a managerial situation. All people, places and financial

data are fictionalized with the exception of direct quotations from publically available documents.

Strategic Approach of Business Valuation

Dr. Rishma Vedd, & Nataliya Yassinski

Abstract

A comprehensive financial statement analysis and valuation framework that inte-

grates strategy, industry, financial reporting, and business valuation draw an under-

standing of the company performance and provide a basis for making reasonable

valuation estimates. The fundamental financial statement analysis uses various tools

and techniques for business valuation. Topics include profitability analysis, evaluat-

ing sustainable growth, cash flow analysis and prospective analysis using various

business valuation models such as income, market and cost approach.

Introduction

The Hershey Company is one of the

leaders in the Confectioners Industry

(Yahoo Finance, The Hershey Compa-

ny). The company is organized into two

business units; these are the chocolate

business unit and the sweets and re-

freshment business unit. The company

manufactures, markets, sells, and dis-

tributes along with its subsidiaries,

chocolate candy, sugar confectionery,

gum and mint, baking and pantry, and

snacks throughout the world. The com-

pany’s iconic brands are Hershey’s,

Reese’s, Hershey’s Kisses, Hershey’s

Bliss, Twizzlers, Almond Joy, Mounds,

York, Kit Kat, and Pieces. The company

is organized around geographic regions,

and the company’s key region is the

United States, the Americas, Asia, Eu-

rope, the Middle East, and Africa. The

company exports to approximately 70

countries worldwide. Sales representa-

tives and food brokers sell a significant

amount of the Hershey Company’s

products to wholesale distributors, chain

grocery stores, mass merchandisers,

chain drug stores, vending companies,

wholesale clubs, convenience stores, dol-

lar stores, concessionaires and depart-

ment stores. The business was founded

in 1894 by Milton S. Hershey and is

headquartered in Hershey, Pennsylvania

(The Hershey Company, Annual Report,

2012).

Business Analysis and Industry Analy-

sis

Business analysis links firm’s economics

and strategy and analysis of its financial

statements, with the objective of gaining

insights about the firm’s profitability

and risk. The process of assessing strat-

egy analysis has five major blocks. This

Hershey’s business and industry analy-

sis is demonstrated Chart 1.

Environment Analysis (PEST)

Environment analysis is a part of strate-

gic analysis. The broader business envi-

ronment affects the level of profitability

that a company can expect to achieve.

This includes global economic forces,

quality and cost of labor, government

regulations, and borrowing procedures.

Understanding the environment and

competitive forces within an industry

helps with evaluating the quality of a

particular firm’s strategy and profitabil-

ity.

Environmental factors, such as political,

economic, social, and technological, af-

fect the Hershey Company’s activities.

Among many legal governmental laws

and regulations that applied to the con-

fectionary industry, the most important

is the pricing practices. This is influ-

enced by price floor legislation for choc-

olate and other ingredients. The FDA re-

quirement for nutritional information is also a

requirement that all food companies are

subject to. Still another challenge for this

and other corporations are legal chal-

lenges in the U.S. and in other nations.

The Hershey Company, as it mentioned

in its own annual report, became a sub-

ject to a law suit in Canada for its pricing

practices and reached an agreement to

settle the suit with $5.3 million in liabil-

ity (Annual Report, 2012). Any changes

in food or drug laws anywhere Hershey

does can alter the affect its business.

Lastly, child labor laws in Africa have a

significant impact on chocolate produc-

tion. An investor has filed a law suit in

November of 2012 against the Hershey

Company because the company is al-

leged to have received cacao from sup-

pliers who used child labor (Milford,

McCarty, & Church, 2012).

The company’s revenue and profitability

relies on spending levels and impulse

purchases. The aspects are heavily de-

pending on macroeconomic conditions,

consumer confidence, employment, and

availability of consumer credit (The Her-

shey Company, Annual Report, 2012).

One factor that that can mitigate the fluc-

tuation in the main ingredient of choco-

late, cocoa is securing new sources for

the commodity that are reliable. Her-

shey is finding new sources that include

Jamaica.

The Hershey founder, Milton S. Her-

shey, established a responsible citizen-

ship model for the company, and the

company is continuing his legacy and

corporate social responsibility by manu-

facturing high-quality Hershey products,

operating the business with a social re-

sponsibility, and adjusting the business

operations up to the environmental sus-

tainability level. The company has es-

tablished its environment, community,

workplace, and marketplace goals, and

reports their achievements through its

corporate social responsibility (“CSR”)

report in 2009, 2010, and 2011. The other

issue that the company is facing is the

increasing national focus on obesity.

Hershey as part of the confectionary in-

dustry is challenged to increase sales as

well as maintain its reputation as a so-

cially responsible corporate citizen.

The company invests considerable re-

sources in technology to efficiently oper-

ate its business. Included in this effort to

be more efficient are cutting edge agri-

cultural practices which include im-

proved milking machines and improve-

ments to their distribution. Hershey is

utilizing RFID to better track their prod-

ucts to the marketplace. This critical fac-

tor of the industry environment enables

the company to manage manufacturing,

financial, logistic, sales, marketing, and

administrative processes in the compa-

ny.

Chart 1: Hershey’s business and industry analysis

Environment Analysis

(PEST Analysis)

Industry Analysis

(Porter's Five Forces)

Competative

Advantage

SWOT Analysis

Business strategy

• Profit Drivers

• Key Risks

Chart 2: Environmental Analysis

Accounting Analysis

The next critical step is accounting

analysis. Accounting analysis identi-

fies accounting principles and meth-

ods used to prepare financial state-

ments and the ability to adjust these in

order to increase their relevance and

reliability. One of the steps is to make

adjustments. Adjustments for ac-

counting distortions enable financial

reports to better reflect economic reali-

ty.

This step requires:

Among the common adjustments there

can be these infrequent items:

• Discontinued operations

• Extraordinary items

• Changes in accounting princi-

ples

• Impairment losses on long-lived

assets

• Restructuring and other charges

• Changes in estimates

• Gains/losses from peripheral ac-

tivities

• Items in other comprehensive

income (on balance sheet).

All of these elements can be found in

the Hershey Company’s notes to con-

solidated financial statements, item 8

• Factors:

• Innovantions

• Information system

• Communication

• Factors:

• Consumer behavior

• Lifestyle trends

• Consumerism

• Factors:

• Economic enviroment

• Umemployment rate

• Inflation

• Factors:

• Political development

• Tax Laws

• FDA regulations

Political Economic

TechnologicalSocial

of the form 10-K, and management’s

discussion and analysis of financial

conditions and results of operations

(MD&A), item 7 of the form 10-K. The

following information is found in the

MD&A and notes of the Hershey

Company’s 10-K:

As part of the Project Next Century

program, production will transition

from the Company's century-old facili-

ty at 19 East Chocolate Avenue in Her-

shey, Pennsylvania, to an expanded

West Hershey facility, which was built

in 1992 (The Hershey Company, An-

nual Report, 2012).

The company completed an impair-

ment evaluation of goodwill and other

intangible assets associated with Go-

drej Hershey Ltd. Based on this eval-

uation, the firm recorded a non-cash

goodwill impairment charge of $44.7

million, including a reduction to re-

flect the share of the charge associated

with the noncontrolling interests (The

Hershey Company, Annual Report,

2012).

In addition, the Hershey Company

completed three-year supply chain

transformation program (the "global

supply chain transformation pro-

gram"). Manufacturing facilities in

Naugatuck, Connecticut and Smiths

Falls, Ontario have been closed and

are offered for sale. The carrying value

of these properties was $6.9 million as

of December 31, 2011. The fair value of

these properties was estimated based

on the expected sales proceeds. Actual

proceeds from the sale of these proper-

ties could differ from expected pro-

ceeds which could cause additional

charges or credits in 2012 or subse-

quent years (The Hershey Company,

Annual Report, 2012).

Some of the important nonrecurring

charges were:

1. Next Century Program

a. $39,280 thousand recorded in

cost of sales during 2011 relat-

ed primarily to accelerated

depreciation of fixed assets

b. $13,644 thousand recorded in

cost of sales during 2010 relat-

ed primarily to accelerated

depreciation of fixed assets

2. Global Supply Chain Trans-

formation Program

a. $5,816 thousand recorded in

2011 was due to a decline in

the estimated net realizable

value of two properties being

held for sale

b. $10,136 thousand recorded in

cost of sales during 2009 relat-

ed to start-up costs and the ac-

celerated depreciation of fixed

assets over the estimated re-

maining useful life (The Her-

shey Company, Annual Re-

port, 2012).

The Next Century Program and the

Global Supply Chain Transformation

Program have future potential benefits

for the Hershey Company. Both pro-

grams incurred the charges (credits)

associated with business realignment

initiatives and the impairment record-

ed during 2011 in amount of $(886)

thousand, 2010 in the amount of

$83,433 thousand, and 2009 in the

amount of $82,875 thousand that is re-

flected in the company’s income

statement.

Financial Analysis

Financial analysis analyzes and evalu-

ates financial risk, ratios and profita-

bility. The Hershey’s financial analy-

sis determines the company’s

profitability, financial strength, man-

agement’s efficiency, liquidi-

ty/solvency and cash flow predictabil-

ity.

Common-size financial statement ra-

tio analysis

By comparing consecutive balance

sheets, income statements, and state-

ments of cash flows side by side, and

reviewing those changes in individual

categories on a year-to-year basis, fi-

nancial analysts may be able to under-

stand the historical record and future

trends of a company. In this “trend”

analysis, we need to focus on:

• Absolute direction, speed and ex-

tent of a trend

• Relative direction, speed and trend

among different components

Two popular techniques of compara-

tive analysis are:

• Year-to-year change analysis

• Index number trend series analysis

In a common-size balance sheet, each

component of the balance sheet is ex-

pressed as a percentage of total assets.

In a common-size income statement,

each item is expressed as a percentage

of sales.

Prospective Analysis

Another key component of the frame-

work for analysis is a prospective

analysis. Prospective analysis allows

the company to improve its business

strategy and maintain its sustainability

and for investors to make proper deci-

sions about their investments. Dis-

counted dividends, abnormal earn-

ings, and discounted cash flow

methods are used to perform prospec-

tive analysis. The widely used ap-

proach is discounted cash flow meth-

od.

Identify key accounting policy

Assess accounting flexbility

Identify potential red flags

Undo any distortions and noise

The following financial ratios help to evaluate the company’s previous performance:

Liquidity The company's ability to meet its short-term obligations

Current Ratio Total Current Assets/Total Current Liabilities

Quick Ratio (Total Current Assets – Inventories)/ Total Current Liabilities

Average Collection Period Average Accounts Receivable/(Total Sales/365)

Days Inventory Held Days in a year/Inventory Turnover

Leverage The company's ability to meet its liabilities in the long term

Financial Leverage Index Return on Assets/Return on Equity

Debt/Assets (Short Term Debt + Long Term Debt)/Total Assets

Debt/Equity (Short Term Debt + Long Term Debt)/Total Equity

Operating Efficiency The assessment of operating management

Accounts Receivable Turno-

ver Annual Credit Sales/Average Receivables

Inventory Turnover Cost of goods sold/Average Inventory

Total Asset Turnover Sales/Average Total Assets

Profitability The indication of the company's market share (rising, stable, falling)

Gross Profit Margin (Sales – Cost of Sales)/Sales

Return on Assets (ROA) Profit after taxes/Total Assets

Return on Equity (ROE) Profit after taxes/Shareholders’ Equity

Market Measures The assessment of investment opportunity

Price/Earnings Current Market Price per Share/After-tax Earnings per Share

Dividend Payout Cash Dividends Paid/Net Income

The Hershey Company demonstrated over three years’ results from 2009 to 2011 the

following integration of environmental analysis:

New product introductions

Consumer- driven

approach

Core brand investments

Strong financial

performanc e

Improve market share

Cost savings

initiatives

Prospective analysis uses the financial statement data to forecast future earnings,

cash flow and valuation of the business. One of the key approaches to perform

business valuation is the discounted cash flow (DCF) analysis.

Free Cash Flow for business valuation is a different approach from the statement of

cash flow.

Sales

- Operating Expenses

Earnings Before Interest, Taxes, Dep. & Amort. (EBITDA)

- Depreciation and amortization

Operating Profit (EBIT)

* (1 - Average Tax Rate)

Operating Profits After Tax

+ Depreciation and amortization

- Capital Expenditures

- Additions to Working Capital

Free Cash Flows

Next is to assess the Hershey’s cost of capital (WACC). WACC has the following

formula:

Rd = Rd 1 * (1 - Marginal corporate tax rate)

Rd 1 - company's debt rate

Marginal corporate tax rate = Income tax expense / Pretax income

Re = Rf + β * Rm

Rf - risk free rate (20-year U.S. Treasury Bond

Rm - equity risk premium

WACC = (Rd * D) + (Re * (E/(D+E)))

Rd - Cost of Debt Re - Cost of equity

This table consists of essential data for determining the Hershey’s WACC:

Cost of Equity:

Re = Rf + β *Rm

Rf or Risk Free Rate (20-year

U.S.Treasury)

2.89

Rm or Equity risk premium 6%

β or Beta risk 0.12

Cost of Debt:

Rd = Rd1(1- Marginal corporate tax

rate)

Rd1 or Company’s before tax rate 5.11%

Marginal corporate tax rate 35%

Equity/(Debt+Equity) Equity and Debt may be applied as a book value or a

market value

Debt/(Debt+Equity) Debt and Equity may be applied as a book value or a

market value

Cost of Capital (WACC) Cost of Equity and percentile of the company’s equity

in the last projected year (Equity/(Debt+Equity)

Cost of Debt and percentile of the company’s debt in

the last projected year (Debt/(Debt+Equity)

Company’s Growth Rate (g) 3%

Nominal growth rate in the economy 2.5%

Terminal Value (TV) TV=(FCFF(last est. year)*(1+g))/(WACC-g)

Present Value Factor

(PV Factor)

PV Factor = 1/(1+r)n, r = rate of return, n = number of

periods

Present Value (PV) PV = FCFF * PV Factor

Company Value The sum of PV forecasted years

Company Value without Long-term

Debt

Subtract the current portion of the long-term debt

from the Company Value

Projected Price Stock The Company Value without Long-term Debt divided

by the number of outstanding shares;

Provide the factors that indicate why the stock price is

lower or higher than the current stock price

The Hershey Company has the following five-year goals:

• Revenue growth from $6.5 billion in 2012 to $10 billion in 2017

• International revenue growth by 25%

• An increase in growth margin up to 43%

Stock market participation is gradually improved from 2009, and it is now comparable to the prere-

cession 2007 level. The chart below demonstrates this trend on the stock market from 2009 to 2013:

The Hershey Company has significantly improved its performance on the stock market from $30.30 in

2009 up to $87.57 in 2013, and it is reflected on the following graph:

Requirements:

1. Provide an environmental analysis

for the Hershey Company by using

the template (see Environment Analy-

sis section).

2. Identify the key items that need to

be adjusted based on the information

provided and the information from

the MD&A section of the Hershey 10-

K for 2011 to financial statements.

3. Determine the appropriate financial

ratios for forecasted balance sheet and

income statement, and provide a brief

trend analysis.

4. Determine the value of stock using

discounted cash flow and write brief

summary based on your analysis.

References

Bloomberg Businessweek News. (2012).

Hershey sets long-term growth goals.

Retrieved February 3, 2013.

Milford, P., McCarty, D., & Church, S.

(2012). Hershey Investor Sues for Rec-

ords on African Child Labor. Bloomberg.

Retrieved February 2, 2013, from

http://www.bloomberg.com/news/2012

-11-01/hershey-investor-sues-for-

records-on-african-child-labor.html

The Hershey Company. (2012). Hershey

Co 10-K Annual Report: Filed Period

12/31/2012. Retrieved from

http://www.thehersheycompany.com/i

nvestors/financial-reports/sec-

filings.aspx

Yahoo Finance. (n.d.). Profile: The Her-

shey Company. Retrieved January 27,

2013, from

http://finance.yahoo.com/q/pr?s=HSY%

2C+&ql=1

Appendix A: Reported Income Statement

For the years ended December 31, 2011 2010 2009

In thousands of dollars except per share amounts

Net Sales 6,080,788$ 5,671,009$ 5,298,668$

Costs and Expenses:

Cost of sales 3,548,896 3,255,801 3,245,531

Selling, marketing and administrative 1,477,750 1,426,477 1,208,672

Business realignment and impairment (credits) charges, net (886) 83,433 82,875

Total costs and expenses 5,025,760 4,765,711 4,537,078

Income before Interest and Income Taxes 1,055,028 905,298 761,590

Interest expense, net 92,183 96,434 90,459

Income before Income Taxes 962,845 808,864 671,131

Provision for income taxes 333,883 299,065 235,137

Net Income 628,962$ 509,799$ 435,994$

THE HERSHEY COMPANY

CONSOLIDATED STATEMENTS OF INCOME

Source SEC 10-K February 2012, REPORTED

Appendix B: Forecasted Balance Sheet

Estimate Estimate Estimate Estimate Estimate

2009 2010 2011 2012 2013 2014 2015 2016

ASSETS

Cash and Marketable Securities 253,605$ 884,642$ 693,686$ 890,174$ 1,060,046 1,168,303 1,571,668 1,783,021

Accounts Receivable 410,390 390,061 399,499 423,306 441,130 463,450 484,972 508,476

Inventory 519,712 533,622 648,953 634,013 687,836 708,682 748,714 781,353

Other Current Assets 201,727 231,610 309,381 309,381 309,381 309,381 309,381 309,381

Total Current Assets 1,385,434 2,039,935 2,051,519 2,256,874 2,498,393 2,649,815 3,114,734 3,382,231

Property, plant, and equipment (PP&E) 3,242,868 3,330,279 3,602,994 3,950,364 4,322,834 4,722,219 5,150,463 5,609,650

Accumulated depreciation (1,838,101) (1,873,417) (1,989,561) (2,174,204) (2,376,648) (2,598,181) (2,840,181) (3,104,127)

Net property, plant, and equipment 1,404,767 1,456,862 1,613,433 1,776,160 1,946,186 2,124,038 2,310,282 2,505,524

Other assets 884,830 874,505 805,924 805,924 805,924 805,924 805,924 805,924

Total Long-Term Assets 2,289,597 2,331,367 2,419,357 2,582,084 2,752,110 2,929,962 3,116,206 3,311,448

Total Assets 3,675,031$ 4,371,302$ 4,470,876$ 4,838,959$ 5,250,503 5,579,777 6,230,940 6,693,679

LIABILITIES

Accounts Payable 287,935 410,655 420,017 445,348 463,947 487,500 510,099 534,842

Current portion of long-term debt 15,247 261,392 97,593 97,600 250,200 200 250,200 500,100

Accrued expenses 108,633 120,258 117,939 127,704 131,697 139,072 145,167 152,389

Income taxes & other 498,813 543,011 564,794 595,473 625,972 658,488 695,958 726,516

Total Current Liabilities 910,628 1,335,316 1,200,343 1,266,125 1,471,816 1,285,260 1,601,424 1,913,847

Deffered income taxes and other liabilities 501,334 494,461 617,276 617,276 617,276 617,276 617,276 617,276

Long-Term Debt 1,502,730 1,541,825 1,748,500 1,650,900 1,400,700 1,400,500 1,150,300 650,200

Total long-Term Liabilities 2,004,064 2,036,286 2,365,776 2,268,176 2,017,976 2,017,776 1,767,576 1,267,476

Total Liabilities 2,914,692$ 3,371,602$ 3,566,119$ 3,534,301$ 3,489,792 3,303,036 3,369,000 3,181,323

STOCKHOLDERS' EQUITY

Common Stock (3,782,692) (3,809,883) (4,285,657) (4,285,657) (4,285,657) (4,285,657) (4,285,657) (4,285,657)

Additional paid-in capital 394,678 434,865 490,817 490,817 490,817 490,817 490,817 490,817

Retained earnings 4,148,353 4,374,718 4,699,597 5,099,497 5,555,551 6,071,581 6,656,781 7,307,196

Total Shareholders' Equity 760,339 999,700 904,757 1,304,657 1,760,711 2,276,741 2,861,941 3,512,356

Total Liabilities and Shareholders' Equity 3,675,031$ 4,371,302$ 4,470,876$ 4,838,959$ 5,250,503 5,579,777 6,230,940 6,693,679

THE HERSHEY COMPANY

STANDARDIZED, ADJUSTED, & FORECASTED BALANCE SHEETS

Appendix C: Forecasted Statement of Income

Authors

Dr. Rishma Vedd, Professor and Associate Department Chair, California State University, Northridge, CA,

[email protected]

Nataliya Yassinski, Accounting & Information System, California State University, Northridge, Northridge,

[email protected]

Estimate Estimate Estimate Estimate Estimate

2009 2010 2011 2012 2013 2014 2015 2016

Sales 5,298,668$ 5,671,009$ 6,080,788$ 6,520,177$ 6,991,316$ 7,496,498$ 8,038,184$ 8,619,012$

Cost of Sales 3,063,120 3,058,685 3,333,133 3,573,980 3,832,231 4,109,143 4,406,063 4,724,439

Gross Profit 2,235,548 2,612,324 2,747,655 2,946,197 3,159,085 3,387,356 3,632,121 3,894,573

SG&A 1,202,552 1,424,984 1,472,789 1,579,211 1,693,322 1,815,679 1,946,878 2,087,556

Depreciation and amortization expense 172,275 183,472 170,667 184,643 202,445 221,533 242,000 263,946

Interest Expense 90,459 96,434 92,183 94,375 89,386 84,396 71,606 71,596

Income before tax 770,262 907,434 1,012,016 1,087,968 1,173,932 1,265,747 1,371,638 1,471,475

Income tax expense 269,833 335,536 350,945 377,284 407,094 438,934 475,654 510,275

Income (loss) from extraordinary items and

discontinued operations - - - - - - - -

Net Income 500,429 571,898 661,071 710,685 766,838 826,814 895,984 961,200

THE HERSHEY COMPANY STANDARDIZED, ADJUSTED, & FORECASTED STATEMENT OF INCOME

Did Right Case Take a Wrong Turn?

Janet E. Mosebach, & Diana R. Franz

Abstract

This case uses a relatively simple yet relevant income tax issue, worker classification, to

introduce students to the financial reporting issues surrounding uncertain tax positions

(ASC 740-10; commonly known as FIN 48). Worker classification is not only a hot topic

in the U.S., it is being raised in tax audits and labor courts around the world. While in-

come tax regimes vary greatly around the globe, the factors used to determine whether

a worker is an independent contractor or employees are quite similar. The financial re-

porting implications can be significant due to government-mandated employee bene-

fits, penalties, and the retroactive nature of tax adjustments. This case can be used in an

intermediate financial accounting or corporate income taxation course to demonstrate

the issues surrounding ASC 740-10 and the computations necessary to record the liabil-

ity associated with it. This case can also facilitate a discussion of Schedule UTP in a tax

course.

Introduction

Justin Wei sighed at the end of a long day.

He has been the controller at Right Case,

Inc. for almost six months and was begin-

ning to feel comfortable in the role. Right

Case (a publicly-traded U.S. corporation)

manufactures and sells a wide array of of-

fice furniture and modular office systems

(better known as cubicles). Because the

firm’s domestic sales were not growing,

they expanded sales internationally four

years ago.

Right Case’s first international sales ex-

pansion was to India. Due to the growth

rate of the Indian economy, Right Case

was optimistic about their ability to ex-

pand sales into that market. But, in order

to limit the firm’s exposure and make it

easier to withdraw from the country if

necessary, the firm hesitated to hire em-

ployees in India. Instead, Right Case treat-

ed its sales force in India as independent

contractors. Sales in India took off and

three years ago Right Case expanded into

two other countries with growing econo-

mies. Because of Right Case’s success in

India and their satisfaction with inde-

pendent contractors, they structured sub-

sequent operations in other countries in

the same fashion.

The cause of Justin’s long day was a notice

from the Department of Income Tax (part

of the Government of India’s Ministry of

Finance) challenging Right Case’s treat-

ment of its Indian sales force as independ-

ent contractors. The Department of Income

Tax (DIT) claims the sales associates are

misclassified and should be treated as em-

ployees. This concerns Justin because

treating the Indian sales force as employ-

ees would mean Right Case would be re-

sponsible for paying both the employer

and employee share of employment taxes,

and providing various government-

mandated benefits to its Indian workers

retroactively to the date they started. The

DIT notice also indicates the entire amount

of any previously unpaid taxes and bene-

fits is subject to interest and significant

penalties.

Justin remembered being briefed about the

independent contractors when he started

at Right Case but he never actually re-

viewed the contracts. Justin recalled that

the question of worker classification was

an issue at his last employer but he was

not directly involved. He remembers hear-

ing about a list of 20 common law rules the

U.S. Internal Revenue Service (IRS) uses to

determine if a worker is an employee or

independent contractor. Before he leaves

for the day he downloads a copy of the list

and sets up a meeting with Sonny, Right

Case’s sales manager, to discuss the mat-

ter.

At their meeting the next morning, Sonny

tells Justin he cannot understand why

there is a problem because the contract be-

tween Right Case and each sales associate

clearly states in several places that the

sales associate is an independent contrac-

tor. The template contract used for the In-

dian sales force, which Justin and Sonny

review at the meeting, is relatively short

and comparable to other independent con-

tractor agreements the company entered

into in the past. The contracts entitle each

sales associate to a modest flat monthly in-

come plus commissions based on their

monthly sales, and reimbursement for all

sales-related expenses incurred by them.

The contracts are open-ended, meaning ei-

ther party can terminate the contract at

any time without penalty, because Right

Case wanted flexibility in case they decid-

ed to exit the market. The contracts also

restrict the sales associate from holding

similar sales positions with other compa-

nies while they are under contract with

Right Case. Right Case added this provi-

sion to protect their proprietary intellectu-

al property.

Sonny explains that he personally went to

India to interview each sales associate and

have them sign the contract before they

were engaged. While in India, Sonny held

a training session for the sales force, ac-

companied each sales associate on one or

two sales calls to observe and critique their

sales techniques, and made sure they each

had business cards identifying them as

Right Case representatives. Right Case al-

so provides each sales associate with a cell

phone and laptop computer loaded with

the software necessary to facilitate the

processing of sales orders, and preparation

and submission of the monthly sales re-

ports on which their commissions are

based.

Every six months Sonny returns to India to

interview and engage new sales associates

as necessary, and host a two-day retreat

for the entire sales force. On the first day

they review the previous six-month’s sales

figures, attend a sales training seminar,

and become familiar with Right Case’s

new products. On the second day, Sonny

brings in a local motivational speaker to

energize and motivate the sales force, and

treats them to a round of golf in the after-

noon. All sales associates are expected to

attend the retreat.

Based on some research Justin did before

their meeting, he discovered the DIT uses

basically the same common law rules used

by the IRS to differentiate between em-

ployees and independent contractors. He

decides to review the international sales

force arrangement in light of the 20 com-

mon law rules to determine why the DIT

has questioned Right Case’s classification

of the Indian sales force.

Justin is not concerned about any corpo-

rate income tax issues in India because

Right Case has been paying income tax on

their sales in India all along. What does

concern Justin is the significant cash out-

lay that will be required if Right Case has

to pay back employment taxes, income tax

withholdings, and fringe benefits for the

Indian sales force, and the fact that any

penalties owed will be significant and

non-deductible for income tax purposes.

Justin also realizes that Right Case used

this same arrangement in the other coun-

tries they expanded into three years ago

which could open the company up to simi-

lar issues in those countries.

Required

Help Justin to address these concerns by

responding to the following questions:

1. Are the sales associates representing

Right Case in India, and other coun-

tries, independent contractors or Right

Case employees? When explaining

your answer, you should specifically

address at least five of the most rele-

vant of the 20 common law factors

identified by the IRS. (NOTE: Alt-

hough worker classification factors

vary slightly from country to country,

they are remarkably similar. As a re-

sult, the IRS factors act as a proxy for

the Indian factors).

2. Based on your analysis in question 1,

what changes, if any, would you sug-

gest the company make to ensure in-

dependent contractor status going for-

ward?

3. Assuming the notice from the India

Department of Income Tax is correct,

help Justin by preparing the journal en-

try (or entries) needed for the current

year and the prior three years. Assume

that the current year is still open but

remember that a prior period adjust-

ment is required for changes affecting

years in previously issued financial

statements. Assume Right Case has an

effective income tax rate of 30% for

analysis of this issue and use the in-

formation in following Table for your

analysis. To simplify your analysis, as-

sume the financial results of the cur-

rent year and the three prior years are

the same. The financial results of the

current year are shown in the Table.

(The effective income tax rate has been

adjusted because penalties are non-

deductible.)

Table

Panel A: Selected Financial Information (Note: All information is annual.)

Other

U.S. India International Total

Sales $ 1,000,000 $ 600,000 $ 400,000 $ 2,000,000

Payments to independent

contractors - 60,000 40,000 100,000

Net income 40,000 24,000 16,000 80,000

Panel B: Estimate of Cost as a Percentage of Payments to Independent Contractors

Cost Component

Back income tax withholdings (average of top two rates of 20% and 30%) 25%

Back Employees Provident Fund* (12% for employer and employee) 24%

Back benefits (employer’s pension contribution) 3%

Interest and penalties 10%

Total 62%

*Similar to social security in the U.S.

4. Although this issue has not been raised in the other two countries Right Case ex-

panded into three years ago, Justin realizes that it is possible and he needs to ac-

count for this as an uncertain tax position under ASC 740-10.

a) Help Justin estimate the amount Right Case’s potential liability. You will need to

use the financial information in the Table above for your analysis.

b) Justin knows that accounting for uncertain tax positions involves a two-step de-

cision process. Assume Right Case meets the “more likely than not” criteria from

Step 1 of that decision process. Based on his prior experience dealing with the

Indian taxing authorities, Justin believes Right Case can negotiate a lower tax lia-

bility in the other countries by voluntarily raising these issues with the appropri-

ate taxing authorities. He estimates Right Case can reduce its liability to 80% of

the amount that would otherwise be due (i.e., 80% of the potential liability you

estimated in 4a above).

100

Help Justin by completing the following chart to estimate the tax benefit.

Dollar Amount

Probability that Position

will be Upheld

Cumulative

Probability

100%

Total 100%

5. Now, assume the sales force in question was the U.S. sales force instead of the inter-

national sales force. Would you recommend Right Case take advantage of the IRS’s

Voluntary Classification Settlement Program (VCSP)? What impact would this have

on Right Case’s potential ASC 740-10 disclosure, if any? Assume Right Case com-

plied with all annual Form 1099 reporting requirements and is not currently under

an employment tax audit by the IRS.

Case Appendices

Appendix A

20 common law factors identified by the IRS as relevant in determining worker classifi-

cation (as contained in the 2007 U.S. Joint Committee on Taxation report entitled “Pre-

sent Law and Background Relating to Worker Classification for Federal Tax Purposes”);

accessible at http://www.irs.gov/pub/irs-utl/x-26-07.pdf.

Appendix B

Voluntary Classification Settlement Program (VCSP) information provided by the IRS;

accessible at http://www.irs.gov/Businesses/Small-Businesses-&-Self-

Employed/Voluntary-Classification-Settlement-Program.

Authors

Janet E. Mosebach, Assistant Professor of Accounting, Department of Accounting, Col-

lege of Business and Innovation, University of Toledo, Toledo, OH 43606-3390, ja-

[email protected] (Corresponding Author)

Diana R. Franz, Professor of Accounting, University of Toledo, Toledo, OH 43606-3390,

[email protected]

Acknowledgements

We would like to thank Crystal M. Threet at Ernst & Young, Catherine A. Sheets at Plante & Moran, and

Brian Laverty at the University of Toledo for their valuable and insightful input on this case.

101

Quandary at National Health Company

N. Ahadiat, & D. Rice

Abstract

National Health Company (NHC) became one of the nation’s leading providers of

healthcare during the early 2000s, through aggressive mergers and acquisitions. The

company provides both in and out patient care such as convalescent care, rehabilitation,

physical therapy, outpatient surgical centers, ultrasounds, mammograms, MRI’s, CT

scans, and other medical services. The company’s rapid expansion initially resulted in a

substantial amount of profit and success in the healthcare market. However it became

increasingly difficult to maintain the growth and expansion in light of the economic

climate, continued pressure from Medicare, the insurance companies to cut costs, com-

petition from other health field carriers and the concern over potential government

funded health care programs. As the NHC’s management failed to sustain the expected

growth, its management resorted to other strategies that not only maintained the expec-

tation of its shareholders, but would also allow management to keep their extravagant

life style.

In this case, we will follow the struggles and anguish faced by Karen Larson, NHC’s

Chief Financial Officer, as she battles her way through making the right financial and

corporate governance decisions and not to allow herself to be allured, by fancy titles,

avarice and greed as well as upper management pressure placed before her. We will

present not only the decisions she has to make but also the outcome of her decisions.

Background

National Health Company (NHC) is one of

the nation’s largest providers of

healthcare. It is ranked in the top ten na-

tionally in terms of size and revenue. The

company reached its ranking by expand-

ing rapidly through aggressive mergers

and acquisitions throughout the late 1990’s

through the 2006. The company had 50 fa-

cilities across the nation in 1990. By 2006

the company had purchased another 28

hospitals and 45 outpatient rehabilitation

facilities from National Health Enterprise.

In 2003, NHC purchased ReLive, a major

healthcare chain. In 2005, NHC acquired

Medical Surgical Corporation, Novacare,

Health Imaging, Horizon and several oth-

er healthcare providers, with acquisition

costs totaling approximately $2.5 billion.

The buying binge positioned the company

as one of the major players in the

healthcare industry.

As the expansions continued, the NHC’s

stockholders became accustomed to a pe-

riod during which they enjoyed double

digit growth rate in their investments.

Yet, once this growth began to truly slow

down, management and Karen Larson,

NHC’s Chief Financial Officer (“Karen”)

did not pay any heed but instead took var-

ious steps to ensure that the price of the

stock would continue to soar.

102

In December 2008, Karen was celebrating a

triumphant moment in her career. She

had been made the CFO in a company she

loved. For Karen, this moment did not

come soon enough. For 20 years, she had

set her sight on this position. She had

toiled in the trenches, putting in long

hours and sacrificing even her vacation

time in hopes of attaining her dream job.

Achieving this position was a fitting cul-

mination of her years of dedication. It was

a richly deserved reward that she cher-

ished and relished. Now Karen was too

pre-occupied with her thoughts. As she

sat huddled in the corner of her dark pris-

on cell, surrounded by belligerent, mental-

ly unstable inmates, Karen Larson’s mind

could not help but revisit the fateful day

when her plunge from the lofty perch in a

major corporation to the bowels of prison

began. Painfully, it was time for her to

trace back her steps to what had brought

her here.

The Plan

No sooner had Karen settled on her new

position, when her troubles started. Ap-

proximately nine months into her new job,

Karen Larson was lying awake, sleepless

and listless on her bed. Her thoughts

wandering around the meeting she had

earlier in the day with several other mem-

bers in upper-level management. George

Dawson (“George”), the CEO of the com-

pany had gathered all the members of up-

per-level management with direct rela-

tions to the finance and treasury

departments. George had started the

meeting with a speech about how proud

he was to be working with such trustwor-

thy and loyal associates, and how he was

very fond of everyone and how they were

all like family to him. After George’s wel-

coming introduction, the real topic of the

meeting came into play. George stated

that, “I’m sure you’re all aware of our cur-

rent financial position as a company.” Ka-

ren and everyone there nodded with the

understanding of his statement. He con-

tinued, “This recent quarter has been very

bleak, the bleakest one this company has

ever seen in its history.” Everyone contin-

ued to nod in agreement with his words.

George went on, “However, I believe our

company can pull through this stumble.

All I ask is a small favor in order to bring

the company to new heights.” A deep si-

lence swept across the room in the antici-

pation of his next words. “All I ask is that

we hide the stumble we had this quarter

from the public. Not everyone in the pub-

lic might agree with our strengths and

abilities. And if word got out that we the

giant in the healthcare industry was falter-

ing, it would hurt the company as a whole.

And we wouldn’t want that now would

we?” Whispers started out among every-

one all at once, at the notion of what was

being asked of them. George, the CEO of

the company, the one that she had looked

up to, was asking her and everyone else in

the room to commit fraud and falsify the

accounting books and records. George

started to silence the whispers, as he con-

tinued, “I will hold personal responsibility

in this act and request. All I’m asking for

is to make this one quarter look positive to

the eyes of the public. And next quarter,

I’ll ensure the company truly has a posi-

tive quarter. I’ll let you all think it over for

103

a few days, and we’ll continue this meet-

ing then.”

Over the next several days Karen agonized

over the decisions that she was going to

have to make, yet there were so many un-

answered questions. These questions con-

tinued to spin in her mind. Was she really

a part of the play to deceive the public?

And if she wasn’t, should she tell someone

about the company’s wrongdoings and the

CEO? She thought about the sincerity of

George Dawson when he stated that he

would bring the company into positive

cash flow over the next quarter, in line

with the financial markets expectations.

Then she thought about all her fellow as-

sociates, all of her friends and all of the

people who worked under her. She had

been working for NHC for over 20 years,

she had worked hard and diligently to

gain her last position as Chief Financial

Officer. She had also worked hard to gain

the trust and loyalty of her fellow associ-

ates. However, what the members of top

management had asked her to do against

the oath she had sworn when she became

a CPA, and her fiduciary duties as one of

the officers in the company. It also went

against the very morals and fibers of her

upbringings and had left her in utter tur-

moil. She continued to ponder. What

would have been the outcomes if the com-

pany had reported a loss? What would

have been the outcomes if she and those

involved did not get caught in the fraud

they were about to commit? What was

she going to do?

The Afterthought

A debate raged in Karen’s head. She

thought if she agreed to commit fraud

then the company would have no reason

to lay off any of their workers. All of the

jobs would be saved. But then what if the

jobs were saved but the investors lost their

money? She shook the thoughts out of her

head. It was only going to be this one

quarter, as far as she could tell and dared

to believe and hope for. She convinced

herself then that agreeing to commit to the

act would be the best course, especially if

everyone else in the meeting agreed to it.

She didn’t want to be the outcast, nor did

she want to disappoint everyone. She

didn’t want to constantly have to look

over her back with all the ridicules about

why she didn’t go along with the decision.

And she definitely wasn’t going to tell an-

yone for fear of losing her own position in

the company; the position that she had

worked so hard to achieve. Karen had fi-

nally decided that she was going to accept

the CEO’s plea.

The next meeting took place around Octo-

ber of 2009. The meeting room was quiet.

All her fellow upper management associ-

ates looked tired, as if they too didn’t get

very much sleep the last few days. But

they also all had a stern look; she could tell

that everyone else probably went through

a similar ordeal to her own. She could al-

so see in their eyes, as they waited for

George, that they were all going to agree

with what George had proposed a few

days earlier.

As George walked through the doors of

the meeting room, he was quick to notice

104

the deadly silence, and was quick to break

it and get down to business. He asked,

“So has everyone come to a decision?”

They all nodded their heads. “What is it

then?” George asked, “Are you with or

against me?” A short silence fell over eve-

ryone, as no one seemed willing to be the

first to admit to conspiring to the devious

plan. Then Patricia Kim the corporation’s

in-house counsel stood up and gave her

answer, “I agree to your idea George and

stand behind you and your decision all the

way.” At that moment, everyone else was

quick to chime in with similar affirma-

tions.

The rest of the meeting went into a discus-

sion of how they were going to hide this

from the public and cover their tracks to

make it difficult for an auditor to find the

deception, if one ever came to investigate.

The plan that they came up with was to

decrease a contra asset account as well as

the expense accounts, either of which

would increase earnings and correspond-

ingly the assets. In addition, they were go-

ing to create fictitious journal entries to

correspond with the generally accepted

accounting principles. Furthermore they

were going to create false documents to

support the bogus accounting entries.

After the meeting adjourned, George came

into Karen’s office and said “we are going

to be reporting all of this additional in-

come and with the capital gain NHC had

from the sale of an asset this year, I am

concerned about the inability from a cash

flow standpoint for NHC to pay its corpo-

rate income tax. We need to find a way to

offset the company’s potential tax liability,

which in part was due to a large capital

gain from the sale of an asset and I would

like you to consider some of the tax shel-

ters out there.” Karen wanting to help out

George came across a tax shelter, called

“Son of Boss”, 11which was designed to re-

duce capital gains. The transaction is a

“listed transaction” with the IRS. Howev-

er, George had made it clear that it was

necessary to defer any immediate issues

with their taxes with the Securities and

Exchange Commission (SEC) or the Inter-

nal Revenue Service (IRS) and requested

that Karen not file the listed transactions

form with the IRS. Karen complied with

this request in order to please her boss.

The Aftermath

The plan went off without a hitch. Every-

thing had gone according to plan. How-

ever, the next quarter rolled by and passed

rather quickly and still George didn’t or

couldn’t hold up his end of the bargain.

They all held another similar meeting, and

George asked to continue the plan for an-

other quarter. One quarter after another

came and passed with no end to the ac-

counting and financial subterfuges insight.

Then one day, rather unexpectedly and

11 “Son of Boss” tax shelters were designed to re-

duce federal income tax obligations from the sale of

a business or other appreciated assets. Assume

that the statute of limitations was not an issue, as in

the Supreme Court case of U.S. vs. Home Concete &

Supply, LLC, 566 U.S.___(2012). Assume that our

client’s executive offices are located in Texas in

which is a 5th Circuit case, Klamath Strategic Inv. V.

U.S. 568 F.3d 537 (5th Cir. 2009), held that the

transaction lacked any economic substance and

was nothing more than a sham.

105

without discussing it with anyone, George

sold his stocks of NHC.

Even though NHC’s business was suppos-

edly booming, the first of National Heath

Company's accounting problems started to

surface in late 2010 after George sold $85

million in stocks several days before the

company posted a large loss, the first in

the company’s history. The SEC started to

investigate whether or not George’s deci-

sion to sell his stocks was related to the

posting of a large loss. NHC hired an out-

side law firm to review George’s stock sale

in order to try to postpone the SEC’s in-

vestigation. The outside law firm con-

cluded that the sale and profit loss were

not related. This however did not ease the

SEC's suspicions. The SEC not only

looked into the stock sale but began exam-

ining the books and records of the compa-

ny along with the FBI. As the investiga-

tions progressed, various employees were

interviewed, including Karen. The FBI

and the Department of Justice met with

Karen and offered her a reduced sentence

if she would come clean with what she

knew. On the evening of June 13, 2012,

FBI agents executed search warrants at the

company's headquarters after the compa-

ny's CFO Karen agreed to wear a wire, in

which she was able to get George to talk

about the fraud.

A number of months thereafter, the Feder-

al Grand Jury issued indictments against

all upper management, including Karen

for committing fraud, for falsifying NHC’s

books and records, and for aiding and

abetting to defraud shareholders. Now,

less than a year later, Karen agreed to a

plea deal in which she would be sentenced

to 18 months in prison and a fine of

$500,000 in return for her cooperating with

the government. Had she not cooperated

with the government she could have re-

ceived 10 years.

As Karen Larson sat outside the court-

room waiting to testify for the government

against George, the government’s first de-

fendant, she began to recollect her

thoughts on her misguided actions and the

ordeals she would now have to go

through. She no longer was a CFO, she no

longer had a job, she lost her CPA license,

she lost her right to practice before the IRS,

she was facing 18 months in prison and

when she get out of prison, she could look

forward to repaying $500,000 in restitu-

tion.

What could she have done to avoid these

problems, especially of the devastating pit-

fall of languishing in prison for 18

months? How she could be so foolish, Ka-

ren muttered to herself in retrospection.

What was she thinking? How could she

possibly believe that the fraud would only

last a quarter? George was a human, not a

god. Karen sighed deeply. She had al-

lowed herself to be deceived. She had

been myopic to think that she could save

her own skin and her colleagues’ jobs

through fraud. Perhaps now, Karen

thought bitterly, she would be able to

clearly discern her misguided actions to

ensure that she never acts in that manner

again. With at least another year of her

life devoted to testifying on behalf of the

government against other defendants with

respect to the fraud committed by NHC

106

and its officers and directors and 18

months of prison time yet to serve, Karen

will certainly have sufficient time to dwell

on all her missteps.

Questions for Discussion

1. What are the laws governing the proper

practice of accounting and finance?

2. What are the protections afforded to a

whistle blower?

3. What are Karen Larson’s fiduciary du-

ties toward the company as vice presi-

dent to the CFO?

4. Aside from participating in the scheme,

what are Karen Larson’s other options

in face of the dilemma?

5. What are the pros and cons of each of

her options?

6. May the IRS impose a tax preparer pen-

alty under IRC §6694?

7. Has the Corporation violated any of the

tax laws where the IRS could impose a

penalty? If so, under what sections of

the Internal Revenue Code?

8. What ethical duties were violated by

Karen under the AICPA Statements on

Standards for Tax Services as well as

those set forth under Circular 230?

References

American Bar Association. (n.d.). Fiduci-

ary duties and potential liabilities of di-

rectors and officers in financially dis-

tressed corporations. Retrieved

February 24, 2007 from

www.abanet.org/buslaw/newsletter/000

3/materials/tip3.pdf

Burch, R. G. (2006). Director oversight and

monitoring: the standard of care and

the standard of liability post-Enron.

Wyoming Law Review 2006 (6 Wyo. L.

Rev. 481).

Healy Law Offices. (n.d.) A day in the life

of a corporate officer: A general discus-

sion of how officers and directors run

corporations. Retrieved February 25,

2007 from

http://www.healylaw.com/corp.htm#Fi

duciary

Mercer, K. C., & Tomasco, P. B. (Septem-

ber 6, 2001). Fiduciary duties of officers

and directors to creditors. Retrieved

February 24, 2007 from

http://www.brownmccarroll.com/article

s_detail.asp?ArticleID=37

Occupation Safety and Health Administra-

tion, U.S. Department of Labor (2003).

Whistleblower Protection – General. Re-

trieved February 20, 2007 from

http://www.osha.gov/OshDoc/data_Wh

istleblowerFacts/whistleblower_protecti

ons-general.pdf

Sarbanes-Oxley. (November 19, 2002).

Sarbanes-Oxley Act of 2002. Retrieved

February 20, 2007 from

http://www.sarbanes-

ox-

ley.com/section.php?level=1&pub_id=S

arbanes-Oxley

Securities and Exchange Commission.

(June 10, 2004). Securities Act of 1933.

Retrieved February 20, 2007 from

http://www.sec.gov/divisions/corpfin/3

3act/index1933.shtml

Securities and Exchange Commission.

(June 10, 2004). Securities Exchange Act

107

of 1934. Retrieved February 20, 2007

from

http://www.sec.gov/divisions/corpfin/3

4act/index1934.shtml

Authors

N. Ahadiat, Accounting Department, College of Business Administration, California

State Polytechnic University, Pomona, CA 91768, [email protected]

D. Rice, Accounting Department, College of Business Administration, California State

Polytechnic University, Pomona, CA 91768

108

Interest Charge Domestic International Sales Corporations –

The remaining exporter tax benefit

Matthew Yost, & Chris Bjornson

Abstract

This article provides a brief history of the tax breaks given to exporters and explains

how the Interest Charge Domestic International Sales Corporation is the last benefit re-

maining to exporters. A code section by code section analysis of the Interest Charge

Domestic International Sales Corporation tax law is provided. The article then explains

what an Interest Charge Domestic International Sales Corporation is and how to use

one to save on Unites States taxes. The article provides examples of the ways the Inter-

est Charge Domestic International Sales Corporation can save taxes through setting up

a sales transaction or a commission transaction. The article concludes with a brief dis-

cussion of the case law surrounding Interest Charge Domestic International Sales Cor-

poration.

Introduction

Until the 1970, the United States econo-

my was largely a “net exporter”12 as the

U.S. economy was dominant at the time,

and the real competition for foreign im-

ports was not significant. However, be-

ginning in 1971, this position began to

change dramatically as global trade ex-

panded rapidly, along with the U.S. trade

deficit (see Exhibit 1). After increasing to

a peak deficit of $753 Billion, the recent

economic slowdown lowered the deficit

to $381 Billion for 2009, the lowest since

2001, as the U.S. economy simply con-

sumed less. Since that time, the deficit

again grew to $557 Billion in 2011, before

shrinking a bit to 535 billion in 2012. The

most current month (June 2013, see Ex-

hibit 2) showed a negative trade balance

12 U.S. Census Bureau, Foreign Trade Division.

U.S. Trade in Goods and Services – Balance of

Payments Basis. August 12, 2013.

of $34.2 Billion13. It is interesting to note

however, in this data since about the

time that the U.S. began operating in a

net trade deficit, it has been focused in

“goods” while the country continues to

expand a positive trade balance in “ser-

vices.” This truly illustrates the dynam-

ics in the development of the U.S. and

world economies.

Because of this growing trade imbalance,

the United States, since The Revenue Act

of 1971 has attempted to encourage U.S.

companies to export goods (as well as

certain services) via a host of tax benefits.

However, with the growing world econ-

omies and various trade agreements and

treaties that had been entered into

through the years, most of these benefits

have been successfully challenged by

foreign partners and subsequently re-

13 U.S. Census Bureau, Foreign Trade Division.

U.S. International Trade in Goods and Services

Highlights. August 12, 2013.

109

moved from the tax laws. After a series

of challenges and indirectly beneficial

changes to the U.S. tax code, there is one

major benefit that remains to U.S. export-

ers, the Interest Charge Domestic Inter-

national Sales Corporation (“IC-DISC”).

As will be discussed, an IC-DISC is not a

taxable entity14 and was created to allow

an exporter to essentially defer a portion

of income at a low interest charge. How-

ever, more recently with the Jobs and

Growth Tax Relief Reconciliation Act of

2003 allowing dividends to be taxed at

the capital gains rate15 (and subsequent

extensions of this benefit) the effect is es-

sentially an immediate 20% or 15% tax

savings for S-Corp exporters and even

greater benefit for closely held C-Corp

owners, as double taxation is avoided (as

long as the IC-DISC abides by the neces-

sary regulations).

The primary purpose of this article will

be to provide a summary of the current

tax benefit that exists for exporters with

an IC-DISC, and how to take advantage

of them. This cannot be done without

first giving a history of export tax credits,

as well as other tax decisions that have

been made throughout the years. This is

an important step because it truly illus-

trates how the worldwide nature of our

economy, even dating back to the 1970’s,

has had a dramatic effect on how Con-

gress shapes the tax code, and on how

companies must also adapt to these

changes over time. Also, the analysis of

14 I.R.C. §991 15 Jobs and Growth Tax Relief Reconciliation Act

of 2003 §302

the IC-DISC, and history of exporting tax

benefits will help pose some analysis that

will be necessary in evaluating taking

advantage of this benefit.

I History of Legislation and Exporter

Benefits

A Establishment of the DISC

The initial Domestic International Sales

Corporation (“DISC”) legislation was ac-

tually established in 1971, right around

the time the U.S. began to see its trade

surplus move to a deficit. With this legis-

lation, Code Section 991 was established,

exempting the DISC from taxes. The

DISC could essentially “defer” taxes until

the money was paid to its shareholders,

or other events occurred. 16 In practice

however, the DISCs would never actual-

ly pay a dividend, but would lend the

money back to the operating company.

The lack of dividend payment would es-

sentially create a permanent deferral of

these taxes17.

The new DISC creation was quickly chal-

lenged by foreign countries as a violation

of the General Agreement on Tariffs and

Trade (GATT) as an impermissible trade

subsidy. The initial ruling came in 1976

against the DISC setup, and then after

various challenges the final ruling came

in 1981 against the DISC treatment. In

reaction to the elimination of the DISC

benefit the United State took two steps in

revising the tax code and laws. 16 Public Law 92-178, 1971. Title V 17 History of Export Tax Benefit Legislation.

Export Assist.

http://www.exportassist.com/tax_history.html.

Retrieved 11/23/2011.

110

B 1984 Legislation Reaction

One of the steps that the U.S. took after

the GATT decision was to establish For-

eign Sales Corporations (“FSC”). These

FSC’s were created to allow companies to

exclude a portion of the income from ex-

porting goods from the United States.

These were designed in a way that the

U.S. expected them to be upheld against

fair trade challenges.

More Importantly for the purposes of

this discussion, Congress did not fully

repeal the DISC regulations, but they did

make two key modifications to the law.

The first is the limit on tax deferral to $10

million of a DISC’s export receipts. Any

amount above this $10 million is deemed

as immediately distributed, and the

shareholders of the DISC are charged

taxes, even if the cash has not changed

hands.18

The second modification was adding an

interest charge due on the amount of de-

ferred income.19 Essentially, this interest

charge due to the treasury at the base T-

Bill rate20 disallows permanent free de-

ferral of the income without distribution.

This interest charge on the deferred tax

liability is what garnered the “IC” addi-

tion to DISC’s formed after 1984. Once

the income from the DISC is distributed,

there is no longer a deferral, as the

shareholders of the DISC will be paying

taxes on that distribution, so no interest

charge is due.

18 I.R.C. §995(b)(1)(E) 19 I.R.C §995(f) 20 I.R.C §995(f)(1)(B)

It was in 1997 and into 1998 that the Eu-

ropean Union brought a challenge to the

FSC set-up, again challenging it in rela-

tion to the evolving GATT regulations.

In 1999, it was concluded that the FSC

was in violation of these agreements; it

was repealed in 2000 with the FSC Re-

peal and Extraterritorial Income Exclu-

sion Act of 2000.21 However, it is im-

portant to note that with this challenge to

FSCs there was no challenge to the IC-

DISC and these regulations were re-

tained.

C Extraterritorial Income Exclu-

sion Act and Important Effects

Outside of repealing the FSC, the Extra-

territorial Income Exclusion Act (“ETI”)

included another way for exporters to

exclude certain “qualifying foreign trade

income.”22 This was almost immediately

challenged by the EU and World Trade

Organization as a further violation of

GATT. In 2002, the trend continued as

the ETI was determined to be an illegal

trade subsidy.

After some time, and even sanctions

from the E.U. due to lack of action, the

ETI was ultimately repealed in 2004 with

The American Jobs Creation Act of 2004.

The act included certain phase out rules

that eventually fully phased out the ETI

in 2006.23

Outside of the ETI being repealed, the

Jobs Creation Act of 2004 established an-

21 The FSC Repeal and Extraterritorial Income Ex-

clusion Act of 2000 §2 22 The FSC Repeal and Extraterritorial Income Ex-

clusion Act of 2000 §3 23

The American Jobs Creation Act of 2004 §101

111

other important piece of tax legislation

for a U.S. based business. The “domestic

production activity” deduction phase in

was established with this law.24 By estab-

lishing the internal revenue code Section

199, U.S. based businesses, including ex-

porters, can essentially provide them-

selves with a 9% deduction (after full

phase in from 2010 on) on qualifying in-

come, and subject to certain restrictions.25

The domestic production activity deduc-

tion was essentially created as a com-

promise as it applies to all U.S. produc-

ers, and does not single out exporters.

Even if an exporter is taking advantage

of the benefits of the IC-DISC, domestic

production activity deduction remains a

valid deduction to be taken.

Again, with this act in 2004 the DISC

rules remained unchanged.

D Other Important Legislation

Outside of the specific export legislation,

there are a couple of additional im-

portant pieces of legislation that require

attention for the historical background.

As mentioned above, the first and most

important of these acts was the Jobs and

Growth Tax Relief Reconciliation Act of

2003 (GTRRA) that reduced the corporate

dividends paid to individuals to the 15%

rate.26 Initially, this provision was set to

expire as of December 31, 2008. Howev-

er, in 2005, Congress passed the Tax In-

crease Prevention and Reconciliation act

of 2005. With this act, the beneficial

The American Jobs Creation Act of 2004 §102 25

I.R.C 199 26

Jobs and Growth Tax Relief Reconciliation Act of

2003 §302

treatment of dividends to individuals

was extended until December 31, 2010.27

More recently, the Tax Relief, Unem-

ployment Insurance Reauthorization,

and Job Creation Act of 2010 was passed

and further extended this benefit until

December 31, 2012.28 Finally, the Ameri-

can Taxpayer Relief Act of 2012 extended

the treatment of Dividends.29 This act al-

so established a 20% tax rate for Capital

gains and dividends for tax payers with

incomes above $400,000 for individuals,

$425,000 for Head of Household, and

$450,000 for Married Filing Jointly.30

As has been noted before, the reduction

in tax rate of dividends in the GTRRA

and the subsequent extensions are the

primary drivers to the IC DISC benefit.

The American Taxpayer Relief Act of

2012 makes this reduction permanent.

As Congress looks toward a “Grand Bar-

gain” to lower tax rates and eliminate

many tax breaks it is possible that the tax

rate on dividends will go up. Should

congress increase the tax rate on divi-

dends, the IC DISC will continue to pro-

vide some deferral benefits; however, the

most significant benefits that the IC-DISC

provides would be eliminated.

II IC-DISC Regulations

The modern day IC-DISC is governed by

Internal Revenue Code §§ 991 – 997. The

following sections will delineate the legal

aspects of an IC-DISC, the qualifications, 27

Tax Increase Prevention and Reconciliation act of

2005 §102 28

Tax Relief, Unemployment Insurance Reauthoriza-

tion, and Job Creation Act of 2010 §102 29

American Taxpayer Relief Act of 2012 30

American Taxpayer Relief Act of 2012

112

etc. before getting to some examples of

the tangible benefit that IC-DISCs can

create. In these sections, please refer to

the subheading as references. Versus cit-

ing each example all of the following are

taken from the tax code sections and ap-

plicable regulations unless otherwise

noted. Also, from this point on, as the

DISC to IC-DISC evolution has been ex-

plained, the terms DISC and IC-DISC

will be used interchangeably (the tax

code still refers to the entities as a DISC).

A IRC § 991

Code Section 991 is only one sentence,

but it is a relatively powerful one. “For

the purpose of the Taxes imposed by this

subtitle upon a DISC (as defined in sec-

tion 992(a)), a DISC shall not be subject to

the taxes imposed by this subtitle.” As

this regulation is included in the “Subti-

tle A – Income Taxes” it is essentially a

long way of saying that qualifying DISC

entities are not subject to income taxes at

the entity level.

B IC-DISC Ownership

Before delving further into the regula-

tions, there is a quick note about owner-

ship of an IC-DISC. The most advanta-

geous set-up for an IC-DISC is to have

the individual shareholders of the prima-

ry producing entity also personally own

the IC-DISC, versus the actual entity

owning the DISC. This is important to

take full advantage of the favorable divi-

dend rate, and the distribution strategy

that will be discussed later. It is assumed

through the following discussions that

the ownership of the exporter and DISC

are related in this manner.

C IRC § 992

Code Section 992 goes on to further de-

fine what qualifies a company as a DISC.

There are four primary qualifications that

a DISC must meet to qualify under these

regulations. These are:

1) 95% Qualified Gross Receipts Test -

meaning that 95% or more of the gross

receipts must be qualified export re-

ceipts (to be defined in §993);

2) 95% Qualified Gross Assets Test –

meaning that 95% of the total corpora-

tion’s assets must be qualified export

assets (to be defined in §993);

3) It must have only one class of stock

with a minimum total par value of

$2,500;

4) The corporation must make an elec-

tion to be treated as a DISC.

The IC-DISC must elect to be treated as

such by filing form 4876A 90 days before

the beginning of the tax year, and is able

to revoke the status during the first 90

days of the tax year. This section also

spells out the ways for a corporation to

get back into compliance should the

DISC fail to meet the asset or receipt

tests. This requires distribution of the

funds necessary to gain compliance, as

well as defining a “reasonable cause” for

non compliance.

A final point to be made on §992 is the

list of “ineligible corporations.” Of the 7

ineligible corporations, the primary no-

table is the last which is “an S corpora-

tion.” The IC-DISC itself must be orga-

nized as a C-Corporation. Due to the

requirement to distribute profits to make

113

the DISC a taxable entity, this is an im-

portant elimination. The primary pro-

ducing and export entity may be orga-

nized as any type of entity, and the

owner of the DISC may be any type of

organization or an individual.

D IRC §993

Code Section 993 goes into further depth

on defining what qualified export re-

ceipts and export assets are for the pur-

pose of the 95% tests.

There are 8 different types of qualified

export receipts. These range significantly

from simple gross sales from sale, ex-

change, or disposition of export property,

receipts for services on qualified sales,

specified qualifying interest and divi-

dends, engineering and architectural ser-

vices outside of the U.S., and an im-

portant allowance for the performance of

managerial services. This essentially al-

lows the DISC to not complete significant

actions, but collect a commission (as cal-

culated in the next section). This section

also notes the excluded receipts. These

definitions are explained and defined in

Regulation §1.993, which provides fur-

ther clarity such as required time frames

that payments must be made (such as

commission payments within 60 days of

the tax year close).

As far as the qualified export assets, there

are 9 varying qualifications. The most

broad and important of these is the first,

which includes “export property” that is

defined as follows:

1) Manufactured, produced, grown, or

extracted in the U.S. by a person other

than the DISC;

2) Held by or to a DISC for primary con-

sumption or disposition outside of the

U.S.;

3) Not more than 50% attributable to ar-

ticles imported into the U.S.

In addition to this, there are other assets

which one would expect to be included

such as, accounts receivable, reasonable

working capital requirements, etc. Regu-

lation §1.993 again provides further de-

lineation. One such delineation, § 1.993-

2(d)(2) allows for the commissions re-

ceived to be included as a qualifying as-

set. This section also notes excluded as-

sets, which interestingly enough also can

include property that the President de-

termines is in “short supply.”

Another importation delineation in

§993(d) is the determination of Produc-

er’s Loans. In effect, this section allows

for the DISC to loan its accumulated (un-

distributed) income back to the primary

operating company / exporter, while still

deferring the income from taxes, as it has

yet to be distributed. There are some

general restrictions or limitations that are

calculated within this subsection. These

loans do also qualify as an export asset

and the interest income is a qualified ex-

port receipt, although the interest is im-

mediately “deemed distributed,” as will

be discussed later. These producers’

loans are more important if the income of

the DISC is not distributed and deferred,

however, the current environment may

114

not make this the most advantageous

treatment of the DISC.

E IRC §994

Code Section is another relatively short

section on a standalone basis, although

the supportive regulations in §1.994-1 are

significantly detailed. In general, §994

spells out the way that a DISC can record

and calculate its income. The taxable in-

come of will be based on a price (regard-

less of actual prices charged) to result in

income which does not exceed the great-

est of:

Determination #1:

4% of the qualified export receipts on

the sale of such property by the DISC,

plus 10% of the qualifying export

promotion expenses to the DISC, or;

Determination #2:

50% of the combined taxable income

of the DISC and the person which is

attributable to the qualified export re-

ceipts as a result of the sale by the

DISC, plus 10% of the qualifying ex-

port promotional expenses to the

DISC, or;

Determination #3:

Taxable income based on the sales

price actually charged (but subject to

the rules provided in §482).

Additionally, §994 allows for regulations

to be determined to further delineate the-

se applications in the case of commis-

sions and expenses that are consistent

with the above, and these are spelled out

in Regulation §1.994-1. In the regulation,

it notes the DISC does not have to per-

form substantial economic function to

apply the sections 1&2 above. In the ex-

amples that follow, a commission pay-

ment is made using the same determina-

tion as above, but no actual sale is made

by the DISC as implied in the code. Also,

§994 further defines the export promo-

tion expenses noted above.

Another important distinction of applica-

tion of these rules is the “no loss” rule in

the regulations under §1.994-1(e), which

limits the DISC benefit. In its most sim-

ple application, in the use of a DISC, the

commission or transfer price (in the case

of an actual sale to the DISC) may not

create a combined loss on the product

when the direct costs to the producer and

DISC are considered together. Along

this line, it should be noted that

§267(f)(3)(A) does specifically eliminate a

DISC from the definition of a “controlled

group” allowing the deduction of the ex-

penses between related parties in the

DISC transaction, which otherwise

would be essentially a stepped transac-

tion to specifically avoid taxes.

The code section 482 noted above (De-

termination #3), is prevalent in the DISC

rules, as this section along with its regu-

lations, sets forth the determination of

arms length prices, etc. It also allows the

I.R.S. to re-distribute income and other

items among related parties if it deter-

mines transactions were made simply to

evade taxes. In the case of Determination

#3, the sales price and IC-DISC income

calculation may be subject to further au-

dit scrutiny if they allow for a greater

115

deduction than the first 2 prescribed

methods.

F IRC §995

This section is the one that ultimately

discusses the taxation of the DISC in-

come and its distribution to shareholders.

For practical reasons, the current tax en-

vironment incents the IC DISC to dis-

tribute its income immediately to share-

holders. However, if a distribution is not

paid, there are some factors that limit the

amount of deferral that the DISC can cre-

ate. The limitations force income to be

“Deemed Distributions” even if no divi-

dend is paid. These include various

items, among other things, interest from

producer’s loans and any taxable income

in excess of $10,000,000, essentially elim-

inating any deferral benefit over the $10

million cap and focusing on “smaller”

exporting enterprises. The section also

discusses immediately deemed distribu-

tions of illegal or boycotted country in-

come. Additionally, if the shareholder is

a C-Corp, 1/17 of the income is deemed

distributed immediately. Also, included

in this section are rules on how the de-

ferred income is to be treated if the DISC

is no longer treated as a DISC or revokes

its status.

Section f of 995 also provides the all im-

portant “Interest Charge” that garners

the IC-DISC its name. Essentially, the

regulation states that for any tax year, the

shareholder of a DISC pays the amount

of its DISC related deferred tax liability

(times) the base period T-Bill rate (the 1

year constant maturity Treasury yields -

currently 0.11%).31 For 2012, this was

0.16%32

G IRC §996

Section 996 is used to illustrate the

ordering of distribution treatment, losses,

and basis.

H IRC §997

Section 997 is again a short section,

which has special meaning for C-

corporations. In the case of a C-

corporation that owns a DISC (versus an

individual or a pass-through entity), the

distributions are treated the same as if

the distribution were made to an indi-

vidual, and have that same basis in the

hands of the recipient corporation. This

regulation essentially eliminates the

“dividends received deduction” as the

income at a DISC is already tax free and

not subject to the double taxation issue.

An additional issue with corporations

and the DISC benefit is addressed else-

where in the code under §1504(b)(7)

which disallows the inclusion of a DISC

in a consolidated return, again eliminat-

ing the possibility of total tax avoidance

on the DISC income.

I Summary

As seen even in this brief summary,

though the DISC is simple in theory,

there are hundreds of pages of regula-

tions that support the DISC, its proper

usage, and limitations. Also, hopefully

the benefit of the DISC is evident,

providing the possibility for significant

http://www.bankrate.com/rates/interest-

rates/treasury.aspx retrieved August 12, 2013 32

Revenue Ruling 2012-22

116

income deferral from taxes at a low inter-

est rate. Also, with the current dividend

rate environment, the deferral is a sec-

ondary benefit compared to the savings

from immediate distribution. Following

are brief examples of how to use the IC-

DISC and calculate its current benefits.

III Examples of IC-DISC Application

As mentioned earlier, the rules on

how an IC-DISC is applied and its limita-

tions are numerous, but the brief over-

simplified examples below will give a

basic understanding on how a sales

transaction or a commission transaction

would work. There are various other

items, such as allowing the DISC to have

supporting promotional expenses that

could increase the deferral; however

there is significant law built around this

that would add significant detail and

necessary understanding to properly ap-

ply.

A Sales Transaction

Company X – Domestic Entity that pro-

duces an export product

Company Y – IC-DISC entity owned by

the shareholders of Company X

In this example Company X would sell a

product to Y at a determined fair price of

$800; assume X’s input costs are $700.

Then Company Y would perform further

substantive actions at a cost of $200 and

then ultimately sell the good for export at

the cost of $1,000.

To compute the maximum profit that the

DISC entity may earn you must first

compute the combined income, as the

profit at the DISC may not exceed this

amount:

Y Sales Price $1,000

-X Cost $700

-Y Costs $200

Combined Income $100

The profit at the DISC will be the highest

of the 3 determinations, assuming the

amount would not create a combined

loss. Here are those calculations:

50% of the combined taxable income:

50% * $100

DISC Income $50

4% of the gross receipts method:

4%*$1,000

DISC Income $40

Section 482 Method:

Y Sales Price $1,000

-Cost of Goods Sold (Price Paid) $800

-Additional Expenses (Y) $200

Y Profit $0

Since the 50% method does not exceed

the combined income, the transfer price

that is recorded by X may be adjusted as

long as it is not below $750, computed as

follows:

Y Sales Price $1,000

-Y Expenses $200

-Y Profit $50

Total Subtractions $250

Transfer Price $750

The effect of this adjustment, allows the

DISC to record $50 of the income, while

reducing the producing entity’s income

117

by $50. This essentially would create a

deferral of that $50, as that income would

be recorded at the DISC, versus holding

all of the costs at Company X and not uti-

lizing the DISC. This is illustrated here:

Company X Sales (Transfer) Price $750

-Company X Expense $700

Total Company A Taxable Income $50

(versus initial $100)

Company Y Sales Price $1,000

-Transfer Price from X $750

-Additional Costs at Y $200

Total Y Deferred DISC Income $50

B Commission Transaction

Company A – Domestic Entity that pro-

duces an export product

Company B – IC-DISC entity owned by

the shareholders of Company A

In this example, Company A produces a

good then sells the product at a qualify-

ing export price of $1,000. Assume the di-

rect cost (COGS and direct selling ex-

penses) for A to produce these goods are

$900. Company B is set up as an IC-DISC

performing no substantive action other

than collecting the commission related to

the export sale.

Again, as before you must begin with the

calculation of total income:

Company A Sales Price $1,000

-Company A Expense $900

Total Income $100

Also, you must still determine the in-

come allowable to the DISC:

50% of the combined taxable income:

50% * $100

DISC Income $50

4% of the gross receipts method:

4%*$1,000

Disc Income $40

Section 482 Method:

The section 482 Method would not apply

here for a commission, as the 482 method

only applies when the related supplier

(Company A) had sold the property to

the DISC and the DISC then subsequent-

ly sold the property to a third party to

determine a fair price.33

Since the 50% method again produces the

larger of the two incomes and does not

create a combined loss, it may be deduct-

ed as a commission at Company A and

produce income of the same amount for

the DISC, Company B, as follows:

Company A Sales Price $1,000

-Company A Expense $900

-IC DISC Commission $50

Total Company A Taxable Income $50

Company B DISC Commission $50

The result of this transaction is a valid

deduction of $50 at the Company A level,

reducing the immediate taxable income,

and tax deferred income of $50 at the IC-

DISC level.

C Tax Savings Calculations

The above calculations both show a tax

deferral of $50 for the exporter, and $50

of income for the IC-DISC. As noted be-

Federal Tax Regulation §1.994-1(d)(2)

118

fore, the IC-DISC has the option to retain

these funds at an interest charge to the

treasury. In this case, assuming a general

35% rate, the savings would have an im-

mediate effect of $17.50 of tax savings for

the current year ($50 * 35%) with the time

value of money theoretically creating the

remaining benefit and offsetting the in-

terest charge. The possible changes in fu-

ture income rates do provide some un-

certainty.

However, as presented earlier, with the

evolution of the dividend laws, there can

be a much greater benefit than just defer-

ral. Recent legislation has made the cal-

culation of the benefit more complicated.

Below is a calculation that essentially

shows that versus deferring taxes, there

is an immediate benefit that can be gar-

nered by paying out the dividend. This

calculation assumes a single taxpayer

with AGI no higher than $200,000, or a

married couple with AGI no more than

$250,000.

Corporate Tax Savings (35%*$50)

$17.50

Dividend Tax Paid by Owner (15%*$50)

$7.50 (assuming all $50 of DISC

income is distributed)

Total Immediate Benefit

$10 (20% of original $50)

As noted, this benefit is immediate and

eliminates uncertainty of future tax rates,

etc. that deferral may be exposed to.

For single taxpayers earning in excess of

$200,000, married couples earning more

than $250,000 net investment income is

subject to an additional 3.8% tax. Single

taxpayers with AGI in excess of $400,000,

married couples filing jointly AGI in ex-

cess of $450,000.the capital gains rate is

now 20%. For the rest of this paper all

calculations will assume taxpayers with

AGI of $200,000 or less, but for taxpayers

with higher AGIs the rates are higher

and the benefits are lower.

D C-Corp vs. S-Corp

The above example essentially calculates

the benefit as if the exporting entity was

a privately held S-Corp and the DISC has

related individual ownership (corpora-

tion and dividend are recorded on the

same return). The effect of a DISC in this

case is an immediate 20% tax gain. As

both the dividend income and any re-

maining entity income would flow

through to a personal return, the IC-

DISC would not lower AGI, but would

effectively reduce the tax rate.

It should be noted that in the case of a C-

Corp, the effect is similar, however be-

cause of the double taxation, the savings

is essentially 30%. In theory, the profit of

$50 would be taxed first at the corporate

rate (assume 35%), then a distribution of

the remaining profits would again be

taxed at 15%. This creates an effective

tax rate of 44.75%. Compare this to the

single taxation of 15% on the DISC de-

duction; there is a 29.75% savings in this

example.34

If your primary exporting entity was

formed as a C-Corp, there is theoretically

a more significant tax benefit, there are 34

Misey, Robert R. Jr. Tax-Advantaged Planning for

Closely Held Exporters-Return of the IC-DISC. Taxes- The Tax Magainze. July, 2006

119

obviously many other factors should

play into the choice of business entity.

E Real World Effects

Theoretically, the DISC provides an easy

way for nearly immediate tax savings.

As the benefit is dependent on payment

of a dividend, the cash flow concerns are

real. In the examples above, approxi-

mately half of the producing company’s

net income was expensed in the IC-DISC

(and would ultimately have to be dis-

tributed). For strong companies, this

may be possible; however, when this

strategy is put into practice, it does raise

concerns such as maintaining creditor

covenants, as well as retaining enough

cash in the company to sustain opera-

tions and growth.

As noted the regulations do provide for

such items as “Producer’s Loans” which

allow the DISC to lend the deferred

funds back to the primary entity, while

retaining the tax deferral. Much of the

benefit results from the lower dividend

rates. While congress recently made the

lower dividend rates permanent there is

consistent talk about rewriting the IRC, a

so called “Grand Bargain.’ It is possible

that the dividends rate will be part of the

bargain. If dividends are once again

taxed at ordinary tax rates the benefit of

immediate distribution to receive lower

dividend tax rates will no longer apply.

IV Case Law

A search of IC-DISC related case law, did

not show any real challenge to the benefit

that can be garnered from the DISC regu-

lations. However, it did provide for

some very important warnings for com-

panies looking to take advantage of the

DISC.

For instance, all of the discussion that has

preceded this is an analysis of Federal tax

laws and regulations. Each state may or

may not allow the DISC deduction in the

calculation of that jurisdiction’s taxable

income. There were many cases of indi-

vidual states challenging company’s re-

turns for a deficiency after taking a de-

duction for the DISC. This was evident

in a Kentucky case of Armco, Inc. Here,

Armco argued that since Federal Law en-

couraged trade through the DISC, the

state should also be bound by this as they

have an interest in encouraging trade this

as well. Based on this argument, they

used the gross income determinations of

the Federal Tax Code for apportionment,

etc. As Kentucky has not adopted the

Federal IC-DISC regulations, Armco was

required to pay taxes on the combined

income, and was not allowed the DISC

deduction.35

The second primary reason for cases

brought by the commission against IC-

DISCs are due to qualifying circumstanc-

es, such as lack of adherence to the vari-

ous detailed regulations. Again, this

simply shows the importance of under-

standing what the rules and regulations

are, and adhering to the necessary re-

quirements. An example of this is the

case of Boeing, which made it all the way

to the United States Supreme Court, as

35Armco Inc. v. Revenue Cabinet, Commonwealth of Kentucky. Supreme Court of Kentucky, No. 87-SC- 331-DG, 748 S.W. 2d 372, March 3, 1988.

120

they affirmed the misallocation of R&D

funds in the calculation of combined tax-

able income, increasing the deferral.36

Boeing paid the tax initially and then

challenged it, but was denied the refund

request.

Finally, most of the case law revolved

around pre-1984 law, as well as FSC’s,

which are no longer available. Overall,

the case law shows the need to properly

apply the complex regulations.

V Conclusion

The I.R.S. reported in 2008 there were

1,917 IC-DISC returns filed, up steadily

from a low of 425 filed in 2004.37 This is

not a surprising rise based on the 2003

dividend benefit and subsequent exten-

sion in 2005. A more recent business

week article reported about 6,000 busi-

nesses taking advantage of the benefit.38

Even considering these statistics, it ap-

pears as if it is a tremendously under

used benefit as according to the Interna-

tional Trade Administration, there are

over 275,000 identified U.S. exporters.39

36 The Boeing Company and Consolidated Subsid-

iaries, Petitioners v. United States. U.S. Supreme

Court; 01-1209, 01-1382, 123 SCt 1099, March 4,

2003, 537 US 437, 123 SCt 1099. 37 Statistics of Income Bulletin, Summer 2011. In-

terest-Charge Domestic International Sales Cor-

porations, 2008. 38 Zerbe, Dean and Young, Jim. Save the IC-DISC

Export Tax Break. Business Week.

http://www.businessweek.com/smallbiz/content/j

ul2010/sb20100726_149647.htm. Retrieved No-

vember, 27 2011. 39 Smaller Companies Have Vast Untapped Ex-

port Potential. http://trade.gov/cs/factsheet.asp.

Retrieved December 8, 2011.

As noted in the introduction, the primary

purpose of this paper was to show how

the IC-DISC came about, and how much

of a significant advantage can be gar-

nered from it. Based on the analysis, it

seemingly provides an immediate tax

advantage on a specified amount of in-

come of 20%+. However, this benefit

comes with two major caveats. First,

there is a significant amount of detailed

law, and though at its heart it is a simple

deduction, attention to detail is needed.

This includes jurisdictional awareness, so

you can treat the DISC properly at all

levels. Secondly, exporter benefits are

extremely vulnerable to legislation, here

and abroad. It is important to be aware

of the current laws in relation to the

DISC, the dividend rate, and internation-

al challenges to the benefit.

There is clearly a risk of this benefit go-

ing away, as the continual extension of

the favorable rate has continued to be

challenged before ultimate extension.

Also, if any special dispensation is made

for DISC’s when or if the dividend law is

reversed there is risk of international

challenge as that would separate the

DISC out again and make it a special

case, similar to the previous export laws.

121

Exhibit 1

U.S. Trade in Goods and Services - Balance of Payments (BOP) Basis Value in millions of dollars

1960 through 2012

Balance Exports Imports

Period Total Goods

BOP Services Total

Goods

BOP Services Total

Goods

BOP Services

1960 3,508 4,892 -1,384 25,940 19,650 6,290 22,432 14,758 7,674

1961 4,195 5,571 -1,376 26,403 20,108 6,295 22,208 14,537 7,671

1962 3,370 4,521 -1,151 27,722 20,781 6,941 24,352 16,260 8,092

1963 4,210 5,224 -1,014 29,620 22,272 7,348 25,410 17,048 8,362

1964 6,022 6,801 -779 33,341 25,501 7,840 27,319 18,700 8,619

1965 4,664 4,951 -287 35,285 26,461 8,824 30,621 21,510 9,111

1966 2,939 3,817 -878 38,926 29,310 9,616 35,987 25,493 10,494

1967 2,604 3,800 -1,196 41,333 30,666 10,667 38,729 26,866 11,863

1968 250 635 -385 45,543 33,626 11,917 45,293 32,991 12,302

1969 91 607 -516 49,220 36,414 12,806 49,129 35,807 13,322

1970 2,254 2,603 -349 56,640 42,469 14,171 54,386 39,866 14,520

1971 -1,302 -2,260 958 59,677 43,319 16,358 60,979 45,579 15,400

1972 -5,443 -6,416 973 67,222 49,381 17,841 72,665 55,797 16,868

1973 1,900 911 989 91,242 71,410 19,832 89,342 70,499 18,843

1974 -4,293 -5,505 1,212 120,897 98,306 22,591 125,190 103,811 21,379

1975 12,404 8,903 3,501 132,585 107,088 25,497 120,181 98,185 21,996

1976 -6,082 -9,483 3,401 142,716 114,745 27,971 148,798 124,228 24,570

1977 -27,246 -31,091 3,845 152,301 120,816 31,485 179,547 151,907 27,640

1978 -29,763 -33,927 4,164 178,428 142,075 36,353 208,191 176,002 32,189

1979 -24,565 -27,568 3,003 224,131 184,439 39,692 248,696 212,007 36,689

1980 -19,407 -25,500 6,093 271,834 224,250 47,584 291,241 249,750 41,491

1981 -16,172 -28,023 11,851 294,398 237,044 57,354 310,570 265,067 45,503

1982 -24,156 -36,485 12,329 275,236 211,157 64,079 299,391 247,642 51,749

1983 -57,767 -67,102 9,335 266,106 201,799 64,307 323,874 268,901 54,973

1984 -109,072 -112,492 3,420 291,094 219,926 71,168 400,166 332,418 67,748

1985 -121,880 -122,173 294 289,070 215,915 73,155 410,950 338,088 72,862

1986 -138,538 -145,081 6,543 310,033 223,344 86,689 448,572 368,425 80,147

1987 -151,684 -159,557 7,874 348,869 250,208 98,661 500,552 409,765 90,787

1988 -114,566 -126,959 12,393 431,149 320,230 110,919 545,715 447,189 98,526

1989 -93,141 -117,749 24,607 487,003 359,916 127,087 580,144 477,665 102,479

1990 -80,864 -111,037 30,173 535,233 387,401 147,832 616,097 498,438 117,659

1991 -31,135 -76,937 45,802 578,344 414,083 164,261 609,479 491,020 118,459

1992 -39,212 -96,897 57,685 616,882 439,631 177,251 656,094 536,528 119,566

1993 -70,311 -132,451 62,141 642,863 456,943 185,920 713,174 589,394 123,780

1994 -98,493 -165,831 67,338 703,254 502,859 200,395 801,747 668,690 133,057

1995 -96,384 -174,170 77,786 794,387 575,204 219,183 890,771 749,374 141,397

1996 -104,065 -191,000 86,935 851,602 612,113 239,489 955,667 803,113 152,554

1997 -108,273 -198,428 90,155 934,453 678,366 256,087 1,042,726 876,794 165,932

1998 -166,140 -248,221 82,081 933,174 670,416 262,758 1,099,314 918,637 180,677

1999 -263,755 -337,374 73,618 967,008 698,218 268,790 1,230,764 1,035,592 195,172

2000 -377,337 -446,942 69,605 1,072,782 784,781 288,002 1,450,119 1,231,722 218,397

2001 -362,339 -422,512 60,173 1,007,725 731,189 276,537 1,370,065 1,153,701 216,364

2002 -418,165 -475,842 57,678 980,879 697,439 283,440 1,399,044 1,173,281 225,762

2003 -490,545 -542,273 51,728 1,023,937 729,816 294,121 1,514,482 1,272,089 242,393

2004 -604,897 -666,364 61,466 1,163,724 821,986 341,739 1,768,622 1,488,349 280,272

2005 -707,914 -784,133 76,219 1,288,257 911,686 376,571 1,996,171 1,695,820 300,352

2006 -752,399 -838,788 86,389 1,460,792 1,039,406 421,386 2,213,191 1,878,194 334,998

2007 -699,065 -822,743 123,677 1,652,859 1,163,605 489,255 2,351,925 1,986,347 365,577

2008 -702,302 -833,957 131,655 1,840,332 1,307,329 533,003 2,542,634 2,141,287 401,348

2009 -383,657 -510,550 126,893 1,578,187 1,069,475 508,712 1,961,844 1,580,025 381,819

2010 -499,379 -650,156 150,777 1,844,468 1,288,795 555,674 2,343,847 1,938,950 404,897

2011 -556,838 -744,139 187,301 2,112,825 1,495,853 616,973 2,669,663 2,239,991 429,672

2012 -534,656 -741,475 206,819 2,210,585 1,561,239 649,346 2,745,240 2,302,714 442,527

U.S. Census Bureau, Foreign Trade Division.

NOTE: (1) Data presented on a Balance of Payment (BOP) basis. Information on data sources and methodology

are available at www.census.gov/foreign-trade/www/press.html.

June 4, 2013

122

Exhibit 1 contd..

Authors

Matthew Yost, Fifth Third Bank, [email protected]

Chris Bjornson, Indiana University Southeast, [email protected]

123

Generating Financial Statements using QuickBooks: A Group Project in

Financial Accounting

Christopher Aquino, & Lei Han

Abstract

This case study introduces a QuickBooks project, which requires students in groups to

use the software of QuickBooks to prepare journal entries and adjusting entries and to

generate financial statements for a virtual company based on a list of hypothetical

transactions. After finishing the bookkeeping task, each team is required to audit the fi-

nancial records for another team. The project in this case study was designed for an in-

troductory-level financial accounting class, which could be easily modified to accom-

modate the needs of higher level financial accounting classes such as intermediate,

advanced, or government and not-for-profit accounting. The project helps students ob-

tain real-world hands-on experience in journalizing transactions and reinforces the con-

cepts of the accounting cycle and auditing functions by way of an active and collabora-

tive learning experience.

Key words: QuickBooks, journal entries, financial accounting

Overview

Welcome to your group project assign-

ment for this semester. Below is a brief

description of the requirements and specif-

ic instructions on how to go about accom-

plishing them. However, before you begin

you should know the importance of the

accounting function to society and how

this project fits in with it.

Accounting is much more than just journal

entries, financial statements, and a set of

complicated rules. It is a necessary part of

any well-functioning capital investment

system. Without reliable and relevant fi-

nancial information, investment dollars

would not efficiently make their way to

investment opportunities and the world

would be a much less productive place.

Unemployment would likely be higher,

products would be less dependable and

more expensive, and your options as a

consumer would be fewer. In general, the

standard of living across the planet would

be lower. These are important points to

keep in mind as you embark on this very

important active-learning project on the

development of financial statements from

corporate transactions.

Hopefully, the lessons you have learned in

class about how to properly record journal

entries and build and interpret financial

statements will help you see how im-

portant electronic accounting information

systems (AIS) such as QuickBooks are to

the business world. And by the way,

QuickBooks is definitely the “Big Dog” in

the industry with more than an 85% retail

market share in small business accounting

software40. This means you are likely to

see and/or use this software at some time

See description at

http://www.wikinvest.com/stock/Intuit_(INTU)

124

during your career. In other words, this

assignment has real-world implications.

Anyway, that’s enough ranting about the

value of accounting. Below are the speci-

fications for this assignment. Hope you

enjoy it!

You will be assigned (or will choose your

own teammates) to a group of four (or

fewer) students and will be responsible for

the:

� recording of a set of transactions (see

Appendix 1 for a sample of transaction

list) for your company using the Quick-

Books software,

� review of transactions and financial

statement of another group’s work (the

“audit”)

� presentation of your financial state-

ments and the findings of your “audit”,

and

� preparation of peer-evaluation and self-

evaluation forms (see Appendix 2).

Group Assignment

Assignment of group members will be

students-driven unless team cannot be ad-

equately formed by students alone and

will take place the first week after the 1st

exam in the class. At this time you should

have a good understanding of the account-

ing cycle and how financial statements are

generated from journal entries and adjust-

ing journal entries.

Each group will have up to 4 members. It

is highly recommended you choose at

least one computer savvy person and at

least one accounting expert to be a part of

your team. Just like when starting a busi-

ness, you should choose your employees

according to their skill set. Groups will

name their own companies. At the end of

week 1 (see the proposed schedule below),

each group will inform the instructor of

the group members, a group leader who

will be the primary contact with the in-

structor, and the company name. Notifica-

tion to the instructor will be made by way

of email.

Description of Tasks

Part (a)—Bookkeeping (60 points)

Each group will be provided with their

company’s general information and a de-

scription of transactions taking place dur-

ing the first month of operation. Specifi-

cally, this portion of the assignment will

include:

(1) Preparing journal entries based on

transaction information you will be given;

(2) Making all necessary adjusting journal

entries prior to reporting;

(3) Generating an adjusted trial balance

and complete set of financial statements

(including a month-end balance sheet, in-

come statement, statement of retained

earnings and statement of cash flows);

(4) Preserving the financial records and

delivering them to the transaction review

team in a timely manner;

(5) Delivering their company file to the in-

structor for documentation and grading

purposes in a timely manner.

Part (b)—Audit (20 points)

Three weeks before the end of the semes-

ter, your group will receive the financial

records of another group in the class

(hereafter referred to as “client”). These

records are to be reviewed and by your

team and all errors need to be documented

125

and submitted to the instructor. Your

grade in this area will be negatively im-

pacted if your group either misses an error

or suggests a fix that is not necessary. The

instructor will ensure there are no inter-

locking groups.

The Transaction review group is responsi-

ble for:

(1) Reviewing the transactions of the “cli-

ent”;

(2) Issuing and presenting an opinion (de-

scribing the findings of your review work)

immediately after the presentation of the

financial position of the “client” group

(see Part (c) below).

Part (c)—Presentation (10 points)

During the final week of class, each team

will present the following to the class:

(1) the financial statements for their com-

pany’s first month of operations to the

class at the end of the semester.

(2) an evaluation of the assignment (e.g.,

what we learned/didn’t learn, it was

fun/stunk, accounting is from heaven/hell,

QuickBooks is from heaven/hell, team pro-

jects are from heaven/hell, etc.) Be origi-

nal, entertaining, and honest. This is feed-

back meaning any feelings you have (other

than “no” feelings) are valid and wel-

comed.

Part (d)—Evaluations (10 points)

Each group member will be required to

complete confidential peer evaluations of

themselves and all other members of their

group upon completion of the game. It is

possible the total points earned by a group

may be divided other than equally if the

peer evaluations indicate the existence of

“free riders.” The best way to avoid this is

to participate to the fullest extent in your

team’s work and to fully support your

group members in their effort to fulfill the

requirements of the assignment.

References

Palm, C, and J. Bisman. 2010. Benchmark-

ing introductory accounting curricula:

Experience from Australia. Accounting

Education: an international journal 19 (1-

2): 179-201.

Pincus, K.V. 1997. Is teaching debits and

credits essential in elementary account-

ing? Issues in Accounting Education 12

(2): 575-579.

The Pathways Commission. 2012. Charting

a National Strategy for the Next Generation

of Accountants. Available at:

http://commons.aaahq.org/files/0b14318

188/Pathways_Commission_Final_Repo

rt_Complete.pdf

126

127

Appendix 1

Sample Transaction List

No. Date Transaction Description

1 Sep. 1 Company issues common stock 25,000 shares at $10 per share with par value of

$1 per share.

2 Sep. 1 Takes a six-month short-term loan $50,000 from the bank with the interest rate

6%, with the principal and interest paid at maturity

3 Sep. 1

Purchases a property as office space at $115,000, in which $20,000 is the cost for

the land and the remaining is the cost for the building. The estimated useful life

of the building is 30 years and the residual value is $5,000

4 Sep. 1 Rents a warehouse and prepays the first month's rent $1,000 and security deposit

$2,000

5 Sep. 1

Purchases a delivery truck for $33,000 by cash, with 5 years of estimated useful

life and $3,000 residual value. The truck is estimated to be driven for 100,000

miles.

6 Sep. 2 Issues 500 preferred stocks of par value $3 for $15 each; The annual dividend is

5%.

7 Sep. 2 Purchases supplies by cash for $2,000

8 Sep. 2 Invests $10,000 in short-term investment

9 Sep. 2 Pays for the insurance premium $3,000 for six months, starting from the current

month

10 Sep. 3 Receives cash advance $5,000 from customer Alpha for an order to be filled later

11 Sep. 3 Purchase 1: 2,000 units @ $50 from supplier A (by cash)

12 Sep. 8 Purchase 2: 500 units @ $55 from supplier B (50% paid immediately and the re-

maining is made on account)

13 Sep. 12 Sells 1,000 units priced @ $75 (sold to customer Alpha, the remaining amount is

paid in full by cash immediately)

14 Sep. 15 Purchase 3: 800 units @ $60 from supplier A (made on account)

15 Sep. 16 Lends $6,000 to a client by receiving a promissory note issued by the client with

interest rate of 6% and maturity of six months.

16 Sep. 20 Sells 1,200 units priced @ $78 (on account) to customer Beta

17 Sep. 22 Sells 500 units priced @ 80 (by cash) to customer Gamma

18 Sep. 25 5 units from the sale on Sep. 22 are returned and customer Gamma gets full re-

fund immediately

19 Sep. 29 Repurchases 100 shares at $16 each for the purpose of issuing bonus to employ-

ees at the end of the year

20 Sep. 30 Announces cash dividends to common stocks, with $0.10 per share (Ignore the

dividends to preferred stocks), to be paid at the beginning of next year

21 Sep. 30 Receives a bill from the bank for the month service charge $100

22 Sep. 30 Selling expense accrued in the month is $2,000 and paid in full

23 Sep. 30 Administrative expense for the month is $1,500 and paid in full

24 Sep. 30 Pays the utility bill for current month by cash $500

25 Sep. 30 Accrue salary expense $8,000 for the month, which will be paid at the beginning

of the next month

26 Sep. 30 Pays for the bank service charge by cash

27 Sep. 30 Receives interest in cash from the short-term investment for the month $150

28 Sep. 30 Supplies amount to $800 at the end of the month

128

Additional Info

Method to estimate bad debt expense: 3% Net Credit Sale

Depreciation method for the property: S-L

Depreciation method for the delivery truck: DDB

Perpetual inventory with: FIFO

The income tax rate: 30%

Appendix 2

Peer/Self Evaluation Form

Your Name: ____________________________ Section: __________________________

Return this completed form to me by ____________. DO NOT SEND IT BY EMAIL. This is a mandatory

part of the assignment and is worth 10 percent of your project grade.

General Instructions

Score all team members on each measure below, including yourself. Your peer evaluations will be kept con-

fidential, and will not be returned to you or shared with anyone.

On a scale of 1-10 (1=completely unsatisfactory and 10=outstanding), rate the extent to which each team

member satisfied his/her performance measures. The criteria are described below. For each team mem-

ber, add up the scores of the different performance measures to come up with a total score for each per-

son.

Performance Measure

1. Did your team members show up to all meetings prepared and ready to work? If they had to miss a

meeting after they had agreed to it, did they email or phone at least one group member to let him/her

know they wouldn’t be there?

2. Did your team members agree to task deadlines and complete their individual assignments by those

deadlines?

3. Did your team members help you in completing your tasks when you encountered problems? Did

they help you think of alternate solutions to help get the work done?

4. Did your group members volunteer for tasks assignments rather than avoid extra work?

5. Were any team members unnecessarily dictatorial in telling others what to do? Were your team mem-

bers easy and pleasant to work with? Did they contribute to a sense of harmony and cohesiveness of the

group?

6. Did your team members complete their tasks to the satisfaction of the group? Did their contributions

have to be substantially modified or supplemented by the others? Did they follow the guidelines estab-

lished for the group?

7. What is your assessment of the overall contribution of each team member, including yourself?

Rank in Group

Evaluate your group by assigning a number to each group member depending upon their level of partic-

ipation in the group projects, with “1” being the highest. Enter the ranking for each group member in the

table on the next page under “Rank in Group”.

Use a scale of 1-10 where 1=completely unsatisfactory and 10=outstanding

129

Performance Measure

You (self-

evaluation)

Team

Member 1

Team

Member 2

Team

Member 3

Team

Member 4

Group member name

(first and last):

1: Showed up at meet-

ings?

2: Met deadlines?

3: Helped in problem

solving?

4: Volunteered to per-

form extra tasks?

5: Worked well with

others?

6: Quality of contribu-

tions?

7: Overall assessment?

Total Score (sum of all

above numbers):

Rank in Group

General Comments

(optional):

Appendix 3

Setting up your company in QuickBooks

There are six steps necessary to set up your company in QuickBooks. Before you do this, you should

have (1) the QuickBooks software correctly installed and registered (online) on your computer and (2) the

file Temp Co.QBW saved on your computer somewhere where you can easily access it.

The steps necessary for setting up your company in QuickBooks are as follows:

Step 1: In the opened QuickBooks, select File->Open or Restore Company

Step 2: Select the first option “Open a company file”, click Next

Step 3: Find the file Temp Co.QBW on your computer, and click Open

Step 4: Once the company file is opened, you will see the temporary company’s name on the upper left

corner of the screen

Step 5: Select Company->Company Information, change the company’s name from Temp, Co. to your

own company’s, and click OK

Step 6: Once the company name has been changed, you will see the name in the upper left corner. This

means you have successfully completed this step.

130

Appendix 4

Creation of Portable File (4 steps)

Step 1: Click “File”, and select “Create Copy”

131

Step 2: Select “Portable company file”, and click “Finish”

132

Step 3: Click “OK”, and wait for QB to create a portable company file

133

Step 4: Record the folder where you can locate the portable company file

Authors

Christopher Aquino, MBA, CMA, CFM, Assistant Professor of Accounting, Niagara

University, [email protected]

Lei Han, Ph.D., CPA, Assistant Professor of Accounting, Niagara University,

[email protected]

134

Investing in a Brewpub: A Capital Budgeting Analysis

Elizabeth Webb Cooper

Abstract

Two recent college graduates own a restaurant and want to decide whether to invest in

a brewpub system, which would allow the pair to sell beer on tap to their customers.

The business owners must complete a thorough cash flow analysis of their planned in-

vestment using the concepts of operating cash flows, working capital investment and

capital expenditures. They need to have a keen understanding of relevant versus non-

relevant cash flows. Further, they must use these cash flows in order to come up with

the net present value (NPV) and internal rate of return (IRR) of the investment under

different realistic business scenarios. The pair also must use sensitivity analysis to see

how their investment decision may or may not change as a result of varying costs of

capital. In the end, the pair needs to decide whether to invest in the brewpub in light of

their full analysis.

The Case

Samantha Myers and Grant Patrick gradu-

ated from college seven years ago. Since

then, they opened a casual, American-fare

80-seat restaurant, Explore Café, close to

their college campus. Their clientele main-

ly consists of undergraduate and graduate

students from the college (thus a lot of

their business falls outside of the summer

months), and an enthusiastic group of lo-

cal residents who love to come to the res-

taurant on a regular basis year-round.

Currently the restaurant is BYOB, mean-

ing, the restaurant does not sell alcohol

but allows customers to bring in their own

bottles of wine and beer for a small “cork-

age” fee. After much consultation and

market research (costing them roughly

$2,000 and considerable time and effort),

Samantha and Grant decided that the way

to grow their small restaurant was to in-

clude a brewpub system, thus allowing the

restaurant to offer beer on tap to their cus-

tomers and do away with the BYOB label.

Samantha did some research on the cost of

a new brewpub system. She estimates that

they will need about 1,000 square feet of

space in the store to accommodate a 7 bar-

rel (bbl) system. Currently they do not

have the space available but it just so hap-

pens that the retail space next door to Ex-

plore Café is available for rent. The space

costs $3,000 per month but Samantha

thinks they can negotiate the rent down to

$2,500 per month because of their good re-

lationship with the landlord. However, the

space is not equipped to handle the brew-

pub machinery. After talking with several

contractors (with permission of the land-

lord) Samantha expects that initial con-

struction costs could be as high as

$250,000.

135

In a barrel of beer, there are 31 gallons of

beer. There are 8 pints in a gallon. Saman-

tha estimates that each seat in the restau-

rant will require about 7 barrels of beer

(best case scenario) per year. She is basing

this on the expected number of patrons

and on the number of beers each patron is

expected to order, on average, throughout

the day. She uses some scenario analysis to

also include an estimate of 5 barrels of

beer per year per seat for a worst-case sce-

nario outlook. They plan to sell 10 types of

beer but all will have the same ingredient

costs and sales price.

The cost of a high-quality brewpub system

is $300,000. This includes the heater, fer-

mentation tanks, chiller, stainless steel

beer faucets, hoses, valves, and carbonator

gauges. Samantha looks into some options

for ingredients and finds the best deal

from an outside beer retailer. The ingredi-

ents will cost $4,000 to make 10 barrels of

beer. These costs are expected to increase 5

percent per year based on projected agri-

culture prices. Based on discussions with

the brewpub machinery manufacturer,

Samantha estimates that it will cost about

$15,000 per year (after the first year of op-

erations) in maintenance expenses to keep

the machinery running properly.

Meanwhile, Grant looked into any addi-

tional costs (beyond ingredients and rent)

that the Explore Café would encounter

when they open the brewpub aspect to

their business. He figures that he would

need at least three additional servers per

day at a cost to the restaurant of $80 per

day per server (the servers earn most of

their income through tips, and servers typ-

ically work about 320 days out of the

year). They also plan to hire a person to

run the brewery machinery on a full-time

basis at a starting salary of $40,000 per

year. Generally, Grant and Samantha like

to increase server and employee salaries

by about 3 percent per year. Insurance

costs would increase since the restaurant

will now serve alcohol. Grant figures the

insurance cost will be an additional $3,000

per year with the assumption that this will

increase by 5 percent in five years (based

on his discussions with the insurance

agent) and hold steady at that new rate for

the remainder of the time. The equipment

itself will require additional utilities costs

beyond what the restaurant operates at

without the brewpub option. Grant esti-

mates that utilities costs (water and elec-

tricity) will amount to an additional

$24,000 per year over what the restaurant

currently pays in utilities expenses.

License fees and renewals were not some-

thing Grant initially thought about when

opening the brewpub but after some re-

search, he found that the Explore Café

would be required to pay a $65,000 initial

license fee before they open the doors to

the new brewpub. License renewal for the

first year of sales and every year thereafter

is expected to be $700 per year. This is the

typical cost structure for licensing fees for

this particular city.

Grant and Samantha also decided that

they would put a big effort into an adver-

tisement campaign for the new brewpub.

The pair does not do much advertising

now other than flyers at the college and

around the neighborhood and an occa-

136

sional ad in the city newspaper. With the

addition of the brewpub they plan to in-

crease advertising expenses to around

$80,000 per year to cover costs of outsourc-

ing their Internet presence (website, Face-

book, Twitter, etc.) and more substantial

ads in local newspapers. They decide to

pay a media company fee of $20,000 before

the brewpub opens to immediately rede-

sign their website and to begin advertis-

ing.

As for sale price, the pair decides to set the

price at $5 per pint during the first year of

operation. They hope to increase this price

by 3 percent each year thereafter. Saman-

tha also realizes that they will need to

store up on some inventory and receiva-

bles before they ever sell a single pint of

beer. The increased inventory and receiva-

ble investment will be, she assumes,

$10,000 just to get them started. Samantha

figures that they will unwind the invest-

ment in inventory and receivables when

the brewpub machinery’s economic life is

complete.

It seems that brewpub systems have a 10-

year economic life. They assume that they

can sell the materials from the brewpub

system once the useful life is complete.

They estimate that they can get about

$20,000 back from the scrapped material.

After talking with their accountant, they

decide to depreciate the brewpub system

using the straight-line method (down to

zero) over the usable life of the machine.

Right now, Explore Café pays a tax rate of

30 percent and this is expected to continue

for the duration of the brewpub machin-

ery’s useful life. Grant estimates the cost of

capital for the restaurant to be 8 percent

based on current and long-term loan rates.

To do

1. Estimate the annual cash flows for

the brewpub project. Use the “best

case scenario.” To do this, you will

need to calculate the annual revenues

and annual expenses for the 10-year

project, any changes in net working

capital, and any changes to capital

expenditures. Describe all assump-

tions and calculations you used to ar-

rive at the final cash flows.

2. Calculate the NPV and IRR of the

project given the information pre-

sented using the “best case scenario.”

Should Samantha and Grant go

ahead with the brewpub investment?

Why or why not?

3. What would be the impact on NPV

and IRR if the “worst case scenario”

occurs? Would this alter Grant and

Samantha’s decision whether to in-

vest in the brewpub? Describe how

you found this result (also show in

the spreadsheet).

4. Suppose they are operating under

the best case scenario and they de-

cide that in year 5 they would like to

do major renovations to the restau-

rant (a capital expense). They figure

this will cost an additional $1,000,000

in year 5. Along with the renova-

tions, they figure they could increase

the price of the beer to $7 per pint

and keep it at that price for the dura-

tion of the project. How do these

changes impact NPV and IRR? Is it

worth it for the pair to go forward

137

with the renovations? Describe how

you found this result (also show in

the spreadsheet).

5. Would there be a significant impact

to Samantha and Grant’s brewpub

decision if there were a change in the

cost of capital? Describe how you

found this result (also show in the

spreadsheet).

6. Are there any other issues that you

think might influence the pair’s in-

vestment decision? What, if any-

thing, have Samantha and Grant not

considered in their capital budgeting

analysis?

References

Hawawini, Gabriel and Claude Viallet

(2007). Finance for Executives. (4th ed.).

South-Western Cengage Learning.

Kierulff, Herbert (2012). IRR: A Blind

Guide. American Journal of Business Edu-

cation, 5(4), 417-426.

Ross, Stephen; Randolph Westerfield and

Jeffrey Jaffe (2009). Corporate Finance.

(9th ed.). McGraw-Hill Irwin.

Ryan, Patricia and Glenn Ryan (2002). In-

vestment Practices of the Fortune 1000:

How have things changed? Journal of

Business and Management, 8(4), 355-

364.

Appendix

Calculating NPV and IRR with a Spreadsheet

For NPV and IRR, the Excel functions are as follows:

= NPV

= IRR

• For NPV in Excel, you need to enter the discount rate followed by the FUTURE

cash flows, then you must subtract out the initial cash outflow.

• For IRR in Excel, the initial cash outflow is included in the array of cash flows.

You also should choose a “guess” as a starting point for the discount rate.

Example:

Year Cash Flow

0 -1000

1 500

2 700

3 650

Discount rate is .10

To solve in an Excel spreadsheet, the for-

mulas would look like this:

=NPV(.10, 500, 700, 650) – 1000

=IRR(-1000, 500, 700, 650, .10)

(Answers: NPV = $521.41 and IRR =

36.3%).

Author

Elizabeth Webb Cooper, Ph.D., Associate Professor of Finance, La Salle University,

1900 W. Olney Ave., Philadelphia, PA 19041, [email protected]

138

New Mexico National Bank, a bank with growth in mind (A)

Dr. James F. Cotter

Introduction

New Mexico National Bank is a bank with

growth in mind. Bobby Lowden, the CEO

of the bank has grown the bank rapidly in

the past and would like you to analyze the

bank as well as offer suggestions about

how he can grow the bank in the future.

New Mexico National Bank is particularly

amazing because it is a bank on the move

even in these turbulent times of 2010.

New Mexico National Bank is headquar-

tered in Albuquerque, New Mexico and

the bank has rewarded its shareholders

handsomely. New Mexico National's as-

sets had grown from $166 million in 1981

to over $24 billion in 2010. As shown in

Chart 1, the market capitalization for New

Mexico National shareholders has grown

from $40 million in 1994 to nearly $4 bil-

lion at FYE 2010.

Chart 1: Market Capitalization from 1994 to 2010

The company is lead by the long-standing

dynamic CEO Bobby Lowden who has

had a fabulous record of growth in assets,

revenues and profitability. This growth

can be attributed to New Mexico Na-

tional's focus on establishing a strong

presence in diverse and growing markets.

New Mexico National expanded from its

base of New Mexico to fast growing re-

gional markets such as Arizona, Colorado,

Texas, and Nevada. New Mexico National

Bank is the fifth largest commercial bank

in Arizona and 27th largest commercial

bank in the USA. New Mexico National

Bank is frequently the target of rumors

that it would be acquired by a larger

bank.

0.0

500.0

1,000.0

1,500.0

2,000.0

2,500.0

3,000.0

3,500.0

4,000.0

4,500.0

19941995199619971998199920002001200220032004200520062007200820092010

Market Capitalization (A)

139

Mr. Lowden Is Seeking Advice from

Consulting Services, Inc

As a financial advisor to the bank, you

are tasked with analyzing the bank and

offering advice to the senior management

team about how the bank is doing and

what they should be doing to grow the

bank. How is the bank doing financially?

What areas of success would you identi-

fy? What problem areas do you see?

Description of the company

History of New Mexico National Bank

New Mexico National Bank, a subsidiary

of New Mexico National Bancgroup, Inc,

was established in 1981 as a bank-

holding company with $166 million in

assets. Headquartered in Albuquerque,

New Mexico, New Mexico National Bank

was a major player in the Southwest and

Texas commercial banking market with

over $24 billion in assets. Over its 27-year

history, New Mexico National’s expan-

sion was attributed to its long-term, sus-

tained growth plan and its strong pres-

ence in diverse and growing markets. In

2005, the Wall Street Journal ranked New

Mexico National No. 1 among South-

western banks for the best one, three, and

five-year average shareholder returns.

New Mexico National is the 2nd largest

bank in New Mexico with 7.7% market

share, and the 5th largest bank in Arizo-

na with 3.8% market share.

Customers

New Mexico National’s customer base

spans across over 340 branches in 5

states. Its customers are comprised of in-

dividuals, small businesses, and com-

mercial clients. Since the inception of the

bank in 1981, New Mexico National’s

customer base has grown along with its

geographic footprint. By targeting areas

where population was rising rapidly,

management was able to effectively in-

crease the size of the bank’s customer

base by acquiring dozens of small banks

in states like Arizona and Nevada. After

establishing presence in these areas, the

bank then accelerated its growth by in-

creasing its lending limits to builders. In

such ways, New Mexico National Bank

took advantage of the housing boom and

greatly increased the size of its customer

base. As of 2010, New Mexico National’s

customers are dispersed around its 197

branches locations in Arizona, 90 in Col-

orado, 21 in Texas, 20 in Nevada, and 19

in New Mexico.

Products

New Mexico National Bank conducts

general commercial banking businesses

in its respective service areas and offers a

variety of demand, savings, and time de-

posit products as well as extension of

credit through personal, commercial, and

mortgage loans. The bank also markets

other services such as wealth manage-

ment, electronic banking, and credit

cards. In addition, New Mexico National

Investment Services, New Mexico Na-

tional Bank’s wholly owned subsidiary

provides various insurance products and

annuities for sale to the public. In fact,

loans represented over 67% of New Mex-

ico National’s total sales in 2010. The

bank’s loan portfolio has over 85% of real

estate related loans. Hence New Mexico

140

National’s business is heavily risk-

weighted towards the success of the real

estate market, especially considering the

bank’s heavy presence in Arizona. The

recent past has proven challenging, but

the bank has come through relatively un-

affected by the housing downturn.

New Mexico National Bank has a great

deal of segmentation in its products and

services. There are two main revenue

driving segments - interest bearing

products and non-interest bearing prod-

ucts. Within interest bearing products

loans are the primary source of revenue

accounting for 63% of total revenue. It is

important to look at the segmentation,

which is broken down into five compo-

nents: 1) Residential real estate, 2) Real

estate construction, 3) Commercial real

estate, 4) Consumer and other, and 5)

Commercial, Financial, and Agricultural.

The other primary segments of interest

bearing products are securities and loans

held for sale. The non-interest bearing

group is broken into five primary seg-

ments: 1) Retail banking fees, 2) Wealth

management services, 3) Mortgage

warehouse fees, 4) Bank owned life in-

surance plans, and 5) Mortgage banking,

origination, and sales. These products are

heavily regulated by the New Mexico

State Banking Department and the Fed-

eral Deposit Insurance Corporation

(FDIC), as a way to protect the depositors

of New Mexico National Bank.

Management

New Mexico National’s top executives

signed change-in-control agreements in

2007 with the bank valued around $9.1

million collectively. Among the execu-

tives that signed these agreements, New

Mexico National CEO Bobby Lowden

and Patti Hill, New Mexico National’s

Chief Operating Officer. Sarah Moore

and Sandra Jansky are New Mexico Na-

tional’s chief financial officer and chief

credit officer, respectively. Due to the

condition of financial markets in 2008,

New Mexico National Bank as well as

other banks are operating under height-

ened regulatory scrutiny and have been

and will be taking steps which are ex-

pected to improve their asset quality and

capital.

Customer Relationships

New Mexico National Bank puts a major

focus on maintaining strong customer re-

lationships. In order for this to happen

New Mexico National Banks views it to

be very important to make sure that local

personnel’s time is put towards custom-

ers, not towards other aspects of the

business. In order to ensure that this is

the case New Mexico National Bank has

created a centralized operations support

system so that the local personnel do not

need to be worried with day-to-day op-

erational issue.

Besides customers who deposit money

into New Mexico National Banks, the

bank has other customers who use other

services provided for by the bank. A

large chunk of these revenue producing

customers are real estate construction

companies, and other commercial real es-

tate providers. Other examples are com-

mercial, financial and agricultural com-

141

panies in need of loans, and residences in

need of home and other consumer loans.

Competition

Competition in the financial services sec-

tor is intense, and the intensity is contin-

uing to increase. The national banks that

have greater access to capital and per-

sonnel have started to increase their

market share through the acquisition of

smaller banks that have found trouble

during the financial crisis. Examples in-

clude Wells Fargo which now owns Wa-

chovia, and Bank of America who owns

Meryl Lynch. Commercial banks are not

the only groups that New Mexico Na-

tional competes with- other significant

competitors are issuers of securities and

other interest bearing financial instru-

ments. Furthermore, niche financial ser-

vices companies such as saving and loans

associations, credit unions, mortgage

companies, and insurances companies al-

so are a source of competition.

There is a very low concentration in the

Commercial Banking in the US industry

(52211). Based on IBIS World industry

data, the largest commercial banks have

only a 12.7%, 12.2%, 8.3%, and 5.2% mar-

ket share, which if extrapolated and ana-

lyzed according to the Herfindahl index

provides a value less than 0.1, thus a low

market concentration. Neither New Mex-

ico National Bank had a market share

greater than 3.3%

Bank Overview

Web Site: http://wwwNewMexicoNationalBank.com

Incorporation: Delaware, 1974

Employees: 4,627

Exchange: NASDAQ

FYE: December

Ticker: NMNB

Chairman: Robert E. Lowden

CEO Robert E. Lowden

CFO Sarah H. Moore

How would you assess the company’s

financial performance and prospects for

the future?

In this case, you are asked to analyze the

firm’s financial performance as of 2010

• What do you see with respect to

Capital adequacy?

• What do you see with respect to

Asset quality?

• What do you see with respect to

Management quality and decision

making?

• What do you see with respect to

Earnings and earnings quality?

• What do you see with respect to

Sensitivity to changes in interest

rates?

• Do you think that company is well

poised for future growth?

142

Balance Sheet (2005 to 2010)

New Mexico

National

Bank

New Mexico

National

Bank

New Mexico

National

Bank

New Mexico

National

Bank

New Mexico

National

Bank

New Mexico

National

Bank

All Commercial

Banks

Dollar figures in thousands 31-Dec-05 31-Dec-06 31-Dec-07 31-Dec-08 31-Dec-09 31-Dec-10 31-Dec-10

Total employees (full-time equivalent) 3,737 3,939 4,300 4,605 4,717 4,643 1,368,137

Total assets 15,804,784 16,249,551 18,884,741 21,394,976 22,730,585 25,937,048 8,837,744,666

Cash and due from depository institu-

tions

410,954 362,813 379,111 448,033 428,596 477,975 398,484,067

Interest-bearing balances 2,983 6,674 23,242 8,629 1,375 3,127 171,894,777

Securities 2,507,842 2,979,657 3,485,798 2,701,592 2,932,179 3,440,861 1,154,133,053

Federal funds sold & reverse repo

agrmts

25,000 0 246,491 649,527 621,271 2,120,831 584,807,965

Net loans & leases 11,905,017 11,833,119 13,393,641 15,830,601 16,790,079 17,235,875 4,936,346,628

Loan loss allowance 135,265 138,549 148,802 171,051 174,850 238,845 67,215,879

Bank premises and fixed assets 227,033 240,571 263,023 328,127 393,998 483,672 64,392,848

Other real estate owned 20,467 20,004 14,645 11,031 6,319 15,760 5,562,180

Goodwill and other intangibles 247,451 272,541 394,141 695,012 674,333 1,071,605 384,645,530

All other assets 461,020 540,846 707,891 731,053 883,810 1,090,469 446,111,370

Total liabilities 14,603,429 14,884,885 17,291,862 19,240,341 20,573,506 23,647,723 7,954,313,637

Total deposits 9,393,909 9,867,261 11,966,340 15,545,282 16,249,435 18,610,966 5,528,372,752

Interest-bearing deposits 7,126,690 7,924,845 9,396,649 14,226,423 15,075,088 17,669,250 4,589,325,011

Deposits held in domestic offices 9,391,785 9,865,861 11,754,731 15,268,323 15,752,852 18,119,563 4,037,283,759

Federal funds purchased & repo

agreements

2,650,985 2,211,440 2,283,934 1,292,796 1,605,672 568,721 656,407,926

Other borrowed funds 2,208,307 2,463,534 2,673,690 1,893,029 2,199,357 3,529,146 957,647,486

Subordinated debt 250,000 250,000 250,000 375,118 376,114 378,710 171,070,650

143

All other liabilities 100,228 92,650 117,898 134,116 142,928 560,180 298,565,109

Total equity capital 1,201,355 1,364,666 1,592,879 2,154,635 2,157,079 2,289,325 883,431,030

Total bank equity capital 1,201,355 1,364,666 1,592,879 2,154,635 2,157,079 2,289,325 883,431,030

Perpetual preferred stock 0 0 0 0 0 0 4,599,991

Common stock 21 22 22 22 22 22 15,466,083

Surplus 646,171 737,745 868,656 1,455,957 1,451,147 1,975,642 609,983,434

Undivided profits 555,163 626,899 724,201 698,656 705,910 313,661 253,381,521

Income Statement (2005 to 2010)

In $ Thousands

New Mexico

National

Bank

New Mexico

National

Bank

New Mexico

National

Bank

New Mexico

National

Bank

New Mexico

National

Bank

New Mexico

National

Bank

All Commercial

Banks

31-Dec-05 31-Dec-06 31-Dec-07 31-Dec-08 31-Dec-09 31-Dec-10 31-Dec-10

Number of institutions report-

ing

1 1 1 1 1 1 86

Total interest income 783,413 781,119 848,529 1,162,440 1,455,852 1,556,279 463,136,917

Total interest expense 314,030 266,392 271,243 428,280 676,261 783,272 241,211,094

Net interest income 469,383 514,727 577,286 734,160 779,591 773,007 221,925,823

Provision for loan and lease

losses

35,980 37,378 26,994 26,838 22,142 106,450 48,539,891

Total noninterest income 94,371 111,860 139,459 193,649 177,985 207,817 180,629,706

Fiduciary activities 1,082 2,188 1,425 1,528 1,074 621 24,428,837

Service charges on deposit ac-

counts

44,375 53,061 65,221 66,866 74,142 75,746 30,474,961

Trading account gains & fees 0 4,320 0 0 0 0 4,942,732

Additional noninterest income 48,914 52,291 72,813 125,255 102,769 131,450 120,783,176

Total noninterest expense 309,405 356,554 420,642 508,052 511,115 555,344 244,502,967

Salaries and employee benefits 163,156 195,030 217,049 262,850 274,264 277,124 106,384,278

144

Premises and equipment ex-

pense

70,474 82,462 90,992 106,692 115,976 130,730 29,110,896

Additional noninterest ex-

pense

75,775 79,062 112,601 138,510 120,875 147,490 109,007,793

Pre-tax net operating income 218,369 232,655 269,109 392,919 424,319 319,030 109,512,671

Securities gains (losses) 5,701 4,812 7,544 -24,654 2,274 -31,959 -328,615

Applicable income taxes 77,080 80,740 94,668 124,327 146,476 94,935 33,515,308

Income before extraordinary

items

146,990 156,727 181,985 243,938 280,117 192,136 75,668,748

Extraordinary gains - net -846 0 0 0 0 0 -963,201

Net income attributable to

bank

146,144 156,727 181,985 243,938 280,117 192,136 74,705,547

Net charge-offs 30,752 35,471 23,598 19,211 18,343 56,369 32,363,013

Cash dividends 66,032 67,044 75,535 224,421 281,727 624,573 62,732,319

145

Ratio Analysis (2005 to 2010)

New Mexico

National Bank

New Mexico

National Bank

New Mexico

National Bank

New Mexico

National Bank

New Mexico

National Bank

New Mexico

National Bank

All Commer-

cial Banks

Albuquerque,

Assets more

than $10B

Performance Ratios 31-Dec-05 31-Dec-06 31-Dec-07 31-Dec-08 31-Dec-09 31-Dec-10 31-Dec-10

Yield on earning assets 5.94% 5.36% 5.35% 6.31% 7.27% 7.17% 6.61%

Cost of funding earn-

ing assets

2.38% 1.83% 1.71% 2.33% 3.38% 3.61% 3.44%

Net interest margin 3.56% 3.53% 3.64% 3.99% 3.89% 3.56% 3.17%

Noninterest income to

earning assets

0.72% 0.77% 0.88% 1.05% 0.89% 0.96% 2.58%

Noninterest expense to

earning assets

2.35% 2.45% 2.65% 2.76% 2.55% 2.56% 3.49%

Net operating income

to assets

1.00% 0.96% 1.01% 1.27% 1.25% 0.88% 0.92%

Return on assets

(ROA)

1.02% 0.98% 1.04% 1.19% 1.26% 0.79% 0.91%

Pretax return on assets 1.55% 1.49% 1.59% 1.80% 1.92% 1.18% 1.31%

Return on equity

(ROE)

13.40% 12.38% 12.30% 12.38% 13.01% 8.57% 9.08%

Retained earnings to

average equity (YTD

only)

7.34% 7.09% 7.19% 0.99% -0.07% -19.28% 1.45%

Net charge-offs to

loans

0.28% 0.30% 0.19% 0.13% 0.11% 0.33% 0.69%

Credit loss provision

to net charge-offs

117.00% 105.38% 114.39% 139.70% 120.71% 188.84% 149.99%

Earnings coverage of 8.27 7.61 12.55 21.85 24.34 7.55 4.88

146

net loan charge-offs (x)

Efficiency ratio 54.40% 56.21% 57.80% 53.51% 52.10% 55.26% 58.69%

Assets per employee ($

millions)

4.23 4.13 4.39 4.65 4.82 5.59 6.46

Cash dividends to net

income

45.18% 42.78% 41.51% 92.00% 100.57% 325.07% 83.97%

New Mexico

National Bank

New Mexico

National Bank

New Mexico

National Bank

New Mexico

National Bank

New Mexico

National Bank

New Mexico

National Bank

All Commer-

cial Banks

Albuquerque,

Assets more

than $10B

Performance Ratios 31-Dec-05 31-Dec-06 31-Dec-07 31-Dec-08 31-Dec-09 31-Dec-10 31-Dec-10

Condition Ratios (%)

Loss allowance to loans 1.12% 1.16% 1.10% 1.07% 1.03% 1.37% 1.34%

Loss allowance to non-

current loans

147.07% 203.32% 424.19% 475.79% 788.89% 163.90% 100.65%

Noncurrent assets plus

other real estate owned

to assets

0.71% 0.54% 0.26% 0.22% 0.13% 0.62% 0.82%

Noncurrent loans to

loans

0.76% 0.57% 0.26% 0.22% 0.13% 0.83% 1.33%

Net loans and leases to

deposits

126.73% 119.92% 111.93% 101.84% 103.33% 92.61% 89.29%

Net loans and leases to

core deposits

155.23% 143.88% 135.79% 125.92% 133.79% 119.21% 147.32%

Equity capital to assets 7.60% 8.40% 8.43% 10.07% 9.49% 8.83% 10.00%

Core capital (leverage)

ratio

6.25% 7.01% 6.64% 7.42% 6.97% 6.32% 7.03%

Tier 1 risk-based capital

ratio

7.48% 8.73% 8.16% 8.72% 8.08% 7.77% 8.66%

147

Total risk-based capital

ratio

10.56% 11.83% 10.72% 11.73% 10.75% 10.56% 11.85%

Memoranda:

Average assets 14,393,257 15,953,539 17,444,648 20,463,791 22,272,840 24,403,368 8,233,524,272

Average earning assets 13,178,091 14,562,151 15,870,653 18,411,640 20,026,043 21,711,605 7,008,583,764

Average equity 1,090,820 1,265,780 1,479,833 1,971,166 2,153,377 2,242,546 823,105,601

Average loans 11,063,128 11,971,167 12,706,939 14,897,893 16,751,119 17,131,822 4,656,763,895

148

New Mexico National Bank, a bank with growth in mind (B)

Not the real timing

The real date for the financial statements for the bank:

In fact, the financial statements presented in the (A) part of the case are not as of 2010,

but rather are for 2009. So take the financial statements as presented in part (B) (See be-

low table) that are really 2010 and re-evaluate the bank’s financial statements to identify

problem areas.

What do you see with respect to Capital adequacy?

What do you see with respect to Asset quality?

What do you see with respect to Management quality and decision making?

What do you see with respect to Earnings and earnings quality?

What do you see with respect to Sensitivity to changes in interest rates?

Do you think that company is well poised for future growth?

149

Part B

New

Mexico

National

Bank

New

Mexico

National

Bank

New

Mexico

National

Bank

New

Mexico

National

Bank

New

Mexico

National

Bank

New

Mexico

National

Bank

New

Mexico

National

Bank

All Com-

mercial

Banks

Performance and Condition Ratios 31-Dec-04 31-Dec-05 31-Dec-06 31-Dec-07 31-Dec-08 31-Dec-09 31-Dec-10 31-Dec-10

Yield on earning assets 5.94% 5.36% 5.35% 6.31% 7.27% 7.17% 6.05% 5.09%

Cost of funding earning assets 2.38% 1.83% 1.71% 2.33% 3.38% 3.61% 3.07% 2.02%

Net interest margin 3.56% 3.53% 3.64% 3.99% 3.89% 3.56% 2.99% 3.07%

Noninterest income to earning assets 0.72% 0.77% 0.88% 1.05% 0.89% 0.96% 0.78% 2.13%

Noninterest expense to earning assets 2.35% 2.45% 2.65% 2.76% 2.55% 2.56% 5.34% 3.25%

Net operating income to assets 1.00% 0.96% 1.01% 1.27% 1.25% 0.88% -3.26% 0.16%

Return on assets (ROA) 1.02% 0.98% 1.04% 1.19% 1.26% 0.79% -3.24% 0.15%

Pretax return on assets 1.55% 1.49% 1.59% 1.80% 1.92% 1.18% -4.11% 0.20%

Return on equity (ROE) 13.40% 12.38% 12.30% 12.38% 13.01% 8.57% -38.72% 1.57%

Retained earnings to average equity (YTD) 7.34% 7.09% 7.19% 0.99% -0.07% -19.28% -41.37% -1.82%

Net charge-offs to loans 0.28% 0.30% 0.19% 0.13% 0.11% 0.33% 3.66% 1.44%

Credit loss provision to net charge-offs 117.00% 105.38% 114.39% 139.70% 120.71% 188.84% 112.63% 175.55%

Earnings coverage of net loan charge-offs (x) 8.27 7.61 12.55 21.85 24.34 7.55 -0.56 2.07

Efficiency ratio 54.40% 56.21% 57.80% 53.51% 52.10% 55.26% 73.18% 56.49%

Assets per employee ($ millions) 4.23 4.13 4.39 4.65 4.82 5.59 5.34 7.17

Cash dividends to net income (YTD only) 45.18% 42.78% 41.51% 92.00% 100.57% 325.07% -6.83% 216.47%

Condition Ratios (%)

Loss allowance to loans 1.12% 1.16% 1.10% 1.07% 1.03% 1.37% 1.94% 2.48%

Loss allowance to noncurrent loans 147.07% 203.32% 424.19% 475.79% 788.89% 163.90% 51.88% 82.53%

Noncurrent assets plus OREO to assets 0.71% 0.54% 0.26% 0.22% 0.13% 0.62% 2.90% 1.71%

Noncurrent loans to loans 0.76% 0.57% 0.26% 0.22% 0.13% 0.83% 3.74% 3.00%

Net loans and leases to deposits 126.73% 119.92% 111.93% 101.84% 103.33% 92.61% 86.16% 80.68%

150

Net loans and leases to core deposits 155.23% 143.88% 135.79% 125.92% 133.79% 119.21% 112.49% 125.83%

Equity capital to assets 7.60% 8.40% 8.43% 10.07% 9.49% 8.83% 5.62% 9.11%

Core capital (leverage) ratio 6.25% 7.01% 6.64% 7.42% 6.97% 6.32% 6.03% 6.89%

Tier 1 risk-based capital ratio 7.48% 8.73% 8.16% 8.72% 8.08% 7.77% 8.54% 9.13%

Total risk-based capital ratio 10.56% 11.83% 10.72% 11.73% 10.75% 10.56% 11.37% 12.55%

151

Colonial Bank, a bank with growth in mind (C)

Not the real dates and not the real bank

Epilogue

On August 14, 2009, Colonial Bank was

turned over to the FDIC. In situations such

as these, the FDIC is able to use govern-

ment funds in reserve to cover the losses

of the defaulted loans and insure the de-

posits of the Colonial Bank customers. The

losses resulting from Colonial Bank’s fail-

ure do not disappear but are instead as-

sumed by the U.S. government. Since the

purpose of the government is not to hold

onto the assets and deposits, the FDIC

formulates a deal that is of value to a po-

tential buyer and lessens the loan loss risk

created by the failed bank. The FDIC and

BB&T formulated a transaction which

would result in BB&T acquiring $22 billion

of Colonial Bank’s assets and assuming

$20 billion in deposits. This offer was a

loss sharing agreement to decrease BB&T’s

risk of substantial future losses on the ac-

quired assets

Conclusion

With increased market share, increased

cash flow from the acquired assets, and

limited risk associated with the acquired

assets, BB&T has an opportunity to create

value from this transaction. If the govern-

ment was not guaranteeing limited loan

loss risk in the transaction, BB&T would

benefit from not acquiring any additional

loan loss risk since their own loan losses

could potentially continue to increase in

such a volatile economic environment.

Considering Colonial Bank’s loan and

mortgage investments were situated in the

hardest hit markets, their failure was al-

most inevitable. Given the involvement of

the government in restructuring a package

deal for the transaction to occur, BB&T has

a great opportunity to take a low risk in-

vestment with the potential for a large re-

turn. Losses on Colonial Bank’s portfolio

will mostly likely continue, but the safety

net provided by the U.S. government elim-

inates the risk of any negative impact it

might have on BB&T’s overall market and

shareholder value.

41Colonial BancGroup Inc. was a $26 bil-

lion bank holding company headquartered

in Montgomery, Alabama, USA. Colonial

BancGroup, Inc. (BancGroup) was a finan-

cial services company that, through its

subsidiaries, provided diversified services,

including retail and commercial banking,

wealth management services, mortgage

banking and insurance.

The company ran into problems after it

was revealed that it had bought $1 billion

in mortgages from Taylor, Bean & Whita-

ker that Taylor Bean had forged, in one of

the biggest fraud cases in history.[1]

Bankgroup’s former subsidiary, Colonial

Bank, operated 346 branches in the states

of Alabama, Georgia, Florida, Nevada and

Texas. At the end of the fourth quarter of

2008, Colonial Bancgroup had a Texas ra-

tio of 53.4%, up from a figure of 25% in the

first quarter of 2008.[2]

Source:

http://en.wikipedia.org/wiki/Colonial_Bancgroup

152

Colonial disclosed its legal problems on

August 4, 2009, stating that federal agents

had executed a search warrant at its mort-

gage warehouse lending offices in Orlan-

do, Fla. and that it had been forced to sign

a cease and desist order with the Federal

Reserve and regulators at the end of last

month in relation to its accounting practic-

es and its recognition of losses.[3][4] On Au-

gust 14 it was announced

that BB&T would buy Colonial's branches

and deposits in a deal with the

FDIC.[5] This was the biggest bank failure

of 2009.[6] On August 25 Colonial

BancGroup filed for Chapter 11 bankrupt-

cy. The bankruptcy case's name is "In re

Colonial BancGroup Inc, U.S. Bankruptcy

Court, Middle District of Alabama (Mont-

gomery), No. 09-32303".[7]

1. http://news.yahoo.com/s/ap/20110420/a

p_on_bi_ge/us_tarp_case_trial

2. "One in eight lenders may fail, RBC

says". Reuters. February 9, 2009.

3. Press, CNN (2009-08-15). "BB&T buys

Colonial bank; 4 other banks fail - CNN

Money". Retrieved 2009-08-15.

4. Press, South Florida Business Journal

(2009-06-10). "Colonial hit with cease

and desist order". Retrieved 2009-08-15.

5. Fitzpatrick, Dan; Enrich, David; Crit-

tenden, Michael R. (August 15,

2009). "Major Bank Fails in South". The

Wall Street Journal.

6. Isidore, Chris; Pepitone, Julianne (Au-

gust 14, 2009). "BB&T buys Colonial

bank; 4 other banks fail". CNN. Re-

trieved April 30, 2010.

7. Stempel, Jonathan (August 26,

2009). "Colonial BancGroup files Chap-

ter 11". Reuters. Retrieved 27 August

2009.

153

Coloni-

al Bank

Coloni-

al Bank

Coloni-

al Bank

Coloni-

al Bank

Coloni-

al Bank

Coloni-

al Bank

Coloni-

al Bank

Coloni-

al Bank

Coloni-

al Bank

Coloni-

al Bank

All Com-

mercial

Banks

Colonial Bank 3/31/07 6/30/07 9/30/07 12/31/07 3/31/08 6/30/08 9/30/08 12/31/08 3/31/09 6/30/09 6/30/09

Yield on earning assets 7.36% 7.13% 7.19% 7.17% 6.53% 6.29% 6.20% 6.05% 4.96% 4.91% 4.60%

Cost of funding earning

assets

3.76% 3.59% 3.61% 3.61% 3.39% 3.17% 3.08% 3.07% 2.80% 2.74% 1.16%

Net interest margin 3.60% 3.54% 3.58% 3.56% 3.14% 3.12% 3.11% 2.99% 2.17% 2.18% 3.44%

Noninterest income to

earning assets

0.94% 0.96% 0.95% 0.96% 0.80% 0.87% 0.87% 0.78% 0.80% 0.52% 2.80%

Noninterest expense to

earning assets

2.57% 2.53% 2.54% 2.56% 2.77% 2.81% 2.84% 5.34% 2.96% 3.72% 3.42%

Net operating income

to assets

1.14% 1.12% 1.13% 0.88% 0.35% 0.14% -0.21% -3.26% -2.46% -5.63% 0.19%

Return on assets (ROA) 0.73% 0.93% 1.01% 0.79% 0.42% 0.18% -0.19% -3.24% -2.55% -5.70% 0.14%

Pretax return on assets 1.11% 1.41% 1.52% 1.18% 0.59% 0.22% -0.36% -4.11% -4.03% -4.97% 0.22%

Return on equity (ROE) 7.68% 9.94% 10.86% 8.57% 4.84% 1.99% -2.13% -38.72% -45.55% -115.1% 1.39%

Retained earnings to

average equity (YTD)

2.08% -22.26% -17.30% -19.28% 4.84% -1.24% -5.38% -41.37% -45.55% -115.1% -0.33%

Net charge-offs to loans 0.11% 0.14% 0.18% 0.33% 0.74% 1.18% 1.71% 3.66% 3.15% 4.08% 2.61%

Credit loss provision to

net charge-offs

50.02% 69.18% 58.53% 188.84% 105.80% 107.67% 120.26% 112.63% 195.17% 151.39% 151.18%

Earnings coverage of

net loan charge-offs X

22.39 17.45 14.29 7.55 2.04 1.29 0.87 -0.56 0 -0.34 1.71

Efficiency ratio 55.35% 54.86% 54.59% 55.26% 68.54% 68.68% 69.38% 73.18% 80.45% 101.69% 51.48%

154

Assets per employee ($ millions) 5.02 5.18 5.44 5.59 5.91 5.62 5.58 5.34 5.49 5.38 7.04

Cash dividends to net income (YTD

only)

72.91% 323.86

259.23

325.07

0 162.27

152.2%

-6.83% 0 0 123.52

Condition Ratios (%)

Loss allowance to loans 1.08% 1.02% 1.05% 1.37% 1.26% 1.41% 1.65% 1.94% 2.64% 2.96% 3.23%

Loss allowance to noncurrent loans 493.60

306.38

210.03

163.90

75.93% 75.73% 48.70% 51.88% 48.55% 32.75% 71.03%

Noncurrent assets plus OREO to as-

sets

0.20% 0.27% 0.37% 0.62% 1.23% 1.69% 2.75% 2.90% 4.17% 6.61% 2.59%

Noncurrent loans to loans 0.22% 0.33% 0.50% 0.83% 1.66% 1.87% 3.40% 3.74% 5.43% 9.03% 4.55%

Net loans and leases to deposits 96.47% 100.93

95.96% 92.61% 96.62% 92.53% 90.48% 86.16% 80.75% 80.87% 79.07%

Net loans and leases to core deposits 125.19

131.77

124.33

119.21

127.53

122.42

120.33

112.49

102.04

102.33

118.75

Equity capital to assets 9.57% 9.32% 8.96% 8.83% 8.37% 9.53% 9.42% 5.62% 5.60% 3.59% 10.61%

Core capital (leverage) ratio 6.92% 7.43% 7.01% 6.32% 6.15% 7.20% 7.20% 6.03% 5.54% 4.18% 7.84%

Tier 1 risk-based capital ratio 8.30% 8.55% 8.52% 7.77% 8.12% 9.88% 9.88% 8.54% 8.02% 6.46% 10.34%

Total risk-based capital ratio 10.95% 11.09% 11.09% 10.56% 10.81% 12.65% 12.70% 11.37% 10.78% 9.21% 13.59%

Author

Dr. James F. Cotter, Thomas Goho Chair of Finance, Schools of Business, Wake Forest University, Farrell 384, Winston-

Salem, NC 27109, [email protected]

155

A Case Study: Ethical Implications of friendly takeovers: A Financial

Manager’s Story

Barbara Tarasovich

Introduction

In 2001, Bernadette Michaels was promot-

ed to her dream job, Finance Manager at

Home and Personal Care Products, a glob-

al corporation based in the UK. As a Certi-

fied Management Accountant CMA® and

a Certified Public Accountant (CPA), Ber-

nadette was a trusted employee known for

her attention to detail. In this new role, she

would be responsible for integrating the

financial and accounting functions related

to all mergers and acquisitions. This meant

that she should be responsible for setting

the overall tone and direction for the inte-

gration of personnel, corporate cultures,

financial processes and information tech-

nology systems that track and categorize

the financial accounts of the company. As

an ethical person, Bernadette soon found

herself unprepared for the different corpo-

rate cultures she would soon encounter.

Often, the acquired firm’s approach to

compliance with financial rules and regu-

lations was at odds with what Bernadette

believed was ethical and appropriate.

During an acquisition there is a great deal

to do in a relatively short period, the con-

text is typically very unfamiliar, and there

may be a conflict between financial control

and business growth. There was intense

pressure in the company to generate

growth through acquisitions; therefore,

there was not always sufficient time to ad-

dress areas of concern related to financial

processes and controls. Periods of acquisi-

tions are hectic and there were increasing

demands placed on Bernadette’s time

from both her work colleagues and bosses.

Bernadette was aware that a good perfor-

mance on her part would be an opportuni-

ty to be noticed by her CEO and could

propel her career forward. She was also

acutely aware that a failure to prioritize

many of the new demands placed upon

her from the different companies around

the world could result in important tasks

being delayed or left undone. Bernadette

began to receive requests during the ac-

quisitions from people she had never even

heard of at the corporate headquarters.

The tax and treasury departments were

constantly calling her and she was often

forced to prioritize these requests or face

the danger that important tasks are de-

layed, or worse, never are done.

In accounting, the most important task is

to ensure that corporate assets are secure

(Frankel, 2008, Tarasovich, et.al, 2008).

Over the course of ten years, Bernadette

would be faced with four significant ac-

quisitions with a cost ranging from $1 to

$25 billion. Her company acquired a pres-

tige fragrance company, another company

that manufactured cosmetics and fra-

grances and two major food manufactur-

ers. Although due diligence was per-

formed1 by the external auditors for all the

acquisitions, the biggest challenge was to

156

ensure that the acquired companies came

together with the parent organization in

an ethically appropriate manner. This

means that the company acquired act in

accordance with the values of the parent

company. Home and Personal Care con-

ducts all operations with honesty, integrity

and openness and requires all employees

to comply with the laws and regulations of

the country in which they operate.

In a merger or acquisition transaction due

diligence is a process of verifying and con-

firming information received about the

acquired company is accurate. It is a

method companies and auditors use to

gather more information regarding the fi-

nancial statements of the acquired compa-

ny. They use this information to determine

if the company acquired is presenting fi-

nancial information fairly. The amount of

due diligence can vary depending on ma-

teriality of the acquisition and the time al-

lowed.

Bernadette had been through several inte-

grations before and knew that during the

initial period, employees of both the ac-

quired company and the acquiring com-

pany were often concerned about losing

their jobs or being moved to different job

post integration. Employees are also often

stressed or frustrated due to the additional

work required of them when two different

companies integrate. There is often also a

clash of corporate cultures and values.

Workplace ethics are especially vulnerable

during such strategic transitions. Research

shows that employees in organizations

undergoing mergers or acquisitions often

observe ethical misconduct and feel pres-

sure to engage in questionable business

practices at rates that are nearly double

those in more stable organizations

(Boatright, 2010).

Company Descriptions and Case Back-

ground

Home and Personal Care Products is a

global manufacturer of consumer products

based in the United Kingdom. The com-

pany has deep roots in markets around the

world giving it a wealth of knowledge and

international expertise about local con-

sumers. Its’ top twelve brands generate

sales of 1 billion US dollars and the top

twenty brands account for 70% of sales.

The company operates in several product

areas including skin care, deodorant, ice

cream, tea, spreads, hair care and house-

hold cleaning and is a global leader with

brands that are number one and two in

their markets. The company employs more

than 170,000 people.

The company is a conglomerate, its’ strat-

egy focuses primarily on the acquisition of

existing brands, rather than the develop-

ment and introduction of new ones. Firm

rivalries drive the acquisition strategies of

competitors, thus, several of the compa-

ny’s acquisitions were a direct result of a

competitor acquiring a similar business or

product line. Home and Personal Care

Products only targets companies with

strong market positions and financial

strength in order to develop growth and

innovation in the home and personal care

market. It has a reputation of operating

with the highest standards of corporate

behavior towards its employees, consum-

ers and society. The corporate mission in-

157

cluded the statement, “Our management

team must operate with integrity and re-

spect for the many people, organizations

and environments our business touches.”

Home and Personal Care Products places

a great importance on professionals being

resilient and agile in adapting to different

cultural norms and behaviors in different

companies. As an integration manager,

Bernadette realized early on that she

would need to adapt her management

style and organizational decisions in order

to build credibility with and gain the trust

of the newly acquired or integrated em-

ployees.

Home and Personal Care Products’ em-

ployees are also well aware of the compa-

ny’s code of business conduct. Employees

conduct operations with honesty, integrity

and openness, and with respect for the

human rights and interests of all employ-

ees. The company places great emphasis

on ensuring accounting records and sup-

porting documents accurately describe

and reflect the nature of the underlying

transactions. The company is committed

to diversity in the work environment

where everyone feels responsible for the

performance and reputation of the com-

pany.

A list of the company acquisitions are in-

cluded in Exhibit I. Two of the companies

it acquired were in the cosmetics and fra-

grance segment. The first was a manufac-

turer a pricey line of lotions and fragranc-

es found mostly in department stores and

boutiques. Several years later the compa-

ny acquired a leading manufacturer and

marketer of cosmetics and hair care prod-

ucts, as well as deodorant and other skin-

care products. The products were lower-

priced well-known lines that were sold

mostly in drugstores and supermarkets.

Finally, two food companies were ac-

quired. One company was a leading ice

cream manufacturer with some of the

more recognized brands in the United

States. The second foods company was a

global foods conglomerate a maker of

well-known brands in mayonnaise, peanut

butter, soups, and many other food cate-

gories.

In spite of the enormous pressure to

achieve the synergies forecasted in the

business case, it was important for Berna-

dette to be certain that there was no uneth-

ical behavior on the part of the project and

management team responsible for the ac-

quisition and integration of these compa-

nies. The pressures to achieve synergies

can often result in people problems, cul-

tural value, and ethical differences that

impede the smooth integration of the two

companies. Synergies in acquisitions are

not achieved in over 70% of acquisitions,

as reported in The Complete Guide to Mer-

gers and Acquisitions (Galpin and Herndon,

2008) making this a real and important

consideration in any acquisition or inte-

gration.

For each acquisition, Bernadette needed to

ensure that the newly acquired assets were

secure. In addition, she had to ensure that

the acquired companies were not employ-

ing inappropriate accounting practices in

order to inflate their sales or earnings. In

other words, that the acquiring companies

were not “cooking their books.”

158

Securing the Assets – Acquisition I

The first accounting issue she encountered

was during the acquisition of a prestige

fragrance company. The company was lo-

cated several hours away from Berna-

dette’s office, therefore, she would travel

to the location several times a week and

stay in a local hotel. In the early days of

the company acquisition, Bernadette was

the only representatives of the parent cor-

poration on site. She often felt like an out-

sider and quickly realized that one of the

critical success factors was her ability to

manage herself. She also knew she had to

begin forming relationships and talking to

the people at the new location so she

would better understand the business.

There was much uncertainty in the minds

of the employees she encountered. She

scheduled a meeting with the company

Controller as her first order of business.

Controller Jeffrey Anderson

Bernadette met the Controller, Jeffrey An-

derson, during her first week at the new

location. She came prepared for the meet-

ing with the parent company accounting

manual, chart of accounts, code of conduct

and an accounting project plan for valua-

tion of the company’s assets. These doc-

uments, however, were of little interest to

Mr. Anderson. While he was polite and

professional, his management style was

clearly dictatorial. Jeffrey Anderson had

joined the Prestige Fragrance Company

twelve years before and had worked his

way up in the company with several pro-

motions. He was a CPA with a back-

ground in a major accounting firm. He

played a key role in the company’s growth

to a $1 billion dollar public company. He

was well respected by the Board of Direc-

tors and was not happy that he would

now be part of a small division in a much

larger company. Mr. Anderson’s right

hand employee was a Financial Account-

ing Manager named Allen Carpenter. Al-

len was also a CPA and CMA and had

been with the company for ten years. Al-

len was very concerned about his future

career path now that the company had

been acquired.

Safeguarding the Assets

Bernadette knew that one of her first ac-

tions was to make sure that the assets she

had now become responsible for were se-

cure. She reviewed with Mr. Anderson her

preliminary observations of the acquired

assets and the unusually high proportion

of “Other Assets” on the balance sheet.

She knew that often items in this category

are over looked by management because

they are non-core assets. While Mr. An-

derson did provide a list of the “Other As-

sets” in the acquired balance sheet, as part

of the due diligence, it was difficult to ex-

amine and understand the nature of each

of the items on the list and their relevance

to the operations of the company. Berna-

dette was keenly aware that her lack of

expertise in the prestige fragrance indus-

try might hinder her understanding of the

underlying transactions. She was also

aware that appearing to question the new-

ly acquired company’s accounting practic-

es would not be a first step in her efforts to

ingratiate herself with the Controller and

his staff.

159

After her first meeting with Mr. Ander-

son, she conducted a more detailed exam-

ination of the “Other Assets” and found

that many marketing expenses had been

capitalized. In this business, the controver-

sial and expensive commercials, both print

and television, were used to raise consum-

ers’ awareness of the prestige fragrances.

In some cases, the company pushed the

envelope with provocative and suggestive

advertisements. These costs were material

to the financial statements, in some cases

several million dollars. Concerned about

what she discovered, Bernadette decided

to discuss the matter with Mr. Anderson.

He told her, “Since the ad campaigns were

material to the financial results, even

though the commercials had already aired,

they would benefit future sales.” He

suggested that Bernadette not worry about

the issue she found.

Bernadette was also concerned about an

account entitled “Other accrued liabilities”

as it also relied heavily on estimation and

judgment. Again, she went to the Mr.

Anderson and asked for the standing

journal entry supporting documentation

for this account. He replied, “You don’t

understand our business and the need for

proper provisions to account for legal and

other reserves. These journal entries are

standard practice and you would know

that if you understood the volatility and

uncertainty of the prestige fragrance busi-

ness.” Bernadette scheduled a meeting

with Allen to review her concerns and

gain a further understanding of the sup-

porting documentation. Allen also ex-

plained, “Our business is unique and these

are typical entries for our industry. You do

not have the background or understand-

ing of these accounts. I provided you an

excel spreadsheet supporting the balances.

What else do you need?”

Bernadette believed it was her responsibil-

ity to raise these accounting issues with

the acquisition oversight committee, com-

prised of the CFO’s and CEO’s of both

businesses. Her challenge was to review

the more conservative accounting policies

of Home and Personal Care Products and

make it clear to the CFO of the acquired

company why she did not believe these

costs should be capitalized. She was also

concerned about the lack of supporting ev-

idence of the accruals. Mr. Anderson had

been running the business for years and

surely knew the history of accruals and

provisions required to manage the busi-

ness. Bernadette’s position was difficult.

She had to challenge Mr. Anderson’s posi-

tion without alienating the acquired team

and losing the trust of both him and the

finance team.

Bernadette cancelled all her appointments

the next few days and tried to reflect upon

the main issues that had arisen during her

meeting with Mr. Anderson:

• The acquired company did not ap-

pear to comply with generally ac-

cepted accounting principles but the-

se practices had been going on for

years. Was she correct in her inter-

pretation? Were the company’s rec-

ords unfairly presenting the financial

statements?

• The company had been issues an un-

qualified audit opinion. Should she

160

pursue this investigation with the

audit team? What would be the rami-

fications on her actions with the ac-

quired company’s team? Would they

continue to trust her?

• What further details might the ac-

quired company accountants provide

that would assist Bernadette during

her investigation of the records?

Planning and Reporting – Acquisition II

Bernadette was settled in to her role as the

Financial Accounting Manager for the

combined businesses, when in 2004 Home

and Personal Care Products announced

another acquisition of a $1 billion cosmetic

and fragrance manufacturer, based in Chi-

cago. Having been through a major mer-

ger and acquisition before, this one would

be much easier. After her first meeting

with the members of the new company,

she realized this acquisition was going to

be very different.

The Challenge - The Local Planning Pro-

cess and Team

This time Bernadette‘s challenge was that

she was brought in well after the acquisi-

tion had been finalized. Although Home

and Personal Care was clearly the surviv-

ing entity and the much larger company,

the target company acquired was not re-

ceptive to a finance employee intervening

in their operations. It was already the se-

cond quarter. Bernadette had to start the

budgeting process and, at the same time,

report second quarter results for the com-

bined companies. She met with the ac-

quired company’s Controller, John Ever-

green, who was responsible for financial

planning and reporting. Mr. Evergreen

was appointed to the Controller position

only a few years earlier having spent the

majority of his career at a competitor. He

did not have a detailed budget planning

process nor did she establish ownership

with the budget stakeholders. In addition,

when Bernadette examined the list of the

plan assumptions, they had only allowed

for the best-case scenario.

Again, as the representative of the parent

company, Bernadette would be viewed as

an outsider rather than a trusted colleague

of the close-knit acquired company team.

The annual budget was a closely guarded

document that was viewed as a financial

plan and not a comprehensive business

plan. Bernadette was concerned that the

lack of a detailed planning process might

lead to earnings being inflated or losses

disregarded. She was also concerned that

most departments did not appear to be a

part of the annual budget process. When

she spoke to some of the employees, most

were not aware of the “big picture” per-

spective of the company operations. She

decided to use this as an opportunity to

show the members of the acquired com-

pany that there could be advantages of

working with her and the parent compa-

ny.

The local management team of the ac-

quired company, however, did not trust

Bernadette and some were convinced she

was a spy sent to report their activities

back to headquarters or assess potential

talent. The Assistant Controller of the or-

ganization, Laura Reinhardt, was one of

Bernadette’s main contacts in the acquired

company so she decided to take her to

161

lunch to see if she could gain a better un-

derstanding of the culture and environ-

ment. Laura’s background was with a big

four accounting firm and she was recently

promoted to Assistant Controller several

years earlier.

Bernadette began with a list of questions

for Laura such as “Who takes responsibil-

ity of the final planning figures?” “How

realistic do you believe the budget is?”

“How often do you prepare reports of

progress against the budget?” “Do you

understand the processes that you are

modeling in your budget?” Bernadette

began to realize that many of these ques-

tions were unfamiliar to Laura. Was there

a lack of control in the existing planning

process and did the budgets really reflect

local management’s goals, or were they

even involved in the process? Bernadette

looked at this situation as an opportunity

to build relationships with local manage-

ment and the senior members of the lead-

ership team. She realized her challenge

was to help them develop a realistic budg-

et which truly represented the business

and facilitated both planning and perfor-

mance monitoring. Bernadette knew that a

new financial planning process would un-

cover if the business being acquired was

mismanaged or if there were areas where

controls were weak or worse, non-existent.

Information Security – Acquisition III

Several years’ later Home and Personal

Care Products acquired a premium ice

cream manufacturer with creative flavor

names based in New Hampshire. They

needed to preserve this company’s market

niche, which was based in no small part

on the image of social responsibility and

activism. This company gave ten percent

of their profits to charity. They also creat-

ed many business opportunities for de-

pressed areas and disadvantaged people.

The company used environmentally

friendly packaging and paid a premium to

local dairy farmers who did not give their

cows growth hormones.

This time Bernadette was certain she

would have fun working on the acquisi-

tion. During her first visit there, she no-

ticed skateboards, dogs, and a very casual

laid-back atmosphere, making this corpo-

rate headquarters very different from the

one she had just left. She met with the

Controller who told her the company was

in the process of beginning the implemen-

tation of new Enterprise Resource Plan-

ning (ERP) software to manage the finan-

cials of the company. Bernadette was

concerned that the company might not re-

quire the same high-level implementation

standards as Home and Personal Care

Products, but the Controller was adamant

that the implementation was on track to

begin just one month after the acquisition.

The Controller, Paul Hammerstein, was

promoted up the ranks of the company,

having begun his career in information

technology. He witnessed the company’s

growth from a locally manufactured ice

cream brand made in a small garage, to a

brand that was now nationally recognized

as a premium ice cream. Mr. Hammerstein

explained to Bernadette during their first

meeting that the company’s information

technology infrastructure was failing to

meet the demands of the company’s recent

162

growth in sales. He was extremely con-

vincing in assuring her that “the imple-

mentation of the new system will help

reengineer our business processes and

help support the company’s dramatic

growth in sales.” He told Bernadette that,

“the new ERP system is clearly aligned

with the company’s strategy, structure and

processes, and the project was under the

control of the IT organization.” After all,

he tried to convince Bernadette that

though she understood financial processes

only an IT professional could really un-

derstand a complex ERP system like the

one they were implementing.

Bernadette had prior experience imple-

menting the ERP system and was aware

that it was often a challenging and com-

plex project. She realized during her se-

cond visit that capturing the data she need

to prepared combined financial reporting

and prepare the acquisition balance sheet

was going to be difficult. The company

began the implementation of a software

package that was not integrated with their

other operations. The IT and Accounting

implementation team was made up of

employees of the acquired company

where the culture was much more laid

back with decentralized decision making

authority. Access to the system was con-

trolled by the finance team of the acquired

company and, therefore, Bernadette could

not access user profiles. User profiles play

a significant role in security of information

allowing employees to access only infor-

mation, applications, and functionality re-

quired for their specific jobs.

When Bernadette approached the Mr.

Hammerstein, he told her not to worry

and that he had total control over the fi-

nancial statements. His financial account-

ing manager would provide all the finan-

cial reporting that she needed and the new

system, although delayed, would eventu-

ally be sufficient to comply with our com-

pany’s financial accounting policies and

procedures. He assured her that no key

personnel involved in the new system

would leave and that she would be able to

work with the employees to satisfy any is-

sues of information security. Again, Ber-

nadette faced a difficult choice. How could

she ensure the acquired company’s finan-

cial statement preparation will not be

compromised?

Acquisition IV – Authority Levels

It was now 2011, and having three major

acquisitions under her belt, Bernadette be-

lieved that she had surely seen everything.

She was promoted to Assistant Controller

of Home and Personal Care Global Prod-

ucts when a $24 billion acquisition of a

major foods manufacturer was announced.

This acquisition would make her company

one of the world’s dominant packaged

goods company. With such a significant

acquisition, she was certain that she quick-

ly would be assigned to integrate the fi-

nancials of the two businesses.

This company was also located several

hours away from the company headquar-

ters. She would again be spending her

time in a local hotel and managing the ac-

quisition while away from home. Her first

order of business was to set up a meeting

with Mark Romanowski, the company

163

Controller. Just as she had done in past

acquisitions, she went to the meeting with

her normal arsenal of company docu-

ments. Mr. Romanowski was unlike the

other Controller’s she had met in the past.

He was very receptive to her visit and

even sent her an email that said, “I would

like to arrange a two hour meeting with

you to discuss the financial policies and

procedures of your company and compare

them to our existing accounting manual.”

Bernadette was elated. Surely, this time

the acquisition would be uneventful.

During her very first meeting with Mr.

Romanowski, he provided Bernadette

with the company accounting manual and

table of authorities. He asked her to re-

view the documents and meet with him in

a few days to determine if there was any-

thing in conflict with the parent compa-

ny’s policies or procedures. Bernadette

was pleased with his cooperation. What

she was not prepared for, however, was

the very detailed Table of Authorities’

schedule he gave her. The document was

forty-five pages of detailed positions and

names of individuals who were able to

commit company resources and funds.

When she questioned the finance team and

some of the other departments, she found

that it was not well understood by either

the staff or the management. She found

that while it was well documented it was

not monitored effectively for compliance.

Bernadette decided to dig a little further

and validate some of the agreements sup-

porting the accounts payable transactions.

She knew from her past experiences that a

poorly defined table of authorities might

lead to instances of unethical supplier

agreements where the details were not

disclosed and only visible to the controller

of the acquired company. Bernadette

scheduled another meeting with Mr.

Romanowski upon completion of her re-

view. Mr. Romanowski continued to be

cooperative. He assured Bernadette that a

very detailed table of authorities was the

best way to ensure everyone in the organi-

zation would knew their authority levels

and there would never be any unauthor-

ized transactions.

Case Requirements

Acquisition I - Securing the Assets -

Prestige Fragrance Acquisition –

Q1. In the first acquisition of the Prestige

Fragrance organization, identify factors in-

fluencing the use of inappropriate or ag-

gressive accounting practices during peri-

ods of mergers or acquisitions.

Q2. Discuss the issues facing the Berna-

dette when challenging existing policies

and procedures of the acquired company.

Acquisition II – Hair and Skin Care

Manufacturer - Planning and Reporting

Q3. Once the determination was made

that the budget submitted by the acquired

company Controller was too optimistic

what actions should have been initiated by

the acquiring company’s finance team?

Q4. If the budget was prepared using on-

ly the best case scenario, what might the

acquired company finance manager have

suggested to make the budget a more real-

istic forecast?

Q5. What actions outlined in the Institute

of Management Accountants (IMA)

164

Statement of Ethical Professional Practice

might have helped identify appropriate

actions in resolving the ethics dilemmas

presented in this acquisition.

Acquisition III – Information Security -

Ice Cream Company Acquisition

Q6. What alternative actions could have

been taken to prevent the loss of key fi-

nancial information during the merger?

Q7. What actions outlined in the Institute

of Management Accountants (IMA)

Statement of Ethical Professional Practice

might have helped identify appropriate

actions in resolving the ethics dilemmas

presented in this acquisition.

Acquisition IV – Authority Levels –

Foods Manufacturer

Q8. What other actions should Bernadette

have taken when she realized that inap-

propriate or unethical actions occurred in

the acquired company?

Q9. What other risks to the business exist

when a proper table of authorities is not

well understood by business leaders?

Q10. Are there any other ethical frame-

works that may have helped Bernadette

resolved some of the ethical dilemmas in

this case?

References

Armstrong, R., & Kirk, S. (2013). HP and

autonomy: How to lose $8.8bn. FT.Com

Boatright, J.. (2010). Finance Ethics: Criti-

cal Issues in Theory and Practice (Rob-

ert Kolb Series) (p. 539). John Wiley

and Sons, Hoboken, N.J.

Flanagan, D, Kreuze, J., Smith, O., (2004).

Merger and Acquisition Opportunities,

The Internal Auditor, 61,4,55-59.

Frankel, M. (2005). Merger and Acquisi-

tion Basics. John Wiley and Sons, Ho-

boken, N.J.

Galpin, T., & Whittington, J. L. (2010).

Merger repair: A conceptual framework

for restoring Employer/Employee rela-

tionships. Journal of Behavioral and Ap-

plied Management, 12(1), 48-68

Giving Voice to Values Curriculum. Re-

trieved May 17th, 2013 from

www.givingvoicetovalues.org

Hitt, M. A., Harrison, J. S. & Ireland, R. D.

(2001). Mergers and acquisitions: A

guide to creating value for stakeholders.

Oxford, England: Oxford University

Press.

IMA Statement of Ethical Professional

Practice. Imanet.org. Retrieved May

17th, 2013 from

www.imanet.org/about_ima/our_missio

n.aspx.

Laurence, Capron and, K. S. (2005, Jun 03).

How M&As can lead to governance

failure. Financial Times.

Tarasovich, B., Lyons, B., Gerlach, J. (2008).

After the Acquisition, Strategic Finance,

90, 4, 25-31.

Warnell, J. M. (2011). "Ask more" of busi-

ness education: Giving voice to values

for emerging leaders. Journal of Busi-

ness Ethics Education, 8, 320-325.

Werhane, P. H., & Mead, J. (2009). Cynthia

cooper and WorldCom (A). Char-

lottesville

Werhane, P. H. (1988). Two ethical issues

in mergers and acquisitions. Journal of

Business Ethics, 7(1-2), 41.

165

Exhibit 1

Author

Barbara Tarasovich, D.P.S., C.P.A., Assistant Accounting Professor, Department of Ac-

counting and Information Systems , John F. Welch College of Business, Park Avenue,

Fairfield, CT 06825, [email protected]

166

Drug Revolution/Grace Pharmaceuticals Joint Venture

Karen M. Hogan, & Gerard T. Olson

Abstract

This case is a joint venture decision between a large fictional pharmaceutical company

called Drug Revolution and a biotech firm known as Grace Pharmaceuticals. The joint

venture is an international venture which evaluates the financial potential of a new

Type II Diabetes drug. The drug known as Zipit will be marketed both in the US and

through Europe over the course of the drug’s patented life. The students are asked to

develop detailed proforma and cash flow analyses given marketing and financial esti-

mates already known about the drug, calculate the cost of capital, compute NPVs, do a

sensitivity analysis with expected values, and discuss other investment analysis tools

available to the firm. This case is suitable for both upper level undergraduate corporate

case or mergers and acquisitions class as well as an MBA level corporate class.

Background Information

In early 2013, Kieran Gregory, President

and CEO of Drug Revolution, met with

members of a joint-venture negotiating

team to develop proposed terms of a joint

venture agreement. The venture would

combine capabilities of Drug Revolution,

Inc. and Grace Pharmaceuticals, Inc.

Drug Revolution has announced that it is

interested in acquiring a 70% share to

Zipit a Liquid Filled Capsules from Grace

Pharmaceuticals, Inc. Zipit is specifically

indicated for the relief of mild to moder-

ate acute pain in adults (18 years of age or

older). Zipit is supplied as a 25mg liquid

filled capsule for oral administration. The

approved dose is 25 mg four times a day.

The product uses proprietary delivery

technology to deliver a finely dispersed,

rapidly absorbed formulation of the drug.

The mechanism of action of Zipit, like that

of other NSAIDs, is not completely under-

stood but may involve inhibition of the

cyclooxygenase (COX-1 and COX-2)

pathways. Zipit’s mechanism may also be

related to prostaglandin synthetase inhibi-

tion.

Zipit was introduced to the US market by

Grace Pharmaceuticals in 2009 after it was

approved by the FDA that same year.

While Grace Pharmaceuticals has done a

decent job of marketing Zipit, the compa-

ny doesn’t have much in the way of extra

funds or detailed distribution channels so

the sales could potentially be much higher

than what Grace has been able to achieve

at this point. Drug Revolution is looking

to acquire a 70% share in the product in

return for an upfront payment to Grace of

$25.9 million in cash.

"We are pleased to expand our portfolio

of pain products with the addition of Zipit

to our sales force of 164 reps and 78 flex

reps that today are detailing Drug Revolu-

tion’s small molecule pain medications,"

said Kieran Gregory of Drug Revolution.

"Zipit is an NSAID that we believe is dif-

ferentiated in the pain space, allowing

167

rapid absorption of the lowest available

oral dose of the drug. Zipit will have an

almost immediate positive impact on

Drug Revolution’s financials. We believe

we will have the runway to achieve signif-

icant returns for our shareholders from

this joint venture, with the Orange Book

listed patent for Zipit expiring in 2030. We

plan to utilize our sales force to promote

Zipit to pain specialists, neurologists, and

high prescribing PCPs, including those we

currently detail for our small molecule

drug in addition to current prescribers of

Zipit."

Grace Pharmaceuticals had been looking

for a partner that would contribute cash

and marketing expertise in exchange for a

share of profits in a joint venture.

The joint venture with Grace was attrac-

tive to Drug Revolution for several rea-

sons as noted above. Kieran Gregory was

eager to conclude a deal with Grace’s

board and launch the venture with Grace.

Important questions, however, had to be

addressed before consummating an

agreement.

• What was the likely NPV of the joint

venture? Gregory wanted the joint

venture to be a 70/30 balance of in-

terests between Drug Revolution

and Grace Pharmaceuticals. Initial

discussions had focused on Drug

Revolution paying a lump-sum

payment of $25.9 million for their 70

percent interest in the venture.

Rather than concentrate efforts on the next

big hit Drug Revolution had decided to

manage its R&D like a portfolio by out-

sourcing innovations through partner-

ships. Drug Revolution’s strategy was to

supplement its internal R&D with strate-

gic alliances with external companies in

order to access high-quality products in

late-stage development or recent approv-

al. Because of encouraging results of

Grace Pharmaceutical’s limited launch of

the drug, management believed that Zipit

would be launched full force in the U.S.

immediately and in Europe starting 2014.

The possible joint venture between Drug

Revolution and Grace Pharmaceuticals

would concern only the U.S. and Europe-

an markets. Depending on market condi-

tions (e.g. competition, health-care poli-

cies, patents and market need), the life

cycle of Zipit drug was estimated at 18

years including year 2013.

Market Characteristics

The target markets for Grace Pharmaceu-

ticals were patients with mild to moderate

arthritis who would be treatable with an

NSAID category drug. Drug Revolution’s

projections show that there are approxi-

mately 250 million current prescriptions

filled each year for these types of ail-

ments. Drug Revolution estimates a com-

pounded annual rate of 5 percent over the

last 10 years, driven by multiple factors

including the aging of the population and

increases in the incidence of chronic ill-

ness. They feel comfortable that the 5%

growth rate will continue in the US for the

length of the project. Europe has the same

number of prescriptions for forecasting

purposes, with the prescriptions growing

at approximately 6% annually. These

growth rates were expected to continue

into the foreseeable future.

168

Forecast of Income Statements

Since many factors vary predictably with

the volume of sales, the primary variable

forecasted was Zipit revenues. People

with aspirin-sensitive asthma or allergic

reactions due to aspirin or other NSAIDs

should not take Zipit. Prescription Zipit

should be used exactly as prescribed at

the lowest possible dose for the shortest

time needed. The team projects that after

being fully rolled out in the U.S. market

during 2013 the drug is expected to enter

the European market the following year.

It is estimated that 90 percent of the U.S.

market would be eligible for the drug,

while this ratio might be lower (85 per-

cent) for the European market. Many fac-

tors are expected to influence revenues.

• Peak penetration rate in the mar-

ket: Based on different marketing

analyses and analysts’ reports, the

best guess of market penetration

for the drug are seen in below:

Market 2013 2014 2015 2016 2017 2018 2019 2020 2021

Penetration 7.00% 15.00% 20.00% 35.00% 45.00% 45.00% 45.00% 45.00% 45.00%

Market 2022 2023 2024 2025 2026 2027 2028 2029 2030

Penetration 45.00% 45.00% 45.00% 45.00% 45.00% 30.00% 25.00% 20.00% 20.00%

• Compliance: Not all patients who use

the drug will do so faithfully, even with

a doctor strongly recommending its use.

The team believes that the most likely

compliance rate would be an average of

87 percent. (i.e. The number of actual

prescriptions filled in any given year

would be equal to (eligible prescrip-

tions)*(percent penetration)*(.87))

• Price per prescription: The annual price

of the drug per patient would depend on

many things, including how many cap-

sules the patient used and competitive

pressures on the price that could be

charged for the capsules. The joint-

venture team had worked up an esti-

mated figure of $300 as the average cost

per prescription filled.

Variable Costs:

Although the variable costs of the drug

are hard to pinpoint, they are not the

most critical variable in the success of

the drug. The team members decided

to use the industry average of 30% of

annual sales revenues to forecast varia-

ble costs each year.

Fixed Costs:

Fixed Costs which would include sales,

marketing, and general and administra-

tive expenses are projected as follows

(Note: the values are in thousands of

dollars):

169

Fixed 2013 2014 2015 2016 2017 2018 2019 2020 2021

Expenses 4,800 6,950 10,500 12,500 15,000 16,250 17,500 18,500 19,500

Fixed 2022 2023 2024 2025 2026 2027 2028 2029 2030

Expenses 20,500 21,500 23,000 22,000 22,000 22,000 22,000 22,000 22,000

Net Working Capital:

Net working capital for the joint ven-

ture is estimated to comprise a 45-day

collection period for receivables, a 90-

day period for Zipit inventory, and a 45

day period for payables. Below are the

overall changes in net working capital

for each year. (Note: the values are in

thousands of dollars):

Change 2013 2014 2015 2016 2017 2018 2019 2020 2021

In NWC (100) (1,000) (1,322) (2,358) (5,777) (8,497) (7,887) (3,993) (2,178)

Change 2022 2023 2024 2025 2026 2027 2028 2029 2030

In NWC (2,340) (2,025) (1,607) (1,792) (1,697) (1,242) (315) (215) (100)

Capital Expenses and Depreciation Ex-

penses:

The team forecasts capital spending of

$7.1 million, split over the first three years

of the venture (i.e. outflows of $2.5 million

in 2013, $2.6 million in 2014, and $2.0 mil-

lion in 2015). The yearly depreciation used

is show below (Note: the values are in

thousands of dollars):

2013 2014 2015 2016 2017 2018 2019 2020 2021

Depreciation 400 400 950 950 950 950 950 950 950

2022 2023 2024 2025 2026 2027 2028 2029 2030

Depreciation 950 950 950 950 950 950 950 950 950

Cost of Capital:

The last decision that had to be made by

the Drug Revolution’s joint-venture team is

choosing a required rate of return for dis-

counting the cash flows for the joint ven-

ture. The company’s debt currently has a

yield to maturity of 10%. The tax rate ap-

propriate for the joint-venture was 30%.

Debt constitutes 30% of the cost of capital.

Preferred stock usually makes up 10% of all

capital and the average current cost of pre-

ferred is 14%. Common stock makes up

60% of all capital sources and has an aver-

age cost of 16.5%. While the firm expects

170

the drug to be a success they recognize that

most new drug ventures come with addi-

tional risks and thus have designated a risk

premium of 4.6% in addition to the calcu-

lated weighted average cost of capital.

Capital Budgeting Analysis:

1. Set up the Net Income Statement for

the joint venture.

2. Calculate the Joint-Venture’s annual

cash flows from the project.

3. Calculate the Net Present Value of the

overall joint venture prior to Drug

Revolution’s payment of $25.9 million

under a base case scenario.

4. Assuming Drug Revolution will nego-

tiate a 70% share in the venture and

that they pay a lump sum payment of

$25.9 million in 2013, what is the re-

sulting NPV to Drug Revolution un-

der the base case scenario?

5. How much will Grace end up with in-

cluding the $25.9 million cash pay-

ment under the base case scenario?

6. Should Drug Revolution enter into

this joint venture using only the base

case scenario? Explain your answer.

7. As a way of understanding how sensi-

tive their numbers are to sales fore-

casts Drug Revolution has decided to

analyze the NPV using a sensitivity

analysis based off the Total Revenue

for all sources of income line on the

proforma statement. Drug Revolution

will use a +/- 20% of Total Global Sales

to estimate how sensitive their NPV

results are to changes in total global

revenue. Determine what the NPV

for each of these scenarios would be.

8. Assume the base case is assigned a

probability of occurrence of 50%. Al-

so assume that the best and worst case

scenarios have probabilities of 10%

and 40% respectively. Given these ad-

justments what would the expected

NPV for Drug Revolution be? Should

this analysis adjust your recommen-

dations of an accept/reject decision for

Drug Revolution?

9. What are some of the other methods

that are used to evaluate investment

projects and compare them to NPV?

No specific calculations here, just a

discussion. Explain some of the po-

tential drawbacks in this specific case

with using the other investment eval-

uation methods.

10. Would it be possible to calculate the

IRR of this joint-venture? What are

the possible problems, if any, with its

calculation in this specific problem?

Authors

Karen M. Hogan, Haub School of Business, Saint Joseph’s University, 5600 City Ave,

Philadelphia, PA 19131-1395, [email protected]

Gerard T. Olson, Department of Finance, School of Business, Villanova University, Vil-

lanova PA 19085, [email protected]

171

From Jail Time to Swagger, Romance and Machoism: Changing the Im-

age of the Minivan

Mary Catherine Colley

Abstract

The minivan is considered uncool and embarrassing by most people, and even called

ugly by some. Even though a minivan is more practical, roomier, and gets better gas

mileage than an SUV, many people refuse to drive one. Thus, marketers have been chal-

lenged to change the image of the minivan in the mind of the consumer and are using

commercials focusing on specific target markets to relate to the consumers. The top four

brands which comprise 91% of the minivan market compete head to head to woo con-

sumers. Television commercials used by these brands are analyzed with regard to target

market and the topic of the commercials as it relates to the specific target markets.

Keywords: minivan, target market, brand preference

The minivan. Uncool. Embarrassing.

That’s how some people might describe it.

Practical. Lots of room. Better gas mileage

than an SUV. Better than a truck (yes you

read that right). That is how some people

who do own a minivan will describe it.

How does a marketer change the image

for those who refuse to drive one and turn

them in to potential buyers? For those

who cannot stand the thought of owning

a minivan, marketers are beginning to

understand these types of consumers and

now are utilizing commercials in ways

that help the consumer identify with the

minivan.

I. History of the Minivan

To explain the bad rap of the minivan, it is

best to know the beginnings of the

minivan’s poor image. There is no docu-

mentation of the beginning concept of the

minivan from an “uncool” factor, but one

could argue the style of the minivan did

not help its cause. The stigma attached to

minivans has driven people to purchase

SUVs and crossovers. Although the

minivan’s image may have been en-

grained in people’s minds earlier, one

commercial could have helped set the

precedence. In August 2004 Carmichael

Lynch Advertising created a commercial

for Harley Davidson which also ran dur-

ing March Madness on ESPN, ESPN2, and

ABC the same year. A Harley rider pulls

up next to a man in a minivan and says

“You in the minivan, how long you in for?

It’s time to ride.” Harley may or may not

claim the beginnings of the uncoolness of

the minivan; the birth of the SUV proba-

bly did most of the damage as well as the

bulky style of the minivan, but it certainly

did not help its image. It helped set the

tone for what driving a minivan means:

being a prisoner of the ultimate uncool

vehicle.

Regarding the Harley commercial, Tom

Watson, director of marketing for Mil-

172

waukee-based Harley claimed, “The spot

follows up on a theme which encourages

people to act now and fulfill their dreams

of owning a Harley-Davidson.” In an at-

tempt to express the feeling of freedom

that riding a Harley can bring to a rider, it

also helped convey what it meant to own

a minivan. It gives the notion that owning

a minivan is a jail sentence of which one

can only be set free when the children are

grown and leave the home.

Minivans began to lose its cool image

when SUVs hit the market.42 In addition to

its poor image, Choo and Mokhtarian43

reveal in their research that minivan own-

ers are considered calm, possibly because

they are settled into the throws of

parenthood. So when you put calm and

uncool together, it makes for one boring

vehicle; thus, possibly increasing interest

in the SUV that can seat just as many peo-

ple. The thought of owning a minivan

seems to still make some parents of young

children cringe at the thought of owning

one while others praise the space and ease

of loading and hauling young children

around town, on vacations, and to sport-

ing events.

There are people who drive and embrace

the minivan for its utility and function

and others who despise it for its style.

42 Lyneka Little, “The Man Van: A Gender Neutral Minivan for

Men? Chrysler’s New Dodge Grand Caravan RT: The Minivan

for Men,” ABC News/Money February 9, 2011

(http://abcnews.go.com/m/story?id=12866809&sid =74).

43 Sangho Choo and Patricia Mokhtarian, “What Type of Vehi-

cle Do People Drive? The Role of Attitude and Lifestyle in In-

fluencing Vehicle Type Choice,” Transportation Research Part A

Policy and Practice 38 (2004): 201-222

(http://www.uctc.net/papers/721.pdf).

Some parents refuse to own a minivan be-

cause of the status attached to it and

therefore to a possible level of inconven-

ience, opt for an SUV that looks more hip,

but may be more difficult to load and un-

load children and gets less miles to the

gallon. Haq 44 claims that marketers have

something in their favor though:

“Millenials have grown up around

minivans, driven them for their first cars

and come to appreciate them; therefore,

they should have fewer reservations when

considering a vehicle.” Toyota, Honda

and Dodge have attempted to change the

image of the minivan in the mind of their

consumers by using three different ap-

proaches in their commercials.

The one piece of intriguing information

about the minivan market is that only half

of the minivan owners have children45. So

what about the other half? Although the

thought is only people with young chil-

dren drive minivans, there is another

segment of owners that is not discussed.

Although there was no data found on the

other half of the minivan market, several

comments on discussion boards like

Bunkley’s46 2011 article “Mocked as Un-

cool, the Minivan Rises Again” revealed

that men like minivans better than trucks

for hauling. The argument is that

minivans are enclosed, items are protect- 44 Zain Haq, “Minivan Segment about to be Cool Again…No

Comment,” egmCarTech October 18, 2010

(http://www.egmcartech.com/2010/10/18/minivan-segment-

about-to-be-cool-again-no-comment/).

45 Little, The man van. 46

Nick Bunkley, “Mocked as Uncool, the Minivan Rises

Again,” The New York Times January 3, 2011

(http://www.nytimes.com/2011/01/04/business/

04minivan.html).

173

ed from weather, and there is access from

the inside to what is being hauled. In ad-

dition, older people who have a need for

mobile chairs say minivans are easier to

convert for their needs47. Interestingly

enough, although half of the minivans are

not sold to young families, the focus of

minivan commercials is on either young

families or a young couple thinking about

having a family. There is some question

about the number of minivans sold to

fleet which may play into the “only half of

minivan drivers have children factor”

however, there is some research stating

older people buy minivans as well.

Marketers struggle with identifying well

with their target market to increase pur-

chase intent. The drop in the number of

companies that manufacture minivans is

advantageous for the marketers because

brand recall should be easier to accom-

plish, but the advantages stop there. Re-

cent minivan commercials are now focus-

ing on specific target markets for the

minivan.

II. Creating a Brand Personality

Mark Twain once said “You can’t depend

on your eyes when your imagination is

out of focus.” Just the appearance of the

minivan is a deterrent to many, so mar-

keters have to work with what they have

to attempt to change the image of the

minivan in the consumer’s mind. Some

consumers seem to prefer to forego some

of the conveniences and functionality of

owning a minivan just to not be associat-

ed with it; therefore, creating a personali-

47 Little, The man van.

ty for a brand can bring many positive as-

pects for the product. A few of those posi-

tive aspects include: influencing consumer

preference and usage48, stirring consumer

emotions49, encouraging the processing of

information (Biel, 1992)50, encouraging

self-expression and association51, provid-

ing a basis for product differentiation52,

and influencing brand attitudes and cog-

nitive associations53.

The concept of brand personality in re-

search has gained traction over the last

three decades and is defined by Freling,

Crosno, and Henard54 as “a brand’s ability

to appeal to consumers through the com-

bination of human characteristics associ-

ated with it.” Advertisers and marketers

know that a brand’s personality plays an

important role in consumer attitudes and

purchase intentions toward a product55.

Therefore, to improve purchase intention,

the third dimension of brand preference,

48 M. Joseph Sirgy, “Self-Concept in Consumer Behavior: A

Critical Review,” Journal of Consumer Research 9 (1982): 287-300.

49 Alexander Biel, “Converting Image into Equity,” in David.

A. Aaker and Alexander L. Biel (eds.), Brand Equity and Adver-

tising (Hillsdale: Lawrence Erlbaum, 1993): pp. 67-82.

50 Alexander Biel, “How Brand Image Drives Brand Equity,”

Journal of Advertising Research 32 (1992): RC-6-RC-12.

51Russell Belk, “Possessions and the Extended Self,” Journal of

Consumer Research 15 (1988): 139-168.

52 Jennifer L. Aaker, “The Value of Brand Equity,” The Journal of

Business Strategy 13 (1992): 27-32.

53 Traci H. Freling, and Lukas P. Forbes, “An Examination of

Brand Personality Through Methodological Triangulation,”

Journal of Brand Management 13 (2005): 148-162.

54Traci H. Freling, Jody L. Crosno, and David H. Henard,

“Brand Personality Appeal: Conceptualization and Empirical

Validation,” Journal of the Academy of Marketing Science 39

(2011): 392-406.

55 Joseph T. Plummer, “Brand Personality: A Strategic Concept

for Multinational Advertising,” In Marketing Educators Con-

ference (New York: Young and Rubicam.1985): 1-31.

174

Toyota, Honda and Dodge created brand

personalities to appeal to their target

market which is discussed when describ-

ing the commercials.

Relying on brand personality alone may

not increase purchase intent, so Freling,

Crosno, and Henard56 developed and test-

ed Brand Personality Appeal (BPA). BPA

contains major factors in a consumer’s

purchase intentions and consists of three

dimensions: favorability, originality, and

clarity. It was developed to further ad-

vance Aaker’s57 Brand Personality Scale

(BPS) to “attempt to measure consumers’

feelings regarding a brand’s personality

and how a brand personality will affect

target consumers’ purchase intentions”58.

The BPS consists of five dimensions: sin-

cerity, excitement, competence, sophisti-

cation and ruggedness59.

Just relying on one BPA dimension does

not ensure purchase intent. A product can

be seen as favorable, but it also needs to

be viewed as different from other brand

personalities. However, in addition to

these two dimensions, clarity is also im-

portant. Clarity allows the target consum-

ers to recognize the brand60. Marketers

must ensure the brand personality ap-

peals clearly to their target market. Once

56 Freling and Forbes, “ An Examination of Brand Personality

Through Methodological Triangulation” 57 Jennifer L. Aaker, “Dimensions of Brand Personality,” Journal

of Marketing Research 34 (August 1997): 347-56.

58 Traci H. Freling, Jody L. Crosno, and David H. Henard,

“Brand Personality Appeal: Conceptualization and Empirical

Validation.”

59 Jennifer L. Aaker, “Dimensions of Brand Personality”

60 Traci H. Freling, Jody L. Crosno, and David H. Henard,

“Brand Personality Appeal: Conceptualization and Empirical

Validation.”

the brand personality has been clearly set,

then the marketers can use it to build

brand preference in their target market.

As the minivan commercials mentioned

later show, Toyota Sienna is the only

brand that seemed to really focus on the

personality of the types of people (parents

in this case) that drive a minivan). An

Odyssey commercial helped to show the

lifestage or age that one of the men in the

commercial might be in by using 80s hair-

bands to show the split DVD player.

III. Building Brand Preference

Consumers are known to buy products

that represent their lifestyle and “brands

serve as identity signals for consumers”61.

When consumers choose their vehicles as

a form of self-expression, owning a

minivan is perceived as a poor option.

These days one can customize most new

vehicles such as color, navigation, leather,

sunroof, etc., but the body style of the

minivan leaves little choice. Although, at

one time, 14 minivan models existed in

the U.S., today only four models make up

91% of the minivan sales in the U.S: Hon-

da Odyssey, Dodge Caravan, Chrysler

Town and Country and the Toyota Sien-

na62. Having only four models leaves little

variety for consumers when it comes to

choosing a minivan; therefore, little dis-

tinction or opportunity for self-expression

61 Jonah Berger, and Chip Heath, “Where Consumers Diverge

from Others: Identity Signaling and Product Domains,” Journal

of Consumer Research 34 (2007): 121-34.

62 Colin Bird, “Minivan Segment Swaggers Back to Life,”

Cars.com July 9, 2010

(http://blogs.cars. com/kickingtires/2010/07/minivan-segment-

swaggers-back-to-life.html).

175

for the consumer exists. The number of

competing brands in a product category

affects the consumers’ ability to recall and

evaluate a particular brand63. Since four

models represent the majority of the

minivan purchases in the U.S., marketers

can capitalize on this small number to

build brand preference and use commer-

cials to convey the life stage its target

market.

In order to compete, they must be able to

differentiate beyond brand alone. Market-

ers want to entice those people who have

avoided the minivan because of its overall

poor image. If consumers believe their

vehicle choice to be a form of self-

expression, marketers know the minivan

needs an image makeover in order to

build brand preference. The three dimen-

sions of brand preference are: a brand’s

personal relevance, a brand’s perceived

uniqueness, and a consumer’s willingness

to pay for a particular brand64. These are

all pertinent to wooing minivan buyers.

The brand’s relevance is the degree to

which consumers perceive a brand to be

related to their identity65,66,67. The lack of

variety in style that the minivan offers 63 Kevin Keller, “Conceptualizing, Measuring, and Managing

Customer-Based Brand Equity,” Journal of Marketing, 57

(1993): 1-22.

64 Alexander Chernev, Ryan Hamilton, & David Gal, “Compet-

ing for Consumer Identity: Limits to Self-Expression and the

Perils of Lifestyle Branding,” Journal of Marketing 75 (2011): 66-

82.

65 Aaker, Dimensions of Brand Personality 66 Jennifer L, Aaker, Susan Fourner, and S. Adam Brasel, “When

good brands do bad,” Journal of Consumer Research 31 (1) (2004):

1-16.

67 Susan Fournier, “Consumers and Their Brands; Developing

Relationship Theory in Consumer Research,” Journal of Con-

sumer Research 24 (1998): 343-73.

leads to fewer ways for consumers to be

perceived as unique or different. It is dif-

ficult to be self-expressive when one’s ve-

hicle choice is mostly limited to the four