Professional Documents
Culture Documents
Case 10 81.......................................................2
Quang Company : Financial Analysis and Loan
Structure ................................................................2
CASE 1*....................................................................3
Going Public..............................................................3
Sun Coast Savings Bank............................................3
CASE 2 *....................................................................7
Lease Analysis..........................................................7
Environmental Sciences, Inc......................................7
CASE 3*...................................................................11
Working Capital.......................................................11
Policy and Financing................................................11
Office Mates, Inc.....................................................11
CASE 4....................................................................16
Cash Budgeting.......................................................16
Alpine Wear, Inc. ....................................................16
Question ................................................................17
CASE 5....................................................................23
Entrepreneurship: ..................................................23
Financing and Valuing ............................................23
A New Venture .......................................................23
CASE 6....................................................................31
Project Risks...........................................................31
Cogeneration Corporation........................................31
CASE 7....................................................................41
Profitability and Loan Policy....................................41
Key Bank.................................................................41
Assets................................................................................................ 43
Liabilities & Equity.............................................................................43
Gap Strategies..................................................................................51
Cash flow from operating activities.........................................56
Cash flow from investing activities.........................................56
Cash flow from financing activities.........................................56
CASE 8....................................................................58
Strategic and Industry Analysis................................58
NetGear Industries..................................................58
Years ended December 31................................................................63
NETGEAR®........................................................................................66
CASE 9....................................................................68
Risk Acceptance Criteria & SME Distress Indicators...68
Ho Hung Imports.....................................................68
Assets.....................................................................73
BBA FM CASES - ENGLISH 1/90
Liabilities and equity ..............................................73
Pro Forma Income Statements.................................73
Ho Hung Imports – Part 2.........................................74
SME Distress Indicators...........................................74
Assets.....................................................................78
Liabilities and equity ..............................................78
Assets.....................................................................80
Liabilities and equity ..............................................80
Earnings..............................................81
Statement Date Sales before taxes*.....................81
Quang Company......................................................82
Liquidity............................................................................................. 88
Activity.............................................................................................. 88
Leverage...........................................................................................88
Profitability........................................................................................ 88
Case 10
81
Quang Company : Financial Analysis and Loan Structure
Sun Coat Saving Bank was founded in 1971 in Safety Harbor, Florida, which is just
across the bay from Tampa. Safety Harbor is very popular with people who work in Tampa
but do not wish to live within the city itself. Per-capita income in Safety Harbor is
substantially above the national average; in fact, the town has a reputation for having the
greatest population, of BMWs and Mercedes Benzes per capita in the United States. The
combination of an increasing population, high per capita income, and a huge demand for
funds to finance new home construction has made Sun Coast the fastest-growing association
in the state in terms of both assets and earnings.
Although Sun Coast is very profitable and has experienced rapid growth in earnings,
the company’s quick expansion has put it under severe financial strain. Even though all
earnings have been retained, the net-worth-to-assets ratio has been declining to the extent that,
by 1993, it was just above the minimum required by federal regulations (see Table 1).
Sun Coast now has the opportunity to open a branch office in a new shopping center.
If the office is opened, it will bring in profitable new loans and deposits, further increasing the
company’s growth. However, an inflow of deposits at the present time would cause the net-
worth-to-assets ratio to fall below the minimum requirements. Consequently, Sun Coast must
raise additional equity funds of approximately $3 million if it is to open the new branch.
Table 1
Sun Coast savings Bank
Balance Sheet for Year Ended
Assets
Cash and marketable securities $ 83,441,700
Mortgage loans 815,235,000
Fixed assets 60.423.300
Total assets $959,100,000
Liabilities
Savings accounts
Other liabilities $817,153,200
Capital stock ($100 par value) 83,077,000
Retained earnings 900,000
Total claims 57,969,800
$959,100,000
Note: Federal law requires the ratio of capital plus retained earnings-to-assets to be at least 6
percent.
Even though Sun Coast has a ten-man board of directors, the company is completely
dominated by the three founders and major stockholders: Jim Evans, chairman of the board
add owner of 35 percent of the stock; Tony McCoy, president and owner of 35 percent of the
stock; and Vincent Culverhouse, a builder serving as a director of the company and owner of
20 percent of the stock. The remaining 10 percent of the stock is owned by the other seven
directors. Evans and Culverhouse both have substantial outside financial interests. Most of
McCoy’s net worth is represented by his stock in Sun Coast.
Evans, McCoy, and Culverhouse agree that Sun Coast should obtain the additional
equity funds to make the branch expansion possible. They are not in complete agreement,
BBA FM CASES - ENGLISH 3/90
however, as to how the additional funds should be raised. They could raise the additional
capital by having Sun Coast sell newly issued shares to a few of their friends and associates.
The other alternative is to sell shares to the general public. The three men themselves cannot
put additional funds into the company at the present times.
Evans favors the private sale. He points out that he, McCoy, and Culverhouse have all
been receiving substantial amounts of ancillary, or indirect, income from the savings bank
operation. The three men jointly own a holding company, which operates an insurance agency
that writes insurance for many of the homes financed by Sun Coast and a title insurance
corporation that deal with the association. Also, Culverhouse owns a construction company
that obtains loans from the association. Evans maintains that these arrangements could be
continued without serious problems if the new capital were raised by selling shares to a few
individuals, but questions of conflict of interest would probably arise if the stock were sold to
the general public. He also opposes a public offering on the grounds that the flotation cost
would be high for a public sale, but would be virtually zero if the new stock were sold to a
few individual investors.
McCoy disagrees with Evans. He feels that it would be preferable to sell the stock to
the general public rather than to a limited number of investors. Acknowledging that flotation
cost on the public offering are a consideration, and that conflict-of-interest problems may
occur if shares of the company are sold to the general public, he argues that there would be
several offsetting advantages if the stock were publicly traded: (1) the existence of a market-
determined price would make it easier for the present stockholders to borrow money, using
their shares in Sun Coast as collateral for loans; (2) the existence of a public market would
make it possible for current shareholders to sell some of their shares on the market if they
needed cash for any reason; (3) having the stock publicly traded would make executive stock-
option plans more attractive to key employees of the company; (4) establishing a market price
for the shares would simplify problems of estate tax valuation in the even of the death of one
of the current stockholders; and (5) selling stock to the public at the present time would
facilitate acquiring additional equity capital in the future.
Culverhouse, whole 20 percent ownership of the company gives him the power to cast
the deciding vote, it unsure whether he should back the public sale or the private offering. He
thinks that additional information is needed to help clarify the issues.
The board therefore instructed Madeline Brown, Sun Coast’s chief financial officer, to
study the issue and to report back in two weeks. As a first step, Brown obtained the data on
Sun Coast’s earnings given in Table 2. Brown then collected information on four publicly
traded financial institutions; this data is shown in Table 3. She then set about the task of
coming up with a recommendation for the board of directors.
Table 2
Sun Coast Savings Bank (Selected Information)
Year Net Profit Earnings per Share
1992 $8,562,780 $951.42
1991 7,476,390 830.71
1990 6,521,490 724.61
1989 5,231,610 581.29
1988 4,712,220 523.58
1987 3,905,550 433.95
Questions
1. Table 1 presents Sun Coast’s balance sheet at the end of 1992. Using information
contained in the balance sheet, calculate Sun Coast’s net-worth-to-assets ratio, the
number of shares of stock outstanding, and the book value per share of common stock.
2. Using the data in Table 2, calculate Sun Coast’s average annual growth rate in
earnings per share from 1987 to 1992. (Hint: In your calculations, use only the data for
1987 and 1992).
3. For the four S&L’s listed in Table 3, calculate the following.
a. The net worth/assets ratios for 1992
b. Compound annual growth rates in earnings per share for the five-year period
1987-1992.
c. The price/earnings ratios in 1992.
d. The market value/book value ratios for 1992.
4. Considering your answers to Question 1 through 3, develop a range of values that you
think would be reasonable for Sun Coast’s market/book ratio if it were a publicly held
company.
5. Regardless of your answer to Question 4, assume that 0.8x is an appropriate market
value/book value ratio for Sun Coast. What would be the market value per share of the
company?
6. Investment bankers generally like to offer the initial stock of companies that are going
public at a price ranging from $10 to $30 per share. If Sun Coast stock were to be
offered to the public at a price of $20 per share, how large a stock split would be
required prior to the sale?
7. Assume that Sun Coast chooses to raise $3 million through the sale of stock to the
public at $20 per share.
a. Approximately how large would have to be sold in order for Sun Coast to pay
the flotation cost and receive $3 million net proceeds from the offering?
b. How many shares of stock would have to be sold in order for Sun Coast to pay
the flotation cost and receive $3 million net proceeds from the offering?
8. Assume that each of the three major stockholders decided to sell half of his stock.
a. How many shares of stock and what total amount of money (assuming that the
BBA FM CASES - ENGLISH 5/90
stock split occurred and that these shares were sold at a price of $20 per share)
would be involved in this secondary offering is defined as the sale of stock that
is already issued and outstanding. The proceeds of such offerings accrue to the
individual owners of the stock, not to the company.)
b. Approximately what percentage flotation cost would be involved if the
investment bankers were to combine the major stockholders’ secondary
offering with the sale by the company of sufficient stock to provide it with $3
million?
9. Assume that the major stockholder decide that Sun Coast should go public. Outline in
detail the sequence of events from the first negotiations with an investment banker to
Sun Coast’s receipt of the proceeds from the offering.
10. Can you see why Evans and McCoy might personal differences of opinion on the
question of public ownership?
11. The analysis was based on the comparability of Sun Coast with four other savings
institutions. What factors might tend to invalidate the comparison?
12. All things considered, do you feel that Sun Coast should go public? Fully justify your
conclusion.
Over the past few years, official in Florida and other states that rely primarily on deep wells
for the drinking water have become aware of a potential serious problem – the pollution of
aquifers by the unrestrained use of fertilizers and pesticides. The result of a study conducted
by the United States Geological Survey showed that while the primary aquifer underlying
Florida is not yet contaminated, one chemical commonly found in agricultural pesticides has
caused extensive contamination of wells that tap water-bearing strata near the surface. To
combat this potentially widespread problem, officials in Florida and elsewhere are lobbying
for strict environmental regulation of commercial fertilizers and pesticides. As a result,
companies specializing in agricultural chemical have been working furiously to supply new
products that will not be banned under the proposed regulations.
Environmental Sciences, Inc., a regional producer of agricultural chemicals based in
Orlando, recently developed a pesticide that meets the new regulations. Now the firm must
acquire the necessary equipment to begin production. The estimated internal rate of return
(IRR) of this project is 24 percent and the project is judged to have low risk. Environmental
Sciences uses an after-tax cost of capital of 11 percent for relatively low-risk projects, 13
percent for those of average risk, and 15 percent for high-risk projects; so this low-risk project
passed the hurdle rate with flying colors.
The production-line equipment has an invoice price of $1,375,000, including delivery
and installation charges. It falls into the modified accelerated cost recovery system (MACRS)
five-year class, with current allowances of 0.20, 0.32, 0.19, 0.12, 0.11 and 0.06 in Years 1-6
respectively. Environmental’s effective tax rate is 40 percent. The manufacturer of the
equipment will provide a contract for maintenance and service for $75,000 per year, payable
at the beginning of each year, if Environmental Sciences buys the equipment.
Regardless of whether the equipment is purchased or leased, Susan Baker, the firm’s
financial manager, does not think it will be used for more than four years, at which time
Environmental’s current building lease will expire. Land on which to construct a larger
facility has already been acquired, and the building should be ready for occupancy at that
time. The new facility will be designed to enable Environmental to use several new
production processes that are currently unavailable to it, including one that will duplicate all
processes of the equipment now being considered. Hence, the current project is viewed as a
“bridge” to serve only until the permanent equipment can become operational in the new
facility four years from now. The expected useful life of the equipment is eight years, at
which time it should have a zero market value, but the residual value at the end of the fourth
year should be well above zero. Susan generally assumes that assets salvage values will be
equal to their tax book values at any point in time, but she is concerned about that assumption
in this instance.
Currently, the company has sufficient, capital, in the form of temporary investments in
marketable securities, to pay cash for the equipment and the first year’s maintenance. Susan
estimates that the interest rate on a 4-year secured loan to buy the equipment would be 11
percent, but she has decided to draw down the securities portfolio and pay cash for the
equipment if it is purchased.
Oceanside Capital, Inc. (OSC), the leasing subsidiary of a major regional bank, has
Office Mates, Inc. is a medium-sized manufacturer of metal file cabinets for home and office
use. The company sells its office furniture through regular channels, but its home products are
sold under the trade name “Office Friends” through mass merchandisers such as Wal-Mart.
Sales of both lines have grown substantially over the past 20 years because of the ever
increasing demand for storage containers. Because the demand for paper storage appears to be
slowing, Office Mates has recently moved into the manufacture and distribution of computer,
CDs and diskette storage systems, which it believes to be the “hot” growth area of the future.
Although the firm has always been up to date in manufacturing and marketing,
financial management has tended to take a back seat. In fact, the recently retired financial
manager joined the company right out of high school and worked his way up from an initial
position of mail clerk. To revitalize the finance function, the company brought in Bob Knight,
who has an MBA and who had worked as treasure for several years at a competing company,
as chief financial officer (CFO).
After spending several weeks familiarizing him with Office mates’ operation, Knight
concluded that one of his first tasks should be the development of a rational working capital
policy. With this in mind, he decided to examine three alternative policies: (1) an aggressive
policy, which calls for minimizing the amount of cash and inventories held and for using only
short-term debt, (2) a conservative policy, which calls for holding relatively large amounts of
cash and inventories and for using only long-term debt, and (3) a moderate policy, which falls
between the two extremes. The aggressive policy would result in the smallest.
Tentatively, Knight plans to hold the level of accounts receivable constant, i.e., it
would be the same under each of the three policies. Brian King, the company’s president,
suggested that as a part of the aggressive policy, under which cash and inventories are
minimized, the company could also minimize accounts receivable, and vice versa under the
conservative policy. However, Knight is bothered by labeling a policy, which allows accounts
receivables to rise (while holding sales constant) would include lengthening credit terms and
selling on credit to weaker customers, and neither of those actions seems “conservative”. Still,
Knight knows that King will bring this point up when they discuss the merits of the three
policies, and in the board of directors’ meeting, when the directors are asked to approve one
of the policies.
Knight also concluded that the company’s $5 million of net fixed assets is sufficient to
accommodate a relatively wide range of sales, so fixed assets can remain constant regardless
of what is done in the working capital area. As for current assets, Table 1 contains Knight’s
estimates of the firm’s balance sheet under the three alternative working capital policies.
Office Mates’ stock sells at about its book value, and the company’s target capital structure
calls for debt ratio in the range of 45 to 55 percent, so all three working capital policies are
consistent with Office Mate’s target debt/equity mix. In fact, all three alternatives have a
50/50 debt/equity mix; hence the decision does not affect the mix of debt and equity, but
rather, the level of the current assets and maturity structure of the debt. Knight’s best estimate
of debt costs is 10 percent for short-term debt and 13 percent for long-term debt.
The choice of working capital policy will affect some of the company’s costs. Thus,
while variable costs are expected to be 50 percent of sales regardless of which working capital
BBA FM CASES - ENGLISH 11/90
policy is adopted, fixed costs are likely to be a function of the level of current assets held- the
greater the level of current assets, the greater are fixed costs. This situation results primarily
because of the need to hold the larger inventories in high-cost. Dehumidified warehouses, and
because of higher insurance costs. Knight estimates annual fixed costs to be $4,000,000 under
the aggressive policy, $4,500,00 under a moderate policy, and $5,000,000 with the
conservative policy. Office Mates’ federal-plus-state tax rate is 40 percent.
Table 1
Estimated Balance Sheets
Table 2
Estimated Sales Under Working Capital Policy
Ann, Austin, the recently hired treasured of Alpine Wear, Inc., was summoned to the
office of Billy Joe Durango, the president and chief executive officer. When she got to Billy’s
office, Ann found him shuffling through a set of worksheets. He told her that because of a
recent tightening of credit by the Federal Reserve, hence an impending contraction of bank
loans, the firm’s bank has asked each of its major loan customers for an estimate of their
borrowing requirements for the remainder of 1993 and the first half of 1994.
Billy had a previously scheduled meeting with the firm’s bankers the following
Monday, so he asked Ann to come up with an estimate of the firm’s probable financing
requirements for him to submit at that time, Billy was going away on a white-water rafting
expedition, a trip that had already been delayed several times, and he would not be back until
just before his meeting with the bankers. Therefore, Billy asked Ann to prepare a cash budget
while he was away.
Due to the firm’s rapid growth over the last few years, no one had taken the time to
prepare cash budged recently; thus Ann was afraid she would have to start from scratch. From
information already available, Ann knew that no loans would be needed from the bank before
January, so she decided to restrict her budget to the period from January through June 1994.
As a first step, she obtained the following sales forecast from the marketing department:
November Decembe January February March April May June July August
r
1.
Collections
&
Payments
Gross Sales $300,000 480,000 x 600, 000 720,000 840,000 980,000 $780,00 $600,000 $300,00 $240,00
(expected) x x x x x 0 0 0
Gross Sales $300,000 480,000 x 600, 000 720,000 840,000 980,000 $780,00 $600,000 $300,00 $240,00
(realized) x x x x x 0 0 0
Collection:
Month of $7., 875 $118,200 147,750 177,300 206,850 241,325 $192,07 $147,750
Sale x x x x 5
1. Month 195,000 x 312,000 390, 000 468,000 546,000 637,000 507,000
after Sale x x
2. Months 30,000 x 48,000 x 60, 000 72,000 84,000 98,000
after Sale
$489,75 $615,30 734,850 859,325 913,075 752, 750
Total
0 0 x x x x
Collection
Purchases $120,000 144,000 x 168,000 196,000 $ $120,00 $60,000 $48,000
x x 156,000 0
Payments:
1. Month 60,000 72,000 84,000 98,000 x 78,000 60,000 30,000 x 24,000 x
before Sale
2. Months 60,000 72,000 84,000 98,000 x 78,000 60,000 30,000 x
before Sale
$156,00 182,000 176,000 90,000 x $54,000
Total
0 x x
Payments
Continued
November Decembe January February March April May June July August
r
1. Cash Gain
(Loss) for
Month
Collections $489,750 615,300 734,845 859,325 913,075 752,750
x x x x x
November Decembe January February March April May June July August
r
1. Cash
Surplus of
Loan
Cash at $300,00075 $115,350 39,850 x (15.300) 259,62 722,70
Start 0 X 5x 0x
(No
borrowing)
Cumulative $115,350 39,850 x (15,300) 259,625 722,70 602,65
Cash X x 0x 0x
Target Cash $300,000 300,000 300,000 300,000 300,00 300,00
Balance x x x 0x 0x
Surplus
Cash or
Total
Loan
Outstandin
g to
Maintain
Target
Cash ($184,650) (260,150) (315,300) (40,375) 422,70 302,65
Balance X X X 0x 0x
A New Venture
Table 2
Projected Cash Flow Statements
(In Millions of Dollars)
Year 1 Year2 Year 3 Year 4 Year 5
Sales $20 $53 $102 $117 $129
Cost of goods sold 10 26 51 59 65
Gross margin $10 $27 $51 $58 $64
General/administrative expenses 5 10 19 23 25
Debt service 5 5 5 5 10
Pre-tax income $0 $12 $27 $30 $29
Taxes 0 5 12 13 14
Net income $0 $7 $15 $17 $15
BBA FM CASES - ENGLISH 29/90
Depreciation/amortization 2 6 6 6 6
Terminal value 116
Net cash flow $2 $13 $21 $23 $137
Notes:
a) Depreciation/amortization expense is included in the cost of goods sold; yet it is a
noncash charge. Thus it must be added back to net income to obtain the net cash
flow in each year.
b) The terminal value is the present value, as of the end of Year 5, of the equity cash
flows that are expected to occur after Year 5. This value was obtained by assuming
10 percent annual growth in equity cash flows after Year 5 and cost of equity of 30
percent.
Terminal value = $21(1.1)/[0.30-0.10] = $116
Cogeneration Corporation
The Cogeneration Corporation was formed as a general partnership by Engineering Firm Ltd. and
Local Utility to undertake a cogeneration project. Cogeneration involves the production of steam,
which is used sequentially to generate electricity and to provide heat. The two forms of energy—
electricity and heat—are thus cogenerated. The owners of the cogeneration facility may use some of
the electricity for themselves and/or sell the rest to the local electric utility company. The leftover heat
from the steam has a number of possible commercial uses, such as process steam for a chemical
plant, for enhanced oil recovery, or for heating buildings.
The Project
Engineering Firm has proposed to Chemical Company that it design and build a Cogeneration Project
at Chemical Company's plant in the East Region.
Engineering Firm has considerable experience in designing and managing the construction of energy
facilities. The market for engineering services is very competitive. Engineering Firm has found that its
willingness to make an equity investment, to assist in arranging the balance of financing, and to
assume some of the responsibility for operating the project following completion of construction, can
enhance its chances of winning the mandate to design and oversee construction of a cogeneration
project. Nevertheless, Engineering Firm's basic business is engineering, and its capital resources are
limited. Accordingly, it is anxious to keep its investments "small," and it is unwilling to accept any credit
exposure. However, it is willing to commit to construction of the facility under a fixed-price turnkey
contract, which would be backed up by a performance bond to ensure completion according to
specifications.
Chemical Company's plant began commercial operation in 1964. Two aged, gas-fired steam boilers
produce the process steam used in the chemical manufacturing process at the plant. Local Utility
currently supplies the plant's electricity.
Engineering Firm has suggested building a Cogeneration Project to replace the two boilers. The new
facility would consist of new gas-fired boilers and turbine-generator equipment to produce electricity.
The Cogeneration Project would use the steam produced by the gas-fired boilers to generate
electricity. It would sell to Local Utility whatever electricity the plant did not need. It would sell all the
waste steam to Chemical Company for use as process steam and would charge a price significantly
below Chemical Company's current cost of producing process steam at the plant.
Local Utility is an investor-owned utility company. It provides both gas and electricity to its customers,
including Chemical Company. Local Utility has stated publicly that it is willing to enter into long-term
electric power purchase agreements and long-term gas supply agreements with qualified
cogenerators. It has also formed an unregulated subsidiary for the express purpose of making equity
investments in government-approved independent power projects. The government has authorized
Local Utility to make such investments, provided Local Utility owns no more than 50% of any single
project.
Local Utility has informed Engineering Firm that it is in support of the Cogeneration Project. It is willing
to enter into a 15-year electric power purchase agreement and a 15-year gas supply agreement. Local
Utility has committed to accepting a provision in the gas supply agreement that would tie the price of
gas to the price of electricity: The price of gas will escalate (or de-escalate) annually at the same rate
as the price Local Utility pays for electricity from the Cogeneration Project. Local Utility is willing to
invest up to 50% of the project entity's equity and to serve as the operator of the facility. However, it is
not willing to bear any direct responsibility for repaying project debt. Local Utility would include the
facility's electricity output in its base load generating capability. A 15-year inflation-indexed (but
otherwise fixed-price) operating contract is acceptable to Local Utility. The contract would specify the
operating charges for the first full year of operations. The operating charges would increase thereafter
to match changes in the producer price index (PPI). These charges would represent only a relatively
small percentage of the Cogeneration Project's total operating costs. Because such facilities are
simple to operate, the completed Cogeneration Project will require only a dozen full-time personnel to
operate and maintain it.
The balance of the equity and all of the long-term debt for the project will have to be arranged from
passive sources, principally institutional equity investors and institutional lenders. The equity funds will
have to be invested before the long-term lenders will fund their loans. The passive equity investors will
undoubtedly expect Local Utility to invest its equity before they invest their funds. The strength of the
electric power purchase and gas supply agreements will determine how much debt the Cogeneration
Project will be capable of supporting. The availability of the tax benefits of ownership, as well as the
anticipated profitability of the project, will determine how much outside equity can be raised for the
project.
In the case of the Cogeneration Project, Engineering Firm and Local Utility have agreed to pay various
preconstruction costs—mainly, the fees for securing the many permits the Cogeneration Project will
need to have before lenders will advance any construction funds. Preconstruction costs amount to $3
million. Engineering Firm and Local Utility contributed these permits to the project in return for equity in
Cogeneration Company (see Exhibit 1).
The principal engineering firm usually supplies a construction drawdown schedule. The construction
period allows time for preliminary engineering and licensing in addition to the actual construction. For
the Cogeneration Project, funds needed during the construction period will be supplied by a
commercial bank. Bank debt will fund 100% of the cost during the construction period. Engineering
Firm and Local Utility have arranged a $120 million construction loan facility. In addition, Engineering
Firm and Local Utility committed to the bank that they would arrange permanent financing for
Cogeneration Company. They estimate that Cogeneration Company will incur approximately $2 million
of fees in connection with arranging the permanent financing. Construction-period loans are generally
made on a floating-rate basis.
The construction loan should have sufficient capacity to provide funds for contingencies and for
fluctuations in interest rates. Because the construction loan entails loan fees that depend on the size
of the loan commitment, it is important not to oversize the construction loan. No provision is made for
foreign currency risk since the loan and the project revenues and costs are in dollars.
Capital Cost
Exhibit 2 indicates the total project cost of the Cogeneration Project, given a 24-month construction
schedule and an interest rate of 10%. Interest is paid on funds that are drawn down, and a
commitment fee is charged on the unused balance of the commitment. The loan commitment is
designed to accommodate higher interest rates during the construction period and higher construction
costs (for example, to cover design changes).
Construction is expected to cost $100 million. Commitment fees and interest will add $7.308 million,
bring the construction cost to $107.308 million. The unused balance of $12.692 million shown in
Exhibit 2 is available to cover cost overruns or higher interest charges. Including the $3 million of
preconstruction costs and $3.2 million cost of arranging the financing, total expected project cost is
$113.508 million.
However, the total project cost is sensitive to the interest rate applicable during the construction
period. If the interest rate is higher than expected, project cost increases accordingly.
The Cogeneration Project's target capital structure is 25% equity and 75% debt. The proportions of
equity and debt were determined by analyzing the profitability of the project. The greater the level of
operating income that can be contractually assured, the greater the amount of debt a project can
support. Cogeneration Company's debt will be nonrecourse to the equity investors. Long-term lenders
must look solely to the project's cash flow for their repayment. The equity investors will receive their
returns in the form of tax benefits, dividends paid out of excess cash flow from the project (i.e., after
payment of debt service), and any residual value of the cogeneration plant.
Amount Percent
(millions of $)
Long-term debt $85.131 75.0
Equity:
General partner 2.838 2.5
Limited partner 25.539 22.5
Total equity 28.377 25.0
Total capitalization $113.508 100.0
Engineering Firm and Local utility each own half of the general partner, Cogeneration Corporation.
Each will invest 25% of total project equity, and the passive investors will invest the other half of the
equity. Engineering Firm and Local Utility invest just enough funds in Cogeneration Corporation to
capitalize the general partner adequately for income tax purposes.
Initially, the general partner will receive 10% of the partnership's income, losses, and cash
distributions, and the limited partners will receive the remaining 90%. Once the limited partners have
received cumulative cash distributions equal to their original investment of $25.539 million, the 10/90
split will change to 50/50. The initial spilt is in proportion to the equity investors' respective investments
in the Cogeneration Project. Following reversion, the general partner shares equally with the limited
partners with respect to partnership income, losses, tax credits, and cash distributions. This shift in
distribution arrangements is designed to reward the general partner if the partnership performs well.
The cash flow projection assumptions for the Cogeneration Project are shown in Table 1. The contract
volumes of electricity (as specified in the electric power purchase agreement) and steam (as specified
in the steam purchase agreement) establish the base output levels for 15 years. The electric power
purchase agreement specifies electricity prices. The steam purchase agreement provides a base
steam sales price, which can be escalated using a forecast of future changes in the PPI. (Such
BBA FM CASES - ENGLISH 34/90
forecasts are available from economic forecasting services.) The projected volumes and prices can be
used to forecast annual revenue amounts.
The design of the cogeneration facility will determine the annual levels of gas usage. The gas supply
agreements escalates the gas price to match future increases in electricity prices, which were used to
prepare the revenue projections. Management fees and other operating expenses will also increase
with the PPI, as provided for in the 15-year operating contract entered into with Local Utility.
Management fees are included in "Operating and other cash expenses" in Table 1.
Table 1
Cogeneration Project: Assumptions for the Cash Flow Projectionsa
2. Prices at the time the plant is placed in service, and contracted escalation factors:
3. Predicted volumes:
At Capacity Maximum Annual At 90% Utilization
a
MW = megawatts; MWH = megawatt-hours; PPH = pounds per hour; M P = million pounds; BTU =
British thermal unit; M BTU = million BTUs; B BTU = billion BTUs.
b
The producer price index, which is assumed to escalate at the rate of 5% per annum.
c
Includes operating costs, maintenance expenditures, and management fees amounting to $6 million,
and insurance and local taxes amounting to $2 million.
Questions
Cogeneration Corporation
Limited Partners (General Partner)
_____
a
Reversion occurs when the limited partners have received cumulative cash distributions equal to their original investment of
$25.539 million. Thereafter, the general partner (Cogeneration Corporation) is entitled to receive 50% of all partnership income,
losses, and cash distributions.
37
Exhibit 2
Cogeneration Project: Total Project Cost and Construction Loan Drawdown
(millions of dollars)
Exhibit 3
Cogeneration Project: Projected Traditional Cash Flows
(millions of dollars)
a
Deductible for tax purposes. Assumes the total project cost of $113.508 million can be deducted on
a straight-line basis over 10 years.
b
Before interest charges but after deduction of the equity investors' tax liabilities on their partnership
income.
Assumptions:
Interest Debt
a b
Year EBIT EBITDA Interest Principal Tax- Coverage Service
d
adjusted Ratio Coverage
c
Principal Ratioe
1 $18.10 $29.45 $8.51 $4.26 $7.09 2.13 1.89
2 19.90 31.25 8.09 4.26 7.09 2.46 2.06
3 21.81 33.16 7.66 4.26 7.09 2.85 2.25
4 23.83 35.18 7.24 8.51 14.19 3.29 1.64
5 25.98 37.33 6.38 8.51 14.19 4.07 1.81
6 28.26 39.61 5.53 8.51 14.19 5.11 2.01
7 30.68 42.03 4.68 8.51 14.19 6.55 2.23
8 33.25 44.60 3.83 12.77 21.28 8.68 1.78
9 35.97 47.32 2.55 12.77 21.28 14.08 1.99
10 38.85 50.21 1.28 12.77 21.28 30.43 2.23
a
Earnings before interest and taxes. (example: $78.84 + $4.73 - $46.12 - $8.00 - $11.35 = $18.10)
b
Earnings before interest, taxes, depreciation, and amortization. (example: $78.84 + $4.73 - $46.12 -
$8.00 = $29.45)
c
Principal repayments divided by (1 - tax rate).
d
EBIT divided by interest expense.
e
EBITDA divided by interest expense plus tax-adjusted principal.
Key Bank
At the end of 2008, Key Bank had total resources of $410 million. It served its market area with 16
offices and a staff of 295 full-time officers and employees.
Early 2009, Nguyen Hong Anh, executive vice-president of Key Bank, was reviewing the financial data
he had assembled for the asset and liability committee (ALCO). Hong Anh had joined the bank the
previous November, along with Ho Thi Kim, who was named chairman of the board and chief
executive officer. Shortly after the two men had assumed their new positions, Thi Kim instructed Hong
Anh to respond to the report of national bank examiners, dated 17 October 2008, which was highly
critical of the bank’s policies and procedures for monitoring and controlling its risk position. Hong Anh
was asked to review the bank’s performance and, as soon as he completed his evaluation, to present
his recommendations for corrective measures to the ALCO.
The examiners had found much to criticize. They specifically made note of three areas of concern.
First, the bank’s exposure to credit, interest rate, and liquidity risks was judged excessive in relation to
its capital strength and earnings performance. Second, the bank funded approximately 25% of its
assets through large Certificates of Deposit (CDs), more than twice the peer bank average of about
12%. Finally, the bank’s financial reports and written policy statements regarding interest rate and
liquidity risk management did not provide the data and specific guidelines needed to make well-
reasoned asset and liability management decisions.
During the past few weeks, Hong Anh had worked on evaluating Key Bank’s recent operating
performance and its financial condition. He was also occupied with designing an information system of
financial reports that would be useful in managing the bank’s resources and that would meet the
examiners’ criticism.
For his analysis of Key Bank’s performance, Hong Anh put together the financial data of eight banks
for the last two years, 2007 and 2008. While none of the eight banks competed with Key Bank, each
was about the same size, with total assets that ranged from about $300 million to just under $600
million. Also, the banks selected to form a suitable peer group were located in areas with economic
and demographic characteristics similar to those of Key Bank’s market. The balance sheet and
income statement data for Key Bank and the peer group banks are shown in Exhibits 1 and 2. Exhibit
3 contains key financial ratios for Key Bank and its peers.
The two primary financial reports designed by Hong Anh for management’s use in making asset and
liability management decisions were an interest rate sensitivity report (Exhibit 4) and a liquidity report
(Exhibit 5). Hong Anh felt that the reports would improve management’s ability to monitor and
understand Key Bank’s risk position.
In preparing for the ALCO meeting at which he would discuss his findings and present his
recommendations, Hong Anh talked to each member of the committee and obtained their views on
the outlook for the local and national economies in 2007. The consensus estimate of the ALCO
BBA FM CASES - ENGLISH 41/90
members was that interest rates would bottom out by the end of the second quarter and would
increase during the last half of the year. Hong Anh’s summary of this forecast appears in Exhibit 6.
Questions:
1. Compare the relative earnings performance of Key Bank with its peers.
2. Evaluate the financial risks which Key Bank has taken to attain these returns. Use both the
DuPont Analysis and a Cash Flow Analysis to support your answer.
3. Analyze the interest-sensitivity report in Exhibit 4. Justify your findings with one of the four gap
strategies attached.
4. Using the data in Exhibit 5, determine Key Bank's liquidity needs over the first quarter of 2009.
How should the bank meet its liquidity requirements?
5. Given the outlook for 2009 suggested in Exhibit 6, what specific recommendations would you
make to the management of Key Bank for improving the bank's earnings performance and
financial strength?
2008 2007
Key Peers Key Peers
Assets % % % %
Cash and due from banks 27424 7.03 6.87 25869 7.16 6.97
Interest-bearing bank deposits 8348 2.14 3.10 7299 2.02 2.98
Excess reserves sold 10884 2.79 5.24 9683 2.68 4.95
Investment securities:
Central government 35226 9.03 12.17 35913 9.94 12.96
Local government 24654 6.32 7.93 26628 7.37 9.04
Other securities 5930 1.52 1.75 4805 1.33 1.21
Total investment securities 65810 16.87 21.85 67346 18.64 23.21
Loans and leases:
Commercial 96589 24.76 17.06 90867 25.15 17.03
Real estate 69516 17.82 23.51 56218 15.56 21.59
Consumer 82935 21.26 14.87 74247 20.55 14.89
Other loans 16306 4.18 4.29 17776 4.92 4.82
Lease financing 1053 0.27 0.35 831 0.23 0.31
Total loans and leases 266399 68.29 60.08 239939 66.41 58.64
Less: reserve for losses 3199 0.82 0.73 2746 0.76 0.66
Net loans and leases 263200 67.47 59.35 237193 65.65 57.98
Premises and equipment 7295 1.87 1.69 7045 1.95 1.84
Other assets 7139 1.83 1.90 6865 1.90 2.07
Total assets 390100 100.00 100.00 361300 100.00 100.00
2008 2007
Key Peers Key Peers
% % % %
Interest income:
Loans and leases 30467 7.81 6.80 30156 8.35 7.27
Investment securities 7001 1.79 2.33 7677 2.12 2.64
Interest-bearing balances 689 0.18 0.27 718 0.20 0.29
Excess reserves sold 775 0.20 0.38 794 0.22 0.42
Total interest income 38932 9.98 9.78 39345 10.89 10.62
Interest expense:
Interest on deposits 18828 4.83 4.70 19835 5.49 5.40
Interest on borrowings 989 0.25 0.35 1156 0.32 0.39
Total interest expense 19817 5.08 5.04 20991 5.81 5.79
Provision for loan losses 2146 0.55 0.43 1770 0.49 0.41
Adjusted net interest margin 16969 4.35 4.31 16584 4.59 4.42
Overhead expenses:
Salaries 6671 1.71 1.61 6540 1.81 1.70
Premises and equipment 2302 0.59 0.52 2276 0.63 0.57
Other expenses 5110 1.31 1.24 4914 1.36 1.28
Total overhead expenses 14083 3.61 3.37 13730 3.80 3.55
2008 2007
Peers Peers
Key Key
Profitability measures:
1. Return on assets 0.91 1.04 0.95 1.02
2. Net profit margin 8.36 9.70 8.04 8.80
3. Asset yield or utilization 10.88 10.72 11.81 11.59
4. Return on equity 13.82 14.90 14.73 14.41
5. Leverage or equity multiplier (x) 15.2x 14.33x 15.50x 14.12x
Spread management (% of earning
assets):
6. Net interest margin 5.44 5.25 5.66 5.38
7. Adjusted net interest margin 4.83 4.77 5.11 4.92
8. Net overhead burden 3.01 2.69 3.21 2.87
Asset management (% of assets):
9. Excess reserves sold & interest-
bearing bank balances 4.93 8.34 4.70 7.93
10. Central government securities 9.03 12.17 9.94 12.96
11. Local government securities 6.32 7.93 7.37 9.04
12. Net loans and lease financing 67.47 59.35 65.65 57.98
13. Premises and equipment 1.87 1.69 1.95 1.84
Liability management (% assets):
14. Noninterest demand deposits 17.19 17.14 17.51 17.32
15. Interest-bearing deposits 7.53 8.24 8.03 8.80
16. Regular and money market savings 16.73 26.28 15.98 24.03
17. CDs <$100000 21.24 23.86 21.53 24.57
18. CDs >$100000 25.13 11.49 24.37 11.68
19. Short-term borrowings 3.73 4.77 4.21 5.15
Expense control:
20. Interest expense/assets 5.08 5.04 5.81 5.79
21. Interest expense/interest paying
liabilities 6.83 6.75 7.84 7.80
22. Assets per employee (000 $) 1322 1485 1216 1352
23. Salaries/assets 1.71 1.61 1.81 1.70
24. Other expenses 1.90 1.76 1.99 1.85
25. Provision for loan losses/assets 0.55 0.43 0.49 0.41
Asset yield enhancement:
26. Interest income/assets 9.98 9.78 10.89 10.62
27. Interest income/earning assets 11.08 10.83 12.13 11.83
28. Noninterest income/assets 0.90 0.94 0.92 0.97
29. Loan income/loans and leases 11.44 11.32 12.57 12.40
BBA FM CASES - ENGLISH 45/90
30. Yield on investment securities 10.64 10.66 11.40 11.37
Credit quality (% loans & leases):
31. Net charge-offs 0.64 0.52 0.60 0.47
32. Past-due & nonaccrual loans & 1.93 1.58 1.89 1.71
leases
Liquidity measures:
33. Temporary investments/assets 10.64 15.07 11.02 16.15
34. Volatile liabilities/assets 28.86 16.26 28.58 16.83
35. Net loans & leases/core deposits 107.62 78.59 104.12 77.60
Interest sensitivity measures (% of
assets):
36. Assets repricing in one year 51.92 51.95 53.06 52.24
37. Liabilities repricing in one year 60.37 57.83 59.84 55.04
38. One-year GAP -8.45 -5.88 -6.78 -2.80
Capital adequacy and loan loss
coverage:
39. Equity/assets 6.58 6.98 6.45 7.08
40. Net loans & leases/equity (x) 10.25x 8.50x 10.18x 8.19x
41. Loan loss reserve/loans &
leases 1.20 1.22 1.14 1.13
42. Cash dividends/net income 33.34 38.64 33.90 34.67
43. Internal capital generation rate 9.21 9.14 9.74 9.41
Adjusted net interest margin. The yield realized on earning assets less total interest expense and
the provision for loan losses divided by average earning assets.
Asset yield or utilization. Total operating income (interest income plus noninterest income) divided
by average total assets.
Core deposits. Interest-bearing and noninterest-bearing demand deposits, regular savings, money
market savings, and CDs under $100000.
Earning assets. Interest-bearing assets including total loans and leases, investment securities,
excess reserves sold, interest-bearing deposits with other banks, and other money market
instruments.
GAP. The difference between rate-sensitive assets and rate-sensitive liabilities over a specified time
period.
Leverage or equity multiplier. Average total assets divided by average common shareholders’
equity.
Net charge-offs. The difference between the yield realized on earning assets and total interest
expense divided by average earning assets.
Net loans and leases. Gross loans less unearned income and the loan loss reserve.
Net overhead. The difference between noninterest income and noninterest expense divided by
average earning assets.
Net profit margin. Net income after taxes divided by total operating income.
Nonaccrual loans and leases. Loans and leases on which interest accrual have been discontinued,
usually due to the borrower’s financial difficulties.
Noninterest expense. All operating expenses other than interest expense and the provision for loan
losses, including salaries, benefits, occupancy costs, etc.
Noninterest income. All income other than interest and fees on earning assets, including safe-
keeping income, deposit service charge income, other service charges, etc.
Return on assets. Net income after taxes divided by average total assets.
Return on equity. Net income after taxes divided by average common shareholders’ equity.
Temporary investments. Interest-bearing deposits with banks, excess reserves sold, trading account
securities, and investment securities with remaining maturities of one year or less.
Volatile liabilities. Large CDs and other time accounts in amounts of $100000 and more, excess
reserves purchased, and other short-term borrowings.
Noninterest-bearing deposits
Interest-bearing demand deposits 18506
Regular savings 234 415 508 465
Money market deposit accounts 46367
CDs <$100000 714 2558 22575 4602 2445
CDs >$100000 1565 14267 10046 21842 18024
Excess reserves purchased 15279
Other liabilities
Shareholders’ equity
Loan loss reserve
Total liabilities and equity 17558 81932 33036 26952 20934
Total 65669
Liabilities
Noninterest-bearing demand deposits
8300
Interest-bearing demand deposits
2100
Regular savings 1157
Money market deposits 3500
CDs <$100000 22837
CDs>$100000 47720
Excess reserves purchased 15279
Total 86993 13900
Estimated new loan demand 35000
Estimated new core deposits
(excluding large CDs) 21000
Loan Demand
Loan demand in 2009, especially in real estate and consumer credit card activity, will pick up in our
market area in response to increased population as three major national firms—an electronics
company, an automotive parts and accessories manufacturer, and a building materials supplier—will
open new facilities and hire about 2700 employees during the year. Nationally, we see a recession in
the first two quarters, followed by reasonable recovery in the latter half of 2009.
Interest Rates
In spite of a national economic slowdown, business activity is stronger than anticipated in our region.
Easy monetary policy suggests that the Central Bank will attempt to increase money growth during the
year to stem the recession. Short-term interest rates will fall about 200 basis points, then rise from 50
to 100 basis points above those levels. Big banks’ prime rate should move up to 8.50 to 9.00%, while
3-month Treasury bill and CD rates should move up to 6.50 to 7.00%. All rate bets are off if there is a
continuing recession into 2010. If the recession continues or the recovery is weak, all interest rates will
continue to fall.
Key Bank will pay competitive deposit rates at the high end to enlarge its base of core deposits. It will
not match rates offered by some of the savings banks in our market area but will pay rates above
those of our bank competitors.
Gap Strategies
Definition of Gap
The concept of gap analysis is relatively simple. Each asset and liability category is classified
according to the time that it will be repriced and is then placed in a grouping called a time bucket. Time
buckets refer to the time that assets and liabilities mature, generally grouped in three-month to one-
year intervals.
For most banks, the assets are frequently long-term (loans primarily) while the liabilities are frequently
short-term (customer deposits, for example). This results in a funds gap. A funds gap is defined as
assets minus liabilities within each time bucket. The gap ratio is assets divided by liabilities in each
time bucket. A funds gap or gap ratio of zero means that the bank has exactly matched the maturity of
its assets and that of its liabilities. This match, however, is difficult to achieve based on the balance
sheet structure of most banks.
an acceptable level for this ratio depends on the average loan terms, terms of the liabilities, and
expectations about the movement of interest rates. If the gap ratio is greater than one, it is referred to
as a positive gap or asset-sensitive position. This means that there are more interest rate sensitive
assets for a particular time period than liabilities. If a bank expects interest rates to rise, it will likely
maintain a positive short-term gap. However, if interest rates decline, both assets and liabilities will be
repriced at a lower rate when the time period ends. Because there are fewer repriced liabilities to fund
the repriced assets, the result is increased risk (that is, the lower repriced assets will be funded in part
with higher liabilities that have not yet been repriced.
On the other hand, if the gap ratio is less than one or if there is a negative gap, a liability-sensitive
position results. If interest rates decline, risk is reduced because the lower-priced liabilities will be
funding more assets that are still priced at the higher rate. If a bank anticipates declining interest rates,
it will maintain negative short-term gaps, which allow more liabilities to reprice relative to assets.
Strategies
There are several strategies a bank can employ for an effective gap management. These include:
• Maintain a diversified asset portfolio in terms of rates, maturities, and industry sectors. Loans and
securities should be selected on the basis of their degree of marketability.
• Develop action plans for specific asset and liability categories for particular phases of the business
cycle.
• Analyze carefully any given change in the direction of interest rates before concluding that a new
rate cycle has begun.
The interest rate cycle may be divided into four phases: 1) a period of low interest rates, 2) rising
interest rates, 3) high interest rates, and 4) declining interest rates. Strategies may be employed at
various stages of the cycle as follows:
2. Second phase - rising interest rates (interest rates are expected to reach their top in the near
future):
3. Third phase - high interest rates (rates are expected to decline in the foreseeable future):
4. Fourth phase - declining interest rates (rates are expected to bottom out in the near future):
The above strategic steps to gap management are designed to improve the net interest margin within
a set of risk parameters as determined by the bank’s management. At the same time, the strategic
steps illustrate the risk attached to forecasting interest rates and adjusting assets and liabilities
accordingly. Interest rates and the degree of risk attached to assets and liabilities depend heavily on
external forces, over which a bank has little control and often great difficulty to forecast.
Moreover, it once was a given that lower interest rates were good for banks. When rates fall, the
thinking went, profits grow—since banks pay less for deposits yet still collect interest from existing
That is because banks are paying so little for deposits that it is hard to believe they can cut rates much
further. Although fees make up an increasing portion of bank income, most profits still come from
interest. Lower and lower short-term interest rates are not good for deposit-funded banks since it is
difficult to lower deposit rates in concert with the decline in market rates.
Nevertheless, management oftentimes takes a gamble about which way they think interest rates are
headed and the gap position shows it: a negative gap indicates a bet that interest rates are going to go
down, a positive gap is a bet that interest rates are going to go up. Only the careful managers strike a
balance that does not sink the bank in the process.
Interest
income
Total assets
Net interest
income
Total assets
Interest
expense
Total assets
Return on Exceptional
Equity items (net) Loan loss
Total assets provision
Total assets
Equity
Total assets
Net operating Operating
costs expenses
Total assets Total assets
Other
revenue
Total assets
∆ loans
∆ interest and fees receivable
∆ trading account assets
∆ deposits
∆ accruals
∆ investments
Capital expenditures
∆ other assets
∆ purchased funds
∆ long-term debt
∆ other liabilities
Dividend payments
∆ capital
Profitability Ratios
NetGear Industries
NetGear Industries designs and sells ethernet network kits, pieces of electrical equipment that control
the flow of data among computers—largely for home network use. Your bank is interested in the home
network industry to further diversify its commercial loan portfolio and has identified NetGear as a
prospective client. A credit report is needed immediately.
Fortunately, your bank’s credit files contain considerable information on NetGear, as well as
condensed financial statements and ratios on the company and the home network industry (as shown
in NetGear Industries Analyst Notes). To prepare the report it will be necessary to answer the following
questions (in groups) based on the information in the Analyst Notes.
1. Identify the stage of the home network industry in the industry life cycle. Describe at least two of
the general features that characterize this stage and cite at least three items of evidence from the
Analyst Notes that justify your identification.
2. Identify the pricing strategy used by the leading companies in the home network industry. Cite at
least three items of evidence from the Analyst Notes that justify your identification.
3. State whether the home network industry is likely to sustain rapid growth in unit sales over the
period 2009-2010. Cite at least three items of evidence from the Analyst Notes that justify your
conclusion.
4. Evaluate the competitive structure of the home network industry based on an analysis of the five competitive
forces. For each of these forces, cite at least three items of evidence from the Analyst Notes that justify your
evaluation.
Sample: 6 port hub for PlayStation (5 in front, 1 in the rear); “I0Gear” is a trademark of NetGear.
(Other sample products at end of case.)
Industry Factors
1. Home network kits and USB hubs allow computers (particularly home personal computers or PCs)
to exchange data and communicate via Local Area Networks (LANs) and Wide Area Networks
(WANs). A LAN spans a short distance and connects a small number of computers. A WAN spans
a longer distance and connects a larger number of computers.
2. Starting around 1982, PCs were linked together by cable to share printers, software, and memory.
As time passed, PCs were increasingly connected to larger and more complex computers and
peripherals. However, different computers had different operating systems (“languages”) that
made it difficult for them to communicate with each other. Routers, now called network hubs, were
required to enable them to communicate. Most recently, network distances have increased,
transmission speeds have increased rapidly, and the complexity of computer applications has
increased as well. Each of these developments increases the need for routers, which are a
component of network kits.
3. NetGear specializes in external USB hubs and ethernet network kits. A two-PC starter kit, for
example, contains an installation CD-ROM, a manual, two 10/100-mbps network cards (to be
inserted in each PC), two 8-meter ethernet cables, and a 4-port hub (router).
4. NetGear and one other company have a combined 70% market share in USB hubs and home
network kits. NetGear has about a 57% market share.
5. USB hubs and home network kits have become easier to use, increasingly functional and efficient,
more reliable, and more widely accepted.
6. Prices of low-end (simple and commodity-like) routers are falling 20% per year.
7. Unit costs and prices of USB hub and home network kits are falling due to experience curve
learning. Kit components are being improved, however, so that while older ones fall sharply in
price, new (improved) kits maintain average selling prices.
8. An increasing percentage of PCs is connected in LANs, both at home and at the office.
10. An increasing number of households have more than one PC which share peripherals (printers,
drives, DVD burners, PlayStations, and Internet connections) and require data exchange (file
copies and transfers, e-mail forwarding, etc.).
11. One reason for overall USB hub and home network kit growth is the fashion for home
entertainment centers—systems that combine TVs, disc players, speakers, and even PC
connection.
13. Network users are expected to continue to demand faster transmission speeds for larger and
larger quantities of data in increasingly complex formats. This requires constant upgrading and
product innovation.
14. Multimedia applications (that make the best use of audio, video, and computers) are increasing,
and their higher capacity, speed, precision, and complexity require more sophisticated USB hub
and network kits.
15. Management teams of home network companies expect strong industry growth to continue but
also expect more competition, placing downward pressure on selling prices.
16. Weaker companies in the home network industry have shown poor financial results. Their
profitability is under pressure and a shakeout is expected.
Competitive Factors
18. Network kits are increasingly critical to the day-to-day operations of customers. A network failure
could be extremely costly.
19. Network environments are very complex due to hardware and software technology and the lack of
common standards. Network kits are needed to connect computers with diverse operating
systems (“languages”).
20. Home network kits come in three versions: ethernet, home phone-line, and wireless LANS.
21. Ethernet networks are traditional wired networks, which require cables and a hub (or router).
22. Phone-line networks use the home's existing telephone wiring—without interfering with phone
calls (they operate at a higher frequency than telephones do).
23. Wireless networks use radio waves and require no physical connection.
24. Phone-line and wireless network kits have been available for years, but they have been plagued
by slow speed, high cost, or both.
25. Ethernet kits are inexpensive and fast and allow the addition of PCs to the network wherever a
cable can go. A recent survey indicated that ethernet connections are the fastest at downloading,
transferring, and sending data to other PCs and peripherals.
26. The two leaders' ethernet network kits accommodate 25-30 “languages” whereas newcomers’
traditional wired network kits support five or fewer. Both leaders make available phone-line
network kits as well and are included in their high-end product range.
28. The two ethernet leaders have extensive direct sales and service organizations.
29. Theoretically, ethernet network kits would not be needed if all computers and peripherals had
compatible systems and could communicate easily with each other.
30. New research and development and the adoption of universal “languages” may eventually
eliminate the need for ethernet kits but that is not expected to happen for many years.
31. Other pieces of equipment frequently perform some functions of ethernet network kits, but this is
not yet significant nor is it anticipated that they will be able to duplicate all the functions of today’s
ethernet network kit.
32. The cost of an ethernet network kit is a small percentage of the total cost of a home computer
network.
33. A high quality ethernet kit can significantly increase the efficiency of a home network system
relative to the home network’s cost.
35. Customers who switch to another supplier’s kits face high costs related to the change.
36. Ethernet network kit industry leaders subcontract the manufacturing of their products to
companies whose services are plentiful and commodity-like.
37. Cables and hubs are assembled mostly from commonly available electrical components.
38. Some of the components used to assemble cables and hubs are proprietary to a single supplier
but these are currently insignificant.
39. 80% to 90% of sales of the two ethernet kit leaders are to repeat customers.
40. Competition in the home network industry is based on product features. Price is often secondary.
The two ethernet kit leaders have different sets of product features.
Company Factors
42. About 34% of NetGear’s sales are of lower end products, i.e. non-kit hubs and routers.
43. NetGear offers a full range of wireless routers and adapters; currently these products account for
35% of sales and are growing rapidly.
45. NetGear intends to have no long or short-term debt. “Excess” cash will be invested in long-term
investments.
46. NetGear expects its tax rate to remain similar to that of the last two years.
E. The home network market is estimated to grow by 35% over the next three years.
NetGear Industries
NetGear Industries
Table III
NetGear Industries
Growth
Sales growth 28.01% 17.35% 27.57% 26.89% 2.14%
Net Income growth 79.16% 43.29% 22.33% 11.72% -60.72%
Total Assets growth 46.35% 18.67% 22.90% 25.85% 6.37%
Total Liabilities growth 63.86% 4.56% 19.28% 25.16% 8.72%
Net Worth (Equity) growth 37.24% 27.44% 24.75% 26.19% 5.23%
Profitability
Gross Profit Margin 32.10% 33.77% 33.84% 33.42% 32.42%
Operating Profit Margin 9.23% 11.60% 10.38% 8.95% 6.64%
Net income Margin 6.12% 7.48% 7.17% 6.31% 2.43%
Ms. Nguyen Kieu Trang was gravely concerned. Not only was her reputation as an astute lending
officer and account manager on the line, she could also see the current situation casting a shadow
over her entire career—and she was very ambitious. She was also under pressure to attract new
business as interest rates were falling and banks were now very liquid. The highly competitive
consumer finance area was not a strategic option at the present time.
A little over ten months ago she had come across a new start-up company with what she considered
to have more potential and less risk than any she had ever seen before. It was at her urging that
Credit Bank of Hanoi, her employer, had agreed to provide a $300000 credit line to the new venture,
Ho Hong Imports. Now it appeared very likely that the bank could lose up to several thousand dollars
because she had been fooled by optimistic talk and had not done her homework. Otherwise, she
would have been alerted to several potentially serious problems before they became so large that the
continued viability of the firm was in jeopardy.
As it is, the problems have led to a deterioration of the company’s financial position to the point where
only a massive reorganization and an infusion of additional capital could possibly save it. She feared
that the bank would not be willing to go along with such a reorganization because there was a good
chance that it would be too little too late.
Ho Hong Imports is a classic example of a business operation that should have been a money
generator. The individuals involved in the company all had extensive experience and contacts in the
industry and had demonstrated an ability to make money. Ms. Nguyen thought back to that fatal day
when Ho Hung Cuong and the two Leo brothers first walked into her office.
Ho Hong was an innovative and established designer of housewares such as linens, towels,
tablecloths, and accessories. His reputation for creativity was well known, and many regional retailers
carried merchandise designed by him in preference to the products for export made by local
manufacturers. For the preceding six years he had worked for a design and merchandising company
that had given him almost total carte blanche in creating new patterns and colors for their line of
housewares. He was free to be innovative; his designs were then implemented by textile mills located
mainly in Southern Italy.
This arrangement had proven to be both artistically satisfying and monetarily rewarding for Ho Hong—
despite competition from locally-made and imported products, so he was able to lead the kind of life
about which most people can only read and dream. In March 2008, though, the company for which he
worked was sold to a large retailing conglomerate owned by the Pham family. The new owners wanted
Ho Hong to remain with the company and were willing to pay him even more handsomely than before,
but he would no longer have the total artistic freedom he had come to enjoy. Because of this
constraint, he left the company in June 2008 with no firm prospects for another job.
Soon after he resigned from the company, Ho Hong was contacted by the two Leo brothers. They
proposed that he start his own firm and indicated a willingness to put up two-thirds of the capital
needed to commence operations. Also, they agreed to coordinate production in Naples (Italy) of all
merchandise based on Ho Hong’s designs. This would be handled through Leo Exports, a wholly-
owned subsidiary of Leo Holdings. For his part, Ho Hong would be required to put up one-third of the
capital, to provide the designs for the product line, and to be the primary contact with buyers from the
retail stores.
It seemed like the perfect combination—an experienced and highly visible designer teaming up with
one of the oldest textile firms in Southern Italy. Nothing could stand in their way, or so Ms. Nguyen
thought. When Ho Hong and the Leo brothers came into her office that November day and presented
their ideas, Ms. Nguyen was convinced that someone was looking out for her best interests by
providing such an opportunity to show the bank what a great loan officer and account manager he
was.
Because the proposed company was a start-up with no track record, though, a business plan would
have to be prepared, and numerous restrictive provisions would be imposed on the firm. Neither Ho
Hong nor the Leo brothers thought these requirements unreasonable, so they promised to get back
together with Ms. Nguyen within ten days to review their business plan.
Early the next week Ho Hong and the Leo brothers returned to Credit Bank and presented to Ms.
Nguyen the projections given in Table 1 and the pro forma statements shown in Table 2. The ensuing
conversation convinced Ms. Nguyen that the projections were very realistic, if not somewhat
conservative. She knew that sales of household accessories such as those designed by Ho Hong
tended to fall off the last three or four months of the year and pick up again early spring.
She was very pleased to see this pattern built into the sales estimates. Also, the proposed equity
capital funding, $55000, could be used to support a line of credit of a bit over $300000 according to
the bank’s internal guidelines for new ventures. The maximum anticipated borrowing was within this
limit, so Ms. Nguyen felt good about the plan’s prospects. During the conversation, the Leo brothers
gave a rough estimate of their personal wealth which Ms. Nguyen noted for the files.
The proposed company, to be named Ho Hong Imports, would be equally owned (one-third each) by
Ho Hong and the two Leo brothers. The three men understood the risks associated with start-up
companies and proposed to minimize them for Ho Hong Imports through careful management and
attention to detail. It was their stated intention to import merchandise on a “pre-sold” basis; that is, Ho
Hong Imports would import only what was actually ordered by final customers. That policy would avoid
the need for carrying large inventory and would eliminate much of the commercial risk of the business.
Ho Hong’s customers would be mainly large retail chains and stores with whom Ho Hong had dealt in
the past. Their orders would be placed with the Leo Exports of Italy, Ho Hong’s agent. Leo Exports, in
turn, would obtain the merchandise for export from its own manufacturing facilities and from contract
producers all over Southern Italy. The Leo brothers guaranteed receipt of all orders in Istanbul within
28 days of placing an order, so Ho Hong would be able to guarantee a maximum 60-day ordering lead
time to the department stores. The Leo brothers also agreed to bear all of the exchange rate risk from
the transactions, so the goods would be invoiced in dollars.
Aside from open account terms with suppliers, the requested financing arrangements were also
standard in the industry. Credit Bank would be asked to provide irrevocable letters of credit for Ho
Hong Imports drawn in favor of the Leo Exports. The requested credit period for the letters of credit
would be 30 days, the maximum time required between placing an order and clearing the goods for
delivery to the various stores. At the end of the 30-day period the letters of credit would be turned into
bankers’ acceptances due in 90 days.
In other words, Ho Hong would receive 30 days of financing from the letters of credit and an additional
90 days from the acceptances, for a total of 120 days before payment would be due. Since the credit
terms extended by Ho Hong Imports to the retail stores were to be net 30, this gave sufficient slack to
ensure collection of the receivables before the bankers’ acceptances came due. The Leo brothers
suggested that the advising bank to the L/C transactions be the Napolitano Trade Bank, a wholly-
owned subsidiary of Leo Holdings.
Ms. Nguyen reviewed the plan and was very impressed with its thoroughness and conservatism.
However, bank regulations required that several restrictions be placed on Ho Hong before the credit
line could be extended. First, there had to be an official filing on all assets of Ho Hong Imports.
Second, it had to be certified that the company had paid-in capital of at least $55000 and that proper
insurance coverage was obtained. All three of the owners had to give their personal guarantees (and
other appropriate forms of collateral) for the credit, and all receipts from sales had to be deposited into
a controlled account in the same proportion to which the bankers’ acceptances related to invoice
values.
Finally, at least quarterly financial statements had to be submitted to the bank and, if deemed
necessary by the bank, this could be changed to monthly statements. The interest rate to be charged
on the bankers’ acceptances is 1 percent per month or 3 percent per 90-day period, payable at the
time the acceptance is created.
These terms were acceptable to Ho Hong and the Leo brothers, so Ms. Nguyen agreed to take the
proposal to the senior loan committee when it met in three days. In the meantime, the three men
started work on registering Ho Hong Imports and getting ready to go into business. At Ms. Nguyen’s
urging, the bank agreed to provide a credit line of up to $300000 under the conditions described here.
On January 1, 2009 Ho Hong Imports opened its doors for business.
1. Critique the job performance of Ms. Nguyen. Can you find any errors of omission or commission
she made in evaluating the initial application for the line of credit or in setting up procedures to
monitor the operations of Ho Hong Imports?
2. Do you detect a “hidden agenda” by the Leo brothers in their investment and financing
arrangements with Ho Hong Imports? How much money would the Leo brothers lose if Ho Hong
Imports ran into difficulties?
January 0 - 2000
February 0 - 3000
March 0 - 3000
April 49000 10770 30280
May 98000 14900 90850
June 147000 23390 181690
Assets
Ho Hong Imports’ financial statements covering the first quarter of operations were right on target,
mainly because the company had only placed one order for merchandise and had just received it on
March 31. Ho Hong was very excited about the prospects for the future and told Ms. Nguyen that
everything was running smoothly. This message was repeated whenever she called to inquire about
how things were progressing.
It was not until May 30 that Ms. Nguyen learned of any difficulties experienced by Ho Hong Imports.
On that date Ho Hong came in to see her with the report shown in Table 3. As shown by the income
statements, sales were slightly less than had been anticipated, but not by a significant amount. The
difficulties became apparent, though, in the balance sheets. Ho Hong was in a serious liquidity bind
because none of the receivables had yet been collected, and a tax payment had to be made to the
government tax office the next day for $30623. There was not enough money in Ho Hong’s account to
make a payment of this size, so the company needed a minimum of $12666 just to pay the taxes. Ho
Hong requested that he be permitted to draw down the line of credit by $25000 as a direct loan
borrowing to cover the cash shortage. He explained that the difficulties with the receivables were his
fault—he had been so busy with the myriad details of establishing the company’s presence in the
market that he had failed to follow up on the collections. Ms. Nguyen was assured that it was only a
slip of the mind and that there were no real problems with any of the accounts. When she questioned
the presence of inventory in the balance sheet and noted that orders were not supposed to be placed
with Leo unless a firm commitment had been obtained from a retailer, Ho Hong explained that one
store had burned down after the order had been placed. The small amount of resulting inventory could
be stored in Ho Hong’s warehouse and could be liquidated easily in the coming month.
After verifying that the store had indeed burned to the ground in the middle of May, Ms. Nguyen took
the request for direct borrowing to the senior loan committee. The request was approved without much
dissent, but Ms. Nguyen was instructed to monitor the collection process weekly to ensure that Ho
Hong was not getting into trouble. The $25000 loan would carry an interest rate of 1 1/2 percent per
month and would be considered as a sub-limit of the total $300000 credit line.
The drawdown on the credit line was up to $272535 in outstanding bankers’ acceptances by July 1,
and the direct note borrowing was reduced to $25000. Some of the debtors had been collected in the
past 30 days, but many were overdue. Ms. Nguyen was not particularly alarmed by this development,
though, because some checking had indicated that the department stores were notorious for paying
late—it was one of the “costs” of being in business. However, on August 1 bankers’ acceptances had
increased to $363381 and Ho Hong needed an increase in direct borrowing to $30000 to avoid
liquidity problems. Ms. Nguyen decided it was time to crack down on Ho Hong and force him to take
the collection problems seriously. She agreed to extend the direct borrowing limit to $30000 (this was
still within the guidelines previously set down by the senior loan committee), but told him that direct
borrowings had to be “cleaned up” (reduced to zero) by September 1. Ho Hong assured her that he
would devote his entire attention to collections for the next few weeks and would reduce overdue
receivables to zero by the end of the month. He apologized for neglecting the collection problem in the
past and indicated he had learned his lesson about the importance of cash flows.
On the morning of August 25, the accountant, Truong Vinh Trong, and Ho Hong came to the bank to
see Ms. Nguyen. Truong looked very serious and Ho Hong had a dazed look about him. After ten
minutes Ms. Nguyen understood why the other two looked as they did. Truong had been very
aggressive in trying to collect the overdue receivables. He soon discovered that for several reasons up
to half of them would probably never be collected. Furthermore, rather than follow the previously
established policy of importing on a “pre-sold” basis, Ho Hong had been ordering straight from the
projections given in Table 1 (given in case study Part 1). Sales were below expectations, so almost
$50000 in inventory had been piling up in the Ho Hong Imports warehouse.
To increase sales and clear out the warehouse, Ho Hong had been increasing sales commissions
from the normal 2 percent to a level of 4 percent (Ho Hong Imports used an independent sales agency
which provided sales services to small and medium sized businesses). Compounding the cash flow
problems was the policy of paying the commissions in cash when the merchandise was delivered to
the retailer instead of when the account was collected.
This encouraged the sales force to extend credit to stores that were very bad credit risks and gave no
incentive for them to monitor the collections. Several of these stores had already filed for bankruptcy,
and Truong was pessimistic about ever collecting from many of the others.
This finding was bad enough, but Truong had also uncovered a far more serious problem. When he
contacted several of the large retailers about their overdue accounts, they told him that they had no
intention of paying for the shoddy merchandise Ho Hong was trying to push, and he could take back
the whole lot and never do business with them again. Truong verified that much of the merchandise
was shoddily manufactured and was constructed of inferior materials—not at all like the samples used
by the sales force in soliciting orders.
Ho Hong was devastated to learn of this development and immediately called the Leo brothers in
Naples. They were very evasive on the telephone with Ho Hong but promised to look into the
“allegations.” After some quick calculations, Truong projected the August 31 balance sheet shown in
the Anticipated column of Table 4. To reflect the need to reduce direct loans to zero, he assumed that
the three owners would contribute additional equity of $25000 and that half of the receivables would
have to be written off. The resulting balance sheet is given in the Revised column of Table 4. If these
actions were taken, there would still be a loss carry forward of $93048 to be applied against future
earnings.
Ms. Nguyen looked at the figures in Table 4 with disbelief. How could this have happened? What can
be done to keep the bank from losing its money? Is there a chance that Ho Hong Imports can remain
Hoang Trung Anh, the chairman of the senior loan committee, directed that proceedings be started to
force Ho Hong Imports into involuntary bankruptcy, but that the papers not be filed with the court until
several unknowns were resolved. He did not enjoy taking actions such as this, although he realized
that protecting the bank had to be his first priority. Before the decision would actually be made to file
the bankruptcy papers, the committee would need more information about the value of the assets.
This includes the willingness of the owners to invest more equity capital in the business, and the value
of any collateral put up by the owners to guarantee the line of credit plus other personal assets the
bank might be able to get. He asked Ms. Nguyen to work with Ho Hong and Truong to obtain this
information by the next afternoon and report back to the senior loan committee.
Ho Hong was very cooperative. He was starting to think that the Leo brothers might have taken
advantage of his lack of business savvy for their own purposes, and, in doing so, had damaged his
reputation. Working much of that night and the next morning, Ms. Nguyen, Ho Hong and Truong were
able to gather the following information.
1. The maximum that could be collected from the receivables was approximately $250000. Also, the
inventory could be liquidated for roughly half of its book value, or $75000 in round numbers.
Furniture and fixtures could be sold for about $2500, so the total liquidation value of the company
is $327500. In addition to $423945 outstanding bankers’ acceptances and the $30000 direct loan,
Ho Hong owed Cotton Investors $10000 for the building lease. All other bills had been paid
(except for the $66496 in accrued taxes owed to the government tax office, but the company
would not have to pay this in any case and would be getting back $306230 already paid in taxes
for the year). With the tax refund and assuming that Cotton Investors is paid the $10000, the
bank’s net exposure would be $105822.
2. Ho Hong’s total net worth, not counting the shares in Ho Hong Imports, is $32500. The Leo
brothers are quite wealthy, but it appears unlikely that the bank will be able to recover from them
anything in excess of the value of the collateral they put up as a guarantee for the loans. This
collateral consists of stock in an investment company partially owned by the brothers. At the time it
was pledged it had a market value of $350000, but Ms. Nguyen discovered that the company filed
for bankruptcy in early August when its speculative position in silver collapsed.
3. The Leo brothers were phoned and told of the financial problems with Ho Hong Imports. They
explained that they were very sorry, but they would be unable to increase their stock holdings in
Ho Hong Imports at this time because of financial problems of their own stemming from the
bankruptcy of their investment company and other “financial reverses.” Ho Hong agreed to invest
all of his liquid capital in the company or $25000—if the bank would hold off and not throw the
company into bankruptcy.
As Ms. Nguyen rode up the elevator on her way to the senior loan committee meeting the next
afternoon, she was not entirely sure what her final recommendation would be. She liked Ho Hong and
believed that he was used by the Leo brothers, but she also thought of the implications of the affair on
her career. Maybe she could discover a way to resolve the problems that would be favorable to all
parties.
3. When Ms. Nguyen talked with the local office manager of Cotton Investors about the overdue
lease payment of $10000, she got a distinct impression that he knew the Leo brothers quite well.
Returning to the bank after lunch, she called the Company Registration Office to find out who
owned Cotton Investors. She found it listed under Leo Holdings as a Swiss-based corporation, and
by further digging she discovered that Leo Holdings is a wholly-owned subsidiary of the Leo
Exports of Naples.
4. Should Credit Bank proceed with the bankruptcy filing, or should it attempt to salvage the
company? In your answer consider the magnitude of the loss the bank might realize under various
scenarios as well as the chances for full recovery and the maintenance of a profitable lending
relationship. Assume that the revised balance sheet given in Table 4 is realistic (it assumes that
Ho Hong invests the $25000 and obtains an additional 4,545 shares of Ho Hong stock). This will
give Ho Hong a majority ownership position of about 54 percent.
5. Regardless of your answer to Question 4, assume that the bank decides against forcing Ho Hong
into bankruptcy if Truong takes over all business decision making. He believes that the sales
performance given in Table 5 can be achieved with hard work. No orders will be placed with Leo
Exports or any other manufacturer until all inventory is sold, and orders will be placed in the future
only on a “pre-sold” basis.
a. Suggest ways Ms. Nguyen can make sure that no unpleasant “surprises” with inventory,
receivables, or product quality occur in the future. That is, what controls would you suggest be
placed on Ho Hong Imports if they are allowed to continue operations?
b. How would you suggest handling the relationship with the Leo brothers? If they decline to
invest any more capital in Ho Hong Imports under any circumstances, how should Truong and
Ho Hong react?
Cash 0 126749
Accounts receivable (Debtors) 255333 147000
Inventory (Stocks) 48200
*Note: The figure for EBT is before the application of the loss carry-forward of $93048; the tax rate is
48 percent.
Hồ Xuân Hương was president of Quang Company, a manufacturer of valves and pipe fittings in
Vietnam. In April 2007, she visited Nguyễn Trung, a loan officer for GoldWest Bank, with a loan
request. She gave Trung Quang's financial statements for the years 2005 through 2006 and for the
most recent three-month period ending March 31, 2007. Hồ Xuân Hương indicated that she wanted
GoldWest Bank to provide Quang's banking requirements, including Quang's needs for loan funds.
She complained that her present bank had become careless in serving Quang's banking
requirements and that the loan officers assigned to Quang's account were being changed
frequently, causing her great inconvenience. She was frustrated with having to explain
Quang's needs and business every time there was a change in loan officers. Recently,
Quang's line of credit agreement with its present bank had expired, and the bank seemed
to be delaying action on the firm's request for a much-needed moderate increase in the
line.
Hồ Xuân Hương informed Nguyễn Trung that she would need as much as 10 000 million dongs during
the next 12 months. She wanted part of the credit in 90-day promissory notes and the rest on an
intermediate basis. "Our sales volume continues to grow and our profits are good," she commented to
Trung. "We have been in business for 15 years and we have been profitable every year. Our
equipment is in good condition, and we will not have to expand our plant for at least three more years."
Hồ Xuân Hương offered as references her current mortgage lender, Fair Mutual Bank, and several of
her major suppliers.
Later, Nguyễn Trung made credit checks with these suppliers, who reported a pattern of generally
prompt payment. The highest credit by a single supplier was 1 500 million dongs. However, Quang
was not always able to take trade discounts, which all of its suppliers offered on a 2/10, net 30 basis
(i.e., Quang gets a 2% discount on purchases if it pays within 10 days, otherwise the full amount is
due in 30 days).
Fair Mutual Bank reported a balance of 2 750 million dongs owed on an original 5 000 million dong
loan. Payments of 250 million dongs per quarter were being made promptly. The loan from Fair Mutual
Bank was secured by land and buildings owned by Quang.
Nguyễn Trung had not yet checked with Quang's present bank to discuss its experience with Quang.
GoldWest Bank was very anxious to establish a complete business relationship with Quang, but Trung
was uncertain how to approach Quang's present bank and how to interpret what officers from that
bank might tell him.
After Trung conducted his initial investigation, he called Hồ Xuân Hương to set up a meeting at the
bank. At the meeting, Hồ Xuân Hương made a specific request for a 10 000 million dong loan. In
addition to the financial statements she provided earlier (Exhibits 1 to 3), she provided a personal
financial statement (Exhibit 4). Trung had also received a ratio analysis on Quang from GoldWest
Bank's credit analysis department (Exhibit 5).
Hồ Xuân Hương indicated that Quang's inventory was composed of the following:
Trung was advised by another loan officer that the fractions of values that could be recovered on short
notice for inventories such as Quang's were about 50, 0, and 50 percent, respectively, for raw
materials, work-in-process, and finished goods.
PARTS Task:
2. Amount of the loan: As a check against the 10 000 million dong loan amount
requested by Hồ Xuân Hương, determine how much Quang actually needs to borrow. (Estimate
Quang's balance sheet and income statement for December 31, 2006, based on continued growth and
industry average ratios for an average collection period and inventory turnover. Estimate December
BBA FM CASES - ENGLISH 83/90
31, 2006 accounts payables and turnover based on the company's taking a substantially higher
amount of trade discounts than are presently taken.) Challenge: Calculate cost of trade credit, i.e., the
cost of not taking discounts. See Exhibit 6 for discount formula (use industry average payables in the
denominator as "days taken").
4. Repayment source: Identify the cash flow sources of repayment for each type of borrowing.
5. Rate: Establish the interest rate on each type of borrowing. (Specifically in terms of points or
spread above the base rate, currently 15%.)
6. Security (Collateral value and borrowing base): Assuming that the bank secures the loan with
Quang's accounts receivable and inventories, determine how much value can be recovered if
Quang fails to pay. (Alternatively, determine how much GoldWest Bank can safely lend
against Quang's accounts receivable and inventories.)
7. Security (Guarantees, covenants, and other restrictions): Specify the covenants to be placed
on Quang. Describe the guarantee or other restrictions.
Exhibit 1
Quang Company
Income Statement
For the period ended December 31 (except where indicated)
(000 000's of dongs)
3-Months
ending
2004 2005 2006 March 31,
2007
Exhibit 2
Quang Company
Balance Sheet
Year ended December 31 (except where indicated)
(000 000's of dongs)
March 31,
2004 2005 2006 2007
Assets
Cash 1310 1390 1130 680
Accounts receivable 7830 8590 9140 10100
Inventory 11120 13160 13580 17800
Current assets 20260 23140 23850 28580
Land 1000 1000 1000 1000
Plant and equipment 5980 6030 6100 6140
Less: accumulated -1900 -2300 -2700 -2800
BBA FM CASES - ENGLISH 85/90
depreciation
Net plant and equipment 5080 4730 4400 3340
Total assets 25340 27870 28250 32920
Exhibit 3
Quang Company
Exhibit 4
Assets
Cash 240
Marketable securities 1080
Loan receivable from Hồ Xuân Hương Co. 800
Residence 5500
Automobiles 440
Personal property 600
Shares of Quang Co. (book value) 15060
Total assets 23720
Income
Salary (2003) 1500
Bonus (estimated) 300
BBA FM CASES - ENGLISH 87/90
Other 20
Total income 1820
Exhibit 5
Quang Company
Financial Ratios
Industry
Average
2004 2005 2006 20071 2006
Liquidity
Current ratio 1.89 2.10
Quick ratio 0.71 1.00
Activity2
Receivables-days 49 49
Inventory-days 120 101
Payables-days 43 40
WCN-days 126 110
Leverage
Debt/equity 1.19 1.50
TIE3 8.99 3.50
Profitability
Gross profit margin 29.00% 30.70%
ROA4 6.23% 5.07%
ROE5 13.62% 17.00%
1
2006 quarterly figures are annualized
2
Days are calculated using 365 days, except quarterly figures calculated using 90 days
3
TIE = Times interest earned (interest coverage)
4
ROA = Return on assets
5
ROE = Return on equity
BBA FM CASES - ENGLISH 88/90
Exhibit 6
Statement of Cash Flows 2005 2006
Operating activities:
Net income
Plus: Depreciation & amortization
∆ accounts receivable
∆ inventories
∆ accounts payable
∆ prepaids
∆ accruals
∆ taxes payable
∆ other current items
Investing activities:
Financing activities:
Dividend payments
Current portion of long-term debt (n-1)
∆ short-term bank debt
∆ long-term and other noncurrent debt
∆ capital
∆ in cash
Discount % 365
% Cost = ----------------------- x -------------------------------------------------------------------
100 - Discount % Days taken - Discount period