Subject: Butler Lumber Company
Problem: Whether Mr. Mark Butler should go ahead with financing from Northrop National Bank or should stay with Suburban National Bank.
Options: 1) Enter into a loan agreement with Northrop National Bank for USD 465,000 (Assumption: The condition to sever the relationship with Suburban National Bank applies to Short Term Loan only) 2) Continue short term lending relationship with Suburban National Bank for USD 250,000 and secure the company’s loan with real property
Recommendation: Given available data, Butler Lumber company should enter into a loan agreement with Northrop National Bank for USD 465,000
Our recommendation to Mr. Mark Butler to enter into agreement with Northrop Bank for line credit of USD 465,000 is based on the following factors:
External Financing Need
We assessed the company’s external financing need in 1991 based on the following scenarios:
a)The current quarter net sales of 1991 attributes 26% of annual sales of company in 1991, since first quarter sales of 1990 contributed 26% of total 1990 net sales and hence the total net sales projected for 1991 is USD 2.77 Mn. Balance Sheet and Income statement have been projected at percentage of sales (Please refer to exhibit no. 1). In this scenario, we assume company doesn’t opt to take discounts on its purchases b)Net Sales of USD 2.77Mn, company opts to take discounts on its purchases c)Net sales in 1991 of USD 3.6Mn as indicated by bank’s investigator in the case study
Under both the above scenarios, company would need more financing than its current bank credit facility of USD 250,000.
Under scenario (a), if the company decides not to take discounts, then it would need short term credit facility of USD 211,000 to meet its short term capital requirements, however company’s accounts payables would increase to USD 263,000 and its net profit will be USD 49,000. Hence as far company’s financing need is concerned it can continue its short term relationship with the existing bank. On the other hand, if the company decides to take discounts, then it would need short term loan of USD 407,000 to meets its working capital requirements and hence would have to go into agreement with the new bank. Under this scenario, company’s accounts payables would amount to USD 55,000 and net profit would be USD 61,000.
Under scenario no (b), Butler Lumber total assets are projected to outpace total liabilities (excluding short term loan) by USD 628, 000, hence the existing loan will be far from fulfilling client’s working capital needs and the loan from Northrop Bank will be able to bridge USD 465,000 of the gap, however company would still be needing USD 162,000 under current mode of operation. We recommend that apart from getting new line of credit from Northrop Bank, company should reduce its days receivables period.
Increase in Profitability
If the company remains with the existing bank loan, the total interest expenses are projected to increase by USD 7,000 in 1991 and resulting into after-tax net profit USD 49,000 with loan from existing bank. The effective rate of interest expense is 13.2% with existing loan. (Please refer to exhibit _____)
Compared to 1990, ROA will remain the same at 5% and ROE will remain at 13%.
If the company replaces its short term line of credit from its existing bank to new bank, the total interest expenses are projected to increase by USD 11,000 in 1991, however company will be able to earn discounts of USD 27,000, resulting into after-tax net profit of USD 61,000 with new loan as compared to after-tax net profit of USD 49,000 with loan from existing bank. The effective rate of interest expense with new loan, after taking effect of discount income, is 5.0% compared to 13.2% with existing loan. (Please refer to exhibit _____)
Compared to 1990, ROA will increase to 6% while ROE will increase to 17%. These profitability ratios indicate a better result by taking up the new loan than staying with the old bank. By Dupont analysis (Please see exhibit___), the main drivers for the higher ROE for new loan is due to higher profit margin which offset the lower equity multiplier. The effect of the discount income has driven the profitability, which in turn reflected also in the ROE and ROA ratios.
Changes in Flexibility with the new loan
Decreasing Flexibility in Managerial Decisions:
The company becomes less flexible in its managerial decisions by taking up the new loan. It would be bounded by the negative covenants imposed by the new bank. These negative covenants place clear restrictions to Butler’s future managerial decisions, including investments in fixed assets and limited withdrawals of funds. Because of Butler’s conservative operating so far, he should be able to deal with these restrictions. Furthermore, Butler Lumber’s increased sales are shielded from the general economic downturn to some degree due to the relatively large proportion of its repair business. This will facilitate the maintenance of the net working capital even in a general economic downturn stage.
As additional part of the covenants the bank placed importance on the net working capital. This could have positive impact to the firm’s future. As the firm is affected by liquidity problems, the covenants on net working capital will make Butler to be more mindful about firm liquidity in midst of sales expansion. Thus, it could reduce the chance of Butler ending back with a situation of liquidity issues.
Increasing Flexibility in Financial Opportunities:
Because company’s business is seasonal, the financial opportunities by the new loan offer scope to balance seasonal variations. Another point is the now possible use of discounts provided by suppliers (see Increase in Profitability section).
Ratios (please refer to exhibit ___)
Option 1: If Butler Lumber stays with the old bank we can observe a constant value, from 1990 to 1991, for net working capital, current and quick ratio. At first glance, seems that the firm is able to cover current liabilities with current assets, but, without the inventory (which takes more time to convert into cash), the situation is completely different. The D/E increases from 1,68 to 1,72, while the interest coverage presents a value, that, even if lower, is acceptable. With regard to the profitability, the ROA and the ROE remain constant. The cash cycle increases from 64 to 72: this is due to an increase to both inventory and receivables period, even if we can observe an increase in the payable as well.
Option 2: Taking the new loan lead to an increase in net working capital, mainly due to the reduction of current liabilities (in fact, despite the increase in notes payable, there is a drastic reduction in accounts payable, in order to get the discount). In this scenario both current and quick ratio improve, indicating an improvement in firm’s liquidity. The D/E decreases from 1,68 to 1,62 and the interest coverage presents an acceptable value as well. Unlike scenario (a), profitability improves in a consistent way: ROA increases to 6% and ROE increases to 16%. The cash cycle rises significantly due to the combined effect of increase in inventory and receivables period and decrease in payable.
Exhibit 1: projected income statement and balance sheet
Projected income statement
USD in millions, FYE 31-DecActual% of Sales Scenario a-1Scenario a-2Scenario b Net sales12,694100.00% 2,7712,7713,600
GROSS PROFIT744 765765994
NET INCOME BEFORE TAXES53 5874145
Provision for income taxes59101437
NET INCOME44 4961107
Projected balance sheet
USD in millions, FYE 31-DecActual% of Sales Scenario a-1Scenario a-2Scenario b Cash2411.52%424255
Account receivable, net231711.77%326326424
CURRENT ASSETS776 7987981037
TOTAL ASSETS933 9609601247
Notes payable (bank)6233N.A247407465
Notes payable (Mr. Stark)0N.A000
Notes payable, trade0N.A000
L-t debt, current portion77N.A777
CURRENT LIABILITIES535 556508586
TOTAL LIABILITIES585 599551629
New Net Worth397409455
TOTAL LIABILITIES & NET WORTH933 9969601084
PLUG EFN -360162
-a-1 refers to projected sales of $2,771m in 1991 and a continuing relationship with Suburban National Bank -a-2 refers to projected sales of $2,771m in 1991 and a new relationship with Northrop National Bank -b refers to projected sales of $3,600m in 1991 and a new relationship with Northrop National Bank
1 Q1 1991 sales are $718m. Q1 1990 sales were 25.91% of FY 1990 sales. We assume this ratio to be constant in scenario a. In scenario b, we rely of Northrop National bank’s assumption of $3,600m sales in 1991.
2 Assumed to be percentage of sales.
3 Operating expenses includes Mr. Butler’s salary. Operating expenses are projected by decreasing operating expenses of 1990 by $95K (salary) and applying percentage of sales to the operating expenses without salary, then adding back $88K (annualised Q1 1991 salary) to get the operating expenses of 1991.
4 : As a corporation, Butler is taxed @15% on its first $50,000 sales, @25% on the next $25,000, and @34% on all additional income above $75,000.