BUS 420 Corporate Finance Case 1 Mark X Company

Mark X Company manufactures farm and specialty trailers of all types. More than 85% of the companys sales come from the western part of the United States, particularly California, although a growing market for custom horse transport vans designed and produced by Mark X is developing nationally and even internationally. Also, several major boat companies in California and Washington have had Mark X design and manufacture trailers for their new models, and these boat-trailer packages are sold through the boat companies nationwide dealer networks. Steve Wing, the president of Mark X, recently received a call from Karen Dennison, senior vice president of Wells Fargo Bank. Karen told Steve that a deficiency report generated by the banks computerized analysis system had been filed because of Mark Xs deteriorating financial position. The bank requires quarterly financial statements from each of its major loan customers. Information from such statements is fed into the computer, which then calculates key ratios for each customer and charts trends in these ratios. The system also compares the statistics for each company with the average ratios of other firms in the same industry and against any protective covenants in the loan agreements. If any ratio is significantly worse than the industry average, reflects a marked adverse trend, or fails to meet contractual requirements, the computer highlights the deficiency. The latest deficiency report on Mark X revealed a number of significant adverse trends and several potentially serious problems. Particularly disturbing were the 2009 current, quick, and debt ratios, all of which failed to meet the contractual limits of 2.0, 1.0, and 55%, respectively. Technically, the bank had a legal right to call all the loans it had extended to Mark X for immediate repayment and, if the loans were not repaid within 10 days, to force the company into bankruptcy. Karen hoped to avoid calling the loans if at all possible, as she knew this would back Mark X into a corner from which it might not be able to emerge. Still, her own banks examiners had recently become highly sensitive to the issue of problem loans, because the recent spate of bank failures had forced regulators to become stricter in their examination of bank loan portfolios and to demand earlier identification of potential repayment problems. To keep Mark Xs loan from being reclassified as a problem loan, the Senior Loan Committee will require strong and convincing evidence that the companys present difficulties are only temporary. Therefore, it must be shown that appropriate actions to overcome the problems have been taken and that the chances of reversing the adverse trends are realistically good. Karen now has the task of collecting the necessary information, evaluating its implications, and preparing a recommendation for action. The financial crisis that plagued the U.S. economy in 2008 had caused severe, though hopefully temporary, problems for companies like Mark X. Farm commodity prices have remained low, thus farmers have held their investments in new equipment to the bare minimum. On top of this, the luxury tax imposed in 2008 has had a disastrous effect on top-of-the-line boat/trailer 1

sales. Finally, the tax benefits associated with horse breeding were reduced, leading to a drastic curtailment of demand for new horse transport vans. In light of the softening demand, Mark X had aggressively reduced prices in 2008 and 2009 to stimulate sales. This, the company believed, would allow it to realize greater economies of scale in production and to ride the learning, or experience, curve down to a lower cost position. Mark Xs management had full confidence that national economic policies would revive the ailing economy and that the downturn in demand would be only a short-term problem. Consequently, production continued unabated, and inventories increased sharply. In a further effort to reduce inventory, Mark X relaxed its credit standards in early 2009 and improved its already favorable credit terms. As a result, sales growth did remain high by industry standards through the third quarter of 2009, but not high enough to keep inventories from continuing to rise. Further, the credit policy changes had caused accounts receivable to increase dramatically by late 2009. To finance its rising inventories and receivables, Mark X turned to the bank for a long-term loan in 2008 and also increased its short-term credit lines in both 2008 and 2009. However, this expanded credit was insufficient to cover the asset expansion, so the company began to delay payments of its accounts payable until the second late notice had been received. Management realized that this was not a particularly wise decision for the long run, but they did not think it would be necessary to follow the policy for very long. They predicted that the national economy would pull out of the weak growth scenario in late 2009. Also, there has been some talk in Congress of killing the luxury tax and even giving some tax benefits back to horse breeders. Thus, the company was optimistic that its stable and profitable markets of the past would soon reappear. After Karens telephone call, and the subsequent receipt of a copy of the banks financial analysis of Mark X, Steve began to realize just how precarious his companys financial position had become. As he started to reflect on what could be done to correct the problems, it suddenly dawned on him that the company was in even more trouble than the bank imagined. Steve had recently signed a firm contract for a plant expansion that would require an additional $6,375,000 of capital during the first quarter of 2010, and he had planned to obtain this money with a short-term loan from the bank to be repaid from profits expected in the last half of 2010 as a result of the expansion. In his view, once the new production facility went on line, the company would be able to increase output in several segments of the trailer market. It might have been possible to cut back on the expansion plans and to retrench, but because of the signed construction contracts and the cancellation charges that would be imposed if the plans were canceled, Steve correctly regards the $6,375,000 of new capital as being essential for Mark Xs very survival.

Questions 1. Study the 2007, 2008, and 2009 columns of Tables 3 through 6, disregarding for now the projected data in the 2010 and 2011 columns. Based on the information in the case and in the tables, prepare a list of Mark Xs strengths and weaknesses. In essence, you should look at the common-size statements and each group of key ratios (for example, the liquidity ratios) and see what those ratios indicate about the companys operations and financial condition. Recognizing that you might want to revise your opinion later, does it appear, based on your analysis to this point, that the bank should lend the requested money to Mark X? Explain. Tables 1 and 2 to develop pro forma financial statements for 2010 and 2011 were completed based on the following assumptions: (a) the bank is willing to maintain the present credit lines and to grant an additional $6,375,000 of short-term credit on January 1, 2010, (b) the amounts of inventory and accounts receivable would be carried if inventory utilization and days sales outstanding were set at industry-average levels, (c) all of Mark Xs plans and predictions concerning sales and expenses materialize, and that the firm pays no cash dividends during the forecast period, and (d) the cash and marketable securities account is used as the residual balancing figure. Assume Mark X has determined that its optimal cash balance is 5% of sales and that funds in excess of this amount will be invested in marketable securities, which on average will earn 7% interest. Based on the forecasted financial statements, will Mark X be able to invest in marketable securities in 2010 and 2011? If so, what is the amount of excess funds Mark should invest in marketable securities? Do the financial forecasts reveal any developing conditions that should be corrected? Based on the forecasts, would Mark X be able to retire all of the outstanding short-term loans by December 31, 2010? If the bank decides to withdraw the entire line of credit and to demand immediate repayment of the two existing loans, what alternatives would be available to Mark X?

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Table 1 Historical and Pro Forma Balance Sheets

Pro Forma ----------------2007 ASSETS Cash and marketable securities Accounts receivable Inventory Current assets Land, buildings, plant, and equipment Accumulated depreciation Net fixed assets Total assets $17,761 (2,996) ------$14,765 ------$55,946 ======= LIABILITIES AND EQUITIES Short-term bank loans Accounts payable Accruals Current liabilities Long-term bank loans Mortgage Long-term debt Total liabilities Retained earnings Total equity Total liabilities and equity $55,946 ======= $70,941 ======= $96,102 $106,307 ======= ======== $122,394 ======== 1990 $3,188 6,764 3,443 ------$13,395 $6,375 2,869 ------$9,244 ------$22,639 10,038 ------$33,307 ------Common stock (3.5 mn sh) $23,269 $20,100 (4,654) ------$15,446 ------$70,941 ======= 1991 $5,100 10,506 5,100 ------$20,706 $9,563 2,601 ------$12,164 ------$32,870 $23,269 14,802 ------$38,071 ------$22,874 (6,694) ------$16,180 ------======= 1992 $18,233 19,998 7,331 ------$45,562 $9,563 2,340 -------$11,903 -------$57,465 $23,269 15,368 -------$38,637 -------$29,249 (9,117) ------$20,132 ------======= 1993 $24,608 15,995 9,301 ------$49,904 $9,563 2,104 ------$11,667 ------$61,571 $23,269 21,467 ------$44,736 ------$30,126 (10,940) -------$19,186 -------$122,394 ======== 1994 $24,608 16,795 11,626 -------$53,029 $9,563 1,894 -------$11,457 -------$64,486 $23,269 34,639 -------$57,908 -------$5,149 17,098 18,934 ------$41,181 $4,004 18,462 33,029 ------$55,495 $3,906 29,357 46,659 ------$79,922 $35,874 19,138 31,163 ------$86,175 $46,448 22,009 34,751 -------$103,208 2008 2009 2010 2011

$96,102 $106,307

Table 2 Historical and Pro Forma Income Statements

Pro Forma ---------------2007 Net sales Cost of goods sold Gross profit Admin and selling exp Depreciation Miscellaneous expenses Total operating exp EBIT Interest on ST loans Interest on LT loans Interest on mortgage Total interest Before-tax earnings Taxes Net income Dividends on stock Additions to retained earnings EPS (3,500,000 shares) $7,060 ======== $2.69 ======== $4,764 ======== $1.81 ======== $567 ======== $0.22 $6,099 ======= $1.74 $13,172 ======== $3.76 $170,998 137,684 -------$33,314 $12,790 1,594 2,027 -------$16,411 -------$16,903 $319 638 258 -------$1,215 -------$15,688 6,275 -------$9,413 ======== 2,353 -------2008 $184,658 151,761 -------$32,897 $15,345 1,658 3,557 -------$20,560 -------$12,337 $561 956 234 -------$1,751 -------$10,586 4,234 -------$6,352 ======== 1,588 -------2009 2010 2011 $247,601 198,081 -------$49,520 $18,570 1,823 3,095 -------$23,488 -------$26,032 $2,953 956 170 -------$4,079 -------$21,953 8,781 -------$13,172 ======== 0 --------

$195,732 $215,305 166,837 -------$28,895 $16,881 2,040 5,725 -------$24,646 -------$4,249 $1,823 956 211 -------$2,990 -------$1,259 504 -------$755 ======== 189 -------177,627 ------$37,678 $17,224 2,423 3,768 ------$23,415 ------$14,263 $2,953 956 189 ------$4,098 ------$10,165 4,066 ------$6,099 ======= 0 -------

======== ======== =========

Table 3 Common Size Balance Sheets

2007 ASSETS Cash and marketable securities Accounts receivable Inventory Current assets Land, buildings, plant, and equipment Accumulated depreciation Net fixed assets Total assets 31.75% -5.36% ------26.39% ------100.00% ======= LIABILITIES AND EQUITIES Short-term bank loans Accounts payable Accruals Current liabilities Long-term bank loans Mortgage Long-term debt Total liabilities Common stock Retained earnings Total equity Total liabilities and equity 100.00% ====== 100.00% ======= 100.00% ======= 5.70% 12.09% 6.15% ------23.94% 11.39% 5.13% ------16.52% ------40.47% 41.59% 17.94% ------59.53% ------7.19% 14.81% 7.19% ------29.19% 13.48% 3.67% ------17.15% ------46.33% 32.80% 20.86% ------53.67% ------18.97% 20.81% 7.63% ------47.41% 9.95% 2.43% ------12.39% ------59.80% 24.21% 15.99% ------40.20% ------28.33% -6.56% ------21.77% ------100.00% ======= 23.80% -6.97% ------16.84% ------100.00% ======= 9.20% 30.56% 33.84% ------73.61% 5.64% 26.02% 46.56% ------78.23% 4.06% 30.55% 48.55% ------83.16% 2008 2009

Table 4 Common Size Income Statements

2007 Net sales Cost of goods sold Gross profit Admin and selling exp Depreciation Miscellaneous expenses Total operating exp EBIT Interest on ST loans Interest on LT loans Interest on mortgage Total interest Before-tax earnings Taxes Net income Dividends on stock Additions to retained earnings 4.13% ======= 2.58% ======= 0.29% ======= 100.00% 80.52% ------19.48% 7.48% 0.93% 1.19% ------9.60% ------9.88% 0.19% 0.37% 0.15% ------0.71% ------9.17% 3.67% ------5.50% ======= 1.38% ------2008 100.00% 82.18% ------17.82% 8.31% 0.90% 1.93% ------11.13% ------6.68% 0.30% 0.52% 0.13% ------0.95% ------5.73% 2.29% ------3.44% ======= 0.86% ------2009 100.00% 85.24% ------14.76% 8.62% 1.04% 2.92% ------12.59% ------2.17% 0.93% 0.49% 0.11% ------1.53% ------0.64% 0.26% ------0.39% ======= 0.10% -------

Table 5 Historical Statements of Cash Flows

2008 CASH FLOW FROM OPERATIONS: Sales Increase in receivables Cash sales Cost of goods sold Increase in inventories Increase in accts payable Increase in accruals Cash cost of goods Cash margin Admin and selling exp Miscellaneous expenses Taxes Net CF from operations CF FROM FIXED ASSET INVESTMENT: Investment in fixed assets CF FROM FINANCING ACTIVITIES: Increase in short-term debt Increase in long-term debt Repayment of mortgage Interest expense Common dividends Net CF from fin act Increase (decrease) in cash and marketable securities ($1,145) ======== ($97) ======== $1,912 3,188 (268) (1,751) (1,588) -------$1,493 -------$13,133 0 (261) (2,990) (189) -------$9,693 -------($2,339) -------($2,774) -------$184,658 (1,364) -------$183,294 -------(14,095) 3,742 1,657 --------------$22,837 (15,345) (3,557) (4,234) -------($299) -------$195,732 (10,895) -------$184,837 -------(13,630) 9,492 2,231 --------------$16,093 (16,881) (5,725) (504) -------($7,017) -------2009

(151,761) (166,837)

($160,457)($168,744)

Table 6 Historical and Pro Forma Ratio Analysis

Pro Forma --------------2007 LIQUIDITY RATIOS: Current ratio Quick ratio EFFICIENCY RATIOS: Inv turnover FA turnover TA turnover DSO LEVERAGE RATIOS: Debt ratio TIE coverage 40.47% 13.91 46.33% 7.05 59.80% 1.42 57.92% 3.48 52.69% 6.38 50.00% 7.70 7.27 11.58 3.06 36.00 4.59 11.96 2.60 35.99 3.58 12.10 2.04 53.99 5.70 10.69 2.03 32.00 5.70 12.91 2.02 32.00 5.70 12.00 3.00 32.00 3.07 1.66 2.68 1.08 1.75 0.73 1.73 1.10 1.95 1.29 2.50 1.00 2008 2009 2010 2011 Industry Average

PROFITABILITY RATIOS: Profit margin Gross PM Return on TA ROE OTHER RATIOS: Altman Z Payout ratio 6.55 25.00% 4.68 25.00% 2.97 25.00% 3.75 0.00% 5.08 0.00% 4.65 20.00% 5.50% 19.48% 16.82% 28.26% 3.44% 17.82% 8.95% 16.68% 0.39% 14.76% 0.79% 1.96% 2.83% 17.50% 5.74% 13.63% 5.32% 20.00% 10.76% 22.75% 2.90% 18.00% 8.80% 17.50%