Why Does Mr. Butler Have to Borrow So Much Money to Support This Profitable Business?

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1. Why does Mr. Butler have to borrow so much money to support this profitable business?

Sales growth needs to be supported by increasing working capital and PP&E. Given no substantial decrease in cash conversion cycle and improvements in operating efficiency, retained earning is not sufficient to meet assets demands imposed by sales growth, and in this case, borrowing from banks acts as the sole source of external financing, since equity financing for private firms requires cash injection from owners, while Mr. Bulter has already been short of money after interest purchase from Mr. Stark. Access to extended LOC (Line of Credit) also enables Mr. Bulter to expand business in prospect of massive revenue inflow in second and third quarters. Furthermore, cash ratio keeps decreasing (as exhibited in appendix A) and more external financing other than retained earning is imperative to maintain sufficient cash position. Besides, additional cash from new loan can be used to repay trade payable and thus take advantage of purchase discount provided by suppliers; the cash can also be utilized to consolidate long-term debt with a lower rate.

1. Do you agree with his estimate of the company’s loan requirements? How much will he need to borrow to finance his expected expansion in sales (assume a 1991 sales volume of $3.6 million)?

Given sales volume of $3.6m and unchanged operating efficiency, pro forma statements can be attained by percentage-of-sales approach (as shown in appendix B). Note payable is regarded as the plug to support balance sheet increase abreast with sales growth, and the EFN (external financing needed) is $164,000 which is solely funded by borrowing from bank. As a result, the $465,000 credit line is excessive and $397,000 is a more reasonable estimate. However, $397,000 is just the plug number which exactly makes clean surplus equation hold, and as shown in cash flow statement, the cash position is actually declining given this amount, so LOC above this amount is preferable and acceptable.

3. As Mr. Butler’s financial advisor, would you urge him to go ahead with, or to reconsider, his anticipated expansion and his plans for additional debt financing? As the banker, would you approve Mr. Butler’s loan request, and, if so, what conditions would you put on the loan?

As Mr. Bulter’s financial advisor, I would recommend him to adopt his plans for business expansion and additional debt financing. The revenue has achieved astonishing growth rate at 18.6% in 1989 and 33.8% in 1990, and is estimated to attain 33.6% growth speed given $3.6m sales volume in 1991, so additional working capital is imperative to support such expansion. Moreover, I would suggest him to take the upper limit of LOC, namely $465,000, since 55% of revenue is generated in second and third quarters. Additional credit line also enables BLC to repay trade credit and thus benefit from purchase discount so as to increase working capital. The cash in hand would decrease given $397,000 revolving loan (see in appendix B), resulting in limited financial flexibility and liquidity. As a result, $465,000 loan amount is recommended.

As a banker, I would be conservative regarding this loan request and grant less amount than $465,000 ceiling. Firstly, given revenue of first quarter accounts for 22.5% of yearly revenue, $3.2m is a more reasonable estimate for 1991 turnover compared with aggressive $3.6m forecast. Additionally, there is a downtrend in A/P turnover due to increasing purchase with few discount, and current ratio also decreases throughout 3 years (shown in appendix A). Another alarming fact is downward quick ratio which is below one, suggesting insufficient liquidity caused by cash shortage (see appendix A). The debt ratio is also mounting, along with declining EBIT/Int. ratio, a fact that raises more concern. So should the loan be granted, some financial requirements must be imposed. Given cyclical characteristic of lumber industry, current ratio should be no less than industry average. Quick ratio should also be elevated to close one in order to avoid liquidity dry-up under economic recession. Debt ratio should also be controlled within safety margin, since DuPont analysis indicates that ROE increase mainly attributes to amplified leverage (shown in appendix C). Furthermore, personal wealth such as property and insurance can also be applied as collateral if permitted.

4. Has Butler Lumber Company created value for shareholders? 

The value creation depends on the cost of equity and consequent WACC. As exhibited in appendix A, the ROA has increased from 7.41% in 1988 to 8.25% in 1990 and is expected to reach 8.28%, but the WACC is not available due to lack of information regarding cost of equity. If WACC is less than ROA, the NPV of whole company is positive and the positive conclusion can be drawn. Similarly, though ROIC also increases from 10.17% to 11.23%, the EVA is still not conclusive due to absence of information concerning cost of equity. In theory, beta adjustment is applied to calculate cost of equity of private firms, but relevant data is not attainable since the time period is too far. Should the WACC be less than ROIC, EVA would be positive and thus Bulter Lumber could create value for shareholders; otherwise, Bulter Lumber didn’t create value for shareholders despite positive net income.