Statement of the problem:
Amy McConville, a friend and financial consultant of Wendy Beaumont, the president of Friendly Cards Inc., needs to come up with some suggestions concerning the financing of Friendly’s expansion. Amy has been doing research on the firm and money is tight right now. The cost of financing growth right now is high and Friendly Card’s is projecting 20% growth in sales next year and even more the following year. The company has never been without financing problems. The business is capital intensive and has had to rely on its good relations with its banks and suppliers to achieve success. Friendly’s bankers have begun to feel uneasy about how much the company is relying on debt capital to finance its operations. They have suggested that they agreed to help finance their growth in the past with the assumption that sales would decrease substantially in the future. The firm’s liabilities/equity ratio had peaked to 5.2 in 1986, and was still a couple of years away from returning to historically lower ratios. This scenario has prompted Friendly’s bankers to insist on the firm adhering to some new restrictions. The two restrictions, which would apply by the end of 1988, were the following:
1. The bank loans outstanding at any time could not exceed 85% of Friendly’s accounts receivable.
2. Friendly’s total liabilities could not exceed three times the book value of the company’s net worth.
In addition to these restrictions, Wendy has decided to impose an all interest bearing debt/equity ratio of a maximum of 2 to 1 for the firm. This should help with planning and provide some margin of safety for the firm. Wendy has also asked Amy to analyze three other scenarios:
1. Should Friendly Cards purchase an envelope machine that will enable them make their own envelopes?
2. Should Friendly Cards acquire Creative Designs, a small manufacturer of cards?
3. Should Friendly Cards accept the West Coast investors offer and issue new equity?
Relevant facts:
• Money is tight right now for Friendly Cards and they are predicted a 20% sales increase with more the following year
• Distribution costs are very important to the firms overall profitability
• The seasonal nature of the business provides peaks and lows for borrowing from the banks
• The company borrows at 2 Ѕ % above a prime rate of 8 Ѕ % currently
• Friendly Cards had spent $1.5 million to purchase envelopes in 1987 and could save $218,000 per year for the next 8 years if it purchased the envelope machine
• Wendy believed she could reduce CD’s cost of goods sold by 5% and their expenses by 10%
• CD’s principals were willing to accept Friendly common at $9.50 a share for 198,000 shares to buy their company
• Due to the stock market crash and low trading volume of Friendly Cards, it would be hard to take their stock to the market at more than $8.00 a share
• A west coast group of investors were willing to buy 200,000 shares at $8.00 a share; this deal included a finder’s fee of $80,000 or 10,000 shares in addition to the 200,000 shares.
Envelope Machine option:
Friendly Cards would purchase the machine for $500,000 and when it was operated at full capacity, it would produce all the envelopes that the firm had used in 1987. The machine was estimated to have an economic life of about eight years and that it would cost around $91,000 a year to operate the machine. In addition, they would need to purchase some additional warehouse space to store the envelopes the machine produced at a level rate during the year. After estimating the following savings and expenses, it was determined that Friendly Cards could save $218,000 a year by purchasing the machine.
Savings: $1,500
Expenses:
Materials: $902
Warehouse: $94
Labor: $91
Depreciation: $62
Total exp: $1,149
Increase in Profit before tax: $331
Increase in income tax @ .38: 133
Increase in profit after tax: $218
Purchasing