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1: Financial Management Hampton Machine Tool Company

Group 3 Del Rosario, Martin Ocampo, Ojie Quejado, Nikki Raborar, Rowena Yambao, Liezl

Executive Summary Hampton Machine Tool Company (HMTC), established in 1915, caters to the military aircraft manufactureres and automobile manufactureres in the St. Louis area. The companys current success can be attributed to their conservative financial policies, making them survive the different economic turmoils a couple of years ago. In December 1978, Mr. Cowins, President of HMTC, took down a loan of $1 million from St. Louis National Bank to purchase stocks of dissident stockholders. Now, wanting to improve the companys performance, Mr. Cowins sent a letter to Mr. Eckwood in September 1979, Vice President of the St. Louis Bank, asking him to extend the loan to the end of the year and also for an additional $350,000. After conducting a financial analysis, focusing primarily on their cash budget, it was found out that HMTC would not be able to fully repay their $1.35 million loan by the end of the year. Even if they repay portions of the loan early on to reduce their interest burden and also stop paying dividends, they would still have problems in paying back their loan. However, it was also discovered that the company could pay back their loan on January. As such, Mr. Eckwood should reject HMTCs proposal and instead propose to extend the loan for another month but with an interest rate increase. With a re-negotiation of the loans terms, which are extending the deadline of the payment to January and increasing the interest rate to 1.75%, both HMTC and the bank will have a better outcome. For HMTC, they would have a new equipment to help in their operations. They would also push on with their dividends and finally get rid of their outstanding loan balance. For the bank, they would earn more interest income from the increase in interest rate.

Case Context Hampton Machine Tool Company (HMTC) is a machine tool manufacturing business which started in 1915 and has been a stable company since its establishment. The companys revenues rely heavily on military aircraft and automobile manufacturers within the St. Louis vicinity. During 1960s until end of 1970s, HMTC experienced highs and lows which were mainly due to increases and decreases in production. This is influenced by the Vietnam war, economic conditions, expansion of export market and demise of competitors. Though adverse circumstances happened, HMTC has successfully survived these problems. This can be attributed to the companys conservative financial policies. In December 1978, Benjamin Cowins, President of HMTC, requested a 1M USD loan to St. Louis National Bank to purchase stocks of several dissident shareholders. The interest rate for the loan was 1.5% to be paid monthly and the principal of the loan is to be paid on September 1979. Mr. Jerry Eckwood, Vice President of St. Louis National Bank allowed the loan request because of three reasons: 1) HMTCs submission of projected sales and forecasted financial statements; 2) HMTCs credibility as depositor in St. Louis Bank and 3) Mr. Cowins credibility in the business community. However, in September 1979, Mr. Eckwood received a letter from HMTC requesting to extend repayment of the loan to December 1979 and a further loan request of 350,000USD for equipment purchases. Point of View and Problem Definition The point of view to be taken in this case will be as Jerry Eckwood, a creditor. As a creditor, aside from the financial ratios, one of the most important things to be looked at for a possible borrower is whether they could repay their loan upon the date of the loans maturity. As such, the main problem for this case is: Should Mr. Eckwood accept Mr. Cowins proposal regarding the extension of the original loan and an additional $350,000 loan? Framework The group will take a creditors point of view for this case. As such, the important things to be looked at are the financial ratios and, more importantly, their cash budget. By looking at their cash budget, the group would be able to find out if they could pay their debt in their proposed target date. A. Profitability Ratios B. Liquidity and Leverage Ratios C. Cash Budget

Analysis Financial Ratios To analyze the financial viability of the company, we used financial ratio analysis to evaluate HMTCs profitability, operating efficiency, liquidity and leverage. (See Exhibit A for the financial ratios of HMTC). Profitability HMTCs profitability ratios, generally, has an unstable trend. Though, most of these ratios are seen to be improving over time especially the projected ones. There is a significant increase in HMTCs operating profit margin and gross profit margin from historical trend to its projected using the projected financial statements. As seen in the ratios, its gross profit margin is high except for September. The main reason for this is because of the WIP inventory reduction of $1320 in September. Because of this huge reduction in WIP, operating profit margin for September is -13%, signifying that HMTC would be operating at a loss. However, it would be good to note that after this reduction in WIP, profitability ratios for the company would be seen to be increasing. With COGS and Operating Expenses would be forecasted to be relatively stable from October to December and Sales to be increasing over the period, the profitability ratios would naturally show that HMTC would be profitable for the three months after September. With this, it can be seen that the company is profitable, making them worthy of extending credit to. Liquidity and Leverage The result of the companys liquidity and leverage ratios based on the projected financial statements shows an improving set of ratios. HMTCs quick ratio is less than 1 and has been consistently below 1. Its current ratio trend plays around 1 to 2, which is not acceptable for an industrial machinery company since this only applies to companies which have inventories that can immediately be converted into cash. Furthermore, an average of quick ratio less than 1 connotes that the liabilities end up being greater than the companys assets and thus there is a great reliance on inventories to cover for immediate payment obligations. HMTCs total assets are financed by debt with an average of 56% during June to August but, declined to 46% using its projected ratios. On the other hand, the companys debt-equity ratio has an average of 0.97. For a company with a capital-intensive nature, it is acceptable to have a debt-equity ratio and total liabilities-total assets ratio of above 1 but this implies that most of HMTCs company's assets are financed through debt and thus, the company has a great tendency to aggressively finance its operations and growth with more debt.

Current Cash Budget Seeing, however, that the companys cash budget could be computed, it would be better to focus on this instead of on their ratios. Looking at Exhibit B, it can be noticed that the problem does not have any liquidity problems stemming from their usual operations. Their cash could definitely cover their cash disbursements for operations even though there would be times when their cash receipts are low. The following assumptions were used in coming up with the cash budget: a) 100% of the previous months Accounts Receivable will be collected given the 30 days credit terms. b) Purchases are paid a month after. c) Tax payments will be done on September and December. d) Other Operating Expenses will remain stable for the period and are paid the month itself. As seen in Exhibit B, HMTC would perform quite well once they get their equipment to improve their operations. Their ending cash balances reflect that they dont need additional borrowings to fund their operating activities. However, the only problem HMTC would experience is their repayment of the loan. If they go through with their current cash budget, they will actually need extra funds to cover a negative cash balance of $331,500 due to the loan payment. Actually, even if HMTC restructures their loan by paying ahead of time to decrease the interest burden and also postpone paying dividends (see Exhibit C), HMTC would still have a negative cash balance of $163,500 by December. This shows that HMTC still cant pay their outstanding debt on December even if they tinker with their figures. However, still looking at their current cash budget in Exhibit B, one would notice that HMTC would have a cash balance of $933, 500 on January. This is due to the collection of their accounts receivable coming from December sales. As such, the company, instead of asking for an extension of up to December, should have asked for an extension up to January. HMTC seemingly forgot that, even with their good forecast figures, they have to also check when they expect to collect their sales. In this case, it seems as if they neglected to factor in that they could only collect their sales fully the next month. As such, by extending the payment of the loan to January instead of to December, HMTC would be in a much better position to fulfill their proposal to pay their outstanding loan of $1.35 million. Decision and Justification The decision, after analyzing the companys performance, especially their current cash budget, would be to reject their proposal. As a creditor, whose main concern is the borrowers repayment of the loan along with the required monthly interest payments to it, it would be easy to see that HMTC would not be able to repay in full their outstanding loan on December. Even

by postponing its payment of dividends and repaying part of their loan early on to reduce their interest burden, HMTC would still not be able to pay in full their $1.35 million loan by the end of the year. From the analysis done, however, it was seen that HMTC could repay their outstanding loan on January the next year. It would be better, then, for the bank and also for HMTC if the repayment could be extended for one more month. As such, terms regarding the loan should be renegotiated. Operationalize the Decision Of course, renegotiating the loan repayment should have a penalty attached to it. The penalty will come in the form an increase on the interest rate on the loan HMTC would be facing. By raising the interest rate from 1.5% (18% per annum) to 1.75% (21% per annum), the bank would be gaining more interest income from HMTCs loan (see Exhibit D). As such, the extension of the loan would be good for both parties. For HMTC, they could still distribute dividends on December since they would have cash on hand. Also, though they would be faced with more interest expense, they could still incur this increase as the increase in interest expense would not dent their financials too much. They could also finally settle their outstanding loan and have it finally removed from their liabilities. For the bank, apart from the increase in interest income of $26,625 coming from the renewed terms on HMTCs loan, their working relation with HMTC would improve. HMTC would most likely acknowledge the banks continued assistance to them by accomodating them through the companys tough times. However, as seen with the decision, penalties would arise if HMTC would fail to meet their obligations with the bank. Operating Efficiency - Could we remove this since we will be assuming naman their operations to be fixed to arrive at our forecasts? Comparing the historical data to its projected ratios, HMTC is expecting to have higher turnovers of its accounts receivables and inventories. From June to August, the companys accounts receivable were decreasing in dollar; this decline goes hand-in-hand with the companys dropping net sales. In September, HMTCs projected a grand $2163 from its previous years sales of $507 that is equivalent to a 327% increase. This led to an increasing accounts receivable turnover ratio from August to September. On the other hand, the velocity of conversion of HMTCs inventories into sales is relatively slow if we will compare the companys net sales and inventories. Over the years, the companys inventories have been increasing its share to its total assets. With such high inventory, it is

unlikely to sell everything in less than a year to pay off its current obligations on time and can result to even greater losses. How can you say this if we will assume that we will collect all AR in 30 days?

Exhibit A: Financial Ratios FINANCIAL RATIOS Profitability Return on Assets Return on Equity Net Profit Margin Operating Profit Margin Gross Profit Margin Operating Efficiency Accounts Receivable Turnover Average age of Receivables Inventory Turnover Liquidity/Solvency Current Ratio Quick Ratio Leverage Total Debt/Equity Total Liabilities/Total Assets Historical June 2% 4% 9% 18% n/a 0.856 427 0.495 1.581 0.762 1.216 0.549 Pro Forma Sept. -2% -5% -7% -13% 6% 1.635 223 0.648 1.765 0.666 0.928 0.481

July 1% 2% 8% 17% n/a 0.570 641 0.200 1.572 0.705 1.249 0.555

Aug. 1% 2% 15% 33% n/a 0.741 492 0.106 1.542 0.494 1.327 0.570

Oct. 4% 7% 15% 26% 53% 1.932 189 0.465 1.788 0.636 0.801 0.445

Nov. 4% 6% 15% 30% 56% 1.000 365 0.513 1.814 0.782 0.809 0.447

Dec. 10% 14% 26% 51% 69% 1.000 365 0.749 2.430 0.948 0.488 0.328

Exhibit B: Current Cash Budget September Cash Receipts: Collection of Accounts Receivable Bank Loan: Total Cash Receipts Cash Disbursements: Payment of Accounts Payable Other Operating Expenses Purchase Equipment Tax Payments Interest Expense Payments Principal Repayments to Bank: Dividends Total Cash Disbursements Reconciliation: Beginning Cash Balance Net Cash Flow Ending Cash Balance Total Interest Payments: October November December January

684,000 0 684,000

1,323,000 350,000 1,673,000

779,000 0 779,000

1,604,000 0 1,604,000

2,265,000 0 2,265,000

948,000 400,000 0 181,000 15,000 0 0 1,544,000

600,000 400,000 350,000 0 15,000 0 0 1,365,000

600,000 400,000 0 0 20,250 0 0 1,020,250

600,000 400,000 0 181,000 20,250 1,350,000 150,000 2,701,250

600,000 400,000 0 0 0 0 0 1,000,000

1,559,000 -860,000 699,000 70,500

699,000 308,000 1,007,000

1,007,000 -241,250 765,750

765,750 -1,097,250 -331,500

-331,500 1,265,000 933,500

Exhibit C: Early Payment of Principal Loan and No Dividends September Cash Receipts: Collection of Accounts Receivable Bank Loan: Total Cash Receipts Cash Disbursements: Payment of Accounts Payable Other Operating Expenses Purchase Equipment Tax Payments Interest Expense Payments Payment of 1st Loan Payment of 2nd Loan Dividends: Total cash outflows: Reconciliation: Beginning Cash Balance Net Cash Flow Ending Cash Balance Total Interest Payments: Assumptions: No Dividends Loan Payments will be started early to reduce interest expense October November December January

684,000 0 684,000

1,323,000 350,000 1,673,000

779,000 0 779,000

1,604,000 0 1,604,000

2,265,000 0 2,265,000

948,000 400,000 0 181,000 15,000 300,000 0 0 1,844,000

600,000 400,000 350,000 0 10,500 100,000 0 0 1,460,500

600,000 400,000 0 0 14,250 100,000 0 0 1,114,250

600,000 400,000 0 181,000 12,750 500,000 350,000 0 2,043,750

600,000 400,000 0 0 0 0 0 0 1,000,000

1,559,000 -1,160,000 399,000 52,500

399,000 212,500 611,500

611,500 -335,250 276,250

276,250 -439,750 -163,500

-163,500 1,265,000 1,101,500

Exhibit D: Loan Extension to January and Interest Rate Increase September Cash Receipts: Collection of Accounts Receivable Bank Loan: Total Cash Receipts Cash Disbursements: Payment of Accounts Payable Other Operating Expenses Purchase Equipment Tax Payments Interest Expense Payments Payment of 1st Loan Payment of 2nd Loan Dividends: Total cash outflows: Reconciliation: Beginning Cash Balance Net Cash Flow Ending Cash Balance Total Interest Payments: Assumptions: Interest rate will be increased to 1.75% October November December January

684,000 0 684,000

1,323,000 350,000 1,673,000

779,000 0 779,000

1,604,000 0 1,604,000

2,265,000 0 2,265,000

948,000 400,000 0 181,000 17,500 0 0 0 1,546,500

600,000 400,000 350,000 0 17,500 0 0 0 1,367,500

600,000 400,000 0 0 23,625 0 0 0 1,023,625

600,000 400,000 0 181,000 23,625 500,000 0 0 1,704,625

600,000 400,000 0 0 14,875 500,000 350,000 0 1,864,875

1,559,000 -862,500 696,500 97,125

696,500 305,500 1,002,000

1,002,000 -244,625 757,375

757,375 -100,625 656,750

656,750 400,125 1,056,875

Exhibit E: Hamptons Income Statement Income Statement September October 2,163,000 1,505,000 600,000 600,000 1,320,000 0 105,000 105,000 2,025,000 705,000 138,000 800,000 10,000 400,000 410,000 -272,000 15,000 -287,000 -137,760 -149,240 0 -149,240 10,000 400,000 410,000 390,000 15,000 375,000 145,000 230,000 0 230,000 November 1,604,000 600,000 0 105,000 705,000 899,000 13,646 400,000 413,646 485,354 20,000 465,354 223,370 241,984 0 241,984 December 2,265,000 600,000 0 105,000 705,000 1,560,000 13,646 400,000 413,646 1,146,354 20,000 1,126,354 540,650 585,704 150,000 435,704

Net sales Purchases Work-in-Progress Raw materials reduction Cost of goods sold Gross Profit Depreciation Other expenses Total Other Expenses EBIT Interest expense Net income before taxes Income taxes Net income Dividends Retained Earnings

Exhibit F: Hamptons Balance Sheet Balance Sheet Cash Accounts receivable, net Inventory Current assets Gross fixed assets Accumulated depreciation Net fixed assets Prepaid expenses Total assets Notes payable, bank Accounts payable Accruals Taxes payable* Customer advances Total Liabilities Common stock ($10 par value) Additional Paid-in Capital Total Equity Total Liabilities and Equity 699,000 1,323,000 3,339,000 5,361,000 4,010,000 3,100,000 910,000 42,000 6,313,000 1,000,000 600,000 552,000 160,240 726,000 3,038,240 428,000 2,846,760 3,274,760 6,313,000 1,007,000 779,000 3,234,000 5,020,000 4,360,000 3,110,000 1,250,000 42,000 6,312,000 1,350,000 600,000 552,000 305,240 0 2,807,240 428,000 3,076,760 3,504,760 6,312,000 766,000 1,604,000 3,129,000 5,499,000 4,360,000 3,123,646 1,236,354 42,000 6,777,354 1,350,000 600,000 552,000 528,610 0 3,030,610 428,000 3,318,744 3,746,744 6,777,354 -331,000 2,265,000 3,024,000 4,958,000 4,360,000 3,137,292 1,222,708 42,000 6,222,708 0 600,000 552,000 888,260 0 2,040,260 428,000 3,754,448 4,182,448 6,222,708