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Tire City Inc.

Current Financial Health

Profitability

Tire City has shown strong sales growth from 1993-1995. Sales increased 25.42% in 1994, and
15.48% in 1995 respectively. They have improved their profit margin in every year, 1993 had a
profit margin of 4.81%, 1994 4.90%, while 1995 has improved to 5.06%. Contributing to this
improving margin was a decrease in Cost of Goods Sold as a % of sales, and interest expense as
a % of sales. Tire City’s gross profit margin has improved slightly through the years, 1994 saw
41.55% while 1995 saw 42.05% suggesting that Tire City may be charging slightly higher prices
or have found cheaper suppliers of tires. Interest expense as a % of sales has decreased due to
how they are paying off their original warehouse loan in $125,000 increments.

Asset Turnover

Assisting the improving profit margin Tire City has seen an improved asset turnover ratio. It has
increased every year from 2.47x in 1993, 2.60x in 1994, and 2.62x in 1995. The main
improvement for this increase is fixed asset turnover, which improved in 1995 to 9.65x, from
8.93x in 1994. The increase is a result of decreasing planet & equipment as a % of sales. One can
conclude that the company purchased a little more plant & equipment; however sales increased
significantly thereby increasing fixed asset turnover. A slightly offsetting factor was A/R
turnover, it has decreased slightly from 6.58x in 1994, to 6.44x times in 1995. This is due to a
longer collection time, which has rose from 55.5 days in 1994, to 56.7 days in 1995. Tire City’s
inventory turnover has also slightly declined, from 6.47 in 1994, to 6.22 in 1995. This is due to a
higher inventory period, in 1994 inventory was sold off in 56.4 days, in 1995 this has slightly
increased to 58.7 days. This is a result of a higher inventory as a % of sales in 1995 compared to
1994, in 94’ inventories were 9.03% of sales, in 95’ they were 9.32%.

Financial Leverage

Tire City has moved to reduce its financial leverage, its assets to equity ratio has decreased every
year from 2.01 in 1993, 1.92 in 1994, and 1.79 in 1995. This signals that they are reducing their
risk levels and improving their solvency. Tire City has strong operating cash flows to fund its
day to day operations and pay down its warehouse loan. They have yet to borrow from the line of
credit established with Midbank. Its times interested earned has improved significantly from
18.16x in 1994, to 23.50 in 1995. This has been a result of higher net income and decreased
interest expense. Tire City’s cash conversion cycle has increased from 71.2 days in 1994 to 76.8
days in 1995. This is due to a higher collection period and shortened payable period compared to
1994.

Liquidity

Tire City has improving current and quick ratios from 1994, in 1995 the current ratio was 2.03
(from 1.92) and a quick ratio of 1.35 (from 1.29). They are having no problem generating cash
from operations , in 1994 operating cash flows were $989,000, and $830,000 in 1995. This
reduction in cash flows was due to an increase in spending on inventory to support its sales
growth.

Future Financial Health

Profitability

After predicting future sales growth of 20% in subsequent years of 1996 and 1997. My pro forma
income and balance sheet predicts that the profit margin will rise in 1996 to 5.16%, and then fall
back to 4.98% in 1997. Contributing to the rise in 1996 is a falling depreciation expense as a
percentage of sales and a slightly lower interest expense as a percentage of sales. Contributing to
the fall of the profit margin in 1997 is an increased depreciation expense as a percentage of sales,
since Tire City is allowed to write off 5% of the planned warehouse expansion that year. Another
reason is that interest expense as a percentage of sales has increased due to larger amount of debt
that has been taken on to fund the expansion of the warehouse.

Asset Turnover

Tire City will see a declining asset turnover ratio in 1996 and 1997. They managed a ratio of
2.62x in 1995, which later falls to 2.55x in 1996, and then 2.47 in 1997. Dragging down the ratio
is a slower fixed asset turnover which has resulted in the company’s big investment in fixed asset
in 96’ being the warehouse. In 1995 fixed assets were 27.11% of total assets (10.36% of sales),
in 1996 they were 34.64% of assets (14.97% of sales). Offsetting this slower fixed asset turnover
is an improved inventory ratio, inventory is now being turned over 10.05 times a year compared
to 6.22 times in 1995. This has been due to the company raising $565,000 in 1996 by selling off
a significant amount of their inventory which has resulted in a more efficient turnover. In 1997
inventories come back to their previous levels in proportion to sales, which in turn takes the
inventory turnover back to 6.22x a year, this contributes to the declining asset turnover in 1997.
However in 1997 fixed asset turnover picks up again as a smaller investment in fixed assets is
made and sales increase 20%, as opposed to a huge increased in fixed asset in 1996.

Financial Leverage

Tire City will see a fairly moderate increase in financial leverage through 1996 and 1997. Asset
to equity in 1995 was 1.79, the same ratio found in 1996, and in 1997 the ratio is 1.82, a slight
increase. Tire City makes a substantial operating cash flow of $2,122,000, which can be
attributed to them selling off a majority of their inventory. In 1997 operating cash flows make a
cliff dive down to $354,000, this can be traced to re-buying a large amount of inventories to
make them proportioned to sales like they were in 1995. Times interest earned makes a rise in
1996 to 24.34x then falls back to 19.50x in 1997. The rising sales and lack of an increasing
depreciation expense in 1996 attributed to the gain as well as a lower interest expense as a
percentage of sales, while in 1997 depreciation expense increased and interest expense as a
percentage of sales increased to .48% from .38% in 1996.

Liquidity
Tire City’s current ratio decreased in 1996 to 1.79x from 2.03x in 1995, this ratio however
improves in 1997 to 2.06. Quick ratios remain around the same levels in 1995. The current ratio
is reduced in 1996 due to the selling off inventories to fund operations in 1996, when the levels
go back to normal in 1997, this is what improves the current ratio.

Overall

I’d have to say that Tire City will be in a weaker financial position in 1997 compared to 1995.
Looking at it from a DuPont decomposition standpoint, you can see how ROE has decreased, the
profit margin has fallen, a slower asset turnover, and increased financial leverage.

As a lender I would be willing to loan Tire City the funds needed to expand their warehouse,
they are showing positive operating cash flows on my pro-forma, and remain profitable. The
times interest earned ratio remains high and provides some safety in knowing they can cover
their interest costs 19.50 times over in 1997.

Sensitivity Analysis

Scenario A: Inventory is not sold off in 1996, and maintains its same proportion to sales in 1995.

As you can see above, REO, profit margin, and asset turnover are all lower if we maintain a
proportionate percentage of inventories to sales as 1995. A higher asset to equity ratio results
because of the extra LTD that must be taken out to support the purchase of the inventory. Also
take note that a higher inventory will result in a longer inventory turnover period, which will
lengthen the cash conversion cycle. The times interest earned ratio will fall because of the
interest that must be paid on the extra LTD. Also the current ratio will improve due to more
inventories in current assets.

Scenario B: Tire City Depreciates more than 5% of the warehouse cost in 1997

{draw:frame} {draw:frame}

I’ve made a data table using percentages from the standard 5% depreciation all the way to 10%
from the $2,400,000 warehouse amount. As you can see there is in inverse relationship between
rising depreciation and ROE / profit margin. As depreciation expense increases the profit margin
and ROE fall. The overall asset turnover increases because of an increased fixed asset turnover
due to less amount of net plant and equipment. Financial leverage remains constant throughout.

{draw:frame} {draw:frame}

The data table represents different amounts of accrued expenses in the far left column and the
resulting ratios as well as operating cash flows. As you can see an inverse relationship occurs
with ROE and profit margin with accrued expenses falling. Asset turnover remains constant,
while assets to equity increases due to an increase in LTD to fund the hole in accrued expenses.
An important note is that operating cash flows turn negative around a level between 1928-2142,
an increasingly turn negative as Tire City is forced to expenses more readily instead of accrue
them.

Scenario: Day receivables are reduced, 1997 is used

{draw:frame} {draw:frame}

As the collection period is decreased and Tire City collects its credit sales faster than it normally
does in 1997, you can see how it has a robust effect on ROE and profit margin, both increase a
good amount as the collection period is reduced. Another positive effect is the lower assets to
equity ratio, which signals less financial risk. Operating cash flows increase significantly as cash
is more readily available

Scenario: Day payables are increased, 1997 is used

{draw:frame} {draw:frame}

Here you can see on the data table accounts payable is increased and thus the payable period is
increased, Tire City is taking a longer time to pay its suppliers. ROE and the profit margin
increase as cash can be held longer and a shorter cash conversion cycle will result as seen above.
Financial leverage is marginally decreased, and operating cash flows increase substantially.

Pro Forma Income Statement

Pro forma Balance Sheet

Cash Flow Statement

Ratios

Tire City

After completing the forecast for Tire City for 1996 and 1997 you can see that the firm is in very
good shape. As the Sales increase each year the expenses do not increase at the same level so the
net income of the firm continues to increase. With this number increasing the firm will be able to
cover the loan for the new building without having to raise too much capital outside. The amount
that tire city is expected to spend is $2,400,000 which $2,000,000 of that is accounted for in
1996 and is put into Long term debt and Gross Plant and Equipment. While the remaining
$400,000 will be accounted for in 1997. After adding this data along with the increases to sales
data we can see that in 1996 to firm will have excess cash in 1996 of 1,505,000 and excess cash
of $1,214,000 in 1997.

So with looking at this information Tire City should take out the loan because they have the
funds to pay it back and they have the line of credit with the bank that will make it cheaper for
them. Since they have such an excess in cash they will not only be able to pay off this loan easily
but they will be able to pay off the excess on the previous loan easily too. By going with the loan
the net income of the company will not go down by a whole lot because the only account that
will bring it down will be interest expense. If they were to use the funds that the company had
already accrued then they would not be able to give off as much in dividends and that may make
the stockholder unhappy. While if they get the loan they will have more in excess and may be
able to give off more in dividends which will make the stockholders happier and may even turn
more people into wanting to buy the stock of tire city.

One thing that does need to be done is that they need to manage their inventory a little better. In
1996 the inventory levels went down because they were unable to manage it between the two
warehouses but in 1997 it went back up to its normal level. While overall this does not seem to
be too bad, for someone who does not know about the company and just looks at the financial
statements up till 1996 they may think that the firm is declining and they can not handle as much
inventory as they could in the past. If the company could manage their inventory in 1996 in a
better manner then an outsider looking at the balance sheet would see that the company is doing
very well in almost every aspect.

The financial health of the firm is overall doing very well. The first thing I calculated to find this
was the current ratio which I found out to be 1.8:1. Which means that the firm has assets that
they could turn into cash if they needed to pay off some of their debt. Since the company doesn’t
pay out a large dividend they have much more to put into a company, so even if they do take the
loan they can continue to pay off the loan while continuing to keep the dividend level where it is.
The firm is also able to sell off its inventory quite frequently. By calculating the inventory
turnover ration you can see that Tire City sells of its inventory around 7 times a year. By
calculating the payout ratio I was able to determine that Tire Cities dividends are 20% of their
net income. This is an extremely high level and it the future it is something that could come to
hurt them but as you can see from the financial statements they are fine for now. Tire City also
generates more profit from the shareholders then it does from their own assets which means that
if they lose some of their shareholders they may be in trouble. Tire Cities return on assets is only
11% so this shows that they rely more on their equity then assets for their profits. If Tire City
does not change their reliance on their shareholders it could hurt them in the future. By looking
at these ratios along with the increase in net income from year to year you can see that the firm is
going to continue to do well from year to year. With the edition of the new loan the company
will be able to open their new warehouse that will allow them to create more inventories and
keep track of it in a better manner.

I feel that by looking at the data I came up with that the company should take out the loan but
take it out for less then the value of the new warehouse. If the company takes the loan for a value
of about $1,000,000 then they will be able to pay it off in a short period of time while not earning
too much interest. The remaining part of the building will be payed off using the excess cash that
the company has accrued over the past years. In taking this loan Tire City will be able to add a
major addition to their company while not taking on to much debt or using up all of their excess
revenue.
With a loan of around $1,000,000 the firm would be able to raise more then half off the capitol
for this project internally and only have to raise a little under half from outside the company.
And with the line of credit that they started with Midbank in 1991 the interest rates will continue
to be low so their interest expense will continue to be low and will not affect their net income to
a great extent.

Collaborating with Others:

• I would like to know if we can work on the case with another student to make things a bit
easier and more productive, but still hand in separate copies.

If you wish to discuss the case with another student that's fine. However, if you are "borrowing his
spreadsheet" and modifying it slightly and/or "lifting his analysis" but putting it in your own words the
answer is NO!! It's always easier to work in a group but there is too much free ridership. I HATE remoras
(a tiny fish that gets a free ride and free eats but sticking to the belly of a shark). Also, you already know
the grade you'll be getting if your report and spreadsheet resemble another student's. I don't make idle
threats.
In Class Example:

• I was wondering whether you were going to post a completed version of the Financial
Planning Spreadsheet on the net.

As far as posting a completed version of the Financial Planning Spreadsheet on the net, it is already in
your Financial Modeling book written by yours truly on page 83.
Errata Update:

• On page 1, towards the bottom of the page "At the end of 1995, the balance due on the
loan..." is $875 for 1995 which consists of $750 in Long-term debt and $125 in short term
debt (labeled Current maturities of long-term debt). This $875 for 1995 comes from the
Long-term debt of $875 for 1994.

Accounting Conventions:

• One of the major rules of accounting is that assets = liabilities, I am rather certain that this
is true in this case as well, but I am not 100% sure on that. Would you please clarify that?

Did you look at your accounting text to see whether this is a true statement? You need to revisit
your accounting principles. Finance doesn't exist in a vacuum. It builds on knowledge that you
learn in accounting, marketing, management, etc. The term "balance" sheet means things must
be in balance. Assets (your investments) must equal how you finance those investments (either
through debt and/OR equity). Debt is considered liabilities. What do you think the answer to your
question should be??
Financial Modeling:

• Do we use the assumption/income statement/balance sheet that you use in the sample
sheet or do we use the set up in the Tire City case?
You can model it whichever way you want to. Hey, it's like eating an OREO cookie. Some people
like to unscrew the cookie and eat the cream first, other people just put the whole cookie in their
mouth. I gave you an example where I like to put all of the assumptions on the top so that I can
easily find where I made my mistake.
Sales:

• How can we find the sales increase for year 1993 if we don't know the sales value for
1992?

Use sales for 1993 as the base year.

• Are we supposed to measure the annual increase in sales with 1993 for every year or are
we supposed to compare it to the previous year? The previous year seems more logical.
And I'm having trouble trying to figure out how I'm supposed to find the percentages for
1997 and the forecasting for 1998.

I think that you answered your own question. What does "annual increase" mean? Does it mean
from one year to the next or from the base year to the year in question? The case suggests how
you derive the percentages for 1997 (see the paragraph on page 2 entitled Mr. Martin's Task).
Does the case ask you to forecast 1998???
COGS, Accounts Receivables, Accounts Payable, etc:

• For the A/R in the Tire City Case, do we just take the percentage of sales from the actual
income statement and balance sheets (years 1993 to 1995)? Or do we use the projected
A/R given in the green textbook (Corporate Finance: A Valuation Approach), where
Projected A/R = (projected average collection period)/365 x projected sales.

Do a straight forward A/R as a percentage of sales as stated in the case. The Benninga and Sarig
(BS) give a variation of this simple ratio. This case also entails following instructions so the
formulas may vary from what the BS book say

• When forecasting future A/R, A/P, and inventories, do we also use the percentage of sales
technique? In chapter 6 of BS, they project A/R, A/P, and inventories by calculating the
average collection period, average payable period, and inventory days. Which method do
we use?

It's nice to know that students are reading the BS book prior to doing the assignment. Both
methods are correct. We're doing a simple percentage as was demonstrated in class. More
specifically, calculate the relevant historical ratios such as accounts receivable/sales. Next, look
at the trend in AR/Sales over time. Apply the applicable AR/Sales ratio * Projected Sales to
obtain the expected level of accounts receivable. Ditto for A/P and inventories.

Question: Why are both methods correct? Because we can use AR/Sales to obtain the average
collection period. To prove this, take out a piece of paper and pencil and do the math. It will work
out.
• I have a question about the percentage of sales technique we have to use for our pro
forma income statement and balance sheet. We use the historical percentages as
references to forecast future financial statements. The case mentions that current
accounts and operations margins were expected to be consistent with past experience
and maintain steady relationships with sales. Although percentages of each account to
sales were very similar throughout the past three years, they didn't have exact same
number. For example, the percentages of COGS to sales for 1993, 1994, and 1995 were
58.1%, 58.45%, and 57.91% respectively. Are we suppose to take an average percentage
or just take an educated guess? How many decimal places in the percentage we need to
take? If we need to take an educated guess, everyone is going to have slightly different
percentages. For example, some may estimate the percentage of COGS to sales for the
next two years to be 58% while some may say 58.2%.

Why would they have to be exactly the same number? Also, why calculate the historical
percentage of sales ratios if you don't plan to use them in your decisionmaking process? Look,
forecasting is NOT a science although we have certain benchmarks to guide our predictions.
Given your example of 58% vs. 58.2%, suppose for illustrative purposes that sales are forecasted
to be $25,000 (this is a made up number). Then if you use a COGS to Sales of 58% you would
obtain $14,500 as the predicted COGs while if you use 58.2% the COGs is $14,550 for a
difference of $50. Does it matter is you are off by .2%? What if you did an IRR? (you don't need
to do it in this case). Would the IRR really change? When you covered statistics, you learned
about the mean and standard deviation which are used in combination to obtain the confidence
interval. What happens if an observation falls with the confidence interval? (Sorry but I can't give
you the answer. Thinking is what I want you to do.)

• When forecasting items such as COGS, A/R, etc... on the 1996 &1997 financial statements,
do we have to figure out the percentage of sales for these items for years 1993-1995? For
example, I need to find the COGS for 1996. Do I need to figure out COGS/Net Sales for
years 1993-1995? Or do I use the percentage calculated from 1995 to forecast COGS?

Please see the answer to the preceding question. Also, did you read your book and the financial
modeling notes?

• I am also a little confused about the pro forma balance sheet. In your financial modeling
book pg 83, the pro forma balance does not either specify the components (cash, A/R,
inventories) of current assets or the components of current liabilities. Do we have to
specify those components when we do a pro forma balance sheet for Tire City? On page
131 of your financial modeling book, a more complicated pro forma balance sheet does list
those components.

The reason for this is to give you a simplified example that we could get through in 1 hour and 15
minutes. If I had given you an example that looks exactly like the Tire City case, it would be very
easy with little thinking involved. Think of it this way. If cash to sales are relatively constant over
time, A/R to sales are relatively constant over time, AND inventory to sales are relatively constant
over time, doesn't this also mean that current assets to sales are relatively constant over time?
Since current assets = cash & equivalents + A/R + inventory it follows that current assets as a
percentage of sales = current assets/sales = (cash + A/R + inventory)/ sales = (cash/sales) +
(AR/sales) + (inventory/sales) = cash as a percentage of sales + A/R as a percentage of sales +
inventory as a percentage of sales. A similar logic process follows for current liabilities. And YES,
you do have to specify each component.

• For Liabilties in the tire city case, there are current maturities of long-term debt, accounts
payable, accrued expenses, which are not in your sample sheet, since you only ask for
current liabilites. I can calculate the long term debt from the tire city case, but am I also
suppose to calculate the accounts payable, etc. based on previous years?

Please read the answer to the preceding question.


Dividends:

• There's no dividends in the basic data balance sheets... and the numbers of all the data are
different from the actual case itself...

You should ask for a refund from your accounting professor. Dividends aren't in the balance
sheet. They're in the income statement. Whatever earnings is not paid as dividends is "plowed
back" into the firm as retained earnings. Please read your accounting textbook regarding
dividends and retained earnings.

• Should I take dividends as a function of net income or net sales?

Please re-read the case. Also, read the lecture notes and the book. What do we mean by the
dividend payout ratio?
Capital Expenditures:

• The case mentions that TCI plans to invest $2.4 million in expansion of which $2 million
will be incurred in 1996 and $0 in 1997. Do we just ignore the remaining $0.4 million of
capital expenditure?

Please re-read the passage. If you don't get it, keep re-reading it until you do. The passage states "During
the next 18 months TCI planned to invest $2,400,000 on its expansion, $2,000,000 of which would be
spent during 1996 (no other capital expenditures were planned for 1996 and 1997)."

• Do we add the cost of the warehouse to the plant and equipment section of the balance
sheet?

This case not only deals with finance but accounting as well. What does your accounting textbook say
about how the purchase/cost of the warehouse affects the Property, Plant, and Equipment (PPE) section
of the balance sheet? Think in terms of "T" accounts. Suppose you purchase a new pickup truck (a piece
of equipment) for your business that costs $35,000. You wish to finance the purchase of this truck by
putting down $2,000 in cash and taking out a loan from the auto dealer for the remainder of the purchase
price ($33,000). How would this purchase affect your balance sheet? You would increase your Equipment
by + $35,000 and decrease your Cash by - $2,000 in the Assets section of your balance sheet (the left
hand side of your balance sheet). You would also increase your LT Debt by + $33,000 (the right hand
side of your balance sheet). The effect of this transaction is that the left hand side has a net increase of +
$33,000 and the right hand side has a net increase of + $33,000. Thus, the balance sheet is in "balance"
e.g. the left hand side = right hand side. For all transactions, the left hand side and right hand side should
be in balance. What is left for you to also do is that this transaction will affect your income statement as
well since you can take depreciation on this piece of equipment.
Depreciation:

• For recognizing the depreciation expense of the 'total' warehouse cost, is it referring to
$2.4 million or just $2 million? For the depreciation expense of the other assets, they
mentioned that it would be the same as the dollar value of 1995. Does this mean that it
remains constant at $213 through the forward projections?

Once again re-read the passage and think about what you learned in your accounting class. Suppose you
purchased a car for $35,000. You put down $2000 before walking out of the show room. For the next, 5
years, you pay $400 per month. What is the cost (purchase price) of the car?
If it says that it is the same dollar amount as in 1995, then it should be self evident what the
depreciation expense of other assets will be in 1996 and in 1997.

• In the tire city case, there is deprection in the income statement, but not in your sample
income statement. ARe we suppose to calculate that?

Of course you are suppose to put depreciation in your income statement. Gee whiz. I stated in
the class that my example did not contain depreciation but that you need to consider depreciation
in doing the Tire City case. So why didn't I use depreciation in my example? Because if my
example was almost exactly like the Tire City case, people would simply copy my example and
not THINK! I want to have people think and also link what they've learned in accounting to what
they are learning in finance.
Financing:

• I'm not very clear about the financing of money from the bank. First of all, does the
financing package or rate obtained from Midbank affect the pro-forma statement
projections in any way or is the financing questions simply independent of the
construction of the proforma statement?

IF Tire City can't finance their warehouse expansion using all internal financing (e.g. retained
earnings and cash), then this means that the firm needs some source of external financing. Since
the case suggests that the firm will use bank financing from MidBank in the event that external
financing is required (this is the PLUG), does the financing rate affect the pro-forma projections?
Suppose you wish to start a dot.com company. You have $5,000 cash on hand and can raise an
additional $5,000 from selling your stocks. Depending on what you sell in your first year, you
might have to borrow money from your local bank. If you do borrow the money, does the interest
rate that they will charge you affect your pro-forma projections?
• When it comes to interest expense for the new loan, do we assume that the full 10% will be
charged the year the loan is taken down? I had a hard time following the in-class example.

The in-class example, like the Tire City case, involves first finding the amount of external
financing that Tire City needs. The external financing (all of which is presumed to be NEW bank
debt rather than a combination of new equity and new debt) represents "the plug". Interest
expense is partly based on the new debt amount. For additional insight, please read the
preceding question and answer.

• For the pro forma financial statements, are we assuming that TCI will take out the loan?

What does it state in the case? Please refer to page 2, the paragraph above Mr. Martin's Task.

• I understand that there are two interest expense regarding the old and new loan. And it
also states explicitly that the interest rate is 10%. But do I use the same int. rate (10%) for
the new loan or I need to find out the interest rate charged to the old debt? In order words,
besides having two interest expenses, so there will be two different interest rates also?

We just went over this in class today. Please read the lecture notes. The interest rate on the NEW
loan is at 10%. Is the interest rate on the OLD loan also at the current interest rate or the existing
interest rate? Hmm....

• When we use external financing as the "plug", do we take the external financing in one
year and posted it as debt in the next year?

The way to think of external financing as the "plug" is to ask given that I plan to put new plant and
equipment on my books e.g. increase my assets (the left hand side of the balance sheet), how
am I going to finance these new assets? Am I going to increase my debt or increase my equity
(the right hand side of the balance sheet)? In the case, it suggests that the firm's owner wishes to
fund new plant and equipment using debt financing e.g. issuing bonds or borrowing the money
from the bank. Thus, how much "new" debt is required in each period? "New" is defined as
anything that is not existing debt as of the end of 1995 (the period prior to the forecast period).

• How do we calculate the net interest expense? Because I tried to divide it by the net sales
from 93-95, but the percentages vary. They are more stable when I divide it by gross profit.
Is that what I use to calculate it?

Interest does not vary with sales. Please read Chapters 3 and 4 of your textbook (RWJ) and also
dust off your accounting textbook. Also, it is very clear that you did not go through the example on
page 83 of my Financial Modeling book using an Excel spreadsheet. Why?

Staged-in Financing:
• Could you explain the meaning of taking down the loan into 2 separate parts. It is unclear
in the case. Does this mean that each separate loan is to be repaid in 4 separate annual
installments e.g. there is a first installment for the loan taken in 1996, and a separate first
loan installment to be paid in 1997? As all installments paid in 1998, will they affect the
pro-forma statement or are they just there so we can make the relevant calculations to see
if the bank should extend the loan package to Tire City?

Taking down the loan in two separate parts on an as-needed basis means that suppose you have a line
of credit with the bank for say $500,000 (that at any time, the bank will lend you at up to $500,000) and in
1996 you require $200,000 in external financing then you would borrow $200,000. If you borrow
$200,000 then you have a maximum left on your line of credit of $300,000 which you can use when you
need additional financing. "Taking down" the loan means that you set how much you borrow in each
period. The maximum amount of all borrowings, using my contrived example, is $500,000. Thus, you can
borrow $100,000 this year, $100,000 next year and $300,000 the subsequent year or you can borrow
$400,000 this year and $100,000 next year. It's up to you. You decide when you need the money.
Taking down the loan has nothing to do with loan repayment. Taking down deals with borrowing the
money. Repayment deals with how and when you pay the money back to the bank. It says in the case
that the loan is repaid in 4 equal installments. Thus, if you borrow $500,000 (suppose you don't do this all
at once), the bank will require that $500,000/4 = $125,000 is paid each year.

The $125,000 paid each year assumes that BOTH principal and interest are paid per period. This is NOT
what typically happens. Recall in class that a bond is debt. Suppose once again that you borrow $500,000
by issuing bonds. Assume that the contract rate of interest is 6%, interest is paid annually, and the bonds
mature in 4 years. What is the equal annual payment each year? It will be
6%*$500,000 = $30,000 in interest. At the end of year 4, the principal amount of $500,000 is due.

Several of you have asked where does interest go on the balance sheet. It doesn't. If you go back and
LOOK at your accounting text, interest is posted to your income statement.

Write-Up:

• Do the analysis we need to write for the ratios be in MS Word format or can I write the
analysis right there in Excel

under the actual figures?

If you were doing this presentation for your boss, would you put the analysis right there in Excel
under the actual figures? Remember that you can use this case on job interviews. How? Simply
by waiting for the right "opening" e.g. in response to a question about which is your most
challenging course or who was your toughest professor at Stern and why? This gives you the
perfect opportunity to say this ##@@$%!! professor made the class to resemble a finance boot
camp wherein we had to do pro-forma analysis and other financial modeling techniques. He also
made sure that we could apply the corporate finance theories that we learned in his class. Since
you WILL be using for job interviews, do you want to signal what type of person you are by writing
the analysis in the Excel spreadsheet?