WL CASE STUDY SOLUTION

Presented by:
GROUP 5
Jaouad Serghini – Souhail Ramid – Mahdi Benfares –
Francisco Del Carpio – Franziska Klek - Axel Azogui
Why does a profitable firm need to increase borrowing?
•The fact of being a profitable firm reflects the ability of the company to generate cash due to good
management of the operating activity. It means that the company is working well, and expectations over
future cash flow are positive.
• Therefore, the company is in a good position to issue debt or asking the bank a loan as it would benefit
from low borrowing cost.

•Another benefit for an increase in its borrowings is its tax shield. As the operating activities grows,
profitable companies’ taxable income grows as well. Due to leverage, the PV of the tax shield increase and
lower taxable income.

•As leverage also impacts negatively the agency cost, it can also have a role in reducing wasteful
investment and induce managers and employees to work harder. Hence agency costs would decrease.

•Within the case, the reason given for obtaining additional loans was a shortage of cash.
• Between 1982 and 1985 the cash within the company decreased (at a rate of –16% annually) as it
needed to meet its operating costs and had the extra burden for the repayment of a loan.
• This happened in a context where there was an increase in Accounts Receivable as well as Inventories
and where the Accounts Payable did not increase that rapidly but were used extensively in order not to
exceed its current line credit with Suburban Bank.

•Mr. Wilson highlighted, that the receiving a high credit ($325,000 as opposed to $173,000) would provide a
flexibility for the business.
 What is the cost of trade credit?
• Trade Credit refers to accounts payable. Within small businesses, businesses can finance themselves with trade
credits. It is composed of the amount the business owes to suppliers on inventory, products and other
goods necessary for business operations.
• Companies, like the Wilson Lumber Company, are granted these trade Credits as they are trustworthy, and the
suppliers trust to receive cash later. It gives WL has room to grow, however, the Trade Credit had grown in early
spring 1985 due to its cash shortcoming that could not been addressed by the credit line it currently has.
• The cost of trade credits comes with the cash paid for the products bought from suppliers. If products are bought
on Trade Credit, the amount charged is typically higher. If the price is paid within a certain amount of time,
there is a discount available for the product.
• The cost of trade credit for Wilson Lumber is the following:

• As can be seen, the current cost of trade credit for the company is high, and the fact that it needed to rely more
on this type of financing places it in a very inconvenient position.
 Will the proposed credit line ($325,000) cover WL’s 1985 needs?
• At the first quarter of 1885, WL had a balance of $173k for notes payables for the Bank, almost at the limit of the credit line it has
with Suburban Bank
• This forced the company to obtain financing though trade credit, which as seen was very costly.
• Thus, the required amount needed would be around $283,000 so the new credit line sounds as a solid and convenient alternative.
• By acquiring the new debt from Northrup Bank, Mr. Wilson needs to cut his previous loans with the Suburban National bank. He will
acquire a 90-day note payable of an amount of 325.000$. The reflection in the balance sheet will be:
• A note payable of 325.000$: Repayment of previous loan of 173.000$
• A trade credit payable of 0: repayment of trade credit payable of 110.000$
• And an increase in cash of 42.000$
• The objective of this operation is to avoid a shortage in cash level (decreasing since 1982) which will make the Wilson Lumber
company able to meet its short-term obligations, significantly the accounts payables, without recurring to a costly trade credit.
• The level of the working capital (CA-CL) will stay the same after doing this operation; yet the company will have more cash available.
We assume that the loan will not be used to pay the accounts payables upon reception (Since the suppliers do not mind being paid a
little later). However, the accounts payables will be paid through the activity of the company since Wilson Lumber company expects
an increase in its sales levels.
 What can WL do instead of increasing leverage?
1) Raise equity
• According to the pecking order theory, funds can be raised through debt in a first instance but raising equity
instead could be a cheaper alternative.
• By doing so Mr. Wilson would have to share the profit of its business with the new shareholder whereas with debt
he would only need to pay back the principal plus the interests. In addition, by “inviting” new shareholders to the
table he could increase the chance of facing agency cost.
• As a potential shareholder, Mr Wilson could invite his wife to join the company by the input of capital. This
could be funded by the sale of her private house with a market value of $40.000.
2) Renegotiate the terms of WL’s accounts payables. two options:
• Asking for lower interest rates, based on the solid credit history and management capacity it has. This would
mean a decrease in the accounts payables which will increase the working capital.
• Increasing the time to honor the accounts payable, so more cash would be available.
3) Renegotiate the terms of selling of the firm’s products
• This would modify the accounts receivables, as if shorter terms for the clients to pay for them are applied there
would be more cash available. Nonetheless, this option would not necessarily please the firm’s clients.
 Would you lend $325,000 to WL?
• The analysis of WL's Financial Statements showed:
• Sales and Net Income (NI) have a double-digit growth (14% in 1983 and 29% in 1984 for the Net Income).
• Net Working Capital (NWC)remains stable, starting at $144k in 1982, then $155k and finally $169k in
1984. This show that the company can easily fund its current operations and invest in future activities
and growth.
• Interest Coverage is another ratio that reflects the ability of the company to pay its current interest payment with its
available earnings.
• By computing the historical interest coverage ratio, the ratio is about 3.88, an acceptable level which gives the
creditor a reassurance about the interest expense payment.
• However, the ratio is decreasing through the period 1982-1985 (see Appendix 4). This can be explained by the
fact that cash is decreasing. Nevertheless, the loan will help the company to boost its cash.
• In addition, since the company is expecting an increase in sales, the creditor should not worry about giving the
loan to Wilson Lumber as long as the covenants are involved.
• The points mentioned above meet the requirements derived from the covenants required by Northrup National Bank.
 Conclusion
• Wilson Lumber has strong and growing sales, an acceptable interest coverage
ratio and a good management with a very low exposure to agency cost.
• In addition, by adding some covenants to the equation all the conditions required to
grant a loan are reunited. For all these reasons we will lend $325,000 to WL.
Appendix 1. Wilson Lumber: Horizontal and Vertical analysis of Income
Statement
Appendix 2. Wilson Lumber: Forecasted Income Statement for 1985
Appendix 3. Wilson Lumber: Solvency Ratios

Appendix 4. Wilson Lumber: Interest Coverage Ratio