full version Friendly Cards, Inc Essay

Friendly Cards, Inc

Category: Business

Autor: radonda_84 04 March 2010

Words: 2785 | Pages: 12

Friendly Cards, Inc.



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 the machine would not cost the firm any additional funds then it had spent on envelopes the year before, and it would start saving them money this year.

I have included the firm’s original income statement and balance sheet without the purchase and then with the machine purchase. I have assumed that the firm would use the $218,000 to reduce the bank loans balance for each year. This reduction of the bank loan balance will lower their three restrictive financial ratios.

Originals:

Income Statement

Actual Data Projected Data
1985 1986 1987 1988 1989 1990
Net Sales $8,055 $12,765 $16,253 $19,500 $23,250 $28,000
Cost of goods sold 5,690 8,785 10,540 12,675 15,112 18,200 65% of proj sales
Gross profit on sales $2,365 $3,980 $5,713 $6,825 $8,138 $9,800 35% of proj sales

Selling, del....expenses 1,015 1,793 2,373 2,828 3,371 4,060 14.5% of proj sales
General and admin expense 547 945 1,125 1,365 1,628 1,960 7% of proj sales
Total Expenses $1,562 $2,738 $3,498 $4,193 $4,999 $6,020

Profit before int & taxes $ 803 $ 1,242 $ 2,215 $ 2,632 $ 3,139 $ 3,780
Interest 495 605 950 1,075 1,188 1,320
Profit before taxes $ 308 $ 637 $ 1,265 $ 1,557 $ 1,951 $ 2,460
Income taxes 113 225 481 592 742 935 38% of proj PBT
Net Income $195 $412 $784 $965 $1,209 $1,525
Number of shares (000) 534 550 580 580 580 580
Earnings per share $0.37 $0.75 $1.35 $1.66 $2.08 $2.63

Balance Sheet

Actual Data Projected Data
1985 1986 1987 1988 1989 1990
Assets
Current Assets
Cash $200 $370 $240 $250 $250 $250
Notes & Accounts receivable 2,920 5,883 7,013 8,385 9,998 12,040 43% proj of sales
Inventory 2,500 3,708 5,588 6,630 7,905 9,520 34% proj of sales
Prepaid expenses 43 117 192 195 232 280 1% proj of sales
Total current assets $5,663 $10,078 $13,033 $15,460 $18,385 $22,090
Net Fixed Assets 903 2,208 2,433 2,925 3,488 4,200 15% proj of sales
Other assets 184 907 892 905 905 905
Total assets $6,750 $13,193 $16,358 $19,290 $22,778 $27,195

Liabilities and Owners' Equity
Current liabilities
Bank Loans $2,323 $4,350 $6,070 $7,586 $9,321 $11,404
Accounts & notes payable 1,503 2,748 3,057 3,705 4,417 5,320 19% proj of sales
Accruals 332 683 1,231 1,462 1,744 2,100 7.5% proj of sales
Current portion, long-term debt 117 350 433 450 450 450
Other 0 187 246 250 250 250
Total current liabilities $4,275 $8,318 $11,037 $13,453 $16,182 $19,524
Long-term debt 787 2,752 2,458 2,008 1,558 1,108
Total liabilities $5,062 $11,070 $13,495 $15,461 $17,740 $20,632

Owners' equity
Common stock 53 55 58 58 58 58
Paid in Capital 740 763 815 815 815 815
Retained earnings 895 1,305 1,990 2,956 4,165 5,690
Total owners' equity $1,688 $2,123 $2,863 $3,829 $5,038 $6,563
Total liabilities and net worth $6,750 $13,193 $16,358 $19,290 $22,778 $27,195

Bank Loans/Recs 0.80 0.74 0.87 0.90 0.93 0.95
Liabilities/equity 3.00 5.21 4.71 4.04 3.52 3.14
Int bearing debt/equity 1.91 3.51 3.13 2.62 2.25 1.98

Balance Sheet that includes machine savings:

Balance Sheet $19,500 $23,250 $28,000

Actual Data Projected Data
1985 1986 1987 1988 1989 1990
Assets
Current Assets
Cash $200 $370 $240 $250 $250 $250
Notes & Accounts receivable 2,920 5,883 7,013 8,385 9,998 12,040 43% proj of sales
Inventory 2,500 3,708 5,588 6,630 7,905 9,520 34% proj of sales
Prepaid expenses 43 117 192 195 232 280 1% proj of sales
Total current assets $5,663 $10,078 $13,033 $15,460 $18,385 $22,090
Net Fixed Assets 903 2,208 2,433 2,925 3,488 4,200 15% proj of sales
Other assets 184 907 892 905 905 905
Total assets $6,750 $13,193 $16,358 $19,290 $22,778 $27,195

Liabilities and Owners' Equity
Current liabilities
Bank Loans $2,323 $4,350 $6,070 $7,368 $9,103 $11,186
Accounts & notes payable 1,503 2,748 3,057 3,705 4,417 5,320 19% proj of sales
Accruals 332 683 1,231 1,462 1,744 2,100 7.5% proj of sales
Current portion, long-term debt 117 350 433 450 450 450
Other 0 187 246 250 250 250
Total current liabilities $4,275 $8,318 $11,037 $13,235 $15,964 $19,306
Long-term debt 787 2,752 2,458 2,008 1,558 1,108
Total liabilities $5,062 $11,070 $13,495 $15,243 $17,522 $20,414

Owners' equity
Common stock 53 55 58 58 58 58
Paid in Capital 740 763 815 815 815 815
Retained earnings 895 1,305 1,990 3,174 4,383 5,908
Total owners' equity $1,688 $2,123 $2,863 $4,047 $5,256 $6,781
Total liabilities and net worth $6,750 $13,193 $16,358 $19,290 $22,778 $27,195

Bank Loans/Receivables 0.80 0.74 0.87 0.88 0.91 0.93
Liabilities/equity 3.00 5.21 4.71 3.77 3.33 3.01
Int bearing debt/equity 1.91 3.51 3.13 2.43 2.11 1.88

All three ratios were reduced for the next three projected years and based on these results; Wendy should recommend to Amy that they buy the envelope machine.


Acquisition of Creative Designs:

Friendly Cards would acquire Creative Designs for 198,000 shares of Friendly’s common stock valued at $9.50 a share. The exchange of shares would be considered a tax free transaction; this meant that both companies’ financial statements could be consolidated by adding them together. This made the CD acquisition more attractive to Friendly Cards because of CD’s strong balance sheet. Their low financial ratios would help lower Friendly’s ratios and possibly provide them with consolidated ratios that would fall under the bank’s restrictions.

I have made the following assumptions for the consolidated statements:
• Friendly Cards bought the envelope machine and is using the saving to retire the bank loan balance
• I used the 1987 CD balance sheet numbers based on flat the flat sales for the 1988
• I added the 1987 CD numbers to the projected Friendly numbers
• Friendly issued the new 198,000 shares of common stock to the principals of CD
• CD’s common stock par value is .01

Balance Sheet

Actual Data Projected Data
1985 1986 1987 1988
Assets
Current Assets
Cash $200 $370 $240 $338
Notes & Accounts receivable 2,920 5,883 7,013 9,985
Inventory 2,500 3,708 5,588 8,130
Prepaid expenses 43 117 192 257
Total current assets $5,663 $10,078 $13,033 $18,710
Net Fixed Assets 903 2,208 2,433 4,175
Other assets 184 907 892 905
Total assets $6,750 $13,193 $16,358 $23,790

Liabilities and Owners' Equity
Current liabilities
Bank Loans $2,323 $4,350 $6,070 $7,668
Accounts & notes payable 1,503 2,748 3,057 4,205
Accruals 332 683 1,231 1,462
Current portion, long-term debt 117 350 433 500
Other 0 187 246 700
Total current liabilities $4,275 $8,318 $11,037 $14,535
Long-term debt 787 2,752 2,458 2,958
Total liabilities $5,062 $11,070 $13,495 $17,493

Owners' equity
Common stock 53 55 58 178
Paid in Capital 740 763 815 2,976
Retained earnings 895 1,305 1,990 3,143
Total owners' equity $1,688 $2,123 $2,863 $6,297
Total liabilities and net worth $6,750 $13,193 $16,358 $23,790

Bank Loans/Receivables 0.80 0.74 0.87 0.77
Liabilities/equity 3.00 5.21 4.71 2.78
Int bearing debt/equity 1.91 3.51 3.13 1.77

Income Statement

Actual Data Projected Data
1985 1986 1987 1988 1989 1990
Net Sales $8,055 $12,765 $16,253 $24,500 $28,550 $33,618
Cost of goods sold 5,690 8,785 10,540 15,596 18,208 21,487
Gross profit on sales $2,365 $3,980 $5,713 $8,904 $10,342 $12,131

Selling, del....expenses 1,015 1,793 2,373 4,223 4,850 5,627
General and admin expense 547 945 1,125 1,365 1,628 1,960
Total Expenses $1,562 $2,738 $3,498 $5,588 $6,478 $7,587

Profit before int & taxes $ 803 $ 1,242 $ 2,215 $ 3,316 $ 3,864 $ 4,544
Interest 495 605 950 1,175 1,188 1,320
Profit before taxes $ 308 $ 637 $ 1,265 $ 2,141 $ 2,676 $ 3,224
Income taxes 113 225 481 814 1,017 1,225
Net Income $195 $412 $784 $1,327 $1,659 $1,999
Number of shares (000) 534 550 580 590 590 590
Earnings per share $0.37 $0.75 $1.35 $2.25 $2.81 $3.39

Friendly’s ratios would all fall under the restricted tolerances for 1988. They should be able to maintain these ratios going forward as they consolidate and streamline both businesses to reduce redundancies in operations. The C/D acquisition would increase their Earnings per share and enable them to achieve their growth rates.





Common stock sale option:

Friendly Cards has the option to sell 200,000 shares of its common stock at $8.00 a share to a group of west coast investors. They would have to pay a finder’s fee of $80,000 to the individual who located the group. The firm would be able to generate $1,520,000, net the finder’s fee to use to reduce their bank loan balance. This option would create more shares as in option two, and Wendy needed to consider the EPS effect of the equity financing. The reduction of the bank loan balance should decrease their debt financial ratios, but once the money was allocated to the debt, it would not be reoccurring and the ratios could end up increasing again if sales growth continued at this rate in the future.

I have made the following assumptions for the common stock sale:
• C/S increased by 20,000, APIC by 1,580,000, and they used the 1,520,000 net to reduce the bank loan balance
• Friendly bought the envelope machine and used the $218,000 to reduce the loan
• Sale @ 8.00 per share for 200,000 shares.


Balance Sheet

Actual Data Projected Data
1985 1986 1987 1988 1989 1990
Assets
Current Assets
Cash $200 $370 $240 $250 $250 $250
Notes & Accounts receivable 2,920 5,883 7,013 8,385 9,998 12,040
Inventory 2,500 3,708 5,588 6,630 7,905 9,520
Prepaid expenses 43 117 192 195 232 280
Total current assets $5,663 $10,078 $13,033 $15,460 $18,385 $22,090
Net Fixed Assets 903 2,208 2,433 2,925 3,488 4,200
Other assets 184 907 892 905 905 905
Total assets $6,750 $13,193 $16,358 $19,290 $22,778 $27,195

Liabilities and Owners' Equity
Current liabilities
Bank Loans $2,323 $4,350 $6,070 $5,848 $7,583 $9,666
Accounts & notes payable 1,503 2,748 3,057 3,705 4,417 5,320
Accruals 332 683 1,231 1,462 1,744 2,100
Current portion, long-term debt 117 350 433 450 450 450
Other 0 187 246 250 250 250
Total current liabilities $4,275 $8,318 $11,037 $11,715 $14,444 $17,786
Long-term debt 787 2,752 2,458 2,008 1,558 1,108
Total liabilities $5,062 $11,070 $13,495 $13,723 $16,002 $18,894

Owners' equity
Common stock 53 55 58 78 78 78
Paid in Capital 740 763 815 2,395 2,395 2,395
Retained earnings 895 1,305 1,990 3,094 4,303 5,828
Total owners' equity $1,688 $2,123 $2,863 $5,567 $6,776 $8,301
Total liabilities and net worth $6,750 $13,193 $16,358 $19,290 $22,778 $27,195

Bank Loans/Receivables 0.80 0.74 0.87 0.70 0.76 0.80
Liabilities/equity 3.00 5.21 4.71 2.47 2.36 2.28
Int bearing debt/equity 1.91 3.51 3.13 1.49 1.42 1.35
Income Statement

Actual Data Projected Data
1985 1986 1987 1988 1989 1990
Net Sales $8,055 $12,765 $16,253 $19,500 $23,250 $28,000
Cost of goods sold 5,690 8,785 10,540 12,675 15,112 18,200
Gross profit on sales $2,365 $3,980 $5,713 $6,825 $8,138 $9,800

Selling, del....expenses 1,015 1,793 2,373 2,828 3,371 4,060
General and admin expense 547 945 1,125 1,365 1,628 1,960
Total Expenses $1,562 $2,738 $3,498 $4,193 $4,999 $6,020

Profit before int & taxes $ 803 $ 1,242 $ 2,215 $ 2,632 $ 3,139 $ 3,780
Interest 495 605 950 884 997 1,129
Profit before taxes $ 308 $ 637 $ 1,265 $ 1,748 $ 2,142 $ 2,651
Income taxes 113 225 481 664 814 1,007
Net Income $195 $412 $784 $ 1,084 $1,328 $1,644
Number of shares (000) 534 550 580 780 780 780
Earnings per share $0.37 $0.75 $1.35 $1.39 $1.70 $2.11

Number of shares (000) 580 580 580
Earnings per share 1.66 2.08 2.63


This option reduces the financial ratios so they meet the restrictions, but I do not think that they would be sustainable. As the firm continues to grow, they would need to increase their borrowing again to finance the growth. The EPS decreases under this option because of the new shares issued. Friendly Cards would be diluting each stockholder’s earnings and valuation per share. I do not think this is a good time to raise equity with the market crash and the discount to market value that they have to sell at.


Recommendation/Conclusion:

Friendly Cards should purchase the envelope machine. It will generate a positive cash flow of $218,000 a year for the next eight years. They can use this money to reduce the bank loan balance and help decrease their debt financial ratios. The purchase of the machine will not require any additional funds in respect to last year’s 1.5 million dollar expense for envelopes and will generate a profit the first year.

The firm should acquire Creative Designs Inc with a stock merger. Creative Design’s strong balance sheet and low debt/equity will decrease the new consolidated Friendly Cards Inc ratios. The new ratios would meet the restrictions applied by the banks and allow Friendly Cards to continue to grow at the current rate. The acquisition should be sustainable based on the pooling of interest accounting of both company’s financial statements. It is expected that Friendly Cards will be able to reduce the cost of goods sold and overall expenses of Creative Design by eliminating duplication. The Creative Designs merger will increase the EPS and should generate a larger net income and additional retained earnings. The common stock sale is not a good option for Friendly Cards to pursue at this time. They have to sell the shares at a discount and pay a finder’s fee on top of the discount. The equity market has just crashed within the year and they have been told it would be hard to raise money through an equity issue currently. While this option would create a sizeable amount of money that they could decrease the bank loan balance with, it is not a reoccurring event. The merger is the better option for long-term growth and success of the company.