CASE (1) Financial Planning Butler Lumber

1. Why does Mr. Butler have to borrow so much money to support this profitable business?
After rapid growth from recent years, Butler Lumber Company (BLC) expects a future
increase in sales and therefore considers raising its sales estimate for 1991. As the company faces
a shortage of cash for future operations Mr. Butler is considering external financing to support
his burgeoning business. In addition to this, he was forced to take out a long term loan of
$70,000 in order to buy Mr. Stark's shares in the business in late 1988.

The business is expected to grow rapidly in the near future and Mr. Butler needs to have
the cash flow necessary to handle the costs associated with the expected rise in sales. Although
the BLC business is indeed profitable with positive returns, the net yearly income is very small
in comparison to the sales and inventory costs, with only between 1 and 2% of revenue coming
through as net profit for the past years. In order to grow sales and profit, and growing sales is
much more costly than the one year return. BLC definitely requires funding from the outside
banks due to the small net income compared to the large value of inventory and assets and also
meet Mr. Butlers high expectation of 33.6% growth.
2. Do you agree with his estimate of the companys loan requirements? How much will he
need to borrow to finance his expected expansion in sales (assume a 1991 sales volume of $3.6
million)?
With the assumption of a $3.6M sales revenue in 1991 and net income is entirely retained
(no dividend payout), the calculations for EFN is estimated using both Pro Forma and
Sustainable Growth Rate:
Pro Forma Method with following assumptions:
1.

Assume net income for 1991 is calculated as 1990 net income multiplied by 33.6%, $44 x 1.336 = $58.8

2.

Assume 1991 liability maintains the same level as Q1/1991, $737K

1990

1991 (Projected @ 33.6% growth)

Net Income

44

58.8

Assets

933

1246.5

Liabilities

585

737

Equity

348

406.8

EFN based on Proforma: 1246.5 - 737 - 406.8 = $102.7K

We also tried the SGR method but not able to reach any conclusion regarding the EFN
amount.
Sustainable Growth Rate Method:
g = (ROE x b) / (1 - ROE x b)
Rearranging the equation and assume b = 1 (all net income kept in company and no
dividend payout), we get
ROE = g / (1 +g)
and we plug in g=33.6% to get ROE = 0.25145
ROE = Net Income / Equity where ROE = 0.25145 and Equity is 406.8, solving for net
income we get
Net Income = 102.3
This implies in order to reach 33.6% growth, the net income in 1991 should be 102.3. In
1991 net income from pro forma analysis is 58.8 which means Mr. Butler needs additional
funding to reach 102.3.
3. As the banker, would you approve Mr. Butlers loan request, and, if so, what conditions
would you put on the loan?
As a banker, we believe that Mr. Butler does possess a set of positive
financial/characteristic criteria and thus we would approve Mr. Butlers load request but based
on a set of contingency conditions as shown below.
Reason for approval:
1.

Collateral: Company owned land in the Pacific Northwest is considered valuable. The land with an access to a railroad siding is an
unique feature which adds to the value of the land. In addition, Mr. Butler also holds join equity in his home which is valued at
$72,000 in whole back in 1979. Depending on the housing market in the area, this price may be subjected to fluctuation.

2.

Ability to navigate market downturn:

1.

Even in the expected market downturn, BLC is expected to experience little impact since its service offering has a high proportion of
revenue coming from the repair business. Therefore, with the downturn leading to less housing erection projects, BLC is able to
navigate the downturn and with a hand in the repair segment of the business it would be easier for BLC to realign its company
target to focus more on repair side if the market requires.

2.

BLC does have a relatively low labor resource operation and a conservative business operation. With a low operating expense
which keeps the company very nimble in market downturn scenarios.

1.

Business Ethics: It is a consensus gathered from the client and banks with past dealing with BLC of its exceptional business ethics
and good track record.

2.

Cost Reduction: With the approval of the loan, BLC could immediate enjoy cost reduction to its purchase of raw material through
the terms of payment. Roughly, a 2% reduction would be foreseen with the cash flow available through the loan.

Contingency Conditions to Be Met:

1.

Reduction in loan amount: Based on our calculation based on the available input, we believe that BLCs requested loan value far
exceed the amount that we believe is necessary, please our answer to question #2. With that in mind, we believe that the
requested loan value should be re-evaluated and reduced.

2.

Exclusive Relationship: To secure exclusive relationship with BLC for all future banking arrangements.

3.

Collateral Request: Based on the financial information of BLC we witness a trend in which its account payable and account
receivable has been steadily increasing. With the increase in sales revenue we suppose that on the account receivable side this
could mean that BLC may be having difficulty collecting the money or that to remain competitive in the market BLC may be offering
more relaxed payment terms to its clients. In any case, the increase in these amount plus the fact that BLCs margin is consistently
less than 2%, we feel that combining these two facts that this is a relatively risky transaction and that sufficient collateral should be
demanded by the banker.

ales growth needs to be supported by increasing working capital and PP&E. Given no
substantial decrease in cash conversion cycle and improvements in operating efficiency,
retained earning is not sufficient to meet assets demands imposed by sales growth, and in this
case, borrowing from banks acts as the sole source of external financing, since equity financing
for private firms requires cash injection from owners, while Mr. Bulter has already been short of
money after interest purchase from Mr. Stark. Access to extended LOC (Line of Credit) also
enables Mr. Bulter to expand business in prospect of massive revenue inflow in second and third
quarters. Furthermore, cash ratio keeps decreasing (as exhibited in appendix A) and more
external financing other than retained earning is imperative to maintain sufficient cash position.
Besides, additional cash from new loan can be used to repay trade payable and thus take
advantage of purchase discount provided by suppliers; the cash can also be utilized to
consolidate long-term debt with a lower rate.
1.

Do you agree with his estimate of the companys loan requirements? How much will he need to borrow to finance his expected
expansion in sales (assume a 1991 sales volume of $3.6 million)?

Given sales volume of $3.6m and unchanged operating efficiency, pro forma statements
can be attained by percentage-of-sales approach (as shown in appendix B). Note payable is
regarded as the plug to support balance sheet increase abreast with sales growth, and the EFN
(external financing needed) is $164,000 which is solely funded by borrowing from bank. As a

result, the $465,000 credit line is excessive and $397,000 is a more reasonable estimate.
However, $397,000 is just the plug number which exactly makes clean surplus equation hold,
and as shown in cash flow statement, the cash position is actually declining given this amount,
so LOC above this amount is preferable and acceptable.
3. As Mr. Butlers financial advisor, would you urge him to go ahead with, or to reconsider,
his anticipated expansion and his plans for additional debt financing? As the banker, would you
approve Mr. Butlers loan request, and, if so, what conditions would you put on the loan?
As Mr. Bulters financial advisor, I would recommend him to adopt his plans for business
expansion and additional debt financing. The revenue has achieved astonishing growth rate at
18.6% in 1989 and 33.8% in 1990, and is estimated to attain 33.6% growth speed given $3.6m
sales volume in 1991, so additional working capital is imperative to support such expansion.
Moreover, I would suggest him to take the upper limit of LOC, namely $465,000, since 55% of
revenue is generated in second and third quarters. Additional credit line also enables BLC to
repay trade credit and thus benefit from purchase discount so as to increase working capital.
The cash in hand would decrease given $397,000 revolving loan (see in appendix B), resulting in
limited financial flexibility and liquidity. As a result, $465,000 loan amount is recommended.
As a banker, I would be conservative regarding this loan request and grant less amount
than $465,000 ceiling. Firstly, given revenue of first quarter accounts for 22.5% of yearly
revenue, $3.2m is a more reasonable estimate for 1991 turnover compared with aggressive
$3.6m forecast. Additionally, there is a downtrend in A/P turnover due to increasing purchase
with few discount, and current ratio also decreases throughout 3 years (shown in appendix A).
Another alarming fact is downward quick ratio which is below one, suggesting insufficient
liquidity caused by cash shortage (see appendix A). The debt ratio is also mounting, along with
declining EBIT/Int. ratio, a fact that raises more concern. So should the loan be granted, some
financial requirements must be imposed. Given cyclical characteristic of lumber industry,
current ratio should be no less than industry average. Quick ratio should also be elevated to
close one in order to avoid liquidity dry-up under economic recession. Debt ratio should also be
controlled within safety margin, since DuPont analysis indicates that ROE increase mainly
attributes to amplified leverage (shown in appendix C). Furthermore, personal wealth such as
property and insurance can also be applied as collateral if permitted.
4. Has Butler Lumber Company created value for shareholders?
The value creation depends on the cost of equity and consequent WACC. As exhibited in
appendix A, the ROA has increased from 7.41% in 1988 to 8.25% in 1990 and is expected to
reach 8.28%, but the WACC is not available due to lack of information regarding cost of equity.
If WACC is less than ROA, the NPV of whole company is positive and the positive conclusion can
be drawn. Similarly, though ROIC also increases from 10.17% to 11.23%, the EVA is still not
conclusive due to absence of information concerning cost of equity. In theory, beta adjustment is
applied to calculate cost of equity of private firms, but relevant data is not attainable since the
time period is too far. Should the WACC be less than ROIC, EVA would be positive and thus

Bulter Lumber could create value for shareholders; otherwise, Bulter Lumber didnt create value
for shareholders despite positive net income.

Appendix A: Financial Ratios

Financial Ratios

1988

1989

1990

Gross Margin

27.99%

28.61%

27.62%

Operating Margin

2.95%

3.03%

3.19%

Net Profit Margin

1.83%

1.69%

1.63%

ROA

7.41%

7.34%

8.25%

ROIC

10.17%

10.20%

11.23%

Current Ratio

1.80

1.59

1.45

Quick Ratio

0.88

0.72

0.67

Cash Ratio

0.22

0.13

0.08

EBIT/Interest

3.85

3.05

2.61

A/P turnover

10.31

7.94

7.98

A/P days

34.93

45.35

45.13

Profitability

Liquidity

Activity