Hampton Memo by nuhman10

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									Hampton Machine Tool Company
           Estimating Cash Flows and
  Identifying Remaining Assets at Bankruptcy




                    March 31, 2003




           Prepared by: The Highest Bidders


   Marc Brands, Nobuyasu Sugimoto, Yasuhisa Tsurumi
           Hajime Tamachi, Kunihiro Takahashi
Recommendation

We suggest that Eckwood extend the due date of the existing loan of $1 million as well
as approve on additional loan of $0.35 million to Hampton Machine Tool Company
(hereafter, “Hampton”). Although Hampton will not have sufficient cash flow to
repay the loan in December, the bank will be fully repaid through Hampton’s
liquidation (bankruptcy) since the bank will have the first claim on the liquidated assets.
Our recommendation rely on the assumptions that the bankruptcy cost is less than 56%
of the total capital of Hampton, and that devaluation of the liquidated assets is not
significant.


Statement of the Problems and Possible Actions

Eckwood needed to make two decisions with regard to the loan to Hampton; first,
whether to extends the repayment due date of the existing $1 million loan; second,
whether Eckwood lend the additional $0.35 million. Theoretically, Eckwood has the
following four options:

                             Extension of $1.0M          Addition of $0.35M
                               Loan Due Date                   Loan
                 1)                  -                           -
                 2)                  X                           -
                 3)                  -                           X
                 4)                  X                           X

The situation in this case suggests that 2) and 3) are not realistic as both options will not
allow Hampton to purchase the needed equipment for its operation and will eventually
affect its solvency. Thus, Eckwood needs to investigate which of the remaining options,
1) or 4), is more beneficial to the bank.


Analysis of the Problems

(1) Evaluation of Interest Rate

3-month T-bill rate in 1979 is approximately 10% (see Exhibit 1). The CAPM theory
suggests that the interest rate of the loan (18% annually) is higher than the expected
debt return in the market, provided the risk premium is 8% and the debt beta is less
than 1.0 (also see Exhibit 1). This fact encourages Eckwood to lend more money as long
as it can ensure repayment by Hampton. (The following arguments suggest that it is highly
likely that the loan will be fully repaid even Hampton goes into bankruptcy, and that the loan
transaction has a positive NPV given that the expected debt return is lower than 18%.)




45-907 Venture Capital and Private Equity                                                        1
Hampton Machine Tool Company
(2) Hampton’s Cash Flow Estimation

The table below summarizes the estimated cash flows of Hampton. (See Exhibit 2 to 4
for more details.)

                                                                                         ($ in thousands)
                                            Actual                           Forecast
                                  Jun        Jul     Aug        Sep        Oct        Nov        Dec
Net change in cash                      -      526    (119)       (268)      263        (358)      (373)
Beginning balance of cash               -    1,152   1,678       1,559     1,291      1,554       1,196
Ending balance of cash             1,152     1,678   1,559       1,291     1,554      1,196         823
                                                              Repayment of the Loan               1,350
                                                              Shortage of the Cash                 (527)


Despite Cowins’ statement in the letter, Hampton will not be able to repay the loan,
being by $0.527 million short at the end of year. Moreover, the actual sales are likely
to be less than forecasted according to the historical data, which suggests even more
strongly the insolvency of the company.

(3) Impact of Bankruptcy

Even if Hampton is insolvent, Eckwood will be able to secure the repayment through the
company‟s liquidation (bankruptcy). The key issues in this case are:

             St. Louis National Bank is the only debt holder of Hampton. Thus, the bank
              will have the first priority of the claim on the company‟s liquidated assets.
             Hampton will have assets (to be converted to cash) to fully repay the loan at
              the end of the year, given the bankruptcy cost is less than $1.71 million (or
              56% of total capital). (See Exhibit 5.)
             However, our analysis does not consider the possible devaluation of the
              company’s assets at the bankruptcy.


Conclusion and Additional Issues

The loan will be repaid at least through the company‟s liquidation, given the bankruptcy
cost does not exceed $1.71million (or 56% of total capital). Since it is highly likely that
the loan will be fully recovered (through bankruptcy) and the interest rate is higher than
the expected debt return (i.e. discount rate of expected cash flows), we recommend that
Eckwood extend the due date of the existing $1 million loan as well as lend the
additional $0.35 million loan.

We also recommend that he further investigate the company‟s liquidated value to
determine if there could be significant devaluation of assets. In addition, he should
convince Hampton not to pay dividends of $0.15 million in December.


45-907 Venture Capital and Private Equity                                                               2
Hampton Machine Tool Company
Exhibit 1: Evaluation of Interest Rate

 3-Month T-Bill Rates in 1979

According to the Economic Research of Federal Reserve Bank of St. Lois
(http://research.stlouisfed.org/fred/data/irates.html), the 3-month T-bill rate in
September, 1979 was 10.18%.

 Expected Debt Return by CAPM Theory

         rD  r f   D (rm  r f )
                10%  (0 ~ 1)  8%
                18%

          Notation                             Data Used in this Analysis
          rD         Expected return of debt
          rf         Risk-free rate:           Yield of 3-month t-bill rate. The duration
                                               is in line with that of the additional loan of
                                               $0.35M.
           D        Beta of holding debt:     In general, this is assumed to be less than
                                               one or zero.
          rm -rf     Risk premium:             In this case, this is assumed to be 8%.




45-907 Venture Capital and Private Equity                                                       3
Hampton Machine Tool Company
Exhibit 2: Estimated Balance Sheet

                                            Actual                         Forecast
                                  Jun        Jul      Aug       Sep      Oct      Nov      Dec
Cash                                1152       1678     1559     1,291   1,554     1,196      823
Account Receivable                  1893       1269      684     1,500     956     1,781    2,442
Net inventory                       3276       3624     4764     3,339   3,234     3,129    3,024
Current assets                      6321       6571     7007     6,130   5,744     6,106    6,289
Gross fixed assets                  4010       4010     4010     4,010   4,360     4,360    4,360
Accumulated depreciation            3070       3080     3090     3,100   3,114     3,127    3,141
Net fixed assets                     940        930      920       910   1,246     1,233    1,219
Prepaid expenses                      24         24       42        42       42       42       42
Total assets                        7285       7525     7969      7082    7032      7381     7550

Note payable, bank                 1000       1000      1000    1,000    1,350    1,350    1,350
Accounts payable                    399        621       948      600      600      600      600
Accruals                            678        585       552      552      552      552      552
Tax payable                         354        407       479      530      651      818      878
Customer advance payments          1566       1566      1566      726      -        -        -
Current liabilities                3997       4179      4545    3,408    3,153    3,320    3,380

Common Stock ($10 par value)        428        428       428      428      428      428      428
Surplus                            2860       2918      2996    3,247    3,451    3,632    3,743
Net worth                          3288     3345.72   3423.72   3,675    3,879    4,060    4,171

Total liabilities and net worth    7285     7524.72   7968.72   7,082    7,032    7,381    7,550


Notes:

 Inventory: Gradually decrease each month by 105 (=420/4 month) to offset the
  excessive raw material.
 Fixed assets: the company buys new equipment at the beginning of October and this
  asset will depreciate over 8 year with strait line. The amount of other fixed assets will
  not change over the period.
 Prepaid expenses: This stay the same level over the same period.
 Note payable, bank: The company will borrow $1,350,000 and payback $1,000,000 in
  October.
 Account payable: The company buy raw material by $600,000 on account.
 Accruals: It will stay the same over the same period.
 Tax payable: The company will pay tax of $181,000 in Sep and Dec, and can benefit
  the tax reduction by $35,000 due to the 10% ITC.
 Customer advance payment: No advance payment remains after offsetting this
  account from General Air.




45-907 Venture Capital and Private Equity                                                       4
Hampton Machine Tool Company
Exhibit 3: Estimated Income Statement

                                            Actual                       Forecast
                                 Jun         Jul      Aug     Sep      Oct      Nov      Dec
Net sales                          1620         723     507    2,163   1,505     1,604    2,265
Cost of sales (+depri)             1197         510     276
Gross profit                        423         213     231

Selling and administrative exp       130         87      66
EBIT                                 293        126     165   497.49   346.15   368.92   520.95
 (% per sales)                      18%        17%     33%      23%      23%      23%      23%
Interest expense                      15         15      15       15    20.25    20.25    20.25

Net income before taxes              278       111      150      482     326       349      501
Income taxes                         133        53       72      232     121       167      240
Net Income                           145        58       78      251     204       181      260
Dividends                            100                                                    150


Notes:

 Net sales: It is from the company‟s estimation on Sep.1979
 EBIT: It is to be set at 23% of sales as the case tells.
 Income taxes: 48%. On October, this account will be reduced by $35,000 due to the
  10% ITC reduction.
 Dividends: It is supposed to be paid at the end of December.




45-907 Venture Capital and Private Equity                                                     5
Hampton Machine Tool Company
Exhibit 4: Estimated Cash Flow Statement

                                            Actual                             Forecast
                                 Jun         Jul         Aug       Sep       Oct      Nov       Dec
Operating Activities
Net income                        278            58          78       251      204      181       260
 Depreciation                      10            10          10       10       14       14        14
- increase in working capital   -1494           846         912     -1164      544     -825      -661
- increase in inventory                        -348       -1140      1425      105      105       105
+ decrease in accrual                           -93         -33         0        0        0         0
-Decrease in cash advance payment                 0           0      -840     -726        0         0
tax payment                                      53          72        51      121      167        59
-increase in prepaid expense                      0         -18         0        0        0         0
Cash flow from operation                        526        -119      -268      263     -358      -223

Investing Activities
Cash flow from investing                             0         0         0    -350          0         0

Financing Activities
Borrowing money                                      0         0         0     350          0       0
Paying Dividends                                     0         0         0       0          0    -150
Cash flow from financing                             0         0         0     350          0    -150

Net change in cash                              526       -119      -268       263     -358      -373
Beginning balance of cash                      1152       1678      1559      1291     1554      1196
Ending balance of cash                         1678       1559      1291      1554     1196       823




45-907 Venture Capital and Private Equity                                                             6
Hampton Machine Tool Company
Exhibit 5: Impact of Bankruptcy



                                              B/S @ FMV
                 Cash Flow               Cash
                 Estimation          $.82M ~ .97M
                                                          Debt
                                     Other Assets
                                                         $1.35M
                                       (Valued and
                                    Converted to Cash)


                                     Other Assets        Equity
               Maximum                                            FMV of Stocks
               B.R. Cost               (Valued and                (@$40) + R/E
                                    Converted to Cash)   $1.71M



Cash Balance:

 The ending balance of cash was calculated for both optimistic and pessimistic cases:
 In the optimistic case, the sales forecast suggested by the company were used. The
  resulting cash balance was $0.823 million.
 In the pessimistic case, we discounted the sales forecast by 27% based on the historical
  data (= 1 - $8,688 / $11,919). The resulting cash balance was $967 million. (The cash
  flow increased due to the treatment in the working capital.)

Value of Other Assets:

 Book values are used.

Fair market value of equity:

 Hampton repurchased 75,000 shares of Hampton‟s $10 par value stock at an aggregate
  cost of $3 million in 1978. The per share repurchase price is $40 (= $3 million / 75,000).
 The remaining number of outstanding shares is 42,800.
 Thus, the fair market value of equity is $1.712 million (= $40 * 42,800), provided $40 is
  the fair market per share price.

Maximum bankruptcy cost:

 Maximum bankruptcy cost is total capital minus equity value. This was calculated to
  be approximately 56% of the total capital (market value of debt and equity).
 According to the lecture of „Corporate Finance‟, the average bankruptcy cost is 10%
  to 20% of the company’s total capital (with high variance).




45-907 Venture Capital and Private Equity                                                 7
Hampton Machine Tool Company

								
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