Case (1) – Financial Planning Butler Lumber

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. Butler’s high expectation of 33.6% growth.

2. Do you agree with his estimate of the company’s 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

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