DHR Patio Homes, LLC: "for the sake of a nail, the kingdom was lost!" (1).

Sherman, Herbert ; Rowley, Daniel J.

CASE DESCRIPTION

This is a field-based disguised case which describes the attempts of a small residential construction company to close on a large land deal, a deal that would net them over four million dollars in 12-16 months. The problem for the characters in question is how to raise the $2.5 million dollars needed to purchase the property. Every time the protagonists believed they have resolved the situation, another problem with the loan is introduced. Several factors complicate the transaction: the lending institution changed the loan down payment from 10% to 20%, the protagonists had transactional difficulties in terms of physically acquiring their down payment, and one of the lenders at the last minute insisted on a $50,000 set aside to be placed in an escrow account. The case has a difficulty level appropriate for a sophomore or junior level course. The case is designed to be taught in one to two class periods (may vary from fifty to one hundred minutes depending upon instructional approach employed, see instructor's note) and is expected to require between four to eight hours of outside preparation by students (again, depending upon instructor's choice of class preparation method).

CASE SYNOPSIS

Derived from observation and field interviews, the case describes how two college professors operating a home construction LLC are trying to close on a major land deal ($2.5 million dollars) that would net them over $4 million dollars in estimated profits in a 12-16 month time period. These professors have no experience in raising funds but luckily have the assistance of Justin Martin, the President of the Snowy Mountains, the firm that they will be purchasing their subdivision from (Mountain Trails). Through Justin Martin's connections Stephen Hodgetts and Richard Davis meet with Benefit Bank and arrange for the loan. Davis was under the impression that the bank required a 10% down payment ($250,000) which Davis and Hodgetts finally raise by borrowing on their retirement accounts and liquidating Hodgetts' stock holdings. However, the bank actually required a 20% down payment since Davis and Hodgetts were new customers. Justin Martin promised to lend Davis and Hodgetts this amount ($250,000) as a same day loan to be paid back by them from the proceedings of their closing on Justin Martin's mother-in-law's house. At the last minute, however, Justin Martin insisted that Davis and Hodgetts deposit $50,000 in an escrow account; $50,000 that Davis and Hodgetts did not have access to for at least a few days after the closing date. The case ends with Davis wondering how he is going to raise $50,000 in one day.

INSTRUCTORS' NOTES

Overview

The case subtitle, "for the sake of a nail the kingdom was lost" perhaps best summarizes Davis and Hodgetts' situation in that they are on the cusp of a deal that would propel this small, startup home builder into a full-fledged operation. The estimated profits from this project would be quite substantial and could be used in funding future ventures with the same developer. Furthermore, the timing of this project could not have been better for Davis and Hodgetts since their current development was having legal problems (there were large third party liens on their properties because the land developer did not pay his landscapers). They could not close on their currently constructed homes and it therefore made no sense to build new homes on these properties.

However this "deal of the century" is not an easy one to make given the purchase price of the subdivision ($ 2.5 million) and Davis and Hodgetts' inexperience in raising venture capital. An interesting twist in the case is that Davis and Hodgetts seemed to have found themselves a benefactor and a possible mentor in Justin Martin, the President of Snowy Mountains. Justin first connects them with a lender and then offers Davis and Hodgetts a one day loan using his own money. Ironically, each deal that Justin brokers (the Benefit Bank loan and his own personal loan) seems to have a hidden catch or caveat (including his own) creating last minute problems for Davis and Hodgetts. The case seems to be a comedy (or tragedy) of errors in that every time Davis and Hodgetts think that they have solved one problem related to the purchase of the Mountain Trails subdivision, another unexpected problem rears its ugly head and threatens to ruin the land deal.

Intended Instructional Audience & Placement in Course Instruction

This case was primarily developed for undergraduates taking a course in Small Business Management and/or Entrepreneurship (SBME) although it could also be employed in any course that deals with the raising of venture capital (i.e. Corporate Finance, Venture Capital Investing) and investing in real estate (Real Estate Management). The case should be introduced after students in the SBME class have read the chapters on how to obtain financing for your business, profit planning, and business growth and the entrepreneur (Chapters 6, 13 in Megginson, Byrd, and Megginson, 2003; Chapters 6, 10 in Lambing and Kuehl, 2003) while Corporate Finance students should be familiar with the topics of sources of capital, cost of debt, and income statements (Chapters 4, 9, 13 in Gallagher and Andrew, 2003; Chapters 2, 9, 12, 14 in Keown, Martin, Petty, and Scott, Jr., 2005). Since the case covers numerous chapters in each text, it is recommended that the case be employed as a sectional or comprehensive case rather than an end-of-chapter case.

Secondarily, the case could also be employed in a Business Policy and Strategy course under the topic of strategy implementation; business tactics at the functional level. These students should therefore be exposed to functional tactics with a focus on business financing (Chapter 9 in Pearce and Robinson, 2005; Chapter 6 in Harrison and St. John, 2004).

Learning Objectives

The overall purpose of this case is to introduce students to the nuances associated with managing a small business in the home construction market, specifically the difficulties associated with raising capital for land acquisition. Furthermore, an additional goal is for students to be able analyze DHR's projected profits from the land deal (based upon construction costs and the cost of capital) and determine the general viability (and therefore the value to DHR) of the land acquisition.

Students obtain a "real-world" feel of the situation and tacitly experience some of the frustration associated with trying to close a business deal when one is highly dependent upon other parties' actions. Specific learning objectives are as follows:

1. For students to obtain a basic understanding of the real estate development and residential construction industries.

2. For students to understand and appreciate the difficulties in raising investment capital.

3. For students to determine the profitability of the residential construction project taking into account the cost of capital, taxes, land acquisition costs, and construction costs.

4. For students to understand the importance of cash flow in this type of business and determine what Davis and Hodgetts' cash flow needs might be if they were close on this land deal.

5. For students to develop recommendations on how Davis and Hodgetts should proceed in closing this land deal.

TEACHING STRATEGIES

Preparing the Student Prior to Case Analysis

There are several approaches, none of which are mutually exclusive, that an instructor may employ in terms of utilizing this case. It is strongly recommended that, regardless of which course this case is to be employed with, students should have some exposure to the home construction business and residential land development. The Urban Land Institute provides an excellent handbook on real estate development (Peiser and Frej, 2003) while Gerstel's (2002) builder's guide provides a good overview to the home construction business. Both texts have short introductions to the topics that could be copied and distributed to the class as background material. A one page handout is provided at the end of this teaching note with short descriptions of each industry--see Appendix 1.

Secondly, it is also recommended that students have some grounding in some basic financial analysis techniques including break even analysis, internal rate of return, and net present value. This will be useful in analyzing the profitability of DHR's proposed project. This information may be delivered prior to assigning the case by using at least one (1) of the follow methods:

* a short lecture, student presentation, discussion session, and/or reading assignments on aforementioned topics.

* a guest lecturer from a local builder and/or land developer on project development.

* a guest lecturer familiar with raising venture capital (i.e. a representative from the SBA,

* a local lending institution, a venture capitalist, etc ... )

Case Method

Although most of the students in a small business management or introductory finance course may have had some exposure to the case method, it behooves the instructor to provide the students with a review to the case method of analysis. In the traditional case method, the student assumes the role of a manager or consultant and therein takes a generalist approach to analyzing and solving the problems of an organization. This approach requires students to utilize all of their prior learning in other subject areas although the focus should be on the current course content. It is strongly suggested that students prepare for the case prior to class discussion, using the following recommendations:

* allow adequate time in preparing the case

* read the case at least twice

* focus on the key issues

* adopt the appropriate time frame

* draw on all your knowledge of business. (Pearce and Robinson, 2005)

The instructor's role in case analysis is one of a facilitator. The instructor helps to keep the class focused on the key issues; creates a classroom environment that encourages classroom discussion and creativity; bridges "theory to practice" by referring back to key concepts learned in this or prior courses; and challenges students' analyses in order to stimulate further learning and discussion. There are several variations of the aforementioned approach including: written assignments, oral presentations, team assignments, structured case competitions, and supplemental field work. (Nicastro and Jones, 1994)

Regardless of the variation employed, it is recommended that the students' work be evaluated and graded as partial fulfillment of the course's requirements. However, if this case is not employed as a comprehensive case, it is not recommended that this case (and its related assignments) have a large weight or impact on students' overall course standing.

Using Case Questions

Whether or not the instructor assigns questions for students to analyze with the case is usually a matter of educational philosophy and student readiness. Naumes and Naumes (1999), for example, thought that if the questions were handed out with the case "students will tend to focus only on the issues specifically raised by the questions ... " (p.86). Lynn (1999), on the other hand, noted that the use of assignment questions provided students with more concrete guidance in case preparation and analysis; specifically directing them to consider the decision to be reached.

In deciding whether or not to assign questions, the instructor should first answer the following questions:

1. What is the level of course instruction?

2. What type of case is being taught? (Iceberg, incident, illustrative, head, dialogue, application, data, issue, or prediction--see Lundberg et. al., 2001 for full descriptions.)

3. What is the instructor's preliminary assessment of the students' ability to be self-directed learners?

4. What are the students' previous experience with case instruction?

5. If the students have already been exposed to the case method, what types of cases have they been exposed to? Case incidents (1-2 page cases with questions)? Short cases (3-8 page cases with and/or without case questions? Comprehensive cases (greater than 8-15 pages) Harvard-style cases (greater than 15 pages)? (David, 2003)

6. What is the instructors preferred method for case instruction? (For example, "sage on the stage", "guide on the side", "student as teacher" (student-lead discussions), "observer and final commentator" (open class discussion with faculty summation), etc....

Role-Playing (50 minutes)

Role-playing enacts a case and allows the students to explore the human, social, and political dynamics of a case situation. This case lends itself quite well to a role playing exercise since it involves a rather simple situation with only two characters and therefore most of the class can role play in this exercise.

Prior to role-playing the case part, students should be asked to not only read the case part but to answer the following questions:

1. Who are the key participants in the case? Why?

2. What is the "role" of each of these participants in the organization?

3. What is their motivation or rationale for their behavior?

4. What is the dilemma that the character is facing and/or how can the character assist someone else in solving a problem?

The instructor may either go through these questions prior to case enactment or wait for the role playing exercise to be completed in order to use this material to debrief the class.

Step 1: Assignment of Roles & Instructions (10 minutes). The class should form groups of three students with two of the students enacting the key roles in the case and the other acting as observer. The instructor should pass out a short reminder notice about participants staying within their roles.

Step2: Enactment (20 minutes). The student enacting the role of Davis should be instructed to start the conversation, summarizing the situation for Hodgetts. The instructions to the students playing Davis is that really wants this deal to go through and will do anything within reason to make it happen. The instructions to the students playing Hodgetts is that although his is for pursuing this deal, he is not at all happy that he has had to liquidate his stock holdings and the he has become suspicious of Justin Martin's behavior. The instructor should note how well each groups enacts the role-play and offer suggestions (if necessary) if some groups seem a bit confused or lost.

Step 3: Debriefing (20 minutes). The instructor might want to ask the following questions:

* What was the results of the exercise? Did Davis and Hodgetts solve their problem?

* How many groups ended up needing to with Justin Martin? If so, why?

* How many groups decided they needed to contact a lawyer, an accountant, or an alternative funding source?

* Did Davis and Hodgetts agree or disagree as to whether they should finally go through with the land deal? If the disagreed, what were the reasons?

* If Davis and Hodgetts did disagree, and Hodgetts backed out of the deal, did Davis try to make the deal happen anyway?

The instructor should then have the class as a whole comment on the results of the role play and determine with the class their overall sentiment towards DHR's last minute problem. Students should also be given the opportunity to comment on the role-playing exercise as a learning instrument. The instructor might ask the class the following questions:

* Did this exercise animate the case? Did students get a "feel" for the issues surrounding the business offer?

* What were the strengths and weaknesses of the exercise? What changes would they make to the exercise given their experiences with it?

The debriefing session should produce closure for students by connecting the theory of capital formation and raising venture capital with case specifics and the results of the role-playing exercise.

Suggested Case Questions

1. Before Davis and Hodgetts received Justin Martin's assistance in raising capital, they assigned themselves the task of researching methods of raising capital. Describe some of the methods that Davis and Hodgetts could use to raise the $2.5 million dollars needed to purchase Mountain Trails.

This question requires that students do some reading and research, even beyond the handout supplied in the teaching note (Appendix 2). The below average student in answering this question will provide a laundry list of methods of raising capital without differentiating between equity and debt financing. This student will also list alternatives that are not available to Davis and Hodgetts given their corporate structure (LLC) such as going public and issuing common and preferred stock, or selling corporate bonds.

The average student will discuss the typical methods that small business use to raise funds (self, family, friends, angel and venture capitalists, bank loans, and SBA guaranteed loans) in general terms and perhaps reference Hodgetts' ability to loan the firm $250,000.

The above average student will note that far more information is needed about the personal and business financial situation of both Davis and Hodgetts in order to determine what assets of theirs may be available for leveraging. They may suggest that it may be possible for Davis's and Hodgetts' two other firms to borrow these funds (presumably from their own commercial bank) or open a line of credit without looking for other funding sources. These students also may suggest taking on a business partner who has the capital.

The exceptional student will try to raise the funds creatively or look at rarely used methods. For example, "a new and emerging kind of equity financing is the Small Company Offering Registration ... [this] lets a company raise up to $1 million by selling common stock directly to the public." (Megginson, Byrd, and Megginson, 2003, p. 147.) In terms of debt equity, this student might suggest locating small business investment companies (SBICs), firms regulated by the SBA to make venture investments in small firms. Furthermore , this student would note what investors and lenders would look for before, see TN Table 1 below.

Lastly, this student might also recommend that Davis and Hodgetts seek a new partner with capital. (1)

2. Estimate the total average net profitability for the Mountain Trails project using the data from Table 2, Estimated Profits from Mountain Trails Subdivision.

The purpose of this question is to ascertain whether students can a) estimate what the average profit would be per unit in the development; b) whether students understand that net profit requires that taxes and interest payments be deducted from the gross profit amount denoted in Table 2; and c) that students can calculate the interest associated with a 12-16 month loan and understand the need to make certain assumptions about the loan payment schedule.

The below average student might either conclude that the minimum profit is the average profit or may need some personal guidance in order to start analyzing this question. The average student should be able to calculate the average total profit of the project by first averaging the profit from each of the units (See TN Table 2 below) and then adding on the additional profit for lakeside units.

This is a very basic methodology and excludes interest expenses as well as taxes.

The above average student will realize that interest expenses have not been deducted from the gross profit margin as calculated above. In terms of calculating interest expenses, the student may overlook the one day loan of $200,000 ($250,000 loan-$50,000 collateral; 6%/365 days x $200,000 = $32.86) while realizing that they do not have an exact repayment schedule in terms of either monthly amount or in terms of number of months (estimated between 12-16 months). However, they do know the following: interest rate (6%), amount borrowed ($2.5 million), amount of down payment ($500,000), and the minimum payment is interest only. The student may therefore decide on one of many loan repayment schedules based upon his or her assumptions about Davis's and Hodgetts' cash flow needs and estimated completion time of the project. For demonstration purposes, we have assumed a straight line 12 month repayment schedule. See TN Table 3.

Given the total interest charges of $65,594.31, the estimated average profit after interest would be $4,649,772.70 ($4,715,367 - $65,594.31).

The well above average student will also note that there may be tax liabilities associated with the profits derived from the project. Calculating the tax liability on $4,649,772.70 also requires that the student make several assumptions and also understand tax liabilities for LLC's. First, the student should recognize that the tax liability of the firm is not a function of the project but is a function of total revenues minus total costs during the firm's tax year. There is no financial data (income statements or balance sheets) in the case that will assist students in determining the firm's overall profits and losses and therefore students may make some assumptions in order to proceed.

Second, some students may assume that since Justin Martin has talked about future projects with Davis and Hodgetts, that DHR would reinvest all of its profits into land purchases and therefore avoided any tax liabilities. Given the difficulties that DHR has had obtaining a $2.5 million dollar loan in order to get this first project off the ground, using internal assets for future purchases is a highly likely strategy.

Third, some students who have researched the tax laws may find that the Jobs and Growth Reconciliation Act of 2003 changed the provisions concerning bonus depreciation (depreciation you can take against brand new business property) allowing for a 50% depreciation of property if purchased between May 5, 2003 and before January 1, 2005. (Mancuso, 2004) This would allow DHR to immediately depreciate $1.25 million dollars as expenses and reduce their overall profitability and therein their tax liability.

Most importantly, the exceptional student will realize that for all LLC's, profits and losses pass through the corporation to the personal tax returns of the owners, with the profits and losses allocated by percentage ownership. Since the question asked for average corporate profits from the project, not for the owners, tax liabilities are not an issue. These students may note, however, that if there were profits, these profits would become tax liabilities for Davis and Hodgetts. Therefore Davis and Hodgetts would have to weigh these tax liabilities against the tax liabilities associated with becoming a C corporation. This analysis would have to then compare the personal tax rates of Hodgetts and Davis against the corporate tax rate of 15% (Mancuso, 2004) plus any addition tax liability associated with declared dividends, the cost of converting to a C corporation, as well as the additional administrative expenses associated with maintaining the records of a C corporation. (2)

Looking at Table 3, these students may also question Davis and Hodgetts's ability to repay the loan beyond interest only payments given their cash flow needs, at least for the first three months of operation. Specifically, these students might challenge Davis and Hodgetts' ability to pay $ 172,132.86 per month for the first three months since they would only be drawing slightly more than enough money from their clients' Single-Close Construction-To-Permanent Loan to pay for the land purchases plus their construction expenses. The next question will deal with cash flow needs for the business.

3. Assume that DHR can obtain the additional $50,000 and make the deal for Snowy Mountains. Also assume the project will take 12 months. Describe DHR's monthly cash flow needs for this project in light of Davis and Hodgetts' financial position. (3)

The purpose of this question is to have students analyze the possible cash flow implications of the land deal on DHR. DHR will have the cost of construction covered due to their customers' construction loans, however they still must service both the loan for the land and the loan from Justin Martin.

The below average student will either not attempt this question, require assistance in order to start working on this question, or assume that the cash flow of the firm will be solely the monthly interest payments on the land purchase.

The average student would assume that for the first three months of the project DHR would only receive revenues through their customers' construction loans to offset construction costs including each property's land purchase. DHR would then have expenses equal to the monthly interest payment on approximately $1.91 million ($2.5 million-$500 thousand down payment and-$90 thousand for land reimbursement; @ 6% per annum = $9550/month) and the repayment of Justin Martin's loan. They may also assume that by the time DHR would have to make their first payment to the bank (the next month) that Davis and Hodgetts' TIAA-CREF funds would be available to them, $100,000. From these funds they could easily cover three months' worth of interest only payments as well as pay part of Justin Martin's loan back, say $50,000, leaving them a little over a $20,000 cushion.

The above average student would go beyond this analysis and try to analyze the cash flow needs for the entire project. Once three months had passed and homes had been built (assuming there were no delays in construction), the minimum profit that DHR could expect would be $106,900 per home. An additional $89,000 for seven homes would be generated from lakefront properties. There are several assumptions that have to be made by these students including the number of homes to be built simultaneously and when the lakeside homes would be built.

For example, these students might assume that over the remaining time period that at least three homes would be completed per month for seven months (21 homes) and that four homes per month would be completed for the following three months (12 homes). They might also assume a worst case scenario for revenue generation, that the lakeside homes would be built only in the last two months. See TN Table 4, below.

These students might recommend that by the end of the third month that DHR pay off the remainder of their loan to Justin Martin ($150,000), and Davis and Hodgetts' loan from TIAA-CREF ($ 100,000). They might then recommend that Davis and Hodgetts make nine equal payments toward the loan until the loan was paid off. See TN Table 5, below. These students might also observe that the profit generated from the project would then be calculated as follows:

Profit = Project Revenues--Land Costs--Interest Costs (3 months Interest only + 9 months) $ 4,078,367.61 = $ 6,658,700-$ 2,500,000-$ 80,332.49 ($ 30,000 + $ 50,332.49)

The exceptional student would make several cautionary comments before proceeding in their analyses. First, that although the construction costs are covered by the home buyer's construction loan, there may still be some out-of-pocket expenses that DHR will have to assume since construction loan payments may not based upon actual construction expenses but based upon a fixed payment schedule of the estimated percentage of project completion. (See Appendix 3--Basic Construction Loan Draw Schedule and Formula)

Second, this student might also indicate that there may be other expenses not accounted for in the construction costs that might be incurred by DHR that may impact cash flow. The case specifically mentions a $1000 sales commission and rental fees for show homes (for those homes already built) but there may be other expenses incurred, most probably indirect expenses, that may not be accounted for. Furthermore, the cost of certain critical construction items may go up over time (i.e. wood, plaster board, etc ... ) as well as the cost of some of the subcontractors. DHR will not be able to pass these expenses along to their customers if those customers have already closed on their houses.

Third, and most important, there may be several delays in starting and completing this project (weather, availability of subcontractors and materials) and therefore a three month home building schedule may be unrealistic.4 A longer completion schedule would negatively impact the cash flow since the reimbursement schedules would be spread out over a longer time period thereby increasing the cost of the overall project. This student might allow for an additional month for home building (four months total) and the maximum time allowed to repay the loan (16 months). See TN Tables 6 and 7 below for the recalculation of the building and loan repayment schedule.

Profit = Project Revenues--Land Costs--Interest Costs (4 months Interest only + 12 months)

$ 4,042,640.30 = $ 6,658,700 - $ 2,500,000 - $ 116, 059.74 ($ 30,000 + $ 86059.74)

This student would finally note that given the projected cash flows Justin Martin would be paid off one month later and that this new payment schedule would result in a loss of $ 35,727.31 as compared to a 12 month schedule.

4. Develop recommendations on how Davis and Hodgetts should proceed in closing this land deal.

This question gets to the heart of the case; can Davis and Hodgetts raise $50,000 in one day in order to make this profitable deal go through, and if not, what other options are available to them? The questions asks students to struggle with the facts of the case and to develop some creative solution strategies.

The below average student will have Hodgetts and Davis run around 'willy-nilly' so to speak in order to raise the funds from traditional sources most small businesses would deal with; friends, family, and local lending institutions. They may also suggest that Davis and Hodgetts borrow the money 'off the street,' that is, use illegal lenders (loan sharks) who would charge a rather hefty fee (5% a week, O'Connor, 1997). Given Hodgetts and Davis' profession (college professors), one would find the later solution highly unlikely.

The average student would have Hodgetts and Davis first try to talk Justin Martin out of requiring the $50,000 down payment or to increase the loan to $300,000. Given the information provided in the case in terms of Mr. Martin's overall assistance to DHR in raising capital, as well as his insistence on the down payment, better students might predict that this approach would exacerbate the situation and possibly not only kill this deal but all future dealings with Justin Martin.

The above average student would suggest calling Justin Martin, explaining the situation in detail, and then asking for Mr. Martin's assistance in resolving this problem. The hope is by involving Mr. Martin in the problem-solving process that he will develop ownership of both the problem and the solution (cooptation; see Pfeffer and Salancik, 1978). Students may note that this is a less confrontational approach and gives credence to Justin Martin's role as mentor and supporter of Davis and Hodgetts.

The exceptional student will note that asking for Justin Martin's help has always lead to hidden negative consequences and worse, takes the control of the situation out of Davis and Hodgetts' hands and places it into a third party stakeholder. This student's preferred method would be to develop a set of alternatives that could be explored with Justin Martin and to have DHR and Mr. Martin reach a consensus on how to proceed. Alternatives could include, but are not limited to, the following:

1. Delaying the closing until Hodgetts' bank account cleared or Davis's check cleared the bank.

2. Going ahead with the closing but having DHR put $50,000 in an escrow account once their TIAA-CREF funds cleared.

3. Mr. Martin forgoing the down payment but obtaining a small equity position in the firm equal to $ 50,000--Davis and Hodgetts would have an option to buy him out at the end of the project.

4. Rather than funds being placed into an escrow account, one of the inner lots would be held in escrow.

EPILOGUE

Hodgetts and Davis thought that their only recourse was to call Justin Martin and explain the situation to him as succinctly as they could. When they did get a hold of Justin Martin he was quite pleasant but insisted on maintaining the escrow account. They agreed that they would go to closing on July 15th but that DHR would wire transfer $ 50,000 into the escrow account by the 19th, the day Davis's check was supposedly to clear . An enraged Justin Martin called Davis at around 3 PM on the 19th (since the funds had not been transferred to his escrow account) to find out that Davis's check would not clear until the following business day. Hodgetts's bank account was also not going to clear until the 20th . Hodgetts wired the $ 50,000 the first thing in the morning of the 20th, to Justin Martin's satisfaction. Justin Martin's loan was repaid on August 23, 2004 through an upfront all cash home sale to Justin Martin's mother-in-law (the home was discounted by approximately $50,000).

ENDNOTES

(1) We would like to thank the reviewers for this suggestion.

(2) We would like to thank the reviewers for noting the double taxation issue with C corporations.

(3) We would like to thank the reviewers for raising this extremely important question.

(4) What would like to thank the reviewers for this observation.

APPENDIX 1--CLASS HANDOUT

The Real Estate Development Industry http://strategis.ic.gc.ca/epic/internet/indsib-fsib.nsf/en/ou00013e.html)

Definition

The real estate development industry is comprised of firms that do any combination of land assembly, development, financing, building and the lease or sale of residential, commercial and industrial property.

Overview

The real estate development industry represents a key component of the economy. A vibrant real estate sector boosts demand for goods and services from the building products industries and other sectors such as construction, consulting engineering, architecture and legal. Local and national economic growth, interest rates and changing demographics play key roles in the industry's future direction. Specialization in commercial markets is occurring beyond office buildings with firms targeting entertainment and health care markets.

The industry consists of a large number of small, niche oriented firms who concentrate on home markets, and a few large companies investing in the U.S. and overseas. Development firms typically have a small number of employees responsible for core operations while design, engineering, architecture, planning, legal and construction services are contracted out.

Infrastructure project developers, who build large projects, may comprise consortiums of large construction companies and engineering firms.

The industry has a wide range of associations representing it including:

[section] Building Owners and Managers Association;

[section] Urban Development Institute;

[section] Society of Industrial and Office Realtors.

The Residential Home Construction Industry

This industry comprises establishments primarily responsible for the entire construction (i.e., new work, additions, alterations, and repairs) of single family residential housing units (e.g., single family detached houses, town houses, or row houses where each housing unit is separated by a ground-to-roof wall and where no housing units are constructed above or below). This industry includes establishments responsible for additions and alterations to mobile homes and on-site assembly of modular and prefabricated houses. Establishments identified as single family construction management firms are also included in this industry. Establishments in this industry may perform work for others or on their own account for sale as speculative or operative builders. Kinds of establishments include single family housing custom builders, general contractors, design builders, engineer-constructors, joint-venture contractors, and turnkey contractors.* (http://www.ibisworld.com/industry/ definition.asp?Industry_ID=169)

The Construction Contracting sector of this market consists of general contractors, who undertake the construction of entire structures, and trade contractors, who perform specialized services such as site preparation, structural work (steel or concrete), mechanical and electrical systems installations, and other interior and exterior work. The latter normally operate as subcontractor to the general contractor. (http://strategis.ic.gc.ca/epic/internet/incccc.nsf/en/Home)

APPENDIX 2--CLASS HANDOUT

Small Business Administration (Excerpted from http://www.sbaonline.sba.gov/financing/basics/basics.html, August 23, 2004.)

Financing Basics

While poor management is cited most frequently as the reason businesses fail, inadequate or ill-timed financing is a close second. Whether you're starting a business or expanding one, sufficient ready capital is essential. But it is not enough to simply have sufficient financing; knowledge and planning are required to manage it well. These qualities ensure that entrepreneurs avoid common mistakes like securing the wrong type of financing, miscalculating the amount required, or underestimating the cost of borrowing money.

Before inquiring about financing, ask yourself the following:

1. Do you need more capital or can you manage existing cash flow more effectively?

2. How do you define your need? Do you need money to expand or as a cushion against risk?

3. How urgent is your need? You can obtain the best terms when you anticipate your needs rather than looking for money under pressure.

4. How great are your risks? All businesses carry risks, and the degree of risk will affect cost and available financing alternatives.

5. In what state of development is the business? Needs are most critical during transitional stages.

6. For what purposes will the capital be used? Any lender will require that capital be requested for very specific needs.

7. What is the state of your industry? Depressed, stable, or growth conditions require different approaches to money needs and sources. Businesses that prosper while others are in decline will often receive better funding terms.

8. Is your business seasonal or cyclical? Seasonal needs for financing generally are short term. Loans advanced for cyclical industries such as construction are designed to support a business through depressed periods.

9. How strong is your management team? Management is the most important element assessed by money sources.

10. Perhaps most importantly, how does your need for financing mesh with your business plan? If you don't have a business plan, make writing one your first priority. All capital sources will want to see your for the start-up and growth of your business.

Not All Money Is The Same

There are two types of financing: equity and debt financing. When looking for money, you must consider your company's debt-to-equity ratio--the relation between dollars you've borrowed and dollars you've invested in your business. The more money owners have invested in their business, the easier it is to attract financing.

If your firm has a high ratio of equity to debt, you should probably seek debt financing. However, if your company has a high proportion of debt to equity, experts advise that you should increase your ownership capital (equity investment) for additional funds. That way you won't be over-leveraged to the point of jeopardizing your company's survival.

Equity Financing

Most small or growth-stage businesses use limited equity financing. As with debt financing, additional equity often comes from non-professional investors such as friends, relatives, employees, customers, or industry colleagues. However, the most common source of professional equity funding comes from venture capitalists. These are institutional risk takers and may be groups of wealthy individuals, government-assisted sources, or major financial institutions. Most specialize in one or a few closely related industries. The high-tech industry of California's Silicon Valley is a well-known example of capitalist investing.

Venture capitalists are often seen as deep-pocketed financial gurus looking for start-ups in which to invest their money, but they most often prefer three-to-five-year old companies with the potential to become major regional or national concerns and return higher-than-average profits to their shareholders. Venture capitalists may scrutinize thousands of potential investments annually, but only invest in a handful. The possibility of a public stock offering is critical to venture capitalists. Quality management, a competitive or innovative advantage, and industry growth are also major concerns.

Different venture capitalists have different approaches to management of the business in which they invest. They generally prefer to influence a business passively, but will react when a business does not perform as expected and may insist on changes in management or strategy. Relinquishing some of the decision-making and some of the potential for profits are the main disadvantages of equity financing.

You may contact these investors directly, although they typically make their investments through referrals. The SBA also licenses Small Business Investment Companies (SBICs) and Minority Enterprise Small Business Investment companies (MSBIs), which offer equity financing. Apple Computer, Federal Express and Nike Shoes received financing from SBICs at critical stages of their growth.

Additional Reading

Raising Money through Equity Investments--Inc. Magazine

Debt Financing

There are many sources for debt financing: banks, savings and loans, commercial finance companies, and the U.S. Small Business Administration (SBA) are the most common. State and local governments have developed many programs in recent years to encourage the growth of small businesses in recognition of their positive effects on the economy. Family members, friends, and former associates are all potential sources, especially when capital requirements are smaller.

Traditionally, banks have been the major source of small business funding. Their principal role has been as a short-term lender offering demand loans, seasonal lines of credit, and single-purpose loans for machinery and equipment. Banks generally have been reluctant to offer long-term loans to small firms. The SBA guaranteed lending program encourages banks and non-bank lenders to make long-term loans to small firms by reducing their risk and leveraging the funds they have available. The SBA's programs have been an integral part of the success stories of thousands of firms nationally.

In addition to equity considerations, lenders commonly require the borrower's personal guarantees in case of default. This ensures that the borrower has a sufficient personal interest at stake to give paramount attention to the business. For most borrowers this is a burden, but also a necessity.

APPENDIX 3--BASIC CONSTRUCTION LOAN DRAW SCHEDULE AND FORMULA *

Following is the basic formula used in calculating construction loan progress draws:

* 1. LAND ADVANCE = up to 50% (**gross) of the current value of the property, or the purchase price when purchased within last 6 months, whichever is less. (rule of thumb: More expensive and/or larger parcels impose a lower land advance percentage due to "land to improvements" ratio. This draw is released at close of loan escrow. The loan fees, escrow fees, title insurance, etc. are taken out of this land advance, up front, at close of loan escrow.

* arrangements can be made for payment of 1/2 of your permits and school fees here

* 2. FOUNDATION DRAW = Average usually approximately $10,000.00 to $50,000.00 unless the foundation is engineered or above average in cost in which case this figure might be adjusted. This draw released when the foundation is poured and stripped and all permits paid for and obtained.

* you can add a sub floor and/or top plate draw here

3. ROOF SHEETING = Approximately 40% of the balance of funds after deducting amount of draws 1, 2, and 5. This draw is released upon completion of roof sheeting nailing.

4. SHEETROCK = Approximately 60% of the balance of funds after deducting amount of draws 1, 2, and 5. Draw released upon completion of sheetrock nailing.

* 5. FINAL = 20% of the principal amount of the loan plus accrued interest. This draw released when home is complete, finished and turn key. Half this draw can be set up to be released upon for example "all doors, paint, cabinets etc".

Occasionally a borrower will request more than 5 draws. Additional draws can be created between some of these 5 basic draws and debit the amount of an additional draw created from the succeeding or next in line draw. There's usually a small fee charged for each additional draw created of approximately $100 to $150 each, depending in part on how far an inspector must travel for inspections.

* There is little, if any, room for negotiation in draws marked with an asterisk (*); additional draws probably could not be inserted between draws 1 and 2 (COE and foundation). i.e. Additional draws are possible after draw #2 (foundation), #3 (roof sheeting) and #4 (sheetrock) from draws #3, #4 and #5. For example, one might wish to have a draw created between roof sheeting and sheetrock at "O.K. to cover" or when insulation is in.

** The loan fee, escrow fee, title insurance, etc. come off the top of the loan, they are taken from the land advance, up front, at close of loan escrow.

* Excerpted and modified.http://www.easyconstructionloans.com/ loan_documents_basic_5_draw_schedule.htm, January 18, 2005.

REFERENCES

David, F. R. (2003). Strategic Management Case Writing: Suggestions After 20 Years of Experience S.A.M. Advanced Management Journal (Summer) 68, 3, 36-38.

Gallagher, T. J. & J. D. Andrew (2003). Financial Management: Principles and Practice. 3rd Edition. Upper Saddle River, N. J.: Prentice Hall.

Gertsel, D. (1998). The Builder's Guide to Running a Successful Construction Company. 2nd Edition. Newton, Ct.: The Tauton Press.

Harrison, J. S. & C. H. St. John (2004). Foundations in Strategic Management. 3rd Edition.

Keown, A. J., J. D. Martin, J. W. Petty & D. F. Scott, Jr. (2005). Financial Management: Principles and Applications. 10th Edition. Upper Saddle River, N. J.: Prentice Hall.

Lambing, P. A. & C. R. Kuehl (2003). Entrepreneurship. 3rd Edition. Upper Saddle River, N. J.: Prentice Hall.

Lundberg, C. C., P. Rainsford, J. P. Shay & C.A. Young (2001). Case Writing Reconsidered, Journal of Management Education (August) 25, 4, 450-463.

Lynn, L. E. Jr. (1999). Teaching & Learning with Cases: A Guidebook. New York: Seven Bridges Press.

Mancuso, Anthony (2004). Your Limited Liability Company: An Operating Manual. 3rd Edition. Berkeley, Ca.: Nolo.

Megginson, L. C., M. J. Byrd, & W. L. Megginson (2003). Small Business Management: An Entrepreneur's Guidebook. 4th Edition. New York: McGraw-Hill Irwin.

Naumes, W. & M. J. Naumes (1999). The Art & Craft of Case Writing. Thousand Oaks, Ca.: Sage Publications.

Nicastro, M. L. & D. C. Jones (1994). Cooperative Learning Guide for Marketing Teaching Tips for Marketing

Instructors. Englewood Cliffs, N.J.: Prentice-Hall, Inc..

O'Connor, M. (1997). Loan Shark Talks About Grisly Duty Chicago Tribune [North Sports Final Edition], April 16, p. 6.

Pearce, J. A. II & R. B. Robinson, Jr. (2005). Strategic Management: Formulation, Implementation, and Control. 9th Edition. New York: McGraw-Hill Irwin.

Peiser, R. B. & A. Frej (2003). Professional Real Estate Development 2nd Edition. Washington, D.C.: Urban Land Institute.

Pfeffer J.& G. R. Salancik (1978). The External Control of Organizations: A Resource Dependence Perspective. New York: Harper & Row.

Herbert Sherman, Southampton College--Long Island University

Daniel J. Rowley, University of Northern Colorado

TN Table 1: What Investors and Lenders Look for from a
Small Business

Investor Lender

The ability of the owners Ability to pay back the loan
to be team players. through cash flow--income.

Flexibility of owners and Amount of collateral available
their ability to accept to secure the loan.
possible new management.

Commitment to the new Track record of repaying
project/business. loans--credit history.

Acceptance of Business and/or Marketing Plan.
constructive
criticism/feedback/
assistance.

Fixed and realistic Stability of the business
short term and long and/or owners.
term goals.

* Adopted from Megginson, Byrd, and Megginson, 2003, p. 157-8.

TN Table 2: Calculating Net Profit of Mountain
Trails--Below Average Student

Models Profit

Pine $123,900
Spruce $116,900
Cedar $125,900
Elm $125,900
Sierra $146,000
Olympia $106,900
Aspen $126,800
Vail I (no bonus room) $135,000
Vail II $108,500
Total $1,116,100
Average (Total/9) $124,011

Total Average Profit = 33 lots ($124,011/per lot) + 7 lakeside
lots ($89,000)

= $4,092,367 + $623,000

= $4,715,367

TN Table 3: Loan Amortization Schedule - $2 million @ 6% for one
year (12 payments)

 Loan Amount $2,000,000.00
 Annual Interest Rate 6.00%
 Loan Period in Years 1
 No. of Payments Per Year 12

Pmt Beginning Balance Scheduled Total
No. Payment Payment

 1 $2,000,000.00 $ 172,132.86 $172,132.86
 2 1,837,867.14 172,132.86 172,132.86
 3 1,674,923.62 172,132.86 172,132.86
 4 1,511,165.38 172,132.86 172,132.86
 5 1,346,588.34 172,132.86 172,132.86
 7 1,014,961.51 172,132.86 172,132.86
 8 847,903.46 172,132.86 172,132.86
 9 680,010.11 172,132.86 172,132.86
10 511,277.31 172,132.86 172,132.86
11 341,700.83 172,132.86 172,132.86
12 171,276.48 172,132.86 172,132.86

 Loan Summary
 Scheduled Payment $ 172,132.86
 No. of Payments 12
 Total Interest $ 65,594.31

Pmt Principal Interest Ending
No. Balance

 1 $162,132.86 $ 10,000.00 $1,837,867.14
 2 162,943.52 9,189.34 1,674,923.62
 3 163,758.24 8,374.62 1,511,165.38
 4 164,577.03 7,555.83 1,346,588.34
 5 165,399.92 6,732.94 1,181,188.43
 6 167,226.92 5,905.94 1,014,961.51
 7 167,058.05 5,074.81 847,903.46
 8 167,893.34 4,239.52 680,010.11
 9 168,732.81 3,400.05 511,277.31
10 169,576.47 2,556.39 341,700.83
11 170,424.36 1,708.50 171,276.48
12 170,420.09 856.38 0.00

TN Table 4: Revenue Influx from Snowy Mountains Development

End of
Project
Month # of Homes Building Profit Land Revenue

 3 3 $320,700.00 $228,000.00
 4 3 $320,700.00 $228,000.00
 5 3 $320,700.00 $228,000.00
 6 3 $320,700.00 $228,000.00
 7 3 $320,700.00 $228,000.00
 8 3 $320,700.00 $228,000.00
 9 3 $320,700.00 $228,000.00
10 4 $427,600.00 $304,000.00
11 4 $427,600.00 $304,000.00
12 4 $427,600.00 $304,000.00

Totals 33 $3,527,700.00 $2,508,000.00

End of
Project
Month Lakefront Revenue Total Revenue

 3 $-- $548,700.00
 4 $-- $548,700.00
 5 $-- $548,700.00
 6 $-- $548,700.00
 7 $-- $548,700.00
 8 $-- $548,700.00
 9 $-- $548,700.00
10 $-- $731,600.00
11 $267,000.00 $998,600.00
12 $356,000.00 $1,087,600.00

Totals $623,000.00 $6,658,700.00

TN Table 5: Loan Amortization Schedule-$2 million @ 6% for 9 months

 Analysis

Amount financed 2,000,000.00
Annual interest 6.00
 (e.g., 8.25)
Monthly payments $227,814.72
Total number of 9
 payments
Principal amount $2,000,000.00
Finance charges $50,332.49
Total cost $2,050,332.49

Pmt Beginning Interest Principal Balance
No. Balance

 1 2,000,000.00 10,000.00 217,814.72 1,782,185.28
 2 1,782,185.28 8,910.93 218,903.79 1,563,281.48
 3 1,563,281.48 7,816.41 219,998.31 1,343,283.17
 4 1,343,283.17 6,716.42 221,098.31 1,122,185.86
 5 1,122,184.86 5,610.92 222,203.80 899,981.07
 6 899,981.07 4,499.91 223,314.82 676,666.25
 7 676,666.25 3,383.33 224,431.39 452,234.86
 8 452,235.86 2,261.17 225,553.55 226,681.31
 9 226,681.31 1,133.41 226,681.31 (0.00)

Pmt Accumulative Accumulative
No. Interest Principal

 1 10,000.00 217,814.72
 2 18,910.93 436,718.52
 3 26,727.33 656,716.83
 4 33,443.75 877,815.14
 5 39,054.67 1,100,018.93
 6 43,554.58 1,323,333.75
 7 46,937.91 1,547,765.14
 8 49,199.08 1,773,318.69
 9 50,332.49 2,000,000.00

TN Table 6: Revenue Influx from Snowy Mountains Development
(16 Months)

End of
Project # of Building Land
Month Homes Profit Revenue

3 0 $ -- $ --
4 2 $213,800.00 $152,000.00
5 2 $213,800.00 $152,000.00
6 2 $213,800.00 $152,000.00
7 2 $213,800.00 $152,000.00
8 2 $213,800.00 $152,000.00
9 2 $213,800.00 $152,000.00
10 3 $320,700.00 $228,000.00
11 3 $320,700.00 $228,000.00
12 3 $320,700.00 $228,000.00
13 3 $320,700.00 $228,000.00
14 3 $320,700.00 $228,000.00
15 3 $320,700.00 $228,000.00
16 3 $320,700.00 $228,000.00

Totals 33 $3,527,700.00 $2,508,000.00

End of
Project Lakefront Total
Month Revenue Revenue

3 $ -- $ --
4 $ -- $365,800.00
5 $ -- $365,800.00
6 $ -- $365,800.00
7 $ -- $365,800.00
8 $ -- $365,800.00
9 $ -- $365,800.00
10 $ -- $548,700.00
11 $ -- $548,700.00
12 $ -- $548,700.00
13 $ -- $548,700.00
14 $89,000.00 $637,700.00
15 $267,000.00 $815,700.00
16 $267,000.00 $815,700.00

Totals $623,000.00 $6,658,700.00

TN Table 7: Loan Amortization Schedule--$2 million @ 6%
for 16 months

Analysis

Amount financed $2,000,000.00
Annual interest (e.g., 8.25) 6.00
Monthly payments $30,378.73
Total number of payments 16
Principal amount $2,000,000.00
Finance charges $86,059.74
Total cost $2,086,059.74

Pmt Beginning Interest Principal
No. Balance

1 2,000,000.00 10,000.00 120,378.73
2 1,879,621.27 9,398.11 120,980.63
3 1,758,640.64 8,793.20 121,585.53
4 1,637,055.11 8,185.28 122,193.46
5 1,514,861.65 7,573.20 122,804.43
6 1,392,057.22 6,960.29 123,418.45
7 1,268,638.78 6,343.19 124,036.54
8 1,144,603.24 5,723.02 124,655.72
9 1,019,947.52 5,099.74 125,279.00
10 894,668.52 4,473.34 125,905.39
11 768,763.13 3,843.82 126,534.92
12 642,228.21 3,211.14 127,167.59
13 515,060.62 2,575.30 127,803.43
14 387,257.19 1,936.29 128,442.45
15 258,814.74 1,294.07 129,084.66
16 129,730.08 649.65 129,730.08

Pmt Balance Accumulative Accumulative
No. Interest Principal

1 1,879,621.27 10,000.00 120,378.73
2 1,758,640.64 19,398.11 241,359.36
3 1,637,055.11 28,191.31 362,944.89
4 1,514,861.65 36,376.59 485,138.35
5 1,392,057.22 43,950.89 607,942.78
6 1,268,638.78 50,911.18 731,361.22
7 1,144,603.24 57,254.37 855,396.76
8 1,019,947.52 62,977.39 980,052.48
9 894,669.52 68,077.13 1,105,331.48
10 768,763.13 72,550.47 1,231,236.87
11 642,228.21 76,394.29 1,357,771.79
12 515,060.62 79,605.43 1,484,939.38
13 387,257.19 82,180.73 1,612,742.81
14 258,814.74 84,117.02 1,741,185.26
15 129,730.08 85,411.09 1,870,269.92
16 (0.00) 86,059.74 2,000,000.00