Create-A-Candle, Inc.: A conceptual approach to financing feedback.

Marshall, S. Brooks ; Frazier, Jennifer R. ; Wright, Newell D. 等

CASE DESCRIPTION

The primary focus of this case concerns the borrowing needs of a start-up business, taking into account the financing feedback associated with interest expense. Instead of using the traditional iterative method for debt determination, enough information is provided so the better students could express the relationship in an algebraic construct and solve directly for the requisite loan amount. Secondary issues include developing a forecasted statement for the first year of a start-up business. The case has a difficulty level of three, and is positioned for use in junior level principles of finance courses as well as in integrated business curriculum classes for juniors. The case is designed to be taught in two class hours and is expected to require three to six hours of outside preparation by students.

CASE SYNOPSIS

Bob Fortune has spent a number of years in the candle-making industry and has decided to start his own business. Using a made-to-order approach, he is hoping to carve out a niche in the market. He has obtained $260,000 in equity investment for his business but still needs additional funds and plans to use a line of credit. To determine the amount he needs to borrow, Bob needs to develop his first year financials. Not only does he need to completely forecast his income statement and balance sheet, he also needs to determine the amount of debt financing needed to reach his target cash balance. Deriving the amount of financing needed is complicated by the financing feedback effect, wherein the more he borrows, the more interest he pays.

INTRODUCTION

Bob Fortune had always dreamed of owning his own candle making business. Having worked in the industry for 21 years, he looked forward to less travel and to using the candle making experience he had acquired. Over the years, Bob saved $60,000 for this venture, and was eager to strike out on his own. At last he decided to make the plunge as an entrepreneur. His first problem was financing this venture.

He ultimately raised $200,000 from outside investors, but apparently he had tapped out this source of financing, as no one else seemed interested in investing equity in his vision. Unfortunately, the combined equity from the two sources wasn't going to be enough to launch his business.

Having developed a great banking relationship with Dan Miller at Sunshine Community Bank. When he saw Dan at the Country Club, Bob casually asked him about arranging a line of credit.

"Sure I can arrange a line of credit for you," said Miller. "How much do you need?"

That's a good question, Bob said to himself silently, thinking about his business plan. Even though he thought he had made plenty of good assumptions about the future of his business, his financial statements just wouldn't balance.

The problem perplexed him. If he didn't know the amount of debt he needed to meet his target ending cash balance, then he couldn't calculate his interest expense. However, he couldn't find the amount of debt he needed until he took into account the interest expense associated with the debt borrowed. Bob knew that his financials had to be constructed properly in order the get the line of credit as Dan was a stickler for accurate forecasts. He wondered how he could close the loop on his financial statements and find the amount of debt financing needed.

"That's a good question," he answered. "I probably won't have to borrow more than $200,000, but I don't know for sure. Let me see if I can come up with a concrete number and get back to you."

"Sounds good to me," said Miller.

THE IDEA

The next day, Bob sat in his office. His idea for was to start a candle making company called Create-a-Candle, Inc. (CC) by the beginning of 2005. CC would allow for customized production of candles in jars. Customization would differentiate CC from its competition as customers would be able to create the jars with their desired shape, color and fragrance. While customization was the primary selling point, Bob also believed many customers would be attracted by the opportunity to learn about the candle-making process.

Basically, he would apply the "Build a Bear" concept to candle-making. Bob figured that customers would come to the business to create a unique, personal candle, but leave with both a candle and a happy memory.

Bob opened up his business plan and started to review his assumptions. He definitely wanted to be prepared when he talked with Dan Miller again.

Operations Assumptions

Bob reviewed his estimates of the required equipment for his start-up. He would have to make capital expenditures for production and administrative equipment. The principal manufacturing equipment consisted of three made-to-order) pods (MTOs) that customers would use to manufacture their candles. Each MTO unit contained a wax melter, a wick setter, a temperature gauge, cooling equipment and a terminal. Exhibit 1 presents the combined cost for three MTO's. The company would also need store equipment, including desks, chairs, cash registers and displays. For planning purposes, Bob assumed that all equipment would be depreciated over 5 years using straight-line depreciation to a zero salvage value.

Bob recently negotiated a five-year lease of a 2,000 square foot facility in a conveniently located strip shopping mall at an annual lease rate of $20 per square foot. According to the negotiated lease, CC would incur the building retrofit costs, including a fire suppression system due to the high heat nature of the manufacturing process as well as costs related to modifying the rented floor space. All building retrofit costs were assumed to be depreciated over 5 years using straight-line depreciation to a zero salvage value.

The equipment used on the production process had a maximum capacity of twelve candles per hour per machine. Based on the sales forecast (see marketing assumptions), Bob estimated customer demand would have the machines operating at 25% of capacity in the first year. Store operating hours were as follows:

Hours of Operation: Mon-Sat 10 am-8 pm
 Sunday 12 pm-6 pm
 66 operating hours per week

Bob's best guesses about CC's fixed and variable costs are contained in Exhibit 2, with the only fixed cost being depreciation of manufacturing equipment. Bob assumed that all supplies needed in the production process would be purchased 1 month prior to sale and paid for 1 month after the sale. He assumed that inventory would be maintained at $10,000 in case demand forecasts are too conservative.

Marketing Assumptions

CC's primary target market consisted of married households with children, with the head of the household between 25 and 35 years of age. Bob determined that this segment contained approximately 756,000 potential customers. Bob conservatively assumed CC would capture approximately 1.6% of this market in 2005. This level of customer demand would require that CC operate at 25% of capacity, assuming overall operations averaged 66 hours per week 52 weeks per year.

The average cost of a similar product is $12. Because of customization, Bob believed that CC could charge $15 per candle.

Bob assumed that 60% of customers would pay for their purchases with cash and 40% would use a credit card. He assumed the usual delay of 3 days for credit card purchases to be collected. He also reviewed the promotion plan he would use to attract customers (see exhibit 3).

Management Assumptions

Bob decided to create CC as an S-corporation. Therefore, no taxes would be incurred at the business level.

Based on his business assumptions, he would have to hire a total of 5 non-manufacturing employees during the 1st year (see Exhibit 4, Personnel Plan). His personnel needs included a manager, assistant manager and full- and part-time associates. Full-time employees would receive a standard benefits package equal to 20% of salary. He would pay employees every two weeks and estimated there would be 10 paid days outstanding at the end of 2005 for both manufacturing and administrative employees, assuming a 5-day work week.

Finally, Bob estimated that other Selling, General, and Administrative (SG&A) Expenses would be approximately $160,000 per year (see Exhibit 5, Selling, General & Administrative Annual Expenses). Bob included the promotional plan and administrative salaries, wages, and benefits in his SG&A calculations. Other than wage accruals, he assumed that all SG&A expenses would be paid with cash.

Finance Assumptions

Bob decided to target the year-end cash balance at $52.000, equal to approximately 2 months of SG&A Expenses. He knew that the $260,000 would not be sufficient but he didn't know the amount of the shortfall. Bob fully understood the financials, thanks to his work and individual investing experience. But in any prior forecasting, he had never worried about the exact cash balance. Now that he was using his own money, it became important to target the exact amount.

Bob first projected the cash balance with only equity financing. The shortfall from the $52,000 target balance needed to be made up with the line of credit at, he assumed, a five percent rate. But he then realized that each dollar of financing resulted in a net cash balance of only $.95. Bob reasoned that this relationship could be employed to determine the exact amount of financing he needed. He really wanted to impress somebody as fastidious as Dan Miller by demonstrating his ability to express the fundamental relationship between debt, interest and retained earnings. Bob started with the assumption that all borrowing began on the first day of the planning year and began his forecast. After he figured this out, he would call Dan Miller back and tell him exactly what the line of credit needed to be

QUESTIONS

1. What is projected for operating income (EBIT) for 2005?

2. Calculate the financial statements with the assumptions provided. Do not consider the borrowing needed to meet the target ending cash balance of $52,000. (Note: Cash will be negative without additional borrowing)

3. How does the projected ending cash balance differ from the target cash balance?

4. Explain the debt/interest loop issue and financing feedback impacts on the financial statements.

5. Based on question #3, you have a specified shortfall of cash. Create an equation that represents how much you need to borrow to achieve the desired cash balance after taking into account the interest expense (financing feedback).

6. [To be addressed in class] Specifically, how much debt will it take to balance the balance sheet for this Scorporation, including the impact of interest expense? How much debt does Bob need to meet the target ending cash balance?

7. [To be addressed in class] If the company were a C-corporation with a tax rate of 40%, how much at a minimum would Bob need in a line of credit to meet the target ending cash balance? Include the impact of the tax deductibility of interest.

S. Brooks Marshall, James Madison University Jennifer R. Frazier, James Madison University Newell D. Wright, James Madison University

Exhibit 1: Production and Administrative Equipment

Manufacturing Equipment Wax Melters $95,000
(5-year depreciation schedule) Wick Setters $10,000
 Temperature Gauges $3,000
 Cooling Equipment $30,000
 Customer Service Terminals $45,000

Store Equipment Desks, Chairs $10,000
(5-year depreciation schedule) Displays $60,000
 Cash Registers $15,000

Building Retrofit Costs Fire Suppression System $30,000
(5-year depreciation schedule) Building Modifications $75,000

Exhibit 2: Cost of Production

Variable Costs Wax $0.49
 per Candle Wicks $0.32
 Fragrance $0.04
 Dyes $0.05
 Glass Jars $0.64
 Packaging/Labeling $2.12
 Labor $2.33
Fixed Costs Depreciation on $36,600 per year
 Manufacturing Equipment

Exhibit 3: Advertising Expenses

Print Advertising $10,000
Yellow Page $3,000
Radio $15,000
Coupons $2,000
 Total Advertising $30,000

Exhibit 4: Personnel Plan

1 Manager $30,000 (Plus 20% for Benefits) = $36,000
1 Asst. manager $24,000 (Plus 20% for Benefits) = $28.800
1 Full-time Associate $18,000 (Plus 20% for Benefits) = $21,600
2 Part-time Associates $12,000
Total Administrative $110,400
 Salaries and Benefits
 Cost

Exhibit 5: Selling, General and Administrative Annual Expenses

Advertising/Promotion $30,000
Administrative Salaries and Wages $110,400
Utilities $48,000
Telephone/Telecom $12,000
Insurance $36,000
Lease Expense $40,000
Legal/Accounting $8,000
Training $16,000
Miscellaneous $10,000
Total Selling, General and Administrative Expenses $310,400