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.

INSTRUCTORS' NOTES

Learning Objectives

After successful completion of this case, students will:

** create a forecast for the first year of a start-up business

** describe the impact of financing feedback on financial statements for an S-Corporation and C-Corporation

** solve for the ending debt balance of an S-Corporation which takes into account the financing feedback associated with interest expense on new debt borrowing

** solve for the ending debt balance of an C-Corporation which takes into account the financing feedback associated with the tax deductibility of interest expense on new debt borrowing

Theoretical Frameworks

To successfully analyze this case, students must be familiar with:

** Accounting concepts and terminology. Students must understand basic accounting concepts (e.g. depreciation, cost of goods sold, accounts receivable, etc.) and terminology used to present the assumptions.

** Financial forecasting assumptions. This case provides students with enough information to construct financial statements (income statement and balance sheet) for a 1-year period. Students will need to take information presented in the text and in exhibits and convert this information into financial statement information.

** Financial forecasting methods. Students must understand the basics of forecasting financial statements (transaction-based) and the interrelationship between the income statement and balance sheet.

** Financing feedback. Students should be aware of the debt/interest loop encountered when forecasting financial statements. They should understand the meaning of financing feedback as it relates to new debt borrowing.

ANCILLARY READINGS

Financial forecasting assumptions. A realistic and comprehensive financial planning example is provided in:

Lasher, William R. (2005). Practical Financial Planning, Fourth Edition. United States: Thomson Southwestern, 636-646.

Financial forecasting methods. An example of the transactions-based approach, presented as an accounting equation is in:

Needles, Belverd, et al, (2002). Principles of Accounting, United States: Houghton-Mifflin, 16-23.

Financing feedback. The iterative technique for solving for debt given financing feedback is presented in:

Brigham, Eugene & L.C. Gapenski. (1997). Financial Management: Theory and Practice, Eighth Edition United States: Dryden Press, 536-543.

SUGGESTIONS FOR EFFECTIVELY TEACHING THIS CASE

This case has been "test marketed" in two sections of a principles of finance course. Each section had approximately 80 students. We suggest that student teams be divided into groups of five or six students, and each group be provided with a copy of the case at least 2 days prior to attending class. Student should come to class with a completed income statement and balance sheet assuming no debt is issued (for an S-Corp with no debt, EBIT is equivalent to net profit). Note that the correct ending cash balance will be negative, so the student may think of debt financing as the amount needed to both remove the negative balance and then to achieve the desired target. The students should have also thought about the impact of financing feedback and should have attempted to develop an equation that represents the relationship between the amount borrowed and the amount of cash after paying interest expense.

Two methods may be used to create a forecast--determining each account independently or representing each transaction using either the financial identity (see the answer key) or T-accounts. We prefer the transactions approach since it presents the context for the operations of the firm. We suggest allowing approximately 30 minutes of class time for students to ask questions regarding creating balances. At the end of the question and answer session, we suggest that a handout be provided of the correct estimates needed to forecast debt requirements. A class discussion should be undertaken addressing the debt/interest loop and financing feedback. Each group should brainstorm how debt could be solved for in the context of an S-corporation that would address the financing feedback associated with new debt borrowing required. The group should be pulled together and suggestions should be gathered from each group. This will work well and should lead to discussions as to what financing feedback is and why the debt/interest loop exists. The algebraic equation that closes the debt/interest loop should be shared with the students. The class should walk through how to solve for the amount of new debt financing needed that takes into account financing feedback. The statements should be completed with the new debt financing required.

The students should be asked to brainstorm in their groups how to solve for the ending debt balance needed if the company was a C-corporation. This would require the student teams to take taxes think of how taxes would impact financing feedback. They should develop the changes necessary to the algebraic equation that would adjust for taxes. Allow the students to resolve for the new ending debt balance that includes the tax deductibility of interest impacts. The statements should be completed with the new debt financing required.

ASSIGNED QUESTIONS

Students will be required to find the information in the case that is necessary to calculate operating income.

"A" students will be able to correctly determine EBIT. If a problem does occur, it is likely to concern confusion over depreciation being incorporated into inventory and then "expensed" though COGS.

"B" and "C" students will be able to derive SGA and depreciation expense correctly, but have problems in determining COGS. Also, some may represent PP&E purchases as expenses.

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)

We used the following transaction-based method for forecasting total assets:

"A" students will be able to correctly complete the financial statements, with some relatively minor errors in the determination of cash and/or retained earnings. The balance sheet will balance.

"B" and "C" students will be able to correctly determine 4 of the 6 "simpler" accounts (not Cash or RE). Cash and RE will have most of the transactions correctly represented but some major errors will appear in both accounts.

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

Almost all students will be able to address this question, since it involves finding the difference between the cash balance in the forecast and the target cash balance. The purpose of this question is to have the student to consider the meaning of a negative cash balance in the forecast and the relatively simple math needed to reach the target.

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

The debt/interest loop occurs when taking into account the new debt financing needed in balancing financial statements. Without knowing the borrowing required, interest expense cannot be calculated. Therefore, the income statement cannot be completed. Without a complete income statement, retained earnings cannot be computed. From a cash standpoint, the target ending cash balance cannot be achieved without knowing specifically the amount of debt financing required to create that balance. Therefore, the debt/interest loop prevents the completion of the financial statements.

Most textbook methods use an iterative approach to finding the debt required to balance the statements. We found this technique time consuming and inaccurate. Unfortunately with the iterative methods, students are required to plug in various debt levels and work towards the amount of debt required. At some point the statements are "close enough" and the statements are plugged to balance. Our method allows the student to solve algebraically for the level of new debt required and will balance the statements on the firm attempt.

"A" students will be able to identify the circularity: that the amount of cash you need to raise determines the amount you need to borrow; but the amount you need to borrow requires an interest payment, which increases the amount of debt you need to raise. These students will also be able to relate the interest payment to its impact on retained earnings and retained earnings to its impact on the firm's financing.

"B" and "C" students will be able to identify the circularity but not be able to relate the circularity to 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).

Borrowing Needed = (Target Ending Cash--Forecasted Cash)/(1- Interest Rate)

"A" students will be able to identify the variables and express the variables within an equation context. Only a minority, however, will determine the correct equation.

"B" students will recognize that the amount borrowed will need to be greater than the amount of cash received. However, these students will not completely identify the relevant variables.

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

Upon the in-class presentation, first time through:

"A" students will be able to follow the presentation and clearly determine how this approach works.

"B" and "C" students will be able to identify what they don't understand. After asking questions, the majority will understand how to implement the algebraic approach to determining the required amount of financing.

To calculate the debt required, the students will need to compare the projected ending cash balance with the target ending cash balance. They will then need to borrow enough money to meet the target ending cash balance and to take into account the interest expense associated with borrowing.

New Debt Needed = (Target Ending Cash Balance--Forecasted Ending Cash Balance)/(1--Interest Rate on Debt)

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.

"A" students will find this to be a relatively easy transition.

"B" and "C" students that did not fully understand the treatment with an S-corporation will often begin to understand the approach since the transition from an S-Corporation to a C-Corporation is relatively simple and serves primarily as a review.

The first step is to reforecast the income statement and balance sheet taking into account taxes. Note that due to a loss, there is a tax credit that is treated as a cash inflow and not accrued.

To calculate the debt required, the students will need to once again compare the projected ending cash balance with the target ending cash balance. They will then need to borrow enough money to meet the target ending cash balance and to take into account the tax deductibility of interest expense associated with borrowing. The equation needs to be adjusted such that the after-tax rate of interest is used.

New Debt Needed = (Target Ending Cash Balance--Forecasted Ending Cash Balance)/(1--(Interest Rate on Debt(1-Tax Rate))

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

2005 Operating Income

Revenues $463,320
--COGS (221,619)
Gross Margin 241,701
--SG&A Expenses (310,400)
--Depreciation Exp. (Retrofit) (21,000)
--Depreciation Exp (Office Equip.) (17,000)
EBIT (106,699)

 Cash AR Inv

Beg. Balance 12/31/04 - - -
Pay AP
Pay Accruals
Collect AR's
Initial Inventory (10,000) 10,000
Buy Manufacturing Equipment (183,000)
Buy Office Equipment (85,000)
Building Retrofit (105,000)
Production: Materials Purchases 113,050
Production: Labor 71,969
Production: Depreciation 36,600
Payments for AP's (94,208)
Payments for Labor (69,201)
Revenues 459,459 3,861
COGS (221,619)
SG&A Expenses (310,400)
Depreciation Exp. (Building)
Depreciation Exp (Office Equip.)
Interest -
Taxes
Dividends
Line of Credit Borrowing
Owners Investment 60,000
Outside Equity Investment 200,000
Ending B/S 12/31/05 (137,350) 3,861 10,000

 NFA AP Accruals

Beg. Balance 12/31/04 - - -
Pay AP
Pay Accruals
Collect AR's
Initial Inventory
Buy Manufacturing Equipment 183,000
Buy Office Equipment 85,000
Building Retrofit 105,000
Production: Materials Purchases 113,050
Production: Labor 71,969
Production: Depreciation (36,600)
Payments for AP's (94,208)
Payments for Labor (69,201)
Revenues
COGS
SG&A Expenses
Depreciation Exp. (Building) (21,000)
Depreciation Exp (Office Equip.) (17,000)
Interest
Taxes
Dividends
Line of Credit Borrowing
Owners Investment
Outside Equity Investment
Ending B/S 12/31/05 298,400 18,842 2,768

 Total Assets 174,911

 Debt CS RE

Beg. Balance 12/31/04 - - -
Pay AP
Pay Accruals
Collect AR's
Initial Inventory
Buy Manufacturing Equipment
Buy Office Equipment
Building Retrofit
Production: Materials Purchases
Production: Labor
Production: Depreciation
Payments for AP's
Payments for Labor
Revenues 463,320
COGS (221,619)
SG&A Expenses (310,400)
Depreciation Exp. (Building) (21,000)
Depreciation Exp (Office Equip.) (17,000)
Interest -
Taxes -
Dividends -
Line of Credit Borrowing
Owners Investment 60,000
Outside Equity Investment 200,000
Ending B/S 12/31/05 - 260,000 (106,699)

 Total Liab. & Equity 174,911

Forecasted Ending Cash (137,350)
Target Ending Cash Balance 52,000
Total Cash Needed 189,350 (Target Ending Cash--
 Forecasted Ending Cash)

New Debt Financing Needed

Forecasting Ending Cash (137,350)
Target Ending Cash Balance 52,000
Total Cash Required 189,350 (Target Ending Cash--
Interest Rate on Line of Credit 5.0% Forecasted Ending Cash)
New Financing Required 199,316 (Target Ending Cash--
 Forecasted Ending Cash)/
 (1--Interest Rate)

Income Statement 2005

Revenues $463,320
--COGS (221,619)
Gross Margin 241,701
--SG&A Expenses (310,400)
--Depreciation Exp. (Retrofit) (21,000)
--Depreciation Exp (Office Equip.) (17,000)
EBIT (106,699)
--Interest (9,966)
EBT (116,665)
--Taxes -
EAT (116,665)

Dividends -
Change in Retained Earnings (116,665)

Financial Identity
 Cash AR Inv

Beg. Balance 12/31/04 - - -
Pay AP
Pay Accruals
Collect AR's
Initial Inventory (10,000) 10,000
Buy Manufacturing Equipment (183,000)
Buy Office Equipment (85,000)
Building Retrofit (105,000)
Production: Materials Purchases 113,050
Production: Labor 71,969
Production: Depreciation 36,600
Payments for AP's (94,208)
Payments for Labor (69,201)
Revenues 459,459 3,861
COGS (221,619)
SG&A Expenses (310,400)
Depreciation Exp. (Building)
Depreciation Exp (Office Equip.)
Interest (9,966)
Taxes
Dividends
Line of Credit Borrowing 199,316
Owners Investment 60,000
Outside Equity Investment 200,000
Ending B/S 12/31/04 52,000 3,861 10,000

Financial Identity
 NFA AP Accruals

Beg. Balance 12/31/04 - - -
Pay AP
Pay Accruals
Collect AR's
Initial Inventory
Buy Manufacturing Equipment 183,000
Buy Office Equipment 85,000
Building Retrofit 105,000
Production: Materials Purchases 113,050
Production: Labor 71,969
Production: Depreciation (36,600)
Payments for AP's (94,208)
Payments for Labor (69,201)
Revenues
COGS
SG&A Expenses
Depreciation Exp. (Building) (21,000)
Depreciation Exp (Office Equip.) (17,000)
Interest
Taxes
Dividends
Line of Credit Borrowing
Owners Investment
Outside Equity Investment
Ending B/S 12/31/04 298,400 18,842 2,768

 Total Assets 364,261

Financial Identity
 Debt CS RE

Beg. Balance 12/31/04 - - -
Pay AP
Pay Accruals
Collect AR's
Initial Inventory
Buy Manufacturing Equipment
Buy Office Equipment
Building Retrofit
Production: Materials Purchases
Production: Labor
Production: Depreciation
Payments for AP's
Payments for Labor
Revenues 463,320
COGS (221,619)
SG&A Expenses (310,400)
Depreciation Exp. (Building) (21,000)
Depreciation Exp (Office Equip.) (17,000)
Interest (9,966)
Taxes -
Dividends -
Line of Credit Borrowing 199,316
Owners Investment 60,000
Outside Equity Investment 200,000
Ending B/S 12/31/04 199,316 260,000 (116,665)

 Total Liab. & Equity 364,261

Income Statement 2005

Revenues $463,320
--COGS (221,619)
Gross Margin 241,701
--SG&A Expenses (310,400)
--Depreciation Exp. (Retrofit) (21,000)
--Depreciation Exp (Office Equip.) (17,000)
EBIT (106,699)
--Interest -
EBT (106,699)
--Taxes 42,680
EAT (64,019)

Dividends -
Change in Retained Earnings (64,019)

Financial Identity

 Cash AR Inv

Beg. Balance 12/31/04 - - -
Pay AP
Pay Accruals
Collect AR's
Initial Inventory (10,000) 10,000
Buy Manufacturing Equipment (183,000)
Buy Office Equipment (85,000)
Building Retrofit (105,000)
Production: Materials Purchases 113,050
Production: Labor 71,969
Production: Depreciation 36,600
Payments for AP's (94,208)
Payments for Labor (69,201)
Revenues 459,459 3,861
COGS (221,619)
SG&A Expenses (310,400)
Depreciation Exp. (Building)
Depreciation Exp (Office Equip.)
Interest -
Taxes 42,680
Dividends
Line of Credit Borrowing -
Owners Investment 60,000
Outside Equity Investment 200,000
Ending B/S 12/31/05 (94,671) 3,861 10,000

 NFA AP Accruals

Beg. Balance 12/31/04 - - -
Pay AP
Pay Accruals
Collect AR's
Initial Inventory
Buy Manufacturing Equipment 183,000
Buy Office Equipment 85,000
Building Retrofit 105,000
Production: Materials Purchases 113,050
Production: Labor 71,969
Production: Depreciation (36,600)
Payments for AP's (94,208)
Payments for Labor (69,201)
Revenues
COGS
SG&A Expenses
Depreciation Exp. (Building) (21,000)
Depreciation Exp (Office Equip.) (17,000)
Interest
Taxes
Dividends
Line of Credit Borrowing
Owners Investment
Outside Equity Investment
Ending B/S 12/31/05 298,400 18,842 2,768

 Total Assets 217,590

Financial Identity

 Debt CS RE

Beg. Balance 12/31/04 - - -
Pay AP
Pay Accruals
Collect AR's
Initial Inventory
Buy Manufacturing Equipment
Buy Office Equipment
Building Retrofit
Production: Materials Purchases
Production: Labor
Production: Depreciation
Payments for AP's
Payments for Labor
Revenues 463,320
COGS (221,619)
SG&A Expenses (310,400)
Depreciation Exp. (Building) (21,000)
Depreciation Exp (Office Equip.) (17,000)
Interest -
Taxes 42,680
Dividends -
Line of Credit Borrowing -
Owners Investment 60,000
Outside Equity Investment 200,000
Ending B/S 12/31/05 - 260,000 (64,019)

 Total Liab. & Equity 217,590

New Debt Financing Needed

Forecasting Ending Cash 52,000
Target Ending Cash Balance 52,000
Total Cash Required 146,671 (Target Ending Cash--
 Forecasted Ending Cash)
Interest Rate on Line of Credit 5.0%
Tax Rate 40.0%
New Financing Required 151,207 (Target Ending Cash--
 Forecasted Ending Cash)/
 (1--(Interest Rate(1-Tax
 Rate))

Income Statement 2005

Revenues $463,320
--COGS (221,619)
Gross Margin 241,701
--SG&A Expenses (310,400)
--Depreciation Exp. (Retrofit) (21,000)
--Depreciation Exp (Office Equip.) (17,000)
EBIT (106,699)
--Interest (7,560)
EBT (114,259)
--Taxes 45,704
EAT (68,556)

Dividends -
Change in Retained Earnings (68,556)

Financial Identity

 Cash AR Inv

Beg. Balance 12/31/04 - - -
Pay AP
Pay Accruals
Collect AR's
Initial Inventory (10,000) 10,000
Buy Manufacturing Equipment (183,000)
Buy Office Equipment (85,000)
Building Retrofit (105,000)
Production: Materials Purch. 113,050
Production: Labor 71,969
Production: Depreciation 36,600
Payments for AP's (94,208)
Payments for Labor (69,201)
Revenues 459,459 3,861
COGS (221,619)
SG&A Expenses (310,400)
Depreciation Exp. (Building)
Depreciation Exp (Office Equip.)
Interest (7,560)
Taxes 45,704
Dividends
Line of Credit Borrowing 151,207
Owners Investment 60,000
Outside Equity Investment 200,000
Ending B/S 12/31/05 52,000 3,861 10,000

 NFA AP Accruals

Beg. Balance 12/31/04 - - -
Pay AP
Pay Accruals
Collect AR's
Initial Inventory
Buy Manufacturing Equipment 183,000
Buy Office Equipment 85,000
Building Retrofit 105,000
Production: Materials Purch. 113,050
Production: Labor 71,969
Production: Depreciation (36,600)
Payments for AP's (94,208)
Payments for Labor (69,201)
Revenues
COGS
SG&A Expenses
Depreciation Exp. (Building) (21,000)
Depreciation Exp (Office Equip.) (17,000)
Interest
Taxes
Dividends
Line of Credit Borrowing
Owners Investment
Outside Equity Investment
Ending B/S 12/31/05 298,400 18,842 2,768

 Total Assets 364,261

 Debt CS RE

Beg. Balance 12/31/04 - - -
Pay AP
Pay Accruals
Collect AR's
Initial Inventory
Buy Manufacturing Equipment
Buy Office Equipment
Building Retrofit
Production: Materials Purch.
Production: Labor
Production: Depreciation
Payments for AP's
Payments for Labor
Revenues 463,320
COGS (221,619)
SG&A Expenses (310,400)
Depreciation Exp. (Building) (21,000)
Depreciation Exp (Office Equip.) (17,000)
Interest (7,560)
Taxes 45,704
Dividends -
Line of Credit Borrowing 151,207
Owners Investment 60,000
Outside Equity Investment 200,000
Ending B/S 12/31/05 151,207 260,000 (68,556)

 Total Liab. & Equity 364,261

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