Case Study Questions Clarkson Lumber Company The Clarkson Lumber Company case is divided into 3 parts. Part I deals with assessing the financial performance of the firm. For this section you need to able to understand why Clarkson Company is so short of funds despite its record of profitable operations and, in this connection, develop the distinction between profits and cash requirements. An important contribution in this part is to emphasize the dichotomy between accounting income and cash requirements. Part II covers the calculation of the funding needs. The bank must estimate the amount of funds needed by Mr.
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Clarkson, the probable repayment schedule of its loan, and the nature and degree of the risks it would be incurring in lending to Mr. Clarkson on the scale required. Part III is based on a hypothetical situation where Mr. Clarkson, sole owner and CEO of Clarkson Lumber Company, receives a number of informal inquiries from large, nationally-recognized building materials distributors about purchasing his company. In this part you will help Mr. Clarkson to value the company as an on-going-concern. Part I: Assessing Financial Performance Read the Clarkson Lumber Company case and review the accompanying financial statements.
To help you organize your thoughts for the case discussion during class, I would like to have you complete the assignment and think about the questions below. Complete the attached worksheet, “Clarkson Lumber Co. Part I: Financial Analysis Worksheet,” which includes a summary of balance sheet changes and various financial ratios. Think about what information each ratio is designed to convey. Consider the implications of trends. Do not worry if you have some trouble with the interpretations since this is your first analysis. Be sure to complete the calculations anyway and we will discuss the interpretations as part of the case exercise.
The more familiar you are with the numbers, the easier it will be to grasp the interpretations. Notes: The term Debt is defined as the sum of all interest-bearing liabilities including “Notes Payable Trade. ” When assessing Clarkson’s payment relationship with his suppliers, however, include “Notes Payable Trade” as overdue “Accounts Payable. ” 1. What were the uses of funds between 1993 and 1995? What were the sources of funds over these periods? Has the financial strength of Clarkson Lumber increased or deteriorated? 2. Trace through the effects of the buy-out of Mr. Holtz’s interest in the company in 1994.
How would the transaction show up in the accounting statements? 3. Explain the cause of Clarkson’s on-going financial difficulties and continuing need for additional outside funds? Why have his suppliers put him on a “notes payable” basis? 4. If Clarkson Lumber is as profitable as the income statement seems to indicate, then why is the firm always short of cash? Is it possible that the financial statements are misleading? Is possible that this is a poorly managed firm? Why has this profitable company had to borrow more and more money from the bank? 5. Does rapid sales growth always result in a need for substantial external finance? . If you were Mr. Jackson, would you be eager to loan money to Mr. Clarkson? When do you think he would be able to start repaying the loan? Is a line of credit the most appropriate form of financing for Clarkson? Will the proposed line of credit be adequate? More specifically, will a credit line of $750,000 be sufficient to meet the company’s needs in 1996 it takes “trade discounts”? Part I: Financial Analysis Worksheet Exhibit I: Net Income 7. The business seems profitable, so what is the problem? To simplify the balance sheet, combine the various loans in the following structure: Exhibit 2: Balance Sheet Information
Buy-Out of Mr. Holtz’s Interest Measuring Financial Performance: The Shareholder Perspective Dupont Model 8. What explains the ROE improvement? Why? Let’s now think on the components of the ROE: 9. What do these results imply in terms of operations, investment and financing side? A more detailed look at profitability shows: 10. How do operating margins look like? Why? Why do you think net margins are down? Is it tax expense or is it interest expense the problem? To answer this questions you need to construct the following ratios: * Interest Expense Ratio = Interest Expense / EBIT Effective or Average Tax Rate = Income Taxes / EBT (What is the difference between this tax rate and the marginal tax rate? Which one should we use? Why? Why not? ) 11. Let’s now concentrate on the concept of turnover. For this reason be sure to understand the following concepts: What explains the decline in overall asset turnover? Why? 12. Does Clarkson Lumber have excess funds tied up in the business in 1995 that could be released to alleviate her cash squeeze? For example, suppose that Clarkson Lumber could return to the 1993 DOH levels. Calculate the funds released from achieving these new (or really old! ) targets? 3. Finally, let’s concentrate on the financing side of Clarkson Lumber and its cash cycle. What do you conclude? Why? For this reason be sure to understand the following concepts: Part II: Determining Funding Needs Based on our previous analysis, please estimate the external funds that Clarkson Lumber Company will need at the end of 1996. Project sales of $5. 5 million but assume that 1996 will otherwise be an “average” year compared to 1993-95 ratios except that minimum cash balances are held at 1% of sales and that the tax rate will rise with income (see footnote c to Exhibit 1 and the Tax Rate Schedule below).
Consider two scenarios: * Scenario I: Clarkson gets his payables back to 45 days. * Scenario II: Clarkson pays in time to take the trade discounts. You may find useful to use the pro-forma balance sheet and pro-forma income statement I prepared. First, project the income statement for 1996 incorporating the $13,000 of interest paid in Q1 1996 but ignore any interest for the rest of the year. Next project the pro-forma Balance Sheet: Current Assets, PP&E, Automatic Sources, Debt, and Net Worth. The missing figure required to make it all balance is the external funds needed.
Repeat the same two steps for the second scenario. 14. At the end of 1995, what is the “days payable” for Clarkson. (Include “notes payable trade” as part of accounts payable. ) Is this acceptable to his suppliers? How does this compare to 1993 and 1994? 15. What will be Clarkson’s external funds need if he gets his payables down to 45 days at the end of 1996? Can he take advantage of trades discounts with this level of funding? 16. To what level must Clarkson reduce his days payable to qualify for trade discounts? What external funding level would be required? Is the proposed line of credit large enough to accommodate this?
Is it worthwhile for Clarkson to borrow the extra money in order to take the trade discounts? What is the implied annual interest rate on trade credit? How attractive is to take the “trade discounts”? 17. What are the potential risks to Northwestern National Bank if it extends the necessary line of credit to Clarkson? What collateral is available if Clarkson gets into trouble? 18. Would you, as Mr. Dodge, agree to lend Clarkson the money needed? What are the alternatives open to Mr. Clarkson if Mr. Dodge refuses his request for an increased credit line? 19. What will happen if sales continue to grow 25% annually into the indefinite future?
Will Clarkson be able to start retiring the loan and still take all his trade discounts? Does rapid sales growth always result in a need for substantial external finance? Optional: In addition to first quarter interest of $13,000, incorporate interest of $14,000 on the term loan and Holtz note for the remaining 9 months of 1996. Now repeat the above computations for scenarios (1) and (2) to determine the funding gap incorporating the extra interest. Note: Interest depends on borrowing and borrowing depends on net income (which in turn depends on borrowing) so you must work with a simultaneous relationship.
If you set up this circular reference in your spreadsheet, the solution will be generated for you automatically. The Tax Rate Schedule ($000) is given by: Part III: Valuation of a Firm as On-Going-Concern Keith Clarkson, sole owner and president of the Clarkson Lumber Company, has received a number of informal inquiries from large, nationally-recognized building materials distributors about purchasing his company. Although, Clarkson relishes operating his own business he would be interested if an attractive offer were received. Unfortunately, Mr.
Clarkson is unsure how much his company is worth so he turns to you for guidance. Value Clarkson Lumber at the beginning of 1996 assuming the firm will obtain a credit line at Northwestern National Bank sufficiently large to take advantage of discounts on purchases for paying within 10 days of invoice, thus increasing operating profit margins. With higher mark-ups and continued operating expense controls, Clarkson projects a steady operating profit margin of 6% by 2000 after which he expects the sales growth rate to drop to a fairly steady 5% per year.
Margins and investment requirements will also stabilize in relation to sales growth. Relevant projection inputs are in the table below and the cost of capital is 11. 5%. For simplicity, use a corporate marginal tax rate of 35% throughout the projections. Make whatever other reasonable assumptions are necessary to complete your analysis and explain the rationale for each. 20. Project overall Free Cash Flows for the next five years, 1996-2000. 21. Estimate the terminal value at the end of year 5.
You can provide convincing evidence about the Terminal Value (TV) by going over the following 2 scenarios: * TV as a growing perpetuity with g = 0%, g = 2%, g = 4%. Check how the values change in each of the cases. What do you conclude? * Multiple approach to TV. Which one? Why? What do you conclude? 22. Calculate the Enterprise Value of the company. What is Mr. Clarkson’s equity interest worth? 23. Compute the following multiples using year-end 1995 financial statements and the estimates of market values from your valuation: * Market-sales based on estimated Enterprise Value. Market-EBIT based on estimated Enterprise Value. * Price-earnings based on estimated Equity Value. * Market-book based on estimated Equity Value. In principle, how might you use these multiples to test the reasonableness of your valuation? What other data would you need? What do you conclude in each multiple? 24. What is the effect of slower growth on free cash flow? What about increased operating margins? 25. When will Clarkson start generating a positive Free Cash Flow? 26. [Difficult! Three line qualitative answer! What would you be willing to pay, as an outside investor, for a 30% ownership interest in Clarkson Lumber? On what does your answer depend on? Why? ——————————————– [ 1 ]. Note, holding interest constant at $13,000 is a simplification that avoids circularity: you need the required borrowing to compute interest expense and net income, but you cannot determine net income until you have the interest on the required borrowing. After finding the approximate solution above, you may, if you wish, find the more precise solution to this circularity suggested in the optional question.