Capstan Autos operated an East Coast dealership for a major

Japanese car manufacturer. Capstan?s owner, Sidney Capstan,

attributed much of the business?s success to its no-frills policy of

competitive pricing and immediate cash payment. The business

was basically a simple one?the firm imported cars at the beginning of

each quarter and paid the manufacturer at the end of the

quarter. The revenues from the sale of these cars covered the payment

to the manufacturer and the expenses of running the business, as well

as providing Sidney Capstan with a good return on

his equity investment.

By the fourth quarter of 2004 sales were running at 250 cars

a quarter. Since the average sale price of each car was about

$20,000, this translated into quarterly revenues of 250 $20,000

= $5 million. The average cost to Capstan of each imported car

was $18,000. After paying wages, rent, and other recurring costs

of $200,000 per quarter and deducting depreciation of $80,000, the

company was left with earnings before interest and taxes

(EBIT) of $220,000 a quarter and net profits of $140,000.

The year 2005 was not a happy year for car importers in the

United States. Recession led to a general decline in auto sales,

while the fall in the value of the dollar shaved profit margins for

many dealers in imported cars. Capstan more than most firms

foresaw the difficulties ahead and reacted at once by offering 6

months? free credit while holding the sale price of its cars constant.

Wages and other costs were pared by 25 percent to

$150,000 a quarter and the company effectively eliminated all

capital expenditures. The policy appeared successful. Unit sales

fell by 20 percent to 200 units a quarter, but the company continued

to operate at a satisfactory profit.

The slump in sales lasted for 6 months, but as consumer confidence

began to return, auto sales began to recover. The company?s new

policy of 6 months? free credit was proving sufficiently popular that

Sidney

Capstan

decided

to

maintain

the

Guidelines

policy. In the third quarter of 2005 sales had recovered to 225

units; by the fourth quarter they were 250 units; and by the first

quarter of the next year they had reached 275 units. It looked as

if by the second quarter of 2006 that the company could expect to

sell 300 cars. Earnings before interest and tax were already in excess

of their previous high and Sidney Capstan was able to congratulate

himself on weathering what looked to be a tricky period.

Over the 18-month period the firm had earned net profits of over

half a million dollars, and the equity had grown from just under

$1 million to about $2 million.

Sidney Capstan was first and foremost a superb salesman and

always left the financial aspects of the business to his financial

manager. However, there was one feature of the financial statements

that disturbed Sidney Capstan?the mounting level of

debt, which by the end of the first quarter of 2006 had reached

$9.7 million. This unease turned to alarm when the financial

manager phoned to say that the bank was reluctant to extend further

credit and was even questioning its current level of exposure

to the company.

Capstan found it impossible to understand how such a successful year

could have landed the company in financial difficulties. The company

had always had good relationships with its

bank, and the interest rate on its bank loans was a reasonable 8

percent a year (or about 2 percent a quarter). Surely, Capstan

reasoned, when the bank saw the projected sales growth for the rest

of 2006, it would realize that there were plenty of profits to enable the

company to start repaying its loans.

Required:

You are required to write a report to generally answer these questions:

You need to introduce a framework in details, and answer the below

questions as the main questions of the report.

1. Is Capstan Auto in trouble?

2. Is the bank correct to withhold further credit?

3. Why is Capstan?s indebtedness increasing if its profits are higher

than ever?

Each question should be discussed based on the framework that is

introduced in introduction.

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