CASE 10-3 MAGMA MINERALS, INC.' Menagerial Finance Concept : Cash budgeting as a support to Credit planning Financial Analysis Technique : Preparation of a cash budget Decision Context : The company needs to program its cash flows to meet a maturing bank loan William Chua was reviewing the figures he had gathered from his accountant at Magma Minerals, Inc., a processor of raw kaolin mineral. Kaolin was a nonmetallic mineral used in ceramics and rubber. The company had to pay the current portion of its long- term loan from First Development Bank due at the end of May. The Company planned to generate cash from its sole source of revenue, namely, one processing or "tolling" contract with Megalndustries. Chua wanted to prepare a plan intended to raise the required cash to repay the loan out of that single contract. Company Background Magma Minerals, Inc., was founded by partners William Chuo and Rufino Ledesma, both of whom were engineers with a knack for research and development and entrepreneurship. They saw an opportunity to build a plant that could process the raw mineral kaolin. Manufacturers were importing processed kaoMo which was not locally available. The partners pooled their savings to build an experimental plant using machinery and equipment that they designed and fabricated. Chua became the general manager of the company while Ledesma continued in his research and develop- ment activities. The production of processed kaolin actually involved several steps. The difficult part was manufacturing products that meet the narrow tolerance levels for the degree of fineness of the The case was written by Dr. Cer G. Saldahe, Ph.D. o PSR Consulting, Inc., basis tardeaussion het en varning seminar. Can we not intended Snare constantling of managementuene. De the produced or protocopied when the permission of the particles and in purity from metallic content). The process volved grinding, mixing and drying. To simplify their operations, the partners decided to serve the needs of distributors of kaolin as a processor under a tolling contract. Under this arrangement, the distributor provided the raw kaolin and Magma Minerals only processed the materials, charging a straight per unit (kilogram) fee. Towards the end of the experimental phase of the project, the partners took a five-year term loan from First Development Bank to build the machinery and refurbish the plant for full commercial operation. The loan had a prace period during which time the company paid only the Interest. The first loan amortization was due on May 30. In November of the previous year, the company approached Mege Industries, an importer specializing in kaolin and other mineral products for the ceramics industry, to offer their processed kaolin. Mege Industries agreed to try Magma Minerals' produet with an initial order of 60 tons or about three truckloads. Mega Industries provided raw kaolin to ensure quality of the raw material. The company tested the finished products before delivering to them. After a processing period of two months inclusive of quality testing and use by the ceramics manufacturers, the two parties agreed that the processed kaolin was of acceptable quality. Mega Industries gave Magma Minerals a contract to process kaolin for one year, renewable at the end of each year. The contract was to begin in February Forecast Sales and Future Cash Flows Before the end of January, Chua prepared an estimate of tolling fees (in pesos) for the next eight months, as follows: February 900,000 March 975,000 April 1,125,000 May 2,200,000 June 1.050.000 July 900,000 August 800.000 September 1,850,000 verles under the tolling contract matched the highly casonal sales pattern of ceramic tiles which thrived during the construction peak sonson from April to July. Mega Industries shipped processed kaolin to these companies following the same pattern. reneged on its amortization schedule, the balance of the loer would become due and demandable. In case the internal cash was not sufficient, Chua thought that members of the family could put up the balance if he could give them at least a few months' notice. After examining the loan documents, Chua found out that the first loan amortization due on May 30 amounted to P620,450. He wondered whether he would have sufficient cash by then. He realized that he faced risks because such amortization had to be met to remain in good standing with First Development Bank. Under the tolling contract, Mega Industrias paid the company 50 percent in the month of sale, 30 percent in the month following sales, and 20 percent two months after sale. The staggered payment schedule was designed to allow Mega Industries time to receive feedback from ceramics manufacturers, their customers, regarding the quality of the processed kaolin. If adverse responses were received, Mega Industries will ship back the identified lots and Magma Minerals would re-process them through a "beneficiating process (further refining and mixing). In this way. the payments of accounts in the tolling contract were independent of the manufacturing of the product. GUIDE QUESTIONS c) What variables determine the monthly cash position of the Company? The company planned to hire factory labor and to run the plant According to the level of orders from Mega Industries. Fuel was the main expense at 10 percent of tolling fees per month. Labor was about 8 percent of tolling contract revenues per month. Maintenance Oxpenso was about 5 percent of tolling contract revenues. Other expenses were salaries to administrative staff and sundry expenses amounting to P195,000 per month. Depre- ciation expense came to P129,750 per month. The company had to pay some remaining balances to equipment contractors worth P278,400 in March. Taxes amounting to 35 percent of income were also payable at the end of each quarter. The First Loan Amortization Chua worried about the payment of the first loan amortization on the long-term loan from First Development Bank. The test processing for the initial 60 MT of kaolin nearly depleted the company's cash balance which currently stood at only P50,467. Chua would have wanted to keep at least P150,000 in the bank at any given time. Chua remembered that one of the conditions involved an acceleration clause" that meant that if the company