HOW CHANGES IN THE FINANCIAL STATEMENTS AFFECT FINANCING DECISIONS: THE CASE OF JENLOU CO. Solutions to the Case Study

JenLou Co. Working Papers Financial Summary of JenLou's Financial Options Option 1: Using a Construction Loan After Recognizing Construction After Using the Construction Loan Income Statement Subtotals Net Sales Gross Profit Income from Continuing Operations before Taxes Net Income $9,025,000 $3,551,413 $744,448 $558,336 $9,025,000 $3,551,413 $679,636 $509,727 Balance Sheet Subtotals Current Assets Total Assets Current Liabilities Long-term Debt Total Equity $650,000 $8,040,000 $1,556,664 $1,650,000 $4,833,336 $2,530,000 $9,975,188 $1,540,461 $3,650,000 $4,784,727 $1,650,000 ($2,100,000) $400,000 $1,585,188 ($220,000) $400,000 Cash Flow Subtotals Cash Flow from Operations Total Change in Cash Cash, Dec. 31, Year 9 Option 2: Factoring A/R and Selling AfS Securities After Recognizing Construction After Factoring A/R and Selling Stock Income Statement Subtotals Net Sales Gross Profit Income from Continuing Operations before Taxes Net Income $9,025,000 $3,551,413 $744,448 $558,336 $9,025,000 $3,551,413 $1,251,448 $938,586 Balance Sheet Subtotals Current Assets Total Assets Current Liabilities Long-term Debt Total Equity $650,000 $8,040,000 $1,556,664 $1,650,000 $4,833,336 $1,877,000 $8,592,000 $1,728,414 $1,650,000 $5,213,586 Cash Flow Subtotals Cash Flow from Operations $1,650,000 $1,650,000 Total Change in Cash Cash, Dec. 31, Year 9 ($2,100,000) $400,000 ($50,000) $400,000 Option 3: Issuing a Bond After Recognizing Construction After Issuing the Bond Income Statement Subtotals Net Sales Gross Profit Income from Continuing Operations before Taxes Net Income $9,025,000 $3,551,413 $744,448 $558,336 $9,025,000 $3,551,413 $558,953 $419,215 Balance Sheet Subtotals Current Assets Total Assets Current Liabilities Long-term Debt Total Equity $650,000 $8,040,000 $1,556,664 $1,650,000 $4,833,336 $4,261,460 $11,651,460 $1,570,290 $5,386,955 $4,694,215 $1,650,000 ($2,100,000) $400,000 $1,560,000 $1,511,460 $400,000 Cash Flow Subtotals Cash Flow from Operations Total Change in Cash Cash, Dec. 31, Year 9 HOW CHANGES IN THE FINANCIAL STATEMENTS AFFECT FINANCING DECISIONS: THE CASE OF JENLOU CO. Background Information JenLou Co. is a privately held, medium-sized firm that produces gourmet foods, specializing in high quality desserts and other confections. During the past several years, the company has enjoyed record growth, fueled primarily by a new line of pies and cakes. Because of this new growth, the founders, Matt Jennison and Louis Martinez, were finally able to retire three years ago. When they did so, they hired a CEO to take care of day to day operations. However, they still own 100% of the company and are very much involved in the long-term decisions of the firm. In addition, they still make all of the salary and bonus decisions for the leadership team. Under the direction of the new CEO, the company has begun to expand geographically. They have opened several new stores on the East Coast and in the South. Now they plan to expand their operations to Europe and South America. To help them with these goals, Matt and Louis recently created an expansion fund to save money for their overseas growth in order to avoid excessive debt or the need for them to contribute more cash to the business. Unfortunately, new federal regulations have been passed, requiring the firm to update the equipment in its primary plant. Since the equipment is highly specialized, the JenLou's management team has made arrangements to have the equipment made to order. The new equipment will cost in excess of $2 million, a considerable amount for a firm of this size, especially when they already need a great deal of cash to continue their planned expansion. Matt and Louis, pleased with the performance of the leadership team over the past year, have decided to let the CFO and his team handle this new challenge. They have asked the team to keep in mind their goals for the business, and reminded them that their bonuses this year and in the future will be based primarily on the company's net income and reported financial ratios. Introduction Josh sighed as he gathered his notes and headed down the hall. He normally enjoyed his job as controller for JenLou, Inc., but there were days when he almost wished he was back at the CPA firm where he had started his career. Today was probably going to be one of those days. As usual, he was the first one to arrive in the conference room. After placing his notes on the table, he went to the window and looked out over the factory. Taking a deep breath, he tried to organize his thoughts before the meeting started. One week ago Carrie Samuelson, the CFO, had met with him and Emily Thompson, the VP of Finance. The meeting had focused on the equipment upgrade that the company now needed, a result of new regulations. She had made it very clear that their decision on how to finance the new equipment would not only affect their bonuses for next year, but would also affect how business decisions would be made in the future. 1 He hadn't understood that last part until he had found out that Matt and Louis, JenLou's owners, had decided to not to get involved with this decision. That was definitely a change in company policy. He knew that the new CEO, not to mention Ms. Samuelson, had been pushing for more autonomy, more ability to run the business like a normal corporation. This was their chance to demonstrate to the owners that the team was up to the task of managing the company. The problem, of course, was that the regulations had come as a complete surprise. Normally the executive team, after consulting with the owners, carefully saved for upgrades and refits several years before they had to actually pay for them. This time, however, they didn't have time to save. Instead, they would have to find outside funding. During the last meeting the executive team had reviewed the estimates from the vendor who would be building the new machines, then the CEO had asked the Finance Committee to consider some alternative financing options and make a recommendation to the whole team. Each of the committee members had agreed to look into ways to find the needed funds without asking for more equity funding. Josh sighed again. These meetings always ended the same way. They would talk about options, and then he would be asked to crunch the numbers on all of the options presented. Not that he minded crunching numbers, but next year's budget and estimated financial statements were due to the CEO and owners in less than a week. He really didn't have time for this right now. Meeting of the Finance Committee Before Josh could depress himself further, the door opened and Carrie Samuelson, the CFO, came in with Emily, the VP of Finance. "Oh, good," Carrie said, seeing Josh. "I'm glad you're already here. Let's go ahead and get started." She and Emily sat down as Josh came back from the window and sat down. \"Well,\" Carrie said when they were all settled. \"Let's get right down to business. First of all, here is a detailed estimate of the payment schedule the construction company sent me for the new equipment. I thought it would be a good idea if each of us had the numbers. As you can see, the work will be done by December 31st, allowing us to be up and running by next year.\" She handed Josh and Emily a piece of paper (see Figure 1). \"Now, what ideas do you have for making those payments?\" [Insert Figure 1 about here] \"Well,\" Josh started after a minute. \"I think our best option will be to take out a construction loan on the new equipment. \" \"A construction loan?\" Emily asked, her voice skeptical. \"You've got to be kidding. Think of the interest, not to mention the 30 years of payments.\" \"It doesn't have to become a 30 year mortgage. I was going to recommend a 3 year, quarterly note instead of a mortgage,\" Josh said quickly. \"We would only have to make the interest 2 payments for now, giving us plenty of time to save up for the principal payment at the end of the contract. Besides if we take out a construction loan, we can capitalize some of the interest.\" \"Those interest payments are going to cut into our profits, and they will definitely cut into our cash flow.\" Carrie jumped in before Emily and Josh could continue arguing. \"I think a long-term loan of some sort is going to be our only real option. My thought was to issue a $4 million, 6 year, semi-annual bond in February. That way we could not only spread out our interest payments, but we could also speed up some of our expansion plans with the extra funds. And if we use a lower interest rate, we wouldn't have nearly the cash outflows.\" Josh shook his head a little bit. \"That might be a little risky. Even cutting back to semi-annual payments would still leave us with a large cash drain this year. Although, if we issue a general bond, we would still be able to capitalize the interest like we could with a construction loan...\" Emily sighed loudly, cutting Josh off. \"You guys are both nuts!\" she said. \"Either of those options will leave us with a lower net income, both this year and in the future, not to mention a serious cash drain.\" Carrie raised her eyebrows. \"And I suppose you have a better idea?\" \"Of course.\" Emily said with a smile. \"First, I recommend we factor some of our Accounts Receivable. That wouldn't give us all the money we need,\" she continued quickly before Josh could interrupt her, \"but it would provide almost half of it. After all, we've got $900,000 in our receivables right now. I've already talked to a local collection agency, and they are willing to take them, with recourse, with only a 2 percent discount and a 3 percent withholding for discounts.\" \"Emily,\" Carrie began. \"I hate to break this to you, but that not only leaves us with insufficient funds, but also drops our net income. I don't see how that is better than the loans we've been talking about.\" \"That's because I'm not done yet,\" Emily said quickly. \"I propose that we get the rest of the funds by liquidating part of the expansion fund.\" \"Liquidating the expansion fund?\" Josh asked. \"You're kidding, right? The owners set up the expansion fund for foreign growth, not for redoing a current plant.\" \"Look,\" Emily said. \"Matt and Louis are not here. They have given us the authority to handle this situation ourselves. If we liquidate part of the expansion fund now, we can recognize the gains on the stocks that we have been holding. That will not only offset the loss from factoring the receivables, but it should also provide a nice boost to net income. That means that we'll actually increase our bonus for the year. Then, with the money we save using the more efficient machinery, we can rebuild the expansion fund. It will take a little while, but I think that we can get it all done before Matt and Louis notice that we've reduced the account.\" \"The auditors are bound to notice.\" Josh said. 3 \"Not necessarily,\" Carrie said quietly, a thoughtful look on her face. \"They aren't looking for how we make decisions. They are only looking for the accuracy of our records. As long as we really do liquidate the account, we really would be able to report the gain.\" \"Sure,\" Josh protested. \"But how exactly are we going to hide that sale from Matt and Louis? They'll see the gain in the income statement and know what we did. They have always been very careful to examine the books.\" \"Perhaps,\" Emily said. \"But they are getting older, and we do sell available-for-sale securities when we get a good deal. What they don't know won't hurt them, and will only help us.\" \"It's something to consider,\" Carrie said. \"I think it's ridiculous,\" Josh said. \"If we try something like this, we'll not only miss out on our bonus but we'll get fired.\" \"Let's not get started again,\" Carrie said quickly. \"Josh, I want you to go ahead and run the numbers on all three ideas, keeping in mind that our internal rate of return is 6 percent. Once we've seen the numbers, then we can make a final decision. Do you have all the number you need?\" Josh sighed. \"Well, I've got the information I need for my idea right here (see Figure 2). Do you have some information about your ideas?\" [Insert Figure 2 about here] Carrie and Emily both handed him summaries of their information (see Figures 3 and 4). \"Alright, get the numbers worked out and we'll meet again next week.\" With that, Carrie stood up and walked out. [Insert Figures 3 and 4 about here] Getting to Work Josh walked slowly back to his office with the papers in his hand. He had known that it wasn't going to be a good meeting, but he hadn't expected it to be that bad. Crunching numbers, even when he was busy with the master budget, wasn't really that big a deal. However, the ethical debates made him uncomfortable, especially when he felt like he was being maneuvered so that his only option violated his sense of right and wrong. Why did Emily have to be so pushy? And why did Carrie have to go along with her? He sighed as he pulled out a set of summary numbers from his master budget (see Figure 5). Well, he'd crunch the numbers first, then figure out how to handle the debate. [Insert Figure 5 about here] 4 Part 1 - Calculating the Effects on JenLou's Financial Statements For all questions in this section, round your answers to the nearest dollar. You should calculated the effects from question 1, then use the updated numbers from that question as your baseline in answering each of the remaining questions. 1. Recording the payments to the construction company. a. Assume the equipment being replaced originally cost JenLou $900,000 when the company was founded (at the beginning of Year 1). At that time management assumed that the equipment could be used for 15 years with no salvage value. Make the journal entry to record the abandonment of the old equipment on January 1st of Year 10 if JenLou uses straight line depreciation. If necessary, make an entry to record the tax effect of your entry. JenLou's tax rate is 25%. b. Make the journal entries for the payments to the construction company found in Figure 1. All payments must be made in cash. c. Based on the journal entries you just made (for parts a and b), update JenLou's summary numbers (see Figure 5 for the original balances). 2. Estimating the effects of Josh's idea. a. In addition to the entries made in part 1, what journal entries would JenLou have to make if Josh's idea was accepted? Use the information provided in Figure 2 to make the entries for the issuance of the mortgage note and any interest expense in the current year. Make one summary entry for the tax effects of these entries. b. Make the journal entry to capitalize interest and to adjust income taxes for this adjustment to interest expense. 1 c. Based on the journal entries you just made (in parts a and b), update JenLou's summary numbers (use your adjusted numbers from question 1c as a starting point). 3. Estimating the effects of Emily's idea. a. In addition to the entries made in part 1, what journal entries would JenLou have to make if Emily's idea was accepted? Use the information provided in Figure 3 to make the necessary entries for both the factoring of receivables and the sale of the expansion fund shares. Make one summary entry for the tax effects of these entries. 1 When calculating avoidable interest on this construction loan, don't forget that you can't begin capitalizing interest until the project has started (on February 1st). This means that you would calculate the weighted average expenditures for a maximum of 11 months (out of 12) and that your maximum avoidable interest would be 11/12 of the total interest accrued during the year. 5 b. Based on the journal entries you just made (in part a), update JenLou's summary numbers (use your adjusted numbers from question 1c as a starting point).2 4. Estimating the effects of Carrie's idea. a. In addition to the entries made in part 1, what journal entries would JenLou have to make if Carrie's idea was accepted? Use the information provided in Figure 4 to make the entries for the issuance of the bond and any necessary entries to record the interest. Assume JenLou uses the Effective Interest Method for amortizing premiums or discounts. Make one summary entry for the tax effects of these entries. (HINT: Without a formal market rate, Josh will have to use JenLou's IRR for his time value estimates.) b. Make the journal entry to capitalize interest and to adjust income taxes for this adjustment to interest expense. 3 c. Based on the journal entries you just made (in part a), update JenLou's summary numbers (use your adjusted numbers from question 1c as a starting point). Part 2 - Calculating the Effects on JenLou's Financial Statements Use your answers to part 1 in calculating your answers to the following questions. If you did not complete part 1, your instructor will provide you with the necessary numbers.4 1. Evaluating JenLou's original financial position. a. Calculate the following ratios using JenLou using Josh's original budget numbers: 1) ROA 2) Profit Margin 3) Asset Turnover 4) ROE 2 Remember that the overall goal is to compare the three financing options, so for each financing option you should make your adjustments as if the other financing options were NOT used. 3 When calculating avoidable interest on this construction loan, don't forget that you can't begin capitalizing interest until the project has started (on February 1st). This means that you would calculate the weighted average expenditures for a maximum of 11 months (out of 12) and that your maximum avoidable interest would be 11/12 of the total interest accrued during the year. 4 A suggested version of this handout is available in the Teaching Notes. 6 5) Debt to Equity Ratio 6) Current Ratio b. How would you describe JenLou's financial position prior to paying for the necessary upgrade? Use the ratios and summary financial numbers to support your answer. 2. Determining the effects of each financing option a. Recalculate each of the six (6) ratios listed above for each of the three financing options. b. What are the pros and cons of each of the three financing options? Write one paragraph for each option. 3. Evaluating each financing option. a. Which of the three financing options do you think the members of the finance team (Carrie, Emily, and Josh) prefer? Explain. b. Which of the three financing options do you think JenLou's owners would prefer? Explain. c. Which of the three financing options do you think investors would prefer if JenLou was a publicly traded company instead of a privately held company? Explain. 4. Resolving the Ethical Conflict in JenLou's Finance Team Josh (the controller) felt that Emily's option should be avoided because it was contrary to the owners' stated goals. Emily and Carrie felt that the option with the best income effect in the current period should be used, regardless of the owners' wishes. Using your knowledge of the principles of business ethics: a. Write 1-2 paragraphs defending Josh's opinion. b. Write 1-2 paragraphs defending Emily and Carrie's position. c. What business arguments could Josh use to convince Emily and Carrie not to choose Emily's financing option? d. What do you think the final decision will be? Do you agree with that decision? Why or why not? 7 Figure 1 Estimated Schedule of Payments to the Construction Company Payment Date 1-Feb 15-Mar 30-Jul 15-Sep 1-Dec Amount $100,000 $750,000 $750,000 $225,000 $175,000 $2,000,000 Figure 2 Basic Information for Josh's Suggestion of a Construction Loan Panel A: Construction Loan Details Cash Received $2,000,000 Interest Rate: 6% Years until Repayment 3 Panel B: Other Construction Loan Information - The loan would be taken out on January 1st, Year 10. - Payments would be made on March 31, June 30, September 30, and December 31, beginning in Year 10. Panel C: Information about JenLou's Other Outstanding Debt Long-term Liability Loan Payable Notes Payable 8 Principal $ 250,000 $ 1,400,000 Interest Rate 8.0% 7.0% 9 Figure 3 Basic Information for Emily's Suggestion of Factoring Receivables and Selling Some of the Expansion Fund Panel A: Factoring Information, with Recourse $ Total Accounts Receivable 900,000.00 $ Allowance for Bad Debt 50,000.00 Finance Charge 2% Withholding for Discounts 3% Revised Estimate for Bad Debts 5% Panel B: Summary of Expansion Fund Number of Shares Original Pur. Price Company XYZ Co. Terry Co. Frosty Co. 10,000 25,000 12,000 $30 $15 $9 Est. Price , Jan 1, Yr 10 $32 $35 $22 Only the shares of XYZ Co. and Terry Co. would be sold. The Frosty Co. shares would be saved to keep the expansion fund open. Figure 4 Basic Information for Carrie's Suggestion to Issue a Bond Panel A: Bond Details Principal Amount Stated interest Rate Years 10 $4,000,000 4.5% 6 until Repayment Payments per Year 2 Panel B: Other Bond Information - The bond would be issued on March 1, Year 10 - Payments would be made on August 31 and February 28 each year. 11 Figure 5 Summary Numbers from JenLou's Financial Statements Year 10 (Est.) Income Statement Subtotals Net Sales Gross Profit Income from Continuing Operations before Taxes Net Income Year 9 $9,025,000 $3,551,413 $1,104,448 $828,336 Balance Sheet Subtotals Current Assets $2,650,000 Total Assets $8,400,000 Current Liabilities $1,646,664 Long-term Debt $1,650,000 Total Equity $5,103,336 Cash Flow Subtotals Cash Flow from Operations Total Change in Cash $1,650,000 ($100,000) Cash, Dec. 31, Year 9 12 $2,750 ,000 $6,400 ,000 $1,025 ,000 $1,100 ,000 $4,275 ,000 $400,0 00 Analysis Project: Acct 582 Instructor: Jason Porter Basic Instructions The analysis portion of the comprehensive project will give you the opportunity to analyze your own business and consider how that analysis can help you to improve your processes. This project, on the other hand, will give you the chance to examine and analyze the numbers from specific business options. While the goal of this project is to help you decide which financing option will provide the best option for the business, keep in mind that no analysis is perfect. The principles we've studied, and the analyses you are going to perform, are general rules and guidelines. Each company is too different, each industry is too different, and each national economy is too different for us to give hard and fast rules that will always hold. If you ever come up with some rules like that, though, let me know. I'd be happy to be your investment partner! Assignment Read through the \"Analysis Case\" file available on BBLearn. This case presents a problem commonly faced in the business world: how to get the financing we need in order to make a large investment. In this case, the investment is mandatory (through government regulation), so the company does not need to decide if to invest but rather how to invest. That's where you come in. At the end of the case, you will find two sets of questions. The first set is designed for accounting students and requires extensive journal entries and adjustments to the financial statements. Do NOT attempt this first section! Instead, move on to part 2 and answer all of the questions presented, including question 4 about the ethical dilemma this team is facing. On BBLearn you will find an \"Updated Numbers\" file that includes all of the financial numbers you need for your calculations. Please, that Figure 5 (on the very last page of the case) includes financial numbers from the previous year to help you make your calculations. Grading This project is worth 200 points based on the following: 72 points for the ratio calculations (3 points each; 6 ratios calculated 4 times) 10 points for evaluating the strength of the company prior to investing in the new equipment 30 points for evaluating the pros and cons of each investment option (10 points each) 30 points for answering question 3 (10 points for each portion of the question) 40 points for answering question 4. Your score on this section will be double your score on the ethics rubric available on BBLearn. The final 18 points are for overall formatting. Make sure that your answers are easy to read and to find. The formatting points will be based on the following: 2 Create a title page similar to the one at the beginning of this packet. Use an easy to read table (or tables) to present your ratios Proofread your work to correct grammatical errors and to ensure that your ideas make sense as they are presented. Use either PDF or Word format for your final submission. Use normal (1") margins, standard page set up (i.e. 8 x 11 pages), and 12 point font The project is due by 11:00pm on the date given in the syllabus. However, you may turn it in early if you wish. 3