Kootenai International, Inc. Kootenai International, Inc., (NASDAQ symbol:KHALB) is a diversified furniture and electronics man-ufacturer that sells wood and metal office furniture,lodging furniture, and electronic assemblies (includingcomputer keyboards and mouse pointing devices).*The Lodging Group (part of the "Furniture andCabinets" segment) is experiencing dramatic growth insales and income, increasing market share at the sametime that the hospitality industry is continuing itsrefurbishing cycle. The assistant treasurer isconsidering increasing the company's investment inthis high-growth area. He believes if the companychanges its credit standards and credit period, it willadd profitable sales. Along with the rest of the topmanagement staff and the board of directors, he isconcerned about the slowly growing or declining salesand/or market share in some of Kootenai's segments[such as the original equipment manufacturers (OEM)Furniture and Cabinets unit]. Sales continued to growat a moderate pace in the larger two of the company'sthree business segments(Furniture and Cabinets,and Electronic Contract Assemblies), but sales in thecompany's smallest business segment (ProcessedWood Products and Other) declined from the prioryear's first quarter. According to the company's 10-Kannual report of its financial statements and operatingresults (as filed with the Securities and ExchangeCommission, p. 9): "Sales of Original Equipment Manufacturer(OEM) product lines, primarily television cabi-nets and stands, audio cabinets, and residentialfurniture, decreased in the 3-month period whencompared with one year earlier. Lower sales vol-ume of cabinets were caused by a major cabinetcustomer experiencing lower market demand fortheir products. Although certain other cabinetcustomers increased their volumes, this productline experienced an overall decline in sales vol-ume. Production flexibility is inherent in the OEMsupplier market and may cause short-term fluc-tuations in any given quarter. Volumes of contract 'The company aiid its attributes arc real, hut tin; credit policyaspects are fictitious. Check with your instructor to see if he orshe wishes to have you supplement the cist data gathered fromother print or electronic sources.

residential furniture increased from the prior year.Some OEM production capacity was used for pro-duction of hospitality furniture during the quar-ter. OEM operating income declined from theprior year's level as a result of the decrease in salesvolume and, to a lesser extent, an unfavorablesales mix toward lower margin products." The assistant treasurer believes that the company's fu-ture is linked to significant growth in a few areas suchas the Lodging Group. He has asked for your advice asthe senior credit analyst in the credit department.At present, the company holds roughly 25 percentof its $557 million asset base in the form of cash andmarketable securities. Its present average credit periodfor paying customers of the Lodging Group is 54 days.The company extends 45-day terms to its customers.The bad debt losses on the Group's sales are a re-spectable 1.7 percent. Sales in the Lodging Group areS85 million, almost one-tenth of the company's S983million sales. The variable costs for lodging furniture,excluding credit administration and collection costs,average 45 percent. The company's weighted averagecost of capital is 10 percent. It presently has surplusfunds invested at an average rate of 6.5 percent. Salesestimates under two independent proposals for changesin the credit policy are as follows: Proposal A: Lengthen credit period to 60 days.Proposal B: Ease up on credit standards.Proposal C: Implement both Proposals A and B. Other relevant aspects of the company's financial posi-tion were also provided to the credit analyst from themanagement discussion in the 10-K report (pp. 10-11). Consolidated selling, general and administrativeexpense, as a percent of sales, increased 1.2 per-centage points for the 3-month period (com-pared to the year earlier), primarily as a result ofmoderate additions to the Company's existing in-frastructure supporting the higher sales volume,additions as the result of acquiring ELMO Semi-conductor in the latter half of the prior fiscal year,and certain other costs that are variable withearnings.Operating income for the first quarter of 1997was $19,183,000, increasing 2.8 percentage

Credit Administration & Paying Customers' Lodging Group Bad Debt Expense Rate Collection Expense Collection Policy Sales {% of revenue) (% of revenue) Periodpresent S85 million 1.7% 2% 54 days Proposal A S95 million 2.0% 2.1% 66 daysProposal B $100 million 2.3% 3% 63 daysProposal C $105 million 2.15% 2.5% 68 days

points, as a percent of sales, when compared tothe first quarter of 1996, primarily as a result ofsales volume increases, the diminished effects ofmaterial price increases that were experienced inthe prior year's first quarter, and manufacturingefficiency improvements, including benefits fromquality and cost containment initiatives.Investment income for the first quarter re-mained flat when compared to the same periodin the previous year, as higher investment bal-ances were offset by a lower effective yield.Othernet includes $3.8 million related to a losson the sale of a foreign subsidiary in the currentyear, which is offset by a $3.8 million income taxbenefit recorded in Taxes on Income. The re-maining decrease in Other income or expensenet is primarily due to larger gains realized on thesale of assets in the prior year.Taxes on Income includes a $3.8 million taxbenefit relating to the sale of a foreign subsidiaryin the current year's first quarter. This tax bene-fit was the result of a higher U.S. tax basis in thissubsidiary as a result of previously undeductiblelosses on the investment in this U.K. subsidiary.Excluding this tax benefit, the effective incometax rate decreased 1.3 percentage points in the 3-month period when compared with the prior yearpartly as a result of reduced European operatinglosses that provide no immediate tax benefit.The company achieved net income of$13,521,000, or $0.65 per share, for the first quar-ter of the 1997 fiscal year, a 61% increase over theprior year's first quarter net income of $8,418,000,or $0.40 per share. LIQUIDITY AND CAPITAL RESOURCESCash, Cash Equivalents and Short-Term In-vestments totaled $140 million at September 30,1996, as compared with $117 million one yearearlier. Liquidity remained strong with workingcapital and the current ratio at $230 million and2.7 to 1, respectively, at September 30, 1996, ascompared with $204 million and 2.7 to 1, re-spectively, one year earlier.

Operating activities continued to generatepositive cash flow, which amounted to $38 mil-lion for the three months ended September 30,1996. Portions of the company's cash flow fromoperations were reinvested in the business to fund$9 million of capital investments for the future,primarily production equipment upgrades andimprovements in the company's business infor-mation systems. Five million dollars was used forfinancing activities, primarily to pay dividends.Net cash flow, excluding purchases and maturi-ties of short-term investments, amounted to apositive $26 million for the 3-month periodended September 30,1996.The company anticipates maintaining a strongliquidity position throughout the 1997 fiscal yearwith cash needs being met by cash flows providedby operations, available cash balances, and short-term investments on hand. 1. Which proposal, if any, should Kootenai adopt?Defend your position based on the value effect andthe present financial position of the company.Indicate why you chose the discount rate used inthe analysis. 2. How does the financial position of the companystrengthen or weaken the recommendation youmade in 1? 3. The assistant treasurer indicates to you that one ofthe Electronic Products senior managers thinkscapital should be allocated to his unit instead of tothe Lodging Group. How should the assistanttreasurer respond to this concern? (You may useany business concept or approach to answer this,not limiting the answer to the credit policy pro-posals.) 4. What competitor reactions are likely if Kootenaiunilaterally makes one or both credit policychanges? How might this be incorporated into thepresent analysis?