Please answer question 5

Case Study 5 SECURED SHORT-TERM FINANCING LAVELY CLOTHING COMPANY After rapid business growth in recent years, the Lavely Clothing Company in January 2007 anticipated further substantial increases in sales. Despite good profits, the company Los experienced a shortage of cash and has found it necessary to increase its long-term debt from the Benchmark Community Bank to $520,000 in January 2007. Lately, Tom Hicks, the founder and chief executive officer of the company, has been somewhat concerned about his firm's ability to raise the required amount of capital to finance future growth in sales. While Mr. Hicks has been treated as a preferred customer of the Benchmark Community Bank, Debra Brandon, vice president and loan officer at the bank, showed some signs of considerable displeasure at their recent meeting. The Lavely Clothing Company, located in Richmond, is a manufacturer of sportswear and swimsuits for men, women, and juniors. The company was incorporated in 1987, but until 2004 Mr. Hicks purposely restricted his sales to the Richmond area. During the last few years, however, he did notice a decided increase in his sales volume. From 2004 on, the company's sales grew rapidly and Mr. Hicks found it hard to expand the com- pany fast enough to keep up with demand. The company has now about 720 customers (department stores and specialty shops) throughout the southeastern United States. Reginald Dunnavant, the newly appointed vice president of finance, has been pondering the short-term financial problems of the company. Before Mr. Dunnavant took the job, he knew that his predecessor had been fired for inept working capital management. In order to better understand this alleged ineptness, he decided to analyze the financial data listed in Exhibits 1 and 2. Mr. Dunnavant has noted that the company's net sales and earnings after taxes have increased rapidly since 2004. This growth has been accompanied by comparable in- creases in assets and liabilities. He found that, while earnings rates have continued to improve, they were below industry standards for returns on investment and net sales. Furthermore, he observed that the company's return on owners' equity has been higher than the industry norm in 2007 simply because its debt ratio has increased steadily and has been consistently higher than the industry average. Mr. Dunnavant was stunned by a number of additional findings. First, the current ratio has dropped considerably to well below the industry average. Second, bad debt losses have expanded to four or five times the industry average. Third, the average collection period has been more than twice the industry standard. Fourth, while the dividend as percent of earnings after taxes has declined somewhat during recent years, it has been approximately two times as much as the industry norm. Fifth, the company received a notice from the Benchmark Community Bank which stated that the loan would be de clared due and immediately payable unless the current ratio of 1.76 was not improved to meet the industry average of 2.00 within two months. The bank's notice indicated that Dunnavant's predecessor had received a less severe notice one year earlier. Finally, the Benchmark Community Bank had raised the interest rate on the loan in 2006 and 2007 mainly due to the company's request for increases in the loan and its declining liquidity. Exhibit 1 Lavely Clothing Company Balance Sheets as of December 31, 2004 to 2007 (in thousands of dollars) 2004 2005 2006 $ 303 $ 237 1,185 1.313 Cash Accounts receivable Inventory! Current assets Plant and equipment (net) Total assets 1072 1.247 $ 2,422 649 $ 2,971 $ 240 1,266 1.518 $ 2,824 801 $ 3,525 2007 $261 1,586 1.859 $3,506 $ 2,535 205 $ 3,140 928 $ 4,334 Accounts payable $ 700 $ 830 $ 994 $ 1,368 Accruals 431 468 604 768 Current liabilities $ 1,031 $ 1,198 $ 1,498 $ 2,036 Long-term bank loan 381 362 415 620 Common stock 1,100 1,100 1,100 1,100 Retained earnings 752 780 812 878 Total liabilities and 100 100 100 100 owners' equity $ 2,971 $ 3,140 $ 3,525 $4,334 The inventory consists of 10 percent raw materials, 80 percent work in process, and 10 percent finished goods. 2 The long-term bank loan at an interest cost equal to the prime rate, plus 1 percent 1 (2004-2005); 1.5 percent (2006); and 3 percent (2007). Insiders control about 40 percent of common stock. Mr. Dunnavant has been informed by Mr. Hicks that the company will continue its plan for future sales growth and that it will not reduce its dividend payout ratio below 70 percent. Of course, he knows exactly what Mr. Hicks has asked him to do: (1) quickly meet the bank's mandate of increasing the current ratio, (2) simultaneously lower the average collection period and the debt ratio, and (3) drastically reduce the amount of bad debt losses. As Mr. Dunnavant suspects that stockholders would not approve new preferred or com mon stock issues at this time, he has proposed three alternatives for the consideration of Coding's directors. The first alternative calls for a reduction in current liabilities gh increases in the outstanding long-term bank loan, the latter possibly secured mgr finance company at an interest cost equal to the prime rate, plus a 3 percent Ay mentor. The second alternative calls for the pledging of accounts receivable with Ar the factoring of accounts receivable at a commission rate of 2 percent of net sales the company would be responsible for any bad debt losses. The third alternative calls mm. In this regard, he notes that the prime rate is currently 12 percent. In addition, and an interest cost equal to the prime rate, plus a 2.5 percent premium on advances Detve the receivables average due date. Exhibit 2 Lavely Clothing Company Other Financial Data as of December 31, 2004 to 2007 Industry 2004 2005 2006 2007 Average $4,579 Net sales' (5000) $5,071 $5,797 $6,896 NA $144 Earnings after taxes (5000) $ 166 $ 207 $ 259 NA Dividend as percent of 90.5% 87.3% 84.5% 74.5% 40.0% earnings after taxes Current ratio 2.49 2.22 1.95 1.76 2.00 Average collection period 77 days 78 days 73 days 79 days 35 days Debt ratio 42% 45% 50% 5896 40% Bad debt losses at percent of 1.5% 2.5% 4.0% 5.0% 1.0% gross sales 5.0% Return on investment 5.5% 6.0% 7.0% 6.1% (percent) Return on owners' equity 8.79 9.9% 12.196 14.6% 12.5% 3.296 Return on net sales? (percent) 3.3% 4.5% 3.6% All sales on credit whose terms are equal to the industry average. The operating costs of the company's credit department are 2 percent of net sales. 3.8% QUESTIONS 1. What is the effective interest cost of the second alternative (pledging of accounts receivable) to the company? 2. What is the effective interest cost of the third alternative (factoring of accounts receivable) to the company? 3. If all accounts receivable were factored and these funds were used to pay off current liabilities, what would have been the effect on the current ratio, and the debt ratio for 2007? 4. Do you think the Benchmark Community Bank would increase its loan to the company, even if it were secured by inventory? 5. Which of the three alternatives should the company select