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CASE PROBLEM

Houston Disbursement

Betsy Cotner went to work for a title com$-$

pany after graduating from college. The

department she worked in provided dis$-$

bursement advice to banks with regard to

oil$/$gas$-$related loans. When a bank

granted a construction loan, the money

was paid out according to progress made.

Someone had to monitor the project and

authorize disbursement of cash under the

loan agreement. While most banks moni$-$

tor progress themselves, a few rely on out$-$

side firms to do the monitoring, and this is

what Cotner's department did.

Cotner spent nearly a decade learning

the business and working her way up to as$-$

sistant manager of the department. Then

a recession caused a decline in profits for

the title company. The title company de$-$

cided to get out of oil$/$gas disbursement,

and the department manager decided to

retire.

Cotner thought that there was still

enough business to make a decent living

for herself if she did not have to bear the

overhead cost of the title company. As she

informed the lenders of the title com$-$

pany's decision, she also informed them

that she would be opening her own office.

She had developed an excellent personal

reputation, and several major lenders indi$-$

cated a willingness to continue doing busi$-$

ness with her. Thus, Houston Disburse$-$

ment was born.

As the recession ended, Cotner's busi$-$

ness picked up substantially, but she

began to worry about the vagaries of the

oil business. She decided to diversify into

general commercial construction in the

Houston area. She hired Brent Ross, a

young loan officer in the commercial con$-$

struction field, with the understanding

that he could eventually buy an interest in

Houston Disbursement.

Cotner soon came to realize that she

had gained little from diversification. A

drop in oil prices caused the entire Hous.

ton economy to turn down, even when the

national economy was strong. Based on

her experiences, Cotner prepared an esti$-$

mate of revenue and profits for Houston

Disbursement for both a strong and a weak

economy, and for both high and low oil

prices. Her estimates are summarized in

Table $13-3.$ While the analysis focuses on

earnings before tax, this is approximately

the same as cash flow because capital in$-$

vestments were limited to office furniture,

and net working capital was negligible. Net

working capital was kept negligible by the

practice of collecting retainer fees from

banks at the start of a construction project.

Cotner's salary, based on her estimate of

what she could get if she were working for

another company, is included in the cost

figures. The business was organized as a

Subchapter $S$ corporation and Cotner was

in a $28$ percent tax bracket.

To diversify, Cotner decided to open a

second office. She would go to the new lo$-$

cation and promote Ross to manager of the

Houston office. Two possibilities that would

take advantage of her current contacts were

a commercial construction disbursement

office in San Francisco and an oil business

disbursement office in Alaska. Cotner was

quite willing to move to either area.

Cotner's estimates of profitability ap$-$

pear in Table $13-4.$ The costs include a fair

wage for Cotner; there would be no signif$-$

icant wage savings at the Houston office

because a replacement for Cotner would

be needed.

Cotner considered high and low oil

prices equally likely. However, she be$-$

lieved the probability of a strong economy

was twice that of a weak economy. She did

not believe a weak economy was likely to

last more than $2$ years. Low oil prices, on

the other hand, could continue for at least

$5$ years. Oil prices and the economy were

both strong at the moment.

It would cost approximately $$75,000$ to

open an office in either San Francisco or

Alaska. The costs would be primarily de$-$

velopment costs and would be expensed

for tax purposes. Fixed assets included in

this cost would be under $$10,000,$ and a

provision of the tax law allowed expensing

up to $$10,000$ of fixed asset acquisitions.

Cotner had approximately $$200,000$ in$-$

vested in U$.$S$.$ government securities earn$-$

ing $9$ percent, so she would have no diffi$-$

culty in getting the $$75,000.$

Case Questions:

$1.$ Compute expected return and stan.

dard deviation of annual return for

each alternative separately.

$2.$ Compute covariance of annual re$-$

turns between the Alaska and Hous$-$

ton offices, and between the Califor$-$

nia and Houston offices.

$3.$ Compute the expected return and

standard deviation for each of the two

combinations.

$4.$ Prepare pro forma statements for

each new office combined with the

Houston office, using each of the four

possible conditions.

$5.$ What would you recommend to Cot$-$

ner? Why?