TIRE CITY, INC. (2019*) Jack Martin, Chief Financial Officer of Tire City, Inc. was preparing for a meeting with his companys bank later in the week. At that meeting Mr. Martin intended to present a request that the bank grant Tire City a five-year loan to finance anticipated growth in the company and an expansion of the companys warehouse facilities. In preparation for his meeting, Mr. Martin gathered some recent financial statements for Tire City (see Exhibit 2). COMPANY BACKGROUND Tire City, Inc. (TCI") was a rapidly growing retail distributor of automotive tires in the northeastern United States. Tires were sold through a chain of 10 shops located throughout eastern Massachusetts, southern New Hampshire, and northern Connecticut. These stores kept sufficient inventory on hand to service immediate customer demand, but the bulk of Tire Citys inventory was managed at a central warehouse outside Worcester, Massachusetts. Individual stores could be easily serviced by this warehouse which could usually fill orders from individual stores within 24 hours. For the year ended December 2018, TCI had sales of $23,505,000. Net income for that period was $1,190,000. During the previous three years net sales had grown at a compound annual rate in excess of 20%. This record was a reflection of Tire Citys reputation for excellent service and competitive pricing, which yielded high levels of customer satisfaction. Past Relationship with MidBank In 2014 TCI had borrowed funds from MidBank to build a warehouse. This loan was being repaid in equal annual installments of $125,000. At the end of 2018 the balance due on the loan was $875,000. Also in 2014 TCI established a line of credit with MidBank. The company had not yet borrowed any money under this credit arrangement. The Current Financial Need TCI had decided to expand its current warehouse facilities to accommodate future growth. Indeed, the current warehouse facilities were practically bulging at the seams. During the next 18 months, TCI planned to invest $2,400,000 on its expansion, $2,000,000 of which would be spent during 2019 (no other capital expenditures were Tire City, Inc. (2019) page 2 planned for 2019 or 2020). This expansion would fulfill the companys anticipated needs for several years. The warehouse construction project was expected to be completed in early 2020. Therefore, TCI would not be able to deduct any depreciation on the new building in 2019. However, Mr. Martin was told by his account that in 2020 TCI could recognize a depreciation expense of 5% of the warehouses total cost. The dollar value of TCI's depreciation on its other assets in 2019-2021 would be the same as it was in 2018. The warehouse would be in the MACRS 20-year class. The warehouse expansion project was designed so that disruption of the companys current operations would be minimized. However, management expected that by the end of 2019 TCI would temporarily have to reduce its inventories to a level of $1,625,000, significantly lower than the $2,190,000 shown on the Balance Sheet at the end of 2018. This cutback in inventories was expected to last only until the warehouse construction project was complete in early 2020. Mr. Martin had estimated that by the end of 2020, inventory would rise back to the same proportional level that it had been in 2018. Other than this temporary drop in inventory in 2019, the warehouse expansion was not expected to affect TCIs operations in any other material aspects. Operating margins were expected to be consistent with recent past experience (the temporary drop in inventory would not affect cost of goods sold as a percentage of sales, for example). Likewise, current accounts other than inventory were expected to maintain steady relationships to sales. Cash balances would be maintained at a level of 3% of sales during the next three years. Following the tax law change of late 2017, TCIs combined federal and state income tax rate was expected to be 24% for each of the following years, except that it was possible the new Congress might change that at some point. In view of the companys expected stability in its financial results, Mr. Martin expected TCIs dividend policy to remain unchanged in the foreseeable future. TCI had preliminary discussions with MidBank about borrowing money to finance the warehouse expansion and the growth of the business. The proposed terms of the financing called for taking down (i.e., borrowing) in two separate parts, on an asneeded basis: one in 2019 and one in 2020. The loan would be repaid in four, equal annual installments. The first installment would take place one year after construction of the warehouse was completed (i.e., in 2021). The interest rate was set at 10% per year. In addition to the banks requirement that cash be maintained at 3% of sales, for liquidity, they also require that the CURRENT RATIO be maintained at a level of 2 to 1 (or higher). MR. MARTINS TASK In preparation for his meeting, Mr. Martin intended to prepare a set of pro forma financial statements for the company for the next three years. His first priority was to project sales for the next three years using historical basis: Tire City, Inc. (2019) page 3 Mr. Martins second priority was to project what the rest of the Income Statement and Balance Sheet would look like for the firm at the end of 2019, 2020 and 2021 (a three year projection). His third issue had to do with his and the Bankers concerns: They were concerned that the opposition party in Congress would be successful in raising the tax rate back to a combined rate of 35%, and in a rising interest rate economy there was a possibility that the variable rate loan would need to be repriced to a rate as high as 13%. The bank wanted Mr. Martin to perform a sensitivity analysis showing that TCI could continue to pay their loan obligations if that scenario happened. Exhibit 1: Sales History 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 3166 3725 4382 5478 6848 9130 12173 16,230 20,355 23,505 Tire City, Inc. (2019) page 4 E x h ib it 2 : H is to ric F in a n c ia l S ta te m e n ts 2 0 1 6 2 0 1 7 2 0 1 8 N e t S a le s 1 6 ,2 3 0 2 0 ,35 5 2 3 ,5 0 5 C o s t o f S a le s 9 ,4 3 0 1 1 ,8 98 1 3 ,61 2 G ro s s P ro fit 6 ,8 0 0 8 ,45 7 9 ,8 9 3 S G & A 5 ,1 9 5 6 ,35 2 7 ,4 7 1 D e p re cia tio n 1 6 0 18 0 2 1 3 N e t Inte re s t E x p 1 1 9 10 6 9 3 E B T 1 ,3 2 6 1 ,8 1 9 2 ,1 16 T a x 5 4 6 8 2 2 5 0 8 N e t In c o m e 7 8 0 9 9 7 1 ,6 08 D ivid e n d s 1 5 5 20 0 2 4 0 A S S E T S C a s h 5 0 8 60 9 7 0 6 A /R 2 ,5 4 5 3 ,09 5 3 ,6 5 2 In ven to rie s 1 ,6 3 0 1 ,8 3 8 2 ,1 90 C u rr A s s e ts 4 ,6 8 3 5 ,54 2 6 ,5 4 8 G ro s s P P & E 3 ,2 3 2 3 ,79 5 4 ,1 6 3 A c c D ep r 1 ,3 3 5 1 ,5 1 5 1 ,7 28 N e t P P & E 1 ,8 9 7 2 ,2 8 0 2 ,4 35 T o ta l A s s e ts 6 ,5 8 0 7 ,8 2 2 8 ,9 83 L IA B IL IT IE S C u rre nt L T D 1 2 5 12 5 1 2 5 A c c ts P aya ble 1 ,0 4 2 1 ,32 5 1 ,4 4 0 D e fe rre d In c o m e T a x e s 0 0 0 A c c ru e d E x p 1 ,1 4 5 1 ,4 3 2 1 ,6 53 C u rren t L ia b s 2 ,3 1 2 2 ,8 8 2 3 ,2 18 L T D 1 ,0 0 0 8 7 5 7 5 0 T o ta l L ia b s 3 ,3 1 2 3 ,7 5 7 3 ,9 68 C o m m o n 1 ,1 3 5 1 ,13 5 1 ,1 3 5 R e t E a rn s 2 ,1 3 3 2 ,9 3 0 3 ,8 80 T o ta l E q u ity 3 ,2 6 8 4 ,06 5 5 ,0 1 5 T o ta l L ia b s & E q u ity 6 ,5 8 0 7 ,8 2 2 8 ,9 83 Ac tu a l T IR E C IT Y , IN C . 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