You are a management accountant at Parker Plastics. A few days ago the founder, James Parker, asked you to stop by his office: This past weekend a neighbor mentioned that he owns a 10% stake in Bastion Finance that he would like to sell. He inquired if I would be interested in purchasing the holding. He said it has been paying a generous dividend. I am thinking that the investment could provide a stable source of cash flow for our company. I would like you to review their operations and let me know what you think of the potential. Start by preparing an estimate of what you think their financial statements will look like for next year. I realize the result will only be as good as your assumptions. But if your assumptions are reasonable, the estimated statements should provide a good starting point for deciding whether to pursue an investment in the company.

Mr. Parker went on to say that the 10% stake is currently owned by his neighbor, Lance Edwards. You immediately recognized his name. Lance is one of the countrys most popular professional football players. Back in your office, you called Lance to arrange a meeting to learn more about Bastion Finance.

Lance was happy to meet with you and has been very cooperative in answering your questions and passing on the information he has about the company. Lance mentioned that he is approaching the end of his football career and is now looking for a new challenge. He wants to build a major state-of-the-art athletic training facility for promising young athletes. He plans to fund this venture by selling his stake in Bastion Finance.

Bastion Finance was formed just over six years ago by Eric Lombard and Walter Carson. They each contributed $100,000 in return for a 50% share in the new corporation. Then they each donated a 5% stake to Lance in exchange for an agreement by Lance to regularly appear on TV, radio, and in print advertising on behalf of Bastion Finance. Lance does not participate in the management of the firm nor does he serve on the Board of Directors. The agreement for Lance to provide promotional services has recently expired and Lance is now ready to move on with his plans for his new business.

You learn that Bastion Finance raises cash by selling debentures to investors at interest rates well above those available from banks or insured financial institutions. The interest rates are advertised in the business section of several newspapers, but funds are formally solicited through a prospectus. Most of Bastions investors are retirees, many of whom make their investments through commission-based financial advisors. Although investors are actually purchasing fixed-period debentures, management refers to them as depositors. Bastion is not a bank. It provides no banking-type services for depositors nor does it have a physical facility for one-on-one personal service. Consequently, the firm is not subject to banking regulations.

The funds acquired from depositors are lent to property developers. Bastion concentrates its lending to developers needing second mortgages. These developers typically take out a first mortgage for a project from a traditional bank or insurance company. But these institutions generally limit the amount they will loan on a project to 80% of the construction costs. For well-capitalized developers, this is sufficient for them to proceed with a project by combining the borrowed funds with their own capital. Yet Bastion lends to those developers who must borrow 100% of their construction costs. Bastion provides the additional funds as a second mortgage. These are high-risk mortgages. In the event a development fails to be profitable, the second mortgage holder gets repaid only to the extent that the proceeds from the sale of the development exceed the amount owed on the first mortgage. All of a developments assets are typically pledged as collateral to the first mortgage holder and a developer who must take a second mortgage usually has little or no capital of their own at stake. This added risk of being second in line means that market interest rates for second mortgages are much higher than the prevailing rates on first mortgages. Bastions business plan is to take advantage of these higher rates while being judicious in its selection of which developers to fund. Developers are attracted to Bastion because it does not require developers to make any payments for interest, fees, or principal until a project is completed and sold (but interest is accrued and compounded annually).

Lance said that the company was a success from the start. It far surpassed Eric and Walters expectations. But they are generous in giving me a great deal of credit for their success. They said many of my older fans were eager to invest in a company that I endorsed. The growth rate in deposits in the first couple of years was remarkable and the firm has consistently maintained a large cash balance. The company cites this large cash holding as evidence of the firms solid financial position.

Because Bastion Finance is closely held, it is not required to prepare a formal annual report for public distribution. Yet Lance receives copies of each updated prospectus provided to depositors. These prospectuses contain audited financial statements. In addition, each year he receives a supplementary report containing information thought to be of interest to shareholders. Lance provided you copies of the investor prospectuses. From them, you have prepared the summary financial statements given in Exhibit 1. He also provided you with the supplementary shareholders information he received for Year 6. It is appended as Exhibit 2. Lance laughed and said he also kept souvenir copies of the loan cards for two loans that were not fully repaid. These are presented in Exhibit 3. Lance said, In both cases, Walter pointed out that Bastion made money on these loansjust not in the full amount that had been anticipated.

You returned to your office after the meeting with Lance and reviewed the materials he had given you. It is now time to formulate estimated financial statements for Year 7. You have lots of data available, but you will have to use judgment in making some required forecasts

What are the main risks you identify with Bastion Finance and the proposed investment?

Would you recommend to Mr. Parker that he buy into Bastion Finance and why? (one paragraph).

ReceiptsCash Receipts: From New Term Deposits $10.0 From Loan Customers 116.9 Total Receipts: $126.9 Cash Disbursements: Interest Payments $50.2 Salaries, Wages, Taxes, Other $ 2.3Total Disbursements $52.5 Cash Increase over the Year $74.4 ADD: Beginning Cash Balance $81.1 Cash Available During the Year $155.5 Cash Flow Cash Receipts: From New Term Deposits $10.0 From Loan customers 116.9 Total Receipts $126.9 Cash Disbursements: Interest Payments $50.2 Salaries, Wages, Taxes, Other 2.3 New Loans Made 130.0 Dividends Paid 7.0 Total Disbursements $189.5 Cash Decrease over the Year $62.6 Beginning Cash Balance 81.1

Ending Cash Balance $18.5 Accrued Interest IncomeLOANS: 506 $36.0 x .10 $3.6 405 28.6 x .15 4.3 601 76.9 x .13 10.0 602* 52.1 x .15 3.9 603* 57.2 x .13 3.7 604 96.9 x .10 9.7 605 45.6 x .14 6.4 New* VAR 130.0 x.13 8.5Total Interest Revenue $50.1 * New loans issued July 1, Loans 602 and 603 paid June 30. Income StatementRevenues: Interest Income $50.1 Loan Fees (8% of new loans) 10.4Operating Revenue $60.5 Expenses: Interest Expense $50.6 Salaries and Wages 1.7 Other 0.6 Operating Expenses $52.9 Operating Income $ 7.6 Income Tax ? Net Income $ 7.6 Statement of retained earningsBeginning Retained Earnings $7.0 Plus: Net Income 7.6 Less: Dividends -7.0 Ending Retained Earnings $7.6 Ending Loans ReceivableLoanBeg. Bal. Loan FeesAccrued Int. Ending Bal.405 $28.6 $4.3 $32.9 506 36.0 3.6 39.6 601 76.9 10.0 86.9 604 96.9 9.7 106.6 605 45.6 6.4 52.0 New 130.0 $10.4 8.5 148.9Total Loans Receivable $466.9 Ending Loans ReceivableLoanBeg. Bal. Loan FeesAccrued Int. Ending Bal.405 $28.6 $4.3 $32.9 506 36.0 3.6 39.6 601 76.9 10.0 86.9 604 96.9 9.7 106.6 605 45.6 6.4 52.0 New 130.0 $10.4 8.5 148.9Total Loans Receivable $466.9 Balance SheetAssets: Cash $ 18.5 Loans Receivable 466.9Total Assets $485.4 Liabilities: Interest Payable $ 12.6 Term Deposits 465.0 Total Liabilities $477.6 Owners Equity: Common Stock $ 0.2 Retained Earnings 7.6 Total Liabilities and Equity $485.4