Question: southwest trading company taos new mexico summer is approaching and...

Southwest Trading Company, Taos, New Mexico. Summer is approaching, and Steven
and Sue Mahan have finally decided that their idea of a successful Southwestern
furniture, art, and jewelry trading company has come of age. They know that summer
is a popular tourist time in New Mexico and could be the best time to start this
new business. The Mahans have had a long-time interest in Southwestern art and
furniture. Steven graduated from college with an economics degree about 15 years
ago and received his MBA in finance a few years later. He has been working in Dallas,
Texas, as the controller of a major wholesale distributor company for many years.
His wife, Sue, who will be a full partner in the business, spent the first 10 years of her
career in retail sales. Over the last several years, she has assumed more administrative
duties for the group she works with.
Steven and Sue know they bring the expertise and skill to run a successful business,
but to ensure success they have been researching the market for over five years.
They also know that they must be very careful and thoroughly research the business
and industry they are pursuing. They have traveled extensively to New Mexico and
have spent a good deal of time getting to know the local artists (primarily ski bums).
They have found that there is a great demand for Southwestern furniture in Texas
and elsewhere in the Southwest, and prices are high. Through their contacts with
the local craftspeople, they have found that many of them would like a reliable source
for displaying and selling their goods. They have been able to make tentative
arrangements with a large and dependable group to supply the furniture and art
pieces they will need to run the business.
The Mahans have decided to open a shop called Southwest Trading Company in
Taos, New Mexico, and act as both a retailer and a supplier to furniture and art outlets
in Texas. Steven’s extensive contacts with businesses in Dallas and Houston have
given him the orders needed to make the business a success as soon as they begin
shipping the goods. Sue has already begun marketing the Southwest Trading Company’s
products. Southwest Trading Company’s arrangements with the local craftspeople
will allow very aggressive pricing of the goods to retail establishments in
Texas. This aggressive pricing has been well received, and tentative orders are already
in place.
Steven has found an ideal location in Taos that is currently available. The owner is
asking $275,000 for the space, but Southwest Trading has a contract, contingent on
financing, for $250,000. Steven and Sue have gotten bids on remodeling and should
be able to renovate the space for about $45,000. Although they will purchase the
building, the land is leased on a transferable lease with 65 years remaining. The
Mahan’s have decided to invest $235,000, which represents most of their savings,
into the venture. Sue’s sister is also interested in the possibilities that the company
exhibits and is lending Southwest Trading $90,000. Repayment on the note to Sue’s sister is not expected to begin for five years. They have estimated that they will need
$130,000 in inventory to start the business, and they will buy the inventory in cash to
build goodwill with the local craftspeople. They also estimate that they will need
$20,000 in cash to conduct day-to-day operations and bill payment.
Wanting to use a local bank, Steven has approached Cary Farmer, the senior loan
officer at Santa Fe National Bank in Santa Fe, New Mexico, for financing. Steven’s
background in finance has allowed him to put together the following assumptions
for their preliminary business plan. Steven believes that all renovations to the building
and inventory can be in place by the end of June 2014.
1. Sales are expected to be a bit lower the first year (July through December, 2014),
because only six months will be included in the first fiscal year. Sales are expected
to grow significantly in the first full year, 2015, with growth leveling off in the
third and fourth years. Sales are expected to be $275,000, $675,000, $800,000,
and $900,000 in 2014, 2015, 2016, and 2017, respectively. Sales are expected to
level off after 2017.
2. Based on tentative agreements and orders, it is expected that COGS will average
about 63 percent of sales.
3. General and administrative expenses are expected to be $70,000 for the six
months of operations in 2014, increase to $100,000 in 2015, and level off at
$120,000 from 2016 forward. The land lease expenses and interest expenses are
included in operating expenses.
4. Selling expenses are expected to be about 12 percent of sales and Sue is expecting
to undertake extensive marketing and promotion efforts throughout Texas after
the business is opened. It is expected that these additional promotional expenses
will be about $30,000 in 2014 only.
5. The company will use 10-year straight-line depreciation of the building and
improvements.
6. Southwest’s effective tax rate is expected to be 34 percent.
7. Because they expect a good deal of sales to be paid by credit card and to ship
goods to customers in Texas on credit, they expect to carry about 48 days of
accounts receivable. They also expect that, because of the type of business they
are entering, they will turn their inventory over about three times a year.
8. On the basis of the negotiations they have had with their craftspeople, suppliers,
and other wholesale distributors, they estimate that they can count on about 28
days of accounts payable to help finance the business.
In preparing to go to the bank for the necessary loan, the Mahans want to prepare
projected financial statements showing that Southwest Trading Company can make a
profit and pay back the loan. They also want to know more precisely how much they
will need to borrow from the bank to open the doors for business. The Mahans plan
to prepare five years of balance sheet, income statement, and cash budget data for the
bank. They must also develop an opening balance sheet as of the day they plan to
open the doors, June 30, 2014. These pro forma financial statements will aid them,
and the bank officer, in answering many questions, including the following:
1. How much financing will be needed to open the doors of the business in July
2014?
2. Five years of pro forma balance sheet and income statement data must be prepared
to determine if additional financing is needed, and if so, how much. Ste-ven’s finance background tells him that the estimated financing needed each year
will be an accounting plug figure to ensure that the balance sheet balances. If projected
assets exceed liabilities and equity, the difference will be the bank’s borrowing
needs. If liabilities and equity exceed projected asset purchases, these funds
will be used to pay off debt or increase cash or marketable securities.
3. Because this is a start-up business, it is even more important to identify what the
loan proceeds will be used for, what the primary source of repayment is, and
when the total loan proceeds will be repaid. Using the pro forma projections, the
primary source of repayment and when the loan will be repaid can be determined.
4. A cash budget or cash-based income statement needs to be prepared because Steven
knows the only thing that matters to the bank is cash.
5. Finally, Steven needs to prepare a collateral schedule. He knows that the banker
does not want the collateral but will need all he can get if the business is not as
successful as expected.
6. Prepare a list of questions to which you would need the answers. Be sure to
explain the specifics of the questions as they relate to this case.
a. What types of loan covenants would you require?
b. Identify the bank’s largest risks in making this loan.
c. How would you structure the loan to protect the bank?
d. What is your recommendation concerning the loan request?
Conduct the analysis suggested by the above questions. What is your recommendation
concerning the loan request?