Upstate Canning Corporation, Inc Case Study A. Conclusion and Statement of Case Situation Mr. Shields’ should accept Mr. Fordham’s proposal in relation to the acquisition of Upstate Canning Company, Inc. In this case, Mr. Shields attempts to conclude if he should acquire the company from its owner, Mr. Fordham, using his personal savings of $35,000 in addition to an investment of $65,000 from his associates. Moreover, Mr. Fordham proposes that he will loan Mr. Shields’ $300,000 worth of income bonds, to be repaid in up to 10 years. Mr.
Fordham provides Mr. Shields’ with a bond repayment schedule which allows Mr. Shields’ to repay the bonds at a discount if he meets the wishes to repay the bonds back early. Mr. Shields’ faces a tough decision, as his goal is to run a profitable and efficient company, as well as to attain majority ownership of Upstate Canning within 5 years, while increasing his personal income considerably. The third requirement of this case is that the outside investor, who makes the original $65,000 investment, has his concerns about capital appreciation answered.
Thus, given these three requirements that need to be satisfied simultaneously, I have devised a model that attempts to meet these goals. The explanation and the model itself follow this introduction, and by the end of this statement, you will understand why I believe why all three parties involved will be content as their goals are met by the end of 1962. B. Explanation and Presentation of Pro Formas (Monthly) Balance Sheet a) Assets i) Cash – The beginning cash balance of $100,000 was determined by Mr. Fordham in his capital structure proposal.
According to his proposal, $100,000 of common stock would be issued at $1 par to Mr. Shields and his investors, thus the beginning cash balance of $100,000 on Upstate Canning’s balance sheet during the beginning of the 1957-58 fiscal year. During the following months, the cash line is used to balance total assets and total liabilities and equities. Based on estimated costs of daily activities, I determined that the minimum cash balance would be of $17,500. Thus, the cash balance can never go below $17,500.
The cash line was determined based on the difference between “Total Assets minus Cash” (TA) and “Total Liabilities and Equity without Notes Payable” (TL&E). By using the proper functions on Excel, I was able to establish a condition that if TA was greater than TL&E, the cash balance would simply equal the difference between the two accounts. However, if TL&E was great than TA, the cash balance would not go below the minimum cash balance of $17,500. This capital would be withdrawn out of the Notes Payable account, which was used as a “flex account” throughout this model. Note: the Notes Payable account is explained below) ii) Accounts Receivable- Another one of the conditions in Mr. Fordham’s proposal stated that “current assets (except for the $100,000 in cash and inventory) and current liabilities would not pass to the new company”. Thus, the beginning balance of A/R is zero. Mr. Shields was “informed by Mr. Fordham that collections on accounts receivable caused little trouble in this business: bad-debt losses were rare, and accounts were normally collected within 30 days”.
Thus, since this Pro Forma Balance sheet illustrates the monthly activity of the account, the A/R balance is equal to the sales for that period. iii) Inventory- As mentioned above, finished goods inventory is one of the few current assets passed on to the new company. Thus, the initial balance of inventories is $50,000. For the balance of the other months, the following calculation was used: Beginning Inventory + Cost of Goods Manufactured – Cost of Good Sold = Ending Inventory. The end of the month balance was then transferred over as the next month’s beginning inventory balance. v) Total Current Assets- The sum of all current assets, calculated by adding Cash, A/R and Inventory. v) PP&E, net- According to Mr. Fordham’s proposal, there would be $200,000 worth of Property, Plant, and Equipment transferred from the old company to the new company, thus the beginning balance of $20,000. Even though Mr. Fordham mentions that he in his “Statement of Cost of Goods Manufactured for Year Ended Dec. 31 1956” that he depreciated $24,000 of Plant and Equipment, I decided to change the depreciation schedule so that PP&E would be fully depreciated by the end of the 5 year period.
Thus, I used a straight-line depreciation schedule that accumulated $40,000 worth of depreciation per year, which was spread evenly across the 12 months of this Balance Sheet (or $3,333. 33 per month). (1) PP&E- The original value of the PP&E received by Mr. Shields, constant at $200,000. (2) Accumulated Depreciation- This account accumulates the depreciation over the course of the 12 months. As mentioned above, the appraisal value of PP&E is referred to as “PP&E, net”, which is the original value of $200,000 minus the accumulated depreciation for each month. i) Goodwill- The beginning balance for Goodwill was determined by finding the difference between Total Assets and Total Liabilities at the beginning . Goodwill accounts for all the intangible assets that were transferred from the old company to the new company, including brand name, as well as a premium paid for the company. Goodwill was not amortized in this model. vii) Total Assets- The sum of all assets. Calculated by adding “Total Current Assets” to the sum of “PP&E, net” and “Goodwill”. b) Liabilities and Owner’s Equity iii) Accounts Payable- As referenced in the case, the main components of production Upstate Canning has are vegetables and fruit, labor, cans, and other ingredients. The vegetables and fruits canned by Upstate were bought on a contract basis from farmers in the surrounding area, where farmers were paid cash. Labor was paid on a weekly basis. The direct costs that could be accounted for in A/P were cans and other ingredients, which could be purchased on normal terms of 2/10, net 30 days. Mr. Fordham also mentions that the purchases of cans could be paid in net 60, without ruining Mr. Shields’ line of credit.
Given this information, I deduced that it would be best for Upstate Canning to not take the 2/10 discount, and repay all of its A/P on a 30 day schedule. The A/P account was calculated by finding the sum of all Purchases made on A/P, specifically cans and other ingredients. Given the production schedule developed by Mr. Fordham, July and October each accounted for 16. 67% of production, while production in August and September was of 33. 3% of total production for the year. Thus, the purchases on A/P were made accordingly, multiplying the total cost of cans and other ingredients by the percentage of production of each month. x) Bonds Interest Payable-This account represents the balance of the interest to be paid on the income bonds issued by Mr. Fordham. Thus, the beginning balance is zero. As referenced to in the proposal, the annual interest rate on the bond is of 3%. Thus, for the months where no portion of the bond has been repaid, the monthly accrual of the bond interest is of $750 (or $300,000*(3%/12)). The proposal also says that the bond interest is to be paid semiannually, on June 30 and December 30. Thus, the balance of the account in November is the sum of all the prior increments from July to November, or ($750*5=$3,750).
However, this account is paid off in December, yielding a balance of zero. At the end of February, I opted to have Mr. Shields’ pay off the current portion of his Long Term Debt (or the Bond). Thus, in March the balance of Bonds Interest Payable is the sum of the accounts balance in January and February ($1,500) plus the interest for the month of March ($250,000 of the bond * (3%/12) = $630). The interest accrued in April and May is also of $630. At the end of May, however, I decided that it would be best if Mr. Shields paid off another $50,000 worth of the bond, lowering his interest payment in June to only $500.
As previously mentioned, all the interest accrued was paid off at the end of June. x) Note Interest Payable- My notes interest payable account accrues all the interest to be paid on the bank loan Mr. Shields’ uses to cover some of the liabilities that are greater than the current cash balance. The interest per month is calculated at 6% APR, so 6%/12 monthly. Just like the Bond Interest Payable account, the interest on Notes Payable is paid semiannually, on June 30 and December 31. xi) Notes Payable- Alongside the cash account, this is the other “flex” account in the balance sheet, which is used to balance assets and liabilities.
As previously mentioned, this LOC is borrowed at 6% interest rate. I used an “IF” statement on Excel (much like the one used in my cash account), which makes this account compensate for the difference in TA and TL&E minus Notes Payable. Thus, TA is greater than TL&E minus notes payable; the remainder will be borrowed from this LOC at 6% interest rate, balancing my accounts. If TA is not greater than TL&E minus notes payable, then the balance for notes payable would equal zero since there would be enough assets to cover the liabilities on the balance sheet. The one constraint Mr.
Shields’ faces concerning his LOC, is that he cannot borrow more than 75% his finished goods inventory. This was also accounted for in my formula. xii) Taxes Payable- The beginning balance for this account is zero, given that no liabilities were carried over to the new company. Taxes payable for the month are calculated by adding the previous months’ tax balance to the newly accrued tax liability. The extent collected in this account is further explained below, in the income statement portion of this write up under the subsection “Federal Income Tax”. xiii) Long-Term Debt, Current Portion- According to the proposal presented by Mr.
Fordham, at least $50,000 of the bonds issued by the company would have to be paid by the end of the first fiscal year. Since by definition the current portion of long-term debt is debt that needs to be paid within a year, the initial balance for the month of July is the $50,000 Mr. Fordham needs to collect from the bond issued. This balance remains constant throughout the first few months, until February, where I determined that Mr. Shields’ should pay off the $50,000 in order to maximize his net income for the year, thus yielding a balance of zero on this account. iv) Current Liabilities- The sum of A/P, Bond Interest Payable, Note Interest Payable, Taxes Payable, and Long-term Debt (Current Portion) Payable. xv) Long Term Debt- This account measures the balance of the bonds outstanding. The initial balance is of $300,000, since this was the initial value of the bonds issued by Mr. Fordham. For the succeeding months, the value of the account is of $250,000 since $50,000 is accounted for as the current portion of long term debt. This balance remains constant until the end of May, when I proposed that Mr.
Shields’ should pay off another $50,000 of bonds, given that he can pay off these bonds at a 80% discount in the first year, thus spending $40,000 to pay off $50,000 worth of debt. The closing balance for June and July is of $200,000. xvi) Common Stock- This account reflects the initial capital investment made by Mr. Shields’ and his investors into Upstate Canning. Thus, since the initial investment was of $100,000 (100,000 shares at $1 par), the balance of this account is held constant throughout the first year at $100,000. The ownership breakdown is 35% Mr.
Shields and 65% other investments, given that Mr. Shields’ original investment was of $35,000 and his associates invested $65,000. xvii) Retained Earnings – Given that Upstate Canning does not pay dividends to its investors, this account is equal to the current month’s retained earnings plus previous month’s retained earnings, which is the net income retained by the company. xviii) Total Equity- The sum of common stock and retained earnings. xix) Total Liabilities and Equity- Current Liabilities + Long Term Debt + Total Equity xx) Assets Minus Cash – The sum of Total Assets minus the cash balance.
Used when calculating the cash balance. xxi) Total Liabilities and Equity without N/P- The sum of TL&E minus N/P. Used when calculating the N/P balance, or how much Mr. Shields’ should borrow from his short-term LOC. xxii) Total Assets = Total L&E- An “IF” statement to see if the balance sheet is balanced, and TA = TL&E. xxiii) Loan Check- Another check developed to see if the amount borrowed from the LOC does not surpass its constraint of 75% of inventory. xxiv) Max Loan- Simply calculating the maximum that can be borrowed in form of Notes Payable.
Calculates what 75% of the inventory balance is. Income Statement i) Net Sales – According to the information presented by Mr. Fordham, 50% of the total sales schedule would be sold by October 1, and 70% would be sold by December 30. Thus, I divided 50% of the total sales for the first year (which according to the schedule given by Mr. Fordham should equal $850,000) into the months of July, August and September, yielding $141,667 of sales a month. The sales balance for the months of October, November, and December was of $56,667, or the remainder necessary to meet the 70% estimate previously mentioned.
The other 30% was spread evenly across the months of January through June, assuming that these months would have equal sales, or $42,500 a month. ii) Cost of Goods Sold- According to the Income Statement for 1956 that Mr. Fordham presents to us in Exhibit 2, the Cost of Goods Sold is 74% of sales. Thus, I assumed that this value would remain constant throughout the years. So for this account, the COGS is held constant at 74% of sales. iii) Gross Profit- Difference between Sales and Cost of Goods Sold. iv) Selling and Delivery- In reference to the Income Statement for 1956, the annual expense for selling and delivery was $64,000.
Thus, I assumed that this cost would remain a constant percentage of total sales, and divided S&D by the total sales for 1956. So, S&D was 7. 53% of sales, and this value is used monthly to calculate the monthly value of S&D. v) Admin and General- The administrative and general expense for 1956 was of $56,000, but is also included Mr. Fordham’s $20,000 salary. Thus, after subtracting Mr. Fordham’s salary from G&A, I spread out the balance of $36,000 over the 12 months evenly, yielding a balance of $3,000 per month. vi) Shields’ Base Salary- The $15,000 Mr.
Shields’ is expected to make as a base salary divided by the 12 months evenly, yielding $1,250 a month. vii) Sales, General & Admin- The sum of S&D, G&A and Shields’ base salary. viii) Bond Interest- The bond interest expensed at the end of the month. Since the bond interest rate is 3%, this line was calculated by multiplying the bonds issued balance by 3%/12months. Thus, until the month of March when no bonds are paid back, the yield is equal to $750. Once the bond is paid back, the interest paid on the bond decreases as the bond balance decreases. ix) Note Interest- Interest expensed on the loans at 6% interest rate.
Simply reflects the interest expensed per month on the notes payable account, multiplied by 6%/12months. x) Interest Expense- The sum of bond interest and note interest. xi) Gain on Early Bond Buyback- Reflects the discount gained after repurchasing more than the minimum required amount of bonds. The balance of this line is zero until May, when $50,000 worth of bonds are bought back above the $50,000 minimum required, thus yielding a $10,000 gain on early buyback (due to the 80% discount for the first year). xii) EBBT- Earnings before Bonus and Tax. Gross Profit – SG&A and Interest Expense . xiii) Bonus- According to the proposal, Mr.
Shields’ will get 5% on yearly earnings before taxes (and after interest). Thus, this is calculated by taking 5% of each month’s EBBT. His yearly bonus is of $4,950. xiv) EBT- Earnings before Taxes, or EBBT – Bonus. xv) Federal Income Tax- According to Exhibit 2 in the case study, Upstate Canning will be taxed on the basis of 30% of the first $25,000 of taxable income, plus 52% of income in excess of $25,000. Thus, I developed a formula in my “Tax” tab that breaks down the monthly taxable income into different brackets, taxing the first $25,000 received 30%, and the remainder of the balance 52%.
The monthly income tax was calculated using this formula, and shown accordingly. Note that in January, since the Taxable income is below $25,000, only 30% of it is taxed, but once the total balance exceeds the $25,000 bracket, the income is taxed on a 52% basis. xvi) Net Income- EBT – Taxes. The balance of this account reaches a low of $1,010 in January due to the end of the production season and the beginning of the bond buyback plan. However, this should not be of too much concern due to the constraints given in the first year and the fact that Mr. Shields’ was able to buy back a total of $100,000 of bonds back in the first year. vii) EBITDA- Earnings Before Interest, Tax, Depreciation and Amortization. Presented as a measure of the company’s overall performance. Calculated by adding back Interest and Taxes to Net Income. C. Explanation and Presentation of Pro Formas (Annually) Balance Sheet a) Assets i) Cash- A balancing account, calculated in the same manner as previously mentioned in the Monthly Pro Formas statement. i) Accounts Receivable- Assuming that all of sales goes into accounts receivable, I determined that for this line the balance would equal the sales for that given year. i) Inventory- Given that Upstate Canning has a seasonal production plan, that is, it produces its goods only during the months of July-October, each year’s ending inventory is equal to the previous year’s beginning inventory, or $50,000 iii) Current Assets- Sum of Cash, Inventory, and Accounts Receivable. iv) PP&E, net- Depreciated on a straight line schedule to zero. Thus, year accumulated depreciation increases by 20% of $200,000 or $40,000, and PP&E, net decreases by $40,000 until it reaches $0 by the end of 1962. v) Goodwill- Goodwill is not amortized and therefore remains at $50,000. i) Total Assets- Current Assets + PP&E, net + Goodwill b) Liabilities and Owner’s Equity vii) Accounts Payable- Since the accounts payable is paid net 30 days, the annual balance for this account is zero, since the last purchase on A/P occurs in October. viii) Bond Interest Payable- Since bond interest payable is paid semiannually on June 30 and December 30, the balance for this account is zero at the end of the fiscal year. ix) Tax Interest Payable- Same as Bond Interest Payable. x) Notes Payable- Calculated the same way as Notes Payable in the Monthly Pro Forma Balance Sheet.
Measures the difference in TA and TL&E without Notes Payable, and functions as a flex account. For all 5 years the end of year balance for this line is zero. xi) Taxes Payable- The case mentions that taxes are to be paid in the succeeding fiscal year, having 50% paid on the 15th day of the third month and 50% on the 15th day of the sixth month. Since this is an annual Pro Forma Balance Sheet, this does not play into effect, as the Taxes Payable account will reflect the balance of the previous year’s tax payable account. ii) Long Term Debt (Current)- Given the requirement that $15,000 of bonds needs to be paid back each year, or 50% of net income, this line is calculated by another “IF” formula that determines what is the current balance given these constraints. If half of that year’s net income was greater than last year’s long term debt, then the current debt value would equal last year’s debt value. If this was not the case, then the current portion would equal the minimum to be paid, or 50% of net income for that year. iii) Current Liabilities- Sum of all the current liabilities mentioned above (A/P + Bond Interest Payable + Tax Interest Payable + Notes Payable + Tax Payable + LTD Current) xiv) Long Term Debt- Last year’s long term debt minus the LTD Current portion, minus any bonds that have been bought back. xv) Common Stock- This remains at $100,000 for each year because the model assumes that there is no stock issuance or repurchase, and the case mentions that the stock is to be held at $1 par. xvi) Retained Earnings- Found by adding a year’s net income to the previous year’s retained earnings. vii) Total Equity- Sum of Retained Earnings + Common Stock xviii) Total Liabilities and Equity- Sum of Current Liabilities + Long Term Debt + Total Equity xix) Assets minus Cash- Found the same way as in monthly Pro Forma. xx) Total Liabilities and Equity without N/P- Found the same way as in monthly Pro Forma. Income Statement i) Sales- Projected sales as provided in the sales schedule in Exhibit 1. (1) % Net Sales Growth – Line showing the % increase in sales relative to the previous year. Calculated by dividing the difference between Sales in Year1 and Year0 by Year0. i) Cost of Goods Sold- Calculated in the same way as in the Monthly Pro Forma, or multiplying 74. 5% and net Sales. iii) Gross Profit- Sales – COGS iv) Selling and Delivery- Found using same method as monthly S&D values v) Admin and General- Found using same method as G&A for monthly Pro Forma. vi) Shields’ Base Salary- Held constant at $15,000 per annum. vii) Sales, General & Admin- Sum of S&D, A&G and Shield’s Base Slary. viii) Bond Interest- Sum of interest accrued over the course of the year, or 3% of Bonds Payable for that year. x) Note Interest – Calculated by multiplying the growth in sales for that year to the previous year’s note interest balance. This assumes that Mr. Shields’ is borrowing at a constant rate, proportional to the rate of growth to Upstate Canning. x) Interest Expense- Sum of Note Interest + Bond Interest xi) Gain on Early Buyback- The proposal presented by Mr. Fordham contained a stipulation that if the bonds were repurchased at a level above the minimum required, Mr. Shields’ could repurchase the bonds at a discount. The discount would be of 80% in the first year; 82. % on the second year; 85% on the third year, and so forth. Thus, this line measures the amount Mr. Shields’ gained by repurchasing the bonds early. It calculates the amount of bonds repurchased over the minimum level, multiplied by (1-discount rate) of the bond, or simply the amount he saved by doing so. In my model, Mr. Shields’ gains on early buyback are of $31,560 over the course of the five years. He gained $10,000 in the first year, since he bought back $100,000 bonds, $15,450 in the second year, as he repurchased $121,402 at a 82. % discount, and gained $6,111 in the 1959-1960 fiscal year, as he repurchased the remaining balance of $78,598 at a 85%. xii) EBBT- Earnings before Bonus and Taxes. Gross Profit – SG&A – Interest Expense + Gain on Bond Buyback xiii) Bonus- 5% of EBT before Bonus each year. xiv) Taxes- Using the tax schedule developed and referenced to above, I developed a formula that breaks down the taxable income into the first $25,000, where it is taxed on a 30% basis, and the remaining balance above $25,000 on a 52% basis. xv) Net Income- EBT After Bonus – Taxes vi) EBITDA – Net income + Taxes + Interest D. Statements: a. Accomplishment of Shields’ Objective: Mr. Shields’ original goal was to attain majority ownership, or control, of Upstate Canning within five years, as well as build up some income after the five year period. The case states that Mr. Shields’ yearly living expenses sum up to 60% of his total income (salary and bonus included). Thus, his net savings are 40% of his yearly total income. After the five year period, his net savings accumulates to $52,010 prior to any stock repurchase.
His yearly savings also seems a drastic increase due to the increase in revenue sales Upstate undergoes each year. In order to attain his goal of controlling Upstate, Mr. Shields’ must repurchase 15,001 shares (as he already has 35,000), and also pay back all of his income bonds (as debtors would have preference in being paid back in case of a default, for example). Shields’ is able to repurchase all of the bonds by the end of the 1959-1960 fiscal year. Thus, for Mr. Shields’ to attain majority ownership and control of Upstate he must purchase 15,001 shares.
Given that the shares are at $1 par, Mr. Shields’ must determine what premium he is willing to pay for each stock, as a means to provide his associates with some return on their investment. Based on the market returns companies with similar risk and size as Upstate are returning around 20-25% on average, I decided that Mr. Shields’ should compound 25% per year as a risk premium per share. Thus, if he were to purchase one share in year 1 he would pay $1. 25, 1. 56 in the second year and so forth (as shown in “Shields’ Finances tab”).
Hence, by following this model, Mr. Shields’ is able to buy back 9,060 shares in the first year, and 5,941 shares in the second year, giving him the necessary 15,001 shares. Moreover, he spent $11,333 (or all of his net savings in the first year) on stock repurchase, and $9,280 the second year. At the end of the five years, Mr. Shields’ has accumulated $44,440 in net savings (assuming it earned the risk free rate of 4% for 1957, compounded yearly). As this goal is accomplished, Mr. Shields’ should accept this plan. b. Accomplishment of Mr. Fordham’s Goals: Mr.
Fordham’s goals were to sell Upstate Canning as quickly as possible and receive his $300,000 in bonds back within a ten year window. As mentioned in the statement above, Mr. Shields’ is able to buyback the bonds by the end of the 1959-1960 fiscal year, or the third year after its issuance. The key to such a hasty buyback, apart from Mr. Shields’ ability to run Upstate in a much more efficient and profitable manner, was the discount schedule presented by Mr. Fordham. The discount schedule presented some clear incentives for Mr. Shields’ to buyback the bonds earlier rather than later, especially in the first year when Mr.
Shields’ bought back $100,000 worth of bonds. As this goal is accomplished, Mr. Fordham should accept this plan. c. Accomplishment of Investors’ Goals: The associates’ main concern was that Mr. Shields’ would not be able to deliver a solid return on their investment, and that there would ultimately be no capital appreciation. In 1957, the risk free assets (T-Bill) were yielding 3-4%. Instead, these investors opted to take a risk and invest in Upstate Canning, and they therefore expected to be rewarded for undertaking this risk. According to the stock repurchase plan Mr.
Shields’ will follow, investors would be able to sell their stock to Mr. Shields’ for a 25% yield, which is a significant return in comparison to historical S&P returns from June of 1957, where the average market yield was of about 15%. Moreover, the investors still hold 49% of the company after 1960. Another way to measure capital appreciation would be to look at the growth of the Book Value over the course of the five years. Upstate’s book value grows at a 33% per year, meaning that investors are receiving a 33% on their investor.
While Upstate’s growth does indeed slow toward the end of year 5, its Book Value still grows by 26% from 1960-61 to 1961-62, an extremely rewarding return. In addition, Upstate’s EBITDA at the end of 1962 is of $778,560, a considerable amount for a company that was recently struggling. If we assume an average EBITDA multiple of 3. 14 over the course of the 5 years, the company is valued at $2,449,000. Due to this astounding capital appreciation Upstate underwent, and the growing potential of future returns as Upstate continues to gain market share, the investor should also accept this deal. ——————————————- [ 1 ]. P. 873 [ 2 ]. P. 872 [ 3 ]. Exhibit 3, p. 875 [ 4 ]. P. 875 [ 5 ]. 2/10 refers to a 2% discount if A/P is collected within 10 days. [ 6 ]. I looked on Yahoo Finance for historical data and I decided that the average return on the S&P is the best way to measure a benchmark for Upstate, since it could be considered a small equity. Even so, 25% is considerably greater than the 15% return, despite the slightly riskier asset that is holding equity in Upstate. [ 7 ]. CAGR [ 8 ]. Assuming a multiple of 2 in year 1, 2. 5 in year 2, 3 in year 3, 3. 5 in year 4, and 4 in year 5