Guidance for completing the Bastion Finance Case. You are asked to use the information provided to...

Transcribed Image Text:

Guidance for completing the Bastion Finance Case. You are asked to use the information provided to prepare forecasted financial statements for year 7. You must identify and evaluate risks associated with the investment and weigh these risks when deciding whether to recommend Bastion as a potential investment. Bastion Finance raises cash by selling debentures (management refers to them as depositors) and the funds acquired from the debentures are lent to property developers. Step 1- Prepare a Cash Flows Statement. Do not prepare the Cash Flows statement using the Direct or Indirect methods. The is a simple cash flows statement starting with the beginning cash balance plus receipts minus disbursements. Using past results as a starting point prepare a simple cash flow statement. Determine the cash receipts from new deposits and loan repayments (including interest) and cash disbursements from interest payments to depositors, salaries, wages, and other, cash dividends (assume 7M will be paid for dividends) and new loans to property owners for year 7. To determine how much to lend in year 7-assume you will want to keep $25.5M "on hand". Cash receipts minus cash disbursements will give you the change in cash. You will add the change in cash to beginning cash for year 6 to calculate ending cash in year 7. Hints: 1. The amount of new term deposits received for year 7 can be estimated by reviewing the change in Term Deposit liability balances on the balance sheet for past years. Determine if you see an incremental increase or decline over the years. Is there a pattern that you can use to project the amount of new deposits in year 7? 2.Cash receipts from loan repayments can be estimated from the firm's loan cards for outstanding loans. There are two loans that are repaid in year 7, loans 602 and 603. Assume that the loans, interest, and fees anticipated as being due in year 7 are actually collected. Assume loans are paid off mid-year. 3. Using the new and existing deposits assumed in 1, calculate the interest paid to depositor at prevailing interest rate on term deposits of 11% provided in the annual report). Assume all interest payable at the end of year 6 was paid in year 7. Impact to cash: Interest payable year 6 (paid in year 7) add: Interest expense year 7 11% for new and existing term deposits subtract -Interest payable year 7 (paid in year 8) 25% of interest expense for the year 7 * *25% payable amount calculated interest payable/interest expense year 6 calculated as follows 12.2/48.7-25%. Apply the same percentage (25%) to calculate the interest payable for year 7 above. Exhibit 3: Loan Cards for Defaulted Loans Principal Amount Loan Number 303 $25.0 Year Loan Granted 3 Interest Rate 12% Year for Scheduled Repayment Loan Origination Fee 4 $2.0 Borrower Phoenix Horizons Principal Officers Linda Gibson and Phillip Greene Transactions Year Description Loan Balance 3 Loan Principal $25.0 $25.0 3 Loan Origination Fee $2.0 $27.0 3 Interest $1.6 $28.6 4 Interest $3.4 $32.0 5 Interest $1.9 $33.9 5 Repayment $30.0 $3.9 5 Loss Write Off $3.9 Notes: Holder of the first mortgage foreclosed the property. There were insufficient funds to fully re-pay our second mortgage. Loan Number 502 Year Loan Granted 5 Interest Rate 13% Principal Amount Year for Scheduled Repayment Loan Origination Fee $65.0 6 $5.2 Borrower Westwood Shopping Complex Principal Officers Phyllis and David Edins Transactions Year Description Loan Balance 5 Loan Principal $65.0 $65.0 5 Loan Origination Fee $5.2 $70.2 5 Interest $5.9 $76.1 6 Interest $3.9 $80.0 6 Repayment $73.7 $6.3 6 Loss Write Off $6.3 Notes: Proceeds from the sale of the complex failed to cover the full development costs. The company went into liquidation. 8 Loan Number Year Loan Granted Interest Rate Borrower 405 4 12% ** Principal Amount Year for Scheduled Repayment Loan Origination Fee Prestige Development Principal Officers Comelius Bowden, Sandy Maier, and Anthony Roest $20.0 5 $1.6 Transactions Year Description Loan Balance 4 Loan Principal $20.0 $20.0 4 Loan Origination Fee $1.6 $21.6 4 Interest $0.6 $22.2 5 Interest $2.7 $24.9 6 Interest $3.7 $28.6 Notes: Builder has encountered severe stability problems in the geological substrata of the building site. Project delayed indefinitely. **Interest rate raised to 15% as of start of Year 6. Loan Number 506 Principal Amount $30.0 Year Loan Granted 5 Interest Rate 10% Year for Scheduled Repayment Loan Origination Fee 9 $2.4 Borrower Gold Coast Condominiums Principal Officers Barbara Liveris, Eric Lombard, and Phillip Greene Transactions Year Description Loan Balance 5 Loan Principal $30.0 $30.0 5 Loan Origination Fee $2.4 $32.4 5 Interest $0.3 $32.7 6 Interest $3.3 $36.0 Notes: 9 Loan Number 601 Principal Amount $65.0 Year Loan Granted 6 Year for Scheduled Repayment 8 Interest Rate 13% Borrower Principal Officers Loan Origination Fee Kingsland Hotels James Franklin and Jacqueline Bell $5.2 Transactions Year Description Loan Balance 6 Loan Principal $65.0 $65.0 6 Loan Origination Fee $5.2 $70.2 6 Interest $6.7 $76.9 Notes: Loan Number 602 Principal Amount $45.0 Year Loan Granted 6 Year for Scheduled Repayment 7 Interest Rate 15% Loan Origination Fee $3.6 Borrower Green Lane Apartments Principal Officers Wang Lim, Henry Shi, and Chong Xie Transactions Year Description Loan Balance 6 Loan Principal $45.0 $45.0 6 Loan Origination Fee $3.6 $48.6 6 Interest $3.5 $52.1 Notes: 10 10 Loan Number Year Loan Granted Interest Rate Borrower Principal Officers 603 Principal Amount Year for Scheduled Repayment Loan Origination Fee 6 13% Lumineria Partners Madeleine Lindquist and Heidi Coleman $50.0 7 $4.0 Transactions Year Description Loan Balance 6 Loan Principal $50.0 $50.0 6 Loan Origination Fee $4.0 $54.0 6 Interest $3.2 $57.2 Notes: Loan Number 604 Principal Amount $85.0 Year Loan Granted 6 Interest Rate 10% Year for Scheduled Repayment Loan Origination Fee 9 $6.8 Borrower Dorchester Management Company Principal Officers Gordon Reynolds, Phillip Greene, and Walter Carson Transactions Year Description Loan Balance 6 Loan Principal $85.0 $85.0 6 Loan Origination Fee $6.8 $91.8 6 Interest $5.1 $96.9 Notes: 11 Loan Number 605 Principal Amount $40.0 Year Loan Granted 6 Year for Scheduled Repayment 9 Interest Rate 14% Loan Origination Fee $3.2 Borrower Hampton Arms Apartments Principal Officers Anne Ward, Paul McLeahy, and Hamilton Wood Transactions Year Description Loan Balance 6 Loan Principal $40.0 $40.0 6 Loan Origination Fee $3.2 $43.2 6 Interest $2.4 $45.6 Notes: Company Risk Factors Bastion Finance is exposed to several sources of risk in its ordinary course of business. These include credit risk, interest rate risk, liquidity risk, and general business risk. Credit risk refers to the potential that some of our customers may default on the loans we have made to them. This risk is augmented by our focus on second mortgages and our concentration in a narrow market segment. Interest rate risk means that we may not be able to maintain a profitable spread between our cost of borrowing and the returns from lending. Liquidity risk arises because we borrow from term depositors on maturities ranging from 6-18 months while our loans to developers may extend for multiple years. General business risk is inherent in the competitive nature of our industry. We cannot be assured that our term depositors or loan customers will continue to conduct business with us rather than with one or more of our competitors. Bastion Finance is not exposed to foreign exchange risk and does not engage in derivatives trading. 12 4, Salaries, Wages, and Other expenses have been paid as incurred (no accrued liabilities). The amount for year 7 can be estimate by reviewing the trend in expenses for Salaries, Wages, and Other over the past 6 years. 5. Per the Notes to the Financial Statement the information in the annual report indicates that taxes are calculated using cash-basis accounting. The expenses actually paid to depositors would exceed the interest and origination fees received resulting in a loss using cash basis accounting so no taxes would be due. Deferred taxes are not immaterial and not recognized in the accounts. You do not have to consider bad debt expense. The defaulted loans have already been accounted for. The only interest and loan fee income expected to be collected in cash during the year will be from loans 602 and 603. The loan fees and the interest accrued on these loans during prior years are given on the loan cards Step 2- Prepare the Income statement Revenue can be calculated from the loan cards provided. Use the loan balance times the given interest rate per loan. For any new loan use the origination rate of 8% of the amount borrowed. Expenses should include interest payments, salaries, and other expenses. (refer to the cash flows statement for these numbers). Salaries and other expenses were paid as incurred. Step 3-Statement of Retained Earnings Beginning RE (yr 6 ending balance) Add Net Income Less Dividend (use $7M) Ending RE year 7 Step 4-Prepare a Balance Sheet Assets Cash-should tie to ending balance cash flow statement Loan Receivable from loan cards plus interest accrued. on loans outstanding during the year. plus loan origination fees.on new loans (should not include loans 602 and 603-paid off during year 7. Assume any new loans are outstanding for half the year. Liabilities Interest payable is calculated at 25% of interest expense. (see cash flow statement) Term deposits are existing term deposits as of year 6 ($455) plus any new term deposits. Stockholder's equity Common Stock Retained Earnings (from Statement of RE) Vol 6. Issue 1 Article 2 march 2013 Bastion Finance Shane Moriarity University of Oklahoma and Unitec New Zealand Andrew Slessor Unitec New Zealand 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 country's 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 Bastion's 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. 1 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 development's 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. Bastion's 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 Walter's 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 firm's 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 loans-just 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. REQUIRED 1. Prepare forecasted financial statements for Year 7 (cash flow statement, income statement, and balance sheet). Prepare a brief justification for each assumption that you make when forecasting a specific value. 2. Use the insights you have gained from preparing the forecasted financial statements to identify the risks and concerns that should be brought to Mr. Parker's attention. 3. Based upon an evaluation of the potential risks and returns, recommend whether the investment in Bastion should be pursued. 2 Exhibit 1: Annual Summary Financial Statements Bastion Finance Summary of Audited Financial Statements ($ Millions) Income Statements Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Revenues Interest Income 4.3 19.0 28.3 36.4 39.2 46.7 Loan Fees 5.2 15.4 8.0 11.2 20.0 22.8 Operating Revenue 9.5 34.4 36.3 47.6 59.2 69.5 Expenses Interest Expense 4.5 15.8 24.7 31.7 41.5 48.7 Salaries and Wages 0.7 0.8 0.9 1.1 1.3 1.5 Other 0.2 0.2 0.2 0.3 0.3 0.5 Operating Expenses 5.4 16.8 25.8 33.1 43.1 50.7 Operating Income 4.1 17.6 10.5 14.5 16.1 18.8 Bad Debts 0.0 0.0 0.0 0.0 3.9 6.3 Income Tax 0.0 0.0 0.0 0.0 4.8 1.6 Net Income 4.1 17.6 10.5 14.5 7.4 10.9 Statements of Retained Earnings Beginning Retained Earnings 0.0 1.1 5.7 5.2 5.7 6.1 Net Income 4.1 17.6 10.5 14.5 7.4 Dividends 3.0 13.0 11.0 14.0 7.0 10.9 10.0 Ending Retained Earings 11 5.7 5.2 5.7 6.1 7.0 Balance Sheets Assets Cash i 2.9 2.0 71.8 96.2 102.4 81.1 Loans Receivable Total Assets Liabilities Interest Payable 74.5 232.9 264.8 312.6 77.4 234.9 336.6 408.8 349.3 393.3 451.7 474.4 Term Deposits Total Liabilities 1.1 4.0 6.2 75.0 225.0 325.0 395.0 76.1 7.9 10.4 12.2 435.0 455.0 229.0 331.2 402.9 445.4 467.2 Owner's Equity Common Stock Retained Earnings 0.2 0.2 0.2 0.2 0.2 0.2 1.1 5.7 5.2 5.7 6.1 7.0 Total Liabilities and Equity 77.4 234.9 336.6 408.8 451.7 474.4 3 Exhibit 2: Information from the Company's Annual Report to Shareholders. Bastion Finance Fiscal Year The fiscal year for Bastion Finance runs from March 16 through March 15. To avoid confusion, dates are not used in the following discussion. Instead, references are made to each full fiscal year of operation. Thus Year 1 refers to the firm's first full year of business and Year 6 to its most recently completed year. Company Regulatory Matters The company is organized as a commercial investment company. It is not subject to regulatory oversight as a bank. Securities regulations require that term investors be supplied with a current prospectus. Depositor's investments are not insured or guaranteed by any governmental agency. Company Shareholders Shares in Bastion Finance are not listed on any exchange nor are they publicly traded. Private transactions between individuals have occurred infrequently. As of the end of Year 6, the firm is aware of 15 individuals owning shares-most consist of very small holdings. The five largest shareholders and their holdings are: Shares % Eric Lombard Walter Carson Lance Edwards 1,290,000 43% 1,050,000 35% 300,000 10% LeRoy Fisk Linda Hobbs 150,000 5% 60,000 2% In Year 3, Linda Hobbs purchased 60,000 shares from Walter Carson for $2,816,000, a price representing eight times per share earnings for Year 2. At the end of Year 4. LeRoy Fisk purchased 150,000 shares from Walter Carson for $7,250,000, a price representing 10 times the estimated per share earnings for Year 4. Several smaller trades have occurred at various prices over the past six years. Board of Directors Six individuals serve on the company's Board of Directors. Directors who are not managers are paid an annual retainer of $25,000 per year and receive 1,000 shares in the firm. The Chair of the Audit Committee and the Chair of the Compensation Committee each receive an additional fee of $5,000. The total fees earned in Year 6 and shareholdings as of the end of Year 6 for each of the directors are given below. 5 Eric Lombard, Chairman of the Board Fees Shareholding $- 1,290,000 1,050,000 Walter Carson, Chief Executive Officer - Brendon Sheppard 25,000 6,000 Susan Richee, Chair of the Audit Committee 30,000 2,000 Bruce Ludlow, Chair of the Compensation Committee Gordon Meyers 30,000 3,000 25,000 5,000 Executive Compensation The firm has only four executive-level employees. The compensation for the executive officers for the past two years was as follows: Year 5 Year 6 Eric Lombard, Chairman of the Board Walter Carson, Chief Executive Officer $350,000 $400,000 $350,000 $400,000 Paul Brekkar, Legal Officer $180,000 $200,000 Denise Horton, Finance Officer $135,000 $150,000 The Compensation Committee reviews the compensation levels paid by a sample of 10 other firms in the industry. It is the Board's policy to maintain executive compensation at levels competitive with comparator firms. Notes to Financial Statements The preparation of our financial statements in conformance with generally accepted accounting principles (GAAP) requires management to make estimates and assumptions affecting the amounts to be reported. Actual results may differ from those estimates. The company prepares its financial reporting accounts on an accrual accounting basis. It prepares its tax retum using cash-basis accounting. Deferred taxes are not material and are not recognized in the accounts. The firm faces a tax rate of 30% on income. The company has no fixed assets. The firm's premises, furniture, office equipment, and all fittings are leased. Lease obligations are $215,000 for Years 7 through 10 and $135,000 for Years 11 through 14. We are exposed to claims and litigation arising in the ordinary course of business and use various methods to resolve these matters in a manner which we believe best serves the interest of the firm. We do not believe any pending claim or action will have a material adverse effect on the firm The firm has been experiencing an increase in the cost to acquire term deposits. Management has been successful in passing the increase onto the firm's borrowers. The average annual interest rates paid and earned for the past six years are given below along with the average maturities. Interest is paid quarterly to depositors and is received at maturity from borrowers. 6 Term Depositors Loan Customers Year Annual Interest Paid Average Maturity (Months) Annual Interest Eamed 123456 8% 18 11% Average Maturity (Months) 21 9% 19 12% 25 9% 16 12% 25 9% 15 12% 24 10% 11% 13 13% 19 12 13% 26 Bastion Finance has received an unqualified audit opinion from its auditor, Goodman Cole, in each of its six years of operation. Loans Outstanding at Year End The loan cards from the firm's Loan Book for all of the loans outstanding as of the end of Year 6 are reproduced below. (Dollar amounts are shown in millions rounded to one decimal.) Guidance for completing the Bastion Finance Case. You are asked to use the information provided to prepare forecasted financial statements for year 7. You must identify and evaluate risks associated with the investment and weigh these risks when deciding whether to recommend Bastion as a potential investment. Bastion Finance raises cash by selling debentures (management refers to them as depositors) and the funds acquired from the debentures are lent to property developers. Step 1- Prepare a Cash Flows Statement. Do not prepare the Cash Flows statement using the Direct or Indirect methods. The is a simple cash flows statement starting with the beginning cash balance plus receipts minus disbursements. Using past results as a starting point prepare a simple cash flow statement. Determine the cash receipts from new deposits and loan repayments (including interest) and cash disbursements from interest payments to depositors, salaries, wages, and other, cash dividends (assume 7M will be paid for dividends) and new loans to property owners for year 7. To determine how much to lend in year 7-assume you will want to keep $25.5M "on hand". Cash receipts minus cash disbursements will give you the change in cash. You will add the change in cash to beginning cash for year 6 to calculate ending cash in year 7. Hints: 1. The amount of new term deposits received for year 7 can be estimated by reviewing the change in Term Deposit liability balances on the balance sheet for past years. Determine if you see an incremental increase or decline over the years. Is there a pattern that you can use to project the amount of new deposits in year 7? 2.Cash receipts from loan repayments can be estimated from the firm's loan cards for outstanding loans. There are two loans that are repaid in year 7, loans 602 and 603. Assume that the loans, interest, and fees anticipated as being due in year 7 are actually collected. Assume loans are paid off mid-year. 3. Using the new and existing deposits assumed in 1, calculate the interest paid to depositor at prevailing interest rate on term deposits of 11% provided in the annual report). Assume all interest payable at the end of year 6 was paid in year 7. Impact to cash: Interest payable year 6 (paid in year 7) add: Interest expense year 7 11% for new and existing term deposits subtract -Interest payable year 7 (paid in year 8) 25% of interest expense for the year 7 * *25% payable amount calculated interest payable/interest expense year 6 calculated as follows 12.2/48.7-25%. Apply the same percentage (25%) to calculate the interest payable for year 7 above. Exhibit 3: Loan Cards for Defaulted Loans Principal Amount Loan Number 303 $25.0 Year Loan Granted 3 Interest Rate 12% Year for Scheduled Repayment Loan Origination Fee 4 $2.0 Borrower Phoenix Horizons Principal Officers Linda Gibson and Phillip Greene Transactions Year Description Loan Balance 3 Loan Principal $25.0 $25.0 3 Loan Origination Fee $2.0 $27.0 3 Interest $1.6 $28.6 4 Interest $3.4 $32.0 5 Interest $1.9 $33.9 5 Repayment $30.0 $3.9 5 Loss Write Off $3.9 Notes: Holder of the first mortgage foreclosed the property. There were insufficient funds to fully re-pay our second mortgage. Loan Number 502 Year Loan Granted 5 Interest Rate 13% Principal Amount Year for Scheduled Repayment Loan Origination Fee $65.0 6 $5.2 Borrower Westwood Shopping Complex Principal Officers Phyllis and David Edins Transactions Year Description Loan Balance 5 Loan Principal $65.0 $65.0 5 Loan Origination Fee $5.2 $70.2 5 Interest $5.9 $76.1 6 Interest $3.9 $80.0 6 Repayment $73.7 $6.3 6 Loss Write Off $6.3 Notes: Proceeds from the sale of the complex failed to cover the full development costs. The company went into liquidation. 8 Loan Number Year Loan Granted Interest Rate Borrower 405 4 12% ** Principal Amount Year for Scheduled Repayment Loan Origination Fee Prestige Development Principal Officers Comelius Bowden, Sandy Maier, and Anthony Roest $20.0 5 $1.6 Transactions Year Description Loan Balance 4 Loan Principal $20.0 $20.0 4 Loan Origination Fee $1.6 $21.6 4 Interest $0.6 $22.2 5 Interest $2.7 $24.9 6 Interest $3.7 $28.6 Notes: Builder has encountered severe stability problems in the geological substrata of the building site. Project delayed indefinitely. **Interest rate raised to 15% as of start of Year 6. Loan Number 506 Principal Amount $30.0 Year Loan Granted 5 Interest Rate 10% Year for Scheduled Repayment Loan Origination Fee 9 $2.4 Borrower Gold Coast Condominiums Principal Officers Barbara Liveris, Eric Lombard, and Phillip Greene Transactions Year Description Loan Balance 5 Loan Principal $30.0 $30.0 5 Loan Origination Fee $2.4 $32.4 5 Interest $0.3 $32.7 6 Interest $3.3 $36.0 Notes: 9 Loan Number 601 Principal Amount $65.0 Year Loan Granted 6 Year for Scheduled Repayment 8 Interest Rate 13% Borrower Principal Officers Loan Origination Fee Kingsland Hotels James Franklin and Jacqueline Bell $5.2 Transactions Year Description Loan Balance 6 Loan Principal $65.0 $65.0 6 Loan Origination Fee $5.2 $70.2 6 Interest $6.7 $76.9 Notes: Loan Number 602 Principal Amount $45.0 Year Loan Granted 6 Year for Scheduled Repayment 7 Interest Rate 15% Loan Origination Fee $3.6 Borrower Green Lane Apartments Principal Officers Wang Lim, Henry Shi, and Chong Xie Transactions Year Description Loan Balance 6 Loan Principal $45.0 $45.0 6 Loan Origination Fee $3.6 $48.6 6 Interest $3.5 $52.1 Notes: 10 10 Loan Number Year Loan Granted Interest Rate Borrower Principal Officers 603 Principal Amount Year for Scheduled Repayment Loan Origination Fee 6 13% Lumineria Partners Madeleine Lindquist and Heidi Coleman $50.0 7 $4.0 Transactions Year Description Loan Balance 6 Loan Principal $50.0 $50.0 6 Loan Origination Fee $4.0 $54.0 6 Interest $3.2 $57.2 Notes: Loan Number 604 Principal Amount $85.0 Year Loan Granted 6 Interest Rate 10% Year for Scheduled Repayment Loan Origination Fee 9 $6.8 Borrower Dorchester Management Company Principal Officers Gordon Reynolds, Phillip Greene, and Walter Carson Transactions Year Description Loan Balance 6 Loan Principal $85.0 $85.0 6 Loan Origination Fee $6.8 $91.8 6 Interest $5.1 $96.9 Notes: 11 Loan Number 605 Principal Amount $40.0 Year Loan Granted 6 Year for Scheduled Repayment 9 Interest Rate 14% Loan Origination Fee $3.2 Borrower Hampton Arms Apartments Principal Officers Anne Ward, Paul McLeahy, and Hamilton Wood Transactions Year Description Loan Balance 6 Loan Principal $40.0 $40.0 6 Loan Origination Fee $3.2 $43.2 6 Interest $2.4 $45.6 Notes: Company Risk Factors Bastion Finance is exposed to several sources of risk in its ordinary course of business. These include credit risk, interest rate risk, liquidity risk, and general business risk. Credit risk refers to the potential that some of our customers may default on the loans we have made to them. This risk is augmented by our focus on second mortgages and our concentration in a narrow market segment. Interest rate risk means that we may not be able to maintain a profitable spread between our cost of borrowing and the returns from lending. Liquidity risk arises because we borrow from term depositors on maturities ranging from 6-18 months while our loans to developers may extend for multiple years. General business risk is inherent in the competitive nature of our industry. We cannot be assured that our term depositors or loan customers will continue to conduct business with us rather than with one or more of our competitors. Bastion Finance is not exposed to foreign exchange risk and does not engage in derivatives trading. 12 4, Salaries, Wages, and Other expenses have been paid as incurred (no accrued liabilities). The amount for year 7 can be estimate by reviewing the trend in expenses for Salaries, Wages, and Other over the past 6 years. 5. Per the Notes to the Financial Statement the information in the annual report indicates that taxes are calculated using cash-basis accounting. The expenses actually paid to depositors would exceed the interest and origination fees received resulting in a loss using cash basis accounting so no taxes would be due. Deferred taxes are not immaterial and not recognized in the accounts. You do not have to consider bad debt expense. The defaulted loans have already been accounted for. The only interest and loan fee income expected to be collected in cash during the year will be from loans 602 and 603. The loan fees and the interest accrued on these loans during prior years are given on the loan cards Step 2- Prepare the Income statement Revenue can be calculated from the loan cards provided. Use the loan balance times the given interest rate per loan. For any new loan use the origination rate of 8% of the amount borrowed. Expenses should include interest payments, salaries, and other expenses. (refer to the cash flows statement for these numbers). Salaries and other expenses were paid as incurred. Step 3-Statement of Retained Earnings Beginning RE (yr 6 ending balance) Add Net Income Less Dividend (use $7M) Ending RE year 7 Step 4-Prepare a Balance Sheet Assets Cash-should tie to ending balance cash flow statement Loan Receivable from loan cards plus interest accrued. on loans outstanding during the year. plus loan origination fees.on new loans (should not include loans 602 and 603-paid off during year 7. Assume any new loans are outstanding for half the year. Liabilities Interest payable is calculated at 25% of interest expense. (see cash flow statement) Term deposits are existing term deposits as of year 6 ($455) plus any new term deposits. Stockholder's equity Common Stock Retained Earnings (from Statement of RE) Vol 6. Issue 1 Article 2 march 2013 Bastion Finance Shane Moriarity University of Oklahoma and Unitec New Zealand Andrew Slessor Unitec New Zealand 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 country's 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 Bastion's 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. 1 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 development's 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. Bastion's 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 Walter's 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 firm's 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 loans-just 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. REQUIRED 1. Prepare forecasted financial statements for Year 7 (cash flow statement, income statement, and balance sheet). Prepare a brief justification for each assumption that you make when forecasting a specific value. 2. Use the insights you have gained from preparing the forecasted financial statements to identify the risks and concerns that should be brought to Mr. Parker's attention. 3. Based upon an evaluation of the potential risks and returns, recommend whether the investment in Bastion should be pursued. 2 Exhibit 1: Annual Summary Financial Statements Bastion Finance Summary of Audited Financial Statements ($ Millions) Income Statements Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Revenues Interest Income 4.3 19.0 28.3 36.4 39.2 46.7 Loan Fees 5.2 15.4 8.0 11.2 20.0 22.8 Operating Revenue 9.5 34.4 36.3 47.6 59.2 69.5 Expenses Interest Expense 4.5 15.8 24.7 31.7 41.5 48.7 Salaries and Wages 0.7 0.8 0.9 1.1 1.3 1.5 Other 0.2 0.2 0.2 0.3 0.3 0.5 Operating Expenses 5.4 16.8 25.8 33.1 43.1 50.7 Operating Income 4.1 17.6 10.5 14.5 16.1 18.8 Bad Debts 0.0 0.0 0.0 0.0 3.9 6.3 Income Tax 0.0 0.0 0.0 0.0 4.8 1.6 Net Income 4.1 17.6 10.5 14.5 7.4 10.9 Statements of Retained Earnings Beginning Retained Earnings 0.0 1.1 5.7 5.2 5.7 6.1 Net Income 4.1 17.6 10.5 14.5 7.4 Dividends 3.0 13.0 11.0 14.0 7.0 10.9 10.0 Ending Retained Earings 11 5.7 5.2 5.7 6.1 7.0 Balance Sheets Assets Cash i 2.9 2.0 71.8 96.2 102.4 81.1 Loans Receivable Total Assets Liabilities Interest Payable 74.5 232.9 264.8 312.6 77.4 234.9 336.6 408.8 349.3 393.3 451.7 474.4 Term Deposits Total Liabilities 1.1 4.0 6.2 75.0 225.0 325.0 395.0 76.1 7.9 10.4 12.2 435.0 455.0 229.0 331.2 402.9 445.4 467.2 Owner's Equity Common Stock Retained Earnings 0.2 0.2 0.2 0.2 0.2 0.2 1.1 5.7 5.2 5.7 6.1 7.0 Total Liabilities and Equity 77.4 234.9 336.6 408.8 451.7 474.4 3 Exhibit 2: Information from the Company's Annual Report to Shareholders. Bastion Finance Fiscal Year The fiscal year for Bastion Finance runs from March 16 through March 15. To avoid confusion, dates are not used in the following discussion. Instead, references are made to each full fiscal year of operation. Thus Year 1 refers to the firm's first full year of business and Year 6 to its most recently completed year. Company Regulatory Matters The company is organized as a commercial investment company. It is not subject to regulatory oversight as a bank. Securities regulations require that term investors be supplied with a current prospectus. Depositor's investments are not insured or guaranteed by any governmental agency. Company Shareholders Shares in Bastion Finance are not listed on any exchange nor are they publicly traded. Private transactions between individuals have occurred infrequently. As of the end of Year 6, the firm is aware of 15 individuals owning shares-most consist of very small holdings. The five largest shareholders and their holdings are: Shares % Eric Lombard Walter Carson Lance Edwards 1,290,000 43% 1,050,000 35% 300,000 10% LeRoy Fisk Linda Hobbs 150,000 5% 60,000 2% In Year 3, Linda Hobbs purchased 60,000 shares from Walter Carson for $2,816,000, a price representing eight times per share earnings for Year 2. At the end of Year 4. LeRoy Fisk purchased 150,000 shares from Walter Carson for $7,250,000, a price representing 10 times the estimated per share earnings for Year 4. Several smaller trades have occurred at various prices over the past six years. Board of Directors Six individuals serve on the company's Board of Directors. Directors who are not managers are paid an annual retainer of $25,000 per year and receive 1,000 shares in the firm. The Chair of the Audit Committee and the Chair of the Compensation Committee each receive an additional fee of $5,000. The total fees earned in Year 6 and shareholdings as of the end of Year 6 for each of the directors are given below. 5 Eric Lombard, Chairman of the Board Fees Shareholding $- 1,290,000 1,050,000 Walter Carson, Chief Executive Officer - Brendon Sheppard 25,000 6,000 Susan Richee, Chair of the Audit Committee 30,000 2,000 Bruce Ludlow, Chair of the Compensation Committee Gordon Meyers 30,000 3,000 25,000 5,000 Executive Compensation The firm has only four executive-level employees. The compensation for the executive officers for the past two years was as follows: Year 5 Year 6 Eric Lombard, Chairman of the Board Walter Carson, Chief Executive Officer $350,000 $400,000 $350,000 $400,000 Paul Brekkar, Legal Officer $180,000 $200,000 Denise Horton, Finance Officer $135,000 $150,000 The Compensation Committee reviews the compensation levels paid by a sample of 10 other firms in the industry. It is the Board's policy to maintain executive compensation at levels competitive with comparator firms. Notes to Financial Statements The preparation of our financial statements in conformance with generally accepted accounting principles (GAAP) requires management to make estimates and assumptions affecting the amounts to be reported. Actual results may differ from those estimates. The company prepares its financial reporting accounts on an accrual accounting basis. It prepares its tax retum using cash-basis accounting. Deferred taxes are not material and are not recognized in the accounts. The firm faces a tax rate of 30% on income. The company has no fixed assets. The firm's premises, furniture, office equipment, and all fittings are leased. Lease obligations are $215,000 for Years 7 through 10 and $135,000 for Years 11 through 14. We are exposed to claims and litigation arising in the ordinary course of business and use various methods to resolve these matters in a manner which we believe best serves the interest of the firm. We do not believe any pending claim or action will have a material adverse effect on the firm The firm has been experiencing an increase in the cost to acquire term deposits. Management has been successful in passing the increase onto the firm's borrowers. The average annual interest rates paid and earned for the past six years are given below along with the average maturities. Interest is paid quarterly to depositors and is received at maturity from borrowers. 6 Term Depositors Loan Customers Year Annual Interest Paid Average Maturity (Months) Annual Interest Eamed 123456 8% 18 11% Average Maturity (Months) 21 9% 19 12% 25 9% 16 12% 25 9% 15 12% 24 10% 11% 13 13% 19 12 13% 26 Bastion Finance has received an unqualified audit opinion from its auditor, Goodman Cole, in each of its six years of operation. Loans Outstanding at Year End The loan cards from the firm's Loan Book for all of the loans outstanding as of the end of Year 6 are reproduced below. (Dollar amounts are shown in millions rounded to one decimal.)