Ivan Petrov was a member of the newly formed entrepreneur class in Bulgaria; partly out of desire,

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Question:

Ivan Petrov was a member of the newly formed entrepreneur class in Bulgaria; partly out of desire, mostly out of necessity. The changes occurring as the country moved from a centrally planned to a market economy had dumped many individuals like Petrov into the unemployment abyss. Gone were the days of guaranteed lifetime employment requiring minimal effort. In its place was a country with tremendous opportunities coupled with great risk. Petrov found he enjoyed the new challenges but that finding the right venture was elusive. His most recent venture fell on hard times in part because of the difficulty in finding qualified customers. Building on this venture but he saw an opportunity emerge where he could contract with a more secure group of clients outside of Bulgaria. All that stood in his way was the financing.

Introduction

Ivan Petrov is searching for BGN 25,000 to purchase a Buttonhole Sewing machine. The machine is the final production-line piece of equipment necessary for the successful start-up of the sewing factory established by Petrov. The machine is a vital piece of professional equipment for the production of sports coats in which Petrov will specialize. The machine guarantees quality workmanship along with decreased production times, which are essential preconditions for receiving “Cut, Make, and Trim” (CMT) orders for export.

Petrov lives in Ruse, Bulgaria. Bulgaria is a small country with 8,000,000 people located in Southeastern Europe. Ruse is in the northeastern part of the country 300 km from the Sofia and 200 km from the Black Sea Coast. Ruse has the most significant Bulgarian river port feeding into the Black Sea. As a port city Ruse enjoys a long history as a trading center and textile manufacturing base. However, the transition to a market-driven economy has not been easy with the unemployment rate hovering around 22 percent and banks charging upwards of 18 percent for business loans.

At the time there wasn’t a great deal of trust or history between SMEs and the banking sector. Banks were used to working with large, state owned enterprises and private business was in its infancy. State-owned enterprises were on the way out & banks needed to generate a return greater than what they could get off of government bonds. A major source of finance for emerging SMEs was the local mafia sector that would loan money at 3+ percent a month with monthly rate as high as 20%. SMEs needed a source of finance offering rates at a reasonable rate. Hurting their cause was the belief among many SME owners that the goal wasn’t to develop a long term relationship with a bank but to get a loan and figure out how to not pay it back. Fortunately some banks recognized the opportunity the SME sector presented and the need to better understand this sector, but their patience was not unlimited and they needed to show positive results quickly.

Petrov began his entrepreneurial career in 19xx trading buttons and sewing related products. He expanded rapidly and in 19xx began trading in more expensive items such as sewing machines and related equipment. Petrov’s sales for 20xx were roughly BGN 200,000, but declined to BGN 100,000 the next year primarily due to the scarcity of loans to SMEs for new equipment and because industrial sewing equipment is not frequently replaced. At this point Petrov started looking for other opportunities that led him to establishing his most recent venture – the sewing facility. Some of the new machines from his unsold inventory make up part of his current production line.

To date, Petrov has agreements with Marisa Textile LTD, Elina Jsc. and Magic LTD for CMT orders that will be exported to the USA, Holland and Germany. Along with these orders Petrov has had verbal discussions with representatives of CMT suppliers to provide approximately 3,100 sports coats starting in August this year. Prices of CMT sports coats produced in Bulgaria range from BGN 5.50 to BGN 8, depending on the complexity of the model.

Customers provide all the necessary materials needed for CMT orders. The manufacturer’s inputs are thus limited to the sewing equipment and the personnel capable of completing the orders on time at the level of quality desired by the client.

Petrov is requesting a loan of BGN 25,000 to purchase the necessary machine. He is willing to pay an annual interest rate is 9% per year with a 5-year payback on the loan.

Petrov approaches the “Bulgarian United” bank in Ruse and presents them with the following set of financial projections. Boyko Borisov was the loan officer assigned to Petrov. Boyko takes the proposal and adds the following notes in the margin on further discussions with Petrov.

Financial Projections

The Balance Sheet

Petrov presents you with the following balance sheet (assuming the loan is made): Ivan Petrov Balance Sheet

Current Assets

Cash BGN 20,000

Plant & Equipment 82,000

Less: Accumulated Depreciation

- Net Plant & Equipment 82,000

know-how 50,000

Total Assets BGN 152,000

Liabilities BGN 25,000

Paid In Capital 127,000

Retained Earnings

Total Liabilities & Equity BGN 152,000

NOTES – Cash represents what his friends have promised him if he can get the plant opened. Ivan insists he can pay this money back whenever he wants and it carries a zero interest rate. Plant and equipment consists of BGN 10,000 in improvements (he painted the facility and added some lights), BGN 47,000 in equipment he had in inventory. The BGN 47,000 represents the “sales price” of the equipment, Petrov’s actual cost was BGN 30,000 and the equipment could probably be sold quickly for half of his actual cost . The buttonhole machine to be purchased for BGN 25,000 is also included in Plant & Equipment. The “know-how” represents what Ivan believes his experience is worth. Liabilities – the BGN 25,000 is the amount borrowed on the new machine. Paid in Capital is a plug figure. Current Assets Cash BGN 20,000 Plant & Equipment 82,000 Less: Accumulated Depreciation - Net Plant & Equipment 82,000 know-how 50,000 Total Assets BGN 152,000 Liabilities BGN 25,000 Paid In Capital 127,000 Retained Earnings - Total Liabilities & Equity BGN 152,000 Petrov’s projected first-year income statement was based on the following assumptions: Sport coat production of 3100 pieces per month earning BGN 7.5 per coat, Note - Petrov signed contracts for 1 000 pieces per month at BGN 5.5 per piece, the remaining 2100 units represents what Petrov “hopes” to get. Operating at full capacity will require 30 employees at BGN 205 per month.

Producing 1,000 units per month will require 12 employees. Administrative salaries do not depend on the level of production. Every July the facility closes down for maintenance and vacations. No revenue will be earned during this period but the firm will continue to incur operating costs except for transportation. Electricity will be reduced to BGN 150. Assume the first month of operation with the new machine is August. Employee transportation to and from the facility of BGN 750 per month for 30 employees. This is a fixed cost and will not change with a lower number of employees Electricity consumption based on producing 3100 pieces per month (operating two shifts per day). With one shift per day the electricity consumption should fall in half. All long term assets except “know how” are depreciated over 5 years. Telephone bills are estimated based on expected use. Approximately BGN 200/month.

Assume this is a fixed cost. Depreciation = 5 year straight line method Security includes payments for a security system and guards. This is a fixed cost. Miscellaneous expenses should scale down to BGN 500 per month with 1,000 units per month in production. Interest rate on the loan = 9% per year, this is what Petrov believes is reasonable – banks in the region are currently charging 18% per year for lending to small firms. Loan term = 5 year payoff, monthly payments Total Revenues BGN 279,000 Direct Costs Employee Salaries 73,800 COGS 73,800 Gross Margin 205,200 Operating Expenses Rent for facility 3,600 Electricity 18,000 Administrative Salaries 7,200 Telephone 2,400 Transportation 9,000 Security 4,200 Depreciation 16,400 Miscellaneous 12,000 Total Operating Expenses 72,800 EBIT 132,400 Interest Expense 2,082 EBT 130,318 Taxes 45,611 Net Income/(Loss) BGN 175,930 Original Projections Income Statement Tax Rate 35%, After a couple of meetings Boyko developed a genuine level of respect and admiration for Petrov. He fully understood the challenging business environment and took great pleasure in helping his clients succeed.

That said, the loan decision wasn’t his; he was tasked with vetting the client & developing a proposal the loan committee would review. Boyko’s task was to submit proposals that made sense to the loan committee that also worked for the client. If that wasn’t possible, better to turn the client away than running the risk of hurting his reputation by submitting a proposal the committee rejects out of hand. The outreach to the SME sector was still new and Boyko knew some of the senior management was skeptical of this approach. Pondering Petrov’s proposal and knowing that he only had a little over an hour to get his write-up done Boyko got to work in developing his write-up for the loan committee.

Instructions

1) What do you think of Petrov’s pro forma financial statements? What does the balance sheet look like at the end of the first year if he achieves the expected results? Do you see any unintended consequences in presenting this set of projections to the loan committee?

2) Recalculate the current balance sheet to reflect the additional information provided in the “financial projections” section of thecase.

3) Develop monthly projections (income statement & cash flow) for the first year of operations based on the existing forecast (use the format in the attached spreadsheet). What errors/omissions do you find in the above projected income statement?

4) Develop monthly projections for the first year of operations based on the additional information.

5) Develop a projected balance sheet for the end of the first year assuming the revised projections.

6) Based on the available information would you recommend granting the loan? What would you tell Petrov? Is there a possible solution that may appeal to both Petrov and the bank?