Hampton Machine Tool Company was founded in 1915 and began supplying parts to military and automobile companies. Beginning in the 1960’s, heavy increases in defense spending prompted by the Vietnam War in conjunction with a blossoming automobile industry allowed Hampton Machine Tool Company to experience a period of high growth and increased profitability. By the mid-1970’s, defense spending was slashed at the conclusion of the conflict and there was a severe downturn in the automobile market resulting in a significant decline in sales for Hampton Machine Tool. In December of 1978, Hampton Machine Tool was approved for a $1 million loan to repurchase stock. The loan was to be repaid by September of 1979 with monthly interest payments at 1.5% of principle. Due to a backlog of unfilled orders summing to $16.5 million, Hampton Machine Tool was unable to repay the loan.
In order for the company to get back on track they must take out an additional loan of $350,000 in order to purchase new equipment. Mr. Cowin of Hampton Machine Tool Company has incorporated the company’s financials in the loan request letter sent to the bank. Using this information we have prepared Hampton Machine Tool Company’s financial statements including a projected cash budget, pro forma income statement, and pro forma balance sheet. After conducting an analysis of theses financial statements, we do not believe Hampton Machine Tool Company would be able to repay $350,000 in the necessary time frame due to a lack of projected cash flow in the month of December.
A.) Why can’t a profitable firm like Hampton repay its loan on time, and why does it need more financing? What major developments between November 1978 and August 1979 contributed to this situation?
If the loan is undertaken Hampton would have a negative cash balance at the end of the year. This could be due to the slow production in the months of October and November as well as the result of accounts receivables not being collected until the next month.
B.) Based on the information in the case, prepare a projected cash budget for the four months September through December 1979, a projected income statement for the same period, and a pro forma balance sheet as of December 31,1979
C.) Review the results of your forecast. Do the cash budgets and the pro forma financial statements yield the same results? Why? Yes, because the large account negative cash balance in December is more than the loan can cover.
D.) Critically evaluate the assumptions on which your forecasts are based. What developments could alter your results? Is MR. Cowins correct in his belief that Hampton can repay the loan in December? Based on the forecasts we assume that Hampton will operate at a full capacity, as well as receiving the extension on the loan. With these findings we are confident that if the loan would not be able to be repaid in December but with the extension the loan could be repaid the next quarter.
E.) What action should Mr. Eckwood take on Mr. Cowins loan request? What are the major risks associated with the proposed loan? What other alternatives does Mr. Eckwood have, and what are their pros and cons? What would you do? Mr. Eckwood should not approve this loan request. The financial statements show that Hampton will default on the loans. If he decides to allow the loan the bank will be at risk at not being repaid. The statement shows that there will be a negative cash balance at the end of December. Mr. Eckwood should focus on the amount of funds that are reported that are customer advances on the goods and services provided. An alternative that Mr. Eckwood could consider is allowing the loan which could allow Hampton to buy more equipment. Overall Hampton should focus on paying off the current loan before adding new debt onto it.
F.) Why did Hampton repurchase a substantial fraction of its outstanding common stock? What is the impact of this repurchase on Hamptons financial performance? Critically assess Hampton’s dividend policy. Do you agree with Mr. Cowins proposal to pay substantial dividend in December?
Hampton repurchased stock from some of the stockholders. By doing this Hampton reduced the number of shares outstanding and increased the net worth of the company added to the surplus making Hampton look more profitable. The company is already negative and the payment would not be a wise choice. So Hampton should not pay the dividend payment in December, and wait until the loan debt is repaid and then focus on paying dividends.