George Stamper a credit analyst with Micro-Encapsulators Corp. (MEC) needs to re

Question

George Stamper a credit analyst with Micro-Encapsulators Corp. (MEC) needs to respond to an urgent email request from the southeast sales office. The local sales manager reported that she had an opportunity to clinch an order from Miami Spice (MS) for 50 encapulators at $10,000 each She added that she was particularly keen to secure this order since MS was likely to have a continuing need for 50 encapulators a year and could therefore prove a very valuable customer. However, orders of this size to a new customer generally required head office agreement, and it was therefore George's responsibility to make a rapid assessment of MS's creditworthiness and to approve or disapprove the sale.

Mr. Stamper knew that MS was a medium-sized company with a patchy earnings record. After growing rapidly in the 1980s, MS had encountered strong competition in its principal markets and earnings had fallen sharply. Mr. Stamper was not sure exactly to what extent this was a bad omen. New management had been brought in to cut costs, and there were some indicators that the worst was over for the company. Investors appeared to agree with this assessment, for the stock price had risen to $5.80 from its low of $4.25 the previous year. Mr. Stamper had in from of him MS's latest financial statements, which are summarized in table 20.4. He rapidly calculated a few key financial ratio's and the companies Z score. Mr. Stamper also made a number of other checks on MS. The company had a small issue of bonds outstanding, which were rated B by Moody's. Inquiries through MEC's bank indicated that MS had unused lines of credit totaling $5 million but had entered into discussions with its bank for a renewal of a $15 million bank loan that was due to be repaid at the end of the year. Telephone calls to MS's other suppliers suggested that the company had recently been 30 day's late in paying its bills.

Mr. Stamper also needed to take into account the profit that the company could make on MS's order. Encapulators were sold on standard terms of 2/30, net 60. So if MS paid promptly, MEC would receive additional revenues of 50 X $9,800 =$490,000. However, given MS;s cash position, it was more than likely that it would forgo the cash discount and would not pay until sometime after the 60 days. Since interest rates were about 8%, any such delays in payment could reduce the present value to MEC of the revenues. Mr. Stamper also recognized that there were production and transportation costs in filling MS's order. These worked out at $450,000 or $9,500 a unit. Corporate profits were taxed at 35%.

QUESTIONS: 1) What can you say about Miami Spice's creditworthiness?

2) What is the break-even probability of default? How is it affected by the delay before MS pays its bills?

3) How should George Stamper's decision be affected by the probability of repeat orders?

The attached image is a table of financial statements.

Explanation / Answer

Part 1. Credit worthyness of MS seems to be nutral on both positive & negative side , since past event cannot determine future events, in past MS might not be doing well , but as per the info provide It seems a silver lines on future on MS.

Following are the notable points on credit worthiness of MS based on the Info
1. Cureent Ratios seems to be 1:1, which lower than the ideal ratios considered of 2:1, however on the positive side it is still not below 1

2. MS turnover has interest over 2011 & also Gross Margins from 8.6% in 2011 to 12.5 % in 2012 showing postive indicator

3. New management of MS had been brought in to cut costs and stock price had risen to $5.80 from its low of $4.25 the previous year.

4. MS had unused lines of credit totaling $5 Million & going for renewal of a $ 15 M bank loan that was due to be repaid at the end of the year, which is going to be used in busines for expansion.

However following are the negatives

1. MS had recently been 30 days late in paying its bills and such delays would reduce the present value of MEC.

Keeing all these points , it seems MS can be relied on Creditworthiness

Part 2. Marginal Cost for each encapulators is $ 9500, whole the Selling price is 10,000

so there this will naturally add total profits of MEC, in case MS avail 2% cash discount then new revnue realiseable will be 9800 which is again more than my marginal cost

however, if we look at if MS does pay on due date then lets work out interest cost on this

per month interest cost loss is 8% x 9,500 = $63.33 per encapulators

now total margin on per encapulators sold is $500 , so total month of delay or breakeven of no. of months of relealsation of revenue = 500 / 63.33 = ~7.5 months

which means that if it is expected that MS is not going to pay before ~7.5 month of sales then MEC should not sale to MS encapulators

Part 3 :- Mr. Stamper's Decision will not be impacted by the repeat orders but would be impacted by the credit worthiness & how sooner MS is capable of repaying MEC for the sales.

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