Credit sales and credit purchases are assumed to be paid the following month. For applicable ratios (except those for the year ended 1979, for March 1979, and for June 1979), the average ending balances of balance sheet accounts were used.
It was also assumed that there are 365 days in 1 fiscal year, and 30 days in 1 month. Monthly outlays (except for interest and purchases) for January 1980 were assumed to be $400,000.The following assumptions pertain to the pro-forma statements. The income before interest and tax is assumed to be 23% of the month’s sales. Accruals and prepaid expenses are assumed to be constant from September to December 31, 1979. Inventories are assumed to equal total liabilities and stockholder’s equity minus total assets (without inventories), as balances for the given data for inventories is insufficient to determine effects of less raw materials purchases, etc.The advantage of this tactic is that bank’s losses on this customer would be cut, and it would also keep the bank from throwing more money at a poorly performing customer that is nearing default.
The disadvantage of this route is that Hampton is in a poor foreclosure position, as its machines are becoming inefficient. The company’s operations would suffer sooner or later, and Hampton would not be able to raise an amount to cover the bank’s existing loan on December.Furthermore, as shown in Exhibit C, the interest rate should be less than -15. 35% per month so that Hampton could pay the $1,000,000 debt on September 30 and the $350,000 debt on December 31.
A rate like this is impossible, and thus, payment of both debts is also very unlikely. This alternative would allow Hampton to make capital purchases that would enable it to manufacture at capacity.The problem with this option is that, according to the Pro-Forma statements, Hampton would probably not have the cash to make capital purchases, pay a dividend and still pay the loan back by the end of December.
Assuming that the cash budget would be accurate, Hampton would be able to pay the $1,000,000 loan, and it would still have a cash balance of $29,000 on December 31, 1979. The effective interest rate is 6%, and the bank would earn $60,000 in interest from this transaction. This might put the bank and Hampton in a new default situation.