ACCOUNTING

Estimated time 50 minutes

Jeans Incorporated, which sells men’s and women’s jeans in 10 stores in large shopping centers in Southern California, began having financial difficulty in 1993. The controller provided you with the following balance sheet as of December 31, 1994:

Jeans Incorporated
December 31, 1994

Balance Sheet (in thousands)

The controller also provided you with the following liquidation values (in thousands):

The Chairman of the Board owns 40 per cent of the outstanding stock of Jeans Incorporated. Other family members own 15 percent, and the balance is owned by employees and the general public. The stock is traded over the counter. On July 1, 1994, the Chairman turned over the duties as president and chief operating officer to you as a turnaround specialist. After making several changes in the operations, the Controller provides you with the following information regarding projected income from operations for the next five years.

No taxes are due in 1995 through 1997 due to a $3.5 million net operating loss carryover ($2.0 is assumed to be available for use). Jeans Incorporated will need cash for working capital and capital expenditure requirements above the amount of depreciation reported in 1995 and 1996 of $100 and $200 in each year from 1997 through 1999. Management expects depreciation to equal cash flows for years ending after 1999. Jeans Incorporated has a cost of capital of 14 percent.

You expect to have an agreement either in bankruptcy or out of court during 1995. Assets not needed for continuing the business, including the value of leaseholds, can be sold for $200,000, and the proceeds will be used to pay part of the fees and expenses of the reorganization.

Required:

1. Included in the information provided by the Controller was an estimate that the cost of capital for Jeans Incorporated was 14 percent.

1. a. Define cost of capital
2. b. What approaches might the Controller have used to estimate the cost of capital for Jeans Incorporated.
3. c. As you attempt to obtain an agreement with creditors in an out-of-court workout or in a Chapter 11 filing, how would the cost of capital of 14 percent be used.

2. Your Controllers suggested to you that Jeans Incorporated has a reorganization (going concern or enterprise) value of $4.4. million.

1. a. Is it important that you know the value of Jean Incorporated as you begin negotiating with creditors? Explain.
2. b. What approaches might the Controller have used to develop the $4.4 million value?
3. c. How is the $200,000 proceeds expected on the sale of the leaseholds relevant in determining reorganization value?
4. d. Which approach to determine the reorganization value Jeans Incorporated would you think was best? Explain.

3. Assume that a Chapter 11 petition was filed. You have been retained by the debtor, with court approval, to manage the business. One of the first issues that you must deal with is the shortage of cash. You have been told that the only manner in which you can use the cash collected from accounts receivable is for the court to approve the use unless the secured lender agrees to its use.

1. a. Define cash collateral.
2. b. What condition(s) must be considered by the court in deciding whether or not to release the cash collateral.
3. c. What type of information (both financial and nonfinancia) would you need from the accountant to convince the court to release the cash collateral

LAW

Part I

1. Debtor, Inc., needed funds for its manufacturing operations. Its president, Malcolm Debtor, contacted Union Bank to discuss a loan on August 1st. The loan committee approved Debtor, Inc.’s preliminary application on August 15th, but only for $100,000 rather than for the $175,000 that Malcolm had requested. Nevertheless, the parties began preparing the documentation. Malcolm Debtor signed a financing statement on behalf of Debtor, Inc., on August 18th and Union Bank filed it immediately. The parties closed the loan on the 25th: Malcolm, again on behalf of Debtor, Inc., signed a security agreement granting Union Bank a security interest in Debtor, Inc.’s equipment; and Union Bank issued a check for $100,000.

Meanwhile, on August 16th, Malcolm Debtor had contacted American National for additional funds. American checked the records on the 17th and, finding no pre-existing security interest, agreed to lend Debtor, Inc., $75,000. American’s loan closed on August 20th, and its financing statement was filed that afternoon.

Debtor, Inc., defaulted on both loans a few months later and both banks claimed first priority in the equipment. Which bank wins?

1. Union Bank, because it was first to obtain approval of the loan committee.
2. Union Bank, because it was first to file its financing statement.
3. American Bank, because it was first to obtain a signed security agreement.
4. American Bank, because it was first to issue a check.

2. Debtor Corp. filed a Chapter 11 bankruptcy. Among its secured creditors was Commercial Finance, which was owed $250,000 on a loan secured by the real property on which Debtor’s Corp.’s office was located. The land was worth only $100,000. Debtor Corp. proposed a plan under which commercial finance was treated as having a secured claim of $100,000 and an unsecured claim of $150,000. On its second claim, Commercial Finance was to receive interest-only payment of $4,000 per year of 10 yeas and then a lump sum payment of principal. Commercial Finance is dissatisfied with this proposed treatment of its secured claim. (Its unsecured claim was also covered, but Commercial Finance wants to resolve this first.) Which of the following arguments represents the best grounds for a successful attack on Commercial Finance’s treatment under the proposed plan?

a) The 1994 Amendments to the Bankruptcy Code prohibit the modification of real estate loans in Chapter 11.

1. The amount of the secured claim should be $250,000, rather than $100,000.
2. Principal must be amortized over the life of the plan, so interest-only payments are impermissible.
3. The interest rate is too low.

Part II

Bluebell Berries, Inc., is a wholesale nursery that supplies blueberry bushes to garden centers. The corporate stock is owned, in equal shares, by Joe and Mary Greene, and their daughter, Emily Greene Jones. They are also the president, vice-president, and chief financial officer, respectively, of Bluebell. The business was incorporated and began operations in 1988. It never did well, although it was marginally profitable in its second and third years of operation. It began losing money in 1991 and filed a Chapter 11 petition on October 1, 1994.

Commercial Bank extended an unsecured $500,000 revolving credit line to Bluebell in 1989. Interest was payable quarterly and principal could be der. Emily Jones drew a corporate check for the appropriate amount and mailed it to Commercial. The check was usually paid from the corporation’s account on the second or third day of the month.

Although Bluebell had not defaulted, Commercial learned that Bluebell had financial problems and demanded security. The parties signed a financing statement on June 21, 1994, that granted the bank a security interest in Bluebells’ inventory, currently owned and thereafter acquired. The bank filed a financing statement immediately. At that time, Bluebell owed the bank $450,000. The inventory Bluebell owned was worth $200,000 on a wholesale basis; it had a retail value of $300,000.

The corporation fell into arrears on its federal tax obligations. The officers were concerned about their possible personal liability for some or all of these taxes. Thus, on August 1, 1994, the corporation paid $5,000 in FICA taxes withheld from its employee wages over several months. It also paid $2,500 in corporate income taxes incurred over the past few months.

Bluebell Berries does business on land originally purchased for $220,000. The land had declined in value recently, however, and was worth only $195,000 at the time bankruptcy was filed. The property is subject to a first mortgage, held by First Federal, and a second mortgage, held by Second Mortgage Bank. Bluebell Berries had had a spotty payment record with both of its mortgages. When bankruptcy seemed inevitable, Bluebell stopped paying certain suppliers, saved up funds, and paid the $7,500 arrearage on the first mortgage to First Federal of September 10, 1994. The second mortgage was also in arrears, but Second Mortgagee Bank did not want a direct payment. Instead the bank asked Bluebell to make a deposit into the checking account the corporation maintained at the bank. Bluebell deposited $5,000 (the amount of the arrearage) into the account on September 13th, increasing the balance form $10,000 to $15,000. As of the date bankruptcy was filed, Bluebell owed $175,000 on the first Mortgage and $35,000 on the second.

The following issues have arisen in Bluebell Berries’ Chapter 11 case. Please analyze each question fully, in light of the facts. You may assume that Bluebell Berries has numerous unsecured creditors and has been insolvent since at least late 1992. The corporation does, however, have assets sufficient to pay claims entitled to priority, in cash, on the effective date of the plan.

1. Bluebell issued a check to Commercial Bank on June 30, 1994, in the amount of $7,500 in payment of quarterly interest on its revolving credit line. The check was honored on July 2, 1994. Debtor would like to recover the payment, if possible.
2. On the date bankruptcy was filed, Bluebell owed Commercial Bank $500,000. The inventory then on hand was worth $250,000 on a retail basis and $150,000 on a wholesale basis. Commercial Bank has asserted a claim in Bluebells’ bankruptcy. Discuss whether the Bank’s security interest is enforceable and the appropriate amount of the bank’s claim.
3. Can Bluebell recover any of the taxes paid on August 1, 1994?
4. Can Bluebell Berries recover the $7,500 paid to First Federal on September 10, 1994, under any theory?
5. After bankruptcy was filed, Second Mortgage Bank sought relief from the automatic stay in order to set off the $15,000 in Bluebells Berries checking account against the amount owed the bank. What arguments are available to Bluebell to block setoff?

MANAGEMENT

1. The primary objectives of the "Return to Normal" Stage of the Turnaround Process are [Circle all correct answers] (0 to 4 points)

1. a. To enhance profitability through better management of current operation.
2. b. To restructure the business for increased profitability and return on equity.
3. c. To seek out opportunities for profitable growth.
4. d. To build the competitive strength needed to exploit new market opportunities

2. Which of the following is not one of the variables in Altman’s Z-score model for predicting corporate bankruptcy? [Circle the correct answer] (1 point)

1. a. Working Capital/Total Assets
2. b. Retained Earnings/Total Assets
3. c. EBIT/Sales
4. d. Sales/Total Assets
5. e. Market Value of Equity/Book Value of Debt

3. What value is typically received for assets sold as part of a liquidation sale effort?

1. a. Market Value
2. b. Replacement Value
3. c. Book Value
4. d. 1/2 Book Value
5. e. 1/5 Book Value
6. f. Scrap Value

4. In a critical turnaround situation with substantial and continuing losses, which of the following would be the most appropriate approach to personnel reductions after the analysis of the situation is complete? [Circle the most correct answer] ( 1 point)

1. a. Make the maximum cuts immediately, including those that are absolutely essential, those that are probable and those that are borderline
2. b. Make only the minimum absolutely essential cuts now. Wait until the situation becomes more clear to decide on the probable and the borderline cuts.
3. c. Make the absolutely essential and the probable cuts now. Wait on the borderline cuts until the situation becomes more clear.

5. Explain your answer to Question 4 in the space below. Be as complete as necessary to explain both why your specific choice is the most appropriate one and why the other two choices are less appropriate (3 points)