Case Problems in Finance

SureCut Shears, Inc.

SureCut Shears is a household scissors and industrial shears manufacturer. The products were distributed
by wholesalers throughout the US to speciality hardware and department stores while cheaper products distributed
directly to large chains. The sales and profit growth fairly steadily since 1958 though there were severe competitors in
the industry.
SureCut Shears held fairly sizable deposit balances in its principal banks and had sufficient capital to cover
its permanent requirements over the immediate future. The company attempted to produce at an even rate
throughout the year in order to accounted as good performance for borrow from bank. Each year during July to
December, the company will borrow the capital to support their seasonal sales peak.
In June 1995, David Fischer, treasurer of SureCut Shears, credit $3.5 million from Hudson National Bank
(HNB) to support its seasonal working capital and anticipated that loan will completely paid off by December at the
same year. Pro forma income statement and balance sheets were shown to support the company request.
Mr. Fischer also request for approximately $1 million funding for the companys plant modernization program
in June 1996. This program is about half completed and it expected to save about $900,000 a year before taxes in
manufacturing cost. However, the program required an expenditure of $6 million and estimated to complete by August
1995. In September 1995, $350,000 was requested in addition to the $3.5 million seasonal loan. While in January
1996, SureCuts Shears again request an additional short term loan to support the industry downturn. HNB had
agreed with all funding requested by SureCut Shears.
Finally in April 1996, Surecut Shears informed HNB that the company would not be able to pay $1.25 million
outstanding short-term loan balance due to the retailing recession and also the companys inability to liquidate the
loan. While agreeing to renew SureCut Shears outstanding loan, HNB would first explore if the the modernization
program is the cause of SureCut Shears unable to repay its seasonal loan. Various profit and loss statements and
balance sheets were examined over the previous 9 months to uncover the reason for the company loan repays
inability. SureCut Shears actually did not grow rapidly and needed extra fund to support its unstable sales and the risk
of excess inventories during the seasonal sales.

Case Problems in Finance

American Home Products Corporation

American Home Products Corporation is a leading company of prescription drugs, packaged drugs, food
products, housewares and household products. AHPs largest and most profitable business is prescription drugs.
AHP is almost debt-free balance sheet and growing cash reserves. AHP had its own corporate culture: reticence;
frugality and tight financial control; conservatism and risk-aversion; and the firms long-standing policy of centralizing
complete authority in the chief executive.
Expenditures greater than $500 had to be personally approved by William Laporte. In addition, AHP often
avoided risk of R&D and new-product development and introduction in the volatile drug industry. AHP often licensed
its new product after other firms development or copied competitors new products. AHP was more utilized its
marketing prowess to promote acquired products and product extensions. Finally, AHP is a management from the top
company and their authority was interested in making money for the stockholders and minimizing costs. However, the
managerial philosophy performed stable, consistent growth and profitability.
AHPs sales, earnings, and dividends grew for 29 consecutive years through 1981. AHPs ROE rose from
24% in 1960s to 30% in 1980s. AHP able to pay almost 60% of its annual earning as dividend and also able to value
up its stock price AHPs P/E ratio fell about 60% during the resignation of Laporte.
Major institutional investors mainly owned AHPs stock. In addition, AHP was excess liquidity and had low
degree of leverage in its industry. Many drug firms were relatively unleveraged compared to AHPs conservative
capital structure. However, it is difficult to compare other companies with AHP because of AHPs diversified
operations. Analysts had compare Warner-Lambert Company, a similar size company that doing the similar business
with AHP. Analysts found that unlike AHP almost free of debt, Warner-Lambert had a debt ratio of 32%.
For many years analysts had speculated on the impact of a more aggressive AHP capital structure policy.
The pro forma recapitalization analysis shows actual 1981 performance and pro forma restatements of the 1981
results under three alternative capital structures: 30% debt, 50% debt, and 70% debt.
The pro forma restatements assume that AHP issued debt and used the proceeds plus $233 million of
excess cash to repurchase stock in early 1981 to achieve a higher debt ratio. This assumption illustrates the impact
of higher debt on AHPs financial performance. However, AHP has a corporate culture that it has been following for
years. It would be very difficult to change the culture of a company

Lex Service PLC: Cost of Capital

Case Problems in Finance

Lex Service PLC began in garage and petrol business in 1928. In 1945, Lex began to expand through a
series of automotive distributions acquisitions and became a leading company in automotive distribution and leasing
in the United Kingdom during 1988. Lex then began to diversify into other service businesses in the UK. Lex earned
90 million on total revenues of 911 million with an asset of 420 million.
Lex then realized the danger of sole dependence on UK market after the British 1973-1974 economic
recession and began to acquire US based distributors. Lex structured around two principal groups: automotive and
electronics. However, the UK car and truck market hit low and Lexs sales affected badly and reported a loss of 3
million compared to its profit of 5 million in 1990. Lex then implements a new business strategy and strengthens its
automotive and leasing business.
Lex then sold its electronic business to Arrow Electronics Inc. in 1991 and 1992. Lex also sold nearly its
entire share in Arrow Electronics by May 1993. In March 1992, Volvo ended 4 years earlier than its import agreement
with Lex and provides 100 million as the value of concession. However, of the 100 million, 20 million was received
in cash on completion of the sale and three sterling loan notes of 26 million, 26 million and 28 million was payable
on 1 January 1993, 1994 and 1995, respectively. Lex then acquired Swan National Limited, Lucas Autocentres and
Arlington Motor Group after the termination of Volvo import agreement. Finally, Lex bought 50.1% interest of the
business from I.M. Group, which owned the Hyundai franchise.
Lex owned two major lines of business: automotive distribution and contract-to-hire, comprising of vehicle
leasing and financing. Automotive distribution was wholly or majority owned subsidiaries. Contract hire conducted
through joint owned where, Lex and Lombard each held 50% of leasing business. The contract hire joint ventures
consolidated into Lombard account whereas Lex managed business operation while Lombard provided financial
supports. L.E.K. also estimated that Lex possessed investment properties with a book value of 31.4 million.
Lex concerned its capital budgeting procedures and cost of capital. Between 1991 and 1993, Lex owned 340 million
in sales and assets while also spending 132.5 million in new automotive distributor acquisition. Most of the balance
from its sales was used to pay about 197 million of debt, leaving this company very little financial leverage.
L.E.K. Partnership was then request to analyze Lexs Cost of Capital. L.E.K. applied CAPM to estimate the
rate of return on a risky investment of Lex. L.E.K observed that average equity market premium over long-term gilts
had varied over time. L.E.K also found that Lex actual leverage was below managements future target levels. It
raised the concern on how one should estimate Lexs cost of capital and how the estimates should be used. While
Lex was concerned if the results provided by L.E.K. should be used for valuation and capital budgeting purposes.

Case Problems in Finance

Ocean Carriers
Ocean Carriers Inc. owned and operated vessels and mainly carried iron ore worldwide and sail around
Cape Horn, travel between Atlantic and Pacific Oceans. The route is longer than Panama Canal.
Ocean Carriers vessels were mainly chartered on a time charter basis for 1, 3, or 5-year periods. The
charterer paid Ocean Carriers a daily hire rate for the entire length of contract. Ocean Carriers then supply a
seaworthy vessel with full operations. Operating costs were estimated for average $4,000/day and increase 1%
above inflation annually. Daily rate was not charged during maintenance and repair but operating costs incurred.
Due to the costly maintenance requirement by the international regulations, Ocean Carriers would not
operate vessels older than 15 years. Capital expenditures would depreciate on a straight-line basis over a 5-year
period. The company would sell older vessels to secondhand market or scrap the vessel for $5M before 15 years.
Daily hire rates were determined by supply and demand. Supply affected by the ships availability, market
demand for shipping capacity, and the ships size and efficiency. While capesizes demand were determined by world
economy: supply and demand of iron ore and coal. Trade patterns also affected the demand for capesizes. However,
it was hard to predict the future ship orders of more than 2 years because of the market outlook.
Spot charter rates fluctuate than daily hire rate at about $22,000/day. Ship owners sought time to lock high
rates while charterers preferred to trade in the spot market to avoid high daily rates. About 48% of the capesize fleet
in Ocean Carriers was less than 10 years and this make them premium to the market. Because new ships earned
15% premium in daily hire rates while ships over 25 years received 35% discount.
63 new vessels were scheduled for delivery in 2001. Spot rates predicted to fall in 2001 and 2002. Iron ore
and coal imports expected to remain stagnant over next two years. However, Australian and Indian ore exports would
begin in 2003 and it would increase the demand and prices for capesizes. The worldwide iron ore vessel shipments
grew 2% annually during 2002 to 2005, and drop to 1.5% thereafter.
A charterer requested a 3-year time charter with Ocean Carriers begin in 2003 for $20,000/day with an
annual escalation of $200/day. The inflation rate was expected to be 3%. However, vessels in Ocean Carriers could
not commit to a time charter beginning in 2003. A capesize contract signed two years before delivery and there were
no sufficiently large capesizes available in the second-hand market.
Ocean Carriers was deciding if it should order a new ship cost $39M for early 2003 delivery. The order
request 10% of the price now, another 10% due in a year and the balance due on delivery. New ship depreciated on a
straight-line basis over 25 years. The proposed contract was only for three years, there is a risk the charterer would

Case Problems in Finance

stop paying and terminate contract. Linn might consider the use of the ships after 3-year contract and also the
taxation differences between Hong Kong and United States.
NetFlix.com, INC
NetFlix.com, Inc was an internet based DVD rental service founded in 1997. It offered unlimited new release
and older DVD movies rental by online subscription and delivered by U.S. mail. Netflix provided unlimited virtual
shelf space to improve user movie selection experience. Netflix also integrated movie theater time schedule and the
ability to watch movie trailer on its own website.
Netflix offered its service with no late fees, free shipping and anytime cancellation with a subscription fee
ranging from $15.95 to $19.95 a month. In 1999, Netflix subscribers can rent four DVD a month with a fee of $15.95.
In February 2000, subscribers could rent unlimited DVD with a fee of $19.95 a month and could keep a DVD as long
as desire. The existing subscribers were migrated to the new service for the old price.
Coupons for a free month were distributed with DVD manufacturer to attract new subscribers. The purpose
is to convert the free trial to a month paid subscription and retain the subscription as long as possible. Approximately
70% converted from free trial to a paid subscription while 40% of the subscription stays for more than 6 months. The
coupon strategy had made up the majority of sales and able to cover the cost and marketing expenses. Based on the
market test and data collected from its subscribers, Netflix believed its ability to retain its subscribers better than a
cable service.
Netflixs Marquee Queue concept allowed subscriber to create and edit their own to-watch list. Netflix will
send the DVD on the top of the list and send up to 4 DVD at one time. DVD in the queue will automatically sent once
the subscriber had return the previous order. Netflix also track subscribers movie preference to improve movie rating
and recommendation.
US consumer spent $25.6B on movie theater and home video with $8.3B (32%) in home video rental. Netflix
was tremendous success and reached 5,048 NASDAQ Composite Index in March 10, 2000. However, it dropped to
3,794 (-25%) by April 18, 2000, the day of Netflix S1 Filing. The collapse of Netflix stock market in NASDAQ may
force Netflix to withdraw their IPOs. In order to launch its IPO, Netflix needs to provide a positive cash flow within a 12
months horizon. Netflix actually had no profit earning to show a positive cash flow.
To sustain the sales growth, Netflix may consider a revenue sharing agreement with movie studios.
However, it is uncertain if movie studio willing to sign a revenue sharing agreement with Netflix since Blockbuster
already signed with the major movie studios. In addition, Netflix also consider dropping the free-month service
promotion in order to free up enough working capital.

Case Problems in Finance