Running head: THOMPKINS AUTO GROUP 1
THOMPKINS AUTO GROUP:
CAPITAL IMPROVEMENT AND EQUIPMENT FINANCING DECISION
Introduction
It is 2020 and the auto dealership, Thompkins Auto Group, was thriving in a stable and
growing economy. Sales were averaging a strong $50 million annually, and cost management
was very effective. As a result, the dealership was producing above average profits of 3% on
sales. However, Jerry, the far-sighted managing stockholder, knew that to keep the sales
momentum in a competitive environment, it was time to make significant improvements to
physical facilities and key equipment. His education, training, and extensive experience in the
industry all contributed to his conclusion—the financial success of Thompkins was not
sustainable without the needed improvements.
Jerry and his two co-owners had purchased the dealership from the previous owners only
five years ago. The business, located in North Central Texas, included sales of new and used
vehicles as well as the parts and service. The geographical area from which Thompkins drew its
customers was primarily rural, with several small towns located nearby. Ft. Worth is the largest
city in the region with a population of about 800,000, and the dealership, only 60 miles away,
was able to attract many customers from that city.
The economy in this North Texas area was heavily dependent on the oil industry which
was the primary source of employment. Other major sources of employment were farming,
ranching, light industry, retailing, and the service sector (private and governmental). The oil
industry was currently experiencing a low price shock. Jerry, however, knew well the vagaries
of the oil industry and had worked to make Thompkins at least somewhat resilient to the frequent
ups and downs in that industry.
Management Philosophy
THOMPKINS AUTO GROUP 2
Over the years, the financial success of Thompkins had been driven by the overriding
business philosophy of its three stockholders—to attain a consistently high level of customer
satisfaction. They felt it would lead to repeat business and, through word-of-mouth, would
contribute to growth in their customer base. Several other dealerships were active in the area; so
in addition to its development of strong repeat and referral business, Thompkins used targeted,
creative advertising to further differentiate itself from its competitors.
The partners believed that happy customers would tend to be repeat customers and would
tend to speak favorably about the company. The owners also believed that their success in
maintaining high levels of customer satisfaction was due to achieving two strategic goals. The
first was to provide excellent service. To that end, Thompkins provided first-rate, job-specific
employee training on a regular basis. In addition, the dealership provided its employees with the
most up-to-date equipment and techno.
Running head THOMPKINS AUTO GROUP 1 THOMPKINS AUTO GR.docx
1. Running head: THOMPKINS AUTO GROUP 1
THOMPKINS AUTO GROUP:
CAPITAL IMPROVEMENT AND EQUIPMENT FINANCING
DECISION
Introduction
It is 2020 and the auto dealership, Thompkins Auto Group, was
thriving in a stable and
growing economy. Sales were averaging a strong $50 million
annually, and cost management
was very effective. As a result, the dealership was producing
above average profits of 3% on
sales. However, Jerry, the far-sighted managing stockholder,
knew that to keep the sales
momentum in a competitive environment, it was time to make
significant improvements to
physical facilities and key equipment. His education, training,
and extensive experience in the
industry all contributed to his conclusion—the financial success
of Thompkins was not
2. sustainable without the needed improvements.
Jerry and his two co-owners had purchased the dealership from
the previous owners only
five years ago. The business, located in North Central Texas,
included sales of new and used
vehicles as well as the parts and service. The geographical area
from which Thompkins drew its
customers was primarily rural, with several small towns located
nearby. Ft. Worth is the largest
city in the region with a population of about 800,000, and the
dealership, only 60 miles away,
was able to attract many customers from that city.
The economy in this North Texas area was heavily dependent on
the oil industry which
was the primary source of employment. Other major sources of
employment were farming,
ranching, light industry, retailing, and the service sector
(private and governmental). The oil
industry was currently experiencing a low price shock. Jerry,
however, knew well the vagaries
of the oil industry and had worked to make Thompkins at least
somewhat resilient to the frequent
ups and downs in that industry.
3. Management Philosophy
THOMPKINS AUTO GROUP 2
Over the years, the financial success of Thompkins had been
driven by the overriding
business philosophy of its three stockholders—to attain a
consistently high level of customer
satisfaction. They felt it would lead to repeat business and,
through word-of-mouth, would
contribute to growth in their customer base. Several other
dealerships were active in the area; so
in addition to its development of strong repeat and referral
business, Thompkins used targeted,
creative advertising to further differentiate itself from its
competitors.
The partners believed that happy customers would tend to be
repeat customers and would
tend to speak favorably about the company. The owners also
believed that their success in
maintaining high levels of customer satisfaction was due to
achieving two strategic goals. The
first was to provide excellent service. To that end, Thompkins
provided first-rate, job-specific
4. employee training on a regular basis. In addition, the
dealership provided its employees with the
most up-to-date equipment and technology to support employee
productivity and quality
customer service.
Thompkins’ second goal was to build and sustain strong
business relationships with
customers. Customers served by happy, competent, and helpful
employees were more likely to
be highly satisfied customers. To that end, the dealership's
employees enjoyed a more generous
package of wages, benefits, and other perks than peers working
for other dealerships in the area.
In turn, employees had become fully engaged and highly
productive. The benefits of adhering to
the two operational goals were apparent from the amount of
repeat and referral business
experienced by Thompkins.
Current Situation
The dealership’s potential to continue to meet the two strategic
goals, however, would be
seriously impaired without a major investment in new
equipment in the service department,
5. THOMPKINS AUTO GROUP 3
including lifts and hoists, balancers, alignment machines, tire
changers, HVAC machines, brake
lathes, engine analyzers, and other specialized equipment to
meet the demands of newly
redesigned vehicles. A major concern was the ability of the
parts and service departments to
continue providing the excellent service customers had come to
expect. Thompkins’ employees
were committed to their jobs, but improved technology,
equipment, and facilities were essential.
The owners agreed that employees were in need of increased
inventories of parts and better
“tools” with which to do their jobs. Also, the outside of the
entire facility was due for a
franchise required facelift. It was time, therefore, for
Thompkins to make these major repairs
and to provide equipment upgrades. Several cost estimates were
requested and analyzed. The
owners computed the total cost of completing the repairs,
expansion, upgrades, and external
6. building improvementsi to be $1,000,000 and shop equipment to
be an additional $1,000,000.
As the owner most active in the management of the business,
Jerry had always been very
open in his decision-making and responsive to the views of his
co-owners, even though he
owned a majority of the firm. Jerry owned 80% and each other
partner owned 10% each. His
collaborative, consensus-seeking management style had been
well received by his co-owners.
To the benefit of the entire organization, the three of them had
consistently agreed on all major
decisions. The financing decision would not affect sales or
NWC requirements.
Although the current expenditures were mainly for the facility
image upgrade and costly
equipment required by the service department, Jerry was also
wary of the impact of the ups and
downs of the oil prices on the local economy. Thus, he wanted
to minimize the negative effect
the current financing needs might have in the event of an
economic downturn.
Jerry had thoroughly researched financing possibilities for these
current needs and had
7. narrowed the options to three he considered feasible: borrowing
the entire amount from a
THOMPKINS AUTO GROUP 4
financial institution; issuing new shares of Thompkins stock; or
financing through the sale of the
dealership’s subprime notes receivable. He planned to take the
morning to analyze these
alternatives in order to present his suggestions at the meeting
this afternoon.
Financing Alternatives
Debt Financing
Jerry first considered the alternative of borrowing the entire
$2,000,000. The dealership
has no other debt other than a floating floor plan loan for new
and used vehicles. He explored
two options that banks had presented to him, using an unsecured
loan or using a secured loan.
For an unsecured loan, the terms would be a five-year loan at
six percent interest and
would require a $200,000 deposit in a compensating accounting
that would earn 1%.
8. A secured loan would mean pledging the dealership’s three
million in notes receivable as
collateral for the loan. The terms and payback of a secured loan
would also be for a five-year
time period at four percent interest.
The income tax rate for Thompkins Auto Group is 35%.
Equity Financing
With that in mind, Jerry turned his thoughts to the prospect that
Thompkins could issue
new shares of its stock in order to yield the $2,000,000. The
cost of issuing the new shares
would be minimal, and equity financing would have a positive
impact on the debt/equity ratio
but would tend to dampen the return on equity. The dealership
was earning approximately
$1,500,000 per year. Due to the nature of automobile dealer
inventories, the target capital
structure is 30% equity and 70% debt. Targeted dividend
payout ratio is 70%. The company
had been experiencing about 10% growth in sales per year;
however, net income had remained
fairly constant. The company was set up utilizing 10,000 shares
of stock. Jerry holds 8,000
9. THOMPKINS AUTO GROUP 5
shares and each of the other two partners hold 1,000 shares
each. Current market values of
untraded equity suffer from a liquidity risk premium and are
valued at 5x EBITDA. Current 10
year U.S. Treasury bond yields are .63%. Betas of comparable
publicly traded companies, such
as CarMax, are 1.4.
Financing through Sales of Receivables
Jerry then began to focus on the third financing option, that of
selling the $3,000,000
subprime notes receivable portfolio at a discount. The notes
consisted of subprime loans made to
customers who were typically unable to receive conventional
auto loans and had been financed
by the dealership. Because of the relatively high risk and
proportion of bad debt write-offs, the
market interest rate charged on the loans was 18%.
Selling these notes would mean that it would no longer benefit
from their cash flows.
The impact on net cash flow may be more favorable if the
10. dealership continued to hold the notes
and simply borrow against them.
Since first offering these sub-prime loans five years ago, the
dealership has experienced
average annual write-offs of around 15 percent, but the notes
were definitely subject to higher
risks. In fact, during the recent economic downturn, write-offs
became as high as 18 percent.
The economy seemed to be slowly recovering, but an extended
new downturn, especially
in the oil industry, would result in increased write-offs. If the
notes were used as collateral for a
loan, the dealership would experience smaller amounts of cash
inflow while making loan
payments.
The notes could be sold with or without recourse, and Jerry
considered these two
possibilities. If the dealership sold the loans without recourse,
it would not be liable for future
THOMPKINS AUTO GROUP 6
defaults, but it would have to deeply discount the loans and
11. would receive only 65% of their face
value.
On the other hand, if the dealership sold the loans with
recourse, it would receive 85% of
the face value but would be liable for future defaults.
While the dealership would receive more by selling the notes
with recourse, Jerry
considered the additional risk factor associated with selling
with recourse. Loan losses from the
subprime portfolio had been relatively stable at 15% over the
past few years, Jerry considered
this estimate to be very solid because it was determined through
several years’ experience.
These three options, borrowing the entire amount from the bank,
issuing new shares of
stock, or selling its notes and the alternatives within each
option, seemed to provide ample
financing possibilities from which to make a selection. Since
the impact on future cash flows
would be extremely important in the ultimate decision, Jerry
had computed the annual cash flow
impact of the alternatives and had included the results in tables
to present to his co-owners. He
12. turned his attention to those tables.
Depreciation
Jerry typically favors MACRS depreciation schedules for the
building improvements;
however, the current Section 179 deduction is being considered
for the equipment. Essentially,
Section 179 of the IRS tax code allows businesses to deduct the
full purchase price of qualifying
equipment and/or software purchased or financed during the tax
year. That means that if you buy
(or lease) a piece of qualifying equipment, you can deduct the
full purchase price from your
gross income. It’s an incentive created by the U.S. government
to encourage businesses to buy
equipment and invest in themselves.
Leasing
THOMPKINS AUTO GROUP 7
Leasing the shop equipment is another alternative for acquiring
the necessary shop
equipment. Jerry is interested in finding out the net advantage
to leasing (NAL).
13. Cash flow impact
From his tables, however, Jerry noticed that the impact on
future cash flow would vary
significantly among the alternatives. Stockholders would
probably expect dividends as a return
on their investment of at least 15 percent. Although financing
through the sale of notes
receivable would require little if any cash outflow, the proceeds
from collecting those notes and
interest would be lost. The tables illustrated the future cash
outflow requirements for both an
unsecured bank loan and a bank loan secured with notes
receivable. They also pointed out the
amount of cash inflow lost by selling the notes receivable.
Except for equity financing, the least
negative impact on future cash flow would be through a secured
bank loan; the largest negative
impact would be through selling the notes without recourse to
the first financial institution.
Estimate the cost of capital for each option and the impact of
the decision and
recommendation for the company.
Summary
14. Jerry realized that the cash flow information would be useful in
selecting one of the
alternatives. Thus, each financing option had strong points and
weak points, and each owner’s
opinion was extremely important. Your task is to play the role
of a consultant and provide
guidance along with quantitative evidence to support your
recommendations. Based on the given
information what is the best financing option for Thompkins?
i The IRS requires you to depreciate a building improvement
over the same time frame that you depreciate your
building. Commercial real estate buildings typically have a 39-
year life.
Name: ____________________________________
Company Name: _____________________________
SWOT Analysis
Enablers
Challenges
Internal
STRENGTHS:
WEAKENESS: