Fairfax Group was founded in 1993 as a manufacturer of critical electronics and high-precision components for the shipbuilding industry. The company has since enjoyed successful years as the shipbuilding industry experienced rapid growth fueled by globalization, expansion of international trade, and higher demand for transportation of fossil fuels. Sales growth was steady and the company’s revenues have not been touched by the recent 2008 crisis as there was sufficient demand for new ships.

Thus, it came as a surprise to the CEO of Fairfax, Dr. Kevin Ross, who was also the company’s founder, when the chief financial officer, Mr. Patrick Bacon, revealed recently that the company’s liquidity position has been weakening. Dr. Ross, who obtained a PhD degree in electrical and aerospace engineering from California Institute of Technology in Pasadena, had little knowledge of finance, relying on Mr. Bacon to keep the firm’s finances in order. One of the reasons for the trend that Mr. Bacon suspected was that the company has recently altered its credit policy to 1/10, net 90.

“1/10, net 90” means that the buyer receives 1% discount off the purchase price if pays within 10 days. Otherwise, the full purchase price has to be paid within 90 days.

The reason for the move was that some – particularly smaller – customers requested to expand payment period citing similar offers by their suppliers from South-Eastern Asia. Mr. Bacon argued that in order to maintain a solid liquidity position, the firm will need to increase its holdings of cash, or increase accounts payable. Purchases of Fairfax’s supplies are generally on terms of 2/15, net 90.

Due to the increase in sales, the company was in a dire need of an expansion of their production facilities. Over the recent years,Fairfax has invested in updating some of its existing equipment and keeping it up-to-date with new technologies. However, in order to meet the expected increase in demand over the next 5 years, Fairfax would need to build a new facility that would more than double the company’s capacity. The facility would house state-of-the-art machinery. The facility would require an investment of$2,500,000 dollars and will be operational in 2013. In addition, Dr. Ross believed that the equipment used by research and development laboratory of Fairfax need to be updated as well, requiring an influx of an additional $600,000. The investment was expected to be depreciated straight-line over the next 5 years.

Mr. Bacon forecasted that the huge demand for supplies that Fairfax was using for its production would force increase component prices and reduces the firm’s profit margin over the next five years. He estimated that the prices of components are expected to increase at the rate of 1% per year over the next five years. Components generally made up 50% of the costs of goods sold ofFairfax.

Unable to finance the expansions with internal capital (cash or cash flow), Fairfax needed to raise additional external capital. Dr. Ross and Mr. Bacon had recently met with Mr. Norton, a loan officer from Cardinal National Bank. Cardinal National is a local bank in Virginia, with whom Fairfax banked since the company’s inception. Having looked through the financial statements of Fairfax, Mr. Norton agreed to provide a ten-year line of credit to Fairfax up to the amount of $5,000,000, at the interest rate of 10% per year. Dr. Ross and Mr. Bacon still had to decide on the final amount of the loan that the firm would like to take on. The current loan outstanding of Fairfax was raised at the interest rate of 12% per year and is due to be repaid in full by year-end 2018.

The firm’s dividend policy was to maintain a payout ratio of 40%, with a minimum level of dividends of $500,000 per year.

Questions:

Construct a long-term financial plan for Fairfax for the next three years. Assume that most accounts will grow with sales. Also assume that the company undertakes the expansion and continues its DSI, DRO, and DPO at the current level. Assume that sales growth 15% in each of the next three years. Assume that equipment already in place is depreciated straight-line over 7 years.Assume that the firm needs to maintain a minimum cash balance equal to 5% of its total assets.

How much of the line of credit will Fairfax need to draw over the next two years? 

Compute the next 2 years.