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SOUTHWEST WINDPOWER: A CASE STUDY Lisa F. Borstadt Northern Arizona University ABSTRACT This case was developed from an SBI client report prepared for a small entrepreneurial manufacturing firm in Flagstaff, AZ. The company had designed and patented several models of small scale, battery charging wind turbines to supply electricity in rural areas. The company had been experiencing phenomenal growth and demand for its products greatly exceeded their manufacturing capacity. At the time of the consulting engagement, the company had just secured a loan to obtain a new manufacturing facility which would provide the company with the necessary capacity to meet demand. One of the main tasks of the SBI student team was to identify the financing needs of the company and compute a per share value for the company. Upon completion of the consulting engagement this valuation subsequently was used in negotiations with venture capital firms. INTRODUCTION Andrew Kruse looked away from the sales analysis that he had just completed and began to think ahead (Exhibit 1). If he had done his work correctly, Southwest Windpower sales revenues for 1996 would top $4 million and grow steadily to over $12 million by the year 2000. Kruse was projecting a whopping 400% increase during 1996, starting with January sales of $150,000 and ending with December sales of almost $600,000. Kruse believed that this tremendous growth in sales was feasible for two reasons. First, hundreds of back orders had piled up for their most popular products and growth in demand was not expected to cease in the near future. Secondly, due to the tremendous demand and backlog of orders for their products, Southwest Windpower secured a $200,000 bank loan and moved from their small shop to a much larger production facility in December 1995. This new manufacturing facility boosted their capacity by over 1200%. Additionally, industry observers are expecting Southwest Windpower to substantially increase 1996 sales as the newly acquired plant and planned equipment Purchases boost their manufacturing capacity. As Kruse pondered the numbers on the page he wondered if the sales forecasts were too optimistic. He thought they were achievable, but the success implied by the forecasts would require that he find a way to manage and finance this projected growth. Kruse knew that growth does not finance itself.

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COMPANY BACKGROUND Southwest Windpower, incorporated in Arizona in 1990, was established in early 1986 by David Calley and Andrew Kruse. Calley had seen the need for a small, reliable battery charging wind generator that could be used in rural areas of the world. He performed the research necessary to identify the small scale wind turbine market and the results showed a tremendous need for the technology. Calley invented and patented his prototype wind turbine, called the WINDSEEKER, and began production in 1986. From 1986-1990, the WINDSEEKER Wind turbine was produced and marketed worldwide from the company's facilities in Flagstaff, Arizona. By mid 1990, sales had increased faster than manufacturing could produce and in December 1990, Southwest Windpower entered into a contract with Wind Baron Corporation in Flagstaff, AZ to exclusively produce and market the WINDSEEKER. Unfortunately, Wind Baron was unable to raise the funds necessary to perform their contractual obligations. In April 1993, the contract was canceled and Southwest Windpower was re-established. Wind Baron subsequently went out of business. In 1993, Calley and Kruse saw the need for a smaller less expensive wind generator that was more flexible and easier to install than the WINDSEEKER. In June of 1994, Southwest Windpower introduced a second product to fill this need, the AIR. Market responses were very positive and a backlog of over 1200 orders quickly accumulated. Sales in 1994, their first full year of business since Southwest Windpower was re-established were $200,000. In 1995 sales jumped fivefold to $1.1 million. By year-end 1995 Kruse estimated that over 2800 WINDSEEKER turbines were operating in 42 countries around the world. The management team of Southwest Windpower consists of the two co-founders: David Calley (age 32), Andrew Kruse (age 33) and Aric Stewart, who joined the company in 1994. Calley, the president, is responsible for research & development and is also the manufacturing director. Calley spent the past ten years in the area of wind turbine development and is considered by the industry to be a leader in new product development. He invented and developed both the WINDSEEKER wind generator and a smaller, less expensive version, the AIR. Kruse, the vice-president, is responsible for all business level operations including sales and marketing, purchasing, and accounting. He was previously employed for 10 years as a manager of purchasing and was involved in marketing for a medical products division at W.L. Gore and Associates in Flagstaff. Aric Stewart, a mechanical engineer assists Calley in research and development and also is responsible for organizing production. Calley and Kruse share

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the vision that their business should improve the lives of millions of people who live in poor countries without electricity, while creating no harmful effects on the environment. THE INDUSTRY AND COMPETITION Over the last 10 years, the renewable energy industry has grown at a rate of up to 30% per year. According to the Solar Energy Industries Association, the renewable energy market is now approximately $550 million and it is expected to grow to $5 billion by the year 2000. Southwest Windpower, if financially positioned to expand their production facilities and fund their growth, could capitalize on the projected growth of an industry in its early stages. There are approximately 30-40 manufacturers of small battery charging wind generators throughout the world. Most of these companies failed to reach the point of full product development and therefore only a few are considered as serious competitors. Several of these competitors are presently experiencing problems related to product reliability. As a result, Calley and Kruse believe that while competition must be recognized, it is not a serious threat. For this reason, they believe that capturing market share should be a relatively easy process. In terms of technology, Calley estimates that Southwest Windpower is about five years ahead of the closest competitors. This competitive advantage should enable the company to achieve a high profit margin on sales. Southwest Windpower's distributors and other manufacturers in the industry agree that the newest member of the product line, the AIR has a unique design and is the best value in terms of price and power generated per dollar cost. In addition, the AIR is the easiest wind turbine in the world to install. Distributors see the company's major challenge to be supplying the wind turbines rapidly enough to meet industry demand. CURRENT DILEMMA Kruse returned his gaze to the sales forecast data. With the company's recent move to larger production facilities and plans to invest in equipment to further increase their manufacturing capacity and cut production costs, Kruse believed that his forecasts were achievable. He was in agreement with those who saw outside financing required to fuel the growth as the major obstacle to the success of Southwest Windpower. The next task was to determine the financing needs to support their five-year sales projections. To aid in this analysis, Kruse had compiled information for all financial variables which were relevant to

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the task at hand (Exhibits 2,3, & 4). Once the financing needs were quantified, Calley and Kruse would need to address how to raise the funds necessary for their expansion. Kruse would have to be prepared to explain the various financing options to Calley when they met to consider the future of Southwest Windpower. Exhibit 1. Sales Projection 1996 Monthly January $150,000 February $180,000 March $210,000 April $254,500 May $265,700 June $338,950 July $371,450 August $424,575 September $478,575 October $530,075 November $550,575 December $595,575

Yearly 1996 $ 4,349,975 1997 $ 7,010,460 1998 $ 7,908,300 1999 $ 9,523,400 2000 $12,632,100

Exhibit 2. Financial Assumptions Income Statement: * Raw material cost is 30% of sales * Direct manufacturing labor cost is $19,703/month in 1996; $302,205 total for 1997; $405,368 for 1998; $503,056 in 1999; and $546,410 in 2000 * Manufacturing overhead cost is 3.4% of sales * Payroll taxes are 20% of direct manufacturing labor cost * Variable Selling, General, and Administrative (SGA) expenses are 23.1% of sales * Fixed SGA expenses are $23,476/year * Research and Development expense is 13% of sales * Moving Expenses of $4000 were incurred in 1996 * The corporate tax rate is 34% and taxes are assumed to be paid as incurred Balance Sheet: * The accounts receivable collection schedule is 25%55%-10%10% (month of sale, 1 month lag, 2 months lag, and 3 months lag, respectively) * The accounts payable schedule is 32%-40%-23%-5% (month of purchase, 1 month lag, 2 months lag, and 3 months lag, respectively) * Minimum cash balance required is $10,000. * All current liability accounts are assumed to be paid off in January 1996 * Accounts receivable and employee advances are assumed to be

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* *

received in January 1996 Prepaid expenses is assumed to remain unchanged over time Sales for October, November, and December 1995 are $172,380.22, $113165.56, and $97,558.57 respectively. Exhibit 3. 1995 Balance Sheet

ASSETS Current Assets Cash Accounts Receivable Employee Advances Inventory Prepaid Expenses Total Current Assets Long Term Debt Fixed Assets Plant, Property, Equipment Less Acc. Depreciation Total Fixed Assets Total Assets LIABILITIES & EQUITY Current Liabilities Credit Card Payable Sales Tax Payable Payroll Taxes Payable Accounts Payable Total Current Liabilities Long Term Debt Total Liabilities

$ $ $ $ $ $ $

291,961.23 151,922.21 2,148.50 106,299.33 3,029.48 442,320.68 179,364.94

$ 138,337.00 $ 20,475.61 $ 117,861.39 $ 560,182.07

$ 13,685.19 $ 100.53 $ 6,905.E $ 135,465.33 $ 156,156.91 $ 179,364.94 $ 448,561.92

EQUITY Common Stock Retained Earnings Total Equity Total Liabilities & Equity

$ $ $ $

172,581.83 (60.961.68) 111,620.15 560,182.07

Exhibit 4. Loan Schedules, Asset Purchases and Depreciation OTHER LOANS Total Monthly Payments 1996 $ 2,565.95 1997 $ 2,312.65 1998 $ 2,193.24 1999 2000

Total Yearly Payments $ 31,883.40 $ 27,751.80 $ 26,318.92 $ 46,753.56

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Principal Balance $ 85,000.57 $ 66,377.38 $ 46,753.56

Interest Payments $ 11,438.35 $ 9,128.61 $ 6,695.04

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MORTGAGE LOAN Monthly Loan Payments

Total Yearly Payments

Principal Balance

Interest Payment

1996 1997 1998 1999 2000

$ $ $ $ $

$295,035.78 $289,551.75 $283,493.47 $276,800.80 $269,407.33

$ $ $ $ $

Manufacturing Equipments

Engineering & CAD Station

Shipping & Receiving Equipment

$268,000.00

$ 26,834.00

$ 20,000.00

$ $ $ $ $

Building Improvements $ 45,000.00 $ 10,000.00 $ 10,000.00 $ 10,000.00 $ 10,000.00

Total Assets Purchases $861,584.00 $ 32,000.00 $ 85,000.00 $ 40,000.00 $ 85,000.00

$

2,895.06

ASSET PURCHASES New Molds & Tooling 1996 1997 1998 1999 2000

1996 1997 1998 1999 2000

$149,100.00

34,740.72 34,740.72 34,740.72 34,740.72 34,740.72

$ 20,000.00

Office Equipment $ 90,000.00 $ 10,000.00 $ 30,000.00 $ 15,000.00 $ 45,000.00

Building Purchase $259,250.00

29,776.56 29,256.75 28,382.50 28,048.11 27,347.30

23,400.00 12,000.00 25,000.00 15,000.00 10,000.00

DEPRECIATION PER YEAR 1996 1997 1998 1999 2000

$140,680.46 $188,680.46 $150,448.01 $124,029.46 $115,982.49

Exhibit 5. 1996 MONTHLY INCOME STATEMENT

January February March April May June

Sales

Cost of Goods Sold Raw Materials Labor Cost

Overhead

$150,000.00 $180,000.00 $210,000.00 $254,500.00 $265,700.00 $338,950.00

$ 45,000.00 $ 54,000.00 $ 63,000.00 $ 76,350.00 $ 79,710.00 $101,685.00

$ 5,100.00 $ 6,120.00 $ 7,140.00 $ 8,653.00 $ 9,033.80 $ 11,524.30

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$ $ $ $ $ $

19,703.00 19,703.00 19,703.00 19,703.00 19,703.00 19,703.00

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January February March April May June

Total COGS $ 69,803.00 $ 79,823.00 $ 89,843.00 $104,706.00 $108,446.80 $132,912.30

Gross Profit $ 80,197.00 $100,177.00 $120,157.00 $149,794.00 $157,253.20 $206,037.70

Operating & Sales Expenses Payroll Variable SG&A Taxes Expenses January $ 3,940.60 $ 34,650.00 February $ 3,940.60 $ 41,580.00 March $ 3,940.60 $ 48.510.00

Fixed SG&A Expenses $ 1,956.33 $ 1,956.33 $ 1,956.33

Depreciation

April May June

$ 58,789.50 $ 61,376.70 $ 78,297.45

$ $ $

$ 10,890.04 $ 10,890.04 $ 10,890.04

Moving

TOTAL SELLING

Earnings Befo

ADMIN EXP.

Interest & Ta

re

$ $ $

3,940.60 3,940.60 3,940.60

R&D

xes January February March April May June

$ $ $ $ $ $

19,500.00 23,400.00 27,300.00 33,085.00 34,541.00 44,063.50

Interest Expense January February March April May June

$ $ $ $ $ $

2,481.38 2,481.38 2,481.38 2,481.38 2,481.38 2,481.38

January February March April May June

Net Income $ 1,204.80 $ 9,883.80 $ 15,922.80 $ 24,880.65 $ 27,135.21 $ 41,880.43

$

4,000.00

1,956.33 1,956.33 1,956.33

$ 74,936.97 $ 81,766.97 $ 92,596.97 $108,661.47 $112,704.67 $139,147.92

OTHER INCOME (EXPENSE) Other Loan Earnings Interest Before Taxes Payment $ 953.20 $ 1,825.45 $ 953.20 $ 14,975.45 $ 953.20 $ 24,125.45 $ 953.20 $ 37,697.95 $ 953.20 $ 41,113.95 $ 953.20 $ 63,455.20

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$ 10,890.04 $ 10,890.04 $ 10,890.04

$ $ $ $ $ $

5,260.03 18,410.03 27,560.03 41,132.53 44,548.53 66,889.78

Taxes $ 620.65 $ 5,091.65 $ 8,202.65 $ 12,817.30 $ 13,978.74 $ 21,574.77

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Cost of Goods Sold

July August September October November December

Sales

Raw Materials

Labor Cost

Overhead

$317,450.00 $424,575.00 $478,575.00 $530,075.00 $550,575.00 $595,575.00

$111,435.00 $127,372.00 $143,575.50 $159,022.50 $165,172.50 $178,672.50

$ $ $ $ $ $

$12,629.30 $14,435.55 $16,271.55 $18,022.55 $18,719.55 $20,249.55

19,703.00 19,703.00 19,703.00 19,703.00 19,703.00 19,703.00

Total COGS July $143,767.30 August $161,511.05 September $179,547.05 October $196,748.05 November $203,595.05 December $218,625.05

Gross Profit $227,682.70 $263,063.95 $299,027.95 $333,326.95 $346,979.95 $376,949.95

Payroll Taxes July $ 3,940.60 August $ 3,940.60 September $ 3,940.60

Variable SG&A Expenses $ 85,804.95 $ 98,076.83 $100.550.83

Fixed SG&A Expenses $ 1,956.33 $ 1,956.33 $ 1,956.33

Depreciation

October November December

$122,447.33 $127,182.83 $137,577.83

$ $ $

$ 10,890.04 $ 10,890.04 $ 10,890.04

Moving

TOTAL SELLING

Earnings Befo

ADMIN EXP.

Interest & Ta

$150,880.42 $170,058.55 $189,552.55 $208,144.05 $215,544.55 $231,789.55

$ 76,802.28 $ 93,005.40 $109,475.40 $125,182.90 $131,435.40 $145,160.40

Other Loan Interest Payment

Earnings Before Taxes

Taxes

$ $ $ $

$ 73,367.70 $ 89,570.82 $106,040.82 $121,748.32

$ $ $ $

re

$ $ $

3,940.60 3,940.60 3,940.60

R&D

xes July August September October November December

$ $ $ $ $ $

48,288.50 55,194.75 62,214.75 68,909.75 71,574.75 77,424.75

OTHER INCOME (EXPENSE) Interest Expense July August September October

$ $ $ $

2,481.38 2,481.38 2,481.38 2,481.38

953.20 953.20 953.20 953.20

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1,956.33 1,956.33 1,956.33

$ 10,890.04 $ 10,890.04 $ 10,890.04

21,945.02 30,454.08 36,053.88 41,394.43

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November December

$ $

2,481.38 2,481.38

$ $

953.20 953.20

$128,000.82 $141,725.82

$ 43,520.28 $ 48,186.78

Net Income July August September October November December

$ $ $ $ $ $

48,422.68 59,116.74 69,986.94 80,353.89 84,480.54 93,539.04

Exhibit 6. 1996 Monthly Cash Budget Cash Inflows Cash Rec. From Cstmrs (month of sale) (1-month) (2-month) sale) January 37,500.00 53,657.21 11,316.56 February 45,000.00 82,500.00 9,755.86 March 52,500.00 99,000.00 15,000.00 April 63,625.00 115,500.00 18,000.00 May 66,425.00 139,975.00 21,000.00 June 84,737.50 146,135.00 25,450.00 Lagged cash inflow from 1995 A/R January February March April May June

38,882.14

Cash Outflows Month of Sale January February March April May June

(15,360.00) (18,432.00) (21,504.00) (26,060.82) (27,207.68) (34,708.48) Current Liab. Pyb 1995 Bal Sheet

Employee Advances

(3-month) 17,238.02 11,316.56 9,755.86 15,000.00 18,000.00 21,000.00

TOTAL CASH INFLOW

2,148.50

160,742.43 148,572.41 176,255.86 212,125.00 245,400.00 277,322.50

Cash Paid to Supplier 1 month ago (19,200.00) (23,040.00) (26,880.00) (32,576.00) (34,009.60) A/P from 1995 Balance Sheet

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2 months ago

3 months ago

(11,040.00) (13,248.00) (15,456.00) (18,731.20)

(2,400.00) (2,880.00) (3,360.00)

Cash paid for Labor & Manf. OH

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January February March April May June

January February March April May June

(20,691.58)

New Molds and Tooling

Manufacturing Equipment

(64,046.93) (70,876.93) (81,706.93) (97,771.43) (101,814.63) (128,257.88)

(18,000.00) (20,000.00) (28,000.00) (40,000.00) (30,000.00) (5,900.00)

(45,000.00) (40,000.00) (50,000.00) (40,000.00) (30,000.00) (15,000.00)

(26,834.00)

Loan Payments January

(2,895.06)

February March April May June

(2,895.06) (2,895.06) (2,895.06) (2,895.06) (2,895.06)

January February March April May June

(24,803.00) (25,823.00) (26,843.00) (28,356.80) (28,736.80) (31,227.30)

Selling & Taxes Paid Admin. Expenses

Engineering & CAD station January February March April May June

(135,465.33)

(620.65) (5,091.65) (8,202.65) (12,817.30) (13,978.74) (21,574.77) Shipping & Receiving Equipment (15,000.00) (2,000.00) (2,000.00) (2,000.00) (2,000.00) (300.00) Building Purchase (259.250.00)

Office Equipment (30,000.00) (20,000.00) (20,000.00) (10,000.00) (3,000.00) (1,000.00) Other Loan Payments

Building Improvements (17,000.00) (10,000.00) (5,000.00) (5,000.00) (1,000.00) (1,000.00) Total Cash outflow

(2,656.92)

(677,623.48)

(2,656.92) (2,656.92) (2,656.92) (2,656.92) (2,656.92)

(323,322.98) (282,888.57) (310,085.52) (292,501.84) (300,621.22)

NET CASH FLOW FLOW

Beginning Cash Balance

(516,881.05) (88,403.16) (106,632.71) (97,960.52)

291,961.23 (224,919.82) (313,322.98) (419,955.69)

10,000.00 10,000.00 10,000.00 10,000.00

(234.919.82) (323,322.98) (429,955.69) (527,916.21)

(47,101.84) (23,298.72)

(517,916.00) (565,018.05)

10,000.00 10,000.00

(575,018.05) (598,316.77)

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Minimum Cash Balance Required

SURPLUS

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Cash Inflows Cash Rec. From Cstmrs (month of sale) (1-month) (2-month) sale) July 92862.50 186422.50 2657.00 August 106143.75 204297.50 33895.00 September 119643.75 233516.25 37145.00 October November December

132518.75 137643.75 148893.75

263216.25 291541.25 302816.25

42457.50 47857.50 53007.50

(3-month) 25450.00 26570.00 33895.00 37145.00 42457.50 47857.00

TOTAL CASH INFLOW January February March April May June

331305.00 370906.25 424200.00 475337.50 519500.00 552575.00

Cash Outflows Month of Sale January February March April May June

-38036.48 -43476.48 -49006.08 -54279.68 -56378.88 -60986.88 Cash paid for Labor & Manf. OH

July August September October November December

July August

Cash Paid to Supplier 1 month ago -43385.60 -47545.60 -54345.60 -61257.60 -67849.60 -70473.60 Selling & Admim. Exp

2 months ago -19555.52 -24946.72 -27338.72 -31248.72 -35223.12 -39013.52

-4072.00 -4251.20 -5423.20 -5943.20 -6793.20 -7657.20

Taxes Paid

New Molds & Tooling -1200.00 -1200.00 -1200.00 -1200.00 -1200.00 -1200.00

-32332.30 -34138.55 -35974.55 -37725.55 -38422.55 -39952.55

-139990.38 -159168.51 -178662.51 -197254.01 -204654.51 -220899.51

-24945.02 -30454.08 -36053.88 -41394.43 -43520.28 -48186.78

Manufacturing Equipment

Engineering & CAD station

Shipping & Receiving Equipment

-15000.00 -10000.00

-0.00 -0.00

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3 months ago

-300.00 -300.00

Office Equipment -1000.00 -1000.00

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September October November December

-10000.00 -5000.00 -5000.00 -3000.00 Building Improvements

-0.00 -0.00 -0.00 -0.00 Loan Payments

-300.00 -300.00 -300.00 -300.00 Other Loan Payments

-1000.00 -1000.00 -1000.00 -1000.00 Total Cash Outflow

July

-1000.00

-2895.06

-2656.92

-326369.29

August September October November December

-1000.00 -1000.00 -1000.00 -1000.00 -1000.00

-2895.06 -2895.06 -2895.06 -2895.06 -2895.06

-2656.92 -2656.92 -2656.92 -2656.92 -2656.92

-363033.12 -405856.52 -443155.17 -466894.12 -499222.02

NET CASH FLOW

Beginning Cash Balance

Minimum Cash Balance Required

July August September October November December

4935.71 7873.13 18343.48 32182.33 52605.88 53352.98

-588316.77 -583381.05 -575507.93 -557164.45 -524982.12 -472376.25

10000.00 10000.00 10000.00 10000.00 10000.00 10000.00

SURPLUS

-593381.05 -585507.93 -567164.45 -534982.12 -482376.25 -429023.27

CASE SOLUTION The case can be used to support a number of finical analyses and discussions at differing levels of difficulty. The first student task would be to prepare monthly proforma income statements and cash budgets, plus a year-end balance sheet for the first year to determine immediate financing needs. Secondly students should prepare proforma income statements, balance sheets and cash budgets yearly for five years to identity the long-term financing needs of the company. An extension of this would require the students to perform a cash flow valuation and sensitivity analysis for purposes of determining a per share price for the company. Finally, a discussion also could be generated regarding the sources of funding, potential private investor/venture capital interest in the company, risk assessment, etc. All of the information necessary to prepare the pro-forma statements is provided in Exhibits 1-4 of the case. Thus, for this task there is no need for students to make assumptions regarding any of the financial variables. However, if one wishes to extend the analysis to include a per share valuation, information on the number of shares and the variables that go into determining a weighted average cost of capital would need to

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be provided. Students performing a valuation of the company should probably be advised to perform some sensitivity analysis on the discount rate and growth rate used in the traditional discounted cash flow approach to valuation. Changes in these two variables would have a very dramatic effect on the per share price. The first year monthly cash budget indicates a need for approximately $600,000 in capital. The challenge for the students will be to get their ending cash balance on the cash budget to reconcile with the cash balance obtained on the balance sheet (the plug figure to balance the balance sheet). When the pro-forma statements are prepared over a five year horizon, there is no need for additional funds beyond the first year. Because of the large profit margin on sales due to the company's competitive advantage technologically, the growth over time can be financed internally. This situation, however does create a dilemma for management in terms of where to obtain the capital. In December 1995 the company obtained a $200,000 bank loan to fund their new manufacturing facility, and this facility is pledged as collateral. Thus, with little in the way of marketable collateral, it would be difficult to obtain additional debt to fund their expansion. There likely would be considerable venture capital/private interest in providing capital, however, the price they would have to pay for this capital may be very high and would negate the opportunity for the company to later go public and cash in if they are in fact successful. On the following two pages the solutions are given for the first year monthly income statement (Exhibit 5) and cash budget (Exhibit 6). Due to space limitations, the entire spectrum of solutions cannot be provided.

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