Transmittal Email to Noelle[pic 1]

TRANSMITTAL EMAIL TO NOELLE[pic 1]

Dear Noelle

The letter of advice that you have requested regarding the payment of the additional rebate to Nick is attached.

The letter outlines:

• the financial analysis and impact on the company between not paying the additional rebate and declaring it this year
• agency theory and how it can be used to explain the impact of the Board’s role in making an appropriate decision
• alternative options that may be considered and a cost-benefit analysis of each alternative.

The letter also includes a recommendation on the suitable course of action to take in regards to the additional rebate payment to Nick.

Kindly let me know the Board’s decision and please do not hesitate to contact me should you require additional clarification or further assistance.

Best regards

xxxxxxxxxxxx

Accountant

Curtin Accounting

92 Jalan Rajah

SINGAPORE 329162

Phone: +65 6593 8000

Website: www.curtinaccounting.com.sg 

The information in this message is intended only for the recipient and may contain information that is confidential. If you are not the intended recipient of this communication please notify us by replying to this message and deleting it from your computer.

LETTER OF ADVICE TO THE BOARD

Curtin Accounting

92 Jalan Rajah

SINGAPORE 329162

Phone: +65 6593 8000

Email: rebekah.keng@curtinaccounting.com.sg

9 December 2016

Board of Directors

Carcraft Ltd

42 Pilbara Street

WELSHPOOL WA 6106

Dear Board Members,

I am grateful for this opportunity to be able to advice you on the present situation the company is facing for the financial year 2015/2016.

EXECUTIVE SUMMARY

The objective of this letter is to provide a recommendation to the Board on whether they should reject Nick’s demands for an additional rebate payment or to declare it in the current financial year. The financial analysis included in this letter is based on the projected financial statements and facts provided by Noelle in her written correspondence with us. The breakdown of the financial calculations can be found in the appendixes. The analysis establishes that rejecting Nick’s claims for an additional rebate payment will ensure Carcraft Ltd does not breach the debt covenant with the bank. On the other hand, committing to the rebate payment in the current year will result in a direct breach of the covenant. With the facts surrounding this issue, agency theory that looks at owner-manager and manager-lender relationships can be used to help the Board make an appropriate decision that balances out the interest of all key stakeholders. It is recommended that the best option for Carcraft is to divide the additional rebate payment evenly over financial years 2015/2016 and 2016/2017 so as to placate Nick and ensure that the company is still meeting its bottom line.

INTRODUCTION AND FACTS

I have learnt that Carcraft earns rebate income from its paint suppliers. This rebate income is dependent on how much each shareholder business acquires from the main paint supplier. A small amount of rebate income will then be paid out to shareholders in proportion to how much they have contributed. One of the shareholders, Nick, is demanding that he be paid an additional rebate of $300,000 or he will leave the group. He argues that he has contributed well over half of the rebate income for the current year and hence deserves it. As such, the Board has to decide whether to deny Nick of this additional payment or to give in to his demands. They would have to take into consideration the impact and consequences of their decision on the company as well as on other key stakeholders. Factors that needs to be taken into account is the debt covenant that Carcraft has with the bank to maintain a current ratio of at least 2, and the company’s policy of paying annual dividends to shareholders. The sections below will discuss this whole issue and reach a conclusion on the most appropriate course of action for Carcraft to take.

FINANCIAL ANALYSIS OF PROPOSED REBATE PAYMENT

Rejecting Nick’s demands for an additional $300,000 rebate payment will ensure that the company meets its obligations to maintain a current ratio of at least 2 imposed on it by the bank for acquiring a commercial property recently. In the current financial year 2015/2016, this option will give a current ratio of 4 (Appendix A), and the company’s projected financial statements will be unaffected.

On the other hand, choosing to go with the other option by declaring the additional rebate in the 2015/2016 financial year but pay it in the 2016/2017 year will result in a current ratio of 1.71 this year (Appendix B), which is lower than the imposed ratio of 2. This will be a direct violation of the debt covenant. In addition, Carcraft will incur a net loss after tax and dividends of $95,000 (Appendix B).

While it seems that going with the first option will make more financial sense for the company, however both options will have varying degrees of implications on various key stakeholders, including Carcraft, that has to be deliberated on and weighed out.

CONSIDERATION OF THE IMPACT OF THE BOARD’S ROLE IN THE CONTEXT OF AGENCY THEORY

Agency theory focuses on the relationship between agents and principals whereby the principal(s) will engage an agent to carry out activities on their behalf that will involve giving authority in regards to the decision-making process to the agent (Rankin et al. 2012, 135). Jensen and Meckling (1976) argues that while an agent has a fiduciary duty to act in the best interest of the principal, it is assumed that both parties aim to maximize their satisfaction. Hence, agents will tend to protect their self-interest and behave opportunistically whenever possible. This resultant moral hazard creates three agency costs: monitoring, bonding and residual loss (Jensen and Meckling 1976^[a]).

There are two relationships that is applicable to this situation on hand. The first is the manager-lender agency relationship. Carcraft’s management team is the agent, while the bank who has provided funds to the company for the acquisition of a commercial rental property is the principal.  As mentioned previously, the bank has imposed a current ratio debt covenant of at least 2.

Debt covenants are employed to restrict a borrower’s actions and protect the interest of lenders through the potential relinquishing of control rights to the lender (Whitehead 2009). In a bank-borrower relationship, debt covenants help to reduce monitoring cost and is the least costly means for banks to mitigate credit risk (Whitehead 2009). Moreover, the results from a study carried out by Bradley and Roberts (2004) affirms their proposal of the Agency Theory of Covenants (ATC), that covenants are utilized due to the presence of agency problems that relates to moral hazard.

There are however several adverse consequences of technical default of a debt covenant. A technical violation allows the lender (bank) to take action against the borrower (company). For a company looking to renegotiate their loans, a breach of debt covenant will often result in an increase in interest rates, reduction of loan maturity such that payment has to paid more quickly, and imposing additional constraints and covenants (Beneish and Press 1993). A breach could also result in the immediate repayment of the loan, termination of loan contract and in some cases a waiver of the covenant violation, especially for private debt agreements (Gopalakrishnan and Parkash 1995).

Current ratio is measured as current assets over current liabilities. It is a measure of a company’s short-term liquidity and is considered critical for credit quality (Demerjian 2007). If the Board decides to declare the additional rebate payment to Nick this year, it will increase current liabilities to $300,000, and assuming current assets remain the same, current ratio will be 1.71 (Appendix B). This will be a direct breach of the financial ratio covenant and Carcraft will be placed in an unfavorable position whereby it faces increased risk of the consequences of technical default. Therefore, we would want to avoid this breach of debt covenant as far as possible due to the high costs involved and I strongly advise against declaring the additional rebate this year (2015/2016).