Question

Mad Vlad Microbrewery

Mad Vlad Microbrewery is owned by Sam and Sadie, craft brewers. They began producing their special brand of craft beer in Transylvania County. When they were getting started, Mad Vlad was produced in a small facility owned by a family member with production primarily sold in their hometown. Over time, as the craft beer industry grew, and microbreweries were in increasing demand, Sam and Sadie began to expand in response to demand for their product.

Within the last two years, Mad Vlad relocated to a small business incubator facility in Raleigh, the state capital. Mad Vlad had to move to the incubator because they had landed a contract to supply a local grocery store with six locations in the state. Over the past several months, Sam and Sadie have been working to obtain contracts for distribution through Ingles Stores, a larger regional grocery store with two hundred locations. Recently, Ingles contacted Sam and Sadie with the good news that their stores will begin to distribute Mad Vlad products.

In order to meet the production demands of the new regional grocery store, Sam and Sadie will need an additional capital infusion of $38,500 just to meet demand. They are concerned 1) for the next couple of years while they increase production their available cash will just barely meet their operating needs, and 2) that they will have other needs for financing in about three years (related to updating their production equipment). They talked about selling additional stock, but Sadie has a controlling interest (51%) and no additional capital. She fears that if they sell more stock, she will lose her control in the company. So, they have decided to forego issuing more stock and to consider their debt options.

Sam and Sadie have done some of their research and come up with the following options. First, Mad Vlad can issue a 4-year, $46,800 zero-interest bearing note to Simpson Company. Mad Vlad would receive $38,500 for the note when issued. Alternatively, Sam and Sadie can go to their primary bank, Origin Bank, and borrow $38,500 at 4.5% for 4 years. Origin Bank has insisted on debt covenants related to working capital and prohibiting additional debt with which Mad Vlad would have to stay compliant. As a related party, Simpson Company, has no similar requirement.

Sam and Sadie are very confused about their options. Their biggest concerns are controlling their cash flow and their expenses to that their financial statements remain as healthy as possible. Please write them a memo that answers the following questions and provides your recommendation to them:

What is a zero-interest bearing note? Isn’t that automatically better than a note borrowed from a bank?

2.What does either option do to the income statement? What about cash flow?

The bank mentioned debt covenants. What does that mean to Sam and Sadie?

4.What is the better option for Mad Vlad?

Mad Vlad Microbrewery

Mad Vlad Microbrewery is owned by Sam and Sadie, craft brewers. They began producing their special brand of craft beer in Transylvania County. When they were getting started, Mad Vlad was produced in a small facility owned by a family member with production primarily sold in their hometown. Over time, as the craft beer industry grew, and microbreweries were in increasing demand, Sam and Sadie began to expand in response to demand for their product.

Within the last two years, Mad Vlad relocated to a small business incubator facility in Raleigh, the state capital. Mad Vlad had to move to the incubator because they had landed a contract to supply a local grocery store with six locations in the state. Over the past several months, Sam and Sadie have been working to obtain contracts for distribution through Ingles Stores, a larger regional grocery store with two hundred locations. Recently, Ingles contacted Sam and Sadie with the good news that their stores will begin to distribute Mad Vlad products.

In order to meet the production demands of the new regional grocery store, Sam and Sadie will need an additional capital infusion of $38,500 just to meet demand. They are concerned 1) for the next couple of years while they increase production their available cash will just barely meet their operating needs, and 2) that they will have other needs for financing in about three years (related to updating their production equipment). They talked about selling additional stock, but Sadie has a controlling interest (51%) and no additional capital. She fears that if they sell more stock, she will lose her control in the company. So, they have decided to forego issuing more stock and to consider their debt options.

Sam and Sadie have done some of their research and come up with the following options. First, Mad Vlad can issue a 4-year, $46,800 zero-interest bearing note to Simpson Company. Mad Vlad would receive $38,500 for the note when issued. Alternatively, Sam and Sadie can go to their primary bank, Origin Bank, and borrow $38,500 at 4.5% for 4 years. Origin Bank has insisted on debt covenants related to working capital and prohibiting additional debt with which Mad Vlad would have to stay compliant. As a related party, Simpson Company, has no similar requirement.

Sam and Sadie are very confused about their options. Their biggest concerns are controlling their cash flow and their expenses to that their financial statements remain as healthy as possible. Please write them a memo that answers the following questions and provides your recommendation to them:

What is a zero-interest bearing note? Isn’t that automatically better than a note borrowed from a bank?

2.What does either option do to the income statement? What about cash flow?

The bank mentioned debt covenants. What does that mean to Sam and Sadie?

4.What is the better option for Mad Vlad?

Answer 1

Sam and Sadie, the owners of Mad Vlad Breweries are considering two options of raising the finance required for expanding its operations to fulfill the supply of craft beer to a large store Ingles. The first option is issue a zero interest bearing note for $38500. The face value of the note is 46800 and the second option is borrowing from the bank $38500 at interest rate of 4.5%.

Zero interest bearing notes are debts which do not have any coupon payments, however these notes are issued at a discount and ar eto be repaid at the face value. It cannot be said that these debts are automatically better than a note borrowed from bank which carries interest. This is becuase instead of paying regular interest payments, the borrower pays a lumpsum amount at the maturity which may be higher than the total interest income.

Under the borrowings from bank, the interest income is charged to the income statement as an expense. There is a cash flow of interest periodically. Under the zero interest notes, the discount on the note is amortized over the period of the instrument and the amortized amount is treated as an expense in the income statement. There is no cash flow until the maturity of the debt and there is cash outflow when the debt is repaid at maturity.

Debt covenants is a promise by the borrower to carry or not carry certain activities as mentioned by the bank during the period of the loan. The debt covenants in this case is restriction on acquiring additional loan and others relating to working capital.

It is better to go for zero interest bearing note as the company will require further funds apart from $38500 for operating needs and to upgrade production facilities. the bank loan will put restriction on further acqusition of loan and moreover the company can acquire further loan after the zero interets debt.