ACCOUNTING

COLLECTIBLES, INC.

Collectibles, Inc., produces a variety of consumer products, including dolls and jewelry. It's primary products are manufactured in China and sold through gift shops throughout the United States as well as via the Television Shopping Network (TSN). The television marketing also involves the use of a well-known celebrity whose name has become associated with the various dolls that she “pitches” on six different days during the year.

Prior to 2015, Collectibles (formerly, Knicknacks, Inc.) had concentrated solely on the gift items categories. In late 2014, Knicknacks completed the acquisition of the Bock Company. Bock was a designer and manufacturer of custom jewelry that was sold in a variety of Asian and Middle Eastern countries but had encountered financial difficulties necessitating that it seek protection in bankruptcy court. Knicknacks was able to structure a merger with Bock that resulted in the formation of Collectibles. The merger resulted from a combination of new equity infusion and the restructuring of supplier debt, both in the form of preferred stock that carried a zero percent dividend rate but was payable over a five-year period (an equity “kicker” was included as part of the preferred stock). The proposal was viewed as superior to a competing bid and won approval from the bankruptcy court.

The result of the business combination proved to be quite successful as a result of the synergies realized by relocation of the jewelry manufacturing to the Asian continent and the ability to introduce one line of jewelry to the U.S. market through the Television Shopping Network. Collectibles was also beginning to make in-roads into the European market as a result of the distribution channels of the Bock jewelry line. The European market proved to be receptive to the dolls and other collectible product lines of the company and was expected to provide a significant source of sales growth over the next three years.

Collectibles currently is in negotiations with Starlight Jewelry Manufacturing, Inc., a company that manufactures and sells low-end jewelry throughout the United States. The appeal of Starlight to Collectibles is two-fold: first, it provides a complement to the higher-priced custom jewelry lines that it currently sells and is expected to allow certain synergies to be realized through consolidation of facilities. The CFO anticipates the consolidations to produce savings of approximately $600,000 per year. Moreover, the resulting surplus productive capacity would be such that no capital expenditures were considered necessary in the foreseeable future. Even then, the use of subcontracted Asian manufacturing facilities was expected to result in the shifting of the burden of equipment purchases to the subcontractors. In addition to the annual consolidation savings, the CFO felt that the Cost of Goods Sold of the combined entity could be reduced by one percent by pressuring suppliers to pass along some of the economies of scale that the larger volume of purchasing would provide.

The second incentive for acquiring Starlight was the fact that TSN had been pressuring Collectibles to develop a low-end jewelry line that was more in line with the buying habits of its customers. Although the sales of Collectibles' Bock jewelry line had been favorable, the relatively high price of the custom jewelry line was seen as being quite limiting in the ability of the network to fully develop a customer base for the jewelry. Starlight Jewelry appeared to be a means by which Collectibles could produce a low-cost, low profit margin line that would bolster the Bock brand name on TSN while being affordable to the viewers. The added distribution channel of TSN was, therefore, viewed as a means of significantly expanding the sales of Starlight over the next two-to-three years.

The acquisition of Starlight would be through an asset purchase and would necessitate that Collectibles restructure its own financing as well as finance the acquisition. The long-term debt of Collectibles contained a clause that dictated no additional debt (other than a revolving line of credit secured by inventories and receivables) was allowed. The revolving line of credit utilized by Collectibles was from Econova Bank and carried an interest rate of prime plus 4½% (the prime rate is currently 3.25%). The revolver was limited to 70% of accounts receivable plus 18% of inventories based upon the historical breakdown of an aging of accounts receivable and the work-in-process versus finished goods inventories. Econova Bank was also the provider of the current $4½ million of long-term debt of Collectibles and indicated a willingness to refund the current debt as well as providing some of the funding for the acquisition of Starlight Jewelry. The new long-term debt would be at the same rate as the revolving line of credit (currently 7.75%) and payable over a five-year period on a fully amortized basis. The refunding of the long-term debt at a lower interest rate than the current long-term debt was agreed upon in order to reflect the new equity as well as the threat to move the company’s financing to the Eastern Seaboard Bank which had made a competitive offer of financing. The restrictions would be similar to the restrictions on the current debt: 1) no new debt would be allowed except for revolving debt secured by receivables and inventories; 2) the firm must maintain a Quick Ratio of at least 1.25; and 3) the company must maintain a Debt Service Coverage Ratio [EBITDA/(Interest + Principal)] of at least 1.75.

Your task:

Determine the value that Collectibles should be willing to pay for Starlight Jewelry. Note that Collectibles will not assume any of Starlight's debt (i.e., it is buying the assets of Starlight debt-free). Once a value has been determined, assume that the acquisition will be at the price that you determined and will be paid for through a loan and additional equity from venture capitalists. The venture capitalists like to see 50-60% of the purchase be financed through debt and want a rate of return of 25-30% on their equity investment. Since Collectibles will be acquiring the financing, assume that the terms of the line of credit for Starlight's receivables and inventories will be those of Collectibles. Also, assume that a completely new loan package will have to be structured that will refinance all of Collectible's existing debt in addition to the 50-60% acquisition price. The new loan will be payable over five years and have similar restrictions to Collectible's current debt.

Finally, write up your analysis as a concise, coherent report. I should be able to read through the report and have a good understanding of what you have done in your analysis. Your projections should be attached as exhibits and referred to in the report as needed. Your ability to clearly communicate what you have done is at least as important as your analysis.