ALAC International

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Working Capital
Financing
 Case Background

ALAC International is an importer cum distributor of specialty chemicals sourced

usually from Asia and sold to in the United States of America. It was founded by Lily
Frishman and Aaron Wei with Mr. Alan Frishman joining in later as the Chief
Operating Officer. The three of them held a 40%, 40% and 20% stake in the firm
respectively. In this business, there were four major players in the supply chain –
an exporter (based in Asia), an importer (based in the United States), a wholesaler
and the local distributor. ALAC International managed the entire supply chain on
their thereby executing all the above mentioned roles by and large by itself. This
allowed them higher over-all margins viz. any individual stakeholder in the supply
chain. They positioned themselves as a supplier of specialty chemicals and serviced
clients who preferred to source their materials from more than one supplier
(usually the market leader – Exxon). ALAC accounted for revenues north of $14
Million in 2009 and net profits of $310,000 before taxes.
A new opportunity came knocking for ALAC in 2009 when the American
representative of Nan Ya Plastics, one of the largest producers of di-isononyl
phthalate (DINP), went bankrupt. Nan Ya Plastics, based out of Taiwan, was a fully
integrated chemicals producer who operated and supplied mainly to the Asian
markets but exported some of their produce to the United States, where they were
now looking for a new representative. DINP being a niche product, seemed like an
attractive proposition for ALAC International to take up and distribute.
First up, they bought the remaining inventory from the bankrupt representative in
spite of heavy competition from the other players in the market. Lily Frishman got
it at a bargain price below the market price. A quarter of the amount was paid up-
front with the remaining to be paid up within a span of two months. Then, ALAC
approached Nan Ya and offered to take up their distributorship in the USA. The deal
worked out in favour of ALAC and their projected revenue grew by almost 146% to
$35 Million and a staggering profit of $3.1 Million before taxes. Earlier no individual
product of ALAC contributed more than 20% of its total revenue but now, 82% of
its revenue came from the distribution of DINP.
The DINP cash cycle lasted four months with the shipment taking close to two
months to arrive, sales taking one more and finally the collection of receivables
taking another month. Due to the large cycle time, ALAC stacked up on some DINP
to service assured deliveries every month.
ALAC needed to find ways to expand its capital which for the time being was funded
through personal loans from friends and family ($4.3 Million) and a loan of $5
Million from John Herzog. Also a new idea was being toyed around with – wherein
ALAC could have the chemicals delivered on the west coastal port of Los Angeles
instead of the east coast, as was the case presently. This would reduce shipping
time by close to a month. But since most of their existing clients were on the east
coast, a substantial amount would have to spent then on transporting their
chemical across from the western coast which estimated to be about $90 per ton.

Financial Problems

1. What is the need for a personal guarantee of the loans that have been
procured from friends and family as well as the wealthy individual as listed
in the case?
A. The personal guarantee it to ensure that all assets of ALAC International are
liquidated without any hassles in case of a default on their part. This would
increase the security of the loans provided to them as far as the lenders are
concerned.
2. What are the issues with having the shipment delivered to the east coast as
is the case currently?
A. The cycle time for ALAC International is four months at present and a major
chunk of that is spent in transit from Taiwan. It takes close to two months to
have it delivered in the eastern coast of the United States as it has to take a
longer route. This decreases the liquidity of the firm as a big portion of their
capital (more than $4Million) is stuck up as inventory at any given point in
 time. By shifting their point of delivery to Los Angeles, they can have their
cycle time reduced by 25% to three months thereby increasing the liquidity
of their capital.
3. How risky are the payments (or the lack of it) from clients of ALAC
International?
A. As far as the case is concerned, there has been no mention of any default of
payments on the client side. However, ALAC International has insured
against such a risk by an amount of up to 90% of the face value of the order.
This protects them against any incident of non-payment on the part of the
client.
4. Comment on the risk of price decline of the commodity (DINP).
A. Due to the high cash cycle nature of the business, ALAC International were
particularly concerned about the fluctuations in the price of DINP. They
originally toyed with the idea of pre-selling their product, but later
discontinued this practice as it has a major bearing on their margins
(lowering it down to 5%). The risk of price decline was now being managed
by diverting the chemicals to better markets and also by working out
contracts whereby they could stop the processing of new orders at their
source.
5. Should ALAC International source all of its funds through financial
instruments (debentures and bonds) alone or continue taking personal loans
as well until the bank starts giving them the required loans?
A. ALAC International should combine the funding through financial
instruments with the personal loans as the latter still has a lower cost of
capital (13%) as against 14% (kindly refer to the analysis section for the
 working out) through the former. Even after banks provide them the loans,
ALAC should continue using a combination of fund-sources as their cost of
capital would still remain largely lower than their profit margin ratios while
helping them deal in higher volumes which would subsequently translate to
higher profits.

Analysis

ALAC International was current valued at close to $13 Million as per their balance
sheets. But for mid-sized company like ALAC, a big part of their capital (more than
$5 Million) was being tied up in the form of inventory. Of the $5 Million inventory,
$1.3 Million lay in the warehouse - $400,000 in the form of DINP and the remaining
as other dry chemicals. But close to $4.2 Million of their inventory was in transit
from Taiwan as bulk DINP. As mentioned earlier in the case analysis, this transit
took close to two months to arrive once it set sail from Taiwan.

Each of these shipments contained 2000 metric tons of DINP and costed ALAC $4.5
Million and had imported close to 12000 metric tons by the year end. ALAC believed
that it could double or maybe even triple its imports without having to fear a
counter-response from the leading players in the Industry. However, their
constrained capital budget and high cycle time had not let them import as much as
they desired and had to restrict themselves to placing orders of 2000 metric tons
once in two months. This also hit their ability to bargain with the clients on monthly
allocations and placed them at an overall disadvantage. By increasing their capital
flow, ALAC would be able to double their sales to $70 million from the current $35
Million.
So far, ALAC funded most of their capital requirements through personal loans (to
a tune of $4.3 Million) and a loan of $5 Million from John Herzog. The promoter,
Lily Frishman and her husband and COO of ALAC, Alan Frishman provided the
personal guarantees for the loan. But now to fuel their expansion plans, ALAC was
now looking into other forms of funding. They could borrow up to $9 Million from
the bank and raise close to $6 Million each from senior subordinated bonds and
preferred equity.

The proposals for bank loans are as given below:

Particular Loan to Value

Ratio
Loans against Value of Inventory 60%
Loans against Accounts Receivable 80%
Interest Rate 3.875%
Maximum Allowable amount of Loan $9 Million

The funding through bonds would come at a cost of 12% while the equity investors
could be assured a return of 18%. The average cost of capital could be still be
maintained below the 12% mark owing to the low interest rate that the banks were
willing to offer.

However, the banks were not willing to finance ALAC’s 2011 working capital needs
and they needed to rely on the debentures and sale of preferred equity stock to
fund them for the time-being. ALAC required close to $9 Million in order to triple
their inputs. This could be funded majorly through debentures ($6 Million) and
partly through equity ($ 3Million) as the former had a lower cost of capital. The cost
of capital in that case could be estimated as follows
 𝑊𝑒𝑖𝑔ℎ𝑡𝑒𝑑 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐶𝑜𝑠𝑡 𝑜𝑓 𝐶𝑎𝑝𝑖𝑡𝑎𝑙
𝐷 𝐸
= 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑅𝑎𝑡𝑒 𝑜𝑛 𝐷𝑒𝑏𝑡 ∗ + 𝑅𝑒𝑡𝑢𝑟𝑛 𝑜𝑛 𝑒𝑞𝑢𝑖𝑡𝑦 ∗
𝑉 𝑉
6 3
= 12% ∗ ( ) + 18% ∗ ( )
9 9

= 14%

This would be fair source of funding for the time being as the margins were likely
to increase from the existing rate of 18% with the increase in their bargaining
power with their larger customers. This could be attributed to their ability to make
orders every month instead of the existing bi-monthly system and thereby creating
monthly contracts with their customers.

Alternatively, ALAC could also have their shipments delivered on the western port
of Los Angeles but it would incur the firm a cost of $90 per ton to have it trucked
across to the east coast where most of their clients were based out of. So each 2000
metric ton of chemicals would now cost them $180,000 more than the current $4.5
Million adding up to a total of $4.68 Million towards procurement.

But by having their shipments delivered to Los Angeles, ALAC would be able to cut
down their cycle time from the existing four months to three months thereby
increasing their ability to provide higher levels of service and create monthly
contracts with their clients. Their trucking cost could be covered through this
increase in the profit margins.
 Specific Recommendations and Implementations
ALAC International have the following options available to them:
 External funding through issue of debentures and preferred equity
 Changing their delivery port from the east coast to the west coast
ALAC should try and secure funding through bonds and sale of preferred equity as
the cost of capital remains largely lower than their profit margin, which again were
likely to increase. By changing their delivery port to the west coast, they would be
able to reduce their cycle time but they would incur trucking expenses. This
strategy can however be used once ALAC acquires a few customers in the western
part of the country which should now be an area of focus for them. This would be
financially viable as with the extra funds coming in, ALAC was now in a position to
place orders for bigger quantities which would further increase their bargaining
power with their suppliers in Taiwan.
From 2012 onwards, ALAC would begin getting a bulk of their funding from banks
and to keep up with the expansionary plans of the firm, they would have to
combine their financing from multiple sources. Considering that the banks would
give a loan of up to $9 Million at an interest rate of 3.875%, the cost of capital can
be estimated as follows
𝑊𝑒𝑖𝑔ℎ𝑡𝑒𝑑 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐶𝑜𝑠𝑡 𝑜𝑓 𝐶𝑎𝑝𝑖𝑡𝑎𝑙
9 6 3
= 0.03875 ∗ ( ) + 0.12 ∗ ( ) + 0.18 ∗ ( )
18 18 18
= 8.9375 %
With margins around 18% and cash cycles likely to reduce, ALAC international can
look forward to making huge profits at an increased volume of sales from 2012
onwards.