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Historic Tours Ltd (HTL)

It was late December 2009 and you, John Smith, have just arrived home from a meeting of HTL, with
Lyn Chen and Captain Mike McDonald, in which you had discussed the results of the HTL’s first year of
operations. Mike McDonald was particularly excited and anxious to find out how much his compensation
would be, which had been $50k in previous years while working for another company.

HTL specialized in authentic around-the-world sailing expeditions based on the trading ships of the
1600s. The company is based on fully re-creating the experience of early trading ships, and hundreds of
adventurers apply for only 18 spots on the ship and an experience of a lifetime. The company is owned by
John Smith and Lyn Chen, who owned 75% and 25% of the Company, respectively. The main assets of
the business consist of a large trading ship and trading-related inventory. Before forming HTL, John
Smith had operated as a sole proprietor, in the same business. He operated a historic sailing company in
the Caribbean, but it was a much smaller operation and he had captained the much smaller ship himself.

Results for the Company’s first year of operations were excellent. The Company’s large ship sailed from
England in March of 2009, captained by Mike McDonald. In the hold of the ship was 100,000 yards of
cloth, which consisted of 85,000 yards of fine English cotton, 5,000 yards of French velvet and 10,000
yards of Indian silk. Carrying the velvet and silk was a historic recreation, but no other adventure tourism
business offered that level of authenticity. Mike McDonald had no problem selling all the cloth in ports
around the old trading routes, 75,000 yards of which had been pre-ordered by Smith customers in the
previous season. Mike had returned in late September with pre-order agreements for 100,000 yards of
cloth for the 2010 season from approximately 70 customers, 10 of which were new. He also insisted and
received deposits of $1,220k (approximately 40% of the value) for these orders. Demand for cloth in the
ports along the tour was very strong. They were mostly purchased by local tourist shops and highlighted
the trading history of the place. The demand was so high that many tourist shops were willing to place
orders well ahead of time to make sure they were filled.

Mike had also purchased 2,000 barrels of premium Jamaican Rum for import into England. He had sold
these barrels on credit to various high-end taverns and inns across England that catered to richer clientele.
Gross margins on these products were excellent and averaged about 50%. Jamaican rum was not normally
associated with the luxury market. But Mike, a liquor connoisseur, was confident that the premium
version, could easily compete in this high-end market. Certainly the tavern owners who tried the product
seemed to think highly of it.

The only blight in the venture was that one of the tourists (“sailor” – as they are all called for sake of
authenticity) fell on the deck and broke his arm on the way back home. Mike had investigated the matter
and determined that the sailor was drunk on duty. You had also investigated the matter with the crew and
believed the tale. The wife of the sailor had asked for the compensation but Mike had refused. He argued
that paying any money for a sailor’s incompetence would set a bad precedent and send the wrong signal
to future tourists (since again, the whole expedition was based on authenticity) . The wife had recently
filed a formal letter of complaint, a copy of which is in Exhibit 1.

You also had to decide whether to purchase any additional fine cotton cloth from the London cloth guild.
The poor cotton crops had led to higher cotton prices for authentic local materials. The price of fine
English cotton increased to $16k per 1000 yards as of September 1, 2009 and is scheduled to increase to
$18k per 1000 yards as of January 1, 2010. If you purchase and receive the cloth this year, then you will
pay $16k per 1000 yards, as the guild would honor the 2009 fall price schedule. You already purchased
20,000 yards a few weeks ago. Even with these raw material price increases, you were not worried as you
traditionally maintained your percentage margins and passed on any increased costs to your customers.

Adaptation based on “English Merchant” Case


At the meeting, you had also discussed the future of the company. Mike had suggested buying another
ship, perhaps a small one. He felt that there was a huge untapped market for this kind of expeditions and
profitable trading. Of course a new ship and the initial inventory would require more investment capital.

As John Smith, you were pleased. You initially had misgivings about partnering with other people but
you could not argue with success. Your task right now was to prepare the first draft of the Company’s
financial statements for the fiscal period ending December 31, 2009 according to GAAP, as required both
by the lending agreement with London Bank (see exhibit 2) and Mike McDonald’s employment contract
(see exhibit 3). Exhibit 4 outlines in more detail the cash purchases and receipts of the Company as well
as some miscellaneous information you had collected. The final statements would be prepared in the first
week of January, once the fiscal year had actually finished. London Bank’ auditor, whose job was to
ensure that the financial statements were properly prepared, was due to arrive in the second week of
January. Now that your business was organized as a company, you would also need to present the
finalized financial statements prepared according to GAAP to the taxation authorities and pay the
customary 20% of your profits within the 30 days of the fiscal year end.

Exhibit 1
Formal letter for compensation

This letter is to petition for my husband’s injury companesation of $5k while serving on the HTL Ship.
My husband was a loyal and dutiful sailor while on the expedition. The allegations by Captain McDonald
that my husband was drunk while on duty are untrue and unproven.

Exhibit 2
Summary of lending agreement with London Bank

London Bank agrees to lend the HTL 5,000k. Annual interest of 10% is due on December 31 of each
year. The loan is secured against all assets of the Company. The Company is not allowed to sell its ship or
to further borrow more money without the express written permission of London Bank. The Company
agrees to provide annual financial statements, prepared according to local Generally Accepted
Accounting Principles (GAAP), to London Bank and have these financial statements audited by a
representative of London Bank. The principle is due on December 31, 2015 unless one of the following
covenants based on these financial statements is broken, in which case the principal is due immediately.
The covenants include maintaining a debt-to-equity ratio of at most 1:1 and an interest coverage ratio
(earnings before interest and taxes divided by interest expense) of at least 2.5.

Exhibit 3
Summary of employment agreement with Mike McDonald

The HTL agrees to pay Mike McDonald the sum of 10% of the Company’s annual profits before taxes
(and Mike McDonald’s salary) calculated according to GAAP. The Company will pay Mike McDonald
$20k in March and $20k in October as an advance against his 10% of the profit before taxes. In return,
Mike will exercise appropriate judgment, skill and entrepreneurship as Captain of the Company ship and
as the sole representative to the Company’s customers in the colonies. This agreement will be in effect
until December 31, 2019.

Adaptation based on “English Merchant” Case


Exhibit 4
List of all cash receipts, cash disbursements, and inventory

Cash receipts for the period January 1, 2009 to December 15, 2009

Month Amount Explanation


Jan $2,000k Lyn Chen equity investment
Jan $5,000k John Smith equity investment
Feb $5,000k London Bank loan
Jul $2,295k Sold 85,000 yards of fine English cotton at $27k per 1,000 yards
Jul $200k Sold 5,000 yards of French velvet at $40k per 1,000 yards
Jul $500k Sold 10,000 yards of Indian silk at $50k per 1,000 yards
Aug $1,220k Customer cloth prepayments for orders to be shipped in 2010
Dec $1,200k Customers payments (for premium Jamaican rum originally sold on credit)

Cash disbursements for the period January 1, 2009 to December 15, 2009

Month Amount Explanation


Feb $9,000k Purchased large ship. Ship was 25 years old at time of purchase and was
expected to last another 15 to 30 years
Mar $1,020k Purchased 85,000 yards of fine English cotton at $12k per 1,000 yards
Mar $80k Purchased 5,000 yards of French velvet at $16k per 1,000 yards
Mar $200k Purchased 10,000 yards of Indian silk at $20k per 1,000 yards
Mar $220k Purchased miscellaneous supplies and gear
Apr $200k Paid Royal Navy annual “Protection” fee
Apr $400k Purchased inventory and ship insurance that would last five years
Apr $20k Advance to Captain Mike McDonald (Spring)
Jun $30k Purchased miscellaneous supplies and gear
Aug $50k Purchased miscellaneous supplies and gear
Aug $4,000k Purchased 2,000 barrels of premium Jamaican rum at 2k per barrel
Sep $90k Paid crew of 18 “sailors” at $5k each
Sep $60k Paid three officers (excluding Captain)
Oct $20k Advance to Captain Mike McDonald (Fall)
Dec $320k Purchased 20,000 yards of fine English cotton at $16k per 1,000 yards

Inventory as of December 15, 2009

Current inventory on the ship consists of 20,000 yards of fine English cotton and approximately $15k of
miscellaneous supplies and gear.

Adaptation based on “English Merchant” Case

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