Question

Secured Problem 1 - Structuring a Secured Loan Transaction

Marine Systems, Inc. is a retail seller of personal watercraft, which it manufactures from component parts. Marine Systems operates five stores in the Seattle area along with a separate manufacturing facility. It leases the premises for the stores and manufacturing facility. Its total inventory of watercraft and component parts has a wholesale value of $800,000, which Marine Systems sells at a 75% markup. Marine Systems also owns $150,000 in display cases, cash registers, tools, computers, and the like.

Marine Systems currently owes its various unsecured creditors approximately $500,000. After deducting its monthly payments to these creditors and overhead costs, Marine Systems nets $5000 per month. Marine Systems regularly sells watercraft to the City of Seattle and The University of Washington. Marine Systems invoices both purchasers with payment due within 30 days after delivery. Presently, each customer owes $25,000.

The job of a commercial attorney is to identify risks and propose ways to minimize them. Answer the following questions:

a.      Marine Systems has asked Credit, Inc. for a $150,000 loan to expand its workforce. Credit, Inc. is inclined to make the loan but requests advice as to whether it should demand security. What do you advise?

1. What are the advantages of a secured credit transaction for the creditor?

2. Why would Marine Systems, the debtor, agree to a secured debt transaction? In other words, can Marine Systems benefit from the transaction?
3. What is Marine Systems’ balance sheet (i.e., assets v. liabilities)

4. How big is the risk if the loan were unsecured? What is the worst case scenario?

5. If Marine Systems wanted an unsecured loan, would a higher interest rate compensate Credit Inc., for the risks?

b.      If Credit, Inc. wants a security interest, what collateral would you recommend? There are risks associated with all of these categories of collateral. How will you protect the secured creditor from these risks?

1. Marine Systems’ $5,000 monthly profit?

2. Inventory?

3. Equipment

4. Accounts Receivable?

Answer 1

a)

1.Advantages of secured credit transaction to the creditor-

• Because of secured credit transaction the main advantage is if the party to whom goods are sold is unable to pay the amount then such amount can be recovered through security made against it .
• Secured credit transaction also helps to claim the amount owed against other claimants of the debtor.
• Collateral may also helps to reduce the cost of monitoring the debtor regarding increasing the riskiness of the amount.
• The interest charged against secured credit transaction is generally less than unsecured transaction because lender has collateral guarantee for recovery.
• In certain cases if the value of the collateral is less than amount owed by the debtor then it may possible that all the amount is not recoverable but in most of the cases it certainly assures the recovery of cost at least.

2.Marine systems will definately benefit from the transaction even if it is secured because currently Marine systems have creditors to the extent of $500,000.And it have debtors of $50,000 which is recoverable after 30 days. It can sale its inventory with 75% markup i.e.800,000*.75=600000.But this $600000 is the amount which can be available to Marine system after selling the inventory.Out of that $600000 some amount may be recoverable from debtors after 30 days of sale.

                     Hence if any creditors make the demand to Marine system then it has cash available only to the extent of $5000 , it can also sale computers,tools etc but it will receive amount lesser than its market value because it is used things.Hence by taking the loan it may secure some margin in case of any emergency payment arises.Also it can pay off the same after it receives the amount from the sale of inventory and recovery from debtors.

3.Marine systems have following assets -Inventory worth $.800,000(which can be sold @75% markup). Computers and other tools having original cost of $150000.Debtors of $25000 and cash after all the expenses $5000.

It has following liablities- Creditors worth $500000.Lease payments(for the premises taken on lease for manufacturing and storing facility)

4.If the loan is unsecured then risk is very high because Marine systems most of the funds are blocked up in the form of inventories and debtors.If the marine systems unable to sell enough inventories it have or unable to recover from debtors the amount owed then Credit Inc dont have any way to recover the loan given to Marine system as it is unsecured.

5.Higher rate loan would not compensate the risk because Marine system does not have any Quick Asset which it can sold immediately to pay off the loan.Even if interest rate is higher if Marine system does not have enough ability to pay of principal amount itself there is no use to charge any higher interest.

B.Marine systems $5000 monthly ($60000 annually)profit will not enough as collateral for the amount of loan which is $180000.The better option available for collateral for Credit Inc is to have collateral of inventories available with marine systems as it have higher value than Loan amount.Also Inventory is available at cost which can be sold at 75% mark up in market in case if Marine system fails to make payment.

However Equipments and Account receivable are not good options because equipments are used items and there cost is $150,000 but when Credit Inc will try to sold them it may happen that it will fetch lesser amount because of its depreciation.Also Account receivable credit period is 30 days which means that in case of any default by Marine system the amount can be recovered after 30 days and that too to the extent of $50000 only.