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CASE 4

Nikolas Corporation is suffering from financial distress as it can be seen from its balance sheet:

Two scenarios are possible for Nikolas in Year 3:

In scenario 1, Year 3 for Nikolas is expected to result in an additional $100,000 operating loss.

In scenario 2, Year 3 is expected to be a breakout year for Nikolas when higher sales and lower costs owing to economies of scale are forecasted to produce operating profits of $300,000 in Year 3.

Total assets are expected to remain at $200,000 under either scenario. Total debt will be increased to finance additional operating losses. Operating profits will be used to reduce total debt.

Instructions:

a. Show Nikolass balance sheets under both scenarios. (10 points)

b. Based on your analysis, will Nikolas Corporation still be balance sheet insolvent in Year 3 under scenario 1? If this trend continues, would you describe Northlands financial distress as a temporary or a permanent problem? (5 points)

c. Based on your analysis, will Nikolas Corporation still be balance sheet insolvent in Year 3 under scenario 2? If this trend continues, would you describe Northlands financial distress as a temporary or a permanent problem? (5 points)

d. There are two basic options in the situation of financial distress: liquidation or reorganization. Explain them. (5 points)

YEAR O $100,000 100,000 $200,000 $ 0 YEAR 1 $100,000 100,000 $200,000 $100,000 YEAR 2 $100,000 100,000 $200,000 $250,000 Current assets Fixed assets Total assets Total debt Equity Common stock Retained earnings Total equity Total debt and equity 200,000 0 200,000 $200,000 200.000 -100,000 100,000 $200.000 200,000 -250,000 -50,000 $200,000 YEAR O $100,000 100,000 $200,000 $ 0 YEAR 1 $100,000 100,000 $200,000 $100,000 YEAR 2 $100,000 100,000 $200,000 $250,000 Current assets Fixed assets Total assets Total debt Equity Common stock Retained earnings Total equity Total debt and equity 200,000 0 200,000 $200,000 200.000 -100,000 100,000 $200.000 200,000 -250,000 -50,000 $200,000

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