ISSN 1940-204X
Bastion Finance
Shane Moriarity
University of Oklahoma and
Unitec New Zealand
Andrew Slessor
Unitec New Zealandº
You are a management accountant at Parker Plastics. A few
days ago the founder, James Parker, asked you to stop by his
office: “This past weekend a neighbor mentioned that he
owns a 10% stake in Bastion Finance that he would like to
sell. He inquired if I would be interested in purchasing the
holding. He said it has been paying a generous dividend.
I am thinking that the investment could provide a stable
source of cash flow for our company. I would like you to
review their operations and let me know what you think of
the potential. Start by preparing an estimate of what you
think their financial statements will look like for next year.
I realize the result will only be as good as your assumptions.
But if your assumptions are reasonable, the estimated
statements should provide a good starting point for deciding
whether to pursue an investment in the company.”
Mr. Parker went on to say that the 10% stake is currently
owned by his neighbor, Lance Edwards. You immediately
recognized his name. Lance is one of the country’s most
popular professional football players. Back in your office,
you called Lance to arrange a meeting to learn more about
Bastion Finance.
Lance was happy to meet with you and has been very
cooperative in answering your questions and passing on the
information he has about the company. Lance mentioned
that he is approaching the end of his football career and is
now looking for a new challenge. He wants to build a major
state-of-the-art athletic training facility for promising young
athletes. He plans to fund this venture by selling his stake in
Bastion Finance.
Bastion Finance was formed just over six years ago by
Eric Lombard and Walter Carson. They each contributed
IM A ED U C ATIO NA L C A S E JOURNAL
$100,000 in return for a 50% share in the new corporation.
Then they each donated a 5% stake to Lance in exchange for
an agreement by Lance to regularly appear on TV, radio, and
in print advertising on behalf of Bastion Finance. Lance does
not participate in the management of the firm nor does he
serve on the Board of Directors. The agreement for Lance to
provide promotional services has recently expired and Lance
is now ready to move on with his plans for his new business.
You learn that Bastion Finance raises cash by selling
debentures to investors at interest rates well above those
available from banks or insured financial institutions. The
interest rates are advertised in the business section of several
newspapers, but funds are formally solicited through a
prospectus. Most of Bastion’s investors are retirees, many of
whom make their investments through commission-based
financial advisors. Although investors are actually purchasing
fixed-period debentures, management refers to them as
depositors. Bastion is not a bank. It provides no banking-type
services for depositors nor does it have a physical facility for
one-on-one personal service. Consequently, the firm is not
subject to banking regulations.
The funds acquired from depositors are lent to property
developers. Bastion concentrates its lending to developers
needing second mortgages. These developers typically take
out a first mortgage for a project from a traditional bank or
insurance company. But these institutions generally limit the
amount they will loan on a project to 80% of the construction
costs. For well-capitalized developers, this is sufficient for
them to proceed with a project by combining the borrowed
funds with their own capital. Yet Bastion lends to those
developers who must borrow 100% of their construction costs.
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VOL. 6, N O. 1, ART. 1, MARCH 2013
REQUIRED
Bastion provides the additional funds as a second mortgage.
These are high-risk mortgages. In the event a development
fails to be profitable, the second mortgage holder gets repaid
only to the extent that the proceeds from the sale of the
development exceed the amount owed on the first mortgage.
All of a development’s assets are typically pledged as collateral
to the first mortgage holder and a developer who must take a
second mortgage usually has little or no capital of their own
at stake. This added risk of being “second in line” means
that market interest rates for second mortgages are much
higher than the prevailing rates on first mortgages. Bastion’s
business plan is to take advantage of these higher rates while
being judicious in its selection of which developers to fund.
Developers are attracted to Bastion because it does not
require developers to make any payments for interest, fees, or
principal until a project is completed and sold (but interest is
accrued and compounded annually).
Lance said that the company was a success from the start.
“It far surpassed Eric and Walter’s expectations. But they are
generous in giving me a great deal of credit for their success.
They said many of my older fans were eager to invest in a
company that I endorsed. The growth rate in deposits in
the first couple of years was remarkable and the firm has
consistently maintained a large cash balance. The company
cites this large cash holding as evidence of the firm’s solid
financial position.”
Because Bastion Finance is closely held, it is not required
to prepare a formal annual report for public distribution.
Yet Lance receives copies of each updated prospectus
provided to depositors. These prospectuses contain audited
financial statements. In addition, each year he receives a
supplementary report containing information thought to be
of interest to shareholders. Lance provided you copies of
the investor prospectuses. From them, you have prepared
the summary financial statements given in Exhibit 1. He
also provided you with the supplementary shareholders’
information he received for Year 6. It is appended as Exhibit
2. Lance laughed and said he also kept souvenir copies of the
loan cards for two loans that were not fully repaid. These are
presented in Exhibit 3. Lance said, “In both cases, Walter
pointed out that Bastion made money on these loans—just
not in the full amount that had been anticipated.”
You returned to your office after the meeting with Lance
and reviewed the materials he had given you. It is now time
to formulate estimated financial statements for Year 7. You
have lots of data available, but you will have to use judgment
in making some required forecasts.
IM A ED U C ATIO NA L C A S E JOURNAL
1.Prepare forecasted financial statements for Year 7 (cash
flow statement, income statement, and balance sheet).
Prepare a brief justification for each assumption that you
make when forecasting a specific value.
2.Use the insights you have gained from preparing the
forecasted financial statements to identify the risks and
concerns that should be brought to Mr. Parker’s attention.
3.Based upon an evaluation of the potential risks and
returns, recommend whether the investment in Bastion
should be pursued.
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VOL. 6, N O. 1, ART. 1, MARCH 2013
Exhibit 1:
Annual Summary Financial Statements
Bastion Finance
Summary of Audited Financial Statements ($ Millions)
Income Statements
Year 1
Year 2
Year3
Year 4
Year 5
Year 6
Revenues
Interest Income
4.3
19.0
28.3
36.4
39.2
46.7
Loan Fees
5.2
15.4
8.0
11.2
20.0
22.8
Operating Revenue
9.5
34.4
36.3
47.6
59.2
69.5
Expenses
Interest Expense
4.5
15.8
24.7
31.7
41.5
48.7
Salaries and Wages
0.7
0.8
0.9
1.1
1.3
1.5
Other
0.2
0.2
0.2
0.3
0.3
0.5
Operating Expenses
5.4
16.8
25.8
33.1
43.1
50.7
Operating Income
4.117.610.514.516.1
18.8
Bad Debts
0.0
0.0
0.0
0.0
3.9
6.3
Income Tax
0.0
0.0
0.0
0.0 4.8
1.6
Net Income
4.1
17.6
10.5
14.5
7.4
10.9
Statements of Retained Earnings
Beginning Retained Earnings
0.0
1.1
5.7
5.2
5.7
6.1
Net Income
4.1
17.6
10.5
14.5
7.4
10.9
Dividends
3.0
13.0
11.0
14.0
7.0
10.0
1.1
5.7
5.2
5.7
Ending Retained Earnings
6.1 7.0
Balance Sheets
Assets
Cash
2.9
2.0
71.8
96.2
102.4
81.1
Loans Receivable
74.5
232.9
264.8
312.6
349.3
393.3
Total Assets
77.4
234.9
336.6
408.8
451.7
474.4
Liabilities
Interest Payable
1.1
4.0
6.2
7.9
10.4
12.2
Term Deposits
75.0
225.0
325.0
395.0
435.0
455.0
Total Liabilities
76.1
229.0
331.2
402.9
445.4
467.2
Owner’s Equity
Common Stock
Retained Earnings
Total Liabilities and Equity
0.2
0.2
0.2
0.2
0.2
0.2
1.1
5.7
5.2
5.7
6.1
7.0
77.4
234.9
336.6
408.8
451.7
474.4
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VOL. 6, N O. 1, ART. 1, MARCH 2013
Exhibit 2:
Information from the Company’s Annual Report to Shareholders.
Bastion Finance
Fiscal Year
The fiscal year for Bastion Finance runs from March 16 through March 15. To avoid confusion, dates are not used in the following discussion.
Instead, references are made to each full fiscal year of operation. Thus Year 1 refers to the firm’s first full year of business and Year 6 to its most
recently completed year.
Company Regulatory Matters
The company is organized as a commercial investment company. It is not subject to regulatory oversight as a bank. Securities regulations require
that term investors be supplied with a current prospectus. Depositor’s investments are not insured or guaranteed by any governmental agency.
Company Shareholders
Shares in Bastion Finance are not listed on any exchange nor are they publicly traded. Private transactions between individuals have occurred
infrequently. As of the end of Year 6, the firm is aware of 15 individuals owning shares—most consist of very small holdings. The five largest
shareholders and their holdings are:
Eric Lombard
Walter Carson
Lance Edwards
LeRoy Fisk
Linda Hobbs
Shares%
1,290,000
1,050,000
300,000
150,000
60,000
43%
35%
10%
5%
2%
In Year 3, Linda Hobbs purchased 60,000 shares from Walter Carson for $2,816,000, a price representing eight times per share earnings for Year
2. At the end of Year 4, LeRoy Fisk purchased 150,000 shares from Walter Carson for $7,250,000, a price representing 10 times the estimated per
share earnings for Year 4. Several smaller trades have occurred at various prices over the past six years.
Board of Directors
Six individuals serve on the company’s Board of Directors. Directors who are not managers are paid an annual retainer of $25,000 per year and
receive 1,000 shares in the firm. The Chair of the Audit Committee and the Chair of the Compensation Committee each receive an additional fee
of $5,000. The total fees earned in Year 6 and shareholdings as of the end of Year 6 for each of the directors are given below.
FeesShareholding
Eric Lombard, Chairman of the Board
$
—
1,290,000
Walter Carson, Chief Executive Officer
—
1,050,000
Brendon Sheppard
25,000
6,000
Susan Richee, Chair of the Audit Committee
30,000
2,000
Bruce Ludlow, Chair of the Compensation Committee
30,000
3,000
Gordon Meyers
25,000
5,000
Executive Compensation
The firm has only four executive-level employees. The compensation for the executive officers for the past two years was as follows:
Eric Lombard, Chairman of the Board
Walter Carson, Chief Executive Officer
Paul Brekkar, Legal Officer
Denise Horton, Finance Officer
Year 5
Year 6
$350,000
$350,000
$180,000
$135,000
$400,000
$400,000
$200,000
$150,000
The Compensation Committee reviews the compensation levels paid by a sample of 10 other firms in the industry. It is the Board’s policy to
maintain executive compensation at levels competitive with comparator firms.
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VOL. 6, N O. 1, ART. 1, MARCH 2013
Exhibit 2:
Information from the Company’s Annual Report to Shareholders (continued)
Notes to Financial Statements
The preparation of our financial statements in conformance with generally accepted accounting principles (GAAP) requires management to make
estimates and assumptions affecting the amounts to be reported. Actual results may differ from those estimates.
The company prepares its financial reporting accounts on an accrual accounting basis. It prepares its tax return using cash-basis accounting.
Deferred taxes are not material and are not recognized in the accounts. The firm faces a tax rate of 30% on income.
The company has no fixed assets. The firm’s premises, furniture, office equipment, and all fittings are leased. Lease obligations are $215,000 for
Years 7 through 10 and $135,000 for Years 11 through 14.
We are exposed to claims and litigation arising in the ordinary course of business and use various methods to resolve these matters in a manner
which we believe best serves the interest of the firm. We do not believe any pending claim or action will have a material adverse effect on the firm.
The firm has been experiencing an increase in the cost to acquire term deposits. Management has been successful in passing the increase onto
the firm’s borrowers. The average annual interest rates paid and earned for the past six years are given below along with the average maturities.
Interest is paid quarterly to depositors and is received at maturity from borrowers.
Term Depositors
Loan Customers
Year
Annual Interest Paid
Average Maturity (Months)
Annual Interest Earned
Average Maturity (Months)
1
8%
18
11%
21
2
9%
19
12%
25
3
9%
16
12%
25
4
9%
15
12%
24
5
10%
13
13%
19
6
11%
12
13%
26
Bastion Finance has received an unqualified audit opinion from its auditor, Goodman Cole, in each of its six years of operation.
Loans Outstanding at Year End
The loan cards from the firm’s Loan Book for all of the loans outstanding as of the end of Year 6 are reproduced below. (Dollar amounts are
shown in millions rounded to one decimal.)
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VOL. 6, N O. 1, ART. 1, MARCH 2013
Exhibit 2:
Information from the Company’s Annual Report to Shareholders (continued)
Loan Cards for Outstanding Loans
Loan Number
Year Loan Granted
Interest Rate
Borrower
Principal Officers
405
Principal Amount $20.0 M
4
Year for Scheduled Repayment 5
12%**
Loan Origination Fee
$1.6 M
Prestige Development
Cornelius Bowden, Sandy Maier, and Anthony Roest Transactions
Year Description
Loan Principal
Loan Origination Fee
Interest
Interest
Interest
4
4
4
5
6
Loan Balance
$20.0 $1.6 $0.6 $2.7 $3.7 $20.0 $21.6 $22.2 $24.9 $28.6 Notes: Builder has encountered severe stability problems in the geological substrata of the building site.
Project delayed indefinitely. **Interest rate raised to 15% as of start of Year 6.
Loan Number
Year Loan Granted
Interest Rate
Borrower
Principal Officers
506
Principal Amount $30.0 M
5
Year for Scheduled Repayment 9
10%
Loan Origination Fee
$2.4 M
Gold Coast Condominiums
Barbara Liveris, Eric Lombard, and Phillip Greene
Transactions
Year Description
Loan Principal
Loan Origination Fee
Interest
Interest
5
5
5
6
Loan Balance
$30.0 $2.4 $0.3 $3.3 $30.0
$32.4
$32.7
$36.0
Notes: IM A ED U C ATIO NA L C A S E JOURNAL
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VOL. 6, N O. 1, ART. 1, MARCH 2013
Exhibit 2:
Information from the Company’s Annual Report to Shareholders (continued)
Loan Cards for Outstanding Loans
Loan Number
Year Loan Granted
Interest Rate
Borrower
Principal Officers
601
Principal Amount $65.0 M
6
Year for Scheduled Repayment 8
13%
Loan Origination Fee
$5.2 M
Kingsland Hotels
James Franklin and Jacqueline Bell
Transactions
Year Description
6
6
6
Loan Principal
Loan Origination Fee
Interest
Loan Balance
$65.0 $5.2 $6.7 $65.0
$70.2
$76.9
Notes: Loan Number
Year Loan Granted
Interest Rate
Borrower
Principal Officers
602
6
15%
Green Lane Apartments
Wang Lim, Henry Shi, and Chong Xie
Principal Amount $45.0 M
Year for Scheduled Repayment 7
Loan Origination Fee
$3.6 M
Transactions
Year Description
6
6
6
Loan Principal
Loan Origination Fee
Interest
Loan Balance
$45.0 $3.6 $3.5 $45.0
$48.6
$52.1
Notes: IM A ED U C ATIO NA L C A S E JOURNAL
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VOL. 6, N O. 1, ART. 1, MARCH 2013
Exhibit 2:
Information from the Company’s Annual Report to Shareholders (continued)
Loan Cards for Outstanding Loans
Loan Number
Year Loan Granted
Interest Rate
Borrower
Principal Officers
603
Principal Amount $50.0 M
6
Year for Scheduled Repayment 7
13%
Loan Origination Fee
$4.0 M
Lumineria Partners
Madeleine Lindquist and Heidi Coleman Transactions
Year Description
6
6
6
Loan Principal
Loan Origination Fee
Interest
Loan Balance
$50.0 $4.0 $3.2 $50.0
$54.0
$57.2
Notes: Loan Number
Year Loan Granted
Interest Rate
Borrower
Principal Officers
604
Principal Amount $85.0 M
6
Year for Scheduled Repayment 9
10%
Loan Origination Fee
$6.8 M
Dorchester Management Company
Gordon Reynolds, Phillip Greene, and Walter Carson
Transactions
Year Description
6
6
6
Loan Principal
Loan Origination Fee
Interest
Loan Balance
$85.0 $6.8 $5.1 $85.0
$91.8
$96.9
Notes: IM A ED U C ATIO NA L C A S E JOURNAL
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VOL. 6, N O. 1, ART. 1, MARCH 2013
Exhibit 2:
Information from the Company’s Annual Report to Shareholders (continued)
Loan Cards for Outstanding Loans
Loan Number
Year Loan Granted
Interest Rate
Borrower
Principal Officers
605
Principal Amount $40.0 M
6
Year for Scheduled Repayment 9
14%
Loan Origination Fee
$3.2 M
Hampton Arms Apartments
Anne Ward, Paul McLeahy, and Hamilton Wood Transactions
Year Description
6
6
6
Loan Principal
Loan Origination Fee
Interest
Loan Balance
$40.0 $3.2 $2.4
$40.0
$43.2
$45.6
Notes: Company Risk Factors
Bastion Finance is exposed to several sources of risk in its ordinary course of business. These include credit risk, interest rate risk, liquidity
risk, and general business risk. Credit risk refers to the potential that some of our customers may default on the loans we have made to them.
This risk is augmented by our focus on second mortgages and our concentration in a narrow market segment. Interest rate risk means that we
may not be able to maintain a profitable spread between our cost of borrowing and the returns from lending. Liquidity risk arises because we
borrow from term depositors on maturities ranging from 6-18 months while our loans to developers may extend for multiple years. General
business risk is inherent in the competitive nature of our industry. We cannot be assured that our term depositors or loan customers will
continue to conduct business with us rather than with one or more of our competitors. Bastion Finance is not exposed to foreign exchange risk
and does not engage in derivatives trading.
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VOL. 6, N O. 1, ART. 1, MARCH 2013
Exhibit 3:
Loan Cards for Defaulted Loans
Loan Number
Year Loan Granted
Interest Rate
Borrower
Principal Officers
303
Principal Amount $25.0 M
3
Year for Scheduled Repayment 4
12%
Loan Origination Fee
$2.0 M
Phoenix Horizons
Linda Gibson and Phillip Greene
Transactions
Year Description
Loan Principal
Loan Origination Fee
Interest
Interest
Interest
Repayment
Loss Write Off
3
3
3
4
5
5
5
Loan Balance
$25.0 $2.0 $1.6 $3.4 $1.9 $30.0 $3.9 $25.0
$27.0
$28.6
$32.0
$33.9
$3.9
—
Notes: Holder of the first mortgage foreclosed the property. There were insufficient funds to fully re-pay our
second mortgage.
Loan Number
Year Loan Granted
Interest Rate
Borrower
Principal Officers
502
Principal Amount $65.0 M
5
Year for Scheduled Repayment 6
13%
Loan Origination Fee
$5.2 M
Westwood Shopping Complex
Phyllis and David Edins
Transactions
Year Description
Loan Principal
Loan Origination Fee
Interest
Interest
Repayment
Loss Write Off
5
5
5
6
6
6
Loan Balance
$65.0 $5.2 $5.9 $3.9 $73.7 $6.3 $65.0
$70.2
$76.1
$80.0
$6.3
—
Notes: Proceeds from the sale of the complex failed to cover the full development costs. The company went
into liquidation.
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VOL. 6, N O. 1, ART. 1, MARCH 2013