Case Study Anacomp

Case ANACOMP INC. 1. Identify all the economic entities involved in the development of Anacomps CIS software system. The economic entities include Anacomp itself, a limited partnership RTS Associates, banks as codevelopers- four CIS Primary Development Banks, and other banks contracted with Anacomp to provide loans or advisory services in the CIS project. 2. Describe the contractual arrangements between the economic entities involved in the CIS development. Who bears the majority of the risk of failure of the development effort? Who stands to gain most if the development effort succeeds? Are Anacomps shareholders better off or worse off with this arrangement, relative to in-house development of the system? For the contractual arrangements between Anacomp and RTS Associates: the two had entered into an agreement in November 1979. Anacomp agreed to develop the CIS system on behalf of the partnership. In return, RTS agreed to pay a development fee of $6 million, of which $2.2 million was paid in 1980. Upon completion of the development of the CIS system, Anacomp agreed to market CIS for five years on a commission basis. In addition, if the CIS development expenses exceeded $6 million and therefore RTS was required to pay further development fees, Anacomp agreed to loan RTS, without recourse to the limited partners, up to $1.5 million to complete the CIS system. Anacomp also had the option to acquire all rights to the CIS system at the greater of its appraised fair market value or RTSs investment plus a fixed profit. RTS had the right to extend Anacomps five-year marketing agreement an additional five years or to cancel it if Anacomp did not use its best efforts to market CIS. For the contractual arrangements between Anacomp and banks, thirteen major banks, including the National Bank of North America in New York, the Shawmut National Bank in Boston, Provident National Bank in Philadelphia, and the First National Bank in Kansas City, contracted with Anacomp to participate as advisory banks in the CIS project for a nonrefundable fee of $150,000 each. The arrangement permitted each bank to review the project during development and provide input regarding changes to enhance the ultimate marketability of CIS. RTS Associates bears the majority risk of failure of the development effort,because it has large investment into the development. But it can gain most if the effort succeeds. The buyback by Anacomp can turn into good profit.

Relative to in-house development of the system, shareholders face less risk for the new software development for part of the risk and cost born by RTS. The limited partnership alternative buffers the financial risks involved. At the same time they gain less if the effort succeeds. On the whole, they are better off for the fewer risks. 3. What criteria will Anacomps management use in deciding on whether or not to buy back the CIS system from RTS Associates? Is Anacomps management likely to be unbiased in deciding on the timing and the price of the purchase? If not, what will be the direction of the bias? Anacomp has the option to acquire all rights to the CIS system at the greater of its appraised fair market value or RTSs investment plus a fixed profit. This may depend on the performance of CIS system in the market, whether it has a good prospect to profit and its market value. However, it is not very likely for the management to be unbiased on the issues of time and price of the purchase. Several officers and directors of Anacomp were affiliated with the corporate general partner of RTS, and were also investors in the limited partnership arrangement. The Chairman of the Board and President of Anacomp, and three other directors of Anacomp, were also directors and officers of the corporate general partner of RTS. The ownership interest of Anacomps officers and directors in the limited partnership amounted to 38.5% of the total. Although all officers and directors as a group owned 15.1 percent of Anacomps common stock, the managemnt may have incentives to purchase the CIS in a short time and at a higher price to get more money for themselves. 4. Describe how Anacomp accounts for the CIS development effort. How does this type of accounting compare with the accounting for in-house software development? What particular accounts will be affected differentially by the two development arrangements? Anacomp organized and financed the CIS development in a unique manner which it developed CIS on behalf of RTS. Therefore, the accounting for the development would be different from that under the arrangment of in-house software development in several aspects: how Anacomp recognize the money financed to develop new software, how to record loans for the development, the revenue CIS brings and the position of CIS itself, etc. . In the new arrangement, Anacomp would receive development fee from RTS and regard that as Deferred CIS development cost in asset in balance sheet. The bank loans would be in the financial statement of RTS. After CIS is completed, it can recognize only the commission fee as revenue in the income statement. While for the situation of inhouse development, loans for development would be put in the balance sheet of Anacomp as debt; the CIS software would be the asset of Anacomp and as the inventory before its sale.

5. In general, do you think Anacomps use of R&D partnerships is a sensible approach to new product development? What are the overall costs and benefits of this approach? The software R&D partnership is Anacomp innovation to develop new product and it can get prospective customers involved during the development. I think it is a sensible approach to new product development. As for the benefits, Anacomp can develop products with large investments, and face less stress to finance the development, stockholders also face less financial risk, and the involvement of the ultimate users may help to develop a product more suitable for them. If the development is failure, Anacomp does not lose all. The costs are that if the product turns to be successful and Anacomp wants to own it, Anacomp has to buy it back at price, thus reducing the profits from it. 6. Anacomps earnings dropped from $0.87 per share in 1981 to $0.50 per share in 1982. What are the reasons for this earnings decline? Are there any unusual and one-time items that influenced Anacomps 1982 performance? Although revenues rose slightly over 1981, earnings per share declined due to the impact of fourth quarter results. several one-time changes and short-term factors are responsible for the decline. Revenues for 1982 increased only 3% over fiscal 1981, with the increase being generated primarily by internal growth and the addition of internally generated projects. Total operating costs and expenses increased 10.4% during fiscal 1982. Personnel costs and outside services costs associated with the increased software development activity were the major factors in the increase. Higher supply costs, equipment-related costs, and the cost of computer hardware sales, each caused by higher levels of activity are also contributors. Amortization of purchased software added to the overall increase, along with generally higher prices for all purchased goods and services. These increases were partially offset by cost reductions from the synergism obtained from prior acquisitions, a reduction in costs as a result of consolidating certain administrative functions and, in the third quarter, from the recovery of previously recorded expenses. Margins for the current periods were substantially lower than the prior year due to the emphasis on completing large systems development projects as opposed to generating new license fees for other products. Interest expense increased in the convertible year as a result of the interest on the912% Convertible Subordinated Debentures offered during fiscal 1981 and the 1378%Convertible Subordinated Debentures offered in January 1982. Due to the uses of cash mentioned previously and a lowering of interest rates on investments, interest income decreased throughout the current period. Some unusual and one-time items that influenced Anacomps 1982 performance include: the purchase of two major software products CIS and BANKSERVR 10000 and the completion of an

acquisition to 24 micrographic data imaging centers from DSI Corporation and Kalvar Corporation Those also contributed to the decline in earnings. 7. Evaluate Anacomps cash flow situation. The company reported that its operations provided approximately $8 million in 1982. How much cash was generated from Anacomps operations in 1982? In 1981? Anacomps cash flow can come from its operating activities, investing activities and financing activities. The cash from operations can be calculated by: Net income after taxes + Depreciation and Amortization - Amount that Net Working Capital Changes. For 1982s operating cash flow= 4609+6708-(1949-5127+14000+548)=-53; for 1981s operating cash flow= 7938+4368-(4444524639-4000-791)=-2709 8. What is the total amount of debt that Anacomp has on its books? Does the company have any off-balance-sheet liabilities? Notes payable to banks is $ 14,000, Current portion of long-term debt $ 2,907 and Other long term debt is $105,208. In total the amount of debt is $122115 at June 30, 1982. (Shares representing substantially all of the operations of DSI are pledged as collateral for a note with a discounted balance of $2,793. Processing equipment with an aggregate book value of approximately $3,600 is pledged as collateral under certain of the debt agreements.) The company has some off-balance-sheet liabilities.Anacomp is guarantor of a bank loan to Anacomps wholly-owned leasing subsidiary. At June 30, 1982, the balance of the debt being guaranteed is $480. 9. What is your assessment of Anacomps financial flexibility at the end of 1982? Can the company withstand any potential difficulties which could arise with the completion of the CIS system? At the end of 1982, financial ratios of Anacomp becomes worse than the year before. There are drops in earings per share and currnet ratio. The current ratio at June 30, 1982, is 2.40, compared to 3.84 at June 30, 1981. The large drop of the current ratio shows Anacomps ability to meet the short term liability is weakened. It has a large increase in long-term debt, primarily the result of the January offering of $50,000,000 of debentures and to a lesser extent the exercise of warrants to purchase $1,289,000 of additional 9% debentures, which also increase the interest costs a lot.Therefore, the firm has less liquidity and financial flexiblity.

With the completion of the CIS system, Anacomp may choose to buy back it, thus having the difficulties to raise fund. Anacomp also needs to pay a lot of interest expenses and loans. So there are risks for its liquidity. 10. What is your overall assessment of Anacomps future? Do you think Anacomps investors should be worried about the companys viability? Overall, the Anacomps future should be bright. Although it has less financial flexibility at 1982, there are explainations for that and most are related to the future development of the firm. The firm has reasonable long term perspect and strategy. Investors do not need to be too worried about the viability. The competition in the industry for Anacomp is rather fierce, it need to be innovative and always get something changed. However, if the change is too big and without convincible reasons, investors have to care about that.