Financial Planning and Forecasting Brigham Solution

Chapter 15 Financial Planning and Forecasting LEARNING OBJECTIVES

After reading this chapter, students should be able to:

•

Briefly explain the following terms: scope, corporate purpose, corporate strategies.

•

Briefly explain what operating plans are.

•

Identify the six steps in the financial planning process.

•

List the advantages of computerized “pencil-and-paper” calculations.

•

Discuss the importance of sales forecasts in the financial planning process, and why managers construct pro forma financial statements.

•

Briefly explain the steps involved in the percent of sales method.

•

Calculate additional funds needed (AFN), using both financial statement approach and the formula method.

•

Identify other techniques for forecasting financial discussed in the text and explain when they should be used.

mission statement, objectives, and

financial

planning

corporate corporate

models

the

over

projected statements

Learning Objectives: 15 - 1

LECTURE SUGGESTIONS

In Chapter 3, we looked at where the firm has been and where it is now--its current strengths and weaknesses. Now, in Chapter 15, we look at where it is projected to go in the future. The details of what we cover, and the way we cover it, can be seen by scanning Blueprints, Chapter 15. For other suggestions about the lecture, please see the “Lecture Suggestions” in Chapter 2, where we describe how we conduct our classes. DAYS ON CHAPTER:

3 OF 58 DAYS (50-minute periods)

Lecture Suggestions: 15 - 2

ANSWERS TO END-OF-CHAPTER QUESTIONS

15-1

Accounts payable, accrued wages, and accrued taxes spontaneously and proportionately with sales. Retained increase, but not proportionately.

increase earnings

15-2

The equation gives good forecasts of financial requirements if the ratios A*/S0 and L*/S0, as well as M and RR, are stable. Otherwise, another forecasting technique should be used.

15-3

False. At low growth rates, internal financing will take care of the firm’s needs.

15-4

False.

15-5

a. +.

The use of computerized planning models is increasing.

b. -. The firm needs less manufacturing facilities, raw materials, and work in process. c. +. It reduces spontaneous increase retained earnings.

funds;

however,

it

may

eventually

d. +. e. +. f. Probably +. This should stimulate sales, so it may be offset in part by increased profits. g. 0. h. +.

Answers and Solutions: 15 - 3

SOLUTIONS TO END-OF-CHAPTER PROBLEMS

15-1

AFN = (A*/S0)∆S - (L*/S0)∆S - MS1(RR)  $3,000,000  $500,000  =   $1,000,000 -   $1,000,000 $5,000,000  $5,000,000   - 0.05($6,000,000)(0.3) = (0.6)($1,000,000) - (0.1)($1,000,000) - ($300,000)(0.3) = $600,000 - $100,000 - $90,000 = $410,000.

15-2

AFN = 

 $4,000,000  00,000)- ($300,000) (0.3)  $1,000,000- (0.1)($1,0  $5,000,000 

= (0.8)($1,000,000) - $100,000 - $90,000 = $800,000 - $190,000 = $610,000. The capital intensity ratio is measured as A*/S0. This firm’s capital intensity ratio is higher than that of the firm in Problem 15-1; therefore, this firm is more capital intensive--it would require a large increase in total assets to support the increase in sales. 15-3

AFN = (0.6)($1,000,000) - (0.1)($1,000,000) - 0.05($6,000,000)(1) = $600,000 - $100,000 - $300,000 = $200,000. Under this scenario the company would have a higher level of retained earnings, which would reduce the amount of additional funds needed.

15-4

Sales = $300,000,000; gSales = 12%; Inv. = $25 + 0.125(Sales). S1 = $300,000,000 × 1.12 = $336,000,000. Inv. = $25 + 0.125($336) = $67 million. Sales/Inv. = $336,000,000/$67,000,000 ≈ 5.0149 = 5.01.

15-5 Sales = $5,000,000,000; FA = $1,700,000,000; FA are operated at 90% capacity. a. Full capacity sales = $5,000,000,000/0.90 = $5,555,555,556. b. Target FA/S ratio = $1,700,000,000/$5,555,555,556 = 30.6%. Answers and Solutions: 15 - 4

c. Sales increase 12%; ∆FA = ? S1 = $5,000,000,000 × 1.12 = $5,600,000,000. No increase in FA up to $5,555,555,556. ∆FA = 0.306 × ($5,600,000,000 - $5,555,555,556) = 0.306 × ($44,444,444) = $13,600,000. 15-6

a. Sales Oper. costs EBIT Interest EBT Taxes (40%) Net income

2002 $700 500 $200 40 $160 64 $ 96

Dividends (33.33%) Addit. to R/E

$ 32 $ 64

Forecast Basis × 1.25 × 0.70 Sales

2003 $875.00 612.50 $262.50 40.00 $222.50 89.00 $133.50 $ 44.50 $ 89.00

b. ∆Dividends = ($44.50 - $32.00)/$32.00 = 39.06%. 15-7 Sales Oper.costs excluding depreciation EBITDA Depreciation EBIT Interest EBT Taxes (40%) Net income

15-8

a.

Actual $3,000

Forecast Basis × 1.10

2,450 550 250 $ 300 125 $ 175 70 $ 105

× 0.80 Sales

$

× 0.0833 Sales

Pro Forma $3,300 2,640 660 275 $ 385 125 $ 260 104 $ 156 $

T o t a l i a b i l i st i e Acco untspay able+ Lon g-ter m debt . a n de q u i t y = + Co mmonstock + R etaine de arnings $1,200,000 = $375,000 + Long-term debt + $425,000 + $295,000 Long-term debt = $105,000. Total debt = Accounts payable + Long-term debt = $375,000 + $105,000 = $480,000. Alternatively, Total debt =

Total l i a b i l i st i-e Common stock – Retained earnings a n de q u i t y Answers and Solutions: 15 - 5

= $1,200,000 - $425,000 - $295,000 = $480,000. b. Assets/Sales (A*/S0) = $1,200,000/$2,500,000 = 48%. L*/Sales (L*/S0) = $375,000/$2,500,000 = 15%. 2003 Sales = (1.25)($2,500,000) = $3,125,000. ∆S = $3,125,000 - $2,500,000 = $625,000. AFN = (A*/S0)(∆S) - (L*/S0)(∆S) - MS1(RR) - New common stock = (0.48)($625,000) - (0.15)($625,000) - (0.06)($3,125,000)(0.6) - $75,000 = $300,000 - $93,750 - $112,500 - $75,000 = $18,750. Alternatively, using the percent of sales method:

Total assets Current liabilities Long-term debt Total debt Common stock Retained earnings Total common equity Total liabilities and equity

Forecast Basis × Additions (New 2003 2002 2003 Sales Financing, R/E) Pro Forma $1,200,000 0.48 $1,500,000 $ $ $

375,000 105,000 480,000 425,000 295,000 720,000

0.15

$ 75,000* 112,500**

$1,200,000

$ $

468,750 105,000 573,750 500,000 407,500 907,500

$1,481,250

AFN = New long-term debt =

18,750

*Given in problem that firm will sell new common stock = $75,000. **PM = 6%; RR = 60%; NI2003 = $2,500,000 × 1.25 × 0.06 = $187,500. Addition to RE = NI × RR = $187,500 × 0.6 = $112,500.

15-9

S2002 = $2,000,000; A2002 = $1,500,000; CL2002 = $500,000; NP2002 = $200,000; A/P2002 = $200,000; Accrued liabilities2002 = $100,000; A*/S0 = 0.75; PM = 5%; RR = 40%; ∆S? AFN = (A*/S0)∆S - (L*/S0)∆S - MS1(RR)  $300,000  = (0.75)∆S -   ∆S -(0.05)(S1)(0.4)  $2,000,000 = (0.75)∆S - (0.15)∆S - (0.02)S1 = (0.6)∆S - (0.02)S1 = 0.6(S1 - S0) - (0.02)S1 = 0.6(S1 - $2,000,000) - (0.02)S1 = 0.6S1 - $1,200,000 - 0.02S1 $1,200,000 = 0.58S1 $2,068,965.52 = S1.

Answers and Solutions: 15 - 6

$

Sales can increase by $2,068,965.52 - $2,000,000 = $68,965.52 without additional funds being needed.

Answers and Solutions: 15 - 7

15-10 Sales = $320,000,000; gSales = 12%; Rec. = $9.25 + 0.07(Sales). S1 = $320,000,000 × 1.12 = $358,400,000. Rec. = $9.25 + 0.07($358.4) = $34.338 million. DSO = Rec./(Sales/365) = $34,338,000/($358,400,000/365) = 34.97 days ≈ 35 days. 15-11 Sales = $110,000,000; gSales = 5%; Inv. = $9 + 0.0875(Sales). S1 = $110,000,000 × 1.05 = $115,500,000. Inv. = $9 + 0.0875($115.5) = $19.10625 million. Sales/Inv. = $115,500,000/$19,106,250 = 6.0451. 15-12 a. Sales = $2,000,000,000; FA = $600,000,000; FA are operated at 80 capacity.

F u l lc a p a c i t y = Actual sales/(% of capacity at which FA are operated) sales = $2,000,000,000/0.80 = $2,500,000,000. b. Target FA/Sales ratio = $600,000,000/$2,500,000,000 = 0.24 = 24.0%. c. Sales increase 30%; ∆FA = ? S1 = $2,000,000,000 × 1.30 = $2,600,000,000. No increase in FA up to $2,500,000,000. ∆FA = 0.24 × ($2,600,000,000 − $2,500,000,000) = 0.24 × $100,000,000 = $24,000,000. 15-13 a. Sales Operating costs EBIT Interest EBT Taxes (40%) Net income Answers and Solutions: 15 - 8

2002 $1,528 933 $ 595 95 $ 500 200 $ 300

× ×

Forecast Basis 1.20 0.60 Sales

2003 $1,833.60 1,100.16 $ 733.44 95.00 $ 638.44 255.38 $ 383.06

Dividends (25%) $ 75 $ 95.77 Addition to retained earnings $ 225 $ 287.29 b. From the first question we know that the new dividend amount is $95.77. ∆Dividends = ($95.77 − $75.00)/$75.00 = 0.2769 = 27.69%. 15-14 a. AFN = (A*/S0)(∆S) - (L*/S0)(∆S) - MS1(RR)

=

$ $1 11 20 72 .. . 555 ( - ( -$ ( $ ) 7 $ 7 0 4 0 ) 2 ) 0 ) ( 0 . 6 $ $ 3 $ 35 35 0 5 0 0 = $13.44 million.

b.

Tozer Computers Pro Forma Balance Sheet December 31, 2003 (Millions of Dollars) 2003 Pro

Forecast Forma Basis

×

2003

after 2002

2003 Sales

Additions

Pro Forma

Financing

Financing Cash

$

3.5

0.01

$

4.20

$

4.20 Receivables

26.0

0.0743

31.20

Inventories

58.0

0.1657

69.60

31.20 69.60 Total current assets

$ 87.5

$105.00

$105.00 Net

fixed

assets

35.0

0.1000

42.00

42.00 Total

assets

$122.5

$147.00

$147.00 Accounts payable $

9.0

0.0257

Notes payable

18.0

$ 10.80

$

10.80 18.00

+13.44

31.44 Accrued

liab.

8.5

0.0243

10.20

10.20 Total current liabilities

$ 35.5

$ 39.00

$

52.44 Mortgage

loan

6.0

6.00

15.0

15.00

6.00 Common

stock

15.00 Retained

earnings

66.0

7.56*

73.56

73.56 Total liab.

Answers and Solutions: 15 - 9

and

equity

$122.5

$133.56

$147.00 AFN = *PM = $10.5/$350 = 3%. ( $ 1 0 . 5− $ 4 . 2 ) RR = = 60%. $1 0.5 NI = $350 × 1.2 × 0.03 = $12.6. Addition to RE = NI × RR = $12.6 × 0.6 = $7.56.

$ 13.44

c. Current ratio = $105/$52.44 = 2.00× . The current ratio is poor compared to 2.5× in 2002 and the industry average of 3× . Debt/Total assets = $58.44/$147 = 39.8%. The debt-to-total assets ratio is too high compared to 33.9 percent in 2002 and a 30 percent industry average.

(Profitmargin)(Sa les) R a t eo f r e t u r n = on equity Stock + Retainedearnings =

N ie nt $ c 1 o 2 m . e 6 0 = =1 4 . 2 % . E q u$ i8 t8 y. 5 6

The rate of return on equity is good compared to 13 percent in 2002 and a 12 percent industry average. d. 1.

$17.5 F i n a nci a l $122.5 re q u i re m etns = $350 ($70) - $350 ($70) = - (0.03)(0.6)($364 + $378 + $392 + $406 + $420) = $24.5 - $3.5 - $35.28 = -$14.28 million surplus funds.

2.

Tozer Computers Pro Forma Balance Sheet December 31, 2007 (Millions of Dollars)

Forma Financing

2007 Pro

Forecast Basis × 2002 2007 Sales

2007 Additions

Total curr. assets $ 87.50 Net fixed assets 35.00 Total assets $122.50

0.25 0.10

$105.00 42.00 $147.00

Accounts payable Notes payable Accrued liab. Total current

0.0257

$ 10.80 18.00 10.20

Answers and Solutions: 15 - 10

$

9.00 18.00 8.50

0.0243

Pro Forma

after Financing $105.00 42.00 $147.00

-14.28

$ 10.80 3.72 10.20

liabilities Mortgage loan Common stock Retained earnings Total liab. and equity AFN =

$ 35.50 6.00 15.00 66.00 $122.50

$35.28*

$ 39.00 6.00 15.00 101.28

$ 24.72 6.00 15.00 101.28

$161.28

$147.00

-$14.28

*PM = 3%; Payout = 40%. NI = 0.03 × ($364 + $378 + $392 + $406 + $420) = $58.8. Addition to RE = NI × RR = $58.8 × 0.6 = $35.28. 3. Current ratio = $105/$24.72 = 4.25× (good). Debt/Total assets = $30.72/$147 = 20.9% (good). Return on equity = $12.6/$116.28 = 10.84% (low).* *The rate of return declines because of the decrease in the ratio. The firm might, with this slow growth, consider increase. A dividend increase would reduce future increases earnings, and in turn, common equity, which would help boost

debt/assets a dividend in retained the ROE.

e. Tozer probably could carry out either the slow growth or fast growth plan, but under the fast growth plan (20 percent per year), the risk ratios would deteriorate, indicating that the company might have trouble with its bankers and would be increasing the odds of bankruptcy.

Answers and Solutions: 15 - 11

C u r r e n ts a l e s $36,000 Full 15-15 a. c a p a c i t y= % o f c a p a c i t a = $48,000. y t w h i c h = 0.75 sales F A w e r eo p e r a t e d % increase =

$48,000 - $36,000 New sales - Old sales = = 0.33 = 33%. $36,000 Old sales

Therefore, sales could expand by 33 percent before the firm would need to add fixed assets. b.

Krogh Lumber Pro Forma Income Statement December 31, 2003 (Thousands of Dollars)

Sales Operating costs EBIT Interest EBT Taxes (40%) Net income

2002 $36,000 30,783 $ 5,217 1,017 $ 4,200 1,680 $ 2,520

Dividends (60%) Addition to RE

$ 1,512 $ 1,008

Forecast Basis 1.25 0.8551

2003 Pro Forma $45,000 38,479 $ 6,521 1,017 $ 5,504 2,202 $ 3,302 $ 1,981 $ 1,321

Krogh Lumber Pro Forma Balance Sheet December 31, 2003 (Thousands of Dollars)

2002 Cash

Forecast Basis × 2003 Sales Additions

$ 1,800

0.05

2003 1st Pass

AFN

$ 2,250

2003 2nd Pass $

2,250 Receivables

10,800

0.30

13,500

Inventories

12,600

0.35

15,750

13,500 15,750 Total current assets

$25,200

$31,500

$31,500 Net fixed assets

21,600

21,600*

$46,800

$53,100

21,600 Total assets $53,100 Accounts payable 9,000 Notes payable

$ 7,200

0.20

$ 9,000

3,472

3,472

$ +2,549

6,021 Accrued liab. 3,150

Answers and Solutions: 15 - 12

2,520

0.07

3,150

Total current liabilities

$13,192

$15,622

5,000

5,000

$18,171 Mortgage bonds 5,000 Common stock

2,000

2,000

2,000 Retained

earnings

26,608

1,321**

27,929

27,929 Total liabilities and equity

$46,800

$50,551

$53,100 AFN =

$ 2,549

*From Part a we know that sales can increase by 33% before additions to fixed assets are needed. **See income statement. c. The rate of return projected for 2003 under the conditions in Part b is (calculations in thousands): ROE =

$3,302 $29,929

= 11.03%.

If the firm attained the industry average DSO and inventory turnover ratio, this would mean a reduction in financial requirements of: Receivables:

A/R = 90 $45,000/365 New A/R = $11,096.

∆ in A/R = $13,500 - $11,096 = $2,404. Inventory:

$45,000 = 3.33; Inv. = $13,500. Inv.

∆ in Inv. = $15,750 - $13,500 = $2,250. Total ∆ in assets = $2,404 + $2,250 = $4,654. If this freed-up capital was used to reduce equity, then common equity would be $29,929 - $4,654 = $25,275. Assuming no change in net income, the new ROE would be: ROE =

$3,302 $25,275

= 13.06%.

One would, in a real analysis, want to consider both the feasibility of maintaining sales if receivables and inventories were reduced and also other possible effects on the profit margin. Also, note that the current ratio was $25,200/$13,192 = 1.91 in 2002. It is projected to decline in Part b to $31,500/$18,171 = 1.73, and the latest change would cause a further reduction to ($31,500 - $4,654)/ Answers and Solutions: 15 - 13

$18,171 = 1.48. Creditors might not tolerate such a reduction in liquidity and might insist that at least some of the freed-up capital be used to reduce notes payable. Still, this would reduce interest charges, which would increase the profit margin, which would in turn increase the ROE. Management should always consider the possibility of changing ratios as part of financial projections.

Answers and Solutions: 15 - 14

15-16 a.

Morrissey Technologies Inc. Pro Forma Income Statement December 31, 2003

Sales Operating Costs EBIT Interest EBT Taxes (40%) Net income

2002 $3,600,000 3,279,720 $ 320,280 20,280 $ 300,000 120,000 $ 180,000

Dividends: $1.08 × 100,000 = Addition to RE:

$ $

Forecast Basis 1.10 0.9110

108,000 72,000

2003 Pro Forma $3,960,000 3,607,692 $ 352,308 20,280 $ 332,028 132,811 $ 199,217 $ $

112,000* 87,217

*2003 Dividends = $1.12 × 100,000 = $112,000.

Morrissey Technologies Inc. Pro Forma Balance Statement December 31, 2003

Cash Receivables Inventories Total current assets Fixed assets Total assets Accounts payable Notes payable Accrued liab. Total current liabilities Common stock Retained earnings Total liab. and equity AFN =

$

Forecast Basis × 2002 2003 Sales 180,000 0.05 360,000 0.10 720,000 0.20

Additions

2003 Pro Forma $ 198,000 396,000 792,000

$1,260,000 1,440,000 $2,700,000

0.40

$1,386,000 1,584,000 $2,970,000

$

0.10

$

360,000 156,000 180,000 696,000 1,800,000 204,000

0.05

$

$2,700,000

396,000 156,000 198,000

$

750,000 1,800,000 291,217

87,217*

$2,841,217 $

128,783

*See income statement.

Answers and Solutions: 15 - 15

b.

AFN = $2,700,000/$3,600,000(∆Sales) - ($360,000 + $180,000)/$3,600,000(∆Sales) - (0.05)($3,600,000 + ∆Sales)0.4 $0 = 0.75(∆Sales) - 0.15(∆Sales) - 0.02(∆Sales) - $72,000 $0 = 0.58(∆Sales) - $72,000 $72,000 = 0.58(∆Sales) ∆Sales = $124,138.

Growth rate in sales =

15-17 a. & b.

∆ S a l$ e1 s2 4 , 1 3 8 = =3 . 4 5 % . $ 3 ,$6 30,06, 00 00,00 0 0

Lewis Company Pro Forma Income Statement December 31, 2003 (Thousands of Dollars) 2002

Forecast Basis

2003 Pro

Forma Sales Operating costs EBIT Interest EBT Taxes (40%) Net income

$8,000 7,450 $ 550 150 $ 400 160 $ 240

Dividends: $1.04 × 150 = $ Addition to R.E.: $

Answers and Solutions: 15 - 16

156 84

1.2 0.9313

$9,600 8,940 $ 660 150 $ 510 204 $ 306

$1.10 × 150 =

$ 165 $ 141

Lewis Company Pro Forma Balance Sheet December 31, 2003 (Thousands of Dollars)

2002 Cash Receivables Inventories Total current assets Fixed assets Total assets

$

Forecast 1st Basis × Pass 2003 Sales Additions 2003

80 240 720

0.010 0.030 0.090

$1,040 3,200 $4,240

0.400

Accounts payable 160 Accrued liab. 40 Notes payable 252 Total current liabilities $ 452 Long-term debt 1,244 Total debt $1,696 Common stock 1,605 Retained earnings 939 Total liabilities and equity $4,240

$

0.020 0.005

96 288 864

96 288 864

$1,248 3,840 $5,088

$

$

192 48 252

492 1,244 $1,736 1,605 1,080 $4,421

AFN =

$

$1,248 3,840 $5,088

$

141*

2nd AFN Pass Effects 2003

$

+ 51**

192 48 303

$

543 1,492 $2,035 +368** 1,973 1,080 +248**

$5,088

667

*See income statement. **CA/CL = 2.3; D/A = 40%. Maximum total debt = 0.4 × $5,088 = $2,035. Maximum increase in debt = $2,035 - $1,736 = $299. Maximum current liabilities = $1,248/2.3 = $543. Increase in notes payable = $543 - $492 = $51. Increase in long-term debt = $299 - $51 = $248. Increase in common stock = $667 - $299 = $368.

Answers and Solutions: 15 - 17

SPREADSHEET PROBLEM

15-18 The detailed solution for the spreadsheet problem is available both on the instructor’s resource CD-ROM and on the instructor’s side of SouthWestern’s web site, http://brigham.swlearning.com.

INTEGRATED CASE

New World Chemicals Inc. Financial Forecasting 15-19

SUE WILSON, THE NEW FINANCIAL MANAGER OF NEW WORLD CHEMICALS (NWC), A

CALIFORNIA

PRODUCER

OF

SPECIALIZED

CHEMICALS

FOR

USE

ORCHARDS, MUST PREPARE A FINANCIAL FORECAST FOR 2003. SALES

IN

FRUIT

NWC’S 2002

WERE

$2 BILLION, AND THE MARKETING DEPARTMENT IS FORECASTING A 25 PERCENT INCREASE FOR 2003.

WILSON THINKS THE COMPANY WAS OPERATING AT FULL

CAPACITY

BUT

IN

2002,

SHE

IS

NOT

SURE

ABOUT

THIS.

THE

2002

FINANCIAL STATEMENTS, PLUS SOME OTHER DATA, ARE GIVEN IN TABLE IC151.

TABLE IC15-1. FINANCIAL STATEMENTS AND OTHER DATA ON NWC (MILLIONS OF DOLLARS) A.

2002 BALANCE SHEET CASH & SECURITIES $ ACCOUNTS RECEIVABLE INVENTORIES TOTAL CURRENT ASSETS $ NET FIXED ASSETS TOTAL ASSETS

B.

20 240 240 500

500 $1,000

ACCT PAYABLE & ACCRUED LIAB. NOTES PAYABLE TOTAL CURRENT LIABILITIES LONG-TERM DEBT COMMON STOCK RETAINED EARNINGS TOTAL LIABILITIES AND EQUITY

2002 INCOME STATEMENT SALES LESS: VARIABLE COSTS FIXED COSTS EARNINGS BEFORE INTEREST AND TAXES (EBIT) INTEREST EARNINGS BEFORE TAXES (EBT) TAXES (40%) NET INCOME

$2,000.00 1,200.00 700.00 $ 100.00 16.00 $ 84.00 33.60 $ 50.40

DIVIDENDS (30%) ADDITION TO RETAINED EARNINGS

$ $

$

100 100 $ 200 100 500 200 $1,000

15.12 35.28

Integrated Case: 15 - 19

Integrated Case: 15 - 20

C.

KEY RATIOS BASIC EARNING POWER PROFIT MARGIN RETURN ON EQUITY DAYS SALES OUTSTANDING (365 DAYS) INVENTORY TURNOVER FIXED ASSETS TURNOVER TOTAL ASSETS TURNOVER DEBT/ASSETS TIMES INTEREST EARNED CURRENT RATIO PAYOUT RATIO

NWC 10.00% 2.52 7.20 43.80 DAYS 8.33× 4.00 2.00 30.00% 6.25× 2.50 30.00%

INDUSTRY 20.00% 4.00 15.60 32.00 DAYS 11.00× 5.00 2.50 36.00% 9.40× 3.00 30.00%

COMMENT

ASSUME THAT YOU WERE RECENTLY HIRED AS WILSON’S ASSISTANT, AND YOUR FIRST MAJOR TASK IS TO HELP HER DEVELOP THE FORECAST.

SHE

ASKED YOU TO BEGIN BY ANSWERING THE FOLLOWING SET OF QUESTIONS. A.

ASSUME (1) THAT NWC WAS OPERATING AT FULL CAPACITY IN 2002 WITH RESPECT TO ALL ASSETS, (2) THAT ALL ASSETS MUST GROW PROPORTIONALLY WITH SALES, (3) THAT ACCOUNTS PAYABLE AND ACCRUED LIABILITIES WILL ALSO GROW IN PROPORTION TO SALES, AND (4) THAT THE 2002 PROFIT MARGIN

AND

DIVIDEND

PAYOUT

WILL

BE

MAINTAINED.

UNDER

THESE

CONDITIONS, WHAT WILL THE COMPANY’S FINANCIAL REQUIREMENTS BE FOR THE COMING YEAR? ANSWER:

USE THE AFN EQUATION TO ANSWER THIS QUESTION.

[SHOW S15-1 THROUGH S15-6 HERE.]

NWC WILL NEED $180.9 MILLION.

HERE IS THE AFN EQUATION: AFN = (A*/S0)∆S - (L*/S0)∆S - M(S1)(RR) = (A*/S0)(g)(S0) - (L*/S0)(g)(S0) - M(S0)(1 + g)(RR) = ($1,000/$2,000)(0.25)($2,000) - ($100/$2,000)(0.25)($2,000) - 0.0252($2,000)(1.25)(0.7) = $250 - $25 - $44.1 = $180.9 MILLION.

B.

NOW ESTIMATE THE 2003 FINANCIAL REQUIREMENTS USING THE PROJECTED FINANCIAL STATEMENT APPROACH.

DISREGARD THE ASSUMPTIONS IN PART A,

AND NOW ASSUME (1) THAT EACH TYPE OF ASSET, AS WELL AS PAYABLES, ACCRUED

LIABILITIES,

AND

FIXED

AND

VARIABLE

COSTS,

GROW

IN

PROPORTION TO SALES; (2) THAT NWC WAS OPERATING AT FULL CAPACITY; (3) THAT THE PAYOUT RATIO IS HELD CONSTANT AT 30 PERCENT; AND (4) Integrated Case: 15 - 21

THAT EXTERNAL FUNDS NEEDED ARE FINANCED 50 PERCENT BY NOTES PAYABLE AND 50 PERCENT BY LONG-TERM DEBT. (NO NEW COMMON STOCK WILL BE ISSUED.) ANSWER:

[SHOW S15-7 THROUGH S15-14 HERE.]

SEE THE COMPLETED WORKSHEET.

THE

PROBLEM IS NOT DIFFICULT TO DO “BY HAND,” BUT WE USED A SPREADSHEET MODEL FOR THE FLEXIBILITY SUCH A MODEL PROVIDES. PREDICTED g: ACTUAL g: INCOME STATEMENT: SALES LESS: VC(% SALES) FC(% SALES) EBIT INTEREST (8%) EBT TAXES NET INCOME

25.00% 25.00%

60.00% 35.00%

DIVIDENDS ADD’N TO R.E.

40.0% 30.0%

2002 ACTUAL

2003 PRO FORMA

$2,000.00 (1,200.00) (700.00) $ 100.00 (16.00) $ 84.00 (33.60) $ 50.40

$2,500.00 (1,500.00) (875.00) $ 125.00 (16.00) $ 109.00 (43.60) $ 65.40

$ $

$ $

15.12 35.28

19.62 45.78

BALANCE SHEET: 2002 ACTUAL

2003 1ST PASS

CASH & SECURITIES ACCOUNTS RECEIVABLE INVENTORIES CURRENT ASSETS NET FA (% CAP) 100.0% TOTAL ASSETS

$

20.00 240.00 240.00 $ 500.00 500.00 $1,000.00

$

A/P AND ACCRUED LIAB. N/P (SHORT-TERM) L-T DEBT COMMON STOCK RETAINED EARNINGS TOTAL LIAB & EQUITY

$

$

100.00 100.00 100.00 500.00 200.00 $1,000.00

AFN AFN FINANCING: N/P L-T DEBT COMMON STOCK

Integrated Case: 15 - 22

25.00 300.00 300.00 $ 625.00 625.00 $1,250.00 125.00 100.00 100.00 500.00 245.78 $1,070.78 $

WEIGHTS 0.50 0.50 0.00 1.00

179.22 DOLLARS $ 89.61 89.61 0.00 $179.22

2003 2ND PASS

AFN $

25.00 300.00 300.00 $ 625.00 625.00 $1,250.00 $ 89.61 89.61

125.00 189.61 189.61 500.00 245.78 $1,250.00

Integrated Case: 15 - 23

AFN EQUATION FORECAST: AFN = (A*/S0) × g × S0 - (L*/S0) × g × S0 - M × S1 × RR = $250 - $25 - $44.1 = $180.9 VERSUS BALANCE SHEET FORECAST OF $179.22.

C.

WHY DO THE TWO METHODS PRODUCE SOMEWHAT DIFFERENT AFN FORECASTS? WHICH METHOD PROVIDES THE MORE ACCURATE FORECAST?

ANSWER:

[SHOW S15-15 HERE.]

THE DIFFERENCE OCCURS BECAUSE THE AFN EQUATION

METHOD ASSUMES THAT THE PROFIT MARGIN REMAINS CONSTANT, WHILE THE FORECASTED BALANCE SHEET METHOD PERMITS THE PROFIT MARGIN TO VARY. THE BALANCE SHEET METHOD IS SOMEWHAT MORE ACCURATE (ESPECIALLY WHEN ADDITIONAL PASSES ARE MADE AND FINANCING FEEDBACKS ARE CONSIDERED), BUT

IN

THIS

CASE

THE

DIFFERENCE

IS

NOT

VERY

LARGE.

THE

REAL

ADVANTAGE OF THE BALANCE SHEET METHOD IS THAT IT CAN BE USED WHEN EVERYTHING

DOES

NOT

INCREASE

PROPORTIONATELY

WITH

SALES.

IN

ADDITION, FORECASTERS GENERALLY WANT TO SEE THE RESULTING RATIOS, AND THE BALANCE SHEET METHOD IS NECESSARY TO DEVELOP THE RATIOS. IN PRACTICE, THE ONLY TIME WE HAVE EVER SEEN THE AFN EQUATION USED

IS

TO

PROVIDE

(1)

A

“QUICK

AND

DIRTY”

FORECAST

PRIOR

TO

DEVELOPING THE BALANCE SHEET FORECAST AND (2) A ROUGH CHECK ON THE BALANCE SHEET FORECAST.

D.

CALCULATE

NWC’S

FORECASTED

RATIOS,

AND

COMPARE

THEM

COMPANY’S 2002 RATIOS AND WITH THE INDUSTRY AVERAGES.

WITH

THE

HOW DOES NWC

COMPARE WITH THE AVERAGE FIRM IN ITS INDUSTRY, AND IS THE COMPANY EXPECTED TO IMPROVE DURING THE COMING YEAR?

Integrated Case: 15 - 24

ANSWER:

[SHOW S15-16 HERE.]

KEY RATIOS: NWC

BASIC EARNING POWER PROFIT MARGIN ROE DAYS SALES OUTSTANDING (365 DAYS) INVENTORY TURNOVER FIXED ASSETS TURNOVER TOTAL ASSETS TURNOVER DEBT/ASSETS TIMES INTEREST EARNED CURRENT RATIO PAYOUT RATIO

2002 10.00% 2.52 7.20 43.80 DAYS 8.33× 4.00 2.00 30.00% 6.25× 2.50 30.00%

2003(E) 10.00% 2.62 8.77 43.80 DAYS 8.33× 4.00 2.00 40.34% 7.81× 1.99 30.00%

INDUSTRY 2002 20.00% 4.00 15.60 32.00 DAYS 11.00× 5.00 2.50 36.00% 9.40× 3.00 30.00%

NWC’S BEP, PROFIT MARGIN, AND ROE ARE ONLY ABOUT HALF AS HIGH AS THE INDUSTRY AVERAGE--NWC IS NOT VERY PROFITABLE RELATIVE TO OTHER FIRMS IN ITS INDUSTRY. TURNOVER

RATIO

IS

FURTHER, ITS DSO IS TOO HIGH, AND ITS INVENTORY TOO

LOW,

WHICH

INDICATES

CARRYING EXCESS INVENTORY AND RECEIVABLES.

THAT

THE

COMPANY

IS

IN ADDITION, ITS DEBT

RATIO IS FORECASTED TO MOVE ABOVE THE INDUSTRY AVERAGE, AND ITS COVERAGE RATIO IS LOW.

THE COMPANY IS NOT IN GOOD SHAPE, AND THINGS

DO NOT APPEAR TO BE IMPROVING.

E.

CALCULATE NWC’S FREE CASH FLOW FOR 2003.

ANSWER:

[SHOW S15-17 AND S15-18 HERE.] OPERATING CAPITAL2002 = NOWC + NFA = ($500 - $100) + $500 = $900. OPERATING CAPITAL2003 = NOWC + NFA = ($625 - $125) + $625 = $1,125. NET INVESTMENT IN OPERATING CAPITAL = $1,125 - $900 = $225.

Integrated Case: 15 - 25

FCF = NOPAT - NET INVESTMENT IN OPERATING CAPITAL = EBIT(1 - T) - NET INVESTMENT IN OPERATING CAPITAL = $125(0.6) - $225 = $75 - $225 = -$150.

F.

SUPPOSE YOU NOW LEARN THAT NWC’S 2002 RECEIVABLES AND INVENTORIES WERE

IN

LINE

WITH

REQUIRED

LEVELS,

GIVEN

THE

FIRM’S

CREDIT

AND

INVENTORY POLICIES, BUT THAT EXCESS CAPACITY EXISTED WITH REGARD TO FIXED ASSETS. SPECIFICALLY, FIXED ASSETS WERE OPERATED AT ONLY 75 PERCENT OF CAPACITY. 1. WHAT LEVEL OF SALES COULD HAVE EXISTED IN 2002 WITH THE AVAILABLE FIXED ASSETS?

WHAT WOULD THE FIXED ASSETS-TO-SALES RATIO HAVE BEEN

IF NWC HAD BEEN OPERATING AT FULL CAPACITY? ANSWER:

[SHOW S15-19 HERE.]

FULL CAPACITY SALES =

A C T S U A A LL E S $ 2 , 0 0 0 = =$ 2 , 6 6 7 . % O FC A P AA CTW IH TI YC H0 . 7 5 F I XA ES DS W E ETORSPE E R A T E D

SINCE THE FIRM STARTED WITH EXCESS FIXED ASSET CAPACITY, IT WILL NOT HAVE TO ADD AS MUCH FIXED ASSETS DURING 2003 AS WAS ORIGINALLY FORECASTED:

TARGET FA/SALES RATIO =

F I AX SE SD E T$ S5 0 0 = = 1 8 .. 7 5 % F U C L A L P SA AC LI$ ET2 SY, 6 6 7

THE ADDITIONAL FIXED ASSETS NEEDED WILL BE 0.1875(PREDICTED SALES CAPACITY SALES) IF PREDICTED SALES EXCEED CAPACITY SALES, OTHERWISE NO NEW FIXED ASSETS WILL BE NEEDED.

IN THIS CASE, PREDICTED SALES =

1.25($2,000) = $2,500, WHICH IS LESS THAN CAPACITY SALES, SO THE EXPECTED SALES GROWTH WILL NOT REQUIRE ANY ADDITIONAL FIXED ASSETS.

Integrated Case: 15 - 26

F.

2. HOW WOULD THE EXISTENCE OF EXCESS CAPACITY IN FIXED ASSETS AFFECT THE ADDITIONAL FUNDS NEEDED DURING 2003?

ANSWER:

[SHOW S15-20 AND S15-21 HERE.]

WE HAD PREVIOUSLY FOUND AN AFN OF

$179.22 USING THE BALANCE SHEET METHOD AND $180.9 USING THE AFN FORMULA. $125.

G.

IN BOTH CASES, THE FIXED ASSETS INCREASE WAS 0.25($500) =

THERE-FORE, THE FUNDS NEEDED WILL DECLINE BY $125.

WITHOUT ACTUALLY WORKING OUT THE NUMBERS, HOW WOULD YOU EXPECT THE RATIOS TO CHANGE IN THE SITUATION WHERE EXCESS CAPACITY IN FIXED ASSETS EXISTS?

ANSWER:

EXPLAIN YOUR REASONING.

[SHOW S15-22 AND S15-23 HERE.] RATIOS TO IMPROVE.

WE WOULD EXPECT ALMOST ALL THE

WITH LESS FINANCING, INTEREST EXPENSE WOULD BE

REDUCED. DEPRECIATION AND MAINTENANCE, IN RELATION TO SALES, WOULD DECLINE. THESE CHANGES WOULD IMPROVE THE BEP, PROFIT MARGIN, AND ROE.

ALSO,

THE

TOTAL

ASSETS

TURNOVER

RATIO

WOULD

IMPROVE.

SIMILARLY, WITH LESS DEBT FINANCING, THE DEBT RATIO AND THE CURRENT RATIO WOULD BOTH IMPROVE, AS WOULD THE TIE RATIO. WITHOUT

QUESTION,

THE

COMPANY’S

FINANCIAL

POSITION

WOULD

BE

BETTER. ONE CANNOT TELL EXACTLY HOW LARGE THE IMPROVEMENT WILL BE WITHOUT WORKING OUT THE NUMBERS, BUT WHEN WE WORKED THEM OUT WE OBTAINED THE FOLLOWING NUMBERS: KEY RATIOS

2003 PRO FORMA % OF 2002 CAPACITY 2002

BASIC EARNING POWER PROFIT MARGIN ROE DAYS SALES OUTSTANDING INVENTORY TURNOVER FIXED ASSETS TURNOVER TOTAL ASSETS TURNOVER DEBT/ASSETS TIMES INTEREST EARNED CURRENT RATIO PAYOUT RATIO

10.00% 2.52 7.20 43.80 DAYS 8.33× 4.00 2.00 30.00% 6.25× 2.50 30.00%

75% 11.11% 2.62 8.77 43.80 DAYS 8.33× 5.00 2.22 33.71% 7.81× 2.48 30.00%

100% 10.00% 2.62 8.77 43.80 DAYS 8.33× 4.00 2.00 40.34% 7.81× 1.99 30.00%

Integrated Case: 15 - 27

(NOTE

THAT

FINANCING

FEEDBACKS

HAVE

NOT

BEEN

CONSIDERED

IN

THE

RATIOS ABOVE.)

H.

ON THE BASIS OF COMPARISONS BETWEEN NWC’S DAYS SALES OUTSTANDING (DSO)

AND

FIGURES,

INVENTORY

DOES

IT

TURNOVER

APPEAR

THAT

RATIOS

WITH

NWC

OPERATING

IS

THE

INDUSTRY

EFFICIENTLY

RESPECT TO ITS INVENTORIES AND ACCOUNTS RECEIVABLE? WERE

ABLE

TO

BRING

THESE

RATIOS

INTO

LINE

AVERAGE WITH

IF THE COMPANY

WITH

THE

INDUSTRY

AVERAGES, WHAT EFFECT WOULD THIS HAVE ON ITS AFN AND ITS FINANCIAL RATIOS? ANSWER:

[SHOW S15-24 HERE.]

THE DSO AND INVENTORY TURNOVER RATIO INDICATE

THAT NWC HAS EXCESSIVE INVENTORIES AND RECEIVABLES.

THE EFFECT OF

IMPROVE-MENTS HERE WOULD BE SIMILAR TO THAT ASSOCIATED WITH EXCESS CAPACITY

IN

FIXED

ASSETS.

SALES

COULD

PROPORTIONATE INCREASES IN CURRENT ASSETS.

BE

EXPANDED

WITHOUT

(ACTUALLY, THESE ITEMS

COULD PROBABLY BE REDUCED EVEN IF SALES DID NOT INCREASE.)

THUS,

THE AFN WOULD BE LESS THAN PREVIOUSLY DETERMINED, AND THIS WOULD REDUCE FINANCING AND POSSIBLY OTHER COSTS. THERE

MAY

BE

OTHER

COSTS

ASSOCIATED

AS WE SAW IN CHAPTER 14,

WITH

REDUCING

THE

FIRM’S

INVESTMENT IN ACCOUNTS RECEIVABLE AND INVENTORIES, WHICH WOULD LEAD TO IMPROVEMENTS IN MOST OF THE RATIOS. (THE CURRENT RATIO WOULD DECLINE

UNLESS

THE

FUNDS

FREED

UP

WERE

USED

TO

REDUCE

CURRENT

LIABILITIES, WHICH WOULD PROBABLY BE DONE.) AGAIN, TO GET A PRECISE FORECAST, WE WOULD NEED SOME ADDITIONAL INFORMATION, AND WE WOULD NEED TO MODIFY THE FINANCIAL STATEMENTS.

I.

HOW WOULD CHANGES IN THESE ITEMS AFFECT THE AFN? PAYOUT

RATIO,

(2)

THE

PROFIT

MARGIN,

(3)

THE

(1) THE DIVIDEND CAPITAL

INTENSITY

RATIO, AND (4) IF NWC BEGINS BUYING FROM ITS SUPPLIERS ON TERMS THAT PERMIT IT TO PAY AFTER 60 DAYS RATHER THAN AFTER 30 DAYS.

(CONSIDER

EACH ITEM SEPARATELY AND HOLD ALL OTHER THINGS CONSTANT.) ANSWER:

[SHOW S15-25 HERE.] 1. IF THE PAYOUT RATIO WERE REDUCED, THEN MORE EARNINGS WOULD BE RETAINED, AND THIS WOULD REDUCE THE NEED FOR EXTERNAL FINANCING,

Integrated Case: 15 - 28

OR AFN. NOTE THAT IF THE FIRM IS PROFITABLE AND HAS ANY PAYOUT RATIO LESS THAN 100 PERCENT, IT WILL HAVE SOME RETAINED EARNINGS, SO IF THE GROWTH RATE WERE ZERO, AFN WOULD BE NEGATIVE, i.e., THE FIRM WOULD HAVE SURPLUS FUNDS.

AS THE GROWTH RATE ROSE ABOVE

ZERO, THESE SURPLUS FUNDS WOULD BE USED TO FINANCE GROWTH. SOME GROWTH RATE THE SURPLUS AFN WOULD BE EXACTLY USED UP.

AT THIS

GROWTH RATE WHERE AFN = $0 IS CALLED THE “SUSTAINABLE GROWTH RATE,” AND IT IS THE MAXIMUM GROWTH RATE THAT CAN BE FINANCED WITHOUT OUTSIDE FUNDS, HOLDING THE DEBT RATIO AND OTHER RATIOS CONSTANT. 2. IF THE PROFIT MARGIN GOES UP, THEN BOTH TOTAL AND ADDITION TO RETAINED EARNINGS WILL INCREASE, AND THIS WILL REDUCE THE AMOUNT OF AFN. 3. THE CAPITAL INTENSITY RATIO IS DEFINED AS THE RATIO OF REQUIRED ASSETS TO TOTAL SALES, OR A*/S0.

PUT ANOTHER WAY, IT REPRESENTS

THE DOLLARS OF ASSETS REQUIRED PER DOLLAR OF SALES.

THE HIGHER

THE CAPITAL INTENSITY RATIO, THE MORE NEW MONEY WILL BE REQUIRED TO SUPPORT AN ADDITIONAL DOLLAR OF SALES.

THUS, THE HIGHER THE

CAPITAL INTENSITY RATIO, THE GREATER THE AFN, OTHER THINGS HELD CONSTANT. 4. IF

NWC’S

PAYMENT

TERMS

WERE

INCREASED

FROM

30

TO

60

DAYS,

ACCOUNTS PAYABLE WOULD DOUBLE, IN TURN INCREASING CURRENT AND TOTAL LIABILITIES.

THIS WOULD REDUCE THE AMOUNT OF AFN DUE TO A

DECREASED

WORKING

NEED

FOR

CAPITAL

ON

HAND

TO

PAY

SHORT-TERM

CREDITORS, SUCH AS SUPPLIERS.

Integrated Case: 15 - 29