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Hampton Machine Tool Company

9-280-103 Rev. 12/3/91

SUGGESTED ANSWERS
Rocky Higgins
April 2001

a) Prepare a sources and uses of cash statement for Hampton for the period November 30 –
August 31, 1979.

Sources and Uses of Cash November 30, 1978 – August 31, 1979

SOURCES
Increase in bank debt $1,000
Increase in retained earnings 883
Decrease in cash 961
Increase in customer advances 726
Increase in accounts payable 600
Decrease in accounts receivable 561
Increase in taxes payable 329
Decrease in net fixed assets 92
Decrease in prepaid expenses 20
TOTAL SOURCES OF CASH $5,172

USES
Stock repurchase $3,000
Increase in inventories 2,163
Decrease in accruals 9
TOTAL USES OF CASH $5,172
b) Reflecting on this sources and uses statement, why do you think this profitable company
cannot repay its loan on time? What developments between November and August have
contributed to this situation?

Judging from the sources and uses statement it appears that the sharp increase in inventories is
responsible for the company’s inability to repay its loan. This increase in inventories appears
due to unexpected delay in receiving a critical part.

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c) Based on the information in the case, prepare a projected cash budget for the four months,
September through December 1979.

Projected Cash Budget September 1979 through December 1979.

Receipts September October November December


Collection of receivables* $684 $1,323 $779 $1,604
Bank loan 350
Total cash receipts $684 $1,673 $779 $1,604
Disbursements
Payment of accounts payable** $948 $6009 $600 $600
Other operating outlays 400 400 400 400
Tax payments 181 181
Interest payments – bank loan 15 15 20 20
Principal payments – bank loan 1,350
Dividend payments 150
Total disbursements $1,544 $1,365 $1,020 $2,701
Beginning cash balance $1,559 $699 $1,007 $766
Net cash receipts (disbursements) (860) 308 (241) (1,097)
Ending cash balance $699 $1,007 $766 $(331)
* Assumes a 30-day collection period.
** Assumes a 30-day payables period.
October collections of receivables equals $2,163 minus $840 advance payment. Similarly, the November
collections equals $1,505 minus $726 advance payment.
d) Prepare a projected income statement for the same period, and a pro forma balance sheet as of
December 31, 1979. (Your income statement need not be monthly. You can make one
covering the entire four months.)

Pro Forma Income Statement September – December 1979

Sales $7,537 Projected sales Sept. – December


Cost of sales $5,740 See below
Other expenses 117 See below
Profit before tax $1,680 48% of profit before tax - $35 ITC
Taxes 771
Profit after taxes $909
Dividends 150 Proposed Dec. dividend
Addition to retained earnings $759
Notes:

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Basic accounting relationship: beginning inventory + purchases + other outlays – cost of sales = ending
inventory; solving for cost of sales,
Cost of sales = purchases + other outlays – change in inventory
Cost of sales = $1,320 reduction in WIP inventory + $420 reduction in RM inventory + $2,400 purchases +
$1,600 other outlays
Cost of sales = $5,740.
Other expenses =$47 Depreciation + $70 4 month’s interest = $117.
Depreciation of new machines: $350 straight line for 8 years = $43.75 or $3.65 per month. Depreciation
for September – December = 4 months on old equipment plus 2 months on new equipment = $40 + $7.
The division of expenses between cost of sales and other expenses is immaterial. What matters for this
exercise is the sum of the two.
Pro Forma Balance Sheet December 31, 1979

Cash $(331) Plug.


Accounts receivable 2,265 December sales.
Inventories 3,024 $4,764 - $1,320 reduction in WIP - $420 reduction in RM.
Total current assets $4,958
Gross fixed assets $4,300 $4,010 + $350 capital expenditure.
Acc. Depreciation 3,137 $3,090 + $47 depreciation.
Net fixed assets $1,223
Prepaid expenses 42 Unchanged from 8/31/79.
Total assets $6,223

Accounts payable $600 December purchases.


Accruals 552 Unchanged from 8/31/79.
Taxes payable 888 $479 - $362 tax payments + $771 liability Sept. thru Dec.
Total current liabilities $2,040
Net worth 4,183 $3,424 + $759 retained earnings Sept. thru Dec.
Total liabilities & net worth $6,223

e) Do the cash budgets and pro forma financial statements yield the same results? Why, why
not?
Hint: they should.

Further hint: If you relied on the statement on page 6, “… our engineering estimates indicate
that we expect to earn a profit before taxes and interest of about 23% on sales on these
shipments,” they wont. Consider instead using the following accounting relation in
constructing your income statement.

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Beginning inventory + purchases + other expenses – cost of goods sold = ending inventory

Yes. The plug of -$331,000 equals the December ending cash balance of -$331,000.
f) Is Mr. Cowins correct in his belief that Hampton can repay the loan in December? Does it
appear he might be able to repay the loan early next year?

Hampton appears unable to repay the loan in December. However, if you extend the cash
budget another month through January 1980, it appears the company can repay the loan early
next year.
g) What earnings is Hampton forecasting for 1979? How do these earnings compare to the size
of the bank loan? What are the company’s return on assets and return on equity for 1979?
How large is the company’s potential loan collateral in the form of accounts receivable?
What should Mr. Eckwood do with regard to the loan request?

Projected 1979 earnings $1,823,000. ($914 + 909).


Projected earnings / bank loan 1.35 times (1.823 / 1.35).
1979 ROA 29% (1,823 / 6,223 using end of period assets).
1979 ROE 43.5% (1,823 / 4,183 using end of period net worth).
December accounts receivable / bank loan. 1.67 times (2,265 / 1,350).

Despite Hampton’s inability to repay by year-end, this appears to be a safe loan from the
bank’s perspective. The loan is less than one year’s profits at current operations, returns are
quite high, the company has almost a full year’s backlog at what we are told are profitable
prices, and the company has significant collateral in the form of accounts receivable. We
might note, however, that December receivables are high. There would be less collateral in
other months.

Finally, we might note that Hampton borrowed money from the bank to meet long term needs,
stock repurchase and new equipment. It is asking a lot of a business to repay loans used for
long term purposes within a few months. The bank should not be surprised to find that
Hampton cannot repay the loans as rapidly as originally intended.

I would certainly renew and increase the loan.

h) What were the company’s earnings per share in 1978? What would this number have been
using the number of shares outstanding after the share repurchase?

1978 earnings = $783,000. 1978 shares outstanding = 117,800 (11/78 balance sheet, Common
stock = $1,178,000 and par value is $10 per share.) Earnings per share = $6.65 (783 / 117.8).

After repurchase there were 42,800 shares outstanding. Ignoring any foregone income on the
$2 million of excess cash used to repurchase the shares, EPS would have been $18.29 (783 /
42.8), an impressive 3-fold increase in EPS.

Assuming the $2 million of excess cash used in the repurchase was yielding, say, 8% after tax,
earnings in 1978 would have been $623,000 ($783 - .08 X $2,000) and EPS would be $14.56
(623 / 42.8) still an impressive increase.
i) What were dividends per share in 1978? What dividends per share does Mr. Cowins propose
paying in 1979? Do you agree with Mr. Cowins' proposal to pay a substantial dividend in
December?

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DPS in 1978 were $0.42 ($50,000 / 117,800 shares).

Proposed DPS in 1979 are $5.84 ($250,000 / 42,800) an almost 14-fold increase in dividends
per share.

From the bank’s perspective I think this is a little rich. I would try to get him to reduce or
eliminate the December dividend.