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Financial Planning and Forecasting Brigham Solution

# Financial Planning and Forecasting Brigham Solution

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# 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.

mission statement, objectives, and

corporate corporate

• • • • • • •

Identify the six steps in the financial planning process. List the advantages of computerized “pencil-and-paper” calculations. financial planning models over

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. the projected statements

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

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

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. False. At low growth rates, internal financing will take care of the firm’s needs. False. a. +. b. -. The firm needs less manufacturing facilities, raw materials, and work in process. c. +. It reduces spontaneous increase retained earnings. d. +. e. +. f. Probably +. This should stimulate sales, so it may be offset in part by increased profits. g. 0. h. +. funds; however, it may eventually The use of computerized planning models is increasing.

15-3 15-4 15-5

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 Dividends (33.33%) Addit. to R/E 2002 \$700 500 \$200 40 \$160 64 \$ 96 \$ 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 Actual \$3,000 2,450 550 250 \$ 300 125 \$ 175 70 \$ 105 \$ Forecast Basis × 1.10 × 0.80 Sales × 0.0833 Sales Pro Forma \$3,300 2,640 660 275 \$ 385 125 \$ 260 104 \$ 156 \$

15-8

a.

pay able+ Lon g ter m debt T o t a l i a b i l i s i e Acco unts t . a n de q u i t y = + Co mmonstock + R etaine d arnings e
\$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 s i- Common stock – Retained earnings t e 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: 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** \$ \$ \$ 468,750 105,000 573,750 500,000 407,500 907,500

Total assets Current liabilities Long-term debt Total debt Common stock Retained earnings Total common equity Total liabilities and equity 18,750

\$1,200,000

\$1,481,250 \$

AFN = New long-term debt =
*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. Tozer Computers Pro Forma Balance Sheet December 31, 2003 (Millions of Dollars)
Forecast 2003 Pro Basis × Pro Forma 4.20 2003 Financing \$ 31.20 69.60 \$105.00 0.1000 42.00 \$147.00 \$ 10.80 18.00 8.5 \$ 35.5 6.0 15.0 66.0 7.56* 0.0243 \$ 39.00 \$ +13.44 10.20 \$ 6.00 15.00 73.56

b.

Forma after 2002 Financing Cash 4.20 Receivables 31.20 Inventories 69.60 Total current assets \$105.00 Net 42.00 Total \$147.00 Accounts payable \$ 10.80 Notes payable 31.44 Accrued 10.20 Total current liabilities 52.44 Mortgage 6.00 Common 15.00 Retained 73.56 Total liab. earnings stock loan liab. 18.0 9.0 0.0257 assets \$122.5 fixed assets 35.0 \$ 87.5 58.0 0.1657 26.0 0.0743 \$ 3.5 0.01 2003 Sales

Answers and Solutions: 15 - 9

and \$147.00

equity

\$122.5 \$ 13.44

\$133.56

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.

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 e n = \$350 (\$70) - \$350 (\$70) ts
= - (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)
Forecast Basis × 2002 2007 Sales Total curr. assets \$ 87.50 Net fixed assets 35.00 Total assets \$122.50 Accounts payable Notes payable Accrued liab. Total current \$ 9.00 18.00 8.50 0.25 0.10 0.0257 0.0243 2007 Additions \$105.00 42.00 \$147.00 \$ 10.80 18.00 10.20 -14.28 Pro Forma 2007 Pro after Financing \$105.00 42.00 \$147.00 \$ 10.80 3.72 10.20

Forma Financing

Answers and Solutions: 15 - 10

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 \$161.28 -\$14.28

\$ 24.72 6.00 15.00 101.28 \$147.00

*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

Current ales 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 t w h i c h = = = \$48,000. 0.75 y 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) 2002 \$36,000 30,783 \$ 5,217 1,017 \$ 4,200 1,680 \$ 2,520 \$ 1,512 \$ 1,008 Krogh Lumber Pro Forma Balance Sheet December 31, 2003 (Thousands of Dollars)
Forecast Basis × 2003 Sales Additions 0.05 0.30 0.35 2003 1st Pass \$ 2,250 2003 2nd Pass \$ 13,500 15,750 \$31,500 21,600* \$53,100 0.20 \$ 9,000 3,472 0.07 \$ +2,549 3,150

Sales Operating costs EBIT Interest EBT Taxes (40%) Net income Dividends (60%) Addition to RE

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

2002 Cash 2,250 Receivables 13,500 Inventories 15,750 Total current assets \$31,500 Net fixed assets 21,600 Total assets \$53,100 Accounts payable 9,000 Notes payable 6,021 Accrued liab. 3,150

AFN

\$ 1,800

10,800 12,600 \$25,200 21,600 \$46,800 \$ 7,200 3,472 2,520

Answers and Solutions: 15 - 12

Total current liabilities \$18,171 Mortgage bonds 5,000 Common stock 2,000 Retained 27,929 Total liabilities and equity \$53,100 AFN = earnings

\$13,192 5,000 2,000 26,608 \$46,800 \$ 2,549 1,321**

\$15,622 5,000 2,000 27,929 \$50,551

*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 2002 \$3,600,000 3,279,720 \$ 320,280 20,280 \$ 300,000 120,000 \$ 180,000 \$ \$ 108,000 72,000 Forecast Basis 1.10 0.9110 2003 Pro Forma \$3,960,000 3,607,692 \$ 352,308 20,280 \$ 332,028 132,811 \$ 199,217 \$ \$ 112,000* 87,217

Sales Operating Costs EBIT Interest EBT Taxes (40%) Net income Dividends: \$1.08 × 100,000 = Addition to RE:

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

Morrissey Technologies Inc. Pro Forma Balance Statement December 31, 2003 Forecast Basis × 2002 2003 Sales 180,000 0.05 360,000 0.10 720,000 0.20 0.40 0.10 0.05 \$ 87,217* 2003 Pro Forma \$ 198,000 396,000 792,000 \$1,386,000 1,584,000 \$2,970,000 \$ 396,000 156,000 198,000 750,000 1,800,000 291,217

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 =
*See income statement.

\$

\$1,260,000 1,440,000 \$2,700,000 \$ 360,000 156,000 180,000 696,000 1,800,000 204,000

\$

\$2,700,000

\$2,841,217 \$ 128,783

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 =

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

15-17 a. & b.

Lewis Company Pro Forma Income Statement December 31, 2003 (Thousands of Dollars) 2002 Forecast Basis 1.2 0.9313 2003 Pro \$9,600 8,940 \$ 660 150 \$ 510 204 \$ 306 \$ 165 \$ 141

Forma Sales Operating costs EBIT Interest EBT Taxes (40%) Net income \$8,000 7,450 \$ 550 150 \$ 400 160 \$ 240 156 84

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

\$1.10 × 150 =

Answers and Solutions: 15 - 16

Lewis Company Pro Forma Balance Sheet December 31, 2003 (Thousands of Dollars) Forecast 1st Basis × Pass 2003 Sales Additions 2003 0.010 0.030 0.090 0.400 0.020 0.005 \$ 96 288 864 2nd AFN Pass Effects 2003 \$ 96 288 864

2002 Cash Receivables Inventories Total current assets Fixed assets Total assets \$ 80 240 720

\$1,040 3,200 \$4,240

\$1,248 3,840 \$5,088 \$ 192 48 252

\$1,248 3,840 \$5,088 \$ + 51** \$ +248** 192 48 303

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 AFN =
*See income statement.

\$

141*

492 1,244 \$1,736 1,605 1,080 \$4,421 \$ 667

543 1,492 \$2,035 +368** 1,973 1,080 \$5,088

**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

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 WERE WILSON THINKS THE COMPANY WAS OPERATING AT FULL BUT SHE IS NOT SURE ABOUT THIS. THE 2002 CHEMICALS FOR USE IN FRUIT ORCHARDS, MUST PREPARE A FINANCIAL FORECAST FOR 2003. SALES INCREASE FOR 2003. CAPACITY 1. IN 2002, NWC’S 2002

\$2 BILLION, AND THE MARKETING DEPARTMENT IS FORECASTING A 25 PERCENT

FINANCIAL STATEMENTS, PLUS SOME OTHER DATA, ARE GIVEN IN TABLE IC15-

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

\$

100 100 \$ 200 100 500 200 \$1,000

2002 INCOME STATEMENT SALES LESS: VARIABLE COSTS FIXED COSTS EARNINGS BEFORE INTEREST AND TAXES (EBIT) INTEREST EARNINGS BEFORE TAXES (EBT) TAXES (40%) NET INCOME DIVIDENDS (30%) ADDITION TO RETAINED EARNINGS

\$2,000.00 1,200.00 700.00 \$ 100.00 16.00 \$ 84.00 33.60 \$ 50.40 \$ \$ 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. 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. NWC WILL NEED \$180.9 MILLION. SHE

[SHOW S15-1 THROUGH S15-6 HERE.] 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. ACCRUED LIABILITIES, AND DISREGARD THE ASSUMPTIONS IN PART A, AND VARIABLE COSTS, GROW IN AND NOW ASSUME (1) THAT EACH TYPE OF ASSET, AS WELL AS PAYABLES, FIXED 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 DIVIDENDS ADD’N TO R.E. BALANCE SHEET: 2002 ACTUAL CASH & SECURITIES ACCOUNTS RECEIVABLE INVENTORIES CURRENT ASSETS NET FA (% CAP) 100.0% TOTAL ASSETS A/P AND ACCRUED LIAB. N/P (SHORT-TERM) L-T DEBT COMMON STOCK RETAINED EARNINGS TOTAL LIAB & EQUITY AFN AFN FINANCING: N/P L-T DEBT COMMON STOCK WEIGHTS 0.50 0.50 0.00 1.00 \$ 20.00 240.00 240.00 \$ 500.00 500.00 \$1,000.00 \$ 100.00 100.00 100.00 500.00 200.00 \$1,000.00 \$ 2003 1ST PASS 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 \$ 179.22 DOLLARS \$ 89.61 89.61 0.00 \$179.22 89.61 89.61 AFN \$ 2003 2ND PASS 25.00 300.00 300.00 \$ 625.00 625.00 \$1,250.00 \$ 125.00 189.61 189.61 500.00 245.78 \$1,250.00 25.00% 25.00% 2002 ACTUAL \$2,000.00 (1,200.00) (700.00) \$ 100.00 (16.00) \$ 84.00 (33.60) \$ 50.40 \$ \$ 15.12 35.28 2003 PRO FORMA \$2,500.00 (1,500.00) (875.00) \$ 125.00 (16.00) \$ 109.00 (43.60) \$ 65.40 \$ \$ 19.62 45.78

60.00% 35.00%

40.0% 30.0%

Integrated Case: 15 - 22

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?

[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 NOT DIFFERENCE INCREASE IS NOT VERY LARGE. WITH THE REAL IN ADVANTAGE OF THE BALANCE SHEET METHOD IS THAT IT CAN BE USED WHEN EVERYTHING DOES PROPORTIONATELY SALES. 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

WITH

THE

COMPANY’S 2002 RATIOS AND WITH THE INDUSTRY AVERAGES. EXPECTED TO IMPROVE DURING THE COMING YEAR?

HOW DOES NWC

COMPARE WITH THE AVERAGE FIRM IN ITS INDUSTRY, AND IS THE COMPANY

Integrated Case: 15 - 24

[SHOW S15-16 HERE.]

KEY RATIOS: NWC 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%

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%

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 THAT THE COMPANY IS IN ADDITION, ITS DEBT

CARRYING EXCESS INVENTORY AND RECEIVABLES. COVERAGE RATIO IS LOW.

RATIO IS FORECASTED TO MOVE ABOVE THE INDUSTRY AVERAGE, AND ITS THE COMPANY IS NOT IN GOOD SHAPE, AND THINGS DO NOT APPEAR TO BE IMPROVING.

CALCULATE NWC’S FREE CASH FLOW FOR 2003. [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?

[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?

[SHOW S15-20 AND S15-21 HERE.] FORMULA. \$125.

WE HAD PREVIOUSLY FOUND AN AFN OF

\$179.22 USING THE BALANCE SHEET METHOD AND \$180.9 USING THE AFN IN BOTH CASES, THE FIXED ASSETS INCREASE WAS 0.25(\$500) = THERE-FORE, THE FUNDS NEEDED WILL DECLINE BY \$125.

G.

WITHOUT ACTUALLY WORKING OUT THE NUMBERS, HOW WOULD YOU EXPECT THE RATIOS TO CHANGE IN THE SITUATION WHERE EXCESS CAPACITY IN FIXED ASSETS EXISTS? EXPLAIN YOUR REASONING. WE WOULD EXPECT ALMOST ALL THE

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

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 INVENTORY IT TURNOVER THAT RATIOS NWC IS WITH THE INDUSTRY AVERAGE WITH FIGURES, WERE DOES TO APPEAR OPERATING LINE EFFICIENTLY THE

RESPECT TO ITS INVENTORIES AND ACCOUNTS RECEIVABLE? ABLE BRING THESE RATIOS INTO WITH

IF THE COMPANY 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 THE EFFECT OF WITHOUT THUS,

THAT NWC HAS EXCESSIVE INVENTORIES AND RECEIVABLES. CAPACITY IN FIXED ASSETS. SALES COULD BE

IMPROVE-MENTS HERE WOULD BE SIMILAR TO THAT ASSOCIATED WITH EXCESS EXPANDED PROPORTIONATE INCREASES IN CURRENT ASSETS. (ACTUALLY, THESE ITEMS

COULD PROBABLY BE REDUCED EVEN IF SALES DID NOT INCREASE.) REDUCE FINANCING AND POSSIBLY OTHER COSTS. THERE MAY BE OTHER COSTS ASSOCIATED

THE AFN WOULD BE LESS THAN PREVIOUSLY DETERMINED, AND THIS WOULD AS WE SAW IN CHAPTER 14, REDUCING THE FIRM’S WITH

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 (CONSIDER

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

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 HIGHER THE DOLLARS OF ASSETS REQUIRED PER DOLLAR OF SALES. TO SUPPORT AN ADDITIONAL DOLLAR OF SALES. CONSTANT. 4. IF NWC’S PAYMENT TERMS WERE INCREASED FROM 30 TO 60 DAYS,

THE CAPITAL INTENSITY RATIO, THE MORE NEW MONEY WILL BE REQUIRED THUS, THE HIGHER THE CAPITAL INTENSITY RATIO, THE GREATER THE AFN, OTHER THINGS HELD

ACCOUNTS PAYABLE WOULD DOUBLE, IN TURN INCREASING CURRENT AND TOTAL LIABILITIES. DECREASED NEED FOR THIS WOULD REDUCE THE AMOUNT OF AFN DUE TO A WORKING CAPITAL ON HAND TO PAY SHORT-TERM

CREDITORS, SUCH AS SUPPLIERS.

Integrated Case: 15 - 29

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