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Case Abstract
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The owners of a relatlvely small buslness expect slgnlflcant
sales growth and want to estimate how much of the needed funds must
be externally financed. The case also raises issues about credit
policy.
Level of Difficulty
Level "1" if question 10 is not assigned.
Numerical Uniformity
For questions 1-9, only accruals must be estimated. If our
estimate is given to the students, then all of these questions have
unique numerical answers. Q-10, the credit question, can generate
different answers depending on the assumptions used.
Suggestions for Reducing the Case's Difficulty
Q-10 should probably be omitted.
have trouble with 3-a and 5-a.
Instructor's Note
In addition, students may
Topeka (II) can be used independently of this case. The case
is a composite of issues faced by two firms that we are familiar
with.
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1. Davidson is confusing "retained earnings" with "cash on hand."
Retained earnings on the balance sheet do not indicate the
amount of cash' available to spend. It is best viewed as a
"running total" of all profits which have been reinvested in
the firm.
2. 1996 Pro Forma IS (\$000)
Sales
Cost of Goods Sold
Gross Profit
Depreciation
EBIT
Interest
EBT
Taxes(40%)
Net Income
Here's the rationale for each item.
\$1,933.1
1,333.8
599.3
441. 7
63.2
94.4
10.0
84.4
33.8
\$50.6
3. a.
-The sales estimate is given.
-Gross profit is predicted to be 31 percent of sales.
Note that Shatner's original 32 percent estimate was
reduced. ,
-CGS is sales less gross profit.
-Administrative costs are estimated to increase by 20
percent.
-Depreciation is \$34.0 , the 1995 amount, plus one-
sixth of \$175, the 1996 predicted spending on plant,
land and equipment.
-Interest is assumed to remain constant (see case).
The overall ACP can be viewed as a weighted average of
the average collection period, call it ACP30, of those
customers who receive terms of net 30, and the average
collection period, ACP45, of those who receive terms of
net 45.
ACP30 = .80(30) + .20(40) = 32 days
ACP45 = .90(45) + .10(55) = 46 days
The "overall ACP" equals .40(32) + .60(46) = 40.4 days .
...... l; -.
b. Receivables = (\$1,933.1/360) * 40.4 = \$216.9(000).
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4. 1996 i.e., "ending inventory," is estimated to be
\$173.2 = \$1333.8/7.7 since inventory turnover (CGS/INV) is
estimated to be 7.7.
5.
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Purchases = CGS + Ending Inventory - Begi7ning
Purchases = \$1,333.8 + \$173.2 - \$149.5
Purchases = \$1,357.5(000)
a. APP = 1/3*10 + 2/3*30 = 23.33 days

b. Accounts Payable = 23.33*(\$1,357.5/360) = \$87.9(000)
6. a. We will need an estimate of accruals. Using the
information in Exhibit 1 and Exhibit 2, accruals have
averaged 2.2% of sales during the 1993-95 period.
ASSETS LIABILITIES & NW
Cash \$58.0 Accounts Payable \$87.9
Receivables 216.9 Accruals 42.5
Inventory 173.2 Debt -Due 20.0
Other Current 11. 6 Total Current \$150.4
Total Current \$459.7
Gross Fixed 441.1 Long-Term Debt 60.0
(Accumulated Common stock 110.0
depreciation) (188.7) Retained Earnings 215.5
Net Fixed Assets 252.4 Funds Needed 176.2
Total Assets \$712.1 Total Lia. &NW \$712 .. 1
= =
Here's the rationale for each item.
-Cash is predicted to be 3 percent of sales.
-Receivables were calculated in Q3-b.
-Inventory turnover (CGS/inventory) is estimated to be
7.7. Thus the inventory estimate is \$1333.8/7.7 =
\$173.2.
-Other current assets are predicted to be .6 percent of
sales.
-Gross fixed is \$266.1 (1995 total) plus \$175, the
predicted 1996 capital spending.
-Accumulated depreciation is \$125.5 (1995 total) plUS
\$63.2, the 1996 amount.
-Debt due is given in the case.
-Long-term debt is \$80, the 1995 amount, less the debt
due of \$20.
-Retained earnings is \$164.9 ,the 1995 BS total, plus
the estimated 1996 net income of \$50.6 (no dividends
will be paid) .
-Funds needed is the "plug" or balancing item of the
forecast.
b. The balance sheet indicates that the estimated sources
of financing are \$176.1(000) short of the projected
asset requirements.
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7.
8.
c. Inventory turnover (CGS/INV) was 7.1 in 1993, 7.3 in
1994 and 7.2 in 1995. using this average of 7.2, 1996
inventory is predicted to be \$185.3 (=1333.8/7.2).
This is \$12.1(000) more than estimated above (see 6-a).
Thus "funds needed" will be higher but, really, not by
a large amount.
1995 assets are 29.6% of sales. Spontaneous liabilities,
i.e. , accounts payable and accruals, are 5.3% of sales.
The net profit margin is 2.3% and sales are predicted to
increase by \$386.6(000) in 1996. Since no dividends will
be paid, the percent of e.ales method predicts that 1996
funds needed will be \$49 .. 4(000), as shown below.
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Funds Needed = - .053)*\$386.6
Funds Needed = 93.9 - 44.5 = \$49.4(000)
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The percent of sales method assumes that assets,
spontaneous liabilities, and net income are constant
percentages of 'sales over the forecasting period. These
conditions clearly do not hold here, as Topeka is
experiencing significant changes in its working capital
and fixed asset requirements. Note that 1996 assets are
estimated to be 36.8% of sales and spontaneous
liabilities are predicted to be 6.7% of sales.
In addition, the percent of sales method does not consider
any debt due.
So, all things considered, there is no reason to suppose
that the estimates in 6-a and 7 will be similar.
9. Let's calculate the retUJrn from taking the discount.
Percent return = discount %
100-discount %
x _-:--_--=3::..;6:..0:..- _
Final due date-
discount period
Return % = 2/98 x 360/(30 - 10) = 36.7%
By taking the discount, a before-tax return of 36.7 percent
is earned. While we don't know Topeka's cost of funds, this
strikes us as a very hi9h return relative to current and
historical US standards. Taking the discount, therefore,
looks like a wise financial move.
10. Note that the relevant choice is between making this sale
while granting 45 days 1:0 pay, versus not making the sale
and, thus, extending no credit.
Asset requirements
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The incremental asset requirements, assuming excess
capacity, will be the additional investment in receivable:;
and, perhaps, inventory. ,/",,'1
= AR*(1-.31) + INV/'",
= + \$100,000*.69/7.7
= 8,625 + 8,961 = \$17,586
Let's first assume that CGS is the only variable cost and
equals 69 percent' of 1996 estimate (see Q-2).
so, the incremental after-tax profit to Topeka would be
\$100,000*.31*.6 = \$31,000*.6 = \$18,600.
[
sideooint: Technical accuracy requires that we adjust this
for any change in spontaneous liabilities.
Now we need to estimate the capital cost of the decision,
which depends on the cost of capi.tal for funds tied up in
receivables and inventory. This isn't given, but using any
"reasonable" figure these costs will be far less than the
after-tax profit. For instance, suppose the cost of funds
is 20 percent, a figure that is almost surely too high. The
capital cost is \$17,586*.20 = \$3,517. The gain to Topeka
from this sale is as follows.
Gain = \$18,600 - 3,517 = \$15,083.
with these assumptions, we'd recommend that e'xtend4'5
days of credit rather than lose the sale.
We have a "disclaimer," though. rfhe decision to grant this
firm an extra 15 days could set a precedent that Topeka
won't like. will "giving in" to this customer weaken
Topeka'.s bargaining power with other clients? If so, then
there are potential "spillover effects" that need to be
considered.
Now let's assume that Topeka has no excess capacity which
implies that the firm's "overhead" must rncrease if the 'salle
is made. In Q-2, the 1996 IS indicates that administrative
costs are roughly 23 percent of sales. If these costs are
proportional to sales, then the incremental after-tax profit
is (100,000*.31 - 100,000*.23)*.6 = \$4,800.
Asset requirements must now consider the increase in fixed
assets. In Q-6, the 1996 BS shows that net fixed assets are
about 13 percent of sales. Assuming net fixed assets are
proportional to sales,
Asset requirements = \$17,586 + .13*100,000 = \$30,586.
We previously assumed a 20 percent cost of capital for
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decisions of this sort. If so, then the capital cost is
.20*30,586 = \$6,117 and exceeds the expected after-tax
profit. Of course, this 20 percent figure is almost surely
a "high guesstimate." However, if the cost of funds is
above 4,800/30,586 = .16 (which it may be), then granting
this firm 45 days to pay is not a good deal even if there
are no potential spillover effects.
Sidepoint The analysis is relatively simple because we've
assumed that Topeka will not get the sale unless it offers
terms of net 45. The issue becomes trickier if there is
some chance of 'making the sale on terms of net 30. In that
case, we must estimate the probability of making the sale on
these terms and incorporate this into the analysis.