Solution of Chapter 9 Books Problems

Chapter 9
Corporate Valuation and Financial Planning

ANSWERS TO BEGINNING-OF-CHAPTER QUESTIONS
We like to use discussion questions along with relatively simple and easy to follow calculations
for our lectures. Unfortunately, forecasting is by its very nature relatively complex, and it simply
cannot be done in a realistic manner without using a spreadsheet. Accordingly, our primary
“question” for Chapter 9 is really a problem, but one that can be discussed. Therefore, we base
our lecture primarily on the BOC model and we use the class period to discuss forecasting and
Excel modeling. We cover the chapter in about 2 hours, and then our students work a case on
the subject later in the course.
9-1 The major components of the strategic plan include the firm’s purpose, the scope of its
operations, its specific (quantified) objectives, its operating strategies, its operating
plan, and its financial plan.
Engineers, economists, marketing experts, human resources people, and so on all
participate in strategic planning, and development of the plan is a primary function of the
senior executives. Regional and world economic conditions, technological changes,
competitors’ likely moves, supplies of resources, and the like must all be taken into
account, along with the firm’s own R&D activities.
The effects of all these forces, under alternative strategic plans, are analyzed by use of
forecasted financial statements. In essence, the financial statements are used to simulate
the company’s operations under different economic conditions and corporate strategic
plans.
Since the strategic plan is necessarily somewhat nebulous, it is sometimes neglected
in practice on the grounds that it is difficult to quantify. We can only note that if a
company doesn’t think about the direction in which its industry is going, it is likely to
end up in bankruptcy, as most bankruptcies occur because an inaccurate business plan.
9-2 a. The sales forecast is the primary driver of the financial plan. Forecasted sales
determine the amount of capacity needed, inventory and receivables levels, profits,
and capital requirements. If a company forecasts its sales incorrectly, this can be
disastrous, as Cisco and Lucent learned recently. We discuss sales forecasting in the
BOC model.
b. See the BOC model for a detailed explanation. Essentially, we take the prior year’s
financial statements and then change them to reflect (1) changes in sales and (2)
policies that will affect things like the amount of inventories carried to support a
given amount of sales.
Answers and Solutions: 9 - 1

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c. See the BOC model for a detailed explanation. Essentially, we project the assets that
will be required to support the forecasted level of sales, and we also project the
amount of funds that will be available from retained income and spontaneous sources
of funds. The difference is the AFN.
Generally, faster growth would mean the requirement for more assets. That
would reduce FCF and thus increase AFN. Of course, if the firm were extremely
profitable, then faster growth might produce enough extra profits to support that
growth, but that would be unusual. In our illustrative case, the higher the growth rate,
the greater the AFN and the smaller the FCF. Note, though, that since sales are
profitable, the more the firm sells, the higher its profits. Therefore, the faster the
growth rate, the larger is EPS and ROE. This result is shown in the model.
d. See the BOC model for a detailed explanation. Given the projected financial
statements, we can calculate various ratios, EPS, and FCF and then compare the
projected values with historical data and industry benchmarks. Various policies can
be considered, and their effects as revealed by the computer model can be analyzed.
A set of feasible policies that will produce the desired results, or perhaps the best
attainable results, will be adopted. Of course, that’s the easy part. The hard part is
operating the business so that the projected results will be realized.
9-3 The performance of the firm could be compared with the industry average. Also, as
shown in the model, we could see how the firm’s ROE, EPS, etc. would look if it could
get its operating ratios to the same level as the industry average.
Industry average data is also useful when preparing a business plan for a new
business. We could forecast sales, then forecast the financial statements based on
industry average date. The capital requirements (the amount of required debt and equity)
could be determined, and then the new firm could seek to raise the required funds. Many
new businesses fail because they don’t raise enough funds at the outset and are forced out
of business when they run out of cash. Forecasting as done in the model could head off
such disasters.
9-4 Managers are obviously concerned about forecast errors. The effects of such errors can
be analyzed by use of scenario and sensitivity analysis. Both types of analysis are
illustrated in the BOC model.

9-5 Economies of scale refer to situations where unit costs decline as sales increase. Lumpy
assets are assets that must be added in very large units, often resulting in excess capacity
immediately after they go on line and before sales can grow into them. Excess capacity
simply means that the firm could produce more than it is currently producing, in which
case sales can expand with very little increase in capital.
If economies of scale exist, then profits should rise rapidly with sales, so management
should take steps to increase volume. If assets are lumpy, then management will
probably do things like go to second and third shifts to avoid increasing plant and
equipment, or working out arrangements with other firms to sell some capacity until it is
needed. If excess capacity exists, then the marginal cost per unit will be relatively low,
so sales promotions and the like might be used to increase sales. In all of these situations,
management must be concerned with the long-run effects of actions. For example, before
air conditioning was widely used, electric utilities had excess capacity in the summer.
Then they promoted air conditioning through advertising and low summer rates. Demand
increased so much that the peak load was shifted from winter (for heating) to summer.
This resulted in capacity shortages and forced companies to expand their generating
capacity.
9-6 The AFN equation is useful in a pedagogic sense to get an idea of how sales increases
lead to required asset increases, and hence to a need for new capital. The equation is not
used in practice today because spreadsheet models provide so much more information
and are relatively easy to construct.
AFN = (A*/S0)∆S - d(L*/S0)∆S - MS1(RR).
A* is assets that increase at the same rate as sales, L* is liabilities that increase
spontaneously at the same rate as sales, S0 is last year’s sales, S1 is forecasted sales for
the coming year, and ∆S is the forecasted increase in sales, M is the profit margin, and
RR is the percentage of earnings the firm retains.
The formula is simple and easy to use, but it assumes a constant relationship between
sales, assets, and liabilities, and a constant profit margin and retention ratio. As indicated
above, the formula is not used in practice because the financial statement approach is so
much better.
9-7 We could set the AFN equation up and use it to get an idea of the maximum sales growth
rate without external capital. However, we can use the model go get a better
approximation.

ANSWERS TO END-OF-CHAPTER QUESTIONS
9-1 a. The operating plan provides detailed implementation guidance designed to

accomplish corporate objectives. It details who is responsible for what particular
function, and when specific tasks are to be accomplished. The financial plan details
the financial aspects of the corporation’s operating plan.
b. Spontaneous liabilities are the first source of expansion capital as these accounts
increase automatically through normal business operations. Examples of spontaneous
liabilities include accounts payable, accrued wages, and accrued taxes. No interest is
normally paid on these spontaneous liabilities; however, their amounts are limited due
to credit terms, contracts with workers, and tax laws. Therefore, spontaneous
liabilities are used to the extent possible, but there is little flexibility in their usage.
Note that notes payable, although a current liability account, is not a spontaneous
liability since an increase in notes payable requires a specific action between the firm
and a creditor. A firm’s profit margin is calculated as net income divided by sales.
The higher a firm’s profit margin, the larger the firm’s net income available to
support increases in its assets. Consequently, the firm’s need for external financing
will be lower. A firm’s payout ratio is calculated as dividends per share divided by
earnings per share. The less of its income a company distributes as dividends, the
larger its addition to retained earnings. Therefore, the firm’s need for external
financing will be lower.

c. Additional funds needed (AFN) are those funds required from external sources to
increase the firm’s assets to support a sales increase. A sales increase will normally
require an increase in assets. However, some of this increase is usually offset by a
spontaneous increase in liabilities as well as by earnings retained in the firm. Those
funds that are required but not generated internally must be obtained from external
sources. Although most firms’ forecasts of capital requirements are made by
developing forecasted financial statements, the AFN formula is sometimes used as an
approximation of financial requirements. It is written as follows:
Additional Required Increase in Increase in

funds = asset – spontaneous – retained
needed increase liab. earnings
AFN = (A0*/S0)∆S – (L0*/S0)∆S – MS1(1 – Payout rate)
Capital intensity is the dollar amount of assets required to produce a dollar of sales.
The capital intensity ratio is the reciprocal of the total assets turnover ratio. It is
calculated as Assets/Sales. The sustainable growth rate is the maximum growth rate
the firm could achieve without having to raise any external capital. A firm’s self-
supporting growth rate can be calculated as follows:
M(1 − POR )(S 0 )

Self-supporting g =
A 0 * − L 0 * − M(1 − POR )(S 0 )
d. The forecasted financial statement approach using percent of sales develops a

complete set of financial statements that can be used to calculate projected EPS, free
cash flow, various other financial ratios, and a projected stock price. This approach
first forecasts sales, the required assets, the funds that will be spontaneously
generated, and then net income, dividends, and retained earnings.
e. A firm has excess capacity when its sales can grow before it must add fixed assets
such as plant and equipment. “Lumpy” assets are those assets that cannot be acquired
smoothly, but require large, discrete additions. For example, an electric utility that is
operating at full capacity cannot add a small amount of generating capacity, at least
not economically. When economies of scale occur, the ratios are likely to change
over time as the size of the firm increases. For example, retailers often need to
maintain base stocks of different inventory items, even if current sales are quite low.
As sales expand, inventories may then grow less rapidly than sales, so the ratio of
inventory to sales declines.

f. Full capacity sales are calculated as actual sales divided by the percentage of capacity
at which fixed assets were operated. The target fixed assets to sales ratio is calculated
as actual fixed assets divided by full capacity sales. The required level of sales is
calculated as the target fixed assets to sales ratio multiplied by the projected sales
level.
9-2 Accounts payable, accrued wages, and accrued taxes increase spontaneously. Retained
earnings may or may not increase, depending on profitability and dividend payout policy.
9-3 The equation gives good forecasts of financial requirements if the ratios A0*/S and L0*/S,
the profit margin, and payout ratio are stable. This equation assumes that ratios are
constant. This would not occur if there were economies of scale, excess capacity, or
when lumpy assets are required. Otherwise, the forecasted financial statement method
should be used.
9-4 The five key factors that impact a firm’s external financing requirements are: Sales
growth, capital intensity, spontaneous liabilities-to-sales ratio, profit margin, and payout
ratio.
9-5 The self-supporting growth rate is the maximum rate a firm can achieve without having
to raise external capital. The self-supporting growth rate is calculated using the AFN
equation, setting AFN equal to zero, replacing the term ΔS with the term g × S0, and
replacing the term S1 with S0 × (1 + g). Once the AFN equation is rewritten with these
modifications, you can now solve for g. This “g” obtained is the firm’s self-supporting
growth rate.
9-6 a. +.
b. +. It reduces spontaneous funds; however, it may eventually increase retained

earnings.
c. +.
d. +.
e. –.
f. –.

SOLUTIONS TO END-OF-CHAPTER PROBLEMS
9-1 AFN = (A0*/S0)∆S – (L0*/S0)∆S – (PM)(S1)(1 – payout rate)

 $5,000,000   $900,000 
=  $1,200,000 –   $1,200,000 – 0.06($9,200,000)(1 – 0.4)
 $8,000,000   $8,000,000 
= (0.625)($1,200,000) – (0.1125)($1,200,000) – ($552,000)(0.6)
= $750,000 – $135,000 – $331,200
= $283,800.
 $7,000,000   $900,000 
9-2 AFN =   $1,200,000 –   $1,200,000 – 0.06($9,200,000)(1 – 0.4)
 $8,000,000   $8,000,000 
= (0.875)($1,200,000) – $135,000 – $331,200
= $1,050,000 – $466,200
= $583,800.
The capital intensity ratio is measured as A0*/S0. This firm’s capital intensity ratio is
higher than that of the firm in Problem 9-1; therefore, this firm is more capital
intensive—it would require a large increase in total assets to support the increase in
sales.
9-3 AFN = (0.625)($1,200,000) – (0.1125)($1,200,000) – 0.06($9,200,000)(1 – 0)

= $750,000 – $135,000 – $552,000
= $63,000.
Under this scenario the company would have a higher level of retained earnings
which would reduce the amount of additional funds needed.

9-4 S0 = $5,000,000; A0* = $2,500,000; CL = $700,000; NP = $300,000; AP = $500,000;
Accruals = $200,000; M = 7%; payout ratio = 80%; A0*/S0 = 0.50; L0* = (AP +
Accruals)/S0 = ($500,000 + $200,000)/$5,000,000 = 0.14.
AFN = (A0*/S0)∆S – (L0*/S0)∆S – (M)(S1)(1 – payout rate)

= (0.50)∆S – (0.14) ∆S – (0.07)(S1)(1 – 0.8)
= (0.50)∆S – (0.14)∆S – (0.014)S1
= (0.36)∆S – (0.014)S1
= 0.36(S1 – S0) – (0.014)S1
= 0.36(S1 – $5,000,000) – (0.014)S1
= 0.36S1 – $1,800,000 – 0.014S1
$1,800,000 = 0.346S1
$5,202,312 = S1.
Sales can increase by $5,202,312 – $5,000,000 = $202,312 without additional funds

being needed.
9-5 a. Total liab. = Accounts + Long-term + Common + Retained

and equity payable debt stock earnings
$2,170,000 = $560,000 + Long-term debt + $625,000 + $395,000
Long-term debt = $590,000.
Total liab. = Accounts payable + Long-term debt

= $560,000 + $590,000 = $1,150,000.
b. Assets/Sales (A0*/S0) = $2,170,000/$3,500,000 = 62%.

L0*/Sales = $560,000/$3,500,000 = 16%.
2014 Sales = (1.35)($3,500,000) = $4,725,000.
AFN = (A0*/S0)(∆S) – (L0*/S0)(∆S) – (M)(S1)(1 – payout) – New common stock

= (0.62)($1,225,000) - (0.16)($1,225,000) - (0.05)($4,725,000)(0.55) - $195,000
= $759,500 - $196,000 - $129,937 - $195,000 = $238,563.
Alternatively, using the forecasted financial statement method:

Forecast Additions
basis is % (New
of 2015 Financing and
2015 Sales ΔRE) 2016
Sales $3.500,000 $4,725,000
Total assets $2,170,000 0.62 $2,929,500
Current liabilities $ 560,000 0.16 $ 756,000

Preliminary long-term debt 590,000 590,000
Total liabilities $1,150,000 $1,346,000
Common stock 625,000 195,000* 820,000
Retained earnings 395,000 129,937** 524,937
Total common equity $1,020,000 $1,344,937
Preliminary total liabilities and equity $2,170,000 $2,690,937
AFN = Total assets – Preliminary total liabilities & equity = S2,929,500 – 2,690,937 = $238,563
AFN = Additional required long-term debt =$238,563
*Given in problem that firm will sell new common stock = $195,000.
**PM = 5%; Payout = 45%; NI2014 = $3,500,000 x 1.35 x 0.05 = $236,250.
Addition to RE = NI x (1 - Payout) = $236,250 x 0.33 = $129,937.

9-6 Cash $ 100.00 × 2.0 = $ 200.00
Accounts receivable 200.00 × 2.0 = 400.00
Inventories 200.00 × 2.0 = 400.00
Net fixed assets* 500.00 × 1.0 = 500.00
Total assets $1,000.00 $1,500.00
Accounts payable $ 50.00 × 2 = $ 100.00

Accruals 50.00 × 2 = 100.00
Notes payable 150.00 + 0 = 150.00
Long-term debt 400.00 + 0 = 400.00
Common stock 100.00 + 0 = 100.00
Retained earnings** 250.00 + 40 = 290.00
Total liabilities
and equity $1,000.00 $1,140.00
AFN = $ 360.00
*Capacity sales = Sales/0.5 = $1,000/0.5 = $2,000 with respect to existing fixed assets.
Target FA/S ratio = $500/$2,000 = 0.25.
Target FA = 0.25($2,000) = $500 = Required FA. Since the firm currently has $500 of
fixed assets, no new fixed assets will be required.
**Addition to RE = (M)(S1)(1 – Payout ratio) = 0.05($2,000)(0.4) = $40.
9-7 a. AFN = (A0*/S0)(∆S) – (L0*/S0)(∆S) – (M)(S1)(1 – payout)

$122.5 $17.5 $10.5
= ($70) – ($70) – ($420)(0.6) = $13.44 million.
$350 $350 $350
M (1 − POR )(S0 )
b. Self-supporting g =
A 0 * − L 0 * − M (1 − POR )(S0 )
0.03(1 − 0.40)(350)
=
122.5 − 17.5 − .03(1 − .4)(350)
= 6.38%

c. Upton Computers
Pro Forma Balance Sheet
December 31, 2016
(Millions of Dollars)
Forecasted sales = $420 million

Profit margin = M = $10.5/$350 = 3%.
Payout ratio = $4.2/$10.5 = 40%.
NI = Forecasted sales × Profit margin = $350 × 1.2 × 0.03 = $12.6.
Dividends = NI(Payout ratio) = $12.6(40%) = $5.04.
Addition to RE = NI – DIV = $12.6 – $5.04 = $7.56.
Forecast
Basis:
Percent of 2016 Pro
forecasted 2016 Pro Forma after
2015 sales Additions Forma Financing Financing
Cash $ 3.5 0.0100 $ 4.20 $ 4.20
Receivables 26.0 0.0743 31.20 31.20
Inventories 58.0 0.1657 69.60 69.60
Total current assets $ 87.5 $105.00 $105.00
Net fixed assets 35.0 0.100 42.00 42.00
Total assets $122.5 $147.00 $147.00
Accounts payable $ 9.0 0.0257 $ 10.80 $ 10.80

Notes payable 18.0 18.00 18.00
Line of credit 0.0 0.00 +13.44 +13.44
Accruals 8.5 0.0243 10.20 10.20
Total current liabilities $ 35.5 $ 39.00 $ 52.44
Mortgage loan 6.0 6.00 6.00
Common stock 15.0 15.00 15.00
Retained earnings 66.0 7.56 73.56 73.56
Total liab. and equity $122.5 $133.56 $147.00
Deficit = $ 13.44

9-8 Stevens Textiles
Pro Forma Income Statement
December 31, 2016
(Thousands of Dollars)
a.
2016
Forecast 2016
2015 Basis Pro Forma
Sales $36,000 1.15 × Sales15 $41,400
Operating costs 32,440 0.9011 × Sales16 37,306
EBIT $ 3,560 $ 4,094
Interest 460 0.10 × Debt15 560
EBT $ 3,100 $ 3,534
Taxes (40%) 1,240 1,414
Net income $ 1,860 $ 2,120
Dividends (45%) $ 837 $ 954

Addition to RE $ 1,023 $ 1,166

Stevens Textiles
Pro Forma Balance Sheet
December 31, 2016
(Thousands of Dollars)
Forecast 2016 Pro
Basis % 2016 Pro 2016 Forma after
2015 2016 Sales Additions Forma Financing Financing
Cash $ 1,080 0.0300 $ 1,242 $ 1,242
Accts receivable 6,480 0.1800 7,452 7,452
Inventories 9,000 0.2500 10,350 10,350
Total curr. assets $16,560 $19,044 $19,044
Fixed assets 12,600 0.3500 14,490 14,490
Total assets $29,160 $33,534 $33,534
Accounts payable $ 4,320 0.1200 $ 4,968 $ 4,968

Accruals 2,880 0.0800 3,312 3,312
Line of credit 0 0 +2,128 +2,128
Notes payable 2,100 2,100 +2,128
Total curr. liabilities $ 9,300 $10,380 $12,508
Long-term debt 3,500 3,500 3,500
Total debt $12,800 $13,880 $16,008
Common stock 3,500 3,500 3,500
Retained earnings 12,860 1,166* 14,026 14,026
Total liab. and equity $29,160 $31,406 $33,534
Deficit = $ 2,128
*From income statement.
b. Line of credit = $2,128 (thousands of $).
c. If debt is added throughout the year rather than only at the end of the year, interest
expense will be higher than in the projections of part a. This would cause net income to
be lower, the addition to retained earnings to be higher, and the AFN to be higher. Thus,
you would have to add more than $2,128 in new debt. This is called the financing
feedback effect.

9-9 Garlington Technologies Inc.
Pro Forma Income Statement
December 31, 2016
Forecast Pro Forma

2015 Basis 2016
Sales $3,600,000 1.10 × Sales15 $3,960,000
Operating costs 3,279,720 0.911 × Sales16 3,607,692
EBIT $ 320,280 $ 352,308
Interest 18,280 0.13 × Debt15 20,280
EBT $ 302,000 $ 332,028
Taxes (40%) 120,800 132,811
Net income $ 181,200 $ 199,217
Dividends: $ 108,000 Set by management $ 112,000

Addition to RE: $ 73,200 $ 87,217
Garlington Technologies Inc.

Pro Forma Balance Statement
December 31, 2016
Forecast
Basis % AFN With AFN
2015 2016 Sales Additions 2016 Effects 2016
Cash $ 180,000 0.05 $ 198,000 $ 198,000
Receivables 360,000 0.10 396,000 396,000
Inventories 720,000 0.20 792,000 792,000
Total curr. assets $1,260,000 $1,386,000 $1,386,000
Fixed assets 1,440,000 0.40 1,584,000 1,584,000
Total assets $2,700,000 $2,970,000 $2,970,000
Accounts payable $ 360,000 0.10 $ 396,000 $ 396,000

Notes payable 156,000 156,000 156,000
Line of credit 0 0 +128,783 128,783
Accruals 180,000 0.05 198,000 198,000
Total curr. liabilities $ 696,000 $ 750,000 $ 878,783
Common stock 1,800,000 1,800,000 1,800,000
Retained earnings 204,000 87,217* 291,217 291,217
Total liab.
and equity $2,700,000 $2,841,217 $2,970,000
Deficit = $ 128,783
*See income statement.

SOLUTION TO SPREADSHEET PROBLEMS
9-10 The detailed solution is available in the file Ch09 P10 Build a Model Solution.xlsx at the
textbook’s Web site.
9-11 The detailed solution for is available in the file Ch09 P11 Build a Model Solution.xlsx at
the textbook’s Web site.

MINI CASE
Hatfield Medical Supplies’s stock price had been lagging its industry averages, so its
board of directors brought in a new CEO, Jaiden Lee. Lee had brought in Ashley Novak, a
finance MBA who had been working for a consulting company, to replace the old CFO, and
Lee asked Ashley to develop the financial planning section of the strategic plan. In her
previous job, Novak’s primary task had been to help clients develop financial forecasts, and
that was one reason Lee hired her.
Novak began as she always did, by comparing Hatfield’s financial ratios to the
industry averages. If any ratio was substandard, she discussed it with the responsible manager
to see what could be done to improve the situation. The following data shows Hatfield’s latest
financial statements plus some ratios and other data that Novak plans to use in her analysis.
Hatfield Medical Supplies (Millions of Dollars Except Per Share Data)

Balance Sheet, 12/31/2015 Income Statement, Year Ending 2015
Cash $ 20 Sales $2,000
Accts. rec. 280 Op. costs (excl. depr.) 1,800
Inventories 400 Depreciation 50
Total CA $ 700 EBIT $ 150
Net fixed assets 500 Interest 40
Total assets $1,200 Pretax earnings $ 110
Taxes (40%) 44
Accts. pay. & accruals $ 80 Net income $ 66
Line of credit $0
Total CL $ 80 Dividends $20.0
Long-term debt 500 Add. to RE $46.0
Total liabilities $ 580 Common shares 10.0
Common stock 420 EPS $6.60
Retained earnings 200 DPS $2.00
Total common equ. $620 Ending stock price $52.80
Total liab. & equity $1,200
Mini Case: 9 - 16
Selected Additional Data for 2015
Hatfield Industry Hatfield Industry
Op. costs/Sales 90.0% 88.0% Total liability/Total assets 48.3% 36.7%
Depr./FA 10.0% 12.0% Times interest earned 3.8 8.9
Cash/Sales 1.0% 1.0% Return on assets (ROA) 5.5% 10.2%
Receivables/Sales 14.0% 11.0% Profit margin (M) 3.30% 4.99%
Inventories/Sales 20.0% 15.0% Sales/Assets 1.67 2.04
Fixed assets/Sales 25.0% 22.0% Assets/Equity 1.94 1.56
Acc. pay. & accr. / Sales 4.0% 4.0% Return on equity (ROE) 10.6% 16.1%
Tax rate 40.0% 40.0% P/E ratio 8.0 16.0
ROIC 8.0% 12.5%
NOPAT/Sales 4.5% 5.6%
Total op. capital/Sales 56.0% 45.0%
Note: Hatfield was operating at full capacity in 2015. Also, you may observe small differences in items like the ROE
when calculated in different ways. Any such differences are due to rounding, and they can be ignored.
Mini Case: 9 - 17
a. Using Hatfield’s data and its industry averages, how well run would you say
Hatfield appears to be in comparison with other firms in its industry? What are its
primary strengths and weaknesses? Be specific in your answer, and point to various
ratios that support your position. Also, use the DuPont equation (see Chapter 7) as
one part of your analysis.
Answer: The DuPont equation shows the relationship among asset management, profitability
ratios, and leverage. By examining this equation we can determine where Hatfield falls
short of the industry.
ROEHatfield = Profit margin × Asset turnover × Equity multiplier

= 3.30% × 1.67 × 1.94
= 10.6%.
ROEIndustry = Profit margin × Asset turnover × Equity multiplier

= 4.99% × 2.04 × 1.56
= 16.1
From the DuPont equation, you can see that Hatfield’s profitability and asset
management ratios are lower than the industry average and its leverage is higher than the
industry average. The combined effect results in a much lower return on equity for the
firm relative to the industry average. If you study the asset management ratios in detail,
you will see that the firm’s receivables and industry turnovers are lower than the
industry average. Sales are too low for the current assets held, the firm may be holding
receivables that are uncollectible, or the firm may be holding inventory that is obsolete.
The firm’s debt ratio is higher than the industry average. A direct result of this is a
higher interest rate, which increases the firm’s interest expense. As a result, the firm’s
times interest earned ratio is lower than the industry average.
Mini Case: 9 - 18
b. Use the AFN equation to estimate Hatfield’s required new external capital for 2016
if the sales growth rate is 10%. Assume that the firm’s 2015 ratios will remain the
same in 2016. (Hint: Hatfield was operating at full capacity in 2015.)
Answer:
Data for AFN Equation

Growth rate in sales (g) 10%
Sales (S0) $2,000
Forecasted sales (S1) $2,200
Increase in sales (ΔS = gS0) $200
Profit margin (M) 3.30%
Assets (A0*) $1,200
Capital intensity ratio (A0*/S0) 60.0%
Payout ratio (POR) 30.3%
Spontaneous liabilities (L0*) $80
Spont. Liab./Sales (L0*/S0) 4.0%
Here is the AFN equation:
AFN = (A0*/S0)∆S – (L0*/S0)∆S – M(S1)(1 – Payout)

= (0.60)($200) – (0.04)($200) – (3.30)($2,200)(1−0.303)
= $120 – $8 – $50.6 = $61.4 million.
c. Define the term capital intensity. Explain how a decline in capital intensity would
affect the AFN, other things held constant. Would economies of scale combined
with rapid growth affect capital intensity, other things held constant? Also, explain
how changes in each of the following would affect AFN, holding other things
constant: the growth rate, the amount of accounts payable, the profit margin, and
the payout ratio.
Answer: The capital intensity ratio is the amount of assets required per dollar of sales, A0*/S0, and
it has a major effect on capital requirements. A decline in the capital intensity ratio
would lower the need for external capital as this would mean a smaller amount of assets
would be required per dollar of sales. Economies of scale combined with rapid growth
would mean that it is likely that the capital intensity ratio would change over time as the
size of the firm increased.
Mini Case: 9 - 19
Rapidly growing companies require large increases in assets and a corresponding
large amount of external financing, other things held constant. Accounts payable are
spontaneous liabilities that come about due to normal day-to-day business operations.
Firms don’t have a lot of control over the level of spontaneous liabilities as they’re a
function of industry norm and tax laws. The higher the firm’s level of accounts payable
(spontaneous liabilities) the smaller the amount of external financing, other things held
constant. The higher the profit margin, the larger the net income available to support
increases in assets, hence the less the need for external financing, other things held
constant. The less of its income a company distributes as dividends, the larger its
addition to retained earnings, hence the smaller the need for external capital—other
things held constant.
d. Define the term self-supporting growth rate. What is Hatfield’s self-supporting

growth rate? Would the self-supporting growth rate be affected by a change in the
capital intensity ratio or the other factors mentioned in the previous question?
Other things held constant, would the calculated capital intensity ratio change over
time if the company were growing and were also subject to economies of scale
and/or lumpy assets?
Answer: The self-supporting growth rate is the maximum growth rate the firm could achieve if it
had no access to external capital. From the data given, Hatfield’s self-supporting growth
rate is calculated as:
Self-supporting g = [M(1 – POR)(S0)]/[A0* – L0* – M(1 – POR)(S0)]
M= 3.30%
POR = 30.3%
1-POR = 69.7%
S0 = $2,000
A* = $1,200
L* = $80
Self-supporting g = [M(1 – POR)(S0)]/[A0* – L0* – M(1 – POR)(S0)]

= [(0.033)(0.697)($2,000)]/[$1,200 – $80 – 0.033(0.697)($2,000)]
= $46/$1,074
= 0.0428 = 4.28%.
Mini Case: 9 - 20
The higher the firm’s capital intensity ratio, the lower the firm’s self-supporting growth
rate because the firm would require more assets per dollar of sales. The higher the
firm’s profit margin and the lower its payout ratio, the higher the firm’s self-supporting
growth rate.
The calculated capital intensity ratio will change over time if the firm company is
expanding and if economies of scale and lumpy assets exist. When economies occur, the
capital intensity ratio will change over time as the size of the firm increases. In many
industries, technological considerations dictate that if a firm is to be competitive, it must
add fixed assets in large, discrete units. These assets are referred to as lumpy assets.
When this occurs the firm’s capital intensity ratio will change. So, at the point where the
assets must increase in a large amount, the capital intensity ratio will be high, so required
external financing will be high. As sales increase but assets don’t need to increase, the
capital intensity ratio will fall—until sales reach the point where large increases in assets
are required again.
e. Use the following assumptions to answer the questions below: (1) Operating ratios
remain unchanged. (2) Sales will grow by 10%, 8%, 5%, and 5% for the next four
years. (3) The target weighted average cost of capital (WACC) is 9%. This is the
No Change scenario because operations remain unchanged.
Actual Forecast
Inputs 2015 2016 2017 2018 2019
Sales growth rate: 10% 8% 5% 5%
Op. costs/Sales: 90% 90% 90% 90% 90%
Depr./FA 10% 10% 10% 10% 10%
Cash/Sales: 1% 1% 1% 1% 1%
Acct. rec. /Sales 14% 14% 14% 14% 14%
Inv./Sales: 20% 20% 20% 20% 20%
FA/Sales: 25% 25% 25% 25% 25%
AP & accr. / Sales: 4% 4% 4% 4% 4%
Tax rate: 40% 40% 40% 40% 40%
Rate on all debt 8.0% 8% 8% 8%
Div. growth rate: 5% 10% 10% 10% 10%
Target WACC 9%
Mini Case: 9 - 21
e. 1. For each of the next four years, forecast the following items: sales, cash, accounts
receivable, inventories, net fixed assets, accounts payable & accruals, operating
costs (excluding depreciation), depreciation, and earnings before interest and taxes
(EBIT).
Forecast sales as Salest = Salest-1(1+gt). For example, Sales2016 = $2,000(1+0.10) =

$2,200.
Forecast other items as a percent of sales (or as percent of fixed assets for
depreciation). For example, Inventories2016 = $2,200(0.20) = $44
Scenario: No Change Actual Forecast

2015 2016 2017 2018 2019
Net sales $2,000 $2,200 $2,376 $2,495 $2,620
Cash $20 $22 $24 $25 $26
Accounts receivable $280 $308 $333 $349 $367
Inventories $400 $440 $475 $499 $524
Net fixed assets $500 $550 $594 $624 $655
Accts. pay. & accruals $80 $88 $95 $100 $105
Op. costs (excl. depr.) $1,800 $1,980 $2,138 $2,245 $2,358
Depreciation $50 $55 $59 $62 $65
EBIT $150 $165 $178 $187 $196
e. 2. Using the previously forecasted items, calculate for each of the next four years the
net operating profit after taxes (NOPAT), net operating working capital, total
operating capital, free cash flow, (FCF), annual growth rate in FCF, and return on
invested capital. What does the forecasted free cash flow in the first year imply
about the need for external financing? Compare the forecasted ROIC compare
with the WACC. What does this imply about how well the company is performing?
NOPAT = EBIT(1-T)
NOWC = (Cash + accounts receivable + inventories) − (Accounts payable & accruals)
Total operating capital = NOWC + Net fixed assets
FCF = NOPAT − Change in total operating capital
ROIC = NOPAT/Total operating capital
Mini Case: 9 - 22
Scenario: Actual Forecast
No Change 2015 2016 2017 2018 2019
NOPAT $90 $99 $107 $112 $118
NOWC $620 $682 $737 $773 $812
Total op. capital $1,120 $1,232 $1,331 $1,397 $1,467
FCF −$13 $8 $46 $48
Growth in FCF -164% 447.1% 5.0%
ROIC 8.0% 8.0% 8.0% 8.0% 8.0%
e. 3. Assume that FCF will continue to grow at the growth rate for the last year in the
forecast horizon (Hint: 5%). What is the horizon value at 2019? What is the present
value of the horizon value? What is the present value of the forecasted FCF? (Hint:
use the free cash flows for 2016 through 2019). What is the current value of
operations? Using information from the 2015 financial statements, what is the
current estimated intrinsic stock price?
With no rounding in intermediate steps, FCF2019 = $48.025.
FCF2019 (1 + g L ) $48.025(1 + 0.05)

HV2019 = = = $1,261
(WACC − g L ) (0.09 − 0.05)
Scenario:
No Change
Horizon Value: Value of operations $958
+ ST investments $0
9(1+gL )
HV2019 = = $1,261 Estimated total intrinsic value $958
(WACC − gL )
− All debt $500
Value of Operations: − Preferred stock $0
Present value of HV $893 Estimated intrinsic value of equity $458
+ Present value of FCF $64 ÷ Number of shares 10
Value of operations = $958 Estimated intrinsic stock price = $45.75
Mini Case: 9 - 23
The estimated intrinsic stock value of $45.75 is less than the actual market price of
$52.80. The market price indicates that the market expected the operating performance
to improve; if operating performance doesn’t improve, the market price is likely to drop.
But keep in mind that stocks prices are very volatile, so a difference of −13% =
$45.75/$52.80 – 1 is not very big.
f. Continue with the same assumptions for the No Change scenario from the previous
question, but now forecast the balance sheet and income statements for 2016 (but
not for the following three years) using the following preliminary financial policy.
(1) Regular dividends will grow by 10%. (2) No additional long-term debt or
common stock will be issued. (3) The interest rate on all debt is 8%. (4) Interest
expense for long-term debt is based on the average balance during the year. (5) If
the operating results and the preliminary financing plan cause a financing deficit,
eliminate the deficit by drawing on a line of credit. The line of credit would be
tapped on the last day of the year, so it would create no additional interest expenses
for that year. (6) If there is a financing surplus, eliminate it by paying a special
dividend. After forecasting the 2016 financial statements, answer the following
questions.
f. 1. How much will Hatfield need to draw on the line of credit?
Answer: Forecast sales and then items on the balance sheet. The forecast of sales is $2,200.
Forecast the operating items as a percent of sales. The preliminary financial policy
specifies no change in the long-term debt or common stock. Retained earnings increase
by the addition to retained earnings from the forecasted income statement. Leave the line
of credit blank for now.
Mini Case: 9 - 24
Assets 2015 Input Basis for 2016 Forecast 2016
Cash $20 1% × 2016 Sales $22
Accts. rec. $280 14% × 2016 Sales $308
Inventories $400 20% × 2016 Sales $440
Total CA $700 $770
Net fixed assets $500 25% × 2016 Sales $550
Total assets $1,200 $1,320
Liabilities and equity
Accts. pay. & accruals $80 4% × 2016 Sales $88
Line of credit $0 Add LOC if fin. deficit
Total CL $80 $88
Long-term debt $500 No Change $500
Total liabilities $580 $588
Common stock $420 No Change $420
Retained earnings $200 Old RE + Add. to RE $253
Total common equity $620 $673
Total liabs. & equity $1,200 $1,261
Check: TA − TL & Equ. $59
Forecast the items on the income statement. Costs are a percent of sales, depreciation is a
percent of Net PP&E. Forecast interest expense on the long-term debt as the product of
the interest rate and the average balance on the long-term debt (i.e., the average of the
beginning value and the ending value). Pay a regular dividend. Leave the special
dividend blank for now.
2015 Input Basis for 2016 Forecast 2016

$2,20
Sales $2,000 110% × 2015 Sales 0
$1,98
Op. costs (excl. depr.) $1,800 90% × 2016 Sales 0
Depreciation $50 10% × 2016 Net fixed assets $55
EBIT $150 $165
Less: Interest on LTD $40 8% × Avg bonds $40
Interest on LOC $0 8% × Beginning LOC $0
Pretax earnings $110 $125
Taxes (40%) $44 40% × Pretax earnings $50
Net income $66 $75
Regular common dividends $20 110% × 2015 Dividend $22
Special dividends $0 Pay if financing surplus
Addition to RE $46 Net income – Dividends $53
Mini Case: 9 - 25
The next step is to identify the financing surplus or deficit. Start with the additions to
operating assets, subtract the increase in spontaneous liabilities (accounts payable and
accruals), subtract any new external financing from long-term debt or common stock,
and subtract the amount of reinvested net income (the amount that is not paid out in
common dividends). The result is the financing deficit (if it is negative) or the financing
surplus (if it is positive). If there is a deficit, draw on the LOC. If there is a surplus, pay a
special dividend.
Increase in spontaneous liabilities (accounts payable and accruals) $8

+ Increase in long-term debt and common stock $0
+ Net income minus regular common dividends $53
Increase in financing $61
− Increase in total assets $120
Amount of deficit or surplus financing: −$59
If deficit in financing (negative), draw on line of credit $59
If surplus in financing (positive), pay special dividend $0
There is a deficit of $59, so update the balance sheets by adding $59 to the line of credit.
Because the LOC is added at the end of the year, there is no additional interest, so there
is no need to update the income statement. If the LOC were instead added earlier in the
year, there would be additional interest, which would cause lower net income, which
would cause a lower addition to retained earnings, which would cause a bigger financial
deficit. This is called financing feedback. See Ch09 Tool Kit.xls and look at the
worksheet CFO Model for a simple way to resolve financing feedback and for an
extension of the 1-year forecasted financial statements to multiple years.
Mini Case: 9 - 26
Cash $20 1% × 2016 Sales $22
Accts. rec. $280 14% × 2016 Sales $308
Total CA $700 $770
Line of credit $0 Add LOC if fin. deficit $59
Total CL $80 $147
f. 2. What are some alternative ways than those in the preliminary financial policy that
Hatfield might choose to eliminate the financing deficit?
Answer: Here are some alternative ways to eliminate the deficit:
Cut dividends.
Add long-term debt.
Issue common stock.
Cut back on growth in operating plan.
Improve operating plan.
Mini Case: 9 - 27
g. Repeat the analysis performed the previous question but now assume that Hatfield
is able to improve the following inputs: (1) reduce operating costs (excluding
depreciation)/sales to 89.5% at a cost of $40 million; and (2) reduce
inventories/sales to 16% at a cost of $10 million. This is the Improve scenario.
Answer: The impact on the operating plan is shown below:
Scenario: Actual Forecast

Improve 2015 2016 2017 2018 2019
NOPAT $90 $106 $114 $120 $126
NOWC $620 $594 $642 $674 $707
Total op. capital $1,120 $1,144 $1,236 $1,297 $1,362
FCF $82 $23 $58 $61
Growth in FCF -72% 157.3% 5.0%
ROIC 8.0% 9.2% 9.2% 9.2% 9.2%
Scenario:
Improve
Horizon Value: Value of operations $1,314
+ ST investments $0
9(1+gL )
HV2019 = (WACC − gL )
= $1,598 Estimated total intrinsic value $1,314
− All debt $500
Value of Operations: − Preferred stock $0
Present value of HV $1,132 Estimated intrinsic value of equity $814
+ Present value of FCF $182 ÷ Number of shares 10
Value of operations = $1,314 Estimated intrinsic stock price = $81.37
Mini Case: 9 - 28
The impact on the financial statements is shown below.
Scenario:
Improve
Cash $20 1% × 2016 Sales $22
Accts. rec. $280 14% × 2016 Sales $308
Total CA $700 $682
Line of credit $0 Add LOC if fin. deficit $0
Total CL $80 $88
Mini Case: 9 - 29
Improve 2015 Input Basis for 2016 Forecast 2016
Sales $2,000 110% × 2015 Sales $2,200
Op. costs (excl. depr.) $1,800 89.5% × 2016 Sales $1,969
Depreciation $50 10% × 2016 Net fixed assets $55
EBIT $150 $176
Less: Interest on LTD $40 8% × Avg bonds $40
Interest on LOC $0 8% × Beginning LOC $0
Pretax earnings $110 $136
Taxes (40%) $44 40% × Pretax earnings $54
Net income $66 $82
Regular common dividends $20 110% × 2015 Dividend $22
Special dividends $0 Pay if financing surplus $36
Addition to RE $46 Net income – Dividends $24
Increase in spontaneous liabilities (accounts payable and accruals) $8

+ Increase in long-term debt and common stock $8
+ Net income minus regular common dividends $0
Increase in financing $60
− Increase in total assets $68
Amount of deficit or surplus financing: $32
If deficit in financing (negative), draw on line of credit $36
If surplus in financing (positive), pay special dividend $0
g. 1. Should Hatfield implement the plans? How much value would they add to the
company?
Answer: Improvement in value of operations: $1,314 − $958 = $356

Cost of improvements = $50
Company should make improvements.
g. 2. How much can Hatfield pay as a special dividend in the Improve Scenario? What
else might Hatfield do with the financing surplus?
Answer: Hatfield can pay a special dividend of $35. Instead, Hatfield could repurchase stock,
repay debt, or purchase marketable securities.
Mini Case: 9 - 30

Solution of Chapter 9 Books Problems

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Solution of Chapter 9 Books Problems

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Chapter 9

Corporate Valuation and Financial Planning

Answers and Solutions: 9 - 1

Answers and Solutions: 9 - 2

AFN = (A*/S0)∆S - d(L*/S0)∆S - MS1(RR).

Answers and Solutions: 9 - 3

9-1 a. The operating plan provides detailed implementation guidance designed to

Answers and Solutions: 9 - 4

Additional Required Increase in Increase in

M(1 − POR )(S 0 )

d. The forecasted financial statement approach using percent of sales develops a

Answers and Solutions: 9 - 5

b. +. It reduces spontaneous funds; however, it may eventually increase retained

Answers and Solutions: 9 - 6

9-1 AFN = (A0*/S0)∆S – (L0*/S0)∆S – (PM)(S1)(1 – payout rate)

9-3 AFN = (0.625)($1,200,000) – (0.1125)($1,200,000) – 0.06($9,200,000)(1 – 0)

Answers and Solutions: 9 - 7

AFN = (A0*/S0)∆S – (L0*/S0)∆S – (M)(S1)(1 – payout rate)

Sales can increase by $5,202,312 – $5,000,000 = $202,312 without additional funds

9-5 a. Total liab. = Accounts + Long-term + Common + Retained

Long-term debt = $590,000.

Total liab. = Accounts payable + Long-term debt

b. Assets/Sales (A0*/S0) = $2,170,000/$3,500,000 = 62%.

AFN = (A0*/S0)(∆S) – (L0*/S0)(∆S) – (M)(S1)(1 – payout) – New common stock

Alternatively, using the forecasted financial statement method:

Answers and Solutions: 9 - 8

Total assets $2,170,000 0.62 $2,929,500

Current liabilities $ 560,000 0.16 $ 756,000

Answers and Solutions: 9 - 9

Accounts payable $ 50.00 × 2 = $ 100.00

Target FA/S ratio = $500/$2,000 = 0.25.

**Addition to RE = (M)(S1)(1 – Payout ratio) = 0.05($2,000)(0.4) = $40.

9-7 a. AFN = (A0*/S0)(∆S) – (L0*/S0)(∆S) – (M)(S1)(1 – payout)

Answers and Solutions: 9 - 10

Forecasted sales = $420 million

Accounts payable $ 9.0 0.0257 $ 10.80 $ 10.80

Answers and Solutions: 9 - 11

Dividends (45%) $ 837 $ 954

Answers and Solutions: 9 - 12

Accounts payable $ 4,320 0.1200 $ 4,968 $ 4,968

*From income statement.

b. Line of credit = $2,128 (thousands of $).

Answers and Solutions: 9 - 13

Forecast Pro Forma

Dividends: $ 108,000 Set by management $ 112,000

Garlington Technologies Inc.

Accounts payable $ 360,000 0.10 $ 396,000 $ 396,000

*See income statement.

Answers and Solutions: 9 - 14

Answers and Solutions: 9 - 15

Hatfield Medical Supplies (Millions of Dollars Except Per Share Data)

ROEHatfield = Profit margin × Asset turnover × Equity multiplier

ROEIndustry = Profit margin × Asset turnover × Equity multiplier

Data for AFN Equation

Here is the AFN equation:

AFN = (A0*/S0)∆S – (L0*/S0)∆S – M(S1)(1 – Payout)

d. Define the term self-supporting growth rate. What is Hatfield’s self-supporting

Self-supporting g = [M(1 – POR)(S0)]/[A0* – L0* – M(1 – POR)(S0)]

Self-supporting g = [M(1 – POR)(S0)]/[A0* – L0* – M(1 – POR)(S0)]

Forecast sales as Salest = Salest-1(1+gt). For example, Sales2016 = $2,000(1+0.10) =

Scenario: No Change Actual Forecast

With no rounding in intermediate steps, FCF2019 = $48.025.

FCF2019 (1 + g L ) $48.025(1 + 0.05)

AFN = (A/S0)∆S - d(L/S0)∆S - MS1(RR).

9-1 AFN = (A0/S0)∆S – (L0/S0)∆S – (PM)(S1)(1 – payout rate)

AFN = (A0/S0)∆S – (L0/S0)∆S – (M)(S1)(1 – payout rate)

AFN = (A0/S0)(∆S) – (L0/S0)(∆S) – (M)(S1)(1 – payout) – New common stock

9-7 a. AFN = (A0/S0)(∆S) – (L0/S0)(∆S) – (M)(S1)(1 – payout)

AFN = (A0/S0)∆S – (L0/S0)∆S – M(S1)(1 – Payout)