CASE 11 George Tipton began the Tipton Ice Cream Company nearly five decades ago, He patented a soft ice cream and right from the outset paid special attention to quality, “We only make one product, but we make it in many flavors and we make it well,” Tipton was fond of saying, The company was an immediate suc- cess and sales quickly reached seven figures. DEBT AVERSION The firm expects strong growth in the coming year (1996) and Brenda Hood, Tipton’s chief financial officer, hopes she can make a strong case for borrowing to finance the company’s expansion. She realizes, however, that she is likely to {face stiff opposition from the Tipton family. George Tipton, perhaps unduly influenced by the Great Depression of the 1930s, detested borrowing money and his motto was “Never a lender nor borrower be,” For nearly 25 yearsall the company’s stock was owned by the Tipton family, but due to expansion new shares have been sold during the last 15 years to individuals outside the family. By 1995 the Tipton family owns 60 percent of all shares, and although the family has not been very active in running the firm, it does insist on one family tradition: “Never a lender nor borrower be,” To this day Tipton has never owed anything beyond its accounts payable and accruals, Hood knows this is an extreme case of debt aversion and the policy has hurt the owners’ profits. For example, historically Tipton has been slightly above the industry average in retum on total assets but consistently below in retum on owner's equity. At each annual meeting she has tried unsuccessfully to con- vince the Tipton clan to use more debt. And each year Hood heard a chorus of “Never a lender...” But perhaps this year would be different, She recalls two sessions on financial management that she held for the non- financial executives of Tipton. Some members of the Tipton family had70 PART Ill FINANCIAL PLANNING: attended these sessions, She explained that when sales increase, then inventory, cash, and accounts receivable must also increase. Further, ifthe firm’s existing operating capacity was insufficient to support the increased sales, additional fixed assets would be required. She had also stressed the need for pro forma statements to determine the magnitude of the funds needed. It was the first time members of the Tipton family hac received any formal financial exposure, and she recalls they seemed interested and attentive. At the previous annual meetings Hood had avoided using any technical finan- ial analysis to make her case for borrowing. But now she thinks, “Why not?” FORECASTING ASSUMPTIONS She decides to estimate (1) the amount of funds Tipton will have to obtain in 1996; @) the 1996 income statement assuming all of the financing is done through borrowing; and (3) another income statement assuming all new stock is issued. To help in the estimates Hood enlists Frank Davis, a recent MBA. Davis reminds her that 1996 is expected tobe a big year for the company; sales are predicted to increase by 25 percent. Due to the strong demand, marketing feels any cost increases can easily be passed on. Consequently, the gross margin should exceed the current level of 21 percent. Hood notes that the sales-to-inventory ratio will be lowered to 6.5, and that purchases should total $101 A81,000. This suggests cost of goods for 1996 would be $93,750,000. “What about administrative and selling expenses?” Hood asks Davis. He informs her that management salaries would have to rise sharply because these salaries had increased very slightly over the past three years. Davis believes 20 percent increase in administrative and selling expenses is reasonable. Fixed assets are likely to change sharply in the coming year, Currently, ‘Tipton is operating virtually near capacity, demand is expected to remain high, and thus extra capacity will be needed. In addition, some major improvements to existing equipment will have to be made in order for the company to remain competitive. The planning for these changes has been anticipated for some time, and though all of these changes do not have to be made in 1996, it is clear that the company cannot grow beyond 1996 without them, In any event, it is ‘urgent that the financing question be resolved as soon as possible, A reasonable estimate is that Tipton will purchase $5 million of new plant and equipment in 1996. “During the past year we've been a bit slow in paying our suppliers,” Hood remarks, “We definitely will have to pay more promptly or we're going to have some annoyed creditors; plus we'll pick up cash discounts by paying earlier, See if you can come up with an estimate of our payables using past information.” Hood and Davis also feel that over the last few years factors (other than sales) affecting accruals and receivables have been relatively constant. For example, the company has not altered its credit policy in the last three years. Nor can they think of any reason why these items should change significantly in the comingCASE 11 TIPTON ICECREAM 71 year, “Of course, an exact relationship between each of these and sales is unlikely to exist,” Hood cautions, “We can expect some yearly random fluc- tuation. And keep in mind the ‘big /little’ mix will be changing since we'll be selling to smaller food chains. This has implications for our receivables since these firms are relatively slow to pay. This shouldn’t be a major factor, Frank, but it is something you should be aware of when you make your estimate.” Hood and Davis think the cash management of the firm has been a “bit sloppy” over the past few years, and both agree the company could make do with a lower level of liquidity. Davis suggests he assume a level of 2 percent of sales, which is the approximate industry average, and Hood agrees. “What about dividends?” Davis asks Hood, “Our payout ratio is usually around 50 percent. However, if we borrow all the extra money, let’s work backwards on the dividends; that is, out of net income subtract the amount of the retained earnings we would obtain if we used all-equity financing.” FORECASTING RESTRICTIONS There are two final problems. While Hood believes the company should use more debt, she recognizes that the final decision rests with the Tipton family. Given their debt aversion it is important that any projections not appear too debt-heavy. She also wonders how much flexibility she would have to use short-term debt, assuming the decision to borrow is made, Hood, therefore, instructs Davis to work within the following constraints when doing the fore- cast. As working hypotheses she wants Tipton’s debt ratio to remain below 0.5, and the current and quick ratios must not fall below 2 and 1, respectively, In other words, the financial projection cannot violate any one of these restrictions. “Given these limitations, see how much flexibility we have in raising any funds needled,” Hood tells Davis. QUESTIONS 1. Project the 1996 income statement assuming no borrowing, 2, Project Tipton’s 1996 balance sheet assuming no borrowing, 3. Explain how the $93.75 million costofgoods estimate for 1996 was obtained. 4. How much money will Tipton need to raise in 1996? 5. (a) How much of this money can Tipton borrow Jong term without violat- ing the constraints imposed by Hood? (&) How much of this money can be raised using notes payable without violating these constraints?2 PART Ill FINANCIAL PLANNING: 6. Redo the 1996 income statement assuming all of the funds needed are bor- rowed as long-term bondsat 8 percent. (Keep retained earnings at the same level as in question 1) 7. Will the Tipton family own less than 50 percent of the firm's stock if no funds are borrowed? (Assume shares are sold to nonfamily members at $11.50 per share, which nets $10.50 after brokerage fees.) 8 Calculate the dividend per share and eamings per share if the expansion is, (@) Financed by new equity. (©) Financed by borrowing. 9. Use the percent of sales method to forecast the amount of financing, Why oes this estimate differ from your answer in question 4? 10. (@) When making a financial forecast, which one of the items that must be estimated is the most important? Why? (®) Which item do you think is typically the most difficult to forecast? 11. @) What are some ratios you would calculate to help determine the risk of using debt? (©) Play the role of a consultant. Industry averages for all categories of ratios are given in Exhibit 3. Based on your previous answers, the ratios calculated in part (a), and these industry averages, would you endorse the debt financing if you were a member of the Tipton family? Explain, SOFTWARE QUESTION 12. Hood is generally quite comfortable with the assumptions of her forecast. Still, she recognizes that her estimates could be wrong and she decides to analyze the following scenarios. SI 2 83 st 19% sales $115,000 15,0000 $125 90000 's13000000 CCS/sales 76 B 75 7 Cash/sales 03 8 05 m AP 3800 3600 3900 3800 AP/sales aw 05 063 063 Sales/inv. 620 650 620) 610 ‘Note: AP refers to accounts payable,CASE 11 TIPTON ICECREAM 73 ‘The first two scenarios, S-1 and S-2, represent the estimates of the firm’s mar- keting director and sales manager, respectively, people whose judgment Hood respects. The third scenario considers the possibility that the firm’s working capital management won't be as efficient as Hood expects. The final set of estimates assumes that sales exceed Hood’s original projection, ‘Analyze each scenario assuming first that all needed funds are raised by equity, and then assume all needed funds are raised by selling bonds, that is, “long-term debt.” How, if at all, do the results affect your answer to question 11(b)? (Keep alll other estimates at their base-case values.) EXHIBIT 1 Selected Financial Information for Previous Three Years. (000s) 1993 1994 Sales $88,500 $95,000 ss1co.000 Receivables AD BRB $8,000 Average collection period (days) 302 2 288 ‘Accounts payable 5700 $6400 950 Aarus 240 1500 3,00 EXHIBIT 2 Balance Sheets (000s) Bauity Deb 1995 1996, 1995 Assets Cash Semarketable securities 300 Aqqounis receivable 800 Inventory 1150) Curnent assets 250 Goss fod assets 2400 Accumulated depreciation (4400) st3600) stun) Net fia assets aon Total assets 42500 — — Liabilities and Exuity Notes payable 9 Accounts payable 9500 ‘Accruals 300 — — Current liabilities 1250) Bonds ‘Common stock 20000 (S10pan) Retained eamings oom ‘Total liabilities and equity S25m (continued)74 PARTI FINANCIAL PLANNING EXHIBIT 2 (Continued) Income Statements (000s) Eauty Deb 1995 1996 197 Net sales 10000 Cost of gookts| Dan Gossprofit, 2100 Administrative & selling expenses 10000 Depreciation iy sooo $0 Miscellaneous 200 20 2) BIT 1020 Interest Earnings before tes 1920 Taxes 60") 540) Net income 51) Dividends 258) ‘To retained eamings 258) EXHIBIT 3 Industry Averages Cument 18 Quick os Debt 0%) 500 ‘Times interest earned 60 Inventory turover (ales) 60 Average collection period (lays) 250 ‘Total asset tumover 2a (Geos profit margin (%) 180 Retum an total assets (7) 85 Net profit on sales (%) 39 Retum on net worth