Solution Manual for Case Studies in Finance 8th

Bruner

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Solution Manual for Case Studies in Finance 8th Bruner

UVA-F-1512TN
Rev. Nov. 2, 2016

Horniman Horticulture

Teaching Note

Synopsis and Objectives

This case captures the problems concerning cash flow and working-capital management typical of small,
growing businesses. At the end of 2015, Bob and Maggie Brown have completed their third year of operating
Horniman Horticulture, a $1-million-revenue woody-shrub nursery in central Virginia. While experiencing
booming demand and improving margins, the Browns are puzzled by their plummeting cash balance. The case
highlights the difference between cash flow and accounting profits, as well as the common negative effects of
growth on cash flow. It also provides a forum for instilling appreciation for the relevance of free cash flow to
business owners and managers, introducing financial-ratio analysis, developing the concept of the cash cycle
and working-capital management, and motivating the use of financial models.

Suggested Student Study Questions

1. What is your assessment of the financial performance of Horniman Horticulture?

2. Do you agree with Maggie Brown’s accounts-payable policy?
3. What explains the erosion of the cash balance?
4. What do you expect the financial position of the business to be in 2016? Extend the financial
statements through 2016, assuming that Bob Brown grows revenue by 30%. Note: To make the balance
sheet balance, define cash as equal to (Curr. liab. + Net worth) – (Accounts
receivable + Inventory + OCA + Net fixed assets).

Suggested Supplementary Material

The case comes with student and instructor spreadsheets. The technical note “Business Performance
Evaluation: Approaches for Thoughtful Forecasting” (UVA-F-1490) provides an overview of financial ratios
and forecasting, with the objective of assisting students in developing meaningful financial forecasts.1

1 Michael J. Schill, “Business Performance Evaluation: Approaches for Thoughtful Forecasting,” UVA-F-1490 (Charlottesville, VA: Darden Business

Publishing, 2015).

This teaching note was prepared by Michael J. Schill, Professor of Business Administration. Horniman Horticulture is a fictional company reflecting the
disguised attributes of an actual nursery. Copyright © 2007 by the University of Virginia Darden School Foundation, Charlottesville, VA. All rights
reserved. To order copies, send an e-mail to sales@dardenbusinesspublishing.com. No part of this publication may be reproduced, stored in a retrieval system, used in a
spreadsheet, or transmitted in any form or by any means—electronic, mechanical, photocopying, recording, or otherwise—without the permission of the Darden School Foundation.

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Page 2 UVA-F-1512TN

Hypothetical Teaching Plan

1. What is going right with this business? What concerns you?

2. Where is the cash going?
3. Will strong business performance in 2016 improve the cash position?
4. Do you agree with Maggie Brown’s accounts-payable policy?
5. What are the alternatives for solving the business’s cash problem?
6. What is the problem?

Case Analysis

1. What is going right with this business? What concerns you?

By many standards, Horniman Horticulture is doing very well. The business is expanding in a market
where the benchmark firms are actually shrinking. Profitability is strong, with margins and ROA/ROC figures
that beat benchmark figures and show impressive gains over time. Customers and employees are happy. The
business is conservatively financed. Suppliers are being paid on time.

Yet, there are a number of concerns. The cash balance has declined, from $120,000 in 2012 to $9,400 at
the end of 2015, which is well below Maggie Brown’s target balance of $83,900. The decline in cash balance
seems odd in a business that is generating so much profit. In addition, the owners of the business have not
been able to increase their salary or generate dividends from business operations. Receivable days and inventory
days have been increasing over the past few years. The increase in inventory days likely reflects the Browns’
shift to selling higher-margin, mature plants, while the increase in receivable days reflects their effort to provide
better financing for customers. In contrast, the number of accounts-payable days has been declining as Maggie
has taken all available trade discounts. These working-capital management policies are worth reviewing.

2. Where is the cash going?

The objective of this discussion is to emphasize the distinction between accounting profitability and cash
flow. To begin the discussion, the instructor can emphasize the profitability of the business by putting the
operating profits on the board. In 2015, the anticipated operating profits for the business were $100,000. To
make the point more dramatically, the instructor can add back depreciation expense as it is not a cash expense.
In 2015, that sum is $140,900. The instructor can then ask, “Where did all this cash go?” This sets up a
discussion of cash flow. Students will immediately observe that some of the profits went to the government:
taxes were $39,200. The resulting balance, $101,700, was the anticipated operating cash flow for 2015.
Page 3 UVA-F-1512TN

What happened to all that operating cash flow (OCF)? A small amount was invested in fixed assets of the
business; capital expenditure (Capex) was only $4,500. The remainder, $97,200, was invested in net working
capital (NWC).2 It is worth noting that this calculation (OCF – Capex – NWC investment) is the definition for
free cash flow. In showing that all operating cash flow is consumed by investment, we also show that the free
cash flow to the owners of the business is zero. The students should understand that the free cash flow in 2015
is exactly zero because no cash was distributed to the owners. Every dollar of profits was reinvested in the
business, through capital expenditures or investments in net working capital. Ultimately, the account that makes
the relationship balance is the cash account. If one computes the free cash flow for earlier years, one sees that
the free cash flow has been zero for every year that the Browns have owned the business. This finding is
consistent with the discussion of their payouts in the case. In effect, the decline in the cash balance demonstrates
how the business has been consuming cash.

The instructor may want to spend some time showing how working capital consumes cash. One effective
way to do this is to go through the mechanics of the cash cycle. This is easy to do using the “days” measures
in case Exhibit 2. The average number of days that inventory costs are held by the business is measured as
“inventory days.” The average number of days that receivables are held is measured as “receivable days.” The
average number of days that accounts payable to suppliers are held is measured as “payable days.” For 2015,
the cash cycle can be measured as follows:

Inventory days 476 days

Receivable days +51 days
= Cash cycle 527 days
Payable days –10 days
= Financing days 517 days

Because of the very long cash cycle in this business, the point should be made that the Browns are actually
in two businesses: the business of producing and selling plants and the business of financing inventory and
customer credit. Because of the amount of capital required to finance this business, one should not be surprised
that it is a cash-hungry operation.

3. Will strong business performance in 2016 improve the cash position?

This question affords an opportunity to use a financial model of the company financials. Exhibit TN1
provides an example of a simple set of assumptions that might be prescribed in a base-case forecasting model.
Almost regardless of the assumptions, the cash consumed next year is expected to be an alarming amount. The
magnitude of the cash need (the cash balance in Exhibit TN1 is −$169,300) provides a dramatic illustration
of the power of a financial model. The business will not continue for long. “Business as usual” is not an option.

To estimate the financing need more succinctly, the class can calculate the free cash flow under the
assumption that the cash balance needs to be returned to the needed amount of 8% of revenue. With an
estimated 2016 revenue of $1.36 million, the cash balance should be $109,000. Under this assumption, the free
cash flow is large and negative (Exhibit TN2 shows that, under the assumptions in Exhibit TN1, the free
cash flow is −$278,300). This creates a dilemma for how to close the financing gap.

2One can detail the individual investments in the line items of net working capital for 2015:
Cash −$57,400
Accounts receivable $26,900
Inventory $133,500
Other current assets −$1,700
These amounts are offset by increases in current liabilities of $4,100. The resulting balance is $97,200, the total net working-capital investment.
Page 4 UVA-F-1512TN

4. Do you agree with Maggie Brown’s accounts-payable policy?

At first blush, the 2% discount achieved appears trivial and seems to be an obvious place to extend
Horniman’s capital. The astute student will show that the 2% savings applies to 20 days of financing, not the
whole year. To annualize the savings, one must multiply 2% by the number of 20-day periods in a year (18.25).
The annualized savings is a pretax return of 36.5%. One can show this further by estimating the savings in
capital that would result in extending the payment to 30 days and comparing this with the 2% loss on purchases.
Based on the estimates in Exhibit TN1, these figures are as follows:

Expected 2016 profit loss 2% × purchases of $240.6K = $4.81K

Expected capital increase Accounts payable increase from $6.5K to $19.7K
where $19.7K = 29.9 days × $240.6K/365 days

By dividing these two amounts, $4.81K/($19.7K − $6.5K), we again get 36%—the effective cost of not taking
the discount.

The annualized figure provides a good foil for thinking about the cost of capital. The case states that
Horniman can obtain mortgage financing at 6.5% a year. Forgoing the discount seems hard to justify when
compared with the cost of borrowing from a bank. One can also motivate a brief discussion that the true cost
of capital also includes a cost of equity financing, which is likely to be higher than 6.5%. Thus, the firm’s pretax
cost of capital is expected to be higher than 6.5% but surely lower than 36%. Maggie’s accounts-payable policy
seems sound.

5. What are the alternatives for solving the business’s cash problem?

The free-cash-flow calculation provides a reasonable framework for establishing the alternatives facing the
Browns.
a. Increase profits

Increase revenue. Horniman already seems to be growing the top line aggressively. It may be worth
considering raising prices to improve margins and slowing unit growth. Although the Browns
might consider further expansion into larger shrubs with better margins, such a move would incur
an additional inventory-investment cost.

Reduce operating costs. The case suggests that the business is run efficiently.

b. Reduce investment

Improve receivable-collection time. Horniman is well above industry norms. One can question the
wisdom of growing the small-nursery business, which appears to require generous financing terms.

Improve inventory days. This is part of Horniman’s business; it is unclear whether the inventory
can be improved, particularly if they are moving to more-mature plants. The analysis to make this
trade-off is similar to that of the payables policy. One would divide the expected margin gain by
the increase in inventory levels to compute a marginal return on capital. One additional level of
concern is the substantial additional risk associated with increasing inventory when facing
uncertainty with respect to the effects of interest rates and adverse weather.
Page 5 UVA-F-1512TN

Reduce investment in net fixed assets. Horniman already seems to be operating efficiently. NFA
turnover has increased strongly over the past year; in fact, there is valid concern that capital
expenditures are going to need to increase going forward.

c. Increase business financing

Debt or equity financing. With annual free cash flow reaching levels of −$278,000, the business is
burning a lot of cash. One should expect that if nothing is done to the business model, debt
requirements will become larger and larger. It is unclear whether Maggie is interested in leveraging
the business and risking possible default with an adverse weather event.

In discussing these alternatives, it is important that they be economically feasible collectively. The business
is bounded by competitive realities and business strategy. As the ideas surface, one can use the model to gain a
sense of the magnitude of their impact.

6. What is the problem?

The Browns face problems common to many businesses. First, they may have confused profits with cash
flow. Second, they may have underappreciated the cash-flow effects of booming business growth. The
fundamental source of their cash-flow problem is the pace of the business growth. Growth commonly requires
heavy asset investment. The cash-flow effects of such growth are to be appreciated. Using the assumptions in
Exhibit TN1, the cash balance is unchanged if the revenue growth is decreased to 4.2%.

As the discussion turns to level of growth as the basis for the problems, the instructor may turn to the
concept of “sustainable growth” as a tool to discuss the challenges faced by the Browns. Sustainable growth
can be defined as follows:

Sustainable growth = ROC × LEV × Retention,

where ROC is the net profit divided by total capital, LEV is total capital divided by net worth, and Retention
is the fraction of profits retained in the business. In this case, the sustainable growth rate is currently equal to
the return on capital, as the leverage ratio is 1 (total capital equals net worth) and the owners are reinvesting all
the profits in the business. (Note that, in the model, this will not work precisely unless the capital expenditures,
depreciation, and change in net working capital are tied to the revenue growth rate.)

One might question the value created by the growth. Current return-on-capital rates are below the cost of
debt. This suggests that the returns are well below the opportunity cost of capital. One way to emphasize this
is to estimate the economic profit (EVA) generated by the business.

Economic profit = (ROC – Cost of capital) × Total capital

Based on a 2015 ROC of 5.4%, an ad hoc estimate of the cost of capital of 9%, and a 2015 total capital of
$1.1 million, the business generated profits above the opportunity cost of capital of −$40,000. The Browns
must increase the profitability of their business; otherwise, it would be better for them to earn their salary from
another firm and deploy their capital at the opportunity cost of capital. Given the effect of carrying capital, it
is worth questioning whether the margin gains for more-mature plants offset the costs of carrying the extra
inventory.
Page 6 UVA-F-1512TN

Exhibit TN1
Horniman Horticulture
Projected 2016 Financial Summary for Horniman Horticulture
(in thousands of dollars)

2012 2013 2014 2015 2016E Assumptions

Profit and loss statement
Revenue 788.5 807.6 908.2 1048.8 1363.4 30.0% Sales growth
Cost of goods sold 402.9 428.8 437.7 503.4 654.4
Gross profit 385.6 378.8 470.5 545.4 709.0 52.0% 2005 Margin
SG&A expense 301.2 302.0 356.0 404.5 525.9 38.6% 2005 % of Revenue
Depreciation 34.2 38.4 36.3 40.9 46.0 Maggie's estimate
Operating profit 50.2 38.4 78.2 100.0 137.2
Taxes 17.6 13.1 26.2 39.2 53.8 39.2% 2005 % of Operating profit
Net profit 32.6 25.3 52.0 60.8 83.4

Balance sheet
Cash 120.1 105.2 66.8 9.4 (169.3) Plug 8% of revenue= 109.1
Accounts receivable 90.6 99.5 119.5 146.4 190.3 50.9 2005 days
Inventory 468.3 507.6 523.4 656.9 854.0 476.3 2005 days
Other current assets 20.9 19.3 22.6 20.9 27.2 2.0% 2005 % of Revenue
Current assets 699.9 731.6 732.3 833.6 902.2
Net fixed assets 332.1 332.5 384.3 347.9 376.9 NFA+Capex-Dep
Total assets 1032.0 1064.1 1116.6 1181.5 1279.1

Accounts payable 6.0 5.3 4.5 5.0 6.5 9.9 2005 days
Wages payable 19.7 22.0 22.1 24.4 31.7 2.3% 2005 % of Revenue
Other payables 10.2 15.4 16.6 17.9 23.3 1.7% 2005 % of Revenue
Current liabilities 35.9 42.7 43.2 47.3 61.5
Net worth 996.1 1021.4 1073.4 1134.2 1217.6

Capital expenditure 22.0 38.8 88.1 4.5 75.0 Maggie's estimate

Purchases 140.8 145.2 161.2 185.1 240.6 37% 2005 COGS %
NWC 664.0 688.9 689.1 786.3 840.7 CA-CL
Solution Manual for Case Studies in Finance 8th Bruner

Page 7 UVA-F-1512TN

Exhibit TN2
Horniman Horticulture
Projected 2016 Free Cash Flow for Horniman Horticulture
(in thousands of dollars)

2013 2014 2015 2016E

Scenario 1: Exhibit TN1 Assumptions with cash balance as plug

Operating profit 38.4 78.2 100.0 137.2

- Taxes 13.1 26.2 39.2 53.8
+ Depreciation 38.4 36.3 40.9 46.0
Operating cash flow 63.7 88.3 101.7 129.4
- Capex 38.8 88.1 4.5 75.0
- Inc in NWC 24.9 0.2 97.2 54.4
Free cash flow 0.0 0.0 0.0 0.0

Scenario 2: Exhibit TN1 Assumptions with cash balance at 8% of revenue

Operating profit 38.4 78.2 100.0 137.2

- Taxes 13.1 26.2 39.2 53.8
+ Depreciation 38.4 36.3 40.9 46.0
Operating cash flow 63.7 88.3 101.7 129.4
- Capex 38.8 88.1 4.5 75.0
- Inc in NWC 24.9 0.2 97.2 332.7
Free cash flow 0.0 0.0 0.0 (278.3)

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