A B C D E F G H I J

1 ffm17-ic-model 10/21/2009 5:28 2/10/2003

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3 Chapter 17. Integrated Case Model
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5
6 Sue Wilson, the new financial manager of New World Chemicals (NWC), a California producer of specialized chemicals for
7 use in fruit orchards, must prepare a financial forecast for 2003. NWC’s 2002 sales were $2 billion, and the marketing
8 department is forecasting a 25 percent increase for 2002. Wilson thinks the company was operating at full capacity in 2002,
9 but she is not sure about this. The 2002 financial statements, plus some other data, are given in table IC17-1.
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11 Assume that you were recently hired as Wilson’s assistant, and your first major task is to help her develop the forecast. She
12 asked you to begin by answering the following set of questions.
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14
15 INPUT DATA (for New World Chemicals)
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17 TABLE IC17-1 Financial Statements and other data on NWC
18 (MILLIONS OF DOLLARS)
19
20 BALANCE SHEET 2002
21 Assets
22 Cash and securities $20
23 Accounts receivable 240
24 Inventory 240
25 Total current assets $500
26 Net fixed assets 500
27 Total assets $1,000
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29 Liabilities and equity
30 Accounts payable & accrued liab. $100
31 Notes payable 100
32 Total current liabilities $200
33 Long-term debt 100
34 Common stock 500
35 Retained earnings 200
36 Total liabilities and equity $1,000
37
38
39 INCOME STATEMENT 2002
40 Sales $2,000
41 Less: variable costs 1,200.00
42 Fixed costs 700
43 EBIT $100.00
44 Interest 16
45 EBT $84.00
46 Taxes (40%) 33.6
47 Net Income $50.40
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49 Dividends (30%) $15.12
50 Addition to Retained Earnings $35.28
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53 KEY RATIOS
54 NWC INDUSTRY COMMENT
55 Basic Earning Power 10.00% 20.00%
56 Profit Margin 2.52% 0.0
57 Return on Equity 7.20% 15.60%
58 Days Sales Outstanding (365 days) 43.8 32.0
59 Inventory Turnover 8.33 11
60 Fixed Assets Turnover 4.0 5.0
61 Total Assets Turnover 2.0 2.5
62 Debt/Assets Ratio 30% 36%
63 Times Interest Earned 6.25 9.4
64 Current Ratio 2.5 3.0
65 Payout Ratio 30.00% 30.00%
66
67 OTHER INPUT DATA
68 Sales growth rate 25%
69 Tax rate 40%
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71
72
73
74 PART A
75 Assume (1) that NWC was operating at full capacity in 2002 with respect to all assets, (2) that all assets must grow
76 proportionally with sales, (3) that accounts payable and accrued liabilities will also grow in proportion to sales, and (4) that the
77 2002 profit margin and dividend payout will be maintained. Under these conditions, what will the company’s financial
78 requirements be for the coming year? Use the AFN equation to answer this question.
79
80 This is the AFN equation:
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82
83 AFN = (A* / S0) * (dS) - (L* / S0) * (dS) - M * (S1) * (RR)
84 AFN = (A* / S 0
) * (g*S 0
) - (L* / S 0
) * (g * S0
) - M * (S0)(1+g) * (1 - payout ratio)
85 AFN = $250.0 - $25.0 - 44.1
86 AFN = $180.9
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88
89 PART B
90 Now estimate the 2003 financial requirements using the projected financial statement approach. Disregard the assumptions
91 in Part A, and now assume (1) that each type of asset, as well as payables, accrued liabilities, and fixed and variable costs, grow in
92 proportion to sales; (2) that NWC was operating at full capacity; (3) that the payout ratio is held constant at 30 percent; and (4)
93 that external funds needed are financed 50 percent by notes payable and 50 percent by long-term debt (no new common stock
94 will be issued).
95
96 We have reproduced some of the input data (growth rate and tax rate) below along with the financial statements. The forecast
97 can be observed below.
98
99 Sales Growth Rate 25%
100 Tax rate 40%
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 A B C D E F G H I J
102 INCOME STATEMENT
103 (in millions of dollars) Forecast basis
104 2002 % of sales 2003
105 Sales $2,000.0 100.00% $2,500.0
106 Less: Variable costs $1,200.0 60.00% $1,500.0
107 Fixed costs $700.0 35.00% $875.0
108 EBIT $100.0 $125.0 Underline is in wrong place.
109 Interest expense $16.0 $16.0
110 EBT $84.0 $109.0 Underline is in wrong place.
111 Taxes (40%) $33.60 $43.60
112 Net income $50.4 $65.4
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114 Dividends to common $15.1 $19.6
115 Addition to retained earnings $35.3 $45.8
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117
118 Funds raised as notes payable 50%
119 Funds raised as long-term debt 50%
120 Funds raised as new common stock 0%
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122
123 BALANCE SHEET (AFTER TWO PASSES)
124 (in millions of dollars) Forecast basis 2003
125 2002 % of sales 1ST PASS AFN 2ND PASS
126 Assets
127 Cash $20.0 1.00% $25.0 $25.0
128 Accounts receivable 240.0 12.00% 300.0 300.0
129 Inventories 240.0 12.00% 300.0 300.0
130 Total current assets $500.0 25.00% $625.0 $625.0
131 Net plant and equipment 500.0 25.00% 625.0 625.0
132 Total assets $1,000.0 50.00% $1,250.0 $1,250.0
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134 Liabilities and equity
135 Accounts payable & accruals $100.0 5.00% $125.0 $125.0
136 Notes payable 100.0 100.0 $89.6 189.6
137 Total current liabilities $200.0 10.00% $225.0 $314.6
138 Long-term bonds 100.0 100.0 $89.6 189.6
139 Total debt $300.0 15.00% $325.0 $504.2
140 Common stock 500.0 500.0 500.0
141 Retained earnings 200.0 +$68.4 245.8 245.8
142 Total common equity $700.0 35.00% $745.8 $745.8
143 Total liabilities and equity $1,000.0 50.00% $1,070.8 $1,250.0
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145 Additional funds needed (AFN) 179.2
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147 AFN FINANCING
148 Notes payable $89.6
149 Long-term debt $89.6
150 Total $179.2
151
152 Notice that the AFN of $179.2 contradicts the result found in the AFN equation from Part A.
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154
155 PART C
156 Why do the two methods produce somewhat different AFN forecasts? Which method provides the more accurate forecast?
157
158 The difference occurs because the AFN equation method assumes that the profit margin remains constant, while the forecasted
159 balance sheet method permits the profit margin to vary. The balance sheet method is somewhat more accurate (especially when
160 additional passes are made and financing feedbacks are considered), but in this case the difference is not very large. The real
161 advantage of the balance sheet method is that it can be used when everything does not increase proportionately with sales. In
162 addition, forecasters generally want to see the resulting ratios, and the balance sheet method is necessary to develop the ratios.
163
164 In practice, the only time we have ever seen the AFN equation used is to provide (1) a “quick and dirty” forecast prior to
165 developing the balance sheet forecast and (2) a rough check on the balance sheet forecast.
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168 PART D
169 Calculate NWC’s forecasted ratios, and compare them with the company’s 2002 ratios and with the industry averages. How
170 does NWC compare with the average firm in its industry, and is the company expected to improve during the coming year?
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172 NWC2003 NWC2002 INDUSTRY
173 Basic Earning Power 10.00% 10.00% 20.00%
174 Profit Margin 2.62% 2.52% 4.00%
175 Return on Equity 8.77% 7.20% 15.60%
176 Days Sales Outstanding (365 days) 43.8 43.8 32.0
177 Inventory Turnover 8.33 8.33 11.0
178 Fixed Assets Turnover 4.0 4.0 5.0
179 Total Assets Turnover 2.0 2.0 2.5
180 Debt/Assets Ratio 40.34% 30% 36%
181 Times Interest Earned 7.81 6.25 9.4
182 Current Ratio 1.99 2.50 3.00
183 Payout Ratio 30.00% 30.00% 30.00%
184
185 NWC’s BEP, profit margin, and ROE are only about half as high as the industry average--NWC is not very profitable relative to
186 other firms in its industry. Further, its DSO is too high, and its inventory turnover ratio is too low, which indicates that the
187 company is carrying excess inventory and receivables. In addition, its debt ratio is forecasted to move above the industry
188 average, and its coverage ratio is low. The company is not in good shape, and things do not appear to be improving.
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191 PART E
192 Calculate NWC’s free cash flow for 2003.
193
194 Operating capital2002 = CA - CL (w/o NP) + Net fixed assets
195 Operating capital2002 = $500.0 - $100.0 + $500.0
196 Operating capital2002 = $900.0
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198 Operating capital2003 = $1,125.0
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200 FCF 2003 = NOPAT - Net investment in operating capital
201 FCF 2003 = $75.0 - $225.0
202 FCF 2003 = ($150.0)
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204
205 PART F
206 Suppose you now learn that NWC’s 2002 receivables and inventory were in line with required levels, given the firm’s credit and
207 inventory policies, but that excess capacity existed with regard to fixed assets. Specifically, fixed assets were operated at only
208 75 percent of capacity.
209
210 (1) What level of sales could have existed in 2002 with the available fixed assets? What would the fixed assets-to-sales ratio
211 have been if NWC had been operating at full capacity?
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213 Full capacity sales = Actual sales / % of capacity for FA
214 Full capacity sales = $2,000 / 75%
215 Full capacity sales = $2,666.67
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217 Since the firm started with excess fixed asset capacity, it will not have to add as much fixed assets during 2003 as was originally
218 forecasted:
219
220 Target FA/Sales ratio= Fixed assets / Full capacity sales
221 Target FA/Sales ratio= $500 / $2,667
222 Target FA/Sales ratio= 18.75%
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224 The additional fixed assets needed will be 0.1875 (predicted sales - capacity sales) if predicted sales exceed capacity sales,
225 otherwise no new fixed assets will be needed. In this case, predicted sales = 1.25 ($2,000) = $2,500, which is less than capacity
226 sales, so the expected sales growth will not require any additional fixed assets.
227
228 (2) How would the existence of excess capacity in fixed assets affect the additional funds needed during 2003?
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230 We had previously found an AFN of $179.22 using the balance sheet method and $180.9 using the AFN formula. In both cases,
231 the fixed assets increase was 0.25($500) = $125. Therefore, the funds needed will decline by $125.
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234 PART G
235 Without actually working out the numbers, how would you expect the ratios to change in the situation where excess capacity in
236 fixed assets exists? Explain your reasoning.
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238 We would expect almost all the ratios to improve. With less financing, interest expense would be reduced. Depreciation and
239 maintenance, in relation to sales, would decline. These changes would improve the BEP, profit margin, and ROE. Also, the total
240 assets turnover ratio would improve. Similarly, with less debt financing, the debt ratio and the current ratio would both improve,
241 as would the TIE ratio.
242
243 Without question, the company’s financial position would be better. One cannot tell exactly how large the improvement will be
244 without working out the numbers, but when we worked them out we obtained the following numbers:
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 A B C D E F G H I J
246 2002 2003
247 @ 75% @ 100%
248 Basic Earning Power 10.00% 11.11% 10.00%
249 Profit Margin 2.52% 2.62% 2.62%
250 Return on Equity 7.20% 8.77% 8.77%
251 Days Sales Outstanding (365 days) 43.80 43.80 43.80
252 Inventory Turnover 8.33 8.33 8.33
253 Fixed Assets Turnover 4.00 5.00 4.00
254 Total Assets Turnover 2.00 2.22 2.00
255 Debt/Assets Ratio 30.00% 33.71% 40.34%
256 Times Interest Earned 6.25 7.81 7.81
257 Current Ratio 2.50 2.48 1.99
258 Payout Ratio 30.00% 30.00% 30.00%
259
260
261 PART H
262 On the basis of comparisons between NWC’s days sales outstanding (DSO) and inventory turnover ratios with the industry
263 average figures, does it appear that NWC is operating efficiently with respect to its inventory and accounts receivable? If the
264 company were able to bring these ratios into line with the industry averages, what effect would this have on its AFN and its
265 financial ratios?
266
267 The DSO and inventory turnover ratio indicate that NWC has excessive inventories and receivables. The effect of improvements
268 here would be similar to that associated with excess capacity in fixed assets. Sales could be expanded without proportionate
269 increases in current assets. (Actually, these items could probably be reduced even if sales did not increase.) Thus, the AFN
270 would be less than previously determined, and this would reduce financing and possibly other costs. As we saw in
271 Chapter 15, there may be other costs associated with reducing the firm’s investment in accounts receivable and inventory,
272 which would lead to improvements in most of the ratios. (The current ratio would decline unless the funds freed up were used to
273 reduce current liabilities, which would probably be done.) Again, to get a precise forecast, we would need some additional
274 information, and we would need to modify the financial statements.
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276
277 PART I
278 How would changes in these items affect the AFN? (1) The dividend payout ratio, (2) the profit margin, (3) the capital intensity
279 ratio, and (4) if NWC begins buying from its suppliers on terms which permit it to pay after 60 days rather than after 30 days.
280 (Consider each item separately and hold all other things constant.)
281
282 (1) If the payout ratio were reduced, then more earnings would be retained, and this would reduce the need for
283 external financing, or AFN. Note that if the firm is profitable and has any payout ratio less than 100 percent,
284 it will have some retained earnings, so if the growth rate were zero, AFN would be negative, i.e., the firm
285 would have surplus funds. As the growth rate rose above zero, these surplus funds would be used to finance
286 growth. At some point, i.e., at some growth rate, the surplus AFN would be exactly used up. This growth rate
287 where AFN = $0 is called the “sustainable growth rate,” and it is the maximum growth rate which can be
288 financed without outside funds, holding the debt ratio and other ratios constant.
289 (2) If the profit margin goes up, then both total and retained earnings will increase, and this will reduce the
290 amount of AFN.
291 (3) The capital intensity ratio is defined as the ratio of required assets to total sales, or A*/S0 . Put another way,
292 it represents the dollars of assets required per dollar of sales. The higher the capital intensity ratio, the
293 more new money will be required to support an additional dollar of sales. Thus, the higher the capital
294 intensity ratio, the greater the AFN, other things held constant.
295 (4) If NWC’s payment terms were increased from 30 to 60 days, accounts payable would double, in turn
296 increasing current and total liabilities. This would reduce the amount of AFN due to a decreased need for
297 working capital on hand to pay short-term creditors, such as suppliers.
298