ENTREPRENEURIAL FINANCE: Strategy Valuation and Deal Structure

Chapter7.MethodsofFinancialForecasting:IntegratedFinancialModeling
QuestionsandProblems

1. Thecashcycleisthetimebetweenwhenacompanypaysforinventoryandwhenitreceivesthe
cashfromitscustomers.Itisdefinedasthenumberofdaysthecompanyhasitscashtiedupin
AccountsReceivableandInventory,minusthedaysinAccountsPayable.Usingthesummarydata
presentedbelow,calculateDellInc.scashcycle.

DellIncorporated
SummaryFinancialData
(millions)

FiscalYear
2006

Revenue

$55,908

CostofGoodSold

$45,620

AccountsReceivable

$5,452

Inventory
AccountsPayable

$576
$9,840

NowusethedatafromSection7.3inthechaptertocalculatethecashcycleforAmazon.comin
2009.ComparetheseresultstoyourDellcalculations.Whatdoyouthinkisbehindthedifferencesin
thetwocompanyscashcycles?
2. Youaredevelopingabusinessplanforanewwholesalespecialtygoodsretailer.Youcollectdataon
typicalindustryworkingcapitalterms.Industrycredittermstocustomerare20daysandaverage
inventorydaysonhandis30.Suppliersgrantwholesalerscreditforanaverageof15days.You
estimatethatadoptingtheindustrytermswouldproduce$3millionofannualrevenue.Costof
goodssoldwillbe70%ofrevenue.
Youareconsideringalternativeterms,includingofferingnewcustomers45daystopay,whichwill
increaserevenueby20%to$3.6million.Anewjustintimeinventorysystemwhichincludes
shipmentsdirectlyfrommanufacturerstoretailerswillreduceinventorydaysonhandto25.Finally,
toestablishstrongtieswithyoursuppliers,youwillkeepaccountspayableat10days.
a. Usingtheindustrydata,computethecashcycleandestimatetheinvestmentinworking
capitalthebusinesswouldrequire.
b. Usingthealternativeterms,computethecashcycleandestimatetheinvestmentinworking
capitalthebusinesswouldrequire.Whataretheprosandconsofthealternativeterms?
3. DownloadtheWorkingCapitalPolicyTemplate(Figure7.2)anduseittocontrasttheeffectsofthe
followingpoliciesonnetworkingcapital(usetheassumptionsreflectedinFigure7.2asastarting
point).Althoughyoucannotassesstotalprofitability,evaluatetheimpactofeachofthesechanges
onprofitperday(i.e.,determinehowmuchdailyprofitwouldincreaseordecrease).
a. Productdemandisinelastic,sothata$1priceincreaseisexpectedtoreducequantityper
dayto95units.Productdemandiselastic,sothata$1priceincreaseisexpectedtoreduce
quantityperdayto80units.

b. Thecompanysellsonlyforcashsothatquantityperdayisexpectedtodeclineto90units.
Thecompanysellsonlyforcash,butreducesproductpriceto$9.50,sothatquantityperday
isexpectednottochange.
c. Thecompanyincreasesitstargetmaterialsinventoryto20days,anditstargetfinished
goodsinventoryto15days.Asaresult,thecompanyisabletomorereliablyrespondto
orders.Therefore,quantityofsalesperdayisexpectedtoincreaseto105units.
d. Thecompanyplanstopayitspayablesin30days.Asaresult,costofmaterialsisexpected
toincreaseto$4.10.
e. Thecompanychangestopayingmonthlysothattheaveragewagespayablebalanceisfor
15daysofwork.Tooffset,itexpectsitwillneedtoincreasewagesto$2.60perunit.
4. DeveloptheYear1financialforecast(incomestatement,balancesheetandstatementofcash
flows)forBennisCo.Revenueisprojectedat$800,000,withagrossmarginof34%.Operating
expenses(includingdepreciationof$30,000)total20%ofrevenueandtaxesareestimatedat35%
ofpretaxincome.
Benniswantstomaintainacashbalanceof3%oftheircostofgoodssold.Accountsreceivableare
10%ofsalesandinventoryturnoverisforecastat9times.Fixedassetsof$500,000willbeneeded
tostarttheventure.Accountspayabledaysareforecasttobe30.IfBenniswillbeallequity
financed,calculatetherequiredinitialinvestmentbytheentrepreneur.
5. Anewventureisexpectedtorequireacapitalinvestmentof$2.5millionandaninvestmentof
$200,000ininitialworkingcapital.Thecapitalinvestmentcanbedepreciatedoverafiveyear
period,onastraightlinebasis.Duringthefirstyearofoperation,theventureisprojectedtoachieve
salesof$800,000.Thesaleslevelisprojectedtotripleinthesecondyear,doubleinthethirdyear,
andincreaseby50percentinthefourthyear.Noadditionalcapitalinvestmentisneededduringthe
firstfiveyears.Theprojectedgrossprofitmarginis60percent,andoperatingexpenses,otherthan
depreciation,areprojectedtobe$500,000peryear,plus15percentofsales.Theventureissubject
toacorporatetaxrateof35percent,andlossesfromprioryearscanbecarriedforwardin
computingthetaxliability.Basedonindustrynormsandtheexpectedgrowthrateofsales,the
ventureisexpectedtoneedendingcashequalto5percentofsalesfortheyear,endingaccounts
receivableequalto30percentofannualsales,endinginventoryequalto10percentofannualsales,
andendingaccountspayableequalto10percentofthecostofsales.
a. Usingaspreadsheet,projectthenetincome,cashflow,andendingbalancesheetofthe
ventureforeachyear,assumingthatnodebtfinancingisused.(Youmaywishtobeginwith
theIntegratedFinancialStatementsTemplateinAppendix7A.)
b. Contrastthenetincomeoftheventurewiththeannualcashflows.Howdothefactorsof
capitalintensity,profitability,salesgrowth,andcashflowaffectthefinancialneedsofthe
venture?
6. UsingthespreadsheetfromProblem5,examinehoweachofthefollowingchangestothe
assumptionswouldaffectnetincomeandcashflows.Assumethattheotherassumptionsfrom
problem5areunchanged.
a.

Thesalesgrowth(percentageincrease)ineachyearisonlyhalfasmuchasexpected.

b.

Thegrossmarginis40percentofsalesrevenue.

c.

Inventoryis30percentofendingsales.

d.
Theinitialcapitalinvestmentintheventureis$4million.Assumetheinitialequity
investmentincreasesasneeded.
7. Anewventurerequiresaninitialcapitalinvestmentandassetsof$2million.Similarventuresinthe
sameindustryhavebeenabletoachievesaleslevelsof60to100percentofassets,withprofitability
onsalesoffrom10to30percent(netprofit).Demandfortheventuresproductisexpectedtogrow
atarateof2to13percentperyear.
a. Usingthemidpointsoftheranges,developaproformaforecastoftheventureforfive
years,assumingsalesgrowthmatchesthegrowthofmarketdemand.Howmuchfreecashis
theventureexpectedtogenerateineachyear,orhowmuchadditionalfinancingisneeded
ineachyear?
b. Developaworstcaseproformaanalysisforfiveyears,assumingalloftheuncertainties
turnoutatthelowendsoftheranges.Howdoesthisaffecttheabilityoftheventureto
distributecashortheneedtoraiseadditionalcapital?
c. Developabestcaseproformaanalysisassumingtheuncertaintiesareresolvedatthehigh
endoftherange,andevaluatethecashneedsordisbursementcapabilitiesoftheventure
underthoseconditions.
d. Supposeyouwanttodevelopaproformaanalysisoftheworstcaseintermsofthefinancial
needsoftheventure.Howwouldyouusetheinformationabouttheuncertaintiesofthe
variousassumptionstodoso?
8. Thinkofaproductyouwouldbeinterestedindeveloping,thatcanserveasthebasisforanew
venture.Whatarethecriticalassumptionsonwhichsuccessoftheventuredepends?
a. UsetheInternettocollectinformationonpubliccompaniesthatarecomparableinsome
ways,suchasfromprospectusesandannualreports.Identifytheinformationfromthese
sourcesthatyoucanusetohelpcalibratethecriticalassumptionsinafinancialmodelof
yourventure.
b. Lookupsomesourcesoffinancialdataforindustriesthatarecomparable,insomeways,to
theoneyouareconsidering.Explainhowtheinformationfromthesesourcescanbeusedto
calibrateafinancialmodeloftheprospectiveventure.
9. Usethefollowingassumptionstodevelopafiveyearsetofproformastatements.Makeany
additionalassumptionsyouneed.(YoumaywanttousethetemplatefromAppendix7A).
a. Theentrepreneurhas$300,000toinvestintheventure,willraiseanadditional$150,000
fromfamilymembersinexchangeforequity,andwillborrow$200,000intheformoflong
termdebt.Atotalof$600,000willbeinvestedinfixedassetsthatcanbedepreciatedona
straightlinebasisoverfiveyears.Thebalanceofinitialinvestmentswillbeheldascash.
Newcapitalinvestmentsareneededeachyeartomaintainnetfixedassetsequalto1.2
timesexpectedsalesinthesubsequentyear.
b. Expectedsalesduringthefirstyearis$250,000.Salesareexpectedtodoubleeachyearfor
thenexttwoyears,toincreaseby50percentinthefourthyear,andtoincreaseby20
percentinthefifthandsixthyears.
c. Basedonindustrydata,costofgoodssoldisexpectedtobe25percentofsales,selling
expenseisexpectedtobe12percentofsales,andgeneralandadministrativeexpenseis

expectedtobe$100,000plus7percentofsales.Therearenoothermaterialoperating
expenses.Theabovefiguresexcludedepreciationexpenses.
d. Theinterestrateondebtisexpectedtobe9percent,andrevenuefromshortterm
investmentofcashisexpectedtobenegligible.
e. Thecorporatetaxrateis35percent.Thereisnotaxlosscarryforward.
f. Typicalexperienceintheindustryforventuresthataregrowingrapidlyisthataccounts
receivableequals20percentofendingsales;inventoryis15percentofcostofgoodssold;
accountspayableis8percentofcostofgoodssold;wagespayableis5percentofcostof
goodssold;andtaxespayableisnegligible.
g. Theventureneedstomaintainacashbalanceequaltothelesserof20percentofannual
salesor$50,000.
h. Ifadditionalfinancingisneeded,theentrepreneurhopestouselongtermdebttothe
extentthatprofitabilityissufficienttocoverinterestexpense(sothatthefulltaxadvantage
ofdebtfinancingisrealized).
10. DownloadacopyofTable7.13anduseittoaddressthefollowing(youmayneedtounhidethe
hiddencolumnsinthefigure):
a. HowmuchinitialcashfromequityinvestorswouldNewCompanyneedsothatitwouldnot
beexpectedtodrawonitslineofcreditduringtheentire78monthsoftheproforma
statements?
b. Howmuchinitialcashfromequityinvestorswouldthecompanyneedsothatitwouldnot
beexpectedtodrawonitslineofcredituntilMonth25(the7thmonthafterdevelopment)?
c. Howmuchinitialcashfromequitywouldthecompanyneedinordertoavoidborrowingif
themonthlyrateofrealsalesgrowthduringthefirstthreeyearsafterstartupis5percent
insteadof8percent?
d. Howmuchinitialcashfromequitywouldthecompanyneedinordertoavoidborrowingif
thegrossprofitmarginis40percentinsteadof50percent?
e.Howmuchinitialcashfromequitywouldthecompanyneedinordertoavoidborrowing:
(i)ifNewCompanymustpurchasematerialsforcash?
(ii)iftheaveragecollectionperiodistwomonthsinsteadof45days?
(iii)ifbothchanges(i)and(ii)aremade?
11. SIMDownloadaversionofTable7.12forMorebucksthathassimulationcapabilitiesenabled(using
thesoftwareofyourchoice)andunprotecttheworksheet.Usethemodeltogenerate1000trials,
keepingtrackofYear3Sales,Year3NetIncome,andOperatingExpenses
a. InwhatfractionofthetrialsisMorebucksNetIncomenegative?
b. CharttherelationshipsbetweenSalesandNetincomeandbetweenOperatingExpenses
andNetIncome?
c. Whatcanyousayabouthowthesaleslevelandoperatingexpensepercentagecontributeto
Year3OperatingProfit?

12. SIMDownloadtheversionoftheexcelfilethatincludesTable7.13andFigure7.6andhas
simulationcapabilitiesenabled(usingthesoftwareofyourchoice)andunprotecttheAssumptions
andFigure7.6worksheets.
a. UsethefiletosimulatetheperformanceofNewCompany.Run1000trialsandkeeptrackof
netincomeinmonth78andsurpluscashinmonth78(youcanfindtheseitemsinthechart
dataintheFigure7.6taboftheworksheet).
i. Supposethatifnetincomeisnegativeinmonth78,theventurehasfailed.Trya
simplevaluationoftheequitybyfindingtheaveragenetincome(replacethe
negativenetincomeswithzeros).Capitalizethisaverageat120times(i.e.,10times
annualizednetincome),andaddtheaveragesurpluscash.Notethatyouwillneed
tolookatthetrialsdatatofindtheinformationforthisvaluation.
ii. DiscountthisMonth78valuetopresentvalueassumingthattheappropriate
discountrateis1%permonth.Whatisyourestimateofthepresentvalueofthe
equity?Inwhatfractionofthetrialsdoestheventurefail?
b. Supposetheexpectedgrowthrateofsalesislessthanthe8percentpermonthshownin
thefigure.Redothevaluationfrompart(a)afterchangingtheexpectedgrowthrateto6%.
Howdoesthischangetheequityvaluation?