Professional Documents
Culture Documents
Learning Objectives: 15 - 1
LECTURE SUGGESTIONS
In Chapter 3, we looked at where the firm has been and where it is now--its
current strengths and weaknesses. Now, in Chapter 15, we look at where it is
projected to go in the future. The details of what we cover, and the way we
cover it, can be seen by scanning Blueprints, Chapter 15. For other
suggestions about the lecture, please see the “Lecture Suggestions” in
Chapter 2, where we describe how we conduct our classes.
Lecture Suggestions: 15 - 2
ANSWERS TO END-OF-CHAPTER QUESTIONS
15-3 False. At low growth rates, internal financing will take care of the
firm’s needs.
15-5 a. +.
d. +.
e. +.
g. 0.
h. +.
$4,000,000
15-2 AFN = $1,000,000- (0.1)($1,0
00,000)- ($300,000)
(0.3)
$5,000,000
= (0.8)($1,000,000) - $100,000 - $90,000
= $800,000 - $190,000
= $610,000.
Under this scenario the company would have a higher level of retained
earnings, which would reduce the amount of additional funds needed.
No increase in FA up to $5,555,555,556.
Total
Total debt = l i a b i l i st i-e Common stock – Retained earnings
a n de q u i t y
Forecast
Basis × Additions (New 2003
2002 2003 Sales Financing, R/E) Pro Forma
Total assets $1,200,000 0.48 $1,500,000
*Given in problem that firm will sell new common stock = $75,000.
**PM = 6%; RR = 60%; NI2003 = $2,500,000 × 1.25 × 0.06 = $187,500.
Addition to RE = NI × RR = $187,500 × 0.6 = $112,500.
DSO = Rec./(Sales/365)
= $34,338,000/($358,400,000/365)
= 34.97 days ≈ 35 days.
Inv. = $9 + 0.0875($115.5)
= $19.10625 million.
Sales/Inv. = $115,500,000/$19,106,250
= 6.0451.
F u l lc a p a c i t y
= Actual sales/(% of capacity at which FA are operated)
sales
= $2,000,000,000/0.80
= $2,500,000,000.
15-13 a. Forecast
2002 Basis 2003
Sales $1,528 × 1.20 $1,833.60
Operating costs 933 × 0.60 Sales 1,100.16
EBIT $ 595 $ 733.44
Interest 95 95.00
EBT $ 500 $ 638.44
Taxes (40%) 200 255.38
Net income $ 300 $ 383.06
$ $1 11 20 72 .. . 555
=
( - ( -$ ( $ ) 7 $ 7 0 4 0 ) 2 ) 0 ) ( 0 . 6
= $13.44 million.
$ $ 3 $ 35 35 0 5 0 0
b. Tozer Computers
Pro Forma Balance Sheet
December 31, 2003
(Millions of Dollars)
2003
Forecast Pro
Forma
Basis × 2003
after
2002 2003 Sales Additions Pro Forma Financing
Financing
Cash $ 3.5 0.01 $ 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 0.1000 42.00
42.00
Total assets $122.5 $147.00
$147.00
AFN = $ 13.44
*PM = $10.5/$350 = 3%.
( $ 1 0 . 5− $ 4 . 2 )
RR = = 60%.
$1 0.5
NI = $350 × 1.2 × 0.03 = $12.6.
Addition to RE = NI × RR
= $12.6 × 0.6 = $7.56.
The current ratio is poor compared to 2.5× in 2002 and the industry
average of 3× .
R a t eo f r e t u r n (Profitmargin)(Sales)
=
on equity Stock + Retainedearnings
N ie nt $ c 1 o 2 m . e 6 0
= = =1 4 . 2 % .
E q u$ i8 t8 y. 5 6
The rate of return on equity is good compared to 13 percent in 2002
and a 12 percent industry average.
2. Tozer Computers
Pro Forma Balance Sheet
December 31, 2007
(Millions of Dollars)
2007
Forecast Pro
Forma
Basis × 2007 after
2002 2007 Sales Additions Pro Forma Financing
Financing
Total curr. assets $ 87.50 0.25 $105.00 $105.00
Net fixed assets 35.00 0.10 42.00 42.00
Total assets $122.50 $147.00 $147.00
AFN = -$14.28
e. Tozer probably could carry out either the slow growth or fast growth
plan, but under the fast growth plan (20 percent per year), the risk
ratios would deteriorate, indicating that the company might have
trouble with its bankers and would be increasing the odds of
bankruptcy.
Forecast 2003
2002 Basis Pro Forma
Sales $36,000 1.25 $45,000
Operating costs 30,783 0.8551 38,479
EBIT $ 5,217 $ 6,521
Interest 1,017 1,017
EBT $ 4,200 $ 5,504
Taxes (40%) 1,680 2,202
Net income $ 2,520 $ 3,302
Dividends (60%) $ 1,512 $ 1,981
Addition to RE $ 1,008 $ 1,321
Krogh Lumber
Pro Forma Balance Sheet
December 31, 2003
(Thousands of Dollars)
Forecast 2003 2003
Basis × 1st 2nd
2002 2003 Sales Additions Pass AFN Pass
$3,302
ROE = = 11.03%.
$29,929
If the firm attained the industry average DSO and inventory turnover
ratio, this would mean a reduction in financial requirements of:
A/R
Receivables: = 90
$45,000/365
New A/R = $11,096.
$45,000
Inventory: = 3.33; Inv. = $13,500.
Inv.
$3,302
ROE = = 13.06%.
$25,275
Forecast 2003
2002 Basis Pro Forma
Sales $3,600,000 1.10 $3,960,000
Operating Costs 3,279,720 0.9110 3,607,692
EBIT $ 320,280 $ 352,308
Interest 20,280 20,280
EBT $ 300,000 $ 332,028
Taxes (40%) 120,000 132,811
Net income $ 180,000 $ 199,217
Forecast
Basis × 2003
2002 2003 Sales Additions Pro Forma
Cash $ 180,000 0.05 $ 198,000
Receivables 360,000 0.10 396,000
Inventories 720,000 0.20 792,000
Total current
assets $1,260,000 $1,386,000
Fixed assets 1,440,000 0.40 1,584,000
Total assets $2,700,000 $2,970,000
AFN = $ 128,783
*See income statement.
∆ S a l$ e1 s2 4 , 1 3 8
Growth rate in sales = = =3 . 4 5 % .
$ 3 ,$6 30,06, 00 00,00 0 0
15-17 a. & b. Lewis Company
Pro Forma Income Statement
December 31, 2003
(Thousands of Dollars)
Cash $ 80 0.010 $ 96 $ 96
Receivables 240 0.030 288 288
Inventories 720 0.090 864 864
Total current
assets $1,040 $1,248 $1,248
Fixed assets 3,200 0.400 3,840 3,840
Total assets $4,240 $5,088 $5,088
AFN = $ 667
*See income statement.
**CA/CL = 2.3; D/A = 40%.
Maximum total debt = 0.4 × $5,088 = $2,035.
Maximum increase in debt = $2,035 - $1,736 = $299.
Maximum current liabilities = $1,248/2.3 = $543.
Increase in notes payable = $543 - $492 = $51.
Increase in long-term debt = $299 - $51 = $248.
Increase in common stock = $667 - $299 = $368.
15-18 The detailed solution for the spreadsheet problem is available both on
the instructor’s resource CD-ROM and on the instructor’s side of South-
Western’s web site, http://brigham.swlearning.com.
INTEGRATED CASE
15-19 SUE WILSON, THE NEW FINANCIAL MANAGER OF NEW WORLD CHEMICALS (NWC),
A CALIFORNIA PRODUCER OF SPECIALIZED CHEMICALS FOR USE IN FRUIT
ORCHARDS, MUST PREPARE A FINANCIAL FORECAST FOR 2003. NWC’S 2002
SALES WERE
$2 BILLION, AND THE MARKETING DEPARTMENT IS FORECASTING A 25 PERCENT
INCREASE FOR 2003. WILSON THINKS THE COMPANY WAS OPERATING AT FULL
CAPACITY IN 2002, BUT SHE IS NOT SURE ABOUT THIS. THE 2002
FINANCIAL STATEMENTS, PLUS SOME OTHER DATA, ARE GIVEN IN TABLE IC15-
1.
Integrated Case: 15 - 19
Integrated Case: 15 - 20
C. KEY RATIOS
NWC INDUSTRY COMMENT
BASIC EARNING POWER 10.00% 20.00%
PROFIT MARGIN 2.52 4.00
RETURN ON EQUITY 7.20 15.60
DAYS SALES OUTSTANDING (365 DAYS) 43.80 DAYS 32.00 DAYS
INVENTORY TURNOVER 8.33× 11.00×
FIXED ASSETS TURNOVER 4.00 5.00
TOTAL ASSETS TURNOVER 2.00 2.50
DEBT/ASSETS 30.00% 36.00%
TIMES INTEREST EARNED 6.25× 9.40×
CURRENT RATIO 2.50 3.00
PAYOUT RATIO 30.00% 30.00%
A. ASSUME (1) THAT NWC WAS OPERATING AT FULL CAPACITY IN 2002 WITH
RESPECT TO ALL ASSETS, (2) THAT ALL ASSETS MUST GROW PROPORTIONALLY
WITH SALES, (3) THAT ACCOUNTS PAYABLE AND ACCRUED LIABILITIES WILL
ALSO GROW IN PROPORTION TO SALES, AND (4) THAT THE 2002 PROFIT
MARGIN AND DIVIDEND PAYOUT WILL BE MAINTAINED. UNDER THESE
CONDITIONS, WHAT WILL THE COMPANY’S FINANCIAL REQUIREMENTS BE FOR
THE COMING YEAR? USE THE AFN EQUATION TO ANSWER THIS QUESTION.
ANSWER: [SHOW S15-1 THROUGH S15-6 HERE.] NWC WILL NEED $180.9 MILLION.
HERE IS THE AFN EQUATION:
Integrated Case: 15 - 21
THAT EXTERNAL FUNDS NEEDED ARE FINANCED 50 PERCENT BY NOTES PAYABLE
AND 50 PERCENT BY LONG-TERM DEBT. (NO NEW COMMON STOCK WILL BE
ISSUED.)
ANSWER: [SHOW S15-7 THROUGH S15-14 HERE.] SEE THE COMPLETED WORKSHEET. THE
PROBLEM IS NOT DIFFICULT TO DO “BY HAND,” BUT WE USED A SPREADSHEET
MODEL FOR THE FLEXIBILITY SUCH A MODEL PROVIDES.
INCOME STATEMENT:
SALES $2,000.00 $2,500.00
LESS: VC(% SALES) 60.00% (1,200.00) (1,500.00)
FC(% SALES) 35.00% (700.00) (875.00)
EBIT $ 100.00 $ 125.00
INTEREST (8%) (16.00) (16.00)
EBT $ 84.00 $ 109.00
TAXES 40.0% (33.60) (43.60)
NET INCOME $ 50.40 $ 65.40
BALANCE SHEET:
2002 2003 2003
ACTUAL 1ST PASS AFN 2ND PASS
AFN $ 179.22
Integrated Case: 15 - 22
Integrated Case: 15 - 23
AFN EQUATION FORECAST:
ANSWER: [SHOW S15-15 HERE.] THE DIFFERENCE OCCURS BECAUSE THE AFN EQUATION
METHOD ASSUMES THAT THE PROFIT MARGIN REMAINS CONSTANT, WHILE THE
FORECASTED BALANCE SHEET METHOD PERMITS THE PROFIT MARGIN TO VARY.
THE BALANCE SHEET METHOD IS SOMEWHAT MORE ACCURATE (ESPECIALLY WHEN
ADDITIONAL PASSES ARE MADE AND FINANCING FEEDBACKS ARE CONSIDERED),
BUT IN THIS CASE THE DIFFERENCE IS NOT VERY LARGE. THE REAL
ADVANTAGE OF THE BALANCE SHEET METHOD IS THAT IT CAN BE USED WHEN
EVERYTHING DOES NOT INCREASE PROPORTIONATELY WITH SALES. IN
ADDITION, FORECASTERS GENERALLY WANT TO SEE THE RESULTING RATIOS,
AND THE BALANCE SHEET METHOD IS NECESSARY TO DEVELOP THE RATIOS.
IN PRACTICE, THE ONLY TIME WE HAVE EVER SEEN THE AFN EQUATION
USED IS TO PROVIDE (1) A “QUICK AND DIRTY” FORECAST PRIOR TO
DEVELOPING THE BALANCE SHEET FORECAST AND (2) A ROUGH CHECK ON THE
BALANCE SHEET FORECAST.
Integrated Case: 15 - 24
ANSWER: [SHOW S15-16 HERE.] KEY RATIOS:
NWC INDUSTRY
2002 2003(E) 2002
BASIC EARNING POWER 10.00% 10.00% 20.00%
PROFIT MARGIN 2.52 2.62 4.00
ROE 7.20 8.77 15.60
DAYS SALES OUTSTANDING (365 DAYS) 43.80 DAYS 43.80 DAYS 32.00 DAYS
INVENTORY TURNOVER 8.33× 8.33× 11.00×
FIXED ASSETS TURNOVER 4.00 4.00 5.00
TOTAL ASSETS TURNOVER 2.00 2.00 2.50
DEBT/ASSETS 30.00% 40.34% 36.00%
TIMES INTEREST EARNED 6.25× 7.81× 9.40×
CURRENT RATIO 2.50 1.99 3.00
PAYOUT RATIO 30.00% 30.00% 30.00%
NWC’S BEP, PROFIT MARGIN, AND ROE ARE ONLY ABOUT HALF AS HIGH AS THE
INDUSTRY AVERAGE--NWC IS NOT VERY PROFITABLE RELATIVE TO OTHER FIRMS
IN ITS INDUSTRY. FURTHER, ITS DSO IS TOO HIGH, AND ITS INVENTORY
TURNOVER RATIO IS TOO LOW, WHICH INDICATES THAT THE COMPANY IS
CARRYING EXCESS INVENTORY AND RECEIVABLES. IN ADDITION, ITS DEBT
RATIO IS FORECASTED TO MOVE ABOVE THE INDUSTRY AVERAGE, AND ITS
COVERAGE RATIO IS LOW. THE COMPANY IS NOT IN GOOD SHAPE, AND THINGS
DO NOT APPEAR TO BE IMPROVING.
Integrated Case: 15 - 25
FCF = NOPAT - NET INVESTMENT IN OPERATING CAPITAL
= EBIT(1 - T) - NET INVESTMENT IN OPERATING CAPITAL
= $125(0.6) - $225
= $75 - $225
= -$150.
F. SUPPOSE YOU NOW LEARN THAT NWC’S 2002 RECEIVABLES AND INVENTORIES
WERE IN LINE WITH REQUIRED LEVELS, GIVEN THE FIRM’S CREDIT AND
INVENTORY POLICIES, BUT THAT EXCESS CAPACITY EXISTED WITH REGARD TO
FIXED ASSETS. SPECIFICALLY, FIXED ASSETS WERE OPERATED AT ONLY 75
PERCENT OF CAPACITY.
1. WHAT LEVEL OF SALES COULD HAVE EXISTED IN 2002 WITH THE AVAILABLE
FIXED ASSETS? WHAT WOULD THE FIXED ASSETS-TO-SALES RATIO HAVE BEEN
IF NWC HAD BEEN OPERATING AT FULL CAPACITY?
A C T S U A A LL E S $ 2 , 0 0 0
= =$ 2 , 6 6 7 .
FULL CAPACITY SALES = % O FC A P AA CTW IH TI YC H0 . 7 5
F I XA ES DS W E ETORSPE E R A T E D
SINCE THE FIRM STARTED WITH EXCESS FIXED ASSET CAPACITY, IT WILL NOT
HAVE TO ADD AS MUCH FIXED ASSETS DURING 2003 AS WAS ORIGINALLY
FORECASTED:
F I AX SE SD E T$ S5 0 0
TARGET FA/SALES RATIO = = = 1 8 .. 7 5 %
F U C L A L P SA AC LI$ ET2 SY, 6 6 7
THE ADDITIONAL FIXED ASSETS NEEDED WILL BE 0.1875(PREDICTED SALES -
CAPACITY SALES) IF PREDICTED SALES EXCEED CAPACITY SALES, OTHERWISE
NO NEW FIXED ASSETS WILL BE NEEDED. IN THIS CASE, PREDICTED SALES =
1.25($2,000) = $2,500, WHICH IS LESS THAN CAPACITY SALES, SO THE
EXPECTED SALES GROWTH WILL NOT REQUIRE ANY ADDITIONAL FIXED ASSETS.
Integrated Case: 15 - 26
F. 2. HOW WOULD THE EXISTENCE OF EXCESS CAPACITY IN FIXED ASSETS AFFECT
THE ADDITIONAL FUNDS NEEDED DURING 2003?
ANSWER: [SHOW S15-20 AND S15-21 HERE.] WE HAD PREVIOUSLY FOUND AN AFN OF
$179.22 USING THE BALANCE SHEET METHOD AND $180.9 USING THE AFN
FORMULA. IN BOTH CASES, THE FIXED ASSETS INCREASE WAS 0.25($500) =
$125. THERE-FORE, THE FUNDS NEEDED WILL DECLINE BY $125.
G. WITHOUT ACTUALLY WORKING OUT THE NUMBERS, HOW WOULD YOU EXPECT THE
RATIOS TO CHANGE IN THE SITUATION WHERE EXCESS CAPACITY IN FIXED
ASSETS EXISTS? EXPLAIN YOUR REASONING.
ANSWER: [SHOW S15-22 AND S15-23 HERE.] WE WOULD EXPECT ALMOST ALL THE
RATIOS TO IMPROVE. WITH LESS FINANCING, INTEREST EXPENSE WOULD BE
REDUCED. DEPRECIATION AND MAINTENANCE, IN RELATION TO SALES, WOULD
DECLINE. THESE CHANGES WOULD IMPROVE THE BEP, PROFIT MARGIN, AND
ROE. ALSO, THE TOTAL ASSETS TURNOVER RATIO WOULD IMPROVE.
SIMILARLY, WITH LESS DEBT FINANCING, THE DEBT RATIO AND THE CURRENT
RATIO WOULD BOTH IMPROVE, AS WOULD THE TIE RATIO.
WITHOUT QUESTION, THE COMPANY’S FINANCIAL POSITION WOULD BE
BETTER. ONE CANNOT TELL EXACTLY HOW LARGE THE IMPROVEMENT WILL BE
WITHOUT WORKING OUT THE NUMBERS, BUT WHEN WE WORKED THEM OUT WE
OBTAINED THE FOLLOWING NUMBERS:
% OF 2002 CAPACITY
Integrated Case: 15 - 27
(NOTE THAT FINANCING FEEDBACKS HAVE NOT BEEN CONSIDERED IN THE
RATIOS ABOVE.)
ANSWER: [SHOW S15-24 HERE.] THE DSO AND INVENTORY TURNOVER RATIO INDICATE
THAT NWC HAS EXCESSIVE INVENTORIES AND RECEIVABLES. THE EFFECT OF
IMPROVE-MENTS HERE WOULD BE SIMILAR TO THAT ASSOCIATED WITH EXCESS
CAPACITY IN FIXED ASSETS. SALES COULD BE EXPANDED WITHOUT
PROPORTIONATE INCREASES IN CURRENT ASSETS. (ACTUALLY, THESE ITEMS
COULD PROBABLY BE REDUCED EVEN IF SALES DID NOT INCREASE.) THUS,
THE AFN WOULD BE LESS THAN PREVIOUSLY DETERMINED, AND THIS WOULD
REDUCE FINANCING AND POSSIBLY OTHER COSTS. AS WE SAW IN CHAPTER 14,
THERE MAY BE OTHER COSTS ASSOCIATED WITH REDUCING THE FIRM’S
INVESTMENT IN ACCOUNTS RECEIVABLE AND INVENTORIES, WHICH WOULD LEAD
TO IMPROVEMENTS IN MOST OF THE RATIOS. (THE CURRENT RATIO WOULD
DECLINE UNLESS THE FUNDS FREED UP WERE USED TO REDUCE CURRENT
LIABILITIES, WHICH WOULD PROBABLY BE DONE.) AGAIN, TO GET A PRECISE
FORECAST, WE WOULD NEED SOME ADDITIONAL INFORMATION, AND WE WOULD
NEED TO MODIFY THE FINANCIAL STATEMENTS.
I. HOW WOULD CHANGES IN THESE ITEMS AFFECT THE AFN? (1) THE DIVIDEND
PAYOUT RATIO, (2) THE PROFIT MARGIN, (3) THE CAPITAL INTENSITY
RATIO, AND (4) IF NWC BEGINS BUYING FROM ITS SUPPLIERS ON TERMS THAT
PERMIT IT TO PAY AFTER 60 DAYS RATHER THAN AFTER 30 DAYS. (CONSIDER
EACH ITEM SEPARATELY AND HOLD ALL OTHER THINGS CONSTANT.)
Integrated Case: 15 - 28
OR AFN. NOTE THAT IF THE FIRM IS PROFITABLE AND HAS ANY PAYOUT
RATIO LESS THAN 100 PERCENT, IT WILL HAVE SOME RETAINED EARNINGS,
SO IF THE GROWTH RATE WERE ZERO, AFN WOULD BE NEGATIVE, i.e., THE
FIRM WOULD HAVE SURPLUS FUNDS. AS THE GROWTH RATE ROSE ABOVE
ZERO, THESE SURPLUS FUNDS WOULD BE USED TO FINANCE GROWTH. AT
SOME GROWTH RATE THE SURPLUS AFN WOULD BE EXACTLY USED UP. THIS
GROWTH RATE WHERE AFN = $0 IS CALLED THE “SUSTAINABLE GROWTH
RATE,” AND IT IS THE MAXIMUM GROWTH RATE THAT CAN BE FINANCED
WITHOUT OUTSIDE FUNDS, HOLDING THE DEBT RATIO AND OTHER RATIOS
CONSTANT.
2. IF THE PROFIT MARGIN GOES UP, THEN BOTH TOTAL AND ADDITION TO
RETAINED EARNINGS WILL INCREASE, AND THIS WILL REDUCE THE AMOUNT
OF AFN.
Integrated Case: 15 - 29