fm12 ch 14 mini case

7/27/2019 FM12 Ch 14 Mini Case

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1/10/2007

Chapter 14 Mini Case

Situation

2007 Balance Sheet (in millions)

Cash and Securities $20.0 1%

Accounts Receivable $240.0 12%

Inventories $240.0 12%

Total Current Assets $500.0

Net Fixed Assets $500.0 25%

Total Assets $1,000.0

Accounts Payable and Accruals $100.0 5%

Notes Payable $100.0

Total Current Liabilities $200.0

Long Term Debt $100.0

Common Stock $500.0

Retained Earnings $200.0

Total Liabilities and Equity $1,000.0

2007 Income Statement (in millions)

Sales $2,000.0Variable Costs $1,200.0 60%

Fixed Costs $700.0 35%

EBIT $100.0

Interest $10.0

EBT $90.0

Taxes(40%) $36.0

Net Income $54.0

Dividends(40%) $21.6

Additions to Retained Earnings $32.4

2007

Betty Simmons, the new financial manager of Southeast Chemicals (SEC), a Georgia producer of specialized chemicals for

use in fruit orchards, must prepare a financial forecast for 2008. SEC's 2007 sales were 2 billion, and the marketing

department is forecasting a 25 percent increase for 2008. Betty thinks the company was operating at full capacity in 2007but is not sure about this. The 2007 financial statements, plus some other data, are shown below.

Percent of

Sales

Percent of

Sales


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Key Ratios SEC Industry

Profit margin 2.70% 4.00%

ROE 7.71% 15.60%

DSO 43.80 32.00

Inventory turnover 8.33 11.00

Fixed asset turnover 4.00 5.00Debt/Assets 30.00% 36.00%

TIE 10.00 9.40

Current ratio 2.50 3.00

NOPAT/Sales 3.00% 5.00%

Operating Capital / Sales 45.00% 35.00%

Return on Invested Capital (NOPAT/Capital) 6.67% 14.00%

USING THE AFN EQUATION

Additional Data

Sales Increase = 25%

2007 Profit Margin= 2.70%

Payout Ratio= 40%

AFN= D RequiredAssets

-

DSpontaneous

Liabilities

- D RetainedEarnings

D RequiredAssets

=Asset to Sales

Ratiox D Sales

= 0.500 x $500.00

= $250.00

DSpontaneous

Liabilities

=

Spontaneous

Liab. to Sales

Ratio

x D Sales

= 0.050 x $500.00

= $25.00

D RetainedEarnings

=Profit

Marginx Sales x

Retention

Ratio

= 0.027 x 2,500.0$ x 0.600

= $40.50

a. Describe three ways that pro forma statements are used in financial planning. Answer: See Chapter 14 Mini Case Show

c. Assume (1) that SEC was operating at full capacity in 2007 with respect to all assets, (2) that all assets must grow

proportionally with sales, (3) that accounts payable and accruals will also grow in proportion to sales, and (4) that the 2007

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.

b. Explain the steps in financial forecasting. Answer: See Chapter 14 Mini Case Show

Assume that you were recently hired as Simmons' assistant, and your first major task is to help her develop the forecast.

She asked you to begin by answering the following set of questions.


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AFN= D RequiredAssets

-

DSpontaneous

Liabilities

- D RetainedEarnings

= $250.00 - $25.00 - $40.50

AFN= $184.50

Actual ProjectedPercent of Sales Inputs 2007 2008

COGS/Sales 60.0% 60.0%

SGA/Sales 35.0% 35.0%

Cash/Sales 1.0% 1.0%

Accounts Rec./Sales 12.0% 12.0%

Inv./Sales 12.0% 12.0%

Net Fixed Assets/Sales 25.0% 25.0%

AP & Accruals/Sales 5.0% 5.0%

Other Inputs

Percent growth in sales 25%

Growth factor in sales 1.25Interest rate on debt 10%

Tax rate 40%

Dividend Payout Ratio 40%

Funds will be generated through:

Notes Payable = 50%

Long Term Debt = 50%

INCOME STATEMENT

(in millions of dollars) Actual Forecast

2007 2008

Sales 2,000.0$ Growth 1.25 2,500.0$

COGS 1,200.0$ % of Sales 60.00% 1,500.0$SGA Expenses 700.0$ % of Sales 35.00% 875.0$

EBIT 100.0$ 125.0$

Less Interest 10.0$ Interest rate x Debt07 20.0$

EBT 90.0$ 105.0$

Taxes (40%) 36.0$ 42.0$

Net Income 54.0$ 63.0$

Dividends 21.6$ 25.2$

Add. To retained earnings 32.4$ 37.8$

Forecast basis

d. How would changes in these items affect the AFN? (1) Sales increase, (2) the dividend payout ratio increases, (3) theprofit margin increases, (4) the capital intensity ratio increases, and (5) SEC begins paying its suppliers sooner. (Consider

each item separately and hold all other things constant.) Answer: See Chapter 14 Mini Case Show

e. Briefly explain how to forecast financial statements using the percent of sales approach. Be sure to explain how to

forecast interest expenses. Answer: See Chapter 14 Mini Case Show

f. Now estimate the 2008 financial requirements using the percent of sales approach. Assume (1) that each type of asset, as

well as payables, accruals, and fixed and variable costs, will be the same percent of sales in 2008 as in 2007; (2) that the

payout ratio is held constant at 40 percent; (3) 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); (4) that all debt carries an interest rate of 10 percent; and

(5) interest expenses should be based on the balance of debt at the beginning of the year.


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BALANCE SHEET 2008 2008

(in millions of dollars) Forecast Forecast

2007 Forecast basis Without AFN AFN With AFN

Assets 0

Cash 20.0$ % of Sales 1.00% 25.0$ 25.0$Accounts receivable 240.0$ % of Sales 12.00% 300.0$ 300.0$

Inventories 240.0$ % of Sales 12.00% 300.0$ 300.0$

Total current assets 500.0$ 625.0$ 625.0$

Net plant and equipment 500.0$ % of Sales 25.00% 625.0$ 625.0$

Total assets 1,000.0$ 1,250.0$ 1,250.0$


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L iabili ties and equity

Accounts payable & Accru 100.0$ % of Sales 5.00% 125.0$ 125.0$

Notes payable 100.0$ Carry-over 100.0$ 93.6$ 193.6$

Total current liabilities 200.0$ 225.0$ 318.6$

Long-term bonds 100.0$ Carry-over 100.0$ 93.6$ 193.6$

Total liabilities 300.0$ 325.0$ 512.2$

Common stock 500.0$ Carry-over 500.0$ 500.0$

Retained earnings 200.0$ RE07 + DRE08 237.8$ 237.8$Total common equity 700.0$ 737.8$ 737.8$

Total liabilities and equity 1,000.0$ 1,062.8$ 1,250.0$

Required assets = 1,250.0$

Specified sources of financing = 1,062.8$

Additional funds needed (AFN) 187.20$

MEASURING OPERATING PERFORMANCE: FREE CASH FLOW AND RATIOS

Forecast

Free Cash Flow 2007 2008

Net operating working capital (NOWC) 400.0$ 500.0$

Total Operating Capital 900.0$ 1,125.0$

NOPAT 60.0$ 75.0$

Investment in Capital 225.0$

FCF (150.0)$

Return on Invested Capital (NOPAT/Capital) 6.67% 14.00%

Key Ratios 2007 2008 Industry

Profit margin 2.70% 2.52% 4.00%

ROE 7.71% 8.54% 15.60%

DSO 43.80 43.80 32.00

Inventory turnover 8.33 8.33 11.00

Fixed asset turnover 4.00 4.00 5.00

Debt/Assets 30.00% 40.98% 36.00%

TIE 10.00 6.25 9.40

Current ratio 2.50 1.96 3.00

PROPOSED IMPROVEMENTS

Inputs Before After

DSO 43.80 32.01

i. (1.) Based on comparisons between SEC's days sales outstanding (DSO) and inventory turnover ratios with the industry

average figures, does it appear that SEC is operating efficiently with respect to its inventory and accounts receivable? (2.)

Suppose SEC were able to bring these ratios into line with the industry averages and reduce its SGA/Sales ratio to 33%.

What effect would this have on its AFN and its financial ratios? What effect would this have on free cash flow and ROIC?

g. Why does the forecasted financial statement approach produce a somewhat different AFN than the equation approach?

Which method provides the more accurate forecast? Answer: See Chapter 14 Mini Case Show

h. Calculate SEC's forecasted ratios, and compare them with the company's 2007 ratios and with the industry averages.Calculate SECs forecasted free cash flow and return on invested capital (ROIC).


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Accounts receivable/sales 12.00% 8.77%

Inventory turnover 8.33 11.00

Inventory/sales 12.00% 9.09%

SGA/sales 35.0% 33.0%

Outputs

AFN $187.2 $15.7FCF -$150.0 $33.5

ROIC 6.7% 10.8%

ROE 8.5% 12.3%

EFFECT OF EXCESS CAPACITY

Suppose in 2007 fixed assets had been operated at only 75% of capacity?

Capacity Sal Actual Sales / % of Capacity

= $2,000 / 0.75

Capacity Sal $2,666.67

Forecasted sales are less than this, so no new fixed assets are needed.

Previously forecasted AFN = $187

Previously forecasted addition to fixed as $125

AFN if there is excess capacity = $62.20

If Sales went up to $3,000, not $2500, what would the F.A. requirement be?

Target Ratio Fixed Assets / Capacity Sales

$500 / $2,666.67

Target Ratio 0.1875

Change in F 0.1875 x $333.33

Change in F $62.50

(2.) How would the existence of excess capacity in fixed assets affect the additional funds needed during 2008?

k. The relationship between sales and the various types of assets is important in financial forecasting. The forecasted

j. Suppose you now learn that SEC's 2007 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 2007 with the available fixed assets?

Note: we used Scenario

Manager to find the after-

improvement values.


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financial statement approach, under the assumption that each asset item grows at the same rate as sales, leads to an AFN

forecast that is reasonably close to the forecast using the AFN equation. Explain how each of the following factors would

affect the accuracy of financial forecasts based on the AFN equation: (1) economies of scale in the use of assets, and (2)

fm12 ch 14 mini case

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