Chapter 4
Financial Planning and Forecasting Financial Statements
ANSWERS TO END-OF-CHAPTER QUESTIONS




4-1 a. The operating plan provides detailed implementation guidance designed to accomplish corporate objectives. It details who is responsible for what particular function, and when specific tasks are to be accomplished. Many companies use an operating plan which spans a
5-year period, and hence is called the “five-year plan.”

b. The financial plan details the financial aspects of the corporation’s operating plan. In addition to an analysis of the firm’s current financial condition, the financial plan normally includes a sales forecast, the capital budget, the cash budget, pro forma financial statements, and the external financing plan.

c. A sales forecast is merely the forecast of unit and dollar sales for some future period. Of course, a lot of work is required to produce a good sales forecast. Generally, sales forecasts are based on the recent trend in sales plus forecasts of the economic prospects for the nation, industry, region, and so forth. The sales forecast is critical to good financial planning.

d. With the percent of sales forecasting method, many items on the income statement and balance sheets are assumed to increase proportionally with sales. As sales increase, these items that are tied to sales also increase, and the values of these items for a particular year are estimated as percentages of the forecasted sales for that year.

e. Funds are spontaneously generated if a liability account increases spontaneously (automatically) as sales increase. An increase in a liability account is a source of funds, thus funds have been generated. Two examples of spontaneous liability accounts are accounts payable and accrued wages. Note that notes payable, although a current liability account, is not a spontaneous source of funds since an increase in notes payable requires a specific action between the firm and a creditor.

f. The percentage of earnings which is paid out as dividends to stockholders is the dividend payout ratio.

g. A pro forma financial statement shows how an actual statement would look if certain assumptions are realized.

h. Additional funds needed (AFN) are those funds required from external sources to increase the firm’s assets to support a sales increase. A sales increase will normally require an increase in assets. However, some of this increase is usually offset by a spontaneous increase in liabilities as well as by earnings retained in the firm. Those funds that are required but not generated internally must be obtained from external sources. Although most firms’ forecasts of capital requirements are made by constructing pro forma income statements and balance sheets, the AFN formula is sometimes used to forecast financial requirements. It is written as follows:



i. Capital intensity is the dollar amount of assets required to produce a dollar of sales. The capital intensity ratio is the reciprocal of the total assets turnover ratio.

j. “Lumpy” assets are those assets that cannot be acquired smoothly, but require large, discrete additions. For example, an electric utility that is operating at full capacity cannot add a small amount of generating capacity, at least not economically.

k. Financing feedbacks are the effects on the income statement and balance sheet of actions taken to finance increases in assets.

l. Simple linear regression is used to estimate how specific balance sheet accounts vary in proportion to sales. The process involves regressing past account levels against past sales figures, which yields a regression equation which can be used to forecast the amount of the balance sheet item required to support an estimated sales level.

m. Computerized financial planning models allow firms to easily assess the effects of different sales levels, different relationships between sales and operating assets, different assumptions about sales prices and operating costs, and different financing methods. Such forecasting models would then generate pro forma financial statements which management can use to assess whether the initial financial plan is feasible or whether it must be revised. Lotus 1-2-3 and Excel are readily available and popular programs that are used for computerized financial planning.

4-2 Accounts payable, accrued wages, and accrued taxes increase spontaneously and proportionately with sales. Retained earnings increase, but not proportionately.

4-3 The equation gives good forecasts of financial requirements if the ratios A*/S and L*/S, as well as M and d, are stable. Otherwise, another forecasting technique should be used.

4-4 False. At low growth rates, internal financing will take care of the firm’s needs.

4-5 a. +.

b. -. The firm needs less manufacturing facilities, raw materials, and work in process.

c. +. It reduces spontaneous funds; however, it may eventually increase retained earnings.

d. +.

e. +.

f. Probably +. This should stimulate sales, so it may be offset in part by increased profits.

g. 0.

h. +.
SOLUTIONS TO END-OF-CHAPTER PROBLEMS



4-1 AFN = (A*/S0)DS - (L*/S0)DS - MS1(1 - d)
= $1,000,000 - $1,000,000 - 0.05($6,000,000)(1 - 0.7)
= (0.6)($1,000,000) - (0.1)($1,000,000) - ($300,000)(0.3)
= $600,000 - $100,000 - $90,000
= $410,000.


4-2 AFN = $1,000,000 – (0.1)($1,000,000) – ($300,000)(0.3)
= (0.8)($1,000,000) - $100,000 - $90,000
= $800,000 - $190,000
= $610,000.

The capital intensity ratio is measured as A*/S0. This firm’s capital intensity ratio is higher than that of the firm in Problem 4-1; therefore, this firm is more capital intensive--it would require a large increase in total assets to support the increase in sales.


4-3 AFN = (0.6)($1,000,000) - (0.1)($1,000,000) - 0.05($6,000,000)(1 - 0)
= $600,000 - $100,000 - $300,000
= $200,000.

Under this scenario the company would have a higher level of retained earnings which would reduce the amount of additional funds needed.


4-4 S2001 = $2,000,000; A2001 = $1,500,000; CL2001 = $500,000;
NP2001 = $200,000; A/P2001 = $200,000; Accruals2001 = $100,000;
PM = 5%; d = 60%; A*/S0 = 0.75.

AFN = (A*/S0)DS - (L*/S0)DS - MS1(1 - d)
= (0.75)DS - DS -(0.05)(S1)(1 - 0.6)
= (0.75)DS - (0.15)DS - (0.02)S1
= (0.6)DS - (0.02)S1
= 0.6(S1 - S0) - (0.02)S1
= 0.6(S1 - $2,000,000) - (0.02)S1
= 0.6S1 - $1,200,000 - 0.02S1
$1,200,000 = 0.58S1
$2,068,965.52 = S1.

Sales can increase by $2,068,965.52 - $2,000,000 = $68,965.52 without additional funds being needed.
4-5 a. AFN = (A*/S)(DS) – (L*/S)(DS) – MS1(1 – d)
= ($70) - ($70) - ($420)(0.6) = $13.44 million.

b. Upton Computers
Pro Forma Balance Sheet
December 31, 2002
(Millions of Dollars)

Forecast Pro Forma
Basis % after
2001 2002 Sales Additions Pro Forma Financing Financing
Cash $ 3.5 0.01 $ 4.20 $ 4.20
Receivables 26.0 0.743 31.20 31.20
Inventories 58.0 0.166 69.60 69.60
Total current
assets $ 87.5 $105.00 $105.00
Net fixed assets 35.0 0.1 42.00 42.00
Total assets $122.5 $147.00 $147.00

Accounts payable $ 9.0 0.0257 $ 10.80 $ 10.80
Notes payable 18.0 18.00 +13.44 31.44
Accruals 8.5 0.0243 10.20 10.20

Total current
liabilities $ 35.5 $ 39.00 $ 52.44
Mortgage loan 6.0 6.00 6.00
Common stock 15.0 15.00 15.00
Retained earnings 66.0 7.56* 73.56 73.56
Total liab.
and equity $122.5 $133.56 $147.00

AFN = $ 13.44

*PM = $10.5/$350 = 3%.
Payout = $4.2/$10.5 = 40%.
NI = $350 ? 1.2 ? 0.03 = $12.6.
Addition to RE = NI - DIV = $12.6 - 0.4($12.6) = 0.6($12.6) = $7.56.

c. Current ratio = $105/$52.44 = 2.00?.

The current ratio is low compared to 2.5? in 2001 and the industry average of 3?.

Debt/Total assets = $58.44/$147 = 39.8%.

The debt-to-total assets ratio is too high compared to 33.9 percent in 1998 and a 30 percent industry average.



The rate of return on equity is good compared to 13 percent in 2001 and a 12 percent industry average.
d. (1) = ($70) - ($70)
- (0.03)(0.6)($364 + $378 + $392 + $406 + $420)
= $24.5 - $3.5 - $35.28 = -$14.28 million surplus funds.

(2) Upton Computers
Pro Forma Balance Sheet
December 31, 2003
(Millions of Dollars)

Forecast Pro Forma
Basis % after
2001 2002 Sales Additions Pro Forma Financing Financing
Total curr. assets $ 87.50 0.25 $105.00 $105.00
Net fixed assets 35.00 0.1 42.00 42.00
Total assets $122.50 $147.00 $147.00

Accounts payable $ 9.00 0.257 $ 10.80 $ 10.80
Notes payable 18.00 18.00 -14.28 3.72
Accruals 8.50 0.0243 10.20 10.20
Total current
liabilities $ 35.50 $ 39.00 $ 24.72
Mortgage loans 6.00 6.00 6.00
Common stock 15.00 15.00 15.00
Retained earnings 66.00 $35.28* 101.28 101.28
Total liab.
and equity $122.50 $161.28 $147.00

AFN = $-14.28

*PM = 3%; Payout = 40%.
NI = 0.03 ? ($364 + $378 + $392 + $406 + $420) = $58.8.
Addition to RE = NI - DIV = $58.8 - $58.8(0.4) = $35.28.

(3) Current ratio = $105/$24.72 = 4.25? (good).
Debt/Total assets = $30.72/$147 = 20.9% (good).
Return on equity = $12.6/$116.28 = 10.84% (low).*

*The rate of return declines because of the decrease in the debt/assets ratio. The firm might, with this slow growth, consider a dividend increase. A dividend increase would reduce future increases in retained earnings, and in turn, common equity, which would help boost the ROE.

e. Upton 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.



4-6 a. Stevens Textiles
Pro Forma Income Statement
December 31, 2002
(Thousands of Dollars)

Forecast Pro Forma
2001 Basis 2002
Sales $36,000 1.15 ? Sales01 $41,400
Operating costs $32,440 0.9011 ? Sales02 37,306
EBIT $ 3,560 $ 4,094
Interest 560 560
EBT $ 3,000 $ 3,534
Taxes (40%) 1,200 1,414
Net income $ 1,800 $ 2,120

Dividends (45%) $ 810 $ 954
Addition to RE $ 990 $ 1,166

Stevens Textiles
Pro Forma Balance Sheet
December 31, 2002
(Thousands of Dollars)

Forecast Pro Forma
Basis % after
2001 2002 Sales Additions Pro Forma Financing Financing
Cash $ 1,080 0.03 $ 1,242 $ 1,242
Accts receivable 6,480 0.1883 7,452 7,452
Inventories 9,000 0.25 10,350 10,350
Total curr.
assets $16,560 $19,044 $19,044
Fixed assets 12,600 0.35 14,490 14,490
Total assets $29,160 $33,534 $33,534

Accounts payable $ 4,320 0.12 $ 4,968 $ 4,968
Accruals 2,880 0.08 3,312 3,312
Notes payable 2,100 2,100 +2,128 4,228
Total current
liabilities $ 9,300 $10,380 $12,508
Long-term debt 3,500 3,500 3,500
Total debt $12,800 $13,880 $16,008
Common stock 3,500 3,500 3,500
Retained earnings 12,860 1,166* 14,026 14,026
Total liabilities
and equity $29,160 $31,406 $33,534

AFN = $ 2,128

*From income statement.


b. Dinterest expense = $2,128 ? 0.10 = $213.

1st Pass Financing 2nd Pass
2002 Feedback 2002
Sales $41,400 $41,400
Operating costs 37,306 37,306
EBIT $ 4,094 $ 4,094
Interest 560 +213 773
EBT $ 3,534 $ 3,321
Taxes (40%) 1,414 1,328
Net income $ 2,120 $ 1,993

Dividends (45%) $ 954 $ 897
Addition to retained
earnings $ 1,166 $ 1,096

D in RE because of feedback = $1,096 - $1,166 = -$70.

1st Pass Financing 2nd Pass
2002 Feedback 2002
Total assets $33,534 $33,534

Accounts payable $ 4,968 $ 4,968
Accruals 3,312 3,312
Notes payable 4,228 4,228
Total curr. liab. $12,508 $12,508
Long-term debt 3,500 3,500
Total debt $16,008 $16,008
Common stock 3,500 3,500
Retained earnings 14,026 -70* 13,956
Total liabilities
and equity $33,534 $33,464

AFN = $ 70

*See income statement.

Thus, the original AFN amount has been reduced after an additional iteration from $2,128 to $70. The cumulative AFN for both passes is $2,198.


4-7 a. & b. Garlington Technologies Inc.
Pro Forma Income Statement
December 31, 2002

Forecast 1st Pass AFN 2nd Pass
2001 Basis Additions 2002 Effects 2002
Sales $3,600,000 1.10 ? Sales01 $3,960,000 $3,960,000
Operating costs 3,279,720 0.911 ? Sales02 3,607,692 3,607,692
EBIT $ 320,280 $ 352,308 $ 352,308
Interest 20,280 20,280 +8,371** 28,651
EBT $ 300,000 $ 332,028 $ 323,657
Taxes (40%) 120,000 132,811 129,463
Net income $ 180,000 $ 199,217 $ 194,194

Dividends: $1.08
? 100,000 = $ 108,000 $ 112,000* +3,005*** $ 115,005
Addition to RE: $ 72,000 $ 87,217 $ 79,189

*Preliminary 2002 Dividends = $1.12 ? 100,000 = $112,000.
**D in Interest = $64,392 ? 0.13 = $8,371.
***D in 2002 Dividends = $64,391/$24 ? 1.12 = $3,005.
D in Addition to RE = $79,189 - $87,217 = -$8,028.

Garlington Technologies Inc.
Pro Forma Balance Statement
December 31, 2002

Forecast
Basis % 1st Pass AFN 2nd Pass
2001 2002 Sales Additions 2002 Effects 2002
Cash $ 180,000 0.05 $ 198,000 $ 198,000
Receivables 360,000 0.1 396,000 396,000
Inventories 720,000 0.2 792,000 792,000
Total current
assets $1,260,000 $1,386,000 $1,386,000
Fixed assets 1,440,000 0.4 1,584,000 1,584,000
Total assets $2,700,000 $2,970,000 $2,970,000

Accounts payable $ 360,000 0.1 $ 396,000 $ 396,000
Notes payable 156,000 156,000 +64,392 220,392
Accruals 180,000 0.05 198,000 198,000
Total current
liabilities $ 696,000 $ 750,000 $ 814,392
Common stock 1,800,000 1,800,000 +64,391 1,864,391
Retained earnings 204,000 87,217* 291,217 -8,028** 283,189
Total liab.
and equity $2,700,000 $2,841,217 $2,961,972

AFN = $ 128,783 $ 8,028

Cumulative AFN = $ 128,783 $ 136,811

*See 1st pass income statement.
**See 2nd pass income statement.

c. AFN = $2,700,000/$3,600,000(DSales)
- ($360,000 + $180,000)/$3,600,000(DSales)
- (0.05)($3,600,000 + DSales)0.4
= 0.75(DSales) - 0.15(DSales) - 0.02(DSales) - $72,000
= 0.6(DSales) - 0.02(DSales) - $72,000

$72,000 = 0.58(DSales); DSales = $124,138.

Growth rate in sales = = = 3.45%.
4-8 a., b., & c. Damon Company
Pro Forma Income Statement
December 31, 2002
(Thousands of Dollars)

Forecast 1st Pass AFN 2nd Pass
2001 Basis 2002 Effects 2002
Sales $8,000 1.2 ? Sales01 $9,600 $9,600
Operating costs 7,450 0.931 ? Sales02 8,940 8,940
EBIT $ 550 $ 660 $ 660
Interest 150 150 +30* 180
EBT $ 400 $ 510 $ 480
Taxes (40%) 160 204 192
Net income $ 240 $ 306 $ 288
Dividends :
$1.04 ? 150 = $ 156 $1.10 ? 150 = $ 165 +24** $ 189

Addition to retained
earnings: $ 84 $ 141 $ 99

*D in interest expense = ($51 + $248) ? 0.10 = $30.
**D in 2002 Dividends = $368/$16.96 ? $1.10 = $24.
D in addition to retained earnings = $99 - $141 = -$42.

Damon Company
Pro Forma Balance Sheet
December 31, 2002
(Thousands of Dollars)

Forecast
Basis % 1st Pass AFN 2nd Pass
2001 2002 Sales Additions 2002 Effects 2002
Cash $ 80 0.01 $ 96 $ 96
Accounts receivable 240 0.03 288 288
Inventory 720 0.09 864 864
Total curr. assets $1,040 $1,248 $1,248
Fixed assets 3,200 0.04 3,840 3,840
Total assets $4,240 $5,088 $5,088

Accounts payable $ 160 0.02 $ 192 $ 192
Accruals 40 0.005 48 48
Notes payable 252 252 +51** 303
Total current
liabilities $ 452 $ 492 $ 543
Long-term debt 1,244 1,244 +248** 1,492
Total debt $1,696 $1,736 $2,035
Common stock 1,605 1,605 +368** 1,973
Retained earnings 939 141* 1,080 -42*** 1,038
Total liabilities
and equity $4,240 $4,421 $5,046

AFN = $ 667 $ 42

Cumulative AFN = $ 667 $ 709

*See income statement, 1st pass.
**CA/CL = 2.3; D/A = 40%.
Maximum total debt = 0.4 x $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.
***See income statement, 2nd pass.

4-9 a.

$1,200,000 = $375,000 + Long-term debt + $425,000 + $295,000
Long-term debt = $105,000.

Total debt = Accounts payable + Long-term debt
= $375,000 + $105,000 = $480,000.

Alternatively,

Total debt = - Common stock - Retained earnings
= $1,200,000 - $425,000 - $295,000 = $480,000.

b. Assets/Sales (A*/S) = $1,200,000/$2,500,000 = 48%.
L*/Sales = $375,000/$2,500,000 = 15%.
2002 Sales = (1.25)($2,500,000) = $3,125,000.

AFN = (A*/S)(DS) - (L*/S)(DS) - MS1(1 - d) - New common stock
= (0.48)($625,000) - (0.15)($625,000) - (0.06)($3,125,000)(0.6) - $75,000
= $300,000 - $93,750 - $112,500 - $75,000 = $18,750.

Alternatively, using the percentage of sales method:

Forecast
Basis % Additions (New
2001 2002 Sales Financing, R/E) Pro Forma
Total assets $1,200,000 0.48 $1,500,000

Current liabilities $ 375,000 0.15 $ 468,750
Long-term debt 105,000 105,000
Total debt $ 480,000 $ 573,750
Common stock 425,000 75,000* 500,000
Retained earnings 295,000 112,500** 407,500
Total common equity $ 720,000 $ 907,500
Total liabilities
and equity $1,200,000 $1,481,250

AFN = Long-term debt = $ 18,750

*Given in problem that firm will sell new common stock = $75,000.
**PM = 6%; Payout = 40%; NI2002 = $2,500,000 x 1.25 x 0.06 = $187,500.
Addition to RE = NI x (1 - Payout) = $187,500 x 0.6 = $112,500.
4-10 Cash $ 100.00 ? 2 = $ 200.00
Accounts receivable 200.00 ? 2 = 400.00
Inventories 200.00 ? 2 = 400.00
Net fixed assets 500.00 + 0.0 = 500.00
Total assets $1,000.00 $1,500.00

Accounts payable $ 50.00 ? 2 = $ 100.00
Notes payable 150.00 150.00 + 360.00 = 510.00
Accruals 50.00 ? 2 = 100.00
Long-term debt 400.00 400.00
Common stock 100.00 100.00
Retained earnings 250.00 + 40 = 290.00
Total liabilities
and equity $1,000.00 $1,140.00
AFN $ 360.00

Capacity sales = Sales/0.5 = $1,000/0.5 = $2,000.

Target FA/S ratio = $500/$2,000 = 0.25.

Target FA = 0.25($2,000) = $500 = Required FA. Since the firm currently has $500 of fixed assets, no new fixed assets will be required.

Addition to RE = M(S1)(1 - Payout ratio) = 0.05($2,000)(0.4) = $40.

SOLUTION TO SPREADSHEET PROBLEMS




4-11 The detailed solution for the spreadsheet problem is available both on the instructor’s resource CD-ROM (in the file Solution for Ch 04-11 Build a Model.xls) and on the instructor’s side of the Harcourt College Publishers’ web site, http://www.harcourtcollege.com/finance/theory10e.

4-12 a. Input data:

Forecasted sales growth:
2002 15.0%
2003 15.0%
2004 15.0%
2005 15.0%
2006 15.0%
AFN financing percentages:
Notes payable 50.0%
Long-term debt 50.0%
Common stock 0.0%
Debt costs:
Notes payable 12.0%
Long-term debt 12.0%
Tax rate 40.0%

Dividend payout ratio 40.0%

Key output:

2002 AFN $ 7.0
2003 AFN $ 8.3
2004 AFN $ 9.7
2005 AFN $11.4
2006 AFN $13.4
Cumulative AFN $49.8

Ratios:

2001 12002 200 2004 2005 2006
Cur 2.5 2.1 1.8 1.6 1.5 1.4
PM 5.0% 4.7% 4.3% 4.1% 3.8% 3.6%
TATO 1.1 1.1 1.1 1.1 1.1 1.1
ROA 5.6% 5.2% 4.8% 4.5% 4.2% 3.9%
Debt 34.7% 40.1% 45.0% 49.5% 53.6% 57.2%
ROE 8.6% 8.7% 8.8% 8.9% 9.1% 9.2%

Projected income statements (in millions):

Initial Final Initial Final Initial Final Initial Final Initial Final
2002 2002 2003 2003 2004 2004 2005 2005 2006 2006
Sales $92.0 $92.0 $105.8 $105.8 $121.7 $121.7 $139.9 $139.9 $160.9 $160.9
Operating costs 82.0 82.0 94.3 94.3 108.4 108.4 124.7 124.7 143.4 143.4
EBIT $10.0 $10.0 $ 11.5 $ 11.5 $ 13.2 $ 13.2 $ 15.2 $ 15.2 $ 17.5 $ 17.5
Less interest 2.0 2.8 2.8 3.8 3.8 5.0 5.0 6.4 6.4 8.0
Earnings
before taxes $ 8.0 $ 7.2 $ 8.7 $ 7.7 $ 9.4 $ 8.2 $ 10.2 $ 8.8 $ 11.1 $ 9.5
Taxes 3.2 2.9 3.5 3.1 3.8 3.3 4.1 3.5 4.4 3.8
NI avail to common $ 4.8 $ 4.3 $ 5.2 $ 4.6 $ 5.6 $ 4.9 $ 6.1 $ 5.3 $ 6.7 $ 5.7
Dividends to common $ 1.9 $ 1.7 $ 2.1 $ 1.8 $ 2.3 $ 2.0 $ 2.5 $ 2.1 $ 2.7 $ 2.3
Additions to RE $ 2.9 $ 2.6 $ 3.1 $ 2.8 $ 3.4 $ 3.0 $ 3.7 $ 3.2 $ 4.0 $ 3.4

Projected balance sheets (in millions):

Initial Final Initial Final Initial Final Initial Final Initial Final
2002 2002 2003 2003 2004 2004 2005 2005 2006 2006
Cash $ 4.6 $ 4.6 $ 5.3 $ 5.3 $ 6.1 $ 6.1 $ 7.0 $ 7.0 $ 8.0 $ 8.0
Accounts rec 13.8 13.8 15.9 15.9 18.3 18.3 21.0 21.0 24.1 24.1
Inventories 18.4 18.4 21.2 21.2 24.3 24.3 28.0 28.0 32.2 32.2
Tot curr assets $36.8 $36.8 $42.3 $42.3 $ 48.7 $ 48.7 $ 56.0 $ 56.0 $ 64.4 $ 64.4
Net plant and equip 46.0 46.0 52.9 52.9 60.8 60.8 70.0 70.0 80.5 80.5
Total assets $82.8 $82.8 $95.2 $95.2 $109.5 $109.5 $125.9 $125.9 $144.8 $144.8

Accounts payable $ 9.2 $ 9.2 $10.6 $10.6 $ 12.2 $ 12.2 $ 14.0 $ 14.0 $ 16.1 $ 16.1
Notes payable 5.0 8.5 8.5 12.7 12.7 17.5 17.5 23.2 23.2 29.9
Accruals 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0
Total curr liab $14.2 $17.7 $19.1 $23.2 $ 24.8 $ 29.7 $ 31.5 $ 37.2 $ 39.3 $ 46.0
Long-term debt 12.0 15.5 15.5 19.7 19.7 24.5 24.5 30.2 30.2 36.9
Total debt $26.2 $33.2 $34.6 $42.9 $ 44.5 $ 54.2 $ 56.0 $ 67.4 $ 69.5 $ 82.9
Common stock 20.0 20.0 20.0 20.0 20.0 20.0 20.0 20.0 20.0 20.0
Retained earnings 29.9 29.6 32.7 32.3 35.7 35.3 39.0 38.5 42.5 41.9
Tot common equity $49.9 $49.6 $52.7 $52.3 $ 55.7 $ 55.3 $ 59.0 $ 58.5 $ 62.5 $ 61.9
Tot liabs & equity $76.1 $82.8 $87.3 $95.2 $100.2 $109.5 $115.0 $125.9 $132.0 $144.8

Initial Final Initial Final Initial Final Initial Final Initial Final
2002 2002 2003 2003 2004 2004 2005 2005 2006 2006
Add Funds
Needed (AFN) $6.7 $7.0 $7.9 $8.3 $9.3 $9.7 $10.9 $11.4 $12.8 $13.4
Add notes payable $3.4 $3.5 $4.0 $4.1 $4.7 $4.9 $ 5.5 $5.7 $ 6.4 $ 6.7
Add L-T debt 3.4 3.5 4.0 4.1 4.7 4.9 5.5 5.7 6.4 6.7
Add common stock ($) 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0
Total new
securities $6.7 $7.0 $7.9 $8.3 $9.3 $9.7 $10.9 $11.4 $12.8 $13.4

Under this scenario, one can see a deterioration of the current assets ratio, profit margin, ROA, and the debt ratio. Note that ROE increases--this is due to the leveraging effect. This trend clearly indicates an increase in risk.


b. Sales growth = 20%

Input data:

Forecasted sales growth:
2002 20.0%
2003 20.0%
2004 20.0%
2005 20.0%
2006 20.0%
AFN financing percentages:
Notes payable 50.0%
Long-term debt 50.0%
Common stock 0.0%
Debt costs:
Notes payable 12.0%
Long-term debt 12.0%
Tax rate 40.0%

Dividend payout ratio 40.0%

Key output:

2002 AFN $10.2
2003 AFN $12.6
2004 AFN $15.4
2005 AFN $18.8
2006 AFN $22.9
Cumulative AFN $79.9

Ratios:

2001 2002 2003 2004 2005 2006
Cur 2.5 1.9 1.7 1.5 1.3 1.2
PM 5.0% 4.5% 4.1% 3.7% 3.3% 3.0%
TATO 1.1 1.1 1.1 1.1 1.1 1.1
ROA 5.6% 5.0% 4.5% 4.1% 3.7% 3.4%
Debt 34.7% 42.6% 49.5% 55.4% 60.6% 65.2%
ROE 8.6% 8.7% 8.9% 9.2% 9.4% 9.7%

Projected income statements (in millions):

Initial Final Initial Final Initial Final Initial Final Initial Final
2002 2002 2003 2003 2004 2004 2005 2005 2006 2006
Sales $96.0 $96.0 $115.2 $115.2 $138.2 $138.2 $165.9 $165.9 $199.1 $199.1
Operating costs 85.6 85.6 102.7 102.7 123.2 123.2 147.8 147.8 177.4 177.4
EBIT $10.4 $10.4 $ 12.5 $ 12.5 $ 15.0 $ 15.0 $ 18.0 $ 18.0 $ 21.6 $ 21.6
Less interest 2.0 3.2 3.2 4.7 4.7 6.6 6.6 8.8 8.8 11.6
Earnings
before taxes $ 8.4 $ 7.2 $ 9.3 $ 7.8 $ 10.3 $ 8.5 $ 11.5 $ 9.2 $ 12.8 $ 10.1
Taxes 3.4 2.9 3.7 3.1 4.1 3.4 4.6 3.7 5.1 4.0
NI avail to common $ 5.1 $ 4.3 $ 5.6 $ 4.7 $ 6.2 $ 5.1 $ 6.9 $ 5.5 $ 7.7 $ 6.0
Dividends to common $ 2.0 $ 1.7 $ 2.2 $ 1.9 $ 2.5 $ 2.0 $ 2.8 $ 2.2 $ 3.1 $ 2.4
Additions to RE $ 3.0 $ 2.6 $ 3.3 $ 2.8 $ 3.7 $ 3.0 $ 4.1 $ 3.3 $ 4.6 $ 3.6

Projected balance sheets (in millions):

Initial Final Initial Final Initial Final Initial Final Initial Final
2002 2002 2003 2003 2004 2004 2005 2005 2006 2006
Cash $ 4.8 $ 4.8 $ 5.8 $ 5.8 $ 6.9 $ 6.9 $ 8.3 $ 8.3 $ 10.0 $ 10.0
Accounts receivable 14.4 14.4 17.3 17.3 20.7 20.7 24.9 24.9 29.9 29.9
Inventories 19.2 19.2 23.0 23.0 27.6 27.6 33.2 33.2 39.8 39.8
Tot curr assets $38.4 $38.4 $46.1 $46.1 $ 55.3 $ 55.3 $ 66.4 $ 66.4 $ 79.6 $ 79.6
Net plant and equip 48.0 48.0 57.6 57.6 69.1 69.1 82.9 82.9 99.5 99.5
Total assets $86.4 $86.4 $103.7 $103.7 $124.4 $124.4 $149.3 $149.3 $179.2 $179.2

Accounts payable $ 9.6 $ 9.6 $11.5 $11.5 $ 13.8 $ 13.8 $ 16.6 $ 16.6 $ 19.9 $ 19.9
Notes payable 5.0 10.1 10.1 16.4 16.4 24.1 24.1 33.5 33.5 44.9
Accruals 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0
Total curr liab $14.6 $19.7 $21.6 $27.9 $ 30.2 $ 37.9 $ 40.7 $ 50.1 $ 53.4 $ 64.8
Long-term debt 12.0 17.1 17.1 23.4 23.4 31.1 31.1 40.5 40.5 51.9
Total debt $26.6 $36.8 $38.7 $51.3 $ 53.6 $ 69.0 $ 71.7 $ 90.5 $ 93.9 $116.8
Common stock 20.0 20.0 20.0 20.0 20.0 20.0 20.0 20.0 20.0 20.0
Retained earnings 30.0 29.6 32.9 32.4 36.1 35.4 39.6 38.8 43.4 42.4
Tot common equity $50.0 $49.6 $52.9 $52.4 $ 56.1 $ 55.4 $ 59.6 $ 58.8 $ 63.4 $ 62.4
Tot liabs & equity $76.6 $86.4 $91.7 $103.7 $109.7 $124.4 $131.3 $149.3 $157.2 $179.2

Initial Final Initial Final Initial Final Initial Final Initial Final
2002 2002 2003 2003 2004 2004 2005 2005 2006 2006
Add Funds
Needed (AFN) $9.8 $10.2 $12.0 $12.6 $14.7 $15.4 $18.0 $18.8 $21.9 $22.9
Add notes payable $4.9 $5.1 $6.0 $6.3 $7.4 $7.7 $ 9.0 $9.4 $11.0 $11.5
Add L-T debt 4.9 5.1 6.0 6.3 7.4 7.7 9.0 9.4 11.0 11.5
Add common stock ($) 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0
Total new
securities $9.8 $10.2 $12.0 $12.6 $14.7 $15.4 $18.0 $18.8 $21.9 $22.9


Sales growth = 10%.

Input data:

Forecasted sales growth:
2002 10.0%
2003 10.0%
2004 10.0%
2005 10.0%
2006 10.0%
AFN financing percentages:
Notes payable 50.0%
Long-term debt 50.0%
Common stock 0.0%
Debt costs:
Notes payable 12.0%
Long-term debt 12.0%
Tax rate 40.0%

Dividend payout ratio 40.0%

Key output:

2002 AFN $ 3.8
2003 AFN $ 4.3
2004 AFN $ 4.9
2005 AFN $ 5.5
2006 AFN $ 6.1
Cumulative AFN $24.6

Ratios:

2001 2002 2003 2004 2005 2006
Cur 2.5 2.2 2.1 1.9 1.8 1.7
PM 5.0% 4.8% 4.7% 4.5% 4.4% 4.2%
TATO 1.1 1.1 1.1 1.1 1.1 1.1
ROA 5.6% 5.4% 5.2% 5.0% 4.8% 4.7%
Debt 34.7% 37.4% 40.0% 42.4% 44.8% 47.0%
ROE 8.6% 8.6% 8.7% 8.7% 8.8% 8.8%


Projected income statements (in millions):

Initial Final Initial Final Initial Final Initial Final Initial Final
2002 2002 2003 2003 2004 2004 2005 2005 2006 2006
Sales $88.0 $88.0 $ 96.8 $ 96.8 $106.5 $106.5 $117.1 $117.1 $128.8 $128.8
Operating costs 78.4 78.4 86.3 86.3 94.9 94.9 104.4 104.4 114.8 114.8
EBIT $ 9.6 $ 9.6 $ 10.5 $ 10.5 $ 11.6 $ 11.6 $ 12.7 $ 12.7 $ 14.0 $ 14.0
Less interest 2.0 2.5 2.5 3.0 3.0 3.6 3.6 4.2 4.2 4.9
Earnings
before taxes $ 7.6 $ 7.1 $ 8.1 $ 7.5 $ 8.6 $ 8.0 $ 9.2 $ 8.5 $ 9.8 $ 9.1
Taxes 3.0 2.8 3.2 3.0 3.4 3.2 3.7 3.4 3.9 3.6
NI avail to common $ 4.5 $ 4.3 $ 4.8 $ 4.5 $ 5.2 $ 4.8 $ 5.5 $ 5.1 $ 5.9 $ 5.4
Dividends to common $ 1.8 $ 1.7 $ 1.9 $ 1.8 $ 2.1 $ 1.9 $ 2.2 $ 2.0 $ 2.4 $ 2.2
Additions to RE $ 2.7 $ 2.6 $ 2.9 $ 2.7 $ 3.1 $ 2.9 $ 3.3 $ 3.1 $ 3.5 $ 3.3

Projected balance sheets (in millions):

Initial Final Initial Final Initial Final Initial Final Initial Final
2002 2002 2003 2003 2004 2004 2005 2005 2006 2006
Cash $ 4.4 $ 4.4 $ 4.8 $ 4.8 $ 5.3 $ 5.3 $ 5.9 $ 5.9 $ 6.4 $ 6.4
Accounts receivable 13.2 13.2 14.5 14.5 16.0 16.0 17.6 17.6 19.3 19.3
Inventories 17.6 17.6 19.4 19.4 21.3 21.3 23.4 23.4 25.8 25.8
Tot curr assets $35.2 $35.2 $38.7 $38.7 $ 42.6 $ 42.6 $ 46.9 $ 46.9 $ 51.5 $ 51.5
Net plant and equip 44.0 44.0 48.4 48.4 53.2 53.2 58.6 58.6 64.4 64.4
Total assets $79.2 $79.2 $87.1 $87.1 $ 95.8 $ 95.8 $105.4 $105.4 $116.0 $116.0

Accounts payable $ 8.8 $ 8.8 $ 9.7 $ 9.7 $ 10.6 $ 10.6 $ 11.7 $ 11.7 $ 12.9 $ 12.9
Notes payable 5.0 6.9 6.9 9.1 9.1 11.5 11.5 14.2 14.2 17.3
Accruals 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0
Total curr liab $13.8 $15.7 $16.6 $18.8 $ 19.7 $ 22.2 $ 23.2 $ 25.9 $ 27.1 $ 30.2
Long-term debt 12.0 13.9 13.9 16.1 16.1 18.5 18.5 21.2 21.2 24.3
Total debt $25.8 $29.6 $30.5 $34.8 $ 35.8 $ 40.7 $ 41.7 $ 47.2 $ 48.4 $ 54.5
Common stock 20.0 20.0 20.0 20.0 20.0 20.0 20.0 20.0 20.0 20.0
Retained earnings 29.7 29.6 32.5 32.3 35.4 35.2 38.5 38.2 41.8 41.5
Tot common equity $49.7 $49.6 $52.5 $52.3 $ 55.4 $ 55.2 $ 58.5 $ 58.2 $ 61.8 $ 61.5
Tot liabs & equity $75.5 $79.2 $83.0 $87.1 $ 91.2 $ 95.8 $100.2 $105.4 $110.1 $116.0

Initial Final Initial Final Initial Final Initial Final Initial Final
2002 2002 2003 2003 2004 2004 2005 2005 2006 2006
Add Funds
Needed (AFN) $3.7 $3.8 $4.1 $4.3 $4.6 $4.9 $ 5.2 $ 5.5 $ 5.8 $ 6.1
Add notes payable $1.8 $1.9 $2.1 $2.2 $2.3 $2.4 $ 2.6 $2.7 $ 2.9 $ 3.1
Add L-T debt 1.8 1.9 2.1 2.2 2.3 2.4 2.6 2.7 2.9 3.1
Add common stock ($) 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0
Total new
securities $3.7 $3.8 $4.1 $4.3 $4.6 $4.9 $ 5.2 $ 5.5 $ 5.8 $ 6.1

Again, when sales growth is increased to 20%, there is an even greater deterioration in the ratios indicated in Part a. When sales growth is decreased to 10%, the deterioration still continues but not as much.


c. (1) Dividend payout ratio = 70 percent.

Input data:

Forecasted sales growth:
2002 15.0%
2003 15.0%
2004 15.0%
2005 15.0%
2006 15.0%
AFN financing percentages:
Notes payable 50.0%
Long-term debt 50.0%
Common stock 0.0%
Debt costs:
Notes payable 12.0%
Long-term debt 12.0%
Tax rate 40.0%

Dividend payout ratio 70.0%

Key output:

2002 AFN $ 8.3
2003 AFN $ 9.7
2004 AFN $11.3
2005 AFN $13.1
2006 AFN $15.2
Cumulative AFN $57.8

Ratios:

2001 2002 2003 2004 2005 2006
Cur 2.5 2.0 1.7 1.5 1.4 1.3
PM 5.0% 4.6% 4.2% 3.8% 3.5% 3.2%
TATO 1.1 1.1 1.1 1.1 1.1 1.1
ROA 5.6% 5.1% 4.6% 4.2% 3.9% 3.5%
Debt 34.7% 41.7% 47.9% 53.5% 58.4% 62.7%
ROE 8.6% 8.7% 8.9% 9.1% 9.3% 9.5%


Projected income statements (in millions):

Initial Final Initial Final Initial Final Initial Final Initial Final
2002 2002 2003 2003 2004 2004 2005 2005 2006 2006
Sales $92.0 $92.0 $105.8 $105.8 $121.7 $121.7 $139.9 $139.9 $160.9 $160.9
Operating costs 82.0 82.0 94.3 94.3 108.4 108.4 124.7 124.7 143.4 143.4
EBIT $10.0 $10.0 $ 11.5 $ 11.5 $ 13.2 $ 13.2 $ 15.2 $ 15.2 $ 17.5 $ 17.5
Less interest 2.0 3.0 3.0 4.2 4.2 5.5 5.5 7.1 7.1 8.9
Earnings
before taxes $ 8.0 $ 7.0 $ 8.5 $ 7.3 $ 9.1 $ 7.7 $ 9.7 $ 8.1 $ 10.4 $ 8.6
Taxes 3.2 2.8 3.4 2.9 3.6 3.1 3.9 3.2 4.2 3.4
NI avail to common $ 4.8 $ 4.2 $ 5.1 $ 4.4 $ 5.4 $ 4.6 $ 5.8 $ 4.9 $ 6.2 $ 5.1
Dividends to common $ 3.4 $ 2.9 $ 3.6 $ 3.1 $ 3.8 $ 3.2 $ 4.1 $ 3.4 $ 4.4 $ 3.6
Additions to RE $ 1.4 $ 1.3 $ 1.5 $ 1.3 $ 1.6 $ 1.4 $ 1.7 $ 1.5 $ 1.9 $ 1.5

Projected balance sheets (in millions):

Initial Final Initial Final Initial Final Initial Final Initial Final
2002 2002 2003 2003 2004 2004 2005 2005 2006 2006
Cash $ 4.6 $ 4.6 $ 5.3 $ 5.3 $ 6.1 $ 6.1 $ 7.0 $ 7.0 $ 8.0 $ 8.0
Accounts receivable 13.8 13.8 15.9 15.9 18.3 18.3 21.0 21.0 24.1 24.1
Inventories 18.4 18.4 21.2 21.2 24.3 24.3 28.0 28.0 32.2 32.2
Tot curr assets $36.8 $36.8 $42.3 $42.3 $ 48.7 $ 48.7 $ 56.0 $ 56.0 $ 64.4 $ 64.4
Net plant and equip 46.0 46.0 52.9 52.9 60.8 60.8 70.0 70.0 80.5 80.5
Total assets $82.8 $82.8 $95.2 $95.2 $109.5 $109.5 $125.9 $125.9 $144.8 $144.8

Accounts payable $ 9.2 $ 9.2 $10.6 $10.6 $ 12.2 $ 12.2 $ 14.0 $ 14.0 $ 16.1 $ 16.1
Notes payable 5.0 9.2 9.2 14.0 14.0 19.7 19.7 26.3 26.3 33.9
Accruals 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0
Total curr liab $14.2 $18.4 $19.7 $24.6 $ 26.2 $ 31.9 $ 33.7 $ 40.2 $ 42.3 $ 50.0
Long-term debt 12.0 16.2 16.2 21.0 21.0 26.7 26.7 33.3 33.3 40.9
Total debt $26.2 $34.5 $35.9 $45.6 $ 47.2 $ 58.5 $ 60.4 $ 73.5 $ 75.6 $ 90.8
Common stock 20.0 20.0 20.0 20.0 20.0 20.0 20.0 20.0 20.0 20.0
Retained earnings 28.4 28.3 29.8 29.6 31.2 31.0 32.7 32.4 34.3 34.0
Tot common equity $48.4 $48.3 $49.8 $49.6 $ 51.2 $ 51.0 $ 52.7 $ 52.4 $ 54.3 $ 54.0
Tot liabs & equity $74.6 $82.8 $85.7 $95.2 $ 98.4 $109.5 $113.1 $125.9 $129.9 $144.8

Initial Final Initial Final Initial Final Initial Final Initial Final
2002 2002 2003 2003 2004 2004 2005 2005 2006 2006
Add Funds
Needed (AFN) $8.2 $8.3 $9.5 $9.7 $11.1 $11.3 $12.9 $13.1 $14.9 $15.2
Add notes payable $4.1 $4.2 $4.8 $4.9 $ 5.5 $ 5.7 $ 6.4 $ 6.6 $ 7.5 $ 7.6
Add L-T debt 4.1 4.2 4.8 4.9 5.5 5.7 6.4 6.6 7.5 7.6
Add common stock ($) 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0
Total new
securities $8.2 $8.3 $9.5 $9.7 $11.1 $11.3 $12.9 $13.1 $14.9 $15.2

(2) Dividend payout ratio = 20 percent.

INPUT DATA:

Forecasted sales growth:
2002 15.0%
2003 15.0%
2004 15.0%
2005 15.0%
2006 15.0%
AFN financing percentages:
Notes payable 50.0%
Long-term debt 50.0%
Common stock 0.0%
Debt costs:
Notes payable 12.0%
Long-term debt 12.0%
Tax rate 40.0%

Dividend payout ratio 20.0%

Key output:

2002 AFN $ 6.1
2003 AFN $ 7.2
2004 AFN $ 8.6
2005 AFN $10.1
2006 AFN $11.9
Cumulative AFN $43.9

Ratios:

2001 2002 2003 2004 2005 2006
Cur 2.5 2.1 1.9 1.7 1.6 1.5
PM 5.0% 4.7% 4.5% 4.2% 4.0% 3.8%
TATO 1.1 1.1 1.1 1.1 1.1 1.1
ROA 5.6% 5.3% 5.0% 4.7% 4.5% 4.2%
Debt 34.7% 39.0% 43.0% 46.7% 50.0% 53.2%
ROE 8.6% 8.6% 8.7% 8.8% 8.9% 9.1%


Projected income statements (in millions):

Initial Final Initial Final Initial Final Initial Final Initial Final
2002 2002 2003 2003 2004 2004 2005 2005 2006 2006
Sales $92.0 $92.0 $105.8 $105.8 $121.7 $121.7 $139.9 $139.9 $160.9 $160.9
Operating costs 82.0 82.0 94.3 94.3 108.4 108.4 124.7 124.7 143.4 143.4
EBIT $10.0 $10.0 $ 11.5 $ 11.5 $ 13.2 $ 13.2 $ 15.2 $ 15.2 $ 17.5 $ 17.5
Less interest 2.0 2.7 2.7 3.6 3.6 4.6 4.6 5.8 5.8 7.3
Earnings
before taxes $ 8.0 $ 7.3 $ 8.8 $ 7.9 $ 9.6 $ 8.6 $ 10.6 $ 9.4 $ 11.7 $ 10.2
Taxes 3.2 2.9 3.5 3.2 3.9 3.4 4.2 3.7 4.7 4.1
NI avail to common $ 4.8 $ 4.4 $ 5.3 $ 4.7 $ 5.8 $ 5.2 $ 6.4 $ 5.6 $ 7.0 $ 6.1
Dividends to common $ 1.0 $ 0.9 $ 1.1 $ 0.9 $ 1.2 $ 1.0 $ 1.3 $ 1.1 $ 1.4 $ 1.2
Additions to RE $ 3.8 $ 3.5 $ 4.2 $ 3.8 $ 4.6 $ 4.1 $ 5.1 $ 4.5 $ 5.6 $ 4.9

Projected balance sheets (in millions):

Initial Final Initial Final Initial Final Initial Final Initial Final
2002 2002 2003 2003 2004 2004 2005 2005 2006 2006
Cash $ 4.6 $ 4.6 $ 5.3 $ 5.3 $ 6.1 $ 6.1 $ 7.0 $ 7.0 $ 8.0 $ 8.0
Accounts receivable 13.8 13.8 15.9 15.9 18.3 18.3 21.0 21.0 24.1 24.1
Inventories 18.4 18.4 21.2 21.2 24.3 24.3 28.0 28.0 32.2 32.2
Tot curr assets $36.8 $36.8 $42.3 $42.3 $ 48.7 $ 48.7 $ 56.0 $ 56.0 $ 64.4 $ 64.4
Net plant and equip 46.0 46.0 52.9 52.9 60.8 60.8 70.0 70.0 80.5 80.5
Total assets $82.8 $82.8 $95.2 $95.2 $109.5 $109.5 $125.9 $125.9 $144.8 $144.8

Accounts payable $ 9.2 $ 9.2 $10.6 $10.6 $ 12.2 $ 12.2 $ 14.0 $ 14.0 $ 16.1 $ 16.1
Notes payable 5.0 8.1 8.1 11.7 11.7 16.0 16.0 21.0 21.0 27.0
Accruals 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0
Total curr liab $14.2 $17.3 $18.6 $22.3 $ 23.8 $ 28.1 $ 30.0 $ 35.0 $ 37.1 $ 43.0
Long-term debt 12.0 15.1 15.1 18.7 18.7 23.0 23.0 28.0 28.0 34.0
Total debt $26.2 $32.3 $33.7 $40.9 $ 42.5 $ 51.1 $ 52.9 $ 63.0 $ 65.1 $ 77.0
Common stock 20.0 20.0 20.0 20.0 20.0 20.0 20.0 20.0 20.0 20.0
Retained earnings 30.8 30.5 34.7 34.3 38.9 38.4 43.5 42.9 48.5 47.8
Tot common equity $50.8 $50.5 $54.7 $54.3 $ 58.9 $ 58.4 $ 63.5 $ 62.9 $ 68.5 $ 67.8
Tot liabs & equity $77.0 $82.8 $88.4 $95.2 $101.4 $109.5 $116.4 $125.9 $133.6 $144.8

2002 2002 2003 2003 2004 2004 2005 2005 2006 2006
Add Funds
Needed (AFN) $5.8 $6.1 $6.8 $7.2 $ 8.1 $ 8.6 $ 9.5 $10.1 $11.2 $11.9
Add notes payable $2.9 $3.1 $3.4 $3.6 $ 4.0 $ 4.3 $ 4.8 $ 5.1 $ 5.6 $ 5.9
Add L-T debt 2.9 3.1 3.4 3.6 4.0 4.3 4.8 5.1 5.6 5.9
Add common stock ($) 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0
Total new
securities $5.8 $6.1 $6.8 $7.2 $ 8.1 $ 8.6 $ 9.5 $10.1 $11.1 $11.9

When the dividend payout is increased to 70%, there is a deterioration in the firm’s ratios indicated in Part a; however, the ratios do not deteriorate as much as in the 20% sales growth scenario. When the dividend payout is decreased to 20%, the deterioration still continues but not as much.
From the ratio analysis above, the firm’s ratios are more sensitive to changes in sales growth rates than to changes in dividend payout.


CYBERPROBLEM




4-13 The detailed solution for the cyberproblem is available on the instructor’s side of the Harcourt College Publishers’ web site: http://www.harcourtcollege.com/finance/theory10e.



MINI CASE



SUE WILSON, THE NEW FINANCIAL MANAGER OF NORTHWEST CHEMICALS (NWC), AN OREGON PRODUCER OF SPECIALIZED CHEMICALS FOR USE IN FRUIT ORCHARDS, MUST PREPARE A FINANCIAL FORECAST FOR 2002. NWC’S 2001 SALES WERE $2 BILLION, AND THE MARKETING DEPARTMENT IS FORECASTING A 25 PERCENT INCREASE FOR 2002. WILSON THINKS THE COMPANY WAS OPERATING AT FULL CAPACITY IN 2001, BUT SHE IS NOT SURE ABOUT THIS. THE 2001 FINANCIAL STATEMENTS, PLUS SOME OTHER DATA, ARE SHOWN BELOW.
ASSUME THAT YOU WERE RECENTLY HIRED AS WILSON’S 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.


FINANCIAL STATEMENTS AND OTHER DATA ON NWC
(MILLIONS OF DOLLARS)

A. 2001 BALANCE SHEET % OF % OF
SALES SALES
CASH & SECURITIES $ 20 1% ACCOUNTS PAYABLE
AND ACCRUALS $ 100 5%
ACCOUNTS RECEIVABLE 240 12 NOTES PAYABLE 100
INVENTORY 240 12 TOTAL CURRENT LIABILITIES $ 200
TOTAL CURRENT ASSETS $ 500 LONG-TERM DEBT 100
NET FIXED ASSETS 500 25 COMMON STOCK 500
RETAINED EARNINGS 200
TOTAL ASSETS $1,000 TOTAL LIABILITIES AND EQUITY $1,000

B. 2001 INCOME STATEMENT % OF
SALES
SALES $2,000.00
COST OF GOODS SOLD (COGS) 1,200.00 60%
SALES, GENERAL, AND ADMINISTRATIVE COSTS 700.00 35
EARNINGS BEFORE INTEREST AND TAXES $ 100.00
INTEREST 16.00
EARNINGS BEFORE TAXES $ 84.00
TAXES (40%) 33.60
NET INCOME $ 50.40
DIVIDENDS (30%) $ 15.12
ADDITION TO RETAINED EARNINGS $ 35.28


C. KEY RATIOS NWC INDUSTRY
BASIC EARNINGS POWER 10.00% 20.00%
PROFIT MARGIN 2.52 4.00
RETURN ON EQUITY 7.20 15.60
DAYS SALES OUTSTANDING (360 DAYS) 43.20 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%
OPERATING PROFIT MARGIN AFTER TAXES
(NOPAT/SALES) 3.00% 5.00%
OPERATING CAPITAL REQUIREMENT
(OPERATING CAPITAL/SALES) 45.00% 35.00%
RETURN ON INVESTED CAPITAL
(NOPAT/OPERATING CAPITAL) 6.67% 14.00%


A. ASSUME (1) THAT NWC WAS OPERATING AT FULL CAPACITY IN 2001 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 2001 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: NWC WILL NEED $180.9 MILLION. HERE IS THE AFN EQUATION:

AFN = (A*/S0)DS - (L*/S0)DS - M(S1)(1 - d)
= (A*/S0)(g)(S0) - (L*/S0)(g)(S0) - M(S0)(1 + g)(1 - PAYOUT)
= ($1,000/$2,000)(0.25)($2,000) - ($100/$2,000)(0.25)($2,000)
- 0.0252($2,000)(1.25)(0.7)
= $250 - $25 - $44.1 = $180.9 MILLION.


B. NOW ESTIMATE THE 2002 FINANCIAL REQUIREMENTS USING THE PERCENT OF SALES APPROACH, MAKING AN INITIAL FORECAST PLUS ONE ADDITIONAL “PASS” TO DETERMINE THE EFFECTS OF “FINANCING FEEDBACKS.” 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 2002 AS IN 2001; (2) THAT THE PAYOUT RATIO IS HELD CONSTANT AT 30 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); AND (4) THAT ALL DEBT CARRIES AN INTEREST RATE OF 8 PERCENT.

ANSWER: 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, AND WE SHOW A THIRD PASS JUST TO SHOW THAT AFTER TWO PASSES VERY LITTLE ADDITIONAL ACCURACY IS GAINED.

PREDICTED g: 25.00%
ACTUAL g: 25.00%

INCOME STATEMENT: 2001 2002 2002
ACTUAL PRO FORMA FEEDBACK 2ND PASS
SALES $2,000.00 $2,500.00 $2,500.00
LESS: COGS(% SALES) 60.00% (1,200.00) (1,500.00) (1,500.00)
SGA(% SALES) 35.00% (700.00) (875.00) ( 875.00)
EBIT $ 100.00 $ 125.00 $ 125.00
INTEREST (8%) (16.00) (16.00) +(14.34)* ( 30.34)
EBT $ 84.00 $ 109.00 94.66
TAXES 40.0% (33.60) (43.60) ( 37.86)

NET INCOME $ 50.40 $ 65.40 $ 56.80

*FEEDBACK EQUALS NEW INTEREST ON NEW DEBT: $14.34 = 8%($179.22).

DIVIDENDS 30.0% $ 15.12 $ 19.62 $ 17.04
ADD’N TO R.E. $ 35.28 $ 45.78 $ 39.76

BALANCE SHEET: 2001 2002 2002
ACTUAL PRO FORMA FEEDBACK 2ND PASS
CASH & SECURITIES $ 20.00 $ 25.00 $ 25.00
ACCOUNTS RECEIVABLE 240.00 300.00 300.00
INVENTORIES 240.00 300.00 300.00
CURRENT ASSETS $ 500.00 $ 625.00 $ 625.00
NET FA (% CAP) 100.0% 500.00 625.00 625.00
TOTAL ASSETS $1,000.00 $1,250.00 $1,250.00

A/P AND ACCRUALS $ 100.00 $ 125.00 $ 125.00
N/P (SHORT-TERM) 100.00 100.00 89.61 189.61
L-T DEBT 100.00 100.00 89.61 189.61
COMMON STOCK 500.00 500.00 500.00
RETAINED EARNINGS 200.00 245.78 (6.02) 239.76
TOTAL LIAB & EQUITY $1,000.00 $1,070.78 $1,243.98

AFN $ 179.22 $ 6.02
CUM. AFN $ 179.22 $ 185.24

CAP. SALES = 2,000 = S1/% CAP. USED.

NEW FA = FA2 = 125: IF CAP. SALES > S1*(1 + g), FA2 = FA1.
OTHERWISE FA2 = (FA1/CAP S)*”EXCESS” SALES

AFN FINANCING: WEIGHTS DOLLARS
N/P 0.50 $ 89.61
L-T DEBT 0.50 89.61
COMMON STOCK 0.00 0.00
1.00 $179.22

AFN EQUATION FORECAST:

AFN = (A*/S0) ? g ? S0 - (L*/S0) ? g ? S0 - M ? S1 ? (1 - PAYOUT)
= $250 - $25 - $44.1
= $180.9 VERSUS BALANCE SHEET FORECAST OF $185.24.


C. WHY DO THE TWO METHODS PRODUCE SOMEWHAT DIFFERENT AFN FORECASTS? WHICH METHOD PROVIDES THE MORE ACCURATE FORECAST?

ANSWER: 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, 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.
D. CALCULATE NWC’S FORECASTED RATIOS, AND COMPARE THEM WITH THE COMPANY’S 2001 RATIOS AND WITH THE INDUSTRY AVERAGES. HOW DOES NWC COMPARE WITH THE AVERAGE FIRM IN ITS INDUSTRY, AND IS THE COMPANY EXPECTED TO IMPROVE DURING THE COMING YEAR?

ANSWER: KEY RATIOS NWC INDUSTRY
2001 2002(E) 2001
BASIC EARNINGS POWER 10.00% 10.00% 20.00%
PROFIT MARGIN 2.52% 2.27% 4.00%
ROE 7.20% 7.68% 15.60%
DAYS SALES OUTSTANDING 43.20 43.20 32.00
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? 4.12? 9.40?
CURRENT RATIO 2.50? 1.99? 3.00?
PAYOUT RATIO 30.00% 30.00% 30.00%
OPERATING PROFIT MARGIN AFTER TAXES 3.00% 3.00% 5.00%
(NOPAT/SALES)
OPERATING CAPITAL REQUIREMENT 45.00% 45.00% 35.00%
(OPERATING CAPITAL/SALES)
RETURN ON INVESTED CAPITAL 6.67% 6.67% 14.00%
(NOPAT/OPERATING CAPITAL)

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.


E. CALCULATE NWC’S FREE CASH FLOW FOR 2002.

ANSWER: = -
= NOPAT - NET INVESTMENT IN OPERATING CAPITAL
FCF = NOPAT - (OPERATING CAPITAL2002 - OPERATING CAPITAL2001)
= $125(1 - 0.4) + [($625 - $125 + $625) - ($500 - $100 + $500)
= $75 - ($1,125 - $900) = $75 - $225 = -$150.

NOTE: OPERATING CAPITAL = NET OPERATING WORKING CAPITAL + NET FIXED ASSETS.


F. SUPPOSE YOU NOW LEARN THAT NWC’S 2001 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.

F. 1. WHAT LEVEL OF SALES COULD HAVE EXISTED IN 2001 WITH THE AVAILABLE FIXED ASSETS? WHAT WOULD THE FIXED ASSET/SALES RATIO HAVE BEEN IF NWC HAD BEEN OPERATING AT FULL CAPACITY?

ANSWER: FULL CAPACITY SALES = = = $2,667.

SINCE THE FIRM STARTED WITH EXCESS FIXED ASSET CAPACITY, IT WILL NOT HAVE TO ADD AS MUCH FIXED ASSETS DURING 2002 AS WAS ORIGINALLY FORECASTED:

TARGET FA/SALES RATIO = = = 18.75%.

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.


F. 2. HOW WOULD THE EXISTENCE OF EXCESS CAPACITY IN FIXED ASSETS AFFECT THE ADDITIONAL FUNDS NEEDED DURING 2002?

ANSWER: 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. THEREFORE, 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: 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 FIGURES:

KEY RATIOS % OF 2001 CAPACITY
2001 100% 75%
BASIC EARNING POWER 10.00% 10.00% 11.11%
PROFIT MARGIN 2.52% 2.27% 2.51%
ROE 7.20% 7.68% 8.44%
DAYS SALES OUTSTANDING 43.20 DAYS 43.20 DAYS 43.20 DAYS
INVENTORY TURNOVER 8.33? 8.33? 8.33?
FIXED ASSETS TURNOVER 4.00? 4.00? 5.00?
TOTAL ASSETS TURNOVER 2.00? 2.00? 2.22?
DEBT/ASSETS 30.00% 40.34% 33.71%
TIMES INTEREST EARNED 6.25? 4.12? 6.15?
CURRENT RATIO 2.50? 1.99? 2.48?
PAYOUT RATIO 30.00% 30.00% 30.00%

(NOTE THAT FINANCING FEEDBACKS HAVE NOT BEEN CONSIDERED IN THE RATIOS ABOVE.)


H. BASED ON COMPARISONS BETWEEN NWC’S DAYS SALES OUTSTANDING (DSO) AND INVENTORY TURNOVER RATIOS WITH THE INDUSTRY AVERAGE FIGURES, DOES IT APPEAR THAT NWC IS OPERATING EFFICIENTLY WITH RESPECT TO ITS INVENTORY AND ACCOUNTS RECEIVABLE? IF THE COMPANY WERE ABLE TO BRING THESE RATIOS INTO LINE WITH THE INDUSTRY AVERAGES, WHAT EFFECT WOULD THIS HAVE ON ITS AFN AND ITS FINANCIAL RATIOS? (NOTE: INVENTORIES AND RECEIVABLES WILL BE DISCUSSED IN DETAIL IN CHAPTER 22.)

ANSWER: THE DSO AND INVENTORY TURNOVER RATIO INDICATE THAT NWC HAS EXCESSIVE INVENTORIES AND RECEIVABLES. THE EFFECT OF IMPROVEMENTS 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 WILL SEE IN CHAPTER 22, THERE MAY BE OTHER COSTS ASSOCIATED WITH REDUCING THE FIRM’S INVESTMENT IN ACCOUNTS RECEIVABLE AND INVENTORY), 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. THE RELATIONSHIP BETWEEN SALES AND THE VARIOUS TYPES OF ASSETS IS IMPORTANT IN FINANCIAL FORECASTING. THE PERCENT OF SALES 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) EXCESS CAPACITY, (2) BASE STOCKS OF ASSETS, SUCH AS SHOES IN A SHOE STORE, (3) ECONOMIES OF SCALE IN THE USE OF ASSETS, AND (4) LUMPY ASSETS.

ANSWER: 1. EXCESS CAPACITY. WE HAVE ALREADY SEEN THAT THE EXISTENCE OF EXCESS CAPACITY INVALIDATES THE AFN EQUATION AND REQUIRES A MODIFICATION IN THE BALANCE SHEET FORECAST. THE AFN EQUATION COULD BE MODIFIED IN SEVERAL WAYS, BUT IT IS NOT WORTHWHILE GOING INTO THESE MODIFICATIONS BECAUSE THE FINANCIAL STATEMENT METHOD IS BETTER AND IT ALSO CAN BE USED TO PRODUCE RATIO DATA, WHICH IS ESSENTIAL. IN ANY EVENT, THE EXISTENCE OF EXCESS CAPACITY LEADS TO TOO HIGH A FORECAST OF AFN UNLESS APPROPRIATE MODIFICATIONS ARE MADE.

2. BASE STOCKS ARE USUALLY ASSOCIATED WITH INVENTORY, WHERE THE FIRM MUST HAVE A MINIMUM STOCK TO DO ANY BUSINESS AT ALL. THINK OF A SHOE STORE, WHICH MUST KEEP A NUMBER OF STYLES, COLORS, AND SIZES ON HAND IN ORDER TO DO EVEN A SMALL AMOUNT OF BUSINESS. THE RELATIONSHIP BETWEEN SALES AND INVENTORY WILL PROBABLY LOOK AS FOLLOWS:
3. ECONOMIES OF SCALE IN THE USE OF ASSETS MEAN THAT THE ASSET ITEM IN QUESTION MUST INCREASE LESS THAN PROPORTIONATELY WITH SALES; HENCE IT WILL GROW LESS RAPIDLY THAN SALES. CASH IS A COMMON EXAMPLE, AND ITS RELATIONSHIP TO SALES WOULD BE AS FOLLOWS:

INVENTORIES OFTEN TAKE A SIMILAR SHAPE, BUT WITH A BASE STOCK ADDED, TO PRODUCE THE FOLLOWING SITUATION:
4. LUMPY ASSETS WOULD CAUSE THE RELATIONSHIP BETWEEN ASSETS AND SALES TO LOOK AS SHOWN BELOW. THIS SITUATION IS COMMON WITH FIXED ASSETS.

J. 1. HOW COULD REGRESSION ANALYSIS BE USED TO DETECT THE PRESENCE OF THE SITUATIONS DESCRIBED ABOVE AND THEN TO IMPROVE THE FINANCIAL FORECASTS? PLOT A GRAPH OF THE FOLLOWING DATA, WHICH IS FOR A TYPICAL WELL-MANAGED COMPANY IN NWC’S INDUSTRY, TO ILLUSTRATE YOUR ANSWER.

SALES INVENTORIES
1999 $1,280 $118
2000 1,600 138
2001 2,000 162
2002E 2,000 192

ANSWER: REGRESSION ANALYSIS COULD BE USED TO SEE IF ONE OF THE CONDITIONS INDICATED IS PRESENT. THE EASIEST THING TO DO IS TO SIMPLY PLOT THE DATA ON A GRAPH. IF THE POINTS SEEM TO LIE ON A LINE THAT IS LINEAR AND PASSES THROUGH THE ORIGIN, THEN IT WOULD BE APPROPRIATE TO ASSUME THAT THE ITEM IN QUESTION WILL INCREASE IN PROPORTION TO SALES. OTHERWISE, THAT ASSUMPTION WOULD NOT APPEAR TO BE VALID. HERE IS THE PLOT FOR THE ASSUMED DATA FOR 1996-2002:

WE RAN A SIMPLE LEAST SQUARES REGRESSION, USING AN HP CALCULATOR, AND OBTAINED THE FOLLOWING REGRESSION EQUATION:

INVENTORIES = 40.0 + 0.0611(SALES).

WE COULD USE THIS EQUATION TO FORECAST INVENTORIES AT THE PROJECTED SALES LEVEL OF $2,500:

INVENTORIES = 40.0 + 0.0611($2,500) = $192.7.

ASSUMING THE REGRESSION EQUATION WOULD BE APPROPRIATE FOR NWC IF ITS INVENTORIES WERE BETTER MANAGED, WE SEE THAT IT COULD OPERATE AT THE PROJECTED SALES LEVEL WITH ONLY $192.7 OF INVENTORY VERSUS THE $300 LEVEL BASED ON THE PROPORTIONAL GROWTH SALES FORECASTING METHOD. THEREFORE, THE COMPANY COULD FREE UP ABOUT $107.3 AND USE THESE FUNDS TO REDUCE DEBT AND THUS IMPROVE ITS PROFITABILITY RATIOS, ITS DEBT RATIO, AND ITS TIE RATIO. NOTE TOO THAT IF NWC LOWERED ITS INVENTORY TO $192.7 FOR SALES OF $2,500, ITS INVENTORY TURNOVER WOULD RISE FROM 8.3 TO 13.0, WHICH WOULD BE EVEN BETTER THAN THE INDUSTRY AVERAGE OF 11.


J. 2. ON THE SAME GRAPH THAT PLOTS THE ABOVE DATA, DRAW A LINE WHICH SHOWS HOW THE REGRESSION LINE MUST APPEAR TO JUSTIFY THE USE OF THE AFN FORMULA AND THE PERCENT OF SALES FORECASTING PROCEDURE. AS A PART OF YOUR ANSWER, SHOW THE GROWTH RATE IN INVENTORIES THAT RESULTS FROM A 10 PERCENT INCREASE IN SALES FROM A SALES LEVEL OF (A) $200 AND (B) $2,000 BASED ON BOTH THE ACTUAL REGRESSION LINE AND A HYPOTHETICAL REGRESSION LINE WHICH IS LINEAR AND WHICH GOES THROUGH THE ORIGIN.

ANSWER: THE REGRESSION LINE WOULD HAVE HAD TO BE LINEAR AND PASS THROUGH THE ORIGIN TO JUSTIFY THE USE OF THE PROPORTIONAL GROWTH PROCEDURE, FOR ONLY THEN WOULD THE RATIO OF INVENTORIES TO SALES REMAIN CONSTANT AT ALL SALES LEVELS. THAT SITUATION OBVIOUSLY DOES NOT HOLD FOR THE DATA WE ARE USING.
IF SALES WERE TO INCREASE FROM $200 TO $220, FROM THE GRAPH ABOVE, YOU COULD SEE THAT THE PROPORTIONAL GROWTH METHOD WOULD GREATLY UNDERSTATE THE INVENTORY VALUE AS ESTIMATED BY THE REGRESSION LINE, WHILE IF SALES INCREASED FROM $2,000 TO $2,200, THE PROPORTIONAL GROWTH METHOD WOULD SLIGHTLY OVERSTATE THE INVENTORY VALUE AS ESTIMATED BY THE REGRESSION LINE.


L. 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) NWC BEGINS BUYING FROM ITS SUPPLIERS ON TERMS WHICH PERMIT IT TO PAY AFTER 60 DAYS RATHER THAN AFTER 30 DAYS. (CONSIDER EACH ITEM SEPARATELY AND HOLD ALL OTHER THINGS CONSTANT.)

ANSWER: 1. IF THE PAYOUT RATIO WERE REDUCED, THEN MORE EARNINGS WOULD BE RETAINED, AND THIS WOULD REDUCE THE NEED FOR EXTERNAL FINANCING, 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 POINT, i.e., 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 WHICH 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 RETAINED EARNINGS WILL INCREASE, AND THIS WILL REDUCE THE AMOUNT OF AFN.

3. THE CAPITAL INTENSITY RATIO IS DEFINED AS THE RATIO OF REQUIRED ASSETS TO TOTAL SALES, OR A*/S0. PUT ANOTHER WAY, IT REPRESENTS THE DOLLARS OF ASSETS REQUIRED PER DOLLAR OF SALES. THE HIGHER THE CAPITAL INTENSITY RATIO, THE MORE NEW MONEY WILL BE REQUIRED TO SUPPORT AN ADDITIONAL DOLLAR OF SALES. THUS, THE HIGHER THE CAPITAL INTENSITY RATIO, THE GREATER THE AFN, OTHER THINGS HELD CONSTANT.

4. IF NWC’S PAYMENT TERMS WERE INCREASED FROM 30 TO 60 DAYS, ACCOUNTS PAYABLE WOULD DOUBLE, IN TURN INCREASING CURRENT AND TOTAL LIABILITIES. THIS WOULD REDUCE THE AMOUNT OF AFN DUE TO A DECREASED NEED FOR WORKING CAPITAL ON HAND TO PAY SHORT-TERM CREDITORS, SUCH AS SUPPLIERS.