1/10/2007

Chapter 14 Mini Case

Situation 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 2007 but is not sure about this. The 2007 financial statements, plus some other data, are shown below.

2007 Balance Sheet (in millions) Cash and Securities Accounts Receivable Inventories Total Current Assets Net Fixed Assets Total Assets $20.0 $240.0 $240.0 $500.0 $500.0 $1,000.0

Percent of Sales 1% 12% 12% 25%

Accounts Payable and Accruals Notes Payable Total Current Liabilities Long Term Debt Common Stock Retained Earnings Total Liabilities and Equity

$100.0 $100.0 $200.0 $100.0 $500.0 $200.0 $1,000.0

5%

2007 Income Statement (in millions) Sales Variable Costs Fixed Costs EBIT Interest EBT Taxes(40%) Net Income Dividends(40%) Additions to Retained Earnings $2,000.0 $1,200.0 $700.0 $100.0 $10.0 $90.0 $36.0 $54.0 $21.6 $32.4 2007

Percent of Sales

60% 35%

Key Ratios Profit margin ROE DSO Inventory turnover Fixed asset turnover Debt/Assets TIE Current ratio NOPAT/Sales Operating Capital / Sales Return on Invested Capital (NOPAT/Capital)

SEC 2.70% 7.71% 43.80 8.33 4.00 30.00% 10.00 2.50 3.00% 45.00% 6.67%

Industry 4.00% 15.60% 32.00 11.00 5.00 36.00% 9.40 3.00 5.00% 35.00% 14.00%

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. a. Describe three ways that pro forma statements are used in financial planning. Answer: See Chapter 14 Mini Case Show b. Explain the steps in financial forecasting. 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. USING THE AFN EQUATION Additional Data Sales Increase = 2007 Profit Margin= Payout Ratio= AFN= D Required Assets D Required Assets

25% 2.70% 40% D Spontaneous Liabilities Asset to Sales Ratio 0.500 $250.00 Spontaneous Liab. to Sales Ratio 0.050 $25.00 Profit Margin 0.027 $40.50 D Retained Earnings D Sales $500.00

= = =

x x

D Spontaneous Liabilities

= = =

x x

D Sales $500.00

D Retained Earnings

= = =

x x $

Sales 2,500.0

x x

Retention Ratio 0.600

AFN= D Required Assets = $250.00 AFN= $184.50

D Spontaneous Liabilities $25.00

D Retained Earnings $40.50

d. How would changes in these items affect the AFN? (1) Sales increase, (2) the dividend payout ratio increases, (3) the profit 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. Actual 2007 60.0% 35.0% 1.0% 12.0% 12.0% 25.0% 5.0% Projected 2008 60.0% 35.0% 1.0% 12.0% 12.0% 25.0% 5.0%

Percent of Sales Inputs COGS/Sales SGA/Sales Cash/Sales Accounts Rec./Sales Inv./Sales Net Fixed Assets/Sales AP & Accruals/Sales Other Inputs Percent growth in sales Growth factor in sales Interest rate on debt Tax rate Dividend Payout Ratio Funds will be generated through: Notes Payable = Long Term Debt = INCOME STATEMENT (in millions of dollars) Sales COGS SGA Expenses EBIT Less Interest EBT Taxes (40%) Net Income Dividends Add. To retained earnings $ $ $ $ $ $ $ $ $ $

25% 1.25 10% 40% 40%

50% 50%

Actual 2007 2,000.0 1,200.0 700.0 100.0 10.0 90.0 36.0 54.0 21.6 32.4

Forecast basis Growth % of Sales % of Sales

1.25 60.00% 35.00%

Interest rate x Debt07

Forecast 2008 $ 2,500.0 $ 1,500.0 $ 875.0 $ 125.0 $ 20.0 $ $ $ $ $ 105.0 42.0 63.0 25.2 37.8

BALANCE SHEET (in millions of dollars) 2007 Assets Cash Accounts receivable Inventories Total current assets Net plant and equipment Total assets $ $ $ $ $ $ 20.0 240.0 240.0 500.0 500.0 1,000.0 Forecast basis % of Sales % of Sales % of Sales % of Sales 1.00% 12.00% 12.00% 25.00%

2008 Forecast Without AFN $ $ $ $ $ $ 25.0 300.0 300.0 625.0 625.0 1,250.0

AFN

2008 Forecast With AFN 0 $ 25.0 $ 300.0 $ 300.0 $ 625.0 $ 625.0 $ 1,250.0

Liabilities and equity Accounts payable & Accruals $ Notes payable Total current liabilities Long-term bonds Total liabilities Common stock $ $ $ $ $

100.0 % of Sales 100.0 Carry-over 200.0 100.0 Carry-over 300.0 500.0 Carry-over 200.0 RE07 + DRE08 700.0 1,000.0

5.00%

$ $ $ $ $ $ $ $ $ $ $ $

125.0 100.0 225.0 100.0 325.0 500.0 237.8 737.8 1,062.8 1,250.0 1,062.8 187.20 $ $ 93.6 93.6

$ $ $ $ $ $ $ $ $

125.0 193.6 318.6 193.6 512.2 500.0 237.8 737.8 1,250.0

Retained earnings $ Total common equity $ Total liabilities and equity $ Required assets = Specified sources of financing = Additional funds needed (AFN)

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). MEASURING OPERATING PERFORMANCE: FREE CASH FLOW AND RATIOS Forecast 2008 $ $ $ $ $ 500.0 1,125.0 75.0 225.0 (150.0) 6.67% 2008 2.52% 8.54% 43.80 8.33 4.00 40.98% 6.25 1.96

Free Cash Flow Net operating working capital (NOWC) $ Total Operating Capital $ NOPAT $ Investment in Capital FCF Return on Invested Capital (NOPAT/Capital) Key Ratios Profit margin ROE DSO Inventory turnover Fixed asset turnover Debt/Assets TIE Current ratio

2007 400.0 900.0 60.0

14.00% Industry 4.00% 15.60% 32.00 11.00 5.00 36.00% 9.40 3.00

2007 2.70% 7.71% 43.80 8.33 4.00 30.00% 10.00 2.50

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? PROPOSED IMPROVEMENTS Inputs DSO Before 43.80 After 32.01

Accounts receivable/sales Inventory turnover Inventory/sales SGA/sales Outputs AFN FCF ROIC ROE

12.00% 8.33 12.00% 35.0%

8.77% Note: we used Scenario 11.00 Manager to find the after9.09% improvement values. 33.0%

$187.2 -$150.0 6.7% 8.5%

$15.7 $33.5 10.8% 12.3%

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? EFFECT OF EXCESS CAPACITY Suppose in 2007 fixed assets had been operated at only 75% of capacity? Capacity SalesActual = Sales = $2,000 Capacity Sales $2,666.67 = / / % of Capacity 0.75

(2.) How would the existence of excess capacity in fixed assets affect the additional funds needed during 2008? Forecasted sales are less than this, so no new fixed assets are needed. Previously forecasted AFN = $187 Previously forecasted addition to fixed assets = $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 = $500 Target Ratio = 0.1875 Change in FA = Change in FA = 0.1875 $62.50 / / Capacity Sales $2,666.67

$333.33

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

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