Forecasting Brigham Case Solution

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Chapter 17. Integrated Case Model 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 2002. 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 IC17-1. 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.

INPUT DATA (for New World Chemicals)

TABLE IC17-1 Financial Statements and other data on NWC (MILLIONS OF DOLLARS) BALANCE SHEET Assets Cash and securities Accounts receivable Inventory Total current assets Net fixed assets Total assets

$20 240 240 $500 500 $1,000

Liabilities and equity Accounts payable & accrued liab. Notes payable Total current liabilities Long-term debt Common stock Retained earnings Total liabilities and equity

$100 100 $200 100 500 200 $1,000

INCOME STATEMENT Sales Less: variable costs Fixed costs EBIT Interest EBT Taxes (40%) Net Income Dividends (30%) Addition to Retained Earnings

2002

2002 $2,000 1,200.00 700 $100.00 16 $84.00 33.6 $50.40 $15.12 $35.28

A B C D E F G H I J 53 KEY RATIOS NWC INDUSTRY COMMENT 54 10.00% 20.00% 55 Basic Earning Power 2.52% 0.0 56 Profit Margin 7.20% 15.60% 57 Return on Equity 43.8 32.0 58 Days Sales Outstanding (365 days) 8.33 11 59 Inventory Turnover 4.0 5.0 60 Fixed Assets Turnover 2.0 2.5 61 Total Assets Turnover 30% 36% 62 Debt/Assets Ratio 6.25 9.4 63 Times Interest Earned 2.5 3.0 64 Current Ratio 30.00% 30.00% 65 Payout Ratio 66 67 OTHER INPUT DATA 25% 68 Sales growth rate 40% 69 Tax rate 70 71 72 73 PART A 74 75 Assume (1) that NWC was operating at full capacity in 2002 with respect to all assets, (2) that all assets must grow 76 proportionally with sales, (3) that accounts payable and accrued liabilities will also grow in proportion to sales, and (4) that the 77 2002 profit margin and dividend payout will be maintained. Under these conditions, what will the company’s financial 78 requirements be for the coming year? Use the AFN equation to answer this question. 79 80 This is the AFN equation: 81 82 (A* / S0) * (dS) (L* / S0) * (dS) M * (S1) * (RR) 83 AFN = (A* / S ) * (g*S ) (L* / S ) * (g * S ) M * (S0)(1+g) * (1 - payout ratio) 84 AFN = 0 0 0 0 AFN = $250.0 $25.0 44.1 85 AFN = $180.9 86 87 88 PART B 89 90 Now estimate the 2003 financial requirements using the projected financial statement approach. Disregard the assumptions 91 in Part A, and now assume (1) that each type of asset, as well as payables, accrued liabilities, and fixed and variable costs, grow in 92 proportion to sales; (2) that NWC was operating at full capacity; (3) that the payout ratio is held constant at 30 percent; and (4) 93 that external funds needed are financed 50 percent by notes payable and 50 percent by long-term debt (no new common stock 94 will be issued). 95 96 We have reproduced some of the input data (growth rate and tax rate) below along with the financial statements. The forecast 97 can be observed below. 98 25% 99 Sales Growth Rate 40% 100 Tax rate 101

102 103 104 105 106 107 108 109 110 111 112 113 114 115 116 117 118 119 120 121 122 123 124 125 126 127 128 129 130 131 132 133 134 135 136 137 138 139 140 141 142 143 144 145 146 147 148 149 150 151 152

A B INCOME STATEMENT (in millions of dollars)

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2002 $2,000.0 $1,200.0 $700.0 $100.0 $16.0 $84.0 $33.60 $50.4

Sales Less: Variable costs Fixed costs EBIT Interest expense EBT Taxes (40%) Net income Dividends to common Addition to retained earnings

Forecast basis % of sales 100.00% 60.00% 35.00%

$15.1 $35.3

Funds raised as notes payable Funds raised as long-term debt Funds raised as new common stock

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$19.6 $45.8

50% 50% 0%

$100.0 100.0 $200.0 100.0 $300.0 500.0 200.0 $700.0 $1,000.0

Additional funds needed (AFN) AFN FINANCING Notes payable Long-term debt Total

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2003 $2,500.0 $1,500.0 $875.0 $125.0 Underline is in wrong place. $16.0 $109.0 Underline is in wrong place. $43.60 $65.4

BALANCE SHEET (AFTER TWO PASSES) (in millions of dollars) Forecast basis 2002 % of sales 1ST PASS Assets Cash $20.0 1.00% $25.0 Accounts receivable 240.0 12.00% 300.0 Inventories 240.0 12.00% 300.0 Total current assets $500.0 25.00% $625.0 Net plant and equipment 500.0 25.00% 625.0 Total assets $1,000.0 50.00% $1,250.0 Liabilities and equity Accounts payable & accruals Notes payable Total current liabilities Long-term bonds Total debt Common stock Retained earnings Total common equity Total liabilities and equity

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5.00% 10.00% 15.00% +$68.4 35.00% 50.00%

$125.0 100.0 $225.0 100.0 $325.0 500.0 245.8 $745.8 $1,070.8

2003 AFN

2ND PASS $25.0 300.0 300.0 $625.0 625.0 $1,250.0

$89.6 $89.6

179.2

$89.6 $89.6 $179.2

Notice that the AFN of $179.2 contradicts the result found in the AFN equation from Part A.

$125.0 189.6 $314.6 189.6 $504.2 500.0 245.8 $745.8 $1,250.0

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A 154 155 156 157 158 159 160 161 162 163 164 165 166 167 168 169 170 171 172 173 174 175 176 177 178 179 180 181 182 183 184 185 186 187 188 189 190 191 192 193 194 195 196 197 198 199 200 201 202 203

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PART C Why do the two methods produce somewhat different AFN forecasts? Which method provides the more accurate forecast? 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.

PART D Calculate NWC’s forecasted ratios, and compare them with the company’s 2002 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? NWC2003 Basic Earning Power Profit Margin Return on Equity Days Sales Outstanding (365 days) Inventory Turnover Fixed Assets Turnover Total Assets Turnover Debt/Assets Ratio Times Interest Earned Current Ratio Payout Ratio

10.00% 2.62% 8.77% 43.8 8.33 4.0 2.0 40.34% 7.81 1.99 30.00%

NWC2002 10.00% 2.52% 7.20% 43.8 8.33 4.0 2.0 30% 6.25 2.50 30.00%

INDUSTRY 20.00% 4.00% 15.60% 32.0 11.0 5.0 2.5 36% 9.4 3.00 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.

PART E Calculate NWC’s free cash flow for 2003. Operating capital2002 = Operating capital2002 = Operating capital2002 =

CA $500.0 $900.0

Operating capital2003 =

$1,125.0

FCF 2003 = FCF 2003 = FCF 2003 =

NOPAT $75.0 ($150.0)

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CL (w/o NP) $100.0

+ +

Net investment in operating capital $225.0

Net fixed assets $500.0

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PART F Suppose you now learn that NWC’s 2002 receivables and inventory 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? Full capacity sales = Full capacity sales = Full capacity sales =

Actual sales $2,000 $2,666.67

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% of capacity for FA 75%

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: Target FA/Sales ratio= Target FA/Sales ratio= Target FA/Sales ratio=

Fixed assets $500 18.75%

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Full capacity sales $2,667

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. (2) How would the existence of excess capacity in fixed assets affect the additional funds needed during 2003? 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.

PART 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. 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:

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Basic Earning Power Profit Margin Return on Equity Days Sales Outstanding (365 days) Inventory Turnover Fixed Assets Turnover Total Assets Turnover Debt/Assets Ratio Times Interest Earned Current Ratio Payout Ratio

D 2002 10.00% 2.52% 7.20% 43.80 8.33 4.00 2.00 30.00% 6.25 2.50 30.00%

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2003 @ 75% 11.11% 2.62% 8.77% 43.80 8.33 5.00 2.22 33.71% 7.81 2.48 30.00%

@ 100% 10.00% 2.62% 8.77% 43.80 8.33 4.00 2.00 40.34% 7.81 1.99 30.00%

PART H On the basis of 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? 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 saw in Chapter 15, 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.

PART 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 which permit it to pay after 60 days rather than after 30 days. (Consider each item separately and hold all other things constant.) (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.