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Mini Case_1 Figure MC-1. Financial Statements and Other Data (Millions except per share data) Balance Sheet, Hatfield, 12/31/10 Cash and securities Accounts receivable Inventories 390 Income Statement, Hatfield, 2010 Sales $3,000 Total operating costs 2,800 EBIT $200 Interest 54 EBT $146 Taxes (40%) 58 Net income $88 Dividends $28 Add. to retain. earnings $60 Shares outstanding 10 EPS $8.76 DPS $2.80 Total current assets Net fixed assets Total assets Accounts pay. + accruals Notes payable Total current liabilities Long-term debt $720 500 $1,220 $120 80 Total common equity $500 Total liab. & equity $1,220 Selected Ratios and Other Data, 2010 Sales, 2010 (S0): Expected growth in sales: Profit margin (M): Assets/Sales (A0*/S0): Payout ratio (POR): Equity multiplier (Assets/Equity): Total liability/Total assets Times interest earned (EBIT/Interest): Increase in sales (ΔS = gS0): (Payables + Accruals)/Sales (L0*/S0): Operating costs/Sales: Cash/Sales: Receivables/Sales: Inventories/Sales: Fixed assets/Sales: Tax rate: Interest rate on all debt: Price/Earning (P/E): ROE (Net income/Common equity): $200 520 $720 300 Retained earnings 200 Total liabilities Common stock Year-end stock price Industry $3,000 20.0% 3.67% 37.0% 35.0% 2 50.0% 5.20 $600 3.0% 90.0% 1.0% 8.2% 11.5% 14.8% 40.0% 9.0% 12.0 19.84% Assets/Equity = 2.44 2.00 $87.60 $40 290 DuPont ROE Hatfield Industry PM 2.92% 3.67% x Sales/Assets 2.46 2.70 Hatfield $3,000 18.0% 2.9% 40.7% 32.0% 2.44 59.0% 3.70 $540 4.0% 93.3% 1.3% 9.7% 13.0% 16.7% 40.0% 9.00% 10.0 17.52% x ROE 17.52% 19.84% AFNHatfield = = = Add'l Req'd Assets (A0*/S0)∆S (A0*/S0)(gS0) - Spontaneous liabi. - (L0*/S0)∆S - (L0*/S0)(gS0) - Add'n to RE - S1 × M × (1–POR) - S1 × M × (1–POR) =-- AFNHatfield = million Self-Supporting Growth Rate. This is the maximum growth rate that can be attained without raising external funds, i.e., the value of g that forces AFN = 0, holding other things constant. 1. Using algebra. The self-supporting growth rate can also be found by solving the equation below that causes AFN to equal zero. This results in the same value as we find with Goal Seek. The algebriac solution is easy if we give you the equation, but if you had to solve the AFN equation for g, you would probably find the Goal Seek solution easier. PM(1 – POR)(S0) Self-Supporting g = = = A0* – L0* – PM(1 – POR)S0 2. Using Goal Seek. To find the self-supporting growth rate with Goal Seek, first highlight cell B56. Then, on the Main Menu bar click Data>What-If-Analysis>Goal Seek. When you click OK, Cell D25 will change to the answer, which will cause Cell B56 to change to $0.00. Record the new growth rate and then return to the base case by clicking Cancel. Or, you could click OK to leave the new growth rate in Cell D25 and then over-type it with 18% in that cell to get back to the base case. In this assignement, please Leave the new value for D25 to receive credits for goal seek. Goal Seek is one of Excel's most useful features. We use it elsewhere in this chapter to find the required amount of new capital. In capital budgeting, we use it to see how high the WACC can go before the NPV becomes negative, how low the WACC must be for the NPV to be positive, how low the initial cost must be to achieve a positive NPV, how long a project must last to achieve a positive NPV, and so forth. We have worked on real world cases dealing with almost every chapter in the text, and we almost always have occasion to use Goal Seek. We can't overemphasize its usefulness. Forecasted Financial Statements Forecast the financial statements using the following assumptions. (1) Operating ratios remain unchanged. (2) No additional notes payable, LT bonds, or common stock will be issued. (3) The interest rate on all debt is 9%. (4) If additional financing is needed, then it will be raised through a line of credit. The line of credit will be tapped on the last day of the year, so there will be no additional interest charges due to the line of credit. (On Tab 2 we relax this assumption and assume that the line of credit is accessed smoothly throughout the year.) (5) Interest expenses for notes payable and LT bonds are based on the average balances during the year. (6) If surplus funds are available, the surplus will be paid out as a special dividend payment. (7) Regular dividends will grow by 11.91%. (8) Sales will grow by 18%. This is called the "Steady" scenario because operations remain unchanged. The same assumptions apply to the Target scenario, except there are improvements in several areas of operations. Use the Scenaro Manager to change scenarios. Inputs for Forecasts Sales growth rate Operating costs/Sales Cash/Sales Receivables/Sales Inventories/Sales Fixed assets/Sales Payables and accruals/ Sales Growth rate in regular dividends Interest rate on all debt Tax rate Cash Accounts receivable Inventories Total assets Liabilities & equity $40 290 390 18.00% 93.30% 1.30% 9.70% 13.00% 16.70% 4.00% 11.91% 9.00% 40.00% Steady 18.00% 93.30% 1.30% 9.70% 13.00% 16.70% 4.00% 11.91% 9.00% 40.00% Forecast Scenarios Target 20.00% 90.00% 1.00% 8.20% 11.50% 14.80% 3.00% 12.90% 9.00% 40.00% Active is Hatfield 2010 Scenario: Hatfield Balance Sheet Assets 2010 Forecast Factor Basis for 2011 Forecast w/o AFN 2011 With AFN 2011 Factor × Forecasted Sales Factor × Forecasted Sales Factor × Forecasted Sales $720 500 Factor × Forecasted Sales $1,220 $120 80 0 Factor × Forecasted Sales Carry over 2010 amount New LOC if AFN > 0 Carry over 2010 amount Carry over 2010 amount $200 520 $720 300 Retained earnings 2010 + Add'n to RE from Income St. Total common equity Total liab. & equity AFN = TA – (Planned Liab & Equity) 200 $500 $1,220 Income Statement Scenario: Hatfield 2010 Forecast Special dividend (if AFN ≤ 0) = w/o AFN With AFN Sales Total operating costs $3,000.0 2,800.0 Factor Basis for 2011 Forecast 2011 2011 (1 + Factor) × 2010 Sales Factor × Forecasted Sales $200.0 Interest: NP planned Interest: LT debt planned Interest: Line of credit 7.2 46.8 0.0 Rate x NP Rate x L-T Debt Rate x Beginning Balance $146.0 58.4 Tax rate × EBT Net inc. for common (NI) $87.6 Dividends- regular (DIVs) Special dividends Add. to ret. earnings $28.0 $0.0 (1 + g) × 2010 Dividends Special dividend if AFN ≤ 0 NI − all dividends $59.6 Steady Forecast Scenarios Target Active is Performance Net operating profits after taxes Net operating working capital Hatfield 2010 $120 $600 Total current assets Net fixed assets Accts pay. and accruals Notes payable: Planned Line of credit (LOC) Total current liabs LT debt: Planned Total liabilities Common stock EBIT Earnings before taxes (EBT) Taxes New line of credit (if AFN > 0) = Total operating capital Free cash flow Return on invested capital AFN EPS DPS (regular dividends) Payout ratio (all dividends) Profit margin Sales/Assets (Assets turnover) Assets/Equity ROE Operating costs/Sales Total liability/Total assets TIE ratio Growth rate Operating costs/sales Cash/Sales Receivables/Sales Inventories/Sales Fixed assets/Sales Payables and Accruals/ Sales Interest rate on notes payable Payout ratio Tax rate P/E ratio Shares outstanding (millions) Hatfield 2010 18.0% 93.3% 1.3% 9.7% 13.0% 16.7% 4.0% 9.0% 32.0% 40% 10.0 10.000 $1,100 NA 10.9% NA $8.76 $2.80 32.0% 2.9% 2.46 2.44 17.5% 93.3% 59.0% 3.70 ADJUSTED FOR INTEREST ON ADDED NOTES PAYABLE Steady State Steady 18.0% 93.3% 1.3% 9.7% 13.0% 16.7% 4.0% 9.0% 32.0% 40% 10.0 10.000 Adjusted for New Interest Data Used in the Scenarios Inputs for Forecasts Target Target 20.0% 90.0% 1.0% 8.2% 11.5% 14.8% 3.0% 9.0% 35.0% 40% 12.0 10.000 Active Adjusted for New Interest Hatfield Forecast This data is for: 2011 Balance Sheet 2010 Factor Procedure for 2011 Forecast Forecast Assets Cash Accounts receivable Inventories Total current assets Net fixed assets Accts payable and accruals Total assets $40 290 390 Factor × Forecasted Sales Factor × Forecasted Sales Factor × Forecasted Sales $720 500 Factor × Forecasted Sales $1,220 Claims on Assets Notes payable Add' notes to balance Total current liabs Long Term Debt Total liabilities Common stock Retained earnings Total common equity Total liabs and equity Shares outstanding $120 80 0 Factor × Forecasted Sales Carry over 2010 amount New notes (+/-) to balance Carry over 2010 amount Carry over 2010 amount 2010 + Add'n to RE from Income Statement $200 520 $720 300 200 $500 Year-end stock price $1,220 10.000 $87.60 Difference between Assets and Liab+Equity: Adjusted for New Interest Adjusted for New Interest Hatfield Forecast 2010 Income Statement 2010 Factors Forecast 2011 Scenario: Sales $3,000.0 Total operating costs 2,800.0 (1 + Factor) × 2010 Sales Factor × Forecasted Sales EBIT Interest on initial debt Total interest Earnings before taxes (EBT) Taxes $200.0 54.0 Interest rate × (NP+L-T Debt) $54.0 $146.0 58.4 Tax rate × 2011 EBT Interest on 1/2 of new debt 0.0 Net income for common (NI) $87.6 Interest rate × (0.5 × Δ notes) Dividends (DIVs) $28.0 Payout Ratio × NI Add. to ret. earns (NI – DIVs) $59.6 Shares outstanding EPS DPS Stock Price 10.000 $8.76 $2.80 $87.60 Adjusted for New Interest Adjusted for New Interest Hatfield Steady State Final Performance EPS Year-end stock price Profit margin (PM) Sales/Assets (Assets turnover) ROE Debt/Assets Assets/Equity TIE ratio Payout ratio 2010 Steady State Target Active Steady Target $8.76 $87.60 2.9% 2.46 17.5% 59.0% 2.44 3.70 32.0% Final comment: Different problems require somewhat different models--one size does not fit all. For example, a firm's growth rate might be low, and if that resulted in a negative AFN, then a model would have to be programmed to do something with the excess funds. The model on Tab 2 is an example. a. Do you think Adam Lee should develop a strategic plan for the company? Why? What are the central elements of such a plan? What is the role of finance in a strategic plan? b. Based on the data in Figure MC-1, how well run does Hatfield appear to be in comparison to other firms in its industry? What are its primary strengths and weaknesses? Be specific in your answer, and point to various ratios that support your position. Also, use the DuPont equation as one part of your analysis. c. Use the AFN equation to estimate Hatfield’s required new external capital for 2011 if the 18% expected growth takes place. Assume its 2010 ratios will remain the same in 2011. d. Define the term “capital intensity.” Explain how a decline in capital intensity would affect the AFN, other things held constant. Would economies of scale combined with rapid growth affect capital intensity, other things held constant? Also, explain how changes in each of the following would affect AFN, holding other things constant: The growth rate, the amount of accounts payable, the profit margin, and the payout ratio. e. Define the term “self-supporting growth rate.” Based on the Figure MC-1 data, what is Hatfield’s self-supporting growth rate? Would the self-supporting growth rate be changed by a change in the capital intensity ratio or the other factors mentioned in question d? Would the calculated capital intensity ratio change over time if the company were growing and was also subject to economies of scale and/or lumpy assets, other things held constant? f. Forecast the financial statements for 2011 using the following assumptions. (1) Operating ratios remain unchanged. (2) No additional notes payable, LT bonds, or common stock will be issued. (3) The interest rate on all debt is 9%. (4) If additional financing is needed, then it will be raised through a line of credit. The line of credit will be tapped on the last day of the year, so there will be no additional interest expenses due to the line of credit. (5) Interest expenses for notes payable and LT bonds are based on the average balances during the year. (6) If surplus funds are available, the surplus will be paid out as a special dividend payment. (7) Regular dividends will grow by 11.91%. (8) Sales will grow by 18%. This is called the "Steady" scenario because operations remain unchanged. 1. How much new capital will the firm need (i.e., what is the forecasted AFN), how does it compare with the amount you calculated using the AFN equation, and why does any difference exist? 2. Calculate the firm’s free cash flow, return on invested capital, EPS, DPS, ROE, and any other ratios you think would be useful in considering the situation. (Just finish the excel file from row 144-160) for Steady case 3. Assuming all of the inputs turn out to be exactly correct, would these answers also be exactly correct? If not, why not? g. Now repeat the analysis done for question f but assume that Hatfield is able to achieve industry averages for the following input variables: Operating costs/Sales, Receivables/Sales, Inventories/Sales, and Fixed assets/Sales. Answer questions (1) and (2) below, under the new assumptions.This is called the "Target" scenario. 1. How much new capital will the firm need for Target Scenario? 2. Calculate the firm’s free cash flow, return on invested capital, EPS, DPS, ROE, and any other ratios you think would be useful in considering the situation. (Just finish the excel file from row 144 to 160 for target case. ) h. Might a strategic plan that included an incentive compensation program affect the firm’s ability to move to or at least toward industry average operating performance? I. Work the excel sheet when we consider the financing feedback effect (just finish the rest of the excel).

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