Financial Planning and Forecasting

LEARNING OBJECTIVES

After reading this chapter, students should be able to:

 Briefly explain the following terms: mission statement, corporate

scope, corporate purpose, corporate objectives, and corporate
strategies.

 Briefly explain what operating plans are.

 Identify the six steps in the financial planning process.

 List the advantages of computerized financial planning models over

“pencil-and-paper” calculations.

 Discuss the importance of sales forecasts in the financial planning

process, and why managers construct pro forma financial statements.

 Briefly explain the steps involved in the percent of sales method.

 Calculate additional funds needed (AFN), using both the projected

financial statement approach and the formula method.

 Identify other techniques for forecasting financial statements discussed

in the text and explain when they should be used.

Learning Objectives: 17 - 1
 LECTURE SUGGESTIONS

In Chapter 3, we looked at where the firm has been and where it is now--its
current strengths and weaknesses. Now, in Chapter 17, we look at where it is
projected to go in the future. The details of what we cover, and the way we
cover it, can be seen by scanning Blueprints, Chapter 17. For other
suggestions about the lecture, please see the “Lecture Suggestions” in Chapter
2, where we describe how we conduct our classes.

DAYS ON CHAPTER: 3 OF 58 DAYS (50-minute periods)

Lecture Suggestions: 17 - 2
 ANSWERS TO END-OF-CHAPTER QUESTIONS

17-1 Accounts payable, accrued wages, and accrued taxes increase

spontaneously and proportionately with sales. Retained earnings
increase, but not proportionately.

17-2 The equation gives good forecasts of financial requirements if the

ratios A*/S0 and L*/S0, as well as M and RR, are stable. Otherwise,
another forecasting technique should be used.

17-3 False. At low growth rates, internal financing will take care of the
firm’s needs.

17-4 False. The use of computerized planning models is increasing.

17-5 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. +.

Answers and Solutions: 17 - 3

 SOLUTIONS TO END-OF-CHAPTER PROBLEMS

17-1 AFN = (A*/S0)S - (L*/S0)S - MS1(RR)

 $3,000,000   $500,000 
=   $1,000,000 -   $1,000,000
 $5,000,000   $5,000,000 
- 0.05($6,000,000)(0.3)
= (0.6)($1,000,000) - (0.1)($1,000,000) - ($300,000)(0.3)
= $600,000 - $100,000 - $90,000
= $410,000.

$4,000,000
17-2 AFN =   $1,000,000 - (0.1)($1,000,000) - ($300,000)(0.3)
$5,000,000
= (0.8)($1,000,000) - $100,000 - $90,000
= $800,000 - $190,000
= $610,000.

The capital intensity ratio is measured as A*/S 0. This firm’s capital

intensity ratio is higher than that of the firm in Problem 17-1;
therefore, this firm is more capital intensive--it would require a large
increase in total assets to support the increase in sales.

17-3 AFN = (0.6)($1,000,000) - (0.1)($1,000,000) - 0.05($6,000,000)(1)

= $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.

17-4 Sales = $300,000,000; gSales = 12%; Inv. = $25 + 0.125(Sales).

S1 = $300,000,000  1.12 = $336,000,000.

Inv. = $25 + 0.125($336)

= $67 million.

Sales/Inv. = $336,000,000/$67,000,000  5.0149 = 5.01.

17-5 Sales = $5,000,000,000; FA = $1,700,000,000; FA are operated at 90%

capacity.

a. Full capacity sales = $5,000,000,000/0.90 = $5,555,555,556.

Answers and Solutions: 17 - 4

b. Target FA/S ratio = $1,700,000,000/$5,555,555,556 = 30.6%.

Answers and Solutions: 17 - 5

 c. Sales increase 12%; FA = ?

S1 = $5,000,000,000  1.12 = $5,600,000,000.

No increase in FA up to $5,555,555,556.

FA = 0.306  ($5,600,000,000 - $5,555,555,556)

= 0.306  ($44,444,444)
= $13,600,000.

17-6 a. 2002 Forecast Basis 2003

Sales $700  1.25 $875.00
Oper. costs 500  0.70 Sales 612.50
EBIT $200 $262.50
Interest 40 40.00
EBT $160 $222.50
Taxes (40%) 64 89.00
Net income $ 96 $133.50

Dividends (33.33%) $ 32 $ 44.50

Addit. to R/E $ 64 $ 89.00

b. Dividends = ($44.50 - $32.00)/$32.00 = 39.06%.

17-7 Actual Forecast Basis Pro Forma

Sales $3,000  1.10 $3,300
Oper.costs excluding
depreciation 2,450  0.80 Sales 2,640
EBITDA $ 550 $ 660
Depreciation 250  0.0833 Sales 275
EBIT $ 300 $ 385
Interest 125 125
EBT $ 175 $ 260
Taxes (40%) 70 104
Net income $ 105 $ 156

Total liabilities Accounts payable  Long-term debt

17-8 a. = .
and equity  Common stock  Retained earnings

$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,

Answers and Solutions: 17 - 6

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

b. Assets/Sales (A*/S0) = $1,200,000/$2,500,000 = 48%.

L*/Sales (L*/S0) = $375,000/$2,500,000 = 15%.
2003 Sales = (1.25)($2,500,000) = $3,125,000.

S = $3,125,000 - $2,500,000 = $625,000.

AFN = (A*/S0)(S) - (L*/S0)(S) - MS1(RR) - 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 percent of sales method:

Forecast
Basis  Additions (New 2003
2002 2003 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 = New long-term debt = $

18,750

*Given in problem that firm will sell new common stock = $75,000.

**PM = 6%; RR = 60%; NI 2003 = $2,500,000  1.25  0.06 = $187,500.

Addition to RE = NI  RR = $187,500  0.6 = $112,500.

17-9 S2002 = $2,000,000; A2002 = $1,500,000; CL2002 = $500,000;

NP2002 = $200,000; A/P2002 = $200,000; Accrued liabilities2002 = $100,000;
A*/S0 = 0.75; PM = 5%; RR = 40%; S?
AFN = (A*/S0)S - (L*/S0)S - MS1(RR)
 $300,000 
= (0.75)S -   S -(0.05)(S1)(0.4)
 $2,000,000 
= (0.75)S - (0.15)S - (0.02)S1
= (0.6)S - (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

Answers and Solutions: 17 - 7

 $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.

Answers and Solutions: 17 - 8

17-10 Sales = $320,000,000; gSales = 12%; Rec. = $9.25 + 0.07(Sales).

S1 = $320,000,000  1.12 = $358,400,000.

Rec. = $9.25 + 0.07($358.4)

= $34.338 million.

DSO = Rec./(Sales/365)
= $34,338,000/($358,400,000/365)
= 34.97 days  35 days.

17-11 Sales = $110,000,000; gSales = 5%; Inv. = $9 + 0.0875(Sales).

S1 = $110,000,000  1.05 = $115,500,000.

Inv. = $9 + 0.0875($115.5)
= $19.10625 million.

Sales/Inv. = $115,500,000/$19,106,250
= 6.0451.

17-12 a. Sales = $2,000,000,000; FA = $600,000,000; FA are operated at 80

capacity.

Full capacity
= Actual sales/(% of capacity at which FA are operated)
sales
= $2,000,000,000/0.80
= $2,500,000,000.

b. Target FA/Sales ratio = $600,000,000/$2,500,000,000

= 0.24 = 24.0%.

c. Sales increase 30%; FA = ?

S1 = $2,000,000,000  1.30 = $2,600,000,000.
No increase in FA up to $2,500,000,000.

FA = 0.24  ($2,600,000,000  $2,500,000,000)

= 0.24  $100,000,000
= $24,000,000.

17-13 a. Forecast
2002 Basis 2003
Sales $1,528  1.20 $1,833.60
Operating costs 933  0.60 Sales 1,100.16
EBIT $ 595 $ 733.44
Interest 95 95.00
EBT $ 500 $ 638.44
Taxes (40%) 200 255.38
Net income $ 300 $ 383.06

Answers and Solutions: 17 - 9

 Dividends (25%) $ 75 $ 95.77
Addition to retained earnings $ 225 $ 287.29
b. From the first question we know that the new dividend amount is
$95.77.
Dividends = ($95.77  $75.00)/$75.00 = 0.2769 = 27.69%.

17-14 a. AFN = (A*/S0)(S) - (L*/S0)(S) - MS1(RR)

$12 .5 $17.5 10.5

=
($70)- ($70)- ($420)(0.6) = $13.44 million.

$350 $350 $350

b. Tozer Computers
Pro Forma Balance Sheet
December 31, 2003
(Millions of Dollars)
2003
Forecast Pro
Forma
Basis  2003 after
2002 2003 Sales Additions Pro Forma Financing
Financing
Cash $ 3.5 0.01 $ 4.20 $
4.20
Receivables 26.0 0.0743 31.20
31.20
Inventories 58.0 0.1657 69.60
69.60
Total current
assets $ 87.5 $105.00
$105.00
Net fixed assets 35.0 0.1000 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
Accrued liab. 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.

Answers and Solutions: 17 - 10

 and equity $122.5 $133.56
$147.00

AFN = $ 13.44
*PM = $10.5/$350 = 3%.
($10.5  $4.2)
RR = = 60%.
$10.5
NI = $350  1.2  0.03 = $12.6.
Addition to RE = NI  RR
= $12.6  0.6 = $7.56.

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

The current ratio is poor compared to 2.5 in 2002 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 2002 and a 30 percent industry average.

Rate of return (Profit margin)(Sales)

=
on equity Stock + Retained earnings

Net income $12.60

= = = 14.2%.
Equity $88.56
The rate of return on equity is good compared to 13 percent in 2002
and a 12 percent industry average.

Financial $122.5 $17.5

d. 1.
requirements = $350 ($70) - $350 ($70)
= - (0.03)(0.6)($364 + $378 + $392 + $406 + $420)
= $24.5 - $3.5 - $35.28
= -$14.28 million surplus funds.

2. Tozer Computers
Pro Forma Balance Sheet
December 31, 2007
(Millions of Dollars)

2007
Forecast Pro
Forma
Basis  2007 after
2002 2007 Sales Additions Pro Forma Financing
Financing
Total curr. assets $ 87.50 0.25 $105.00 $105.00
Net fixed assets 35.00 0.10 42.00 42.00
Total assets $122.50 $147.00 $147.00

Accounts payable $ 9.00 0.0257 $ 10.80 $ 10.80

Notes payable 18.00 18.00 -14.28 3.72
Accrued liab. 8.50 0.0243 10.20 10.20
Total current

Answers and Solutions: 17 - 11

 liabilities $ 35.50 $ 39.00 $ 24.72
Mortgage loan 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  RR = $58.8  0.6 = $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. Tozer 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.

Answers and Solutions: 17 - 12

 Full Current sales $36,000
17-15 a. capacity = % of capacity at which = 0.75 = $48,000.
sales FA were operated

New sales - Old sales $48,000 - $36,000

% increase = = = 0.33 = 33%.
Old sales $36,000

Therefore, sales could expand by 33 percent before the firm would

need to add fixed assets.
b. Krogh Lumber
Pro Forma Income Statement
December 31, 2003
(Thousands of Dollars)

Forecast 2003
2002 Basis Pro Forma
Sales $36,000 1.25 $45,000
Operating costs 30,783 0.8551 38,479
EBIT $ 5,217 $ 6,521
Interest 1,017 1,017
EBT $ 4,200 $ 5,504
Taxes (40%) 1,680 2,202
Net income $ 2,520 $ 3,302
Dividends (60%) $ 1,512 $ 1,981
Addition to RE $ 1,008 $ 1,321

Krogh Lumber
Pro Forma Balance Sheet
December 31, 2003
(Thousands of Dollars)
Forecast 2003 2003
Basis  1st 2nd
2002 2003 Sales Additions Pass AFN Pass

Cash $ 1,800 0.05 $ 2,250 $

2,250
Receivables 10,800 0.30 13,500
13,500
Inventories 12,600 0.35 15,750
15,750
Total current
assets $25,200 $31,500
$31,500
Net fixed assets 21,600 21,600*
21,600
Total assets $46,800 $53,100
$53,100
Accounts payable $ 7,200 0.20 $ 9,000 $
9,000
Notes payable 3,472 3,472 +2,549
6,021
Accrued liab. 2,520 0.07 3,150
3,150

Answers and Solutions: 17 - 13

 Total current
liabilities $13,192 $15,622
$18,171
Mortgage bonds 5,000 5,000
5,000
Common stock 2,000 2,000
2,000
Retained earnings 26,608 1,321** 27,929
27,929
Total liabilities
and equity $46,800 $50,551
$53,100
AFN = $ 2,549
*From Part a we know that sales can increase by 33% before additions
to fixed assets are needed.

**See income statement.

c. The rate of return projected for 2003 under the conditions in Part b
is (calculations in thousands):

$3,302
ROE = = 11.03%.
$29,929

If the firm attained the industry average DSO and inventory turnover
ratio, this would mean a reduction in financial requirements of:

A/R
Receivables: = 90
$45,000/365
New A/R = $11,096.

 in A/R = $13,500 - $11,096 = $2,404.

$45,000
Inventory: = 3.33; Inv. = $13,500.
Inv.

 in Inv. = $15,750 - $13,500 = $2,250.

Total  in assets = $2,404 + $2,250 = $4,654.

If this freed-up capital was used to reduce equity, then common

equity would be $29,929 - $4,654 = $25,275. Assuming no change in
net income, the new ROE would be:

$3,302
ROE = = 13.06%.
$25,275

One would, in a real analysis, want to consider both the feasibility

of maintaining sales if receivables and inventories were reduced and
also other possible effects on the profit margin. Also, note that
the current ratio was $25,200/$13,192 = 1.91 in 2002. It is
projected to decline in Part b to $31,500/$18,171 = 1.73, and the
latest change would cause a further reduction to ($31,500 - $4,654)/

Answers and Solutions: 17 - 14

$18,171 = 1.48. Creditors might not tolerate such a reduction in
liquidity and might insist that at least some of the freed-up capital
be used to reduce notes payable. Still, this would reduce interest
charges, which would increase the profit margin, which would in turn
increase the ROE. Management should always consider the possibility
of changing ratios as part of financial projections.

Answers and Solutions: 17 - 15

17-16 a. Morrissey Technologies Inc.
Pro Forma Income Statement
December 31, 2003

Forecast 2003
2002 Basis Pro Forma
Sales $3,600,000 1.10 $3,960,000
Operating Costs 3,279,720 0.9110 3,607,692
EBIT $ 320,280 $ 352,308
Interest 20,280 20,280
EBT $ 300,000 $ 332,028
Taxes (40%) 120,000 132,811
Net income $ 180,000 $ 199,217

Dividends: $1.08  100,000 = $ 108,000 $ 112,000*

Addition to RE: $ 72,000 $ 87,217
*2003 Dividends = $1.12  100,000 = $112,000.

Morrissey Technologies Inc.

Pro Forma Balance Statement
December 31, 2003

Forecast
Basis  2003
2002 2003 Sales Additions Pro Forma
Cash $ 180,000 0.05 $ 198,000
Receivables 360,000 0.10 396,000
Inventories 720,000 0.20 792,000
Total current
assets $1,260,000 $1,386,000
Fixed assets 1,440,000 0.40 1,584,000
Total assets $2,700,000 $2,970,000

Accounts payable $ 360,000 0.10 $ 396,000

Notes payable 156,000 156,000
Accrued liab. 180,000 0.05 198,000
Total current
liabilities $ 696,000 $ 750,000
Common stock 1,800,000 1,800,000
Retained earnings 204,000 87,217* 291,217
Total liab.
and equity $2,700,000 $2,841,217

AFN = $ 128,783
*See income statement.

Answers and Solutions: 17 - 16

 b. AFN = $2,700,000/$3,600,000(Sales)
- ($360,000 + $180,000)/$3,600,000(Sales)
- (0.05)($3,600,000 + Sales)0.4
$0 = 0.75(Sales) - 0.15(Sales) - 0.02(Sales) - $72,000
$0 = 0.58(Sales) - $72,000
$72,000 = 0.58(Sales)
Sales = $124,138.

Sales $124,138
Growth rate in sales = = = 3.45%.
$3,600,000 $3,600,000
17-17 a. & b. Lewis Company
Pro Forma Income Statement
December 31, 2003
(Thousands of Dollars)

2002 Forecast Basis 2003 Pro Forma

Sales $8,000 1.2 $9,600
Operating costs 7,450 0.9313 8,940
EBIT $ 550 $ 660
Interest 150 150
EBT $ 400 $ 510
Taxes (40%) 160 204
Net income $ 240 $ 306

Dividends: $1.04  150 = $ 156 $1.10  150 = $ 165

Addition to R.E.: $ 84 $ 141

Answers and Solutions: 17 - 17

 Lewis Company
Pro Forma Balance Sheet
December 31, 2003
(Thousands of Dollars)

Forecast 1st 2nd

Basis  Pass AFN Pass
2002 2003 Sales Additions 2003 Effects 2003

Cash $ 80 0.010 $ 96 $ 96
Receivables 240 0.030 288 288
Inventories 720 0.090 864 864
Total current
assets $1,040 $1,248 $1,248
Fixed assets 3,200 0.400 3,840 3,840
Total assets $4,240 $5,088 $5,088

Accounts payable 160 0.020 $ 192 $ 192

Accrued liab. 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 1,080
Total liabilities
and equity $4,240 $4,421 $5,088

AFN = $ 667
*See income statement.
**CA/CL = 2.3; D/A = 40%.
Maximum total debt = 0.4  $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.

Answers and Solutions: 17 - 18

 SPREADSHEET PROBLEM

17-18 The detailed solution for the spreadsheet problem is available both on
the instructor’s resource CD-ROM and on the instructor’s side of South-
Western’s web site, http://brigham.swlearning.com.

Spreadsheet Problem: 17 - 19
 INTEGRATED CASE

New World Chemicals Inc.

Financial Forecasting

17-19 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 2003. 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.

TABLE IC17-1. FINANCIAL STATEMENTS AND OTHER DATA ON NWC

(MILLIONS OF DOLLARS)

A. 2002 BALANCE SHEET

CASH & SECURITIES $ 20 ACCT PAYABLE & ACCRUED LIAB. $ 100
ACCOUNTS RECEIVABLE 240 NOTES PAYABLE 100
INVENTORIES 240 TOTAL CURRENT LIABILITIES $ 200
TOTAL CURRENT ASSETS $ 500 LONG-TERM DEBT 100
COMMON STOCK 500
NET FIXED ASSETS 500 RETAINED EARNINGS 200
TOTAL ASSETS $1,000 TOTAL LIABILITIES AND EQUITY $1,000

B. 2002 INCOME STATEMENT

SALES $2,000.00
LESS: VARIABLE COSTS 1,200.00
FIXED COSTS 700.00
EARNINGS BEFORE INTEREST AND TAXES (EBIT) $ 100.00
INTEREST 16.00
EARNINGS BEFORE TAXES (EBT) $ 84.00
TAXES (40%) 33.60
NET INCOME $ 50.40

DIVIDENDS (30%) $ 15.12

ADDITION TO RETAINED EARNINGS $ 35.28

Integrated Case: 17 - 20
C. KEY RATIOS
NWC INDUSTRY COMMENT
BASIC EARNING POWER 10.00% 20.00%
PROFIT MARGIN 2.52 4.00
RETURN ON EQUITY 7.20 15.60
DAYS SALES OUTSTANDING (365 DAYS) 43.80 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%

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.

A. ASSUME (1) THAT NWC WAS OPERATING AT FULL CAPACITY IN 2002 WITH
RESPECT TO ALL ASSETS, (2) THAT ALL ASSETS MUST GROW PROPORTIONALLY
WITH SALES, (3) THAT ACCOUNTS PAYABLE AND ACCRUED LIABILITIES WILL
ALSO GROW IN PROPORTION TO SALES, AND (4) THAT THE 2002 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: [SHOW S17-1 THROUGH S17-6 HERE.] NWC WILL NEED $180.9 MILLION. HERE
IS THE AFN EQUATION:

AFN = (A*/S0)S - (L*/S0)S - M(S1)(RR)

= (A*/S0)(g)(S0) - (L*/S0)(g)(S0) - M(S0)(1 + g)(RR)
= ($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 2003 FINANCIAL REQUIREMENTS USING THE PROJECTED

FINANCIAL STATEMENT APPROACH. DISREGARD THE ASSUMPTIONS 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 PROPORTION
TO SALES; (2) THAT NWC WAS OPERATING AT FULL CAPACITY; (3) THAT THE
PAYOUT RATIO IS HELD CONSTANT AT 30 PERCENT; AND (4) THAT EXTERNAL

Integrated Case: 17 - 21
 FUNDS NEEDED ARE FINANCED 50 PERCENT BY NOTES PAYABLE AND 50 PERCENT
BY LONG-TERM DEBT. (NO NEW COMMON STOCK WILL BE ISSUED.)

ANSWER: [SHOW S17-7 THROUGH S17-14 HERE.] 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.

PREDICTED g: 25.00% 2002 2003

ACTUAL g: 25.00% ACTUAL PRO FORMA

INCOME STATEMENT:
SALES $2,000.00 $2,500.00
LESS: VC(% SALES) 60.00% (1,200.00) (1,500.00)
FC(% SALES) 35.00% (700.00) (875.00)
EBIT $ 100.00 $ 125.00
INTEREST (8%) (16.00) (16.00)
EBT $ 84.00 $ 109.00
TAXES 40.0% (33.60) (43.60)
NET INCOME $ 50.40 $ 65.40

DIVIDENDS 30.0% $ 15.12 $ 19.62

ADD’N TO R.E. $ 35.28 $ 45.78

BALANCE SHEET:
2002 2003 2003
ACTUAL 1ST PASS AFN 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 ACCRUED LIAB. $ 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 200.00 245.78 245.78
TOTAL LIAB & EQUITY $1,000.00 $1,070.78 $1,250.00

AFN $ 179.22

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

Integrated Case: 17 - 22
 AFN EQUATION FORECAST:

AFN = (A*/S0)  g  S0 - (L*/S0)  g  S0 - M  S1  RR

= $250 - $25 - $44.1
= $180.9 VERSUS BALANCE SHEET FORECAST OF $179.22.

C. WHY DO THE TWO METHODS PRODUCE SOMEWHAT DIFFERENT AFN FORECASTS?

WHICH METHOD PROVIDES THE MORE ACCURATE FORECAST?

ANSWER: [SHOW S17-15 HERE.] 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.

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?

Integrated Case: 17 - 23
ANSWER: [SHOW S17-16 HERE.] KEY RATIOS:

NWC INDUSTRY
2002 2003(E) 2002
BASIC EARNING POWER 10.00% 10.00% 20.00%
PROFIT MARGIN 2.52 2.62 4.00
ROE 7.20 8.77 15.60
DAYS SALES OUTSTANDING (365 DAYS) 43.80 DAYS 43.80 DAYS 32.00 DAYS
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 7.81 9.40
CURRENT RATIO 2.50 1.99 3.00
PAYOUT RATIO 30.00% 30.00% 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.

E. CALCULATE NWC’S FREE CASH FLOW FOR 2003.

ANSWER: [SHOW S17-17 AND S17-18 HERE.]

OPERATING CAPITAL2002 = NOWC + NFA

= ($500 - $100) + $500
= $900.

OPERATING CAPITAL2003 = NOWC + NFA

= ($625 - $125) + $625
= $1,125.

NET INVESTMENT IN OPERATING CAPITAL = $1,125 - $900 = $225.

Integrated Case: 17 - 24
 FCF = NOPAT - NET INVESTMENT IN OPERATING CAPITAL
= EBIT(1 - T) - NET INVESTMENT IN OPERATING CAPITAL
= $125(0.6) - $225
= $75 - $225
= -$150.

F. SUPPOSE YOU NOW LEARN THAT NWC’S 2002 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 2002 WITH THE AVAILABLE
FIXED ASSETS? WHAT WOULD THE FIXED ASSETS-TO-SALES RATIO HAVE BEEN
IF NWC HAD BEEN OPERATING AT FULL CAPACITY?

ANSWER: [SHOW S17-19 HERE.]

ACTUAL SALES $2,000

= = $2,667.
FULL CAPACITY SALES = % OF CAPACITY AT WHICH 0.75
FIXED ASSETS WERE OPERATED
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:

FIXED ASSETS $500

TARGET FA/SALES RATIO = = = 18.75%.
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.

Integrated Case: 17 - 25
F. 2. HOW WOULD THE EXISTENCE OF EXCESS CAPACITY IN FIXED ASSETS AFFECT THE
ADDITIONAL FUNDS NEEDED DURING 2003?

ANSWER: [SHOW S17-20 AND S17-21 HERE.] 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. THERE-FORE, 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: [SHOW S17-22 AND S17-23 HERE.] 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:

KEY RATIOS 2003 PRO FORMA

% OF 2002 CAPACITY

2002 75% 100%

BASIC EARNING POWER 10.00% 11.11% 10.00%

PROFIT MARGIN 2.52 2.62 2.62
ROE 7.20 8.77 8.77
DAYS SALES OUTSTANDING 43.80 DAYS 43.80 DAYS 43.80 DAYS
INVENTORY TURNOVER 8.33 8.33 8.33
FIXED ASSETS TURNOVER 4.00 5.00 4.00
TOTAL ASSETS TURNOVER 2.00 2.22 2.00
DEBT/ASSETS 30.00% 33.71% 40.34%
TIMES INTEREST EARNED 6.25 7.81 7.81
CURRENT RATIO 2.50 2.48 1.99
PAYOUT RATIO 30.00% 30.00% 30.00%

Integrated Case: 17 - 26
 (NOTE THAT FINANCING FEEDBACKS HAVE NOT BEEN CONSIDERED IN THE RATIOS
ABOVE.)

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 INVENTORIES 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?

ANSWER: [SHOW S17-24 HERE.] THE DSO AND INVENTORY TURNOVER RATIO INDICATE
THAT NWC HAS EXCESSIVE INVENTORIES AND RECEIVABLES. THE EFFECT OF
IMPROVE-MENTS 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 INVENTORIES, 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. 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 THAT PERMIT
IT TO PAY AFTER 60 DAYS RATHER THAN AFTER 30 DAYS. (CONSIDER EACH
ITEM SEPARATELY AND HOLD ALL OTHER THINGS CONSTANT.)

ANSWER: [SHOW S17-25 HERE.]

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

Integrated Case: 17 - 27
 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 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 THAT 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 ADDITION TO
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*/S 0. 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.

Integrated Case: 17 - 28