CH-19-20 Long-Term Financial Planning – Fundamentals of Corporate Finance : Book Guide

This Document Contains Chapters 19 to 20 Brealey 5CE Solutions to Chapter 19 1. a. False. It is a process of deciding which risks to take. b. False. Financial planning is concerned with possible surprises as well as the most likely outcomes. c. True. Financial planning considers both the investment and financing decisions. This is one (but not the only) reason that financial planning is necessary. d. False. A typical horizon for long-term planning is 5 years. e. True. Investments are usually aggregated by category. f. True. Perfect accuracy is unlikely to be obtainable, but the firm needs to produce the most accurate possible consistent forecasts. g. False. Excessive detail distracts attention from the crucial decisions. 2. a. Most models are accounting-based and don’t recognize firm value maximization as the objective of the firm. b. Often the relationships among variables specified by the model are somewhat arbitrary, and the decisions they imply are not considered explicitly once the model has been constructed. For example, firms have considerably more flexibility in their decisions than would be reflected in a percentage of sales model. c. Models are expensive to build and maintain. d. Models are often so complicated that it is difficult to use them or to make changes to them efficiently. 3. The ability to meet or beat the targets embodied in a financial plan is obviously a reassuring indicator of management talent and motivation. Moreover, the financial plan focuses attention on the specific targets that top management deems most important. There are, however, several dangers. • Financial plans are usually accounting-based, and thus are subject to the biases inherent in book profitability measures. See Chapter 4 for issues about book profitability measures. 19-1 This Document Contains Chapters 19 to 20 • Managers may sacrifice the firm’s best long-term interests in order to meet the plan’s short- or medium-run targets. • Manager A may make all the right decisions, but fail to meet the plan because of events beyond his control. Manager B may make the wrong decisions, but be rescued by good luck. In other words, it may be difficult to separate performance and ability from results. 4. Sustainable growth rate = Plowback ratio × ROE Internal growth rate = Plowback ratio × ROE × Equity Assets ROE definition used in these formulas: ROE = INet Income nitial Equity Plowback ratio = Addition to retained earnings/Net income Addition to retained earnings = Net income - Dividends To get a formula for Plowback ratio divide this equation for addition to retained earnings by Net Income: Plowback ratio = Addition to retained earnings Net Income = Net Income Net Income - Dividends Net Income = 1 - Dividends Net Income And: Dividends Net Income = Payout ratio So: Plowback ratio = 1 – payout ratio To calculate ROE need to breakdown ROE. In Chapter 4 Measuring Financial Performance we showed how to use the DuPont System to breakdown ROE. In that formula the operating profit margin (=NOPAT/Sales) was used. Here we have the firm’s net income/sales ratio so we to work out a different decomposition of ROE: ROE= INet Income nitial Equity = Initial Assets Initial Equity × Sales Initial Assets × Net Income Sales = asset-equity ratio × asset turnover × profit margin Initial Equity/Initial Assets = .60 so Initial Assets/Initial Equity = 1/.60 Asset turnover = Sales/Initial assets = 1.40 Profit margin = net income/sales = .05 So: ROE = 1 .60 × 1.4 × .05 = .1167 = 11.67% Plowback ratio = 1 – payout ratio = 1 -.25 = .75 Sustainable growth rate = Plowback ratio × ROE = .75 × .1167 = .0875 = 8.75% Internal growth rate = Plowback ratio × ROE × Equity Assets = .75 × .1167 × .60 = 0.0525 = 5.25% 19-2 5. Percentage of sales models assume that most variables vary in direct proportion to sales. In practice, however, the firm can increase sales without increasing long-term assets, by running plants at higher percentages of capacity, or by paying employees overtime. In this case, assets would rise less than proportionally to sales, but wages would rise more than proportionally (since overtime wage rates are higher than normal rates). Net working capital may rise less than proportionally to sales since firms can exploit economies of scale in net working capital management as sales increase. In general, percentage of sales models are better for long-term planning. Short-term plans must deal with specific and detailed cash needs over short horizons. They cannot ignore variations in the relationships among the balance sheet items. Long-term plans can abstract from these details and deal with the bigger picture using more general rules of thumb that tie the levels of these variables together. 6. If the firm reduces prices, sales revenue will increase less than proportionally to output, while costs and assets will increase roughly in proportion to output. Costs and assets will increase as a proportion of sales. 7. Possible balancing items are dividends, borrowing, or equity issues. Firms tend to prefer to keep dividends steady (see Chapter 18), so in practice, this is not the best choice for balancing item. Similarly, equity issues are typically infrequent and for large amounts (see Chapter 16), so this too is not a good choice. In practice, then, borrowing is the most frequent balancing item. Usually, the borrowing source used as a balancing item is a bank loan. 8. Neither the growth rate of earnings nor the growth rate of sales translates generally into value maximizing policies for the firm; in this sense a focus on these variables is not an appropriate corporate goal. Nevertheless, targets for these growth rates might be convenient ways to signal the belief that, in a particular situation, increasing a variable like sales could be value enhancing. Moreover, focusing on a particular variable like sales growth might provide a guideline as to what aspect of corporate performance requires the most attention. These growth rates might be viewed as easily communicated proxies for factors that are more fundamental concerns of management. 9. In 2013, assets will increase by 20% of $3000( =.2 x 3000 = $600). New total assets will be $3,600(= 1.2×3000). Therefore debt and equity each must increase by 20%. Equity will increase by .2 × $2,000 or $400 to become $2400. Debt will also increase by 20% to $1200 (=1.2×2000). Net income will increase to $600 (= 1.2 × 500). The balancing item is dividends. If net income next year is $600 and equity rises by $400, dividends must be $200. This is the case because Addition to retained earnings (change in equity) = Net 19-3 income – Dividends. So Dividends = Net income - addition to retained earnings= 600 – 400 = 200. 10. 2013 Total required external financing is calculated by forecasting the growth (increase) in assets and then subtracting the forecasted retained earnings: 2013 Growth in assets = assumed growth rate × 2012 assets 2013 Net income = 2012 Net income × (1 + growth rate) = 500 × (1 + growth rate) 2013 Retained earnings = 2013 Net income × (1 - 2013 dividend payout ratio) = 2013 Net income × .5 Forecasted 2013 Retained Earnings for different growth rates: Growth Rate 15% 20% 25% Net Income $575.00 $600.00 $625.00 Retained Earnings 287.5 300,00 312.50 Forecasted 2013 Required External Financing for different growth rates: Growth Rate 15% 20% 25% Growth in assets $450.00 $600.00 $750.00 less: Retained earnings (287.50) (300.00) (312.50) Required external financing $162.50 $300.00 $437.50 11. a. (i) No external debt or equity: calculate internal growth rate Internal growth rate = Plowback ratio × ROE × Equity Assets Plowback ratio = 1 – payout ratio = 1 - .5 = .5 Internal growth rate = .5 × 500 1667 × 2000 3000 = .09998 = 10% Notice that ROE = net income in 2012 divided by shareholders’ equity at year-end 2011, which is also shareholders' equity at the beginning of 2012. We assume that ROE will also be true in 2013. (ii) Maintains its 2012 debt-to-equity ratio but issues no equity: calculate sustainable growth rate: Sustainable growth rate = Plowback ratio × ROE = .5 × 500 1667 = .15 = 15% b. Internal Growth rate= 10% With 10% growth, forecasted increase in assets for 2013 is 0.1 × 3000 = 300. Growing internally, no new debt and no new equity is raised. The $300 in new assets must be financed by additional retained earnings. Can it? Forecasted 2013 net income = ROE × 2013 starting Equity = .3 × 2000 = $600 2013 Dividends = 2013 dividend payout × 2013 Net Income = .5 × 600 = 300 Addition to retained earnings = Net Income – dividends = 600 – 300 = 300. 19-4 Yes, sufficient earnings are generated and retained to finance the growth. Sustainable Growth Rate = 15% With 15% growth, forecasted increase in assets is 0.15 × 3000 = 450. The 2012 debt- to-equity ratio is 1000/2000 which is equivalent to debt/asset ratio of 1000/3000 = 1/3. To maintain the leverage the new debt raised must equal 1/3 of the addition to assets. So new debt raised must be 1/3 × 450 = $150. The remaining $450 - $150 = $300 of new assets must be financed by additional retained earnings. Can it? Forecasted 2013 net income = ROE x initial equity = .3 × 2013 initial equity = .3 × 2000 = $600 2013 Dividends = 2013 dividend payout × 2013 net income (NI) = .5 × 600 = 300 Addition to retained earnings = 2013 NI – 2013 dividends = 600 – 300 = 300. Yes, sufficient earnings are retained to finance the growth. 12. a. With all costs proportional to sales, net income in 2013 will increase by 15% from its current value of $500 to a new value of $500 × 1.15 = $575. Seventy percent of earnings are paid out as dividends. So 1-70% = 30% of earnings are retained in the firm. 2013 Assets increase: .15 × $3,000 = $450 − 2013 Retained earnings: 575 (1 – .70) = 172.5 2013 External financing $277.5 b. Since dividend policy is fixed and no equity will be issued, debt must be the balancing item. Debt issued must be $277.5. c. If debt issued in 2013 is limited to $100, and equity issues are ruled out, then the firm must finance its remaining asset requirements out of addition to retained earnings. Addition to retained earnings must be: Increase in assets – debt issued = .15 × $3,000 – $100 = $350 So if the 2013 addition to retained earnings is $350 and 2013 Net income is $350 then 2013 dividends must be: 2013 Dividends = 2013 Net income – 2013 addition to retained earnings = $575 – $350 = $225 The dividend payout ratio = dividends/net income = 225/575 = .3913, or 39.13%. 13. Internal growth rate= Plowback ratio × ROE × Equity Assets = (1 – .70) × 500 1800 × 2 3 = .05556 = 5.556% Sustainable growth rate = Plowback ratio × ROE = (1 – .70) × 500 1800 = .08333 = 8.333% 19-5 Internal Growth rate= 5.556% With 5.556% growth, forecasted increase in assets for 2013 is 0.05556 × 3000 = $166.68. Growing internally, no new debt is raised. The $166.68 in new assets must be financed by additional retained earnings. Can it? Forecasted 2013 net income = ROE × 2013 starting Equity = 500 1800 × 2000 = $555.6 2013 Dividends = 2013 dividend payout × 2013 NI = .7 × 555.6 = 388.92 Addition to retained earnings = NI – dividends = $555.6 – 388.92 = 166.68 Yes, sufficient earnings are retained to finance the growth. NOTE: if calculate with calculator and use all decimal places for all numbers, including the growth rate, you will get the exact answer that the addition to retained earnings equals the forecasted increase in assets. Sustainable Growth Rate = 8.333% With 8.333 % growth, forecasted increase in assets is 0.08333 × 3000 = 249.99. Since the equity-asset ratio is fixed at 2/3, the target debt/asset ratio is 1/3. Thus new debt of 1/3 × 249.99, or $83.33 will be raised. The remaining financing required, investment in assets – new debt raised = $249.99 - $83.33 = $166.66 , must be financed by additional retained earnings. Can it? Forecasted 2013 net income = ROE × 2013 starting Equity = 500 1800 × 2000 = $555.56 2013 Dividends = 2013 dividend payout × 2013 NI = .7 × 555.6 = 388.892 Addition to retained earnings = NI – dividends = $555.56 – 388.892= 166.68 Yes, sufficient earnings are retained to finance the growth. Both the addition to retained earnings and the required financing net of debt round to $166.7 NOTE: if calculate with calculator and use all decimal places for all numbers, including the growth rate, you will get the exact answer that the addition to retained earnings equals the forecasted increase in assets. 14. With the new dividend payout ratio, the 2013 dividends are 1/3 × $108,000 = $36,000 and addition to retained earnings is $72,000 ($108,000 - $36,000), which is $36,000 more than the original forecast. 2013 Shareholders’ equity would be $36,000 more, increasing to $672,000. Therefore, the requirement for external financing (additional debt) falls by $36,000, from $64,000 to $28,000. The asset side of the 2013 pro forma balance sheet is unchanged and the liabilities and equity side becomes (in thousands): Long-term debt $ 428 Shareholders’ equity 672 Total $1,100 19-6 15. a. The following first-stage pro forma statements show that higher revenue growth results in higher required external financing: The Base Case is the financial statements for 2012, from Table 19.4 Base case ($000s) Growth Rates for 2013 ($000s) Income Statement 2012 20% Growth 2% Growth Revenue $2,000 $2,400 $2,040 Cost of goods sold 1,800 2,160 1,836 EBIT 200 240 204 Interest expense 40 40 40 Earnings before taxes 160 200 164 Corporate tax 64 80 66 Net Income $96 $120 98 Dividends 64 80 66 Addition to Retained Earnings $32 $40 $33 Balance Sheet Assets Net operating working capital $200 240 $204 Property, plant & equipment 800 960 816 Total Assets $1,000 $1,200 $1,020 Liabilities & shareholders' equity Long-term debt 400 400 400 Shareholders' equitya 600 640 633 Total liabilities & shareholders’ equity $1,000 $1,040 $1,033 Required external financingb 160 (13) The high 20% growth rate generates $40 addition to retained earnings and also required investment in new assets of $200 ($1,200 – $1,000). So the required external financing is $160 ($200 - $40). The low 2% growth rate generates $33 addition to retained earnings but the required investment in new assets is much lower, only $20 ($1,020 - $1,000). So the required external financing is -$13 ($20 - $33). This will result in a reduction in the debt in the second stage pro forma statement. 19-7 b. Second Stage Pro Forma Balance Sheet Base Year 2012 2013 20% growth 2013 2% growth Assets Net operating working capital $ 200 $ 240 $ 204 Property, plant & equipment 800 960 816 Total Assets $1,000 $1,200 $1,020 Liabilities & shareholders’ equity Long-term debt c $ 400 $ 560 $ 387 Shareholders’ equity 600 640 633 Total liabilities & shareholders’ equity $1,000 $1,200 $1,020 Notes a. Shareholders’ equity increases by earnings retained in 2013 b. Required external financing = balancing item = Forecasted 2013 assets – forecasted 2013 debt and equity, before any new external financing. c. Long-term debt, the balancing item, changes by required external financing. 16. a. The investment in new long-term assets causes net long-term assets to grow by $200, which is 25% of the current value of $800. So 2013 net long-term assets are $1,000, 25% greater than 2012. Net operating working capital will be .5x1000 = 500, which is also 25% greater than 2012. 2013 total assets are $1,500. The fact that net operating capital has a fixed relationship with net long-term assets means that total assets grow at the same rate of growth as net long-term assets. Given the assumption that the ratio of revenues to total assets is to remain constant at 1.5 the 2013 revenues are forecast to be 1.5 times 2013 total assets, 1.5 x $1,500 = $2,250. So, revenues also grow by 25% (2,250/1800 -1 = .25) because of the fixed relationship between total assets and revenues. Pro-forma Income Statement, 2013 Comment Revenue $2,250 25% higher Fixed costs 56 unchanged Variable costs 1,800 80% of revenue Depreciation 100 10% of 2013 net long-term assets Interest 24 .08 × 2012 debt Taxable Income 270 Taxes 108 40% of taxable income Net Income $ 162 Difference Dividends $ 108 Payout ratio = 2/3 Addition to Retained Earnings $ 54 19-8 Balance Sheet, year-end 2013 Assets Net operating working capital $ 500 50% of net long-term assets Net long-term assets 1,000 Increases by 200 Total $1,500 Liabilities & Equity Debt $ 375 25% of total capital (debt + equity) Equity 1,125 75% of total capital Total $1,500 The required external financing is: Increase in assets – addition to retained earnings = $300 – $54 = $246 The assumption that the company maintains its 25 percent debt/capital ratio implies that the new debt level must be .25 x 1500 = 375 and the new equity level must be .75 x 1500= 1,125. So, $75 in new debt will be issued. (=375 – 300). This means that new equity financing must be raised to meet the total required external financing. New equity to be issued equals total required external financing – new debt = $246 - $75 = $171. So the 2013 equity equals 2012 equity plus addition to retained earnings plus the new share issue, $900 + $54 + $171 = $1,125. b. If debt is the balancing item, all external financing will be new debt issues. Therefore, the right-hand side of the balance sheet will now be Debt $ 546 increases by $246 Equity 954 increases by addition to retained earnings $1,500 The debt ratio increases from .25 to 546 1500 = .364. 17. a. Sustainable growth rate = Plowback ratio × ROE ROE = BeginninNet Income g of the Year Equity We assume that ROE from last year will continue this year. What was last year's ROE? What was beginning-of-the-year equity last year? We know that assets at the end of last year were $100,000 and debt was $40,000. Thus, End-of-Year Equity = End-of-Year Assets – End-of-Year Debt = 100,000 – 40,000 = 60,000 19-10 Over last year, the addition to retained earnings was $1,500 (= Net income - Dividends = $2,000 - $500). Assuming no new equity was issued during the year, then: Start-of-Year Equity = End-of-Year Equity – Addition to Retained Earnings = 60,000 – 1,500 = 58,500 Thus, last year's ROE is: ROE = BeginninNet Income g of the Year Equity = 58,500 2,000 = .03419 Last year's plowback: Plowback = Addition to retained earnings Net Income = 2,000 2,000 - 500 = .75 Assuming that in the coming year, the rate of return on beginning equity is the same as last year and the plowback is the same, the sustainable growth rate is: Sustainable growth rate = Plowback ratio × ROE = .75 × .03419 = .02564 = 2.564% b. If g = .02564, assets will grow by .02564 × $100,000 = $2,564. The forecasted net income is ROE× Equity at the beginning of the year = .03419 × 60,000 = $2,051.4. Dividends equal to 25% of net income are paid, leaving the amount available for reinvestment to be .75 × $2,051.4 = $1,538.6. So the required external financing is $2,564 - $1,538.6 = $1,025.4, which must be met by issuing new debt. So, the new debt will be $40,000 + $1,025.4 = $41,025.4. The new equity will be existing equity,$60,000, plus addition to retained earnings, $1,538.6, $61,538.6. So the debt/asset ratio is $41,025.4/($100,000 + $2,564) = .4, which is the same as the current debt/asset ratio = $40,000/$100,000. c. If no new debt or equity is sold, the maximum rate of growth is constrained by profits. If the firm retains all earnings (i.e., is willing to reduce dividends to zero), assets will grow by $2,000, which provides a growth rate of 2%. If it maintains the dividend payout ratio, then the maximum growth rate would be Internal growth rate = Plowback ratio × ROE × Equity Assets = 2,000 1,500 × 58,500 2,000 × .6 = .01538 = 1.538% To check whether this is the correct growth rate, compare the required increase in assets with the amount available for reinvestment. With 1.538% growth, the increase in assets is .01538 × 100,000 = $1,538.5. The forecasted net income is ROE × Equity at the beginning of the year = .03419 × 60,000 = $2,051.4. Dividends equal to 25% of net income are paid, leaving the amount available for reinvestment of .75 × $2,051.4 = $1,538.6. So the investment in assets equals the addition to retained earnings. (The slight difference is due to rounding). 19-11 18. a. The sustainable growth rate is the growth rate that allows a company to finance growth issuing debt and no equity but maintaining its capital structure: Sustainable growth rate = plowback ratio × ROE But this company has no debt because it is 100% equity financed. The internal growth rate is the growth rate that is funded by internally generated financing: Internal growth rate = plowback ratio × ROE × Equity Assets The firm is currently 100% equity financed: Equity Assets = 1.0 Since equity/assets = 1, the internal growth rate equals the sustainable growth rate! Given company information: Plowback ratio = 1 – dividend payout ratio = 1 – .4 = .6 Since it is 100% equity financed: Equity = Assets Asset turnover ratio = Sales/Initial assets = .8 Because equity = assets: Asset turnover ratio = Sales/Initial equity = .8 Profit margin = Net Income/Sales = .1 So: Profit margin x Asset Turnover ratio = Net Income/Sales x Sales/Initial equity = Net Income/initial equity=ROE So: ROE from the past year = Profit margin x Asset Turnover ratio = .1 x.8=.08 = 8% Internal growth rate = plowback ratio × ROE × Equity Assets Sustainable growth rate = plowback ratio × ROE Since equity/assets = 1, the internal growth rate equals the sustainable growth rate! Now calculate the internal growth rate also sustainable growth rate g = Plowback ratio × ROE = .6 × .08 = .048 = 4.8% The 5% target growth rate exceeds the sustainable and internal growth rate. The company cannot grow at 5% without seeking additional external financing. b. Calculate the required ROE to achieve a 5% target growth rate: Target growth rate, g = Plowback ratio × ROE = .6 × ROE = .05 So: ROE must rise to .05/.6 = .0833 = 8.33% Since the firm is 100% equity financed we showed that: ROE = Asset turnover × profit margin Given that ROE needs to be 8.33% and the firm’s current profit margin is 10% the asset turnover must be such that: ROE = .0833 = Asset turnover × .10 Asset turnover = .0833/.10 = .833 So, Asset turnover must increase from .8 to .833, an increase of 4.125% (=.833/.8 –1) to achieve a 5% growth rate while maintaining the 100% equity financing. 19-12 c. In (b) we showed that the required ROE to achieve the 5% growth rate was 8.33% and, since the firm is 100% equity financed: ROE = Asset turnover × profit margin. Assuming that the asset turnover is still .8 the profit margin would need to be such that: ROE = .0833 = .8 × profit margin Profit margin= .0833/.8 = .104125 = 10.4125% Profit margin must increase from 10% to 10.4125%, an increase of 4.125% (10/10.4125 -1) same as in (b). 19. a. Internal growth rate = Plowback ratio × ROE × Equity Assets =.40 × .25 × 1 = .1 = 10% b. Forecasted net income = ROE × Starting Equity= .25 × $1 million =$.25 million Addition to retained earnings = plowback × net income = .40 × $.25 million = $.1 million = $100,000 Firm is growing at 30%. Investment in new assets will be growth rate x initial assets= .30 × $1 million = $300,000. External financing = increase in assets – addition to retained earnings = $300,000 - $100,000 = $200,000. c. If payout ratio = 0 then plowback ratio = 1. The internal growth rate increases to 1 × .25 × 1 = .25 = 25%. Internal growth rate increases from 10% to 25%, an increase of 150%. d. If plowback ratio = 1, then the addition to retained earnings will be 100% of net income. Forecasted net income = ROE x starting equity= .25 × $1 million= $250,000. External financing required to finance the 30% growth of assets is now only $300,000 – $250,000 = $50,000. We conclude that reductions in the dividend payout ratio reduces requirements for external financing. 20. Sustainable growth = Plowback ratio × ROE As we showed in the solution to question 18, the ROE for a firm that is 100% equity financed is such that ROE = Profit margin × Asset turnover ROE = .1 x .6 = 0.06 Plowback ratio = 1 - Dividends/net income = 1 – 4/10 = 1-.4 = .6 Sustainable growth rate = Plowback ratio × ROE = .6 × .06 = .036 = 3.6% 19-13 21. Internal growth rate = Plowback ratio × ROE × Equity Assets Desired internal growth rate =.10 = Plowback ratio × .18 × 1.0 Plowback ratio must be at least .10/(.18 × 1.0) = .556 So the payout ratio can be at most 1 – .556 = .444, or 44.4%. 22. If Debt Equity = 1 3 , then Equity Assets = 3 1+3 = 3 4 =.75 Desired internal growth rate = Plowback ratio × ROE × Equity Assets .10 = Plowback ratio × .18 × .75 Plowback ratio = .10/(.18 × .75) = .741 = 74.1% The maximum payout ratio falls to 1 – .741 = .259, or 25.9%. 23. Internal growth rate = Plowback ratio × ROE × Equity Assets Since the firm is all-equity financed, Equity/Assets = 1 and ROE = Profit margin × Asset turnover. Therefore: g = Plowback ratio × Profit margin × Asset turnover Desired internal growth rate =.10 =.5 × Profit margin × 2.0 Profit margin = .10/(.5 × 2.0) = 10% Given the 2.0 asset turnover ratio and the 50% plowback ratio the profit margin must be at least 10% if the company wants to grow at 10% using only internally generated funds. 24. If profit margin = .06, then Internal growth rate = .08 = Plowback ratio × .06 × 2 Plowback ratio = .08/(.06 × 2 ) = 2/3 Payout ratio = 1- Plowback ratio = 1 – 2/3 = 1/3 25. If the plowback ratio remains at 50%, then the internal growth rate is = Plowback ratio × Profit margin × Asset turnover = .5 × .06 × 2 = .06 = 6% However, for maximum growth, set the plowback ratio equal to 1.0. Then the maximum internal growth rate is g = Plowback ratio × Profit margin × Asset turnover = 1 × .06 × 2 = .12 = 12% 19-14 26. 2013 Income Statement, assuming 20% sales growth Sales $240,000 Costs 180,000 EBIT 60,000 Interest expense 10,000 Taxable income 50,000 Taxes at 35% 17,500 Net income $32,500 Dividends $13,000 Addition to retained earnings $19,500 If all assets are to grow by 20%, then total assets will increase from $200,000 to $240,000. The $40,000 increase is financed in part through the addition to retained earnings of $19,500. The remaining $20,500 requires external financing. 27. If long-term assets (net plant and equipment) are operating at only 75% of capacity, then only .75 × $160,000 = $120,000 of fixed assets would be necessary to support current production levels. Thus, at full capacity, the ratio of fixed assets to sales is $120,000/$200,000 = .6. Since fixed assets are $160,000, sales can increase to $266,667 without requiring additional fixed assets. This means that sales can increase by $66,667 before additional fixed assets are needed. If sales increase by 20%, total sales will be 1.2 × $200,000, or $240,000 and below the maximum sales increase possible with available fixed assets. Thus, the firm still has more than enough long-term assets to meet production. Only net operating working capital (NOWC) will increase. Net operating working capital of the firm in 2012 was $30,000 ($40,000 of current assets minus $10,000 of accounts payable). All current assets (cash, accounts receivable and inventories) are included in net operating current asset because all current assets are projected to increase with sales. This implies that cash is an asset needed for operations. Net operating working capital as a percentage of sales is 30,000/200,000, or 15%. The increase in NOWC will be only .15× 40,000 = $6,000, which is less than the addition to retained earnings ($19,500). Thus required external financing is zero. The firm can use the surplus funds either to pay off some debt, to buy back shares or increase dividends, or to add to its cash balances. If it does add it to cash balance, then some of its cash is for operations and some cash is surplus (non-operating cash). 28. As shown in the answer to question 27, Growth Industries can increase sales to $266,667 without any additional fixed assets. The ratio of net operating working capital to sales is $30,000/$200,000 = .15. The ratio of fixed assets to sales (at full capacity) is .60. Thus for sales levels above $266,667, the 19-15 increase in assets corresponding to an increase in sales from the current level of $200,000 is: ∆NOWC + ∆Fixed assets = .15 × (∆Sales) + .60 × (∆Sales – 66,667) If we set this expression equal to addition to retained earnings, $19,500, we can obtain the maximum level to which sales can grow without requiring external financing. .15 × (∆Sales) + .60 × (∆Sales – 66,667) = 19,500 ∆Sales = (19,500 + .60 × 66,667)/(.15+.6) = $79,333.6 Final sales = Initial sales + ∆Sales = $200,000 + $79,333.6 = $279,333.6 29. If assets rise less than proportionally to sales, then the firm can enjoy greater sales growth before it needs to raise external funds. Thus the firm's internal growth rate will be higher than predicted by the formula. 30. The spreadsheet containing the solution for this problem can be found in Connect. a. The spreadsheet solution incorporates the following changes from the spreadsheet in Figure 19.2: the payout ratio in cell B9 is reduced to 0.6, and the growth rate in cell B3 is increased to 0.15. The external financing required in 2013 is 104.4 and in 2014 is 121.1. b. Given the assumptions in part (a), total assets grow to $1,150.0 in 2013 and $1,322.5 in 2014. In order to maintain the debt-equity ratio at 2/3, we require that debt equal 40% of total assets, and equity equal 60% of total assets. Therefore, for 2013, debt and equity grow to $460 and $690, respectively. Since retained earnings equal $45.6 in 2013 new issues are: Debt: $460 – $400 = $60 Equity: $690 – $600 – $45.6 = $44.4 In 2014 debt and equity grow to $529.0 and $793.5, respectively, and retained earnings equal $52.4, so that new issues are: Debt: $529 – $460 = $69 Equity: $793.5 – $690.0 – $52.4 = $51.1 c. The formula in cell G20 is: 0.40*G17 The formula in cell G21 is: 0.60*G17 19-16 31. The spreadsheet containing the solution for this problem can be found in Connect. NOTE: Two additional interesting ratios for the students to calculate are EBIT/Revenue and EBIT/Assets. In parts a, b and c, EBIT/Sales is 10% each year and EBIT/Assets is 20%. In other words, from an operating perspective, Executive Fruit’s performance doesn’t change. All of the variation in the financial ratios reported below are due to changes in the firm’s financial mix. As leverage increases, the interest rate on the debt doesn’t change but the tax shield increases. Thus the improvement in return on invested capital is solely driven by the reduction in taxes. To see this point clearly, compare the financial ratios in a to those in c. Notice in c that the ratios are constant over time when the debt ratio is held at 40%. Compare the total taxes paid too. a. Assuming that Yummy Food issues debt to fund its external financing requirements, its debt ratio increase each year. It starts at 40% in 2012 and reaches 48% in 2016. However, it remains below the bank’s required maximum debt ratio of 60%. The pro forma financial statements and financial ratios are below: Base year Income Statement 2012 2013 2014 2015 2016 Revenue 2,000 2,200.0 2,420.0 2,662.0 2,928.2 Cost of goods sold 1,800 1,980.0 2,178.0 2,395.8 2,635.4 EBIT 200 220.0 242.0 266.2 292.8 Interest expense 40 40.0 46.4 53.5 61.3 Earnings before taxes 160 180.0 195.6 212.7 231.5 Taxes 64 72.0 78.2 85.1 92.6 Net income 96 108.0 117.4 127.6 138.9 Dividends 64 72.0 78.2 85.1 92.6 Addition to Retained earnings 32 36.0 39.1 42.5 46.3 Balance Sheet (End of year) Base year Assets 2012 2013 2014 2015 2016 Net operating working capital 200 220.0 242.0 266.2 292.8 Property, plant and equipment 800 880.0 968.0 1,064.8 1,171.3 Total assets 1,000 1,100.0 1,210.0 1,331.0 1,464.1 Liabilities and equity Long-term debt 400 464.0 534.9 613.3 700.1 Shareholders' equity 600 636.0 675.1 717.7 764.0 19-17 Total liab.& share. Equity 1,000 1,100.0 1,210.0 1,331.0 1,464.1 Required external financing 64.0 70.9 78.5 86.8 NOPAT (net income + (1-tax rate) interest) 120.000 132.000 145.200 159.720 175.692 Financial Ratios Debt ratio (debt/assets) 0.4000 0.4218 0.4420 0.4608 0.4782 Interest coverage (EBIT/interest) 5.0000 5.5000 5.2155 4.9768 4.7742 Profit margin (net income/revenue) 0.0480 0.0491 0.0485 0.0479 0.0474 Operating profit margin (NOPAT/Revenue) 0.0600 0.0600 0.0600 0.0600 0.0600 EBIT/Revenues 0.1000 0.1000 0.1000 0.1000 0.1000 EBIT/Assets 0.2000 0.2000 0.2000 0.2000 0.2000 ROA (NOPAT/initial assets) 0.1320 0.1320 0.1320 0.1320 ROC ((NOPAT)/(initial debt+equity)) 0.1320 0.1320 0.1320 0.1320 ROE (net income/initial equity) 0.1800 0.1845 0.1890 0.1935 As Yummy Food sales grow its needs more assets and they are financed by more debt. The increase in debt results in its interest coverage falling from 5 times in 2012 to 4.8 times in 2016. The operating profit margin (NOPAT/Revenues), EBIT/Revenues, EBIT/Assets, ROC and ROA are constant because they are based solely on operations and are unaffected by changes in the financing. Profit margin (net income/revenue) is not constant because of the impact of more debt causing interest expense to increase reducing net income. ROE increase over time because the increase in the percentage of debt financing. This reflects the higher tax shield and also the fact that equity is riskier because of the higher leverage. The increase in the operating profit margin and the return on invested capital occurs because as leverage is increased, so does the interest tax shield (taxes are reduced because of the higher interest payments). ROE also increases because of the tax shield but also becomes riskier: add leverage increases the riskiness of equity. b. With the higher interest rates and assuming that all external financial requirements will be funded with debt, Yummy Food’s debt ratio increases to 49.25% by 2016. However, it is still less than the bank’s 60% maximum. Base year Income Statement 2012 2013 2014 2015 2016 Revenue 2,000 2,200.0 2,420.0 2,662.0 2,928.2 Cost of goods sold 1,800 1,980.0 2,178.0 2,395.8 2,635.4 19-18 EBIT 200 220.0 242.0 266.2 292.8 Interest expense 40 60.0 70.2 81.5 94.2 Earnings before taxes 160 160.0 171.8 184.7 198.7 Taxes 64 64.0 68.7 73.9 79.5 Net income 96 96.0 103.1 110.8 119.2 Dividends 64 64.0 68.7 73.9 79.5 Addition to Retained earnings 32 32.0 34.4 36.9 39.7 Balance Sheet (End of year) Base year Assets 2012 2013 2014 2015 2016 Net operating working capital 200 220.0 242.0 266.2 292.8 Property, plant and equipment 800 880.0 968.0 1,064.8 1,171.3 Total assets 1,000 1,100.0 1,210.0 1,331.0 1,464.1 Liabilities and equity Long-term debt 400 468.0 543.6 627.7 721.1 Shareholders' equity 600 632.0 666.4 703.3 743.0 Total liab.& share. Equity 1,000 1,100.0 1,210.0 1,331.0 1,464.1 Required external financing 68.0 75.6 84.1 93.4 NOPAT (net income + (1-tax rate) interest) 120.000 132.000 145.200 159.720 175.692 Financial Ratios Debt ratio (debt/assets) 0.4000 0.4255 0.4493 0.4716 0.4925 Interest coverage (EBIT/interest) 5.0000 3.6667 3.4473 3.2644 3.1099 Profit margin (net income/revenue) 0.0480 0.0436 0.0426 0.0416 0.0407 Operating profit margin (NOPAT/revenue) 0.0600 0.0600 0.0600 0.0600 0.0600 EBIT/Revenue 0.1000 0.1000 0.1000 0.1000 0.1000 EBIT/Assets 0.2000 0.2000 0.2000 0.2000 0.2000 ROA (NOPAT/initial assets) 0.1320 0.1320 0.1320 0.1320 ROC ((NOPAT)/(initial debt+equity)) 0.1320 0.1320 0.1320 0.1320 ROE (net income/initial equity) 0.1600 0.1631 0.1663 0.1695 19-19 c. Notice how the financial ratios are the same each year when the capital structure is held constant at 40% debt. Base year Income Statement 2012 2013 2014 2015 2016 Revenue 2,000 2,200.0 2,420.0 2,662.0 2,928.2 Cost of goods sold 1,800 1,980.0 2,178.0 2,395.8 2,635.4 EBIT 200 220.0 242.0 266.2 292.8 Interest expense 40 40.0 44.0 48.4 53.2 Earnings before taxes 160 180.0 198.0 217.8 239.6 Taxes 64 72.0 79.2 87.1 95.8 Net income 96 108.0 118.8 130.7 143.7 Dividends 64 72.0 79.2 87.1 95.8 Addition to Retained earnings 32 36.0 39.6 43.6 47.9 Balance Sheet (End of year) Base year Assets 2012 2013 2014 2015 2016 Net operating working capital 200 220.0 242.0 266.2 292.8 Property, plant and equipment 800 880.0 968.0 1,064.8 1,171.3 Total assets 1,000 1,100.0 1,210.0 1,331.0 1,464.1 Liabilities and equity Long-term debt 400 440.0 484.0 532.4 585.6 Shareholders' equity 600 660.0 726.0 798.6 878.5 Total liab.& share. Equity 1,000 1,100.0 1,210.0 1,331.0 1,464.1 Required external financing 64.0 70.4 77.4 85.2 New debt issue 40.0 44.0 48.4 53.2 New equity issue 24.0 26.4 29.0 31.9 Total new financing raised 64.0 70.4 77.4 85.2 NOPAT (net income + (1-tax rate) interest) 120.00 132.00 145.20 159.72 175.69 Financial Ratios Debt ratio (debt/assets) 0.4 0.4 0.4 0.4 0.4 Interest coverage (EBIT/interest) 5 5.5 5.5 5.5 5.5 19-20 Profit margin (net income/revenue) 0.048 0.049091 0.04909 0.04909 0.04909 Operating profit margin (NOPAT/Revenue) 0.06 0.06 0.06 0.06 0.06 EBIT/Revenue 0.100 0.100 0.100 0.100 0.100 EBIT/Assets 0.200 0.200 0.200 0.200 0.200 ROA (NOPAT/assets) 0.1320 0.1320 0.1320 0.1320 ROC ((NOPAT)/(debt+equity)) 0.1320 0.1320 0.1320 0.1320 ROE (net income/equity) 0.180 0.180 0.180 0.180 d. Total assets in 2013 are the same as in part a because the investment in assets is based on the forecasted 10% sales growth. Likewise, external finance required and the amount of borrowing in 2013 are the same. However the higher costs of goods sold as a percentage of revenue causes a reduction profitability and rates of return and increased borrowing. Base year Income Statement 2012 2013 2014 2015 2016 Revenue 2,000 2,200.0 2,420.0 2,662.0 2,928.2 Cost of goods sold 1,800 2,090.0 2,299.0 2,528.9 2,781.8 EBIT 200 110.0 121.0 133.1 146.4 Interest expense 40 40.0 48.6 58.2 68.8 Earnings before taxes 160 70.0 72.4 74.9 77.7 Taxes 64 28.0 29.0 30.0 31.1 Net income 96 42.0 43.4 45.0 46.6 Dividends 64 28.0 29.0 30.0 31.1 Addition to Retained earnings 32 14.0 14.5 15.0 15.5 Balance Sheet (End of year) Base year Assets 2012 2013 2014 2015 2016 Net operating working capital 200 220.0 242.0 266.2 292.8 Property, plant and equipment 800 880.0 968.0 1,064.8 1,171.3 Total assets 1,000 1,100.0 1,210.0 1,331.0 1,464.1 Liabilities and equity Long-term debt 400 486.0 581.5 687.5 805.1 Shareholders' equity 600 614.0 628.5 643.5 659.0 Total liab.& share. Equity 19-21 1,000 1,100.0 1,210.0 1,331.0 1,464.1 Required external financing 86.0 95.5 106.0 117.6 NOPAT (net income + (1-tax rate) interest) 120.000 66.000 72.600 79.860 87.846 Financial Ratios Debt ratio (debt/assets) 0.4000 0.4418 0.4806 0.5166 0.5499 Interest coverage (EBIT/interest) 5.0000 2.7500 2.4897 2.2888 2.1295 Profit margin (net income/sales) 0.0480 0.0191 0.0180 0.0169 0.0159 Operating profit margin (NOPAT/sales) 0.0600 0.0300 0.0300 0.0300 0.0300 EBIT/Revenues 0.1000 0.0500 0.0500 0.0500 0.0500 EBIT/Assets 0.2000 0.1000 0.1000 0.1000 0.1000 ROA (NOPAT/initial assets) 0.0660 0.0660 0.0660 0.0660 ROC ((NOPAT)/(initial debt+equity)) 0.0660 0.0660 0.0660 0.0660 ROE (net income/initial equity) 0.0700 0.0707 0.0716 0.0724 e. Calculating interest expense based on the average debt requires changes to Excel to permit circular reference. The impact of the new interest expense has no effect on the operating profitability measures. Interest expense is higher than in question a because debt is increasing over time. So more debt is needed, increasing leverage and lowering interest coverage. But ROA and ROC are the same because these are not affected by borrowing. Base year Income Statement 2012 2013 2014 2015 2016 Revenue 2,000 2,200.0 2,420.0 2,662.0 2,928.2 Cost of goods sold 1,800 1,980.0 2,178.0 2,395.8 2,635.4 EBIT 200 220.0 242.0 266.2 292.8 Interest expense 40 43.4 50.5 58.4 67.1 Earnings before taxes 160 176.6 191.5 207.8 225.7 Taxes 64 70.6 76.6 83.1 90.3 Net income 96 106.0 114.9 124.7 135.4 Dividends 64 70.6 76.6 83.1 90.3 Addition to Retained earnings 32 35.3 38.3 41.6 45.1 Balance Sheet (End of year) Base year 19-22 Assets 2012 2013 2014 2015 2016 Net operating working capital 200 220.0 242.0 266.2 292.8 Property, plant and equipment 800 880.0 968.0 1,064.8 1,171.3 Total assets 1,000 1,100.0 1,210.0 1,331.0 1,464.1 Liabilities and equity Long-term debt 400 468.0 542.7 625.4 716.9 Shareholders' equity 600 632.0 667.3 705.6 747.2 Total liab.& share. Equity 1,000 1,100.0 1,210.0 1,331.0 1,464.1 Required external financing 68.0 74.7 82.7 91.5 NOPAT (net income + (1-tax rate) interest) 120.000 132.000 145.200 159.720 175.692 Financial Ratios Debt ratio (debt/assets) 0.4000 0.4255 0.4485 0.4699 0.4897 Interest coverage (EBIT/interest) 5.0000 5.0691 4.7889 4.5580 4.3629 Profit margin (net income/sales) 0.0480 0.0482 0.0475 0.0468 0.0462 Operating profit margin (NOPAT/sales) 0.0600 0.0600 0.0600 0.0600 0.0600 EBIT/Revenues 0.1000 0.1000 0.1000 0.1000 0.1000 EBIT/Assets 0.2000 0.2000 0.2000 0.2000 0.2000 ROA (NOPAT/assets) 0.1320 0.1320 0.1320 0.1320 ROC ((NOPAT)/(debt+equity)) 0.1320 0.1320 0.1320 0.1320 ROE (net income/equity) 0.1766 0.1818 0.1868 0.1919 32. The spreadsheet containing the solution for this problem can be found in Connect. Note to Instructor: When your students have successfully built the spreadsheet for Dynastatics, ask them to use it to explore variations in the sales forecast, costs etc. a. and b. Below are the spreadsheets for Dynastatics under the two financing assumptions. Under the assumption that Dynastatics pays out 2/3 of its earnings as dividends and maintains a 25% debt/asset ratio (part a.), the firm issues new debt and equity each year. Interest coverage is lowest in 2012, 9.33 times, but increases each year because the firm’s amount of debt increases to finance the investment in new long-term assets. Operating profit margin ranges from 7.47% in 2012 to 8.34% in 2017. ROA, ROC and ROE decrease over time. 19-23 With the assumption that all external financing raised is debt (part b.), by 2017, the total debt ratio is 52.88% and interest coverage is 5.8669. As expected, using debt financing results in lower liquidity and safety. As with the situation in part a., the profit margins and return ratios increase over time. However, the generally they are higher here than in part a. As an example, the operating profit margin in 2017 is 8.5% with all debt external financing and is 8.34% when the debt ratio is maintained at 25%. This is solely due to the tax savings from the higher interest. EBIT/Sales and EBIT/Assets, which are pre-tax and pre-financing, are identical in parts a. and b., when compared year by year. a. Income Statement 2012 2013 2014 2015 2016 2017 Revenue 1,800.0 2,070.0 2,313.0 2,531.7 2,728.5 2,905.7 Fixed costs 56.0 56.0 56.0 56.0 56.0 56.0 Variable costs 1,440.0 1,656.0 1,850.4 2,025.4 2,182.8 2,324.5 Depreciation 80.0 80.0 92.0 102.8 112.5 121.3 EBIT 224.0 278.0 314.6 347.5 377.2 403.9 Interest expense 24.0 24.0 27.6 30.8 33.8 36.4 Earnings before taxes 200.0 254.0 287.0 316.7 343.4 367.5 Taxes 80.0 101.6 114.8 126.7 137.4 147.0 Net income 120.0 152.4 172.2 190.0 206.1 220.5 Dividends 80.0 101.6 114.8 126.7 137.4 147.0 Addition to Retained earnings 40.0 50.8 57.4 63.3 68.7 73.5 Balance Sheet Assets 2012 2013 2014 2015 2016 2017 Net operating working capital 400.0 460.0 514.0 562.6 606.3 645.7 Gross long-term assets 3,000.0 3,200.0 3,400.0 3,600.0 3,800.0 4,000.0 Accumulated depreciation 2,200.0 2,280.0 2,372.0 2,474.8 2,587.3 2,708.6 Net long-term assets 800.0 920.0 1,028.0 1,125.2 1,212.7 1,291.4 Total assets 1,200.0 1,380.0 1,542.0 1,687.8 1,819.0 1,937.1 Liabilities and equity Long-term debt 300 345 386 422 455 484 Shareholders' equity 900 1,035 1,157 1,266 1,364 1,453 Total liab.& share. equity 1,200 1,380 1,542.0 1,687.8 1,819.0 1,937.1 Required external financing 129 105 82 63 45 New debt issue 45 33 19-24 41 36 30 New equity issue 84 64 46 30 15 Check: sum of new debt + new equity 129 105 82 63 45 NOPAT 134.40 166.80 188.76 208.52 226.31 242.32 Financial Ratios Total debt ratio (debt/assets) 0.2500 0.2500 0.2500 0.2500 0.2500 0.2500 Interest coverage (EBIT/interest) 9.3333 11.5833 11.3986 11.2691 11.1739 11.1012 Profit margin (NI/Revenue) 0.0667 0.0736 0.0744 0.0751 0.0755 0.0759 Operating profit margin(NOPAT/sales) 0.0747 0.0806 0.0816 0.0824 0.0829 0.0834 EBIT/Revenue 0.1244 0.1343 0.1360 0.1373 0.1382 0.1390 EBIT/Assets 0.1867 0.2014 0.2040 0.2059 0.2074 0.2085 Return Ratios: Comparing Earnings for the Year with the Assets, Debt and Equity at the Start of Same Year ROA (NOPAT/assets) 0.139 0.137 0.135 0.134 0.133 ROC (NOPAT/debt+equity) 0.139 0.137 0.135 0.134 0.133 ROE (net income/equity) 0.169 0.166 0.164 0.163 0.162 19-25 b. Income Statement 2012 2013 2014 2015 2016 2017 Revenue 1,800.0 2,070.0 2,313.0 2,531.7 2,728.5 2,905.7 Fixed costs 56.0 56.0 56.0 56.0 56.0 56.0 Variable costs 1,440.0 1,656.0 1,850.4 2,025.4 2,182.8 2,324.5 Depreciation 80.0 80.0 92.0 102.8 112.5 121.3 EBIT 224.0 278.0 314.6 347.5 377.2 403.9 Interest expense 24.0 24.0 34.3 42.8 49.6 54.9 Earnings before taxes 200.0 254.0 280.3 304.7 327.6 349.0 Taxes 80.0 101.6 112.1 121.9 131.0 139.6 Net income 120.0 152.4 168.2 182.8 196.6 209.4 Dividends 80.0 101.6 112.1 121.9 131.0 139.6 Addition to Retained earnings 40.0 50.8 56.1 60.9 65.5 69.8 Balance Sheet Assets 2012 2013 2014 2015 2016 2017 Net operating working capital 400.0 460.0 514.0 562.6 606.3 645.7 Gross long-term assets 3,000.0 3,200.0 3,400.0 3,600.0 3,800.0 4,000.0 Accumulated depreciation 2,200.0 2,280.0 2,372.0 2,474.8 2,587.3 2,708.6 Net long-term assets 800.0 920.0 1,028.0 1,125.2 1,212.7 1,291.4 Total assets 1,200.0 1,380.0 1,542.0 1,687.8 1,819.0 1,937.1 Liabilities and equity Long-term debt 300 429 535 620 686 734 Shareholders' equity 900 951 1,007 1,068 1,133 1,203 Total liab.& share. equity 1,200 1,380 1,542.0 1,687.8 1,819.0 1,937.1 Required external financing 129 106 85 66 48 New debt issue 129 106 85 66 48 New equity issue 0.00 0.00 0.00 0.00 0.00 Check: sum of new debt + new equity 129 106 85 66 48 NOPAT 134.40 166.80 188.76 208.52 226.31 242.32 Financial Ratios 19-26 Total debt ratio (debt/assets) 0.2500 0.3110 0.3470 0.3673 0.3770 0.3789 Interest coverage (EBIT/interest) 9.3333 11.5833 9.1624 8.1179 7.6045 7.3623 Profit margin (NI/Revenue) 0.0667 0.0736 0.0727 0.0722 0.0720 0.0721 Operating profit margin(NOPAT/sales) 0.0747 0.0806 0.0816 0.0824 0.0829 0.0834 EBIT/Revenue 0.1244 0.1343 0.1360 0.1373 0.1382 0.1390 EBIT/Assets 0.1867 0.2014 0.2040 0.2059 0.2074 0.2085 Return Ratios: Comparing Earnings for the Year with the Assets, Debt and Equity at the Start of Same Year ROA (NOPAT/assets) 0.139 0.137 0.135 0.134 0.133 ROC (NOPAT/debt+equity) 0.139 0.137 0.135 0.134 0.133 ROE (net income/equity) 0.169 0.177 0.182 0.184 0.185 33. a. Capital expenditure is $200,000 each year. This was assumed but also works by using change in 2012 2013 2014 2015 2016 2017 Net long-term assets 800.0 920.0 1,028.0 1,125.2 1,212.7 1,291.4 Depreciation 80.0 80.0 92.0 102.8 112.5 121.3 For example: 2013 Cap ex = Change in Net long-term debt + depreciation = 920 – 800 + 80 = 200 2017 Cap ex = Change in Net long-term debt + depreciation = 1291.4 -1212.7 + 121.3 = 200 b. Statement of Cash Flow 2013 2014 2015 2016 2017 Net income 152.4 172.2 190.0 206.1 220.5 Depreciation 80.0 92.0 102.8 112.5 121.3 Increase in net working capital (60.0) (54.0) (48.6) (43.7) (39.4) Cash provided by operations 172.4 210.2 244.2 274.8 302.4 Cash used for capital expenditures (200.0) (200.0) (200.0) (200.0) (200.0) Cash flow before financing activities (27.6) 10.2 44.2 74.8 102.4 Cash flow from financing activities New debt 45 41 36 33 30 New equity issue 84 64 46 30 15 Dividends paid (101.6) (114.8) (126.7) (137.4) (147.0) Cash provided (used) in financing activities 27.6 (10.2) (44.2) (74.8) (102.4) 19-27 Net increase (decrease) in cash 0.0 0.0 0.0 0.0 0.0 c. Treating interest as operating expense Cash Flow and Financing Flow Treating Interest as Operating Expense Cash flow from Assets 2013 2014 2015 2016 2017 Cash flow from operations 172.4 210.2 244.2 274.8 302.4 Cash flow from investing activitiies (200.0) (200.0) (200.0) (200.0) (200.0) =Cash flow from assets (27.60) 10.20 44.22 74.84 102.39 Financing Flow Cash flow to debt holders = increase in debt (45.00) (40.50) (36.45) (32.81) (29.52) Cash flow to shareholders: Dividends 101.60 114.80 126.68 137.37 146.99 New equity issue (84.20) (64.10) (46.01) (29.73) (15.08) =cash flow to shareholders 17.40 50.70 80.67 107.64 131.92 Total Financing Flow (27.60) 10.20 44.22 74.84 102.39 d. Treating interest as cash flow to bondholders: Calculating unlevered cash flow from assets (as if the firm had no debt) Cash Flow and Financing Flow Treating Interest as Financing Expense 2013 2014 2015 2016 2017 Cash flow from assets including interest as operating expense (27.60) 10.20 44.22 74.84 102.39 Add after-tax interest expense=1-tax ratexinterest expense 14.40 16.56 18.50 20.25 21.83 Unlevered cash flow from assets (13.20) 26.76 62.72 95.09 124.22 Financing Flow 2013 2014 2015 2016 2017 After-tax interest payment to bondholders 14.40 16.56 18.50 20.25 21.83 New debt issues (45.00) (40.50) (36.45) (32.81) (29.52) Total cash flow to bondholders (30.60) (23.94) (17.95) (12.55) (7.70) Dividends 101.6 114.8 126.7 137.4 147.0 New equity issue (84) (64) (46) (30) (15) Total cash flow to shareholders 19-28 17.40 50.70 80.67 107.64 131.92 Total financing flow (13.20) 26.76 62.72 95.09 124.22 34. a. Sustainable growth rate = Plowback ratio × ROE = (1 – .70) × 500 1800 = .08333 = 8.333% If the sustainable growth rate works the firm does not need to issue equity to finance its growth and maintains it debt/equity ratio. Here’s the forecasted income statement and balance sheet: sales growth 8.333% dividend payout ratio 0.7 2012 2013 Sales 950 1029.17 Cost 250 270.83 EBIT 700 758.33 Taxes 200 216.67 Net Income 500 541.67 Div 300 379.17 Add to RE 200 162.50 2011 2012 2013 Assets 2700 3000 3250.0 Total 2700 3000 3250.0 Debt 900 1000 1087.5 Equity 1800 2000 2162.5 Total 2700 3000 3250.0 external financing 87.5 Balance sheet check 0 Debt/Equity 0.5 0.5 0.5 Equity/Assets 0.67 0.67 0.67 b.Internal growth rate = Plowback ratio × ROE × Equity Assets = (1 – .70) × 500 1800 × 2 3 = .05556 = 5.556% 19-29 sales growth 5.556% dividend payout ratio 0.7 2012 2013 Sales 950 1002.78 Cost 250 263.89 EBIT 700 738.89 Taxes 200 211.11 Net Income 500 527.78 Div 300 369.44 Add to RE 200 158.33 2011 2012 2013 Assets 2700 3000 3166.7 Total 2700 3000 3166.7 Debt 900 1000 1008.3 Equity 1800 2000 2158.3 Total 2700 3000 3166.7 external financing 8.3 Balance sheet check 0 Debt/Equity 0.5 0.5 0.47 Equity/Assets 0.67 0.67 0.68 For some reason the percentage of sales method doesn’t work using the internal growth rate calculated using this formula. With this growth rate, 5.556%, the firm needs external financing to meet the growth in assets. The forecasted net income with this growth rate is 527.78 but the forecasted net income in question 13 using the 5.556% internal growth rate was $555.6. c. New growth rate formula: 2012 1 7 500 1800 052631579 3000 1 7 500 1800 1800 × × × plowback ratio return on equity Assets plowback ratio x return on equity 2011 Equity Growth rate ( . ) . ( . ) − = − = = − − sales growth 0.052631579 19-30 dividend payout ratio 0.7 Net income/sales 0.526315789 0.526315789 2012 2013 Sales 950 1000.00 Cost 250 263.16 EBIT 700 736.84 Taxes 200 210.53 Net Income 500 526.32 Div 300 368.42 Add to RE 200 157.89 2011 2012 2013 Assets 2700 3000 3157.9 Total 2700 3000 3157.9 Debt 900 1000 1000.0 Equity 1800 2000 2157.9 Total 2700 3000 3157.9 external financing 0.0 Balance sheet check 0 Debt/Equity 0.5 0.5 0.5 Equity/Assets 0.67 0.67 0.68 So, using this growth rate results in zero external financing required. This is the formula for calculating the internal growth rate to use to forecast sales and costs, rather than just forecasting net income. 35. Internet: Using financial statement information to calculate sustainable and internal growth rates. Expected Results: Yahoo doesn’t provide financial statements for Canadian companies that aren’t traded in the US and even doesn’t always provide financial statements. So that’s why we’ve provided a choice of websites. Here’s an example of calculating the sustainable and internal growth rates for Canadian National Railways and Canadian Pacific Railway using data from money.ca.msn.com Data is from money.ca.msn.com gathered on October 22, 2011 Canadian Pacific Railway Canadian National Railway 31-Dec-10 31-Dec-10 million Cdn Dollars million Cdn Dollars payout ratio 0.34 0.24 19-31 2009 Revenue 4402.2 7367 2010 Revenue 4981.5 8297 2010 Net income 650.7 2104 2009 Total Equity 4658.1 11233 2010 Total equity 4824.7 11284 2009 Total assets 14154.8 25176 2010 Total assets 13675.9 25206 ROE= 2010 NI/ 2009 equity 0.13969 0.18731 2010 equity/2010 assets 0.3528 0.4477 Sustainable growth 0.0922 0.1424 Internal growth 0.0325 0.0637 Revenue growth rate 0.132 0.126 Asset growth rate -0.0338 0.0012 The statement of cash flow for each company provided information about sources and uses of cash. Canadian Pacific assets were reduced largely because of the use of cash to pay for the investment in assets and payments to sources of financing. Canadian National cash increased. 36. Internet: Starting a business Expected results: The nine topics to starting a business are listed on the web page. Students can learn a lot about starting a business. The topic “Developing your business plan” has the topic “Writing Your Business Plan” and in it is the topic “Financial forecasts and other information”. In that section is a discussion of forecasting. Much of what’s there is what is covered in this chapter. 19-32 Solution to Minicase for Chapter 19 Based on the information provided the case in 2011 the firm was operating 15 computers. Since each computer could support $80,000 revenues, it is consistent with the 2011 revenues: 15 x $80,000 = $1,200,000. Each computer needed one consultant and the salary and benefits are $70,000 so the cost of goods sold in 2011 was 15 x $70,000 = $1,050,000. The 2011 interest expense, based on the initial line of credit of $125,000 was .08 x 125,000 = 10,000. So income statement and balance sheet (statement of financial position) for 2011 are: Income Statement Details of Calculations 2011 Revenue 1,200,000 Cost of goods sold 15 x 70,000= 1,050,000 EBIT 150,000 Interest expense .08 x 12,500= 10,000 Earnings before taxes 140,000 Taxes .35 x Earnings before taxes= 49,000 Net income 91,000 Dividends .7 x Net income = 63,700 Addition to Retained earnings 27,300 Balance Sheet (year end) 2011 Assets Net operating working capital .25 x 2011 sales = .25 x 1,200,00 300,000 Long-term assets 150,000 Total assets 450,000 Liabilities and equity Line of credit Initial line of credit + required external financing = 125,000 + 47,700 172,700 Shareholders' equity initial equity + addition to retained earnings = 250,000 + 27,300= 277,300 Total liab. & share. equity 450,000 Required external financing Total assets – initial line of credit – shareholders’ equity =450,000 – 125,000 – 277,300 = 47,700 19-33 To forecast 2012 to 2015 use the provided information and calculate some ratios using 2011 financial statements: A. Model inputs Sales growth rate 0.200 Tax rate 0.350 Interest rate 0.080 NWC/Sales ratio 0.250 Long-term assets/sales 0.125 COGS/sales 0.875 Payout ratio 0.700 Income Statement 2011 2012 2013 2014 2015 Revenue 1,200,000 1,440,000 1,728,000 2,073,600 2,488,320 Cost of goods sold 1,050,000 1,260,000 1,512,000 1,814,400 2,177,280 EBIT 150,000 180,000 216,000 259,200 311,040 Interest expense 10,000 13,816 18,424 23,981 30,680 Earnings before taxes 140,000 166,184 197,576 235,219 280,360 Taxes 49,000 58,164 69,152 82,327 98,126 Net income 91,000 108,020 128,425 152,892 182,234 Dividends 63,700 75,614 89,897 107,024 127,564 Retained earnings 27,300 32,406 38,527 45,868 54,670 Balance Sheet (year end) Assets Net operating working capital 300,000 360,000 432,000 518,400 622,080 Fixed assets 150,000 180,000 216,000 259,200 311,040 Total assets 450,000 540,000 648,000 777,600 933,120 Liabilities and equity Line of credit 172,700 230,294 299,767 383,499 484,349 Shareholders' equity 277,300 309,706 348,233 394,101 448,771 Total liab. & share. equity 450,000 540,000 648,000 777,600 933,120 Required external financing 47,700 57,594 69,473 83,732 100,850 The forecast shows what the required financing will be if the firm does grow 20% each year. Up to 2015 you can see that the firm’s line of credit is sufficient to fund the forecasted growth. You 19-34 can see in the forecast the 2015 required financing is the line of credit the total line of credit would have to be $484,349 which is greater than the $400,000 borrowing limit. So, by 2015 it will need more external financing than is provided by its line of credit. So, to meet the required external financing in 2015 the company could try to issue equity. The required external equity financing in 2015 = 2015 assets – 400,000 line of credit – (initial 2015 equity + 2015 addition to retained earnings) = 933,120 – 400,000 – (394,101+ 54,670) = $84,349 But given that dividends paid in 2015 were $127,564 another option could be to plan to cut the dividend in 2015. There is no right answer, you just need to make an argument about what you think they should plan to do in 2015. 19-35 Brealey 5CE Solutions to Chapter 20 1. Cash Net Working Capital a. $2 million decline $2 million decline b. $2,500 increase Unchanged c. $5,000 decline Unchanged d. Unchanged $1 million increase e. Unchanged Unchanged f. $5 million increase Unchanged 2. a. Long-term financing, total capital requirement, marketable securities b. Cash, cash, cash balance, marketable securities 3. a. Inventories of raw materials, work in progress, and finished goods increase and cash decreases (use of cash). b. Trade receivables increase (use of cash). c. Decrease in assets (land), increase in cash (source of cash), and decrease in shareholders’ equity when the loss on the land is recognized. The loss on the land has no impact on cash. d. Shareholders’ equity decreases and cash decreases (use of cash). e. Retained earnings and cash decrease when the dividend is paid (use of cash). f. Long-term debt increases (source of cash), short-term debt decreases (use of cash). 4. Remember that the operating cycle = inventory period + receivables period and the cash conversion cycle = inventory period + receivables period – Trade payables period. Notice from these answers that not all actions that shorten the cash conversion cycle are necessarily good for the firm, nor are all actions that lengthen the cash conversion cycle necessarily bad. The costs or benefits of the actions associated with changes in the cycle must also be considered. a. Lower inventory levels will reduce the inventory period and therefore both the operating cycle and the cash conversion cycle are shorter 19-1 b. The trade payables period will fall, which will lengthen the cash conversion cycle. It has no impact on the operating cycle. c. The trade receivables period will fall, which will shorten both the operating and the cash conversion cycles. d. The trade receivables period will rise (since customers pay their bills more slowly), which will lengthen the cash conversion cycle. It has no impact on the operating cycle. e. The shorter manufacturing time will reduce the inventory period, reducing both the operating cycle and the cash conversion cycle. 5. The firm can use its new system to maintain lower inventory levels. This will reduce the inventory period and therefore the cash conversion cycle, and will reduce net working capital as well. 6. Trade receivables period = (100 + 120) / 2 5000 / 365 = 8.0 days Inventory period = (500 + 600)/2 4200/365 = 47.8 days Trade payables period = (250 + 290)/2 4200/365 = 23.5 days Operating cycle = 8.0 + 47.8 = 55.8 days Cash conversion cycle = 8.0 + 47.8 – 23.5 = 32.3 days 7. The operating cycle equals the inventory period plus receivables period. The cash conversion cycle equals inventory period plus receivables period minus trade payables period. a. The discount should induce some customers to pay cash. Trade receivables, the receivables period, and both the operating and cash conversion cycles will fall. b. Lower inventory turnover implies more days in inventory. The operating and cash conversion cycles increase. c. If the firm produces goods more quickly, inventory levels corresponding to work in progress will fall. Therefore, the inventory period, the operating cycle and the cash conversion cycle fall. d. If the trade payables period falls, the cash conversion cycle will increase. The operating cycle is not affected by the change. 19-2 e. Because the goods are already ordered, inventory of finished product will fall relative to sales. Therefore the inventory period, the operating cycle and the cash conversion cycle fall. f. Inventory increases imply a longer inventory period, longer operating cycle and longer cash conversion cycle. 8. a. The firm can use only 75% of the amount it borrows. So, if x is the amount it borrows, then .75 x = 10,000 x = 13,333 b. The effective interest rate with the compensating balance is .10/.75 = .1333 = 13.33%. The 12% loan without the compensating balance is a better deal. c. Now, the effective rate on the compensating balance is determined by finding the net interest paid by the firm. The firm borrows $13,333 and pays 10 percent interest on this amount, which is $1,333. It receives 4 percent interest on the $3,333 left with the bank; this amounts to $133. The net interest payment is therefore $1,200. The effective interest rate is thus $1,200/$10,000 = .12 = 12%, the same as the rate for the alternative loan. The firm will be indifferent between the two offers. 9. Effective rate = interest paid funds available = .08 × loan amount .9 × loan amount = 8% .9 = 8.89% If the compensating balance is 20%, the effective rate is = 8% .8 = 10% 10. The discount is 1.5%, but the firm collects one month earlier than it would otherwise. Suppose the stated price is $100. With the factor, the firm receives $98.50 immediately, = (1 -.015)×$100). Otherwise the firm extends a month of credit to its customers but receives $100. The implicit monthly interest rate is defined by $98.50 × (1 + r) = $100 Which implies that r = .01523 19-3 Therefore, the effective annual rate is given by 1 + rEAR = (1 + rmonthly)12 = (1.01523)12 = 1.1989 Which implies an effective annual rate of 19.89%. If the average collection period is 1.5 months, the firm collects 1.5 months earlier than it would otherwise. Now, r = .01523 is the implicit rate for 1.5 months and the effective annual rate is given by 1 + rEAR = (1 + r)(12/1.5) = (1.01523)8 = 1.1285 Which implies an effective annual rate of 12.85%. 11. a. The discount loan is for one year and interest is only paid once at the end of year annual. The loan repayment and interest is $1,000 at the end of the year and the quoted loan rate is 6%. So the beginning of the year the borrower receives $940 (= 1000 x (1-.06) and repays $1000 in a year. So of the $1000 paid at the end of the year $940 is the loan repayment and $1000 – 940= $60 is the interest payment. The effective annual interest rate is: Interest payment /loan amount = 60/940 = .0638 = 6.38%. You can also use effective annual rate formula, where n=number of periods in the year and will get the same answer. Effective annual interest rate =    1  1 – annual interest rate n n – 1 Here n=1 so the effective annual interest rate= [1/(1-.06)] – 1 = .0638 = 6.38% b. If it is a $1000 loan is for one monthly, then the monthly rate is 6%/12 = 0.5%. So at the beginning of the month the borrower receives 995 (=1000 x (1-.005). So at the end of the month $1000 is paid, of which .005 x 1000 = 5 is interest and $1000 – 5 is loan repayment. So the interest rate paid in the month is 5/995 = .005025. The effective annual equivalent is (1.005025)12 – 1 =.062 You can also use effective annual rate formula, where n=number of periods in the year and will get the same answer: Effective annual interest rate =    1  1 – annual interest rate n n – 1 =    1  1 – .06 12 12 – 1 = (1/.995)12 – 1 = .0620 = 6.20% 19-4 12. a. Consider a loan of $100. The interest over a one year period will be $6. The amount actually available is $75. Therefore, the effective annual rate is $6/$75 = .08 = 8%. b. The firm will pay interest of 6%/12 = .5% per month. If the loan amount has a stated balance of $100, interest is $.50 per month. The effective annual interest rate: = (1 + actual interest paid borrowed funds available )n – 1 = (1 + $.50 $75 )12 – 1 = .0830, or 8.30% 13. Month 3: 18,000 + (.5 × 90,000) + (.3 × 120,000) + (.2 × 100,000) = $119,000 Month 4: 14,000 + (.5 × 70,000) + (.3 × 90,000) + (.2 × 120,000) = $100,000 14. A 30-day period is one-third of a calendar quarter. So one-third of the purchases will be paid in the next quarter, and two-thirds will be paid in the current quarter. If the delay is 60 days, then two-thirds of the purchases will be paid for in the next quarter and one-third will be paid in the current quarter. 15. The order is .75 times the following quarter’s sales forecast Quarter Order 1 .75 × 360 = 270 2 .75 × 336 = 252 3 .75 × 384 = 288 4 .75 × 384 = 288 16. Since the first quarter’s sales forecast was $372, orders placed during the fourth quarter of the preceding year would have been .75 × $372 = $279. Quarter Payment* 1 1/3 × 279 + 2/3 × 270 = 273 2 1/3 × 270 + 2/3 × 252 = 258 19-5 3 1/3 × 252 + 2/3 × 288 = 276 4 1/3 × 288 + 2/3 × 288 = 288 *Payment = (1/3) × previous period order + (2/3) × current period order 17. Quarter Collections* 1 2/3 × 336 + 1/3 × 372 = 348 2 2/3 × 372 + 1/3 × 360 = 368 3 2/3 × 360 + 1/3 × 336 = 352 4 2/3 × 336 + 1/3 × 384 = 352 *Collections = (2/3) × previous period sales + (1/3) × current period sales 18. Quarter First Second Third Fourth Sources of cash Collections on trade receivables $348 $368 $352 $352 Uses of cash Payments of trade payables 273 258 276 288 Labour & administrative expenses 65 65 65 65 Interest on long-term debt 40 40 40 40 Total uses of cash 378 363 381 393 Net cash inflow -$30 $ 5 –$29 -$41 (= sources – uses) 19. Quarter First Second Third Fourth Cash at start of period $40 $10 $15 -$14 + Net cash inflow –30 + 5 -29 - 41 (from problem 18) = Cash at end of period 10 15 - 14 - 55 Minimum operating cash balance 30 30 30 30 Cumulative short-term financing required (minimum cash balance $20 $15 $44 $85 minus cash at end of period) 20. Quarter First Second Third Fourth Cash Requirements Cash required for operations $30 -$5 $29 $41 19-6 Interest on bank loan 0 0.4 0.3 0.9 Total cash required $30 -$4.6 $29.3 $41.9 Cash Raised Bank loan (line of credit) $20 -$4.6 $29.3 $41.9 Total cash raised $20 -$4.6 $29.3 $41.9 Repayments Of bank loan 0 4.6 0 0 Increase in cash balances Addition to cash balances -$10 $ 0 $ 0 $ 0 Line of Credit (bank loan) Beginning of quarter $ 0 $20 $15.4 $44.7 End of quarter 20 15.4 44.7 86.6 21. Dynamic Mattress’s new financing plan (figures in millions): Quarter First Second Third Fourth Cash Requirements 1. Cash required for operationsa $45 $15 -$26 -$35 2. Interest on line of creditb 0 0.9 0.9 0.7 3. Interest on stretched payablesc 0 0 0.8 0 4. Total cash required $45 $15.9 -$24.3 -$34.3 Cash Raised 5. Line of credit (bank loan) $45 $ 0 $ 0 $ 0 6. Stretched payables 0 15.9 0 0 7. Securities sold 5 0 0 0 8. Total cash raised $50 $15.9 $ 0 $ 0 Repayments 9. Of stretched payables 0 0 15.9 0 10. Of line of credit (bank loan) 0 0 8.4 34.3 Increase in cash balances 11. Addition to cash balances $ 5 $ 0 $ 0 $ 0 Line of Credit (bank loan) 12. Beginning of quarter $ 0 $45 $45 $36.6 13. End of quarter $45 $45 $36.6 $ 2.3 19-7 a From Table 20.6, bottom line of Panel B. A negative cash requirement implies positive cash flow from operations. b The interest rate on the bank loan is 2 percent per quarter applied to the loan balance outstanding at the start of the quarter. Thus the interest due in the second quarter is .02 × $45 million = $0.9 million. c The “interest” cost of the stretched payables is 5 percent of the amount of payment deferred. For example, in the third quarter, 5 percent of $15.9 million stretched in the second quarter is about $.8 million. 19-8 22. Working capital information is found on Professor Damodaran’s website (accessed in September 2011) in the section called “Cash Flow Estimation” and the subsection “Working Capital Requirements by Industry Sector”. NOTE: The data can be saved in an Excel file. To do so, right click on the word “download” and choose “Save target as” and save it where you want it to be. Then open the file with Excel. We note that the securities brokerage industry has the highest working capital to sales ratio (301.43%). Indeed financial services firms generally are likely to have relatively high current asset requirements. They have high trade receivables and inventories as percentage of sales. The cable television industry, however, with almost no inventory low receivables to sales has a much smaller working capital to sales ratio. In fact, it is negative 1.63%. Cable companies tend to have higher investments in fixed assets. 23. Reviewing the various jobs listed will reveal that the same job titles can be used to describe quite different positions. A treasury analyst for a financial company is responsible for forecasting monthly cash flows, monitoring the company’s current cash flows and preparing reports for senior management. Here is the detailed job description: Role Summary: Reporting to AVP, Cash Management & Liquidity, and the Treasury Analyst will work closely with the Treasury, Capital and Investment teams to develop and execute our corporate cash and liquidity initiatives. The Treasury Analyst will be responsible for working on a broad array of constantly evolving corporate treasury and capital management initiatives, which will ultimately include interaction at different points in time with all of the operations of Sun Life Financial. The position will provide a unique opportunity to be involved in the development of a global treasury operation. Main Accountabilities: • Support the development of global monthly cash flow forecasting process • Support the implementation of Global Cash Pooling • Support the implementation of a treasury workstation solution that provides visibility of the company's global cash position and other related functionality • Assist with updating and developing global treasury policies and processes 19-9 • Assist with bank relationship management • Assist with Capital Management plans and other capital related analysis • Participate in the preparation of management reports for senior management and external partners, ensuring accuracy and timeliness • Ad hoc research Competencies/Qualifications • Ability to take initiative and use sound judgment to complete assignments, and to identify opportunities for creating value • Excellent knowledge of Excel, Power Point, Lotus Notes and Word, with the ability to develop efficient and easy-to-read reports, as well as documents or spreadsheets that can be used by other areas • Strong communication, organizational and decision making skills • Ability to handle conflicting priorities and meet stringent deadlines • College diploma or University degree in business, finance or accounting 24. At www.bloomberg.com, click on “market data”, and then go to “rates and bonds”, and then “key rates” (http://www.bloomberg.com/markets/rates/keyrates.html) where you will find information on US prime rates and LIBOR rates. Major international banks lend to one another using the benchmark LIBOR rate. In September 2011, the current 3-month LIBOR is 0.34% vs. the current prime of 3.25 %. Using the 3-month LIBOR+ 1 as a base rate for a 3 year loan, the LIBOR plus 1 % (1.34%) is still lower than the current prime rate. Hence, with existing rate information, you would prefer a 3- month LIBOR plus 1 % as your base rate for 3- year loan. Of course, these numbers will change in time and may well lead to a different conclusion at another point in time. 19-10 25. Sources of cash, 2011 Sale of marketable securities $ 2 Increased bank loans 1 Increased Trade payables 5 Cash from operations: Net income 6 Depreciation 2 Total sources $16 Uses of cash Increased inventories $ 6 Increased Trade receivables 3 Investment in long-term assets 6 Dividend paid 1 Total uses $16 Change in cash balance $ 0 Statement of Cash Flow For 2011 Operating Activities: Net income $6 Depreciation 2 Increase in inventory -6 Increase in Trade receivables -3 Increase in Trade payables 5 Cash provided by operating activities $4 Investment Activities: Sale of marketable securities $2 Investment in long-term assets -6 Cash provided by investment activities -$4 Financing Activities: Increase in bank loan $1 Dividends paid -1 Cash provided by financing activities $0 Increase in cash balance $0 19-11 26. Sears Holding Company: As of January 29, 2011, the company operated approximately 1,278 Kmart stores, 842 Full-line stores and 1,354 specialty stores in the United States, as well as 122 full-line stores, 48 furniture and appliance stores, 268 dealer stores, 4 appliances and mattresses stores, 30 Corbeil stores, 11 outlet stores, 20 floor covering stores, 1,822 catalog pick-up locations, and 108 travel offices in Canada. The company was founded in 1899 and is based in Hoffman Estates, Illinois. Wal-Mart: As of January 31, 2011, Wal-Mart operated 708 discount stores, 2,907 supercenters, 189 neighborhood markets, and 609 Sam's Clubs in the United States; and 63 units in Argentina, 479 in Brazil, 325 in Canada, 549 in Central America, 279 in Chile, 414 in Japan, 5 in India, 1,730 in Mexico, and 385 in the United Kingdom, as well as 328 stores through joint ventures in China. The company was founded in 1945 and is based in Bentonville, Arkansas. Data for Wal-Mart (WMT) and Sears Holding Corp (SHLD) is found by clicking on Excel Analytics and then accessing the annual data. Raw Data Sears Wal-Mart Jan11 Jan10 Jan11 Jan10 Net Receivables 710 682 5,089 4,144 Inventories 9,123 8,705 36,318 32,713 Trade Payables 3,658 3,869 52,415 50,532 Sales 43,326 44,043 421,849 408,085 Cost of Goods Sold 31,448 31,824 315,287 3404,444 19-12 Fiscal year ending Jan 2011 ($ million) Sears Holding Corp. Wal-Mart. Inventory turnover (COGS/Avg. inv.) =3.53 =9.13 Inventory period (days) (365/3.53)= 103.4 ( 365/9.13) = 39.98 Receivable turnover (Sales/Avg. rec.) =62.25 = 91.38 Avg. collection period (days) (365/62.25)= 5.86 (365/91.38) = 4.00 Operating Cycle (days) =103.4+ 5.86 = 109.26 =39.98 + 4.0 = 43.98 Payables turnover = COGS/Avg. pay) = 8.36 = 6.13 Trade payables period(days) (365/8.36) = 43.66 (365/ 6.13)= 59.54 Cash Conversion Cycle (days) = 109.26 – 43.66 = 65.6 =43.98 – 59.54 = -15.56 Sears has a much longer operating cycle and a larger cash cycle as the company holds inventory longer and has a shorter number of days to pay their trade payables when compared to Wal-Mart. To reduce the cash cycle by one day, assume that the inventory period reduces by one day. The same result could be achieved by either reducing the receivables period one day or increasing the payables period by one day. For Wal-Mart, the inventory period would fall from 39.98 to 38.98 days. For this to happen, inventory level must fall. To find the new 2011 inventory level, solve for x: → x = 67,341.85 – 32,713 = 34,628.85 Therefore change in working capital will equal the change in inventory. The new 2011 inventory level minus the current 2011 inventory level is = 34,628.85 - 36,318 = -$1,689.15 million or -$1.689 billion. For Wal-mart’s cash conversion cycle to drop by one day, its working capital must fall by $1.689 billion. Wal-Mart’s revenue per employee is $205,652 (431.87B/2,100,000 employees) while Sears’ revenue per employee is $137,372 (42.86B/312,000). Although Wal- Mart’s size dwarfs that of Sears, it has greater efficiencies in terms of higher employee utilization. 19-13 As of September 2011, Sears’ stock price has depreciated over 67% since September 2006. Wal-Mart on the other hand has seen an appreciation of 6% in its stock price during the same period. This is reflective of stronger key profitability ratios (such as earnings per share, gross margin and return on capital) for Wal-Mart when compared to Sears. Accordingly, the market has reacted to the performance differences between the two companies. 27. February March April Sources of cash Collections on current sales $100 $110 $ 90 Collections on trade receivables 90 100 110 Total sources of cash $190 $210 $200 Uses of cash Payments of trade payables $ 30 $ 40 $ 30 Cash purchases 70 80 60 Labour and administrative expenses 30 30 30 Capital expenditures 100 0 0 Taxes, interest, and dividends 10 10 10 Total uses of cash $240 $160 $130 Net cash inflow (sources – uses) -$50 +$50 +$70 Cash at start of period $100 $ 50 $100 + Net cash inflow - 50 + 50 + 70 = Cash at end of period $ 50 $100 $170 Minimum operating cash balance $100 $100 $100 Cumulative short-term financing required (minimum cash balance $ 50 $ 0 -$70 minus cash at end of period) 28. Ritewell’s cash budget shows that they need to find $50 of financing for February but needs no financing in March and in April will have $70 in surplus cash. Ritewell should arrange for a line of credit from its bank. A line of credit will provide Ritewell with flexible short-term financing. It can draw on the line of credit for the needed funds in February and repay it in March when it needs no short-term financing. In March, Ritewell should invest its surplus cash in short-term securities, such as commercial paper. See Chapter 21 an introduction to short-term, “money market”, securities. 19-14 Solution to Minicase for Chapter 20 Capstan Auto has built up a high level of debt because its policy of granting free credit for six months has resulted in a large investment in working capital, specifically in trade receivables. The firm seems to be using the bank loan as its balancing item, and financing its investment in working capital by borrowing ever greater amounts. The following spreadsheet shows the effect of the firm’s new credit policy, which began in 2011. Receivables in 2011:Q1 equal that quarter’s sales. Thereafter, receivables equal current quarter plus last quarter sales, reflecting the six-month payment lag. The build-up of receivables shows up in the increase in net working capital. The firm receives the cars at the beginning of each quarter and pays for them at the end of the quarter, which results in a match between inventory and payables. Changes in inventory and payables therefore cancel out in each quarter: Inventory at the end of each quarter equals the cost of the goods expected to be sold in the following quarter. Payables also equal this value since the firm pays for the cars imported at the start of the quarter (i.e., put into inventory at the end of the previous quarter) at the end of the current quarter. The need for external finance in each quarter equals the investment in working capital minus the cash from the firm’s operations (net income plus depreciation). The firm’s policy has been to use the bank loan as its sole source of external finance. In each period the bank loan increases by the full amount of required external finance. The spreadsheet shows that by 2012:Q1, the bank loan has grown to $9.731 million. If the firm’s sales level off, then the build-up of working capital also should level off. The spreadsheet confirms this by examining the firm’s cash flows and borrowing assuming that sales level off at 300 units a year. By 2012:Q4, sales have been at 300 for 3 consecutive quarters and as a result receivables have leveled off at $12,000. With no further build-up in working capital, the firm’s required external finance is –$146 (which is simply the negative of cash flow from operations, i.e., net income + depreciation). This cash flow can be used to reduce the bank loan and, therefore, interest expense in 2013:Q1 is a bit lower (interest expense in each quarter = .02 × loan balance at the end of the previous quarter). Therefore, in 2013:Q1, interest expense is a bit lower, the cash flow is a bit higher, and the firm can apply $148 to paying off the bank loan. The firm is not necessarily in trouble. Its rapid build-up of debt reflects an investment in working capital, not negative cash flows from operations. However, by the end of 2012:Q1, the firm’s ratio of debt to (debt + equity) has reached a troublesome level of 9731/(9731 + 2059) = .825. If the economy enters a recession, the firm might find itself overextended and unable to service the debt. In effect, the firm’s payment policy results in a permanent investment in working capital. The firm probably ought to finance this investment with long-term sources of capital. 19-15 While some long-term debt would be appropriate, the need right now is for the firm to contribute some additional equity capital. The bank should insist on additional equity financing before extending the line of credit. 2010: Q3 2010:Q 4 2011:Q 1 2011:Q 2 2011:Q 3 2011:Q 4 2012:Q 1 2012:Q 2 2012:Q 3 2012:Q 4 2013:Q 1 1. Cars sold 250 200 200 225 250 275 300 300 300 300 2. Unit price 20 20 20 20 20 20 20 20 20 20 3. Unit cost 18 18 18 18 18 18 18 18 18 18 4. Revenues 5000 4000 4000 4500 5000 5500 6000 6000 6000 6000 5. COGS 4500 3600 3600 4050 4500 4950 5400 5400 5400 5400 6. Wages 200 150 150 150 150 150 150 150 150 150 7. Depreciation 80 80 80 80 80 80 80 80 80 80 8. EBIT 220 170 170 220 270 320 320 320 320 320 9. Net interest 4 0 76 153 161 178 195 211 218 215 10. Pretax profit 216 170 94 67 109 142 125 109 102 105 11. Taxes 76 60 33 23 38 50 44 38 36 37 12. Net income 140 110 61 44 71 92 81 71 66 68 Working capital Cash 10 10 10 10 10 10 10 10 10 10 10 Receivables 0 0 4000 8000 8500 9500 10500 11500 12000 12000 12000 Inventory 4500 4500 3600 4050 4500 4950 500 5400 5400 5400 0 Payables 4500 4500 3600 4050 4500 4950 5400 5400 5400 5400 0 Net Working Capital 10 10 4010 8010 8510 9510 10510 11510 12010 12010 12010 Change in NWC 0 4000 4000 500 1000 1000 1000 500 0 0 Required external finance** -220 3810 3859 376 849 828 839 349 -146 -148 Bank loan 230 10 3819 7678 8055 8904 9731 10570 10919 10773 10625 * excluding bank loan ** Required external finance = -[net income + depreciation - change in working capital] Note: Sums or differences are subject to rounding error. 19-16 Solution Manual for Fundamentals of Corporate Finance Richard A. Brealey, Stewart C. Myers, Alan J. Marcus, Elizabeth Maynes, Devashis Mitra 9780071320573, 9781259272011