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PROBLEMS Planning Assumptions – Example 4.1 (page 135) 1. The Lineberry Golf Cart Co. sold 7,400 carts this year at an average unit price of $3,000. 50 days of sales remained uncollected in accounts receivable at the end of the year. The firm produced the carts at a 42% cost ratio (COGS/Revenue) and had three months of inventory on hand at year end (3/12 of the year’s COGS). The golf business is booming and management plans a 10% increase in unit sales despite a 5% price increase. The firm has programs in place to improve production efficiency, inventory management, and the effectiveness of collections efforts. It is assumed that these programs will decrease the cost ratio to 40%, lower year end inventory to 2 months, and lower year end receivables to 40 days of sales. Compute Lineberry’s revenue, COGS (cost of goods sold) and gross margin as well as ending receivables and inventory for this year and next year’s plan. Calculate using a 360 day year and assume sales are evenly distributed over the year. SOLUTION: This Year Next Year’s Plan Units 7,400 7,400 x 1.1 = 8,140 Price x $3,000 $3,000 x 1.05 = x $3,150 Units x Price = Revenue Revenue = $22,200,000 $25,641,000 Revenue x Cost Ratio = COGS Cost ratio x.42 x .40 COGS $9,324,000 $10,256,400 Revenue – COGS = Gross Margin Gross Margin $12,876,000 $15,384,600 (Days sales in A/R ÷ 360) x Revenue = A/R A/R (50/360) x $22,200,000 = $3,083,333 (40/360) x $25,641,000 = $2,849,000 (Months Cost in INV / 12) x COGS = Inventory COGS (3/12) x $9,324,000 = $2,331,000 (2/12) x $10,256,400 = $1,709,400 The Debt/Interest Planning Problem – Example 4.2 (page 137) 2. The Cambridge Cartage Company has partially completed its forecast of next year's financial statements as follows. FINANCIAL PLAN CAMBRIDGE CARTAGE COMPANY ($000) INCOME STATEMENT BALANCE SHEET NEXT YEAR NEXT YEAR Beginning Ending Rev $17,220 ASSETS Cost/Exp 14,120 Total Assets $12,540 $18,330 EBIT $ 3,100 LIABILITIES & EQUITY Interest ? Current Liabs $ 410 $ 680 EBT ? Debt $ 5,630 ? Tax ? Equity $ 6,500 ?__ EAT ? Total L&E $12,540 $18,330 The firm pays interest at 10% on all borrowings and pays a combined state and federal tax rate of 40%. Complete the forecasted income statement and balance sheet. Begin by guessing at interest expense as 10% of beginning debt. SOLUTION: The iterative procedure results in the following: EBIT $ 3,100 LIABILITIES & EQUITY Interest $ 769 Current Liabs $ 410 $ 680 EBT $ 2,331 Debt $ 5,630 $ 9,751 Tax $ 932 Equity $ 6,500 $ 7,899 EAT $ 1,399 Total L&E $12,540 $18,330 3. Lap Dogs Inc. is planning for next year and has the following summarized results so far ($000): Income Statement EBIT 236 Interest ? EBT ? Income Tax ? EAT ? Balance Sheet This Year Next Year Assets 582 745 Current Liabilities 63 80 Debt 275 ? Equity 244 ? Total Liab & Equity 582 745 The firm pays interest of 12% on all borrowing and is subject to an overall tax rate of 38%. It paid interest of $20,000 this year and plans a $75,000 dividend next year. Complete Lap Dog’s forecast of next year’s financial statements. Round all calculations to the nearest $1,000. Solution: Using this year’s interest as a first guess at next year’s and completing the financial statements yields the following: Income Statement EBIT 236 Interest 20 EBT 216 Income Tax 82 EAT 134 Balance Sheet This Year Next Year Assets 582 745 Current Liabilities 63 80 Debt 275 362 Equity 244 303 Total Liab & Equity 582 745 Check to see if the calculated average debt implies the interest guess [(275 + 362) / 2] × .12 = 38 Since $38,000 is not close to the $20,000 guess, substitute $38,000 and iterate again as follows: Income Statement EBIT 236 Interest 38 EBT 198 Income Tax 75 EAT 123 Balance Sheet This Year Next Year Assets 582 745 Current Liabilities 63 80 Debt 275 373 Equity 244 292 Total Liab & Equity 582 745 Check the new debt figures against the second guess at interest: [(275 + 373) / 2] × .12 = 39 The result is within $1,000 of the $38,000 second guess which is satisfactory for planning purposes. 4. The Libris Publishing Company had revenues of $200 million this year and expects a 50% growth to $300 million next year. Costs and expenses other than interest are forecast at $250 million. The firm currently has assets of $280 million and current liabilities of $40 million. Its debt to equity ratio is 3:1. (I.e., capital is 75% debt and 25% equity.) It pays 12% interest on all of its debt, and is subject to federal and state income taxes at a total effective rate of 39%. Libris expects assets and current liabilities to grow at 40%, 10% less than the revenue growth rate. The company plans to pay dividends of $10 million next year. a. What is the planned debt to equity ratio at the end of next year? b. Do these results indicate a problem? SOLUTION: a. This is a slightly disguised version of the debt interest problem. Next year’s EBIT is $300 $250 = $50. Beginning capital (debt+equity) is $280 $40 = $240, which split 3:1 gives debt of $180 and equity of $60. Next year’s total assets are $280 1.4 = $392, while current liabilities are $40 1.4 = $ 56. Capital is $392 $56 = $336. This sets up the debt-interest iteration problem. The result after two iterations is shown below. Notice that Ending Equity = Beginning Equity + Net Income – Dividends. Income Statement Balance Sheet Beginning Ending Revenue $300 Assets $280 $392 Cost/Exp 250 EBIT $ 50 Liabilities Interest 27 Current $ 40 $ 56 EBT $ 23 Debt 180 272 Tax 9 Equity 60 64 EAT $ 14 $280 $392 The ending debt equity mix is Debt $272 81% Equity 64 19% Capital $336 100% And Debt : Equity is 4.25 : 1 b. Libris may have a problem with this plan. The company’s debt level is dangerously high now, and is forecast to go higher in the next year. The firm is borrowing to fund asset growth while paying most of current earnings out in dividends. Lenders are quite likely to resist advancing more funds under those conditions. Plans with Simple Assumptions – Example 4.3 (page 140) 5. The management of Coker Corp is doing a quick forecast of 20X9 using the modified percentage of sales method in preparation for a more detailed planning exercise later in the month. The estimate is to assume a 10% growth in sales. All other line items are to be assumed to grow at the same rate except for fixed assets which is projected to increase by $88,000 due to an expansion program already underway. Approximate financial statements for the current year, 20X8, and a planning worksheet are shown below. The firm pays 9% interest on all of its debt. Assume the tax rate is a flat 25%. There are no plans for dividends or the sale of additional stock next year. Make a forecast of Coker's complete income statement and balance sheet. Work to the nearest thousand dollars. (Hints: The easiest way to grow a number by 10% is to multiply it by 1.1 rather than taking 10% and adding. Do not grow subtotals. For example grow Revenue and COGS by 10% rounding each to the nearest thousand and subtract for Gross Margin. Don’t grow interest, debt or equity, use the debt/interest iterative technique.) COKER CORP CURRENT AND PROJECTED INCOME STATEMENTS ($000) 20X8 20X9 Revenue $642 COGS 289 Gross Margin $353 Expenses $240 EBIT $113 Interest (9%) 33 EBT $ 80 Inc Tax (25%) $ 25 EAT $ 55 COKER CORP CURRENT AND PROJECTED BALANCE SHEETS ($000) ASSETS LIABILITIES& EQUITY 20X8 20X9 20X8 20X9 C/A $198 C/L $ 87 F/A 552 Debt 325 Total $750 Equity 338 Total $750 SOLUTION: Applying management's assumptions and iterating for interest and debt yields the following: COKER CORP CURRENT AND PROJECTED INCOME STATEMENTS ($000) 20X8 20X9 Revenue $642 $706 COGS 289 318 Gross Margin $353 $388 Expenses $240 $264 EBIT $113 $124 Interest (9%) 33 30 EBT $ 80 $ 94 Inc Tax (25%) $ 25 24 EAT $ 55 $ 70 COKER CORP CURRENT AND PROJECTED BALANCE SHEETS ($000) ASSETS LIABILITIES& EQUITY 20X8 20X9 20X8 20X9 C/A $198 $218 C/L $ 87 $ 96 F/A 552 640 Debt 325 354 Total $750 $858 Equity 338 408 Total $750 $858 6. Larime Corp is forecasting 20X2 near the end of 20X1. The estimated year end financial statements and a worksheet for the forecasts are shown below. LARIME CORP PROJECTED INCOME STATEMENT ($000) 20X1 20X2 $%$% Revenue $245,622 100.0 100.0 COGS $142,461 58.0 Gross Margin $103,161 42.0 Expenses $ 49,124 20.0 EBIT $ 54,037 22.0 Interest (12%) $ 9,642 3.9 EBT $ 44,395 18.1 Inc Tax (43%) $ 19,090 7.8 EAT $ 25,305 10.3 LARIME CORP PROJECTED BALANCE SHEET ($000) ASSETS LIABILITIES& EQUITY 20X1 20X2 20X1 20X2 C/A $178,106 C/L $ 85,700 F/A $142,128 Debt $ 78,178 Total $320,234 Equity $156,356 Total $320,234 Management expects the following next year: An 8% increase in revenue. Price cutting will cause the cost ratio (COGS/Sales) to deteriorate (increase) by 1% of sales from its current level. Expenses will increase at a rate that is three quarters of that of sales. C/A and C/L will increase proportionately with sales. Net fixed assets will increase by $5 million. All interest will be paid at 12%. Federal and state income taxes will be paid at a combined rate of 43%. Make a forecast of Larime's complete income statement and balance sheet. Work to the nearest thousand dollars. SOLUTION: Applying management's assumptions and iterating for interest and debt yields the following: LARIME CORP PROJECTED INCOME STATEMENT ($000) 20X1 20X2 $%$% Revenue $245,622 100.0 $265,272 100.0 COGS $142,461 58.0 $156,510 59.0 Gross Margin $103,161 42.0 $108,762 41.0 Expenses $ 49,124 20.0 $ 52,071 19.6 EBIT $ 54,037 22.0 $ 56,691 21.4 Interest (12%) $ 9,642 3.9 $ 8,476 3.2 EBT $ 44,395 18.1 $ 48,215 18.2 Inc Tax (43%) $ 19,090 7.8 $ 20,732 7.8 EAT $ 25,305 10.3 $ 27,483 10.4 LARIME CORP PROJECTED BALANCE SHEET ($000) ASSETS LIABILITIES& EQUITY 20X1 20X2 20X1 20X2 C/A $178,106 $192,354 C/L $ 85,700 $ 92,556 F/A $142,128 $147,128 Debt $ 78,178 $ 63,087 Total $320,234 $339,482 Equity $156,356 $183,839 Total $320,234 $339,482 7. The Eagle Feather Fabric Company expects to complete the current year with the following financial results ($000). INCOME STATEMENT BALANCE SHEET Revenue $36,100 Assets COGS 14,440 Cash $ 1,000 A/R 5,000 GM $21,660 Inventory 2,888 Expenses 12,635 Curr Assets $ 8,888 EBIT $ 9,025 Net F/A $ 7,250 Int (11%) $ 625 Total Assets $16,138 EBT $ 8,400 Tax (42%) $ 3,528 Liabilities & Equity EAT $ 4,872 Accts Payable $ 1,550 Accruals 530 C/L $ 2,080 Debt $ 5,598 Equity $ 8,460 Total L&E $16,138 Forecast next year using a modified percentage of sales method assuming no dividends are paid and no new stock is sold along with the following. (Note that negative debt in a forecast means the business will generate more cash than is currently owed.) a. a 20% growth in sales and a 40% growth in net fixed assets. b. A 15% growth in sales with a 10% growth in expenses and a 20% growth in net fixed assets. (Negative debt means the business will generate more cash than is currently owed.) SOLUTION: INCOME STATEMENT Current Year a b Revenue $36,100 $43,320 $41,515 COGS 14,440 17,328 16,606 GM $21,660 $25,992 $24,909 Expenses 12,635 15,162 13,899 EBIT $ 9,025 $10,830 $11,010 Interest (11%) $ 625 521 414 EBT $ 8,400 $10,309 $10,596 Tax (42%) $ 3,528 4,330 4,450 EAT $ 4,872 $ 5,979 $ 6,146 BALANCE SHEET ASSETS Cash $ 1,000 $ 1,200 $ 1,150 A/R 5,000 $ 6,000 $ 5,750 Inventory 2,888 $ 3,466 $ 3,321 Current Assets $ 8,888 $10,666 $10,221 Net F/A $ 7,250 $10,150 $ 8,700 Total Assets $16,138 $20,816 $18,921 LIABILITIES& EQUITY Accts Payable $ 1,550 $ 1,860 $ 1,783 Accruals $ 530 $ 636 $ 609 C/L $ 2,080 $ 2,496 $ 2,392 Debt $ 5,598 $ 3,881 $ 1,923 Equity $ 8,460 $14,439 $14,606 Total L&E $16,138 $20,816 $18,921 External Funding Requirement (EFR) – Example 4.4 (page 145) 8. Fleming, Inc. had a dividend payout ratio of 25% this year that resulted in a payout of $80,000 in dividends. Return on sales (ROS) was 8% this year and is expected to increase to 9% next year. If Fleming expects to have $305,100 available from next year’s retained earnings, what percent increase are they forecasting in revenues? SOLUTION: This year’s EAT = $80,000/.25 = $320,000 This year’s revenues = $320,000/.08 = $4,000,000 Next year’s EAT = $305,100/.75 = $406,800 Next year’s revenue = $406,800/.09 = $4,520,000 % Increase in revenue = (4.52 – 4.0)/4.0 = 13% 9. The Dalmation Corporation expects the following summarized financial results this year ($000) INCOME STATEMENT BALANCE SHEET Revenue $10,500 Assets Cost/Exp. 9,100 Curr Assets $ 5,500 Tax $ 560 Net F/A $ 6,900 EAT $ 840 Total Assets $12,400 Dividends $ 420 Liabilities& Equity Current $ 320 Debt $ 5,080 Equity $ 7,000 Total L&E $12,400 Use the EFR relation to estimate Dalmation's external funding requirements under the following conditions. a. Sales growth of 15%. b. Sales growth of 20% and a reduction in the payout ratio to 25%. c. Sales growth of 25%, elimination of dividends, and a 4% improvement in ROS to 12%. SOLUTION: a. EBT = $10,500 $9,100 = $1,400 Tax rate = $560/$1,400 = 40% ROS = $840/$10,500 = 8% EFR = g(ASSETS) g(C/L) (1-d)ROS(1+g)SALES a. EFR = .15($12,400) .15($320) (1.5)(.08)(1.15)($10,500) = $1,860 $48 $483 = $1,329 b. EFR = .20($12,400) .20($320) (1.25)(.08)(1.20)($10,500) = $2,480 $64 $756 = $1,660 c. EFR = .25($12,400) .25($320) (1)(.12)(1.25)($10,500) = $3,100 $80 $1,575 = $1,445 10. Lytle Trucking projects a $3.2 million EBIT next year. The firm’s marginal tax rate is 40%, and it currently has $8 million in long-term debt with an average coupon rate of 8%. Management is projecting a requirement for additional assets costing $1.5 million and no change in current liabilities. They plan to maintain a 30% dividend payout ratio. Any additional borrowing required to fund next year’s asset growth will carry a 7% coupon rate. Lytle does not plan to issue additional stock next year. Use the EFR concept rather than the EFR equation to develop an algebraic formula of your own to compute the additional debt needed to support a asset growth of $1.5 million. (Hint: Start with the idea that additional debt = new assets – internally generated funds.Then write an algebraic expression for internally generated funds based on the income statement from EBIT to EAT and the dividend payout ratio.) SOLUTION: Let D = old debt AD = additional debt NA = new assets RE = retained earnings = internally generated funds T = tax rate d = dividend payout ratio I = interest = .08D + .07AD In general EAT = EBT(1-T) EBT = EBIT – I RE = EAT(1-d) Substituting gives EAT = [EBIT – (.08D + .07AD)](1-T) Now write the expression for additional debt AD = NA – RE = NA – EAT(1-d) Substitute for EAT AD = NA –[EBIT – (.08D + .07AD)](1-T)(1-d) Substitute values ($M) from the problem AD = 1.5 – [3.2 – (.08(8) + .07AD)](1-.4)(1-.3) From which AD = .437667 = $437,667 Sustainable Growth Rate – Example 4.5 (page 147) 11. The Bubar Building Co. has the following current financial results ($000). Revenue $45,000 Assets $37,500 EAT $ 3,600 Equity $28,580 Dividends $ 1,800 On the average, other building companies pay about one quarter of their earnings in dividends, earn about six cents on the sales dollar, carry assets worth about six months of sales, and finance one third of their assets with debt. Use the sustainable growth rate concept to analyze Bubar's inherent ability to grow without selling new equity versus that of an average building company. Identify weak areas and suggest further analyses. SOLUTION: gs = (1-d) ROS T/A Equity ______ Turnover Multiplier Bubar 6.24% = .5 8% 1.2 1.3 Industry 13.5% = .75 6% 2.0 1.5 Bubar's problems are its payout ratio and its asset utilization. The firm can't grow rapidly without some equity capital, and it's paying most of its earnings out in dividends. It also seems to be using its assets inefficiently. Management should check out old A/R, dead inventory, and fixed assets that aren't being used. 12. Broxholme Industries has sales of $40 million, equity totaling $27.5 million and an ROS of 12%. The sustainable growth rate has been calculated at 10.9%. What dividend payout ratio was assumed in this calculation? SOLUTION: ($M) ROS = EAT / Sales From which EAT = Sales (ROS) = $40(.12) = $4.8 Write the sustainable growth formula gS = EAT(1-d) / equity Substituting for EAT and equity yields .109 = $4.8(1–d)]/$27.5 from which d = .375 = 37.5%