Preparatory Question Set

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1 Preparatory Question Set: Financial Forecasting (Module III) 1. Answer the following questions regarding financial forecasting: a. Which items comprise operating current assets? Why is it reasonable to assume that they grow proportionally to sales or COGS? Which ones are proportional to sales and which ones are proportional to COGS? Explain b. What are some reasons that net PP&E might grow proportionally to sales, and what are some reasons that it might not? c. What are spontaneous liabilities and why is it reasonable to assume they grow at proportion of sales or COGS? What are spontaneous liabilities also known as (in fact, we used this alternate name in previous modules)? What are the most common examples of spontaneous liabilities? 2. Answer the following questions regarding financial forecasting: a. How are operating items projected on financial statements? b. How are preliminary levels of debt, preferred stock, common stock, and dividends projected? c. Suppose COGS is currently 67% of sales and over the next year sales growth by 5% and growth COGS is 3%. Do you predict the COGS as a percent of sales will increase, increase, or remain the same over the next year? Explain and verify your intuition by calculating the COGS be as a percent of sales at year-end? d. What is the financing surplus or deficit in general? How is it calculated? 3. Define the following terms related to financial forecasting? a. Operating plan; financing plan b. Spontaneous liabilities; profit margin; payout ratio c. Additional funds needed (AFN); capital intensity ratio; self-supporting growth rate d. Forecasted financial statement approach using percentage of sales e. Excess capacity; lumpy assets; economies of scale f. Full capacity sales; target fixed assets to sales ratio; required level of fixed assets 4. The following questions relate to the process of financial forecasting a. Generally the maximum time horizon over which we forecast pro forma statements is till one year after a firm matures. What are the characteristics of a firm when it matures? b. Discuss a firm’s operating plan and financing plan as it relates to financial forecasting. c. Describe the process (through at least 3 passes) through which you can forecast next year’s statements? Why are multiple passes needed? In which passes is the information in operating plan and financing plan incorporated? 5. Answer the following questions related to AFN. a. The following equation is sometimes used to forecast funding requirements: AFN= (A0*/S0)( ∆ S) – (L0*/S0)( ∆ S) – MS1(1- POR) What key assumption do we make when using this equation? Under what conditions might this assumption not hold true? What would be the more general formula for AFN? b. Name five key factors that affect a firm’s external financing requirements. Explain how each one affects the requirements?

2 c. What is meant by the term “self-supporting growth rate”? How is this rate related to the AFN equation, and show how this equation be used to calculate the self-supporting growth rate? d. Suppose a firm makes the following policy changes listed. If a change means that external, nonspontaneous financial requirements (AFN) will increase, indicate this by a (+); indicate a decrease by a (−); and indicate no effect or an indeterminate effect by a (0) and explain your reasoning. Think in terms of the immediate effect on funds requirements. i) The dividend payout ratio is increased. ii) The firm decides to pay all suppliers on delivery rather than after a 30-day delay in order to take advantage of discounts for rapid payment. iii) The firm begins to offer credit to its customers, whereas previously all sales had been on a cash basis. iv) The firm’s profit margin is eroded by increased competition, although sales hold steady. v) The firm sells its manufacturing plants for cash to a contractor and simultaneously signs an outsourcing contract to purchase from that contractor goods that the firm formerly produced. vi) The firm negotiates a new contract with its union that lowers its labor costs without affecting its output. 6. Answer the following three questions: a. Suppose the CFO does not want to raise external capital (debt or equity) under any circumstance (including when the firm has great investment opportunities but needs external capital to fund them all). What are the firm’s options? How much can the firm grow (Self-supporting growth rate) if no capital is raised (AFN must equal 0). b. Is it possible that after the first pass Total Assets > Total Liabilities + Total Equity? If so, under what situation? What do you do in this situation? c. Is it possible for an increase in sales to be accompanied by no increase in fixed assets? If so, under what condition can this occur? Can this be sustained in the long-run? d. How would economies of scale and lumpy assets affect financial forecasting? 7. (End-of-chapter numerical problem 9.1-9.3) Broussard Skateboard’s sales are expected to increase by 15% from $8 million in 2013 to $9.2 million in 2014. Its assets totaled $5 million at the end of 2013. Broussard is already at full capacity, so its assets must grow at the same rate as projected sales. At the end of 2013, current liabilities were $1.4 million, consisting of $450,000 of accounts payable, $500,000 of notes payable, and $450,000 of accruals. The after-tax profit margin is forecasted to be 6%, and the forecasted payout ratio is 40%. Answer the following questions. a. Use the AFN equation to forecast Broussard’s additional funds needed for the coming year. b. What would be the additional funds needed if the company’s year-end 2013 assets had been $7 million? Assume that all other numbers, including sales, remain the same. Why is the AFN different in this scenario? Is the company’s “capital intensity” ratio the same or different? c. Return to the assumption that the company had $5 million in assets at the end of 2013, but now assume that the company pays no dividends. Under these assumptions, what would be the additional funds needed for the coming year? Why is this AFN different from the one you found in part a? 8. (Instructor Problem – no solutions) The Henley Corporation is a privately held company specializing in lawn care products and services. You are given data for the most recent fiscal year, 2007.

3 Income Statement for the year ending December 31 (Millions of Dollars) 2007 Net sales $800.0 Operating Costs (except depreciation) 576.0 Depreciation 60.0 Earnings before interest and taxes (EBIT) $164.0 Less interest 32.0 Earnings before taxes $132.0 Taxes (40%) 52.8 Net income available for common stockholders $79.2 Number of shares (in millions) 10 Balance Sheet for December 31 (Millions of Dollars) 2007 2007 Assets Liabilities and Equity Cash $8.0 Accounts payable $16.0 Marketable securities 20.0 Notes payable 40.0 Accounts receivable 80.0 Accruals 40.0 Inventories 160.0 Total current liabilities $96.0 Total current assets 268.0 Long-term bonds 315.0 Net Property, Plant and equipment 600.0 Further, the ratios and selected information for the current and 2008 (next fiscal year) are shown below. Actual Projected 2007 2008 Sales growth rate 15% Operating Costs/Sales 72% 60% Depreciation/Net PPE 10 10 Cash/Sales 1 1 Accounts Receivable/Sales 10 10 Inventories/Sales 20 20 Net PPE/Sales 75 75 Accounts payable/Sales 2 2 Accruals/Sales 5 5 Tax rate 40 40 Using this data, answer the following questions: a. If percent of sales method is used to forecast financial statements, which line items can be expected to grow approximately with the sales, and which ones are not? b. Using the percent of sales method, forecast the external financing needs for 2008 (ignore, how financing is raised) c. A firm's additional funds needed (AFN) must come from external sources. What are the typical external sources?

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4 9. (End-of-chapter numerical problem 9.6) The Booth Company’s sales are forecasted to double from $1,000 in 2013 to $2,000 in 2014. Below is the December 31, 2013 balance sheet: Cash $100 Accounts payable $50 Accounts receivable 200 Notes payable 150 Inventories 200 Accruals 50 Net fixed assets 500 Long-term debt 400 Common stock 100 Retained earnings 250 Total assets $1,000 Total liabilities $1,000 Booth’s fixed assets were used to only 50% of capacity during 2013, but its current assets were at their proper levels in relation to sales. All assets except fixed assets must increase at the same rate as sales, and fixed assets would also have to increase at the same rate if the current excess capacity did not exist. Booth’s after-tax profit margin is forecasted to be 5% and its payout ratio to be 60%. What is Booth’s additional funds needed (AFN) for the coming year? 10. (End-of-chapter numerical problem 9.7) Upton Computers makes bulk purchases of small computers, stocks them in conveniently located warehouses, ships them to its chain of retail stores, and has a staff to advise customers and help them set up their new computers. Upton’s balance sheet as of December 31, 2018, is shown here (millions of dollars): Cash $ 3.5 Accounts payable $ 9.0 Receivables 26.0 Notes payable 18.0 Inventories 58.0 Line of credit 0 Total current assets $ 87.5 Accruals 8.5 Net fixed assets 35.0 Total current liabilities $ 35.5 Mortgage loan 6.0 Common stock 15.0 Retained earnings 66.0 Total assets $122.5 Total liabilities and equity $122.5 Sales for 2018 were $350 million, and net income for the year was $10.5 million, so the firm’s profit margin was 3.0%. Upton paid dividends of $4.2 million to common stockholders, so its payout ratio was 40%. Its tax rate was 40%, and it operated at full capacity. Assume that all assets/sales ratios, (spontaneous liabilities)/sales ratios, the profit margin, and the payout ratio remain constant in 2019. a. If sales are projected to increase by $70 million, or 20%, during 2019, use the AFN equation to determine Upton’s projected external capital requirements. b. Using the AFN equation, determine Upton’s self-supporting growth rate. That is, what is the maximum growth rate the firm can achieve without having to employ nonspontaneous external funds? c. Use the forecasted financial statement method to forecast Upton’s balance sheet for December 31, 2019. Assume that all additional external capital is raised as a line of credit at the end of the year and is reflected (because the debt is added at the end of the year, there will be no additional interest expense due to the new debt). Assume Upton’s profit margin and dividend payout ratio will be the same in 2019 as they were in 2018. What is the amount of the line of credit reported on the 2019 forecasted balance sheets? ( Hint: You don’t need to forecast the income statements because the line of credit is taken out on the last day of the year and you are given the projected sales, profit margin, and dividend payout ratio; these figures allow you to calculate the 2019 addition to retained earnings for the balance sheet without actually constructing a full income statement.)

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