financial planning, instructor's manual - leeds school of...

Chapter 12( 14th ed.)Corporate Valuation and Financial Planning

ANSWERS TO MINI CASE

Hatfield Medical Supplies’s stock price had been lagging its industry averages, so its board of directors brought in a new CEO, Jaiden Lee. Lee had brought in Ashley Novak, a finance MBA who had been working for a consulting company, to replace the old CFO, and Lee asked Ashley to develop the financial planning section of the strategic plan. In her previous job, Novak’s primary task had been to help clients develop financial forecasts, and that was one reason Lee hired her.

Novak began as she always did, by comparing Hatfield’s financial ratios to the industry averages. If any ratio was substandard, she discussed it with the responsible manager to see what could be done to improve the situation. The following data shows Hatfield’s latest financial statements plus some ratios and other data that Novak plans to use in her analysis.

Hatfield Medical Supplies (Millions of Dollars Except Per Share Data)Balance Sheet, 12/31/2013 Income Statement, Year Ending 2013Cash $ 20 Sales $2,000Accts. rec. 280 Op. costs (excl. depr.) 1,800Inventories 400 Depreciation 50Total CA $ 700 EBIT $ 150Net fixed assets 500 Interest 40Total assets $1,200 Pretax earnings $ 110

Taxes (40%) 44Accts. pay. & accruals $ 80 Net income $ 66Line of credit $0Total CL $ 80 Dividends $20.0Long-term debt 500 Add. to RE $46.0Total liabilities $ 580 Common shares 10.0Common stock 420 EPS $6.60Retained earnings 200 DPS $2.00 Total common equ. $620 Ending stock price $52.80Total liab. & equity $1,200

Mini Case: 12 - 1© 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Selected Additional Data for 2013Hatfield Industry Hatfield Industry

Op. costs/Sales 90.0% 88.0% Total liability/Total assets 48.3% 36.7%Depr./FA 10.0% 12.0% Times interest earned 3.8 8.9Cash/Sales 1.0% 1.0% Return on assets (ROA) 5.5% 10.2%Receivables/Sales 14.0% 11.0% Profit margin (M) 3.30% 4.99%Inventories/Sales 20.0% 15.0% Sales/Assets 1.67 2.04Fixed assets/Sales 25.0% 22.0% Assets/Equity 1.94 1.56Acc. pay. & accr. / Sales 4.0% 4.0% Return on equity (ROE) 10.6% 16.1%Tax rate 40.0% 40.0% P/E ratio 8.0 16.0ROIC 8.0% 12.5%NOPAT/Sales 4.5% 5.6%Total op. capital/Sales 56.0% 45.0%

Note: Hatfield was operating at full capacity in 2013. Also, you may observe small differences in items like the ROE when calculated in different ways. Any such differences are due to rounding, and they can be ignored.


a. Using Hatfield’s data and its industry averages, how well run would you say Hatfield appears to be in comparison with other firms in its industry? What are its primary strengths and weaknesses? Be specific in your answer, and point to various ratios that support your position. Also, use the Du Pont equation (see Chapter 3) as one part of your analysis.

Answer: The Du Pont equation shows the relationship among asset management, profitability ratios, and leverage. By examining this equation we can determine where Hatfield falls short of the industry.

ROEHatfield = Profit margin × Asset turnover × Equity multiplier= 3.30% × 1.67 × 1.94= 10.6%.

ROEIndustry = Profit margin × Asset turnover × Equity multiplier= 4.99% × 2.04 × 1.56= 16.1

From the Du Pont equation, you can see that Hatfield’s profitability and asset management ratios are lower than the industry average and its leverage is higher than the industry average. The combined effect results in a much lower return on equity for the firm relative to the industry average. If you study the asset management ratios in detail, you will see that the firm’s receivables and industry turnovers are lower than the industry average. Sales are too low for the current assets held, the firm may be holding receivables that are uncollectible, or the firm may be holding inventory that is obsolete. The firm’s debt ratio is higher than the industry average. A direct result of this is a higher interest rate, which increases the firm’s interest expense. As a result, the firm’s times interest earned ratio is lower than the industry average.


b. Use the AFN equation to estimate Hatfield’s required new external capital for 2014 if the sale growth rate is 10%. Assume that the firm’s 2013 ratios will remain the same in 2014. (Hint: Hatfield was operating at full capacity in 2013.)

Answer:

Here is the AFN equation:

AFN = (A0*/S0)∆S – (L0*/S0)∆S – M(S1)(1 – Payout)

= (0.60)($200) – (0.04)($200) – (3.30)($2,200)

(1−0.303)= $120 – $8 – $50.6 = $61.4 million.

c. Define the term capital intensity. Explain how a decline in capital intensity would affect the AFN, other things held constant. Would economies of scale combined with rapid growth affect capital intensity, other things held constant? Also, explain how changes in each of the following would affect AFN, holding other things constant: the growth rate, the amount of accounts payable, the profit margin, and the payout ratio.

Answer: The capital intensity ratio is the amount of assets required per dollar of sales, A0*/S0, and it has a major effect on capital requirements. A decline in the capital intensity ratio would lower the need for external capital as this would mean a smaller amount of assets would be required per dollar of sales. Economies of scale combined with rapid growth would mean that it is likely that the capital intensity ratio would change over time as the size of the firm increased.

Rapidly growing companies require large increases in assets and a corresponding large amount of external financing, other things held constant. Accounts payable are spontaneous liabilities that come about due to normal day-to-day business operations. Firms don’t have a lot of control over the level of spontaneous liabilities as they’re a function of industry norm and tax laws. The higher the firm’s level of accounts payable (spontaneous liabilities) the smaller the amount of external financing, other things held constant. The higher the profit margin, the larger the net income available to support increases in assets, hence the less the need for external financing, other things held constant. The less of its income a company distributes as dividends, the larger its addition to retained earnings, hence the smaller the need for external capital—other things held constant.


Data for AFN MethodGrowth rate in sales (g) 10%Sales (S0) $2,000Forecasted sales (S1) $2,200Increase in sales (ΔS = gS0) $200Profit margin (M) 3.30%Assets/Sales (A0*/S0) 60.0%Payout ratio (POR) 30.3%Spont. Liab./Sales (L0*/S0) 4.0%

d. Define the term self-supporting growth rate. What is Hatfield’s self-supporting growth rate? Would the self-supporting growth rate be affected by a change in the capital intensity ratio or the other factors mentioned in the previous question? Other things held constant, would the calculated capital intensity ratio change over time if the company were growing and were also subject to economies of scale and/or lumpy assets?

Answer: The self-supporting growth rate is the maximum growth rate the firm could achieve if it had no access to external capital. From the data given, Hatfield’s self-supporting growth rate is calculated as:

Self-supporting g = [M(1 – POR)(S0)]/[A0* – L0* – M(1 – POR)(S0)]

M = 3.30%POR = 30.3%

1-POR = 69.7%S0 = $2,000

A* = $1,200L* = $80

Self-supporting g = [M(1 – POR)(S0)]/[A0* – L0* – M(1 – POR)(S0)]= [(0.033)(0.697)($2,000)]/[$1,200 – $800 – 0.033(0.697)($2,000)]= $46/$1,074= 0.0428 = 4.28%.

The higher the firm’s capital intensity ratio, the lower the firm’s self-supporting growth rate because the firm would require more assets per dollar of sales. The higher the firm’s profit margin and the lower its payout ratio, the higher the firm’s self-supporting growth rate.

The calculated capital intensity ratio will change over time if the firm company is expanding and if economies of scale and lumpy assets exist. When economies occur, the capital intensity ratio will change over time as the size of the firm increases. In many industries, technological considerations dictate that if a firm is to be competitive, it must add fixed assets in large, discrete units. These assets are referred to as lumpy assets. When this occurs the firm’s capital intensity ratio will change. So, at the point where the assets must increase in a large amount, the capital intensity ratio will be high, so required external financing will be high. As sales increase but assets don’t need to increase, the capital intensity ratio will fall—until sales reach the point where large increases in assets are required again.


e. Use the following assumptions to answer the questions below: (1) Operating ratios remain unchanged. (2) Sales will grow by 10%, 8%, 5%, and 5% for the next four years. (3) The target weighted average cost of capital (WACC) is 9%. This is the No Change scenario because operations remain unchanged.

Actual ForecastInputs 2013 2014 2015 2016 2017Sales growth rate: 10% 8% 5% 5%Op. costs/Sales: 90% 90% 90% 90% 90%Depr./FA 10% 10% 10% 10% 10%Cash/Sales: 1% 1% 1% 1% 1%Acct. rec. /Sales 14% 14% 14% 14% 14%Inv./Sales: 20% 20% 20% 20% 20%FA/Sales: 25% 25% 25% 25% 25%AP & accr. / Sales: 4% 4% 4% 4% 4%Tax rate: 40% 40% 40% 40% 40%Rate on all debt 8.0% 8% 8% 8%Div. growth rate: 5% 10% 10% 10% 10%Target WACC 9%

e. 1. For each of the next four years, forecast the following items: sales, cash, accounts receivable, inventories, net fixed assets, accounts payable & accruals, operating costs (excluding depreciation), depreciation, and earnings before interest and taxes (EBIT).

Forecast sales as Salest = Salest-1(1+gt). For example, Sales2014 = $2,000(1+0.10) = $2,200.

Forecast other items as a percent of sales (or as percent of fixed assets for depreciation). For example, Inventories2014 = $2,200(0.20) = $44


Scenario: No Change Actual Forecast2013 2014 2015 2016 2017

Net sales $2,000 $2,200 $2,376 $2,495 $2,620Cash $20 $22 $24 $25 $26Accounts receivable $280 $308 $333 $349 $367Inventories $400 $440 $475 $499 $524Net fixed assets $500 $550 $594 $624 $655Accts. pay. & accruals $80 $88 $95 $100 $105Op. costs (excl. depr.) $1,800 $1,980 $2,138 $2,245 $2,358Depreciation $50 $55 $59 $62 $65

EBIT $150 $165 $178 $187 $196

e. 2. Using the previously forecasted items, calculate for each of the next four years the net operating profit after taxes (NOPAT), net operating working capital, total operating capital, free cash flow, (FCF), annual growth rate in FCF, and return on invested capital. What does the forecasted free cash flow in the first year imply about the need for external financing? Compare the forecasted ROIC compare with the WACC. What does this imply about how well the company is performing?

NOPAT = EBIT(1-T)NOWC = (Cash + accounts receivable + inventories) − (Accounts payable & accruals)Total operating capital = NOWC + Net fixed assetsFCF = NOPAT − Change in total operating capitalROIC = NOPAT/Total operating capital

Scenario: Actual ForecastNo Change 2013 2014 2015 2016 2017

NOPAT $90 $99 $107 $112 $118NOWC $620 $682 $737 $773 $812Total op. capital $1,120 $1,232 $1,331 $1,397 $1,467FCF −$13 $8 $46 $48Growth in FCF -164% 447.1% 5.0%ROIC 8.0% 8.0% 8.0% 8.0% 8.0%


e. 3. Assume that FCF will continue to grow at the growth rate for the last year in the forecast horizon (Hint: 5%). What is the horizon value at 2017? What is the present value of the horizon value? What is the present value of the forecasted FCF? (Hint: use the free cash flows for 2014 through 2017). What is the current value of operations? Using information from the 2013 financial statements, what is the current estimated intrinsic stock price?

With no rounding in intermediate steps, FCF2017 = $48.025.

HV 2017=FCF2017(1+gL)(WACC−gL)

=$ 48.025(1+0.05)

(0.09−0.05)=$ 1,261

Scenario:No ChangeHorizon Value: Value of operations $958

+ ST investments $0

=$1,26

1 Estimated total intrinsic value $958− All debt $500

Value of Operations: − Preferred stock $0Present value of HV $893 Estimated intrinsic value of equity $458

+ Present value of FCF $64 ÷ Number of shares 10

Value of operations = $958 Estimated intrinsic stock price = $45.75

The estimated intrinsic stock value of $45.75 is less than the actual market price of $52.80. The market price indicates that the market expected the operating performance to improve; if operating performance doesn’t improve, the market price is likely to drop. But keep in mind that stocks prices are very volatile, so a difference of −13% = $45.75/$52.80 – 1 is not very big.



f. Continue with the same assumptions for the No Change scenario from the previous question, but now forecast the balance sheet and income statements for 2014 (but not for the following three years) using the following preliminary financial policy. (1) Regular dividends will grow by 10%. (2) No additional long-term debt or common stock will be issued. (3) The interest rate on all debt is 8%. (4) Interest expense for long-term debt is based on the average balance during the year. (5) If the operating results and the preliminary financing plan cause a financing deficit, eliminate the deficit by drawing on a line of credit. The line of credit would be tapped on the last day of the year, so it would create no additional interest expenses for that year. (6) If there is a financing surplus, eliminate it by paying a special dividend. After forecasting the 2014 financial statements, answer the following questions.

f. 1. How much will Hatfield need to draw on the line of credit?

Answer: Forecast sales and then items on the balance sheet. The forecast of sales is $2,200. Forecast the operating items as a percent of sales. The preliminary financial policy specifies no change in the long-term debt or common stock. Retained earnings increase by the addition to retained earnings from the forecasted income statement. Leave the line of credit blank for now.

Assets 2013 Input Basis for 2014 Forecast 2014Cash $20 1% × 2014 Sales $22Accts. rec. $280 14% × 2014 Sales $308Inventories $400 20% × 2014 Sales $440Total CA $700 $770Net fixed assets $500 25% × 2014 Sales $550Total assets $1,200 $1,320Liabilities and equityAccts. pay. & accruals $80 4% × 2014 Sales $88Line of credit $0 Add LOC if fin. deficitTotal CL $80 $88Long-term debt $500 No Change $500Total liabilities $580 $588Common stock $420 No Change $420Retained earnings $200 Old RE + Add. to RE $253Total common equity $620 $673Total liabs. & equity $1,200 $1,261

Check: TA − TL & Equ. $59


Forecast the items on the income statement. Costs are a percent of sales, depreciation is a percent of Net PP&E. Forecast interest expense on the long-term debt as the product of the interest rate and the average balance on the long-term debt (i.e., the average of the beginning value and the ending value). Pay a regular dividend. Leave the special dividend blank for now.

2013 Input Basis for 2014 Forecast 2014

Sales $2,000 110% × 2013 Sales$2,20

0

Op. costs (excl. depr.) $1,800 90% × 2014 Sales$1,98

0Depreciation $50 10% × 2014 Net PP&E $55

EBIT $150 $165Less: Interest on LTD $40 8% × Avg bonds $40 Interest on LOC $0 8% × Beginning LOC $0

Pretax earnings $110 $125Taxes (40%) $44 40% × Pretax earnings $50

Net income $66 $75Regular common dividends $20 110% × 2013 Dividend $22Special dividends $0 Pay if financing surplusAddition to RE $46 Net income – Dividends $53

The next step is to identify the financing surplus or deficit. Start with the additions to operating assets, subtract the increase in spontaneous liabilities (accounts payable and accruals), subtract any new external financing from long-term debt or common stock, and subtract the amount of reinvested net income (the amount that is not paid out in common dividends). The result is the financing deficit (if it is negative) or the financing surplus (if it is positive). If there is a deficit, draw on the LOC. If there is a surplus, pay a special dividend.

Increase in spontaneous liabilities (accounts payable and accruals) $8+ Increase in long-term debt and common stock $0+ Net income minus regular common dividends $53

Increase in financing $61− Increase in total assets $120Amount of deficit or surplus financing: −$59

If deficit in financing (negative), draw on line of credit $59If surplus in financing (positive), pay special dividend $0


There is a deficit of $59, so update the balance sheets by adding $59 to the line of credit. Because the LOC is added at the end of the year, there is no additional interest, so there is no need to update the income statement. If the LOC were instead added earlier in the year, there would be additional interest, which would cause lower net income, which would cause a lower addition to retained earnings, which would cause a bigger financial deficit. This is called financing feedback. See Ch12 Tool Kit.xls and look at the worksheet CFO Model for a simple way to resolve financing feedback and for an extension of the 1-year forecasted financial statements to multiple years.

Assets 2013 Input Basis for 2014 Forecast 2014Cash $20 1% × 2014 Sales $22Accts. rec. $280 14% × 2014 Sales $308Inventories $400 20% × 2014 Sales $440Total CA $700 $770Net fixed assets $500 25% × 2014 Sales $550Total assets $1,200 $1,320Liabilities and equityAccts. pay. & accruals $80 4% × 2014 Sales $88Line of credit $0 Add LOC if fin. deficit $59Total CL $80 $147Long-term debt $500 No Change $500Total liabilities $580 $647Common stock $420 No Change $420Retained earnings $200 Old RE + Add. to RE $253Total common equity $620 $673Total liabs. & equity $1,200 $1,320



f. 2. What are some alternative ways than those in the preliminary financial policy that Hatfield might choose to eliminate the financing deficit?

Answer: Here are some alternative ways to eliminate the deficit:

Cut dividends.Add long-term debt.Issue common stock.Cut back on growth in operating plan.Improve operating plan.

g. Repeat the analysis performed the previous question but now assume that Hatfield is able to improve the following inputs: (1) reduce operating costs (excluding depreciation)/sales to 89.5% at a cost of $40 million; and (2) reduce inventories/sales to 16% at a cost of $10 million. This is the Improve scenario.

Answer: The impact on the operating plan is shown below:

Scenario: Actual ForecastImprove 2013 2014 2015 2016 2017

NOPAT $90 $106 $114 $120 $126NOWC $620 $594 $642 $674 $707Total op. capital $1,120 $1,144 $1,236 $1,297 $1,362FCF $82 $23 $58 $61Growth in FCF -72% 157.3% 5.0%

ROIC 8.0% 9.2% 9.2% 9.2% 9.2%

Scenario:ImproveHorizon Value: Value of operations $1,314

+ ST investments

$0

=$1,59

8 Estimated total intrinsic value$1,314

− All debt $500

Value of Operations: − Preferred stock $0

Present value of HV$1,13

2 Estimated intrinsic value of equity$814

+ Present value of FCF $182 ÷ Number of shares 10



Value of operations =$1,31

4 Estimated intrinsic stock price = $81.37

The impact on the financial statements is shown below.

Scenario:ImproveAssets 2013 Input Basis for 2014 Forecast 2014Cash $20 1% × 2014 Sales $22Accts. rec. $280 14% × 2014 Sales $308Inventories $400 16% × 2014 Sales $352Total CA $700 $682Net fixed assets $500 25% × 2014 Sales $550Total assets $1,200 $1,232Liabilities and equityAccts. pay. & accruals $80 4% × 2014 Sales $88Line of credit $0 Add LOC if fin. deficit $0Total CL $80 $88Long-term debt $500 No Change $500Total liabilities $580 $588Common stock $420 No Change $420Retained earnings $200 Old RE + Add. to RE $224Total common equity $620 $644Total liabs. & equity $1,200 $1,232


Improve 2013 Input Basis for 2014 Forecast 2014Sales $2,000 110% × 2013 Sales $2,200Op. costs (excl. depr.) $1,800 89.5% × 2014 Sales $1,969Depreciation $50 10% × 2014 Net PP&E $55

EBIT $150 $176Less: Interest on LTD $40 8% × Avg bonds $40 Interest on LOC $0 8% × Beginning LOC $0

Pretax earnings $110 $136Taxes (40%) $44 40% × Pretax earnings $54

Net income $66 $82Regular common dividends $20 110% × 2013 Dividend $22Special dividends $0 Pay if financing surplus $36


Addition to RE $46 Net income – Dividends $24

Increase in spontaneous liabilities (accounts payable and accruals) $8+ Increase in long-term debt and common stock $8+ Net income minus regular common dividends $0

Increase in financing $60− Increase in total assets $68Amount of deficit or surplus financing: $32

If deficit in financing (negative), draw on line of credit $36If surplus in financing (positive), pay special dividend $0

g. 1. Should Hatfield implement the plans? How much value would they add to the company?

Answer: Improvement in value of operations: $1,314 − $958 = $356Cost of improvements = $50Company should make improvements.

g. 2. How much can Hatfield pay as a special dividend in the Improve Scenario? What else might Hatfield do with the financing surplus?

Answer: Hatfield can pay a special dividend of $35. Instead, Hatfield could repurchase stock, repay debt, or purchase marketable securities.


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