   Chapter 16, Problem 16IC ### Fundamentals of Financial Manageme...

9th Edition
Eugene F. Brigham + 1 other
ISBN: 9781305635937

#### Solutions

Chapter
Section ### Fundamentals of Financial Manageme...

9th Edition
Eugene F. Brigham + 1 other
ISBN: 9781305635937
Textbook Problem
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# INTEGRATED CASENEW WORLD CHEMICALS INC.FINANCIAL FORECASTING Sue Wilson, the new financial manager of New World Chemicals (NWC), a California producer of specialized chemicals for use in fruit orchards, must prepare a formal financial forecast for 2017. NWC’s 2016 sales were $2 billion, and the marketing department is forecasting a 25% increase for 2017. Wilson thinks the company was operating at full capacity in 2016, but she is not sure. The first step in her forecast was to assume that key ratios would remain unchanged and that it would be “business as usual” at NWC. The 2016 financial statements, the 2017 initial forecast, and a ratio analysis for 2016 and the 2017 initial forecast are given in Table IC 16.1.Assume that you were recently hired as Wilson’s assistant and that your first major task is to help her develop the formal financial forecast. She asks you to begin by answering the following questions. a. Assume (1) that NWC was operating at full capacity in 2016 with respect to all assets, (2) that all assets must grow at the same rate as sales, (3) that accounts payable and accrued liabilities also will grow at the same rate as sales, and (4) that the 2016 profit margin and dividend payout will be maintained. Under those conditions, what would the AFN equation predict the company’s financial requirements to be for the coming year? b. Consultations with several key managers within NWC, including production, inventory, and receivable managers, have yielded some very useful information. 1. NWC’s high DSO is largely due to one significant customer who battled through some hardships the past 2 years but who appears to be financially healthy again and is generating strong cash flow. As a result, NWC’s accounts receivable manager expects the Firm to lower receivables enough for a calculated DSO of 34 days without adversely affecting sales. 2. NWC was operating slightly below capacity; but its forecasted growth will require a new facility, which is expected to increase NWC’s net Fixed assets to$700 million. 3. A relatively new inventory management system (installed last year) has taken some time to catch on and to operate efficiently. NWC’s inventory turnover improved slightly last year, but this year NWC expects even more improvement as inventories decrease and inventory turnover is expected to rise to 10×. Incorporate that information into the 2017 initial forecast results, as these adjustments to the initial forecast represent the final forecast for 2017. (Hint: Total assets do not change from the initial forecast.) c. Calculate NWC’s forecasted ratios based on its final forecast and compare them with the company’s 2016 historical ratios, the 2017 initial forecast ratios, and the industry averages. How does NWC compare with the average firm in its industry, and is the company’s financial position expected to improve during the coming year? Explain. d. Based on the final forecast, calculate NWC’s free cash flow for 2017. How does this FCF differ from the FCF forecasted by NWC’s initial “business as usual” forecast? e. Initially, some NWC managers questioned whether the new facility expansion was necessary, especially as it results in increasing net fixed assets from $500 million to$700 million (a 40% increase). However, after extensive discussions about NWC needing to position itself for future growth and being flexible and competitive in today’s marketplace, NWC’s top managers agreed that the expansion was necessary. Among the issues raised by opponents was that NWC’s fixed assets were being operated at only 85% of capacity. Assuming that its fixed assets were operating at only 85% of capacity, by how much could sales have increased, both in dollar terms and in percentage terms, before NWC reached full capacity? f. How would changes in the following items affect the AFN: (1) the dividend payout ratio, (2) the profit margin, (3) the capital intensity ratio, and (4) NWC beginning to buy from its suppliers on terms that permit it to pay after 60 days rather than after 30 days? (Consider each item separately and hold all other things constant.) TABLE IC 16.1 Financial Statements and Other Data on NWC (Millions of Dollars) A. Balance Sheets 2016 2017E Cash and equivalents $20$ 25 Accounts receivable 240 300 Inventories 240 300 Total current assets $500$ 625 Net fixed assets 500 625 Total assets $1,000$1,250 Accounts payable and accrued liabilities $100$ 125 Notes payable 100 190 Total current liabilities $200$ 315 Long-term debt 100 190 Common stock 500 500 Retained earnings 200 245 Total liabilities and equity $1,000$1.250 B. Income Statements 2016 2017E Sales $2,000.00$2,500.00 Variable costs 1,200.00 1,500.00 Fixed costs 700.00 875.00 Earnings before interest and taxes (EBIT) $100.00$ 125.00 Interest 16.00 16.00 Earnings before taxes (EBT) $84.00$ 109.00 Taxes (40%) 33.60 43.60 Net income $50.40$ 65.40 Dividends (30%) $15.12$ 19.62 Addition to retained earnings $35.28$ 45.78 a.

Summary Introduction

To calculate: Company’s financial requirements for 2017.

Additional fund needed is also known as external financing needed. It is the state in which a company needed finance to increase its operation. Additional fund needed is a method in which a company raises the funds through external resources to increase its assets, which helps to increase the sales revenue of the company.

But according to additional fund needed method, a company do not change its financial ratio. Liabilities and retained earnings spontaneously increase with the increase in sales and assets.

Explanation

Computation of AFN equation for the year 2017,

Given,

Projected increase in assets is $250 million (working notes). Spontaneous increase in liabilities is$25 million (working notes).

Increase in retained earnings is $45 million (working notes). Formula to calculate the AFN equation, Additionalfundsneeded=[ProjectedincreaseinassetsSpontaneousincreaseinliabilitiesIncreaseinretainedearnings] Substitute$250 million for projected increase in assets, $25 million for spontaneous increase in liabilities and$45 million for increase in retained earnings.

Additionalfundsneeded=$245million$25million$45million=$175million

Working notes:

Given,

Forecasted assets for 2017 are $1,250 million. Assets for 2016 are$1,000 million.

Calculation of projected increase in assets,

Projectedincreaseinassets=[Forecastedassetsfor2017Assetsfor2016]=$1,250million$1,000million=$250million Given, Forecasted accounts payable and accrued liabilities for 2017 are$125 million

b.

Summary Introduction

To determine: The final forecast for 2017 after the adjustment.

Balance Sheet:

Balance sheet is the summarize statement of total assets and total liabilities of a company in an accounting period. It is one of the financial statements.

c.

Summary Introduction

To calculate: Final forecasted ratio and compare the ratios with the ratios of 2016, initial forecasted ratio of 2017 and with industry ratio.

Current Ratio:

Current ratio is a measurement tool to identify that whether a company has enough current assets to repay its current liabilities or not.

Fixed Asset Turnover:

Fixed asset turnover is a measuring tool to identify that how a company generates its net sales through the efficient use of its fixed assets.

Total Asset Turnover:

Total asset turnover is a measuring tool to identify that how a company generates its net sales through the efficient use of total assets

Profit Margin:

The profit margin is also known as sales margin, as profit margin is the margin or profit calculated on sales revenue and is equal to the excess of sales over cost of goods sold.

Payout Ratio:

Payout ratio indicates the amount of dividend paid to the shareholders of a company from the net income generated by a company over a period of time.

Times Interest Earned Ratio:

It is a ratio that helps in measuring the company’s ability to pay off its interest through the income generated by a company before interest and tax. It tells that how much amount a company has to use to pay off its interest obligation.

Basic Earnings Ratio:

It is a ratio that helps in measuring that what is the company’s earning power before the effect of financial leverage and income tax on business.

Return on Equity:

It is a ratio that tells about the amount of company’s earnings from the amount invested by its shareholder on the equity.

Days Sales Outstanding:

Days sales outstanding mean the ratio to calculate the number of days a company needed to recover the amounts from its debtors.

d.

Summary Introduction

To calculate: Final free cash flow for 2017 and compare with the initially forecasted cash flow for 2017.

Cash flow:

The net amount of cash and equivalents moving into and out of a business

e.

Summary Introduction

To calculate: Increase in sales in terms of dollars and % when fixed assets are operated at 100% capacity.

f.

1.

Summary Introduction

To identify: The effect of dividend payout ratio on AFN.

2.

Summary Introduction

To identify: The effect of profit margin on AFN.

3.

Summary Introduction

To identify: The effect of capital intensity ratio on AFN.

Capital Intensity Ratio:

The capital intensity ratio is the ratio to find the amount of capital a company needed to invest in its assets so that company has enough assets to meet its sales target. It helps to find out the amount of capital a company can invest into its assets.

4.

Summary Introduction

To identify: The effect of suppliers permit to the company to pay after 60 days rather than 30 days.

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