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SUE WILSON, THE NEW FINANCIAL MANAGER OF NORTHWEST CHEMICALS (NWC), AN OREGON
PRODUCER OF SPECIALIZED CHEMICALS FOR USE IN FRUIT ORCHARDS, MUST PREPARE A
FINANCIAL FORECAST FOR 2002. NWC’S 2001 SALES WERE $2 BILLION, AND THE
MARKETING DEPARTMENT IS FORECASTING A 25 PERCENT INCREASE FOR 2002. WILSON
THINKS THE COMPANY WAS OPERATING AT FULL CAPACITY IN 2001, BUT SHE IS NOT SURE
ABOUT THIS. THE 2001 FINANCIAL STATEMENTS, PLUS SOME OTHER DATA, ARE SHOWN
BELOW.
ASSUME THAT YOU WERE RECENTLY HIRED AS WILSON’S ASSISTANT, AND YOUR
FIRST MAJOR TASK IS TO HELP HER DEVELOP THE FORECAST. SHE ASKED YOU TO BEGIN
BY ANSWERING THE FOLLOWING SET OF QUESTIONS.
FINANCIAL STATEMENTS AND OTHER DATA ON NWC(MILLIONS OF DOLLARS)
A. 2001 BALANCE SHEET % OF % OF SALES SALESCASH & SECURITIES $ 20 1% ACCOUNTS PAYABLE AND ACCRUALS $ 100 5%ACCOUNTS RECEIVABLE 240 12 NOTES PAYABLE 100INVENTORY 240 12 TOTAL CURRENT LIABILITIES $ 200 TOTAL CURRENT ASSETS $ 500 LONG-TERM DEBT 100NET FIXED ASSETS 500 25 COMMON STOCK 500 RETAINED EARNINGS 200 TOTAL ASSETS $1,000 TOTAL LIABILITIES AND EQUITY $1,000
B. 2001 INCOME STATEMENT % OF SALESSALES $2,000.00COST OF GOODS SOLD (COGS) 1,200.00 60%SALES, GENERAL, AND ADMINISTRATIVE COSTS 700.00 35 EARNINGS BEFORE INTEREST AND TAXES $ 100.00INTEREST 16.00 EARNINGS BEFORE TAXES $ 84.00TAXES (40%) 33.60NET INCOME $ 50.40DIVIDENDS (30%) $ 15.12ADDITION TO RETAINED EARNINGS $ 35.28
Integrated Case: 7 - 1
C. KEY RATIOS NWC INDUSTRY BASIC EARNINGS POWER 10.00% 20.00%PROFIT MARGIN 2.52 4.00RETURN ON EQUITY 7.20 15.60DAYS SALES OUTSTANDING (360 DAYS) 43.20 DAYS 32.00 DAYSINVENTORY TURNOVER 8.33 11.00FIXED ASSETS TURNOVER 4.00 5.00TOTAL ASSETS TURNOVER 2.00 2.50DEBT/ASSETS 30.00% 36.00%TIMES INTEREST EARNED 6.25 9.40CURRENT RATIO 2.50 3.00PAYOUT RATIO 30.00% 30.00%OPERATING PROFIT MARGIN AFTER TAXES (NOPAT/SALES) 3.00% 5.00%OPERATING CAPITAL REQUIREMENT (OPERATING CAPITAL/SALES) 45.00% 35.00%RETURN ON INVESTED CAPITAL
(NOPAT/OPERATING CAPITAL) 6.67% 14.00%
Western Money Management Inc.Bond Valuation
7-23 ROBERT BLACK AND CAROL ALVAREZ ARE VICE-PRESIDENTS OF WESTERN MONEY MANAGEMENT AND CODIRECTORS OF THE COMPANY’S PENSION FUND MANAGEMENT DIVISION. A MAJOR NEW CLIENT, THE CALIFORNIA LEAGUE OF CITIES, HAS REQUESTED THAT WESTERN PRESENT AN INVESTMENT SEMINAR TO THE MAYORS OF THE REPRESENTED CITIES, AND BLACK AND ALVAREZ, WHO WILL MAKE THE ACTUAL PRESENTATION, HAVE ASKED YOU TO HELP THEM BY ANSWERING THE FOLLOWING QUESTIONS.
B. WHAT ARE CALL PROVISIONS AND SINKING FUND PROVISIONS? DO THESE PROVISIONS MAKE BONDS MORE OR LESS RISKY?
Integrated Case: 7 - 2
INTEGRATED CASE
ANSWER: [SHOW S7-5 THROUGH S7-7 HERE.] A CALL PROVISION IS A PROVISION IN A BOND CONTRACT THAT GIVES THE ISSUING CORPORATION THE RIGHT TO REDEEM THE BONDS UNDER SPECIFIED TERMS PRIOR TO THE NORMAL MATURITY DATE. THE CALL PROVISION GENERALLY STATES THAT THE COMPANY MUST PAY THE BONDHOLDERS AN AMOUNT GREATER THAN THE PAR VALUE IF THEY ARE CALLED. THE ADDITIONAL SUM, WHICH IS CALLED A CALL PREMIUM, IS TYPICALLY SET EQUAL TO ONE YEAR’S INTEREST IF THE BONDS ARE CALLED DURING THE FIRST YEAR, AND THE PREMIUM DECLINES AT A CONSTANT RATE OF INT/N EACH YEAR THEREAFTER.
A SINKING FUND PROVISION IS A PROVISION IN A BOND CONTRACT THAT REQUIRES THE ISSUER TO RETIRE A PORTION OF THE BOND ISSUE EACH YEAR. A SINKING FUND PROVISION FACILITATES THE ORDERLY RETIREMENT OF THE BOND ISSUE.
THE CALL PRIVILEGE IS VALUABLE TO THE FIRM BUT POTENTIALLY DETRIMENTAL TO THE INVESTOR, ESPECIALLY IF THE BONDS WERE ISSUED IN A PERIOD WHEN INTEREST RATES WERE CYCLICALLY HIGH. THEREFORE, BONDS WITH A CALL PROVISION ARE RISKIER THAN THOSE WITHOUT A CALL PROVISION. ACCORDINGLY, THE INTEREST RATE ON A NEW ISSUE OF CALLABLE BONDS WILL EXCEED THAT ON A NEW ISSUE OF NONCALLABLE BONDS.
ALTHOUGH SINKING FUNDS ARE DESIGNED TO PROTECT BONDHOLDERS BY ENSURING THAT AN ISSUE IS RETIRED IN AN ORDERLY FASHION, IT MUST BE RECOGNIZED THAT SINKING FUNDS WILL AT TIMES WORK TO THE DETRIMENT OF BONDHOLDERS. ON BALANCE, HOWEVER, BONDS THAT PROVIDE FOR A SINKING FUND ARE REGARDED AS BEING SAFER THAN THOSE WITHOUT SUCH A PROVISION, SO AT THE TIME THEY ARE ISSUED, SINKING FUND BONDS HAVE LOWER COUPON RATES THAN OTHERWISE SIMILAR BONDS WITHOUT SINKING FUNDS.
E. 1. WHAT WOULD BE THE VALUE OF THE BOND DESCRIBED IN PART D IF, JUST AFTER IT HAD BEEN ISSUED, THE EXPECTED INFLATION RATE ROSE BY 3 PERCENTAGE POINTS, CAUSING INVESTORS TO REQUIRE A 13 PERCENT RETURN? WOULD WE NOW HAVE A DISCOUNT OR A PREMIUM BOND?
Integrated Case: 7 - 3
ANSWER: [SHOW S7-13 HERE.] WITH A FINANCIAL CALCULATOR, JUST CHANGE THE VALUE OF k = i FROM 10 PERCENT TO 13 PERCENT, AND PRESS THE PV BUTTON TO DETERMINE THE VALUE OF THE BOND:
10-YEAR = $837.21.
IN A SITUATION LIKE THIS, WHERE THE REQUIRED RATE OF RETURN, k, RISES ABOVE THE COUPON RATE, THE BONDS’ VALUES FALL BELOW PAR, SO THEY SELL AT A DISCOUNT.
E. 2. WHAT WOULD HAPPEN TO THE BOND’S VALUE IF INFLATION FELL, AND kd DECLINED TO 7 PERCENT? WOULD WE NOW HAVE A PREMIUM OR A DISCOUNT BOND?
ANSWER: [SHOW S7-14 HERE.] IN THE SECOND SITUATION, WHERE k FALLS TO 7 PERCENT, THE PRICE OF THE BOND RISES ABOVE PAR. JUST CHANGE k FROM 13 PERCENT TO 7 PERCENT. WE SEE THAT THE 10-YEAR BOND’S VALUE RISES TO $1,210.71.
THUS, WHEN THE REQUIRED RATE OF RETURN FALLS BELOW THE COUPON RATE, THE BONDS’ VALUE RISES ABOVE PAR, OR TO A PREMIUM. FURTHER, THE LONGER THE MATURITY, THE GREATER THE PRICE EFFECT OF ANY GIVEN INTEREST RATE CHANGE.
E. 3. WHAT WOULD HAPPEN TO THE VALUE OF THE 10-YEAR BOND OVER TIME IF THE REQUIRED RATE OF RETURN REMAINED AT 13 PERCENT, OR IF IT REMAINED AT 7 PERCENT? (HINT: WITH A FINANCIAL CALCULATOR, ENTER PMT, I, FV, AND N, AND THEN CHANGE (OVERRIDE) N TO SEE WHAT HAPPENS TO THE PV AS THE BOND APPROACHES MATURITY.)
Integrated Case: 7 - 4
ANSWER: [SHOW S7-15 AND S7-16 HERE.] ASSUMING THAT INTEREST RATES REMAIN AT THE NEW LEVELS (EITHER 7 PERCENT OR 13 PERCENT), WE COULD FIND THE BOND’S VALUE AS TIME PASSES, AND AS THE MATURITY DATE APPROACHES. IF WE THEN PLOTTED
THE DATA, WE WOULD FIND THE SITUATION SHOWN BELOW:AT MATURITY, THE VALUE OF ANY BOND MUST EQUAL ITS PAR VALUE (PLUS ACCRUED INTEREST). THEREFORE, IF INTEREST RATES, HENCE THE REQUIRED RATE OF RETURN, REMAIN CONSTANT OVER TIME, THEN A BOND’S VALUE MUST MOVE TOWARD ITS PAR VALUE AS THE MATURITY DATE APPROACHES, SO THE VALUE OF A PREMIUM BOND DECREASES TO $1,000, AND THE VALUE OF A DISCOUNT BOND INCREASES TO $1,000 (BARRING DEFAULT).
H. WHAT IS REINVESTMENT RATE RISK? WHICH HAS MORE REINVESTMENT RATE RISK, A 1-YEAR BOND OR A 10-YEAR BOND?
Integrated Case: 7 - 5
ANSWER: [SHOW S7-24 THROUGH S7-26 HERE.] REINVESTMENT RATE RISK IS DEFINED AS THE RISK THAT CASH FLOWS (INTEREST PLUS PRINCIPAL REPAYMENTS) WILL HAVE TO BE REINVESTED IN THE FUTURE AT RATES LOWER THAN TODAY’S RATE. TO ILLUSTRATE, SUPPOSE YOU JUST WON THE LOTTERY AND NOW HAVE $500,000. YOU PLAN TO INVEST THE MONEY AND THEN TO LIVE ON THE INCOME FROM YOUR INVESTMENTS. SUPPOSE YOU BUY A 1-YEAR BOND WITH A YTM OF 10 PERCENT. YOUR INCOME WILL BE $50,000 DURING THE FIRST YEAR. THEN, AFTER 1 YEAR, YOU WILL RECEIVE YOUR $500,000 WHEN THE BOND MATURES, AND YOU WILL THEN HAVE TO REINVEST THIS AMOUNT. IF RATES HAVE FALLEN TO 3 PERCENT, THEN YOUR INCOME WILL FALL FROM $50,000 TO $15,000. ON THE OTHER HAND, HAD YOU BOUGHT 30-YEAR BONDS THAT YIELDED 10 PERCENT, YOUR INCOME WOULD HAVE REMAINED CONSTANT AT $50,000 PER YEAR. CLEARLY, BUYING BONDS THAT HAVE SHORT MATURITIES CARRIES REINVESTMENT RATE RISK. NOTE THAT LONG MATURITY BONDS ALSO HAVE REINVESTMENT RATE RISK, BUT THE RISK APPLIES ONLY TO THE COUPON PAYMENTS, AND NOT TO THE PRINCIPAL AMOUNT. SINCE THE COUPON PAYMENTS ARE SIGNIFICANTLY LESS THAN THE PRINCIPAL AMOUNT, THE REINVESTMENT RATE RISK ON A LONG-TERM BOND IS SIGNIFICANTLY LESS THAN ON A SHORT-TERM BOND.
OPTIONAL QUESTION
SUPPOSE A FIRM WILL NEED $100,000 20 YEARS FROM NOW TO REPLACE SOME EQUIPMENT. IT PLANS TO MAKE 20 EQUAL PAYMENTS, STARTING TODAY, INTO AN INVESTMENT FUND. IT CAN BUY BONDS THAT MATURE IN 20 YEARS OR BONDS THAT MATURE IN 1 YEAR. BOTH TYPES OF BONDS CURRENTLY SELL TO YIELD 10 PERCENT, i.e., k = YTM = 10%. THE COMPANY’S BEST ESTIMATE OF FUTURE INTEREST RATES IS THAT THEY WILL STAY AT CURRENT LEVELS, i.e., THEY MAY GO UP OR THEY MAY GO DOWN, BUT THE EXPECTED k IS THE CURRENT k.
THERE IS SOME CHANCE THAT THE EQUIPMENT WILL WEAR OUT IN LESS THAN 20 YEARS, IN WHICH CASE THE COMPANY WILL NEED TO CASH OUT ITS INVESTMENT BEFORE 20 YEARS. IF THIS OCCURS, THE COMPANY WILL DESPERATELY NEED THE MONEY THAT HAS BEEN ACCUMULATED--THIS MONEY COULD SAVE THE BUSINESS.
6
HOW MUCH SHOULD THE FIRM PLAN TO INVEST EACH YEAR?
7
ANSWER: START WITH A TIME LINE:
0 1 2 18 19 20 | | | | | |PMT PMT PMT PMT PMT FV19
FV18
. . . FV0
SUM OF FVs = 100,000
WE HAVE A 20-YEAR ANNUITY DUE WHOSE FV = 100,000, WHERE k = 10%. WE COULD SET THE CALCULATOR TO “BEGINNING” OR “DUE,” INSERT THE KNOWN VALUES (N = 20, kd = I = 10, PV = 0, FV = 100000), AND THEN PRESS THE PMT BUTTON TO FIND THE PAYMENT, PMT = $1,587.24. THUS, IF WE SAVE $1,587.24 PER YEAR, STARTING TODAY, AND INVEST IT TO EARN 10 PERCENT PER YEAR, WE WOULD END UP WITH THE REQUIRED $100,000. NOTE, THOUGH, THAT THIS CALCULATION ASSUMES THAT THE COMPANY CAN EARN 10 PERCENT IN EACH FUTURE YEAR. IF INTEREST RATES FALL, IT COULD NOT EARN 10 PERCENT ON ITS ADDITIONAL DEPOSITS; HENCE, IT WOULD NOT END UP WITH THE REQUIRED $100,000.
OPTIONAL QUESTION
IF THE COMPANY DECIDES TO INVEST ENOUGH RIGHT NOW TO PRODUCE THE FUTURE $100,000, HOW MUCH MUST IT PUT UP?
ANSWER: TO FIND THE REQUIRED INITIAL LUMP SUM, WE WOULD FIND THE PV OF $100,000 DISCOUNTED BACK FOR 20 YEARS AT 10
8
10%
PERCENT: PV = $14,864.36. IF THE COMPANY INVESTED THIS AMOUNT NOW AND EARNED 10 PERCENT, IT WOULD END UP WITH THE REQUIRED $100,000. NOTE AGAIN, THOUGH, THAT IF INTEREST RATES FALL, THE INTEREST RECEIVED IN EACH YEAR WILL HAVE TO BE REINVESTED TO EARN LESS THAN 10 PERCENT, AND THE $100,000 GOAL WILL NOT BE MET.
GIVEN THE FACTS AS WE HAVE DEVELOPED THEM, IF THE COMPANY DECIDES ON THE LUMP SUM PAYMENT, SHOULD IT BUY 1-YEAR BONDS OR 20-YEAR BONDS? NEITHER WILL BE COMPLETELY SAFE IN THE SENSE OF ASSURING THE COMPANY THAT THE REQUIRED $100,000 WILL BE AVAILABLE IN 20 YEARS, BUT IS ONE BETTER THAN THE OTHER?
TO BEGIN, LET’S LOOK AT THIS TIME LINE:
0 1 2 18 19 20 | | | | | | 14,864.36 100,000 1-YEAR 16,351 ? ? GREATER UNCERTAINTY20-YEAR 1,486 1,486 ? LESS UNCERTAINTY
THE COMPANY WILL INVEST $14,864 AT t = 0. THEN, IT WOULD HAVE $1,486.40 OF INTEREST TO REINVEST AT t = 1 IF IT BOUGHT A 20-YEAR BOND, BUT IT WOULD HAVE $1,486 OF INTEREST PLUS $14,864 OF PRINCIPAL = $16,350.80 TO REINVEST AT t = 1 IF IT BOUGHT THE 1-YEAR BOND. THUS, BOTH BONDS ARE EXPOSED TO SOME REINVESTMENT RATE RISK, BUT THE SHORTER-TERM BOND IS MORE EXPOSED BECAUSE IT WOULD REQUIRE THE REINVESTMENT OF MORE MONEY. OUR CONCLUSION IS THAT THE SHORTER THE MATURITY OF A BOND, OTHER THINGS HELD CONSTANT, THE GREATER ITS EXPOSURE TO REINVESTMENT RATE RISK.
OPTIONAL QUESTION
CAN YOU THINK OF ANY OTHER TYPE OF BOND THAT MIGHT BE USEFUL FOR THIS COMPANY’S PURPOSES?
9
ANSWER: A ZERO COUPON BOND IS ONE THAT PAYS NO INTEREST--IT HAS ZERO COUPONS, AND ITS ISSUER SIMPLY PROMISES TO PAY A STATED LUMP SUM AT SOME FUTURE DATE. J.C. PENNEY WAS THE FIRST MAJOR COMPANY TO ISSUE ZEROS, AND IT DID SO IN 1981. THERE WAS A DEMAND ON THE PART OF PENSION FUND MANAGERS, AND INVESTMENT BANKERS IDENTIFIED THIS NEED.
WHEN ISSUING ZEROS, THE COMPANY (OR GOVERNMENT UNIT) SIMPLY SETS A MATURITY VALUE, SAY $1,000, AND A MATURITY DATE, SAY 20 YEARS FROM NOW. THERE IS SOME VALUE OF kd FOR BONDS OF THIS DEGREE OF RISK. ASSUME THAT OUR COMPANY COULD BUY 20-YEAR ZEROS TO YIELD 10 PERCENT. THUS, OUR COMPANY COULD BUY 100 ZEROS WITH A TOTAL MATURITY VALUE OF 100 $1,000 = $100,000. IT WOULD HAVE TO PAY $14,864.36, THE PV OF $100,000 DISCOUNTED BACK 20 YEARS AT 10 PERCENT. HERE IS THE RELEVANT TIME LINE:
0 1 2 19 20
| | | | |
Value = 14,864.36 16,351 17,986 90,909 100,000 = FV
ASSUMING THE ZERO COUPON BOND CANNOT BE CALLED FOR EARLY PAYMENT, THE COMPANY WOULD FACE NO REINVESTMENT RATE RISK--THERE ARE NO INTERVENING CASH FLOWS TO REINVEST, HENCE NO REINVESTMENT RATE RISK. THEREFORE, THE COMPANY COULD BE SURE OF HAVING THE REQUIRED $100,000 IF IT BOUGHT HIGH QUALITY ZEROS.
OPTIONAL QUESTION
WHAT TYPE OF BOND WOULD YOU RECOMMEND THAT IT ACTUALLY BUY?
ANSWER: IT IS TEMPTING TO SAY THAT THE BEST INVESTMENT FOR THIS COMPANY WOULD BE THE ZEROS, BECAUSE THEY HAVE NO REINVESTMENT RATE RISK. BUT SUPPOSE THE COMPANY NEEDED TO LIQUIDATE ITS BOND PORTFOLIO IN LESS THAN 20 YEARS; COULD THAT AFFECT THE DECISION? THE ANSWER IS “YES.” IF 1-YEAR BONDS WERE PURCHASED, AN INCREASE IN INTEREST
10
10%
RATES WOULD NOT CAUSE MUCH OF A DROP IN THE VALUE OF THE BONDS, BUT IF INTEREST RATES ROSE TO 20 PERCENT THE YEAR AFTER THE PURCHASE, THE VALUE OF THE ZEROS WOULD FALL FROM THE INITIAL $14,864 TO:
PV = $100,000(1.20)-19 = $3,130.09.
WHEN WE REDUCE REINVESTMENT RATE RISK, WE INCREASE INTEREST RATE (OR PRICE) RISK. ALSO, SINCE INFLATION AFFECTS REINVESTMENT RATES AND, OFTEN, THE FUTURE FUNDS NEEDED, THIS COULD HAVE A BEARING ON THE DECISION. THE PROPER DECISION REQUIRES A BALANCING OF ALL THESE FACTORS. ONE CAN QUANTIFY THE OUTCOMES TO A CERTAIN EXTENT, DEMONSTRATING WHAT WOULD HAPPEN UNDER DIFFERENT CONDITIONS, BUT, IN THE END, A JUDGMENT MUST BE MADE.
K. SUPPOSE A 10-YEAR, 10 PERCENT, SEMIANNUAL COUPON BOND WITH A PAR VALUE OF $1,000 IS CURRENTLY SELLING FOR $1,135.90, PRODUCING A NOMINAL YIELD TO MATURITY OF 8 PERCENT. HOWEVER, THE BOND CAN BE CALLED AFTER 4 YEARS FOR A PRICE OF $1,050.
1. WHAT IS THE BOND’S NOMINAL YIELD TO CALL (YTC)?
ANSWER: [SHOW S7-31 AND S7-32 HERE.] IF THE BOND WERE CALLED, BONDHOLDERS WOULD RECEIVE $1,050 AT THE END OF YEAR 4. THUS, THE TIME LINE WOULD LOOK LIKE THIS:
0 1 2 3 4 | | | | | | | | | 50 50 50 50 50 50 50 50 1,050 PV1
. . . PV3
PV4C
PV4CP
1,135.90 = SUM OF PVs
11
THE EASIEST WAY TO FIND THE YTC ON THIS BOND IS TO INPUT VALUES INTO YOUR CALCULATOR: N = 8; PV = -1135.90; PMT = 50; AND FV = 1050, WHICH IS THE PAR VALUE PLUS A CALL PREMIUM OF $50; AND THEN PRESS THE k = I BUTTON TO FIND I = 3.568%. HOWEVER, THIS IS THE 6-MONTH RATE, SO WE WOULD FIND THE NOMINAL RATE ON THE BOND AS FOLLOWS:
kNom = 2(3.568%) = 7.137% 7.1%.
THIS 7.1 PERCENT IS THE RATE BROKERS WOULD QUOTE IF YOU ASKED ABOUT BUYING THE BOND.
YOU COULD ALSO CALCULATE THE EAR ON THE BOND:
EAR = (1.03568)2 - 1 = 7.26%.
USUALLY, PEOPLE IN THE BOND BUSINESS JUST TALK ABOUT NOMINAL RATES, WHICH IS OK SO LONG AS ALL THE BONDS BEING COMPARED ARE ON A SEMIANNUAL PAYMENT BASIS. WHEN YOU START MAKING COMPARISONS AMONG INVESTMENTS WITH DIFFERENT PAYMENT PATTERNS, THOUGH, IT IS IMPORTANT TO CONVERT TO EARS.
K. 2. IF YOU BOUGHT THIS BOND, DO YOU THINK YOU WOULD BE MORE LIKELY TO EARN THE YTM OR THE YTC? WHY?
ANSWER: [SHOW S7-33 AND S7-34 HERE.] SINCE THE COUPON RATE IS 10 PERCENT VERSUS YTC = kd = 7.137%, IT WOULD PAY THE COMPANY TO CALL THE BOND, GET RID OF THE OBLIGATION TO PAY $100 PER YEAR IN INTEREST, AND SELL REPLACEMENT BONDS WHOSE INTEREST WOULD BE ONLY $71.37 PER YEAR. THEREFORE, IF INTEREST RATES REMAIN AT THE CURRENT LEVEL UNTIL THE CALL DATE, THE BOND WILL SURELY BE CALLED, SO INVESTORS SHOULD EXPECT TO EARN 7.137 PERCENT. IN GENERAL, INVESTORS SHOULD EXPECT TO EARN THE YTC ON PREMIUM BONDS, BUT TO EARN THE YTM ON PAR AND DISCOUNT BONDS. (BOND BROKERS PUBLISH LISTS OF THE BONDS THEY HAVE FOR SALE; THEY QUOTE YTM OR YTC DEPENDING ON WHETHER THE BOND SELLS AT A PREMIUM OR A DISCOUNT.)
12
N. WHAT FACTORS DETERMINE A COMPANY’S BOND RATING?
ANSWER: [SHOW S7-38 AND S7-39 HERE.] BOND RATINGS ARE BASED ON BOTH QUALITATIVE AND QUANTITATIVE FACTORS, SOME OF WHICH ARE LISTED BELOW.
1. FINANCIAL PERFORMANCE--DETERMINED BY RATIOS SUCH AS THE DEBT, TIE, AND CURRENT RATIOS.
2. PROVISIONS IN THE BOND CONTRACT:A. SECURED VS. UNSECURED DEBTB. SENIOR VS. SUBORDINATED DEBTC. GUARANTEE PROVISIONSD. SINKING FUND PROVISIONSE. DEBT MATURITY
3. OTHER FACTORS:A. EARNINGS STABILITYB. REGULATORY ENVIRONMENTC. POTENTIAL PRODUCT LIABILITYD. ACCOUNTING POLICY
INTEGRATED CASE
Allied Food ProductsCapital Budgeting and Cash Flow Estimation
11-18 AFTER SEEING SNAPPLE’S SUCCESS WITH NONCOLA SOFT DRINKS AND LEARNING OF COKE’S AND PEPSI’S INTEREST, ALLIED FOOD PRODUCTS HAS DECIDED TO CONSIDER AN EXPANSION OF ITS OWN IN THE FRUIT JUICE BUSINESS. THE PRODUCT BEING CONSIDERED IS FRESH LEMON JUICE. ASSUME THAT YOU WERE RECENTLY HIRED AS ASSISTANT TO THE DIRECTOR OF CAPITAL BUDGETING, AND YOU MUST EVALUATE THE NEW PROJECT.
13
THE LEMON JUICE WOULD BE PRODUCED IN AN UNUSED BUILDING ADJACENT TO ALLIED’S FORT MYERS PLANT; ALLIED OWNS THE BUILDING, WHICH IS FULLY DEPRECIATED. THE REQUIRED EQUIPMENT WOULD COST $200,000, PLUS AN ADDITIONAL $40,000 FOR SHIPPING AND INSTALLATION. IN ADDITION, INVENTORIES WOULD RISE BY $25,000, WHILE ACCOUNTS PAYABLE WOULD GO UP BY $5,000. ALL OF THESE COSTS WOULD BE INCURRED AT t = 0. BY A SPECIAL RULING, THE MACHINERY COULD BE DEPRECIATED UNDER THE MACRS SYSTEM AS 3-YEAR PROPERTY. THE APPLICABLE DEPRECIATION RATES ARE 33 PERCENT, 45 PERCENT, 15 PERCENT, AND 7 PERCENT.
THE PROJECT IS EXPECTED TO OPERATE FOR 4 YEARS, AT WHICH TIME IT WILL BE TERMINATED. THE CASH INFLOWS ARE ASSUMED TO BEGIN 1 YEAR AFTER THE PROJECT IS UNDERTAKEN, OR AT t = 1, AND TO CONTINUE OUT TO t = 4. AT THE END OF THE PROJECT’S LIFE (t = 4), THE EQUIPMENT IS EXPECTED TO HAVE A SALVAGE VALUE OF $25,000.
UNIT SALES ARE EXPECTED TO TOTAL 100,000 CANS PER YEAR, AND THE EXPECTED SALES PRICE IS $2.00 PER CAN. CASH OPERATING COSTS FOR THE PROJECT (TOTAL OPERATING COSTS LESS DEPRECIATION) ARE EXPECTED TO TOTAL 60 PERCENT OF DOLLAR SALES. ALLIED’S TAX RATE IS 40 PERCENT, AND ITS WEIGHTED AVERAGE COST OF CAPITAL IS 10 PERCENT. TENTATIVELY, THE LEMON JUICE PROJECT IS ASSUMED TO BE OF EQUAL RISK TO ALLIED’S OTHER ASSETS.
YOU HAVE BEEN ASKED TO EVALUATE THE PROJECT AND TO MAKE A RECOMMENDATION AS TO WHETHER IT SHOULD BE ACCEPTED OR REJECTED. TO GUIDE YOU IN YOUR ANALYSIS, YOUR BOSS GAVE YOU THE FOLLOWING SET OF QUESTIONS.
TABLE IC11-1. ALLIED’S LEMON JUICE PROJECT(TOTAL COST IN THOUSANDS)
END OF YEAR: 0 1 2 3 4
I. INVESTMENT OUTLAYEQUIPMENT COST INSTALLATION INCREASE IN INVENTORY INCREASE IN ACCOUNTS PAYABLE
14
TOTAL NET INVESTMENT
II. OPERATING CASH FLOWSUNIT SALES (THOUSANDS) 100PRICE/UNIT $ 2.00 $ 2.00
TOTAL REVENUES $200.0OPERATING COSTS,
EXCLUDING DEPRECIATION $120.0DEPRECIATION
36.0 16.8TOTAL COSTS $199.2 $228.0
OPERATING INCOME BEFORE TAXES $
44.0TAXES ON OPERATING INCOME 0.3
25.3OPERATING INCOME AFTER TAXES $
26.4DEPRECIATION 79.2
36.0 OPERATING CASH FLOW $ 0.0 $ 79.7
$ 54.7
III. TERMINAL YEAR CASH FLOWSRETURN OF NET OPERATING WORKING CAPITALSALVAGE VALUETAX ON SALVAGE VALUE
TOTAL TERMINATION CASH FLOWS
IV. NET CASH FLOWSNET CASH FLOW ($260.0)
$ 89.7
V. RESULTSNPV =IRR =MIRR =PAYBACK =
15
B. ALLIED HAS A STANDARD FORM THAT IS USED IN THE CAPITAL BUDGETING PROCESS; SEE TABLE IC11-1. PART OF THE TABLE HAS BEEN COMPLETED, BUT YOU MUST REPLACE THE BLANKS WITH THE MISSING NUMBERS. COMPLETE THE TABLE IN THE FOLLOWING STEPS:
1. FILL IN THE BLANKS UNDER YEAR 0 FOR THE INITIAL INVESTMENT OUTLAY.
ANSWER: [SHOW S11-5 HERE.] THIS ANSWER IS STRAIGHTFORWARD. NOTE THAT ACCOUNTS PAYABLE IS AN OFFSET TO THE INVENTORY BUILDUP, SO THE NET OPERATING WORKING CAPITAL REQUIREMENT IS $20,000, WHICH WILL BE RECOVERED AT THE END OF THE PROJECT’S LIFE. [SEE COMPLETED TABLE IN THE ANSWER TO B5.]
B. 2. COMPLETE THE TABLE FOR UNIT SALES, SALES PRICE, TOTAL REVENUES, AND OPERATING COSTS EXCLUDING DEPRECIATION.
ANSWER: THIS ANSWER REQUIRES NO EXPLANATION. STUDENTS MAY NOTE, THOUGH, THAT INFLATION IS NOT REFLECTED AT THIS POINT. IT WILL BE LATER. [THE COMPLETED TABLE IS SHOWN BELOW IN THE ANSWER TO B5.]
16
B. 3. COMPLETE THE DEPRECIATION DATA.
ANSWER: [SHOW S11-6 HERE.] THE ONLY THING THAT REQUIRES EXPLANATION HERE IS THE USE OF THE DEPRECIATION TABLES IN WEB APPENDIX 11A. HERE ARE THE RATES FOR 3-YEAR PROPERTY; THEY ARE MULTIPLIED BY THE DEPRECIABLE BASIS, $240,000, TO GET THE ANNUAL DEPRECIATION ALLOWANCES:
(DOLLARS IN THOUSANDS)
YEAR 1 0.33 $240 = $ 79.2 YEAR 2 0.45 $240 = 108.0 YEAR 3 0.15 $240 = 36.0 YEAR 4 0.07 $240 = 16.8 1.00 $240.0
B. 4. NOW COMPLETE THE TABLE DOWN TO OPERATING INCOME AFTER TAXES, AND THEN DOWN TO NET CASH FLOWS.
ANSWER: [SHOW S11-7 HERE.] THIS IS STRAIGHTFORWARD. THE ONLY EVEN SLIGHTLY COMPLICATED THING IS ADDING BACK DEPRECIATION TO GET NET CF. [THE COMPLETED TABLE IS SHOWN BELOW IN THE ANSWER TO B5.]
B. 5. NOW FILL IN THE BLANKS UNDER YEAR 4 FOR THE TERMINAL CASH FLOWS, AND COMPLETE THE NET CASH FLOW LINE. DISCUSS NET OPERATING WORKING CAPITAL. WHAT WOULD HAVE HAPPENED IF THE MACHINERY WERE SOLD FOR LESS THAN ITS BOOK VALUE?
ANSWER: [SHOW S11-8 HERE.] THESE ARE ALL STRAIGHTFORWARD. NOTE THAT THE NET OPERATING WORKING CAPITAL REQUIREMENT IS RECOVERED AT THE END OF YEAR 4. ALSO, THE SALVAGE VALUE IS FULLY TAXABLE, BECAUSE THE ASSET HAS BEEN DEPRECIATED TO A ZERO BOOK VALUE. IF BOOK VALUE WERE SOMETHING OTHER THAN ZERO, THE TAX EFFECT COULD BE POSITIVE (IF THE ASSET WERE SOLD FOR LESS THAN BOOK VALUE) OR NEGATIVE.
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TABLE IC11-1. ALLIED’S LEMON JUICE PROJECT(TOTAL COST IN THOUSANDS)
INPUTS: PRICE: $2.00 k: 10.0% INFL: 0.0% VC RATE: 60.0% T-RATE: 40%
END OF YEAR: 0 1 2 3 4
I. INVESTMENT OUTLAYEQUIPMENT COST ($200)INSTALLATION (40)INCREASE IN INVENTORY (25)INCREASE IN ACCOUNTS PAYABLE 5TOTAL NET INVESTMENT (260)
II. OPERATING CASH FLOWSUNIT SALES (THOUSANDS) 100 100
100 100PRICE/UNIT $ 2.00 $ 2.00 $
2.00 $ 2.00TOTAL REVENUES $200.0 $200.0
$200.0 $200.0OPERATING COSTS, EXCLUDING DEPRECIATION $120.0 $120.0
$120.0 $120.0DEPRECIATION 79.2 108.0
36.0 16.8TOTAL COSTS $199.2 $228.0
$156.0 $136.8OPERATING INCOME BEFORE TAXES $ 0.8 ($ 28.0) $
44.0 $ 63.2TAXES ON OPERATING INCOME 0.3 (11.2)
17.6 25.3OPERATING INCOME AFTER TAXES $ 0.5 ($ 16.8) $
26.4 $ 37.9DEPRECIATION 79.2 108.0
36.0 16.8OPERATING CASH FLOW $ 0.0 $ 79.7 $ 91.2 $
62.4 $ 54.7
III. TERMINAL YEAR CASH FLOWSRETURN OF NET OPERATING WORKING CAPITAL
20.0SALVAGE VALUE
25.0
18
TAX ON SALVAGE VALUE (10.0)
TOTAL TERMINATION CASH FLOWS $ 35.0
IV. NET CASH FLOWSNET CASH FLOW ($260.0) $ 79.7 $ 91.2 $
62.4 $ 89.7
CUMULATIVE CASH FLOWFOR PAYBACK: (260.0) (180.3) (89.1)
(26.7) 63.0COMPOUNDED INFLOWS FOR MIRR: 106.1 110.4
68.6 89.7TERMINAL VALUE OF INFLOWS: 374.8
V. RESULTSNPV = -$4.0IRR = 9.3%MIRR = 9.6%PAYBACK = 3.3 YEARS
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E. IF THIS PROJECT HAD BEEN A REPLACEMENT RATHER THAN AN EXPANSION PROJECT, HOW WOULD THE ANALYSIS HAVE CHANGED? THINK ABOUT THE CHANGES THAT WOULD HAVE TO OCCUR IN THE CASH FLOW TABLE.
ANSWER: [SHOW S11-16 HERE.] IN A REPLACEMENT ANALYSIS, WE MUST FIND DIFFERENCES IN CASH FLOWS, i.e., THE CASH FLOWS THAT WOULD EXIST IF WE TAKE ON THE PROJECT VERSUS IF WE DO NOT. THUS, IN THE TABLE THERE WOULD NEED TO BE, FOR EACH YEAR, A COLUMN FOR NO CHANGE, A COLUMN FOR THE NEW PROJECT, AND FOR THE DIFFERENCE. THE DIFFERENCE COLUMN IS THE ONE THAT WOULD BE USED TO OBTAIN THE NPV, IRR, ETC.
H. 1. WHAT IS SENSITIVITY ANALYSIS?
ANSWER: [SHOW S11-27 HERE.] SENSITIVITY ANALYSIS MEASURES THE EFFECT OF CHANGES IN A PARTICULAR VARIABLE, SAY REVENUES, ON A PROJECT'S NPV. TO PERFORM A SENSITIVITY ANALYSIS, ALL VARIABLES ARE FIXED AT THEIR EXPECTED VALUES EXCEPT ONE. THIS ONE VARIABLE IS THEN CHANGED, OFTEN BY SPECIFIED PERCENTAGES, AND THE RESULTING EFFECT ON NPV IS NOTED. (ONE COULD ALLOW MORE THAN ONE VARIABLE TO CHANGE, BUT THIS THEN MERGES SENSITIVITY ANALYSIS INTO SCENARIO ANALYSIS.)
H. 2. DISCUSS HOW ONE WOULD PERFORM A SENSITIVITY ANALYSIS ON THE UNIT SALES, SALVAGE VALUE, AND COST OF CAPITAL FOR THE PROJECT. ASSUME THAT EACH OF THESE VARIABLES DEVIATES FROM ITS BASE-CASE, OR EXPECTED, VALUE BY PLUS AND MINUS 10, 20, AND 30 PERCENT. EXPLAIN HOW YOU WOULD CALCULATE THE NPV, IRR, MIRR, AND PAYBACK FOR EACH CASE.
20
ANSWER: THE BASE CASE VALUE FOR UNIT SALES WAS 100; THEREFORE, IF YOU WERE TO ASSUME THAT THIS VALUE DEVIATED BY PLUS AND MINUS 10, 20, AND 30 PERCENT, THE UNIT SALES VALUES TO BE USED IN THE SENSITIVITY ANALYSIS WOULD BE 70, 80, 90, 110, 120, AND 130 UNITS. YOU WOULD THEN GO BACK TO THE TABLE AT THE BEGINNING OF THE PROBLEM, INSERT THE APPROPRIATE SALES UNIT NUMBER, SAY 70 UNITS, AND REWORK THE TABLE FOR THE CHANGE IN SALES UNITS ARRIVING AT DIFFERENT NET CASH FLOW VALUES FOR THE PROJECT. ONCE YOU HAD THE NET CASH FLOW VALUES, YOU WOULD CALCULATE THE NPV, IRR, MIRR, AND PAYBACK AS YOU DID PREVIOUSLY. (NOTE THAT SENSITIVITY ANALYSIS INVOLVES MAKING A CHANGE TO ONLY ONE VARIABLE TO SEE HOW IT IMPACTS OTHER VARIABLES.) THEN, YOU WOULD GO BACK AND REPEAT THE SAME STEPS FOR 80 UNITS--THIS WOULD BE DONE FOR EACH OF THE SALES UNIT VALUES. THEN, YOU WOULD REPEAT THE SAME PROCEDURE FOR THE SENSITIVITY ANALYSIS ON SALVAGE VALUE AND ON COST OF CAPITAL. (NOTE THAT FOR THE COST OF CAPITAL ANALYSIS, THE NET CASH FLOWS WOULD REMAIN THE SAME, BUT THE COST OF CAPITAL USED IN THE NPV AND MIRR CALCULATIONS WOULD BE DIFFERENT.)
EXCEL® IS IDEALLY SUITED FOR SENSITIVITY ANALYSIS. IN FACT WE CREATED A SPREADSHEET TO OBTAIN THIS PROJECTS’ NET CASH FLOWS AND ITS NPV, IRR, MIRR, AND PAYBACK. ONCE A MODEL HAS BEEN CREATED, IT IS VERY EASY TO CHANGE THE VALUES OF VARIABLES AND OBTAIN THE NEW RESULTS. THE RESULTS OF THE SENSITIVITY ANALYSIS ON THE PROJECT'S NPV ASSUMING THE PLUS AND MINUS 10, 20, AND 30 PERCENT DEVIATIONS ARE SHOWN BELOW.
WE GENERATED THESE DATA WITH A SPREADSHEET MODEL.
1. THE SENSITIVITY LINES INTERSECT AT 0% CHANGE AND THE BASE CASE NPV, AT APPROXIMATELY $15,000. SINCE ALL OTHER VARIABLES ARE SET AT THEIR BASE CASE, OR EXPECTED, VALUES, THE ZERO CHANGE SITUATION IS THE BASE CASE.
2. THE PLOTS FOR UNIT SALES AND SALVAGE VALUE ARE UPWARD SLOPING, INDICATING THAT HIGHER VARIABLE VALUES LEAD TO HIGHER NPVs. CONVERSELY, THE PLOT FOR COST OF CAPITAL
21
IS DOWNWARD SLOPING, BECAUSE A HIGHER COST OF CAPITAL LEADS TO A LOWER NPV.
3. THE PLOT OF UNIT SALES IS MUCH STEEPER THAN THAT FOR SALVAGE VALUE. THIS INDICATES THAT NPV IS MORE SENSITIVE TO CHANGES IN UNIT SALES THAN TO CHANGES IN SALVAGE VALUE.
4. STEEPER SENSITIVITY LINES INDICATE GREATER RISK. THUS, IN COMPARING TWO PROJECTS, THE ONE WITH THE STEEPER LINES IS CONSIDERED TO BE RISKIER.
22
70
60
50
40
30
20
10
0
-30% -20% 10% 20%-10% 0% 30%
NPV(Thousands of Dollars)
Cost of Capital
Salvage Value
Unit Sales
Sensitivity Graph
-10
-20
-30
-40
Change from Base Level
THE SENSITIVITY DATA ARE GIVEN HERE IN TABULAR FORM (IN THOUSANDS OF DOLLARS):
CHANGE FROM RESULTING NPV AFTER THE INDICATED CHANGE IN:
BASE LEVEL UNIT SALES SALVAGE VALUE k -30% ($36.4) $11.9 $34.1 -20 (19.3) 12.9 27.5 -10 (2.1) 13.9 21.1 0 15.0 15.0 15.0 +10 32.1 16.0 9.0 +20 49.2 17.0 3.3 +30 66.3 18.0 (2.2)
H. 3. WHAT IS THE PRIMARY WEAKNESS OF SENSITIVITY ANALYSIS? WHAT ARE ITS PRIMARY ADVANTAGES?
ANSWER: [SHOW S11-28 HERE.] THE TWO PRIMARY DISADVANTAGES OF SENSITIVITY ANALYSIS ARE (1) THAT IT DOES NOT REFLECT THE
23
EFFECTS OF DIVERSIFICATION AND (2) THAT IT DOES NOT INCORPORATE ANY INFORMATION ABOUT THE POSSIBLE MAGNITUDES OF THE FORECAST ERRORS. THUS, A SENSITIVITY ANALYSIS MIGHT INDICATE THAT A PROJECT'S NPV IS HIGHLY SENSITIVE TO THE SALES FORECAST, HENCE THAT THE PROJECT IS QUITE RISKY, BUT IF THE PROJECT'S SALES, HENCE ITS REVENUES, ARE FIXED BY A LONG-TERM CONTRACT, THEN SALES VARIATIONS MAY ACTUALLY CONTRIBUTE LITTLE TO THE PROJECT'S RISK.
24
THEREFORE, IN MANY SITUATIONS, SENSITIVITY ANALYSIS IS NOT A PARTICULARLY GOOD INDICATOR OF RISK. HOWEVER, SENSITIVITY ANALYSIS DOES IDENTIFY THOSE VARIABLES THAT POTENTIALLY HAVE THE GREATEST IMPACT ON PROFITABILITY, AND THIS HELPS MANAGEMENT FOCUS ITS ATTENTION ON THOSE VARIABLES THAT ARE PROBABLY MOST IMPORTANT.
K. 1. BASED ON YOUR JUDGMENT, WHAT DO YOU THINK THE PROJECT'S CORRELATION COEFFICIENT WOULD BE WITH RESPECT TO THE GENERAL ECONOMY AND THUS WITH RETURNS ON "THE MARKET"?
ANSWER: IN ALL LIKELIHOOD, THIS PROJECT WOULD HAVE A POSITIVE CORRELATION WITH RETURNS ON OTHER ASSETS IN THE ECONOMY, AND SPECIFICALLY WITH THE STOCK MARKET. ALLIED FOOD PRODUCTS PRODUCES FOOD ITEMS, AND SUCH FIRMS TEND TO HAVE LESS RISK THAN THE ECONOMY AS A WHOLE--PEOPLE MUST EAT REGARDLESS OF THE NATIONAL ECONOMIC SITUATION. HOWEVER, PEOPLE WOULD TEND TO SPEND MORE ON NON-ESSENTIAL TYPES OF FOOD WHEN THE ECONOMY IS GOOD AND TO CUT BACK WHEN THE ECONOMY IS WEAK. A REASONABLE GUESS MIGHT BE +0.7, OR WITHIN A RANGE OF +0.5 TO +0.9.
K. 2. HOW WOULD CORRELATION WITH THE ECONOMY AFFECT THE PROJECT'S MARKET RISK?
ANSWER: [SHOW S11-34 HERE.] THIS CORRELATION WOULD NOT DIRECTLY AFFECT THE PROJECT'S CORPORATE RISK, BUT IT DOES, WHEN COMBINED WITH THE PROJECT'S HIGH STAND-ALONE RISK, SUGGEST THAT THE PROJECT'S MARKET RISK AS MEASURED BY ITS MARKET BETA IS RELATIVELY HIGH.
SKI Equipment Inc.
25
INTEGRATED CASE
Working Capital Management
14-21 DAN BARNES, FINANCIAL MANAGER OF SKI EQUIPMENT INC. (SKI), IS
EXCITED, BUT APPREHENSIVE. THE COMPANY’S FOUNDER RECENTLY SOLD HIS
51 PERCENT CONTROLLING BLOCK OF STOCK TO KENT KOREN, WHO IS A BIG FAN
OF EVA (ECONOMIC VALUE ADDED). EVA IS FOUND BY TAKING THE AFTER-TAX
OPERATING PROFIT AND THEN SUBTRACTING THE DOLLAR COST OF ALL THE
CAPITAL THE FIRM USES:
EVA = EBIT (1 - T) - CAPITAL COSTS
= EBIT (1 - T) - WACC(CAPITAL EMPLOYED).
IF EVA IS POSITIVE, THEN THE FIRM IS CREATING VALUE. ON THE OTHER HAND, IF EVA IS NEGATIVE, THE FIRM IS NOT COVERING ITS COST OF CAPITAL, AND STOCKHOLDERS’ VALUE IS BEING ERODED. KOREN REWARDS MANAGERS HANDSOMELY IF THEY CREATE VALUE, BUT THOSE WHOSE OPERATIONS PRODUCE NEGATIVE EVAs ARE SOON LOOKING FOR WORK. KOREN FREQUENTLY POINTS OUT THAT IF A COMPANY CAN GENERATE ITS CURRENT LEVEL OF SALES WITH LESS ASSETS, IT WOULD NEED LESS CAPITAL. THAT WOULD, OTHER THINGS HELD CONSTANT, LOWER CAPITAL COSTS AND INCREASE ITS EVA.
SHORTLY AFTER HE TOOK CONTROL OF SKI, KENT KOREN MET WITH SKI’S SENIOR EXECUTIVES TO TELL THEM OF HIS PLANS FOR THE COMPANY. FIRST, HE PRESENTED SOME EVA DATA THAT CONVINCED EVERYONE THAT SKI HAD NOT BEEN CREATING VALUE IN RECENT YEARS. HE THEN STATED, IN NO UNCERTAIN TERMS, THAT THIS SITUATION MUST CHANGE. HE NOTED THAT SKI’S DESIGNS OF SKIS, BOOTS, AND CLOTHING ARE ACCLAIMED THROUGHOUT THE INDUSTRY, BUT SOMETHING IS SERIOUSLY AMISS ELSEWHERE IN THE COMPANY. COSTS ARE TOO HIGH, PRICES ARE TOO LOW, OR THE COMPANY EMPLOYS TOO MUCH CAPITAL, AND HE WANTS SKI’S MANAGERS TO CORRECT THE PROBLEM OR ELSE.
BARNES HAS LONG FELT THAT SKI’S WORKING CAPITAL SITUATION SHOULD BE STUDIED--THE COMPANY MAY HAVE THE OPTIMAL AMOUNTS OF CASH, SECURITIES, RECEIVABLES, AND INVENTORIES, BUT IT MAY ALSO HAVE TOO MUCH OR TOO LITTLE OF THESE ITEMS. IN THE PAST, THE PRODUCTION MANAGER RESISTED BARNES’ EFFORTS TO QUESTION HIS HOLDINGS OF RAW MATERIALS INVENTORIES, THE MARKETING MANAGER RESISTED QUESTIONS ABOUT FINISHED GOODS, THE SALES STAFF RESISTED QUESTIONS ABOUT CREDIT POLICY (WHICH AFFECTS ACCOUNTS RECEIVABLE), AND THE TREASURER DID NOT WANT TO TALK ABOUT HER CASH AND SECURITIES BALANCES. KOREN’S SPEECH MADE IT CLEAR THAT SUCH RESISTANCE WOULD NO LONGER BE TOLERATED.
BARNES ALSO KNOWS THAT DECISIONS ABOUT WORKING CAPITAL CANNOT BE
MADE IN A VACUUM. FOR EXAMPLE, IF INVENTORIES COULD BE LOWERED
WITHOUT ADVERSELY AFFECTING OPERATIONS, THEN LESS CAPITAL WOULD BE
REQUIRED, THE DOLLAR COST OF CAPITAL WOULD DECLINE, AND EVA WOULD
INCREASE. HOWEVER, LOWER RAW MATERIALS INVENTORIES MIGHT LEAD TO
PRODUCTION SLOWDOWNS AND HIGHER COSTS, WHILE LOWER FINISHED GOODS
INVENTORIES MIGHT LEAD TO THE LOSS OF PROFITABLE SALES. SO, BEFORE
INVENTORIES ARE CHANGED, IT WILL BE NECESSARY TO STUDY OPERATING AS
WELL AS FINANCIAL EFFECTS. THE SITUATION IS THE SAME WITH REGARD TO
CASH AND RECEIVABLES.
B. HOW CAN ONE DISTINGUISH BETWEEN A RELAXED BUT RATIONAL WORKING
CAPITAL POLICY AND A SITUATION IN WHICH A FIRM SIMPLY HAS A LOT OF
26
CURRENT ASSETS BECAUSE IT IS INEFFICIENT? DOES SKI’S WORKING CAPITAL
POLICY SEEM APPROPRIATE?
ANSWER: [SHOW S14-5 HERE.] SKI MAY CHOOSE TO HOLD LARGE AMOUNTS OF INVENTORY
TO AVOID THE COSTS OF “RUNNING SHORT,” AND TO CATER TO CUSTOMERS WHO
EXPECT TO RECEIVE THEIR EQUIPMENT IN A SHORT PERIOD OF TIME. SKI MAY
ALSO CHOOSE TO HOLD HIGH AMOUNTS OF RECEIVABLES TO MAINTAIN GOOD
RELATIONSHIPS WITH ITS CUSTOMERS. HOWEVER, IF SKI IS HOLDING LARGE
STOCKS OF INVENTORY AND RECEIVABLES TO BETTER SERVE CUSTOMERS, IT
SHOULD BE ABLE TO OFFSET THE COSTS OF CARRYING THAT WORKING CAPITAL
WITH HIGH PRICES OR HIGHER SALES, AND ITS ROE SHOULD BE NO LOWER THAN
THAT OF FIRMS WITH OTHER WORKING CAPITAL POLICIES.
IT IS CLEAR FROM THE DATA IN TABLE IC14-1 THAT SKI IS NOT AS
PROFITABLE AS THE AVERAGE FIRM IN ITS INDUSTRY. THIS SUGGESTS THAT
IT SIMPLY HAS EXCESSIVE WORKING CAPITAL, AND THAT IT SHOULD TAKE
STEPS TO REDUCE ITS WORKING CAPITAL.
E. SHOULD DEPRECIATION EXPENSE BE EXPLICITLY INCLUDED IN THE CASH
BUDGET? WHY OR WHY NOT?
ANSWER: [SHOW S14-11 THROUGH S14-15 HERE.] NO, DEPRECIATION EXPENSE IS A
NONCASH CHARGE AND SHOULD NOT APPEAR EXPLICITLY IN THE CASH BUDGET
THAT FOCUSES ON THE ACTUAL CASH FLOWING INTO AND OUT OF A FIRM.
HOWEVER, A FIRM’S DEPRECIATION EXPENSE DOES IMPACT ITS TAX LIABILITY,
AND HENCE DEPRECIATION AFFECTS SKI’S QUARTERLY TAX PAYMENTS.
H. WHAT REASONS MIGHT SKI HAVE FOR MAINTAINING A RELATIVELY HIGH AMOUNT
OF CASH?
ANSWER: [SHOW S14-18 HERE.] IF SALES TURN OUT TO BE CONSIDERABLY LESS THAN
EXPECTED, THE COMPANY COULD FACE A CASH SHORTFALL. A COMPANY MAY
CHOOSE TO HOLD LARGE AMOUNTS OF CASH IF IT DOES NOT HAVE MUCH FAITH
IN ITS SALES FORECAST OR IF IT IS VERY CONSERVATIVE. UNFORTUNATELY,
GIVEN ITS CURRENT PRESSURE TO PERFORM, SKI’S MANAGEMENT DOES NOT HAVE
THE LUXURY TO BE EXTREMELY CONSERVATIVE.
27
K. IF THE COMPANY REDUCES ITS INVENTORY WITHOUT ADVERSELY AFFECTING
SALES, WHAT EFFECT SHOULD THIS HAVE ON THE COMPANY’S CASH POSITION
(1) IN THE SHORT RUN AND (2) IN THE LONG RUN? EXPLAIN IN TERMS OF
THE CASH BUDGET AND THE BALANCE SHEET.
ANSWER: [SHOW S14-21 HERE.] REDUCING INVENTORY PURCHASES WILL INCREASE THE
COMPANY’S CASH HOLDINGS IN THE SHORT RUN, THUS REDUCING THE AMOUNT OF
FINANCING OR THE TARGET CASH BALANCE NEEDED. IN THE LONG RUN, THE
COMPANY IS LIKELY TO REDUCE ITS CASH HOLDINGS IN ORDER TO INCREASE
ITS EVA. SKI CAN USE THE “EXCESS CASH” TO MAKE INVESTMENTS IN MORE
PRODUCTIVE ASSETS SUCH AS PLANT AND EQUIPMENT. ALTERNATIVELY, THE
FIRM CAN DISTRIBUTE THE “EXCESS CASH” TO ITS SHAREHOLDERS THROUGH
HIGHER DIVIDENDS OR REPURCHASING ITS SHARES.
N. IF THE COMPANY REDUCES ITS DSO WITHOUT SERIOUSLY AFFECTING SALES,
WHAT EFFECT WOULD THIS HAVE ON ITS CASH POSITION (1) IN THE SHORT RUN
AND (2) IN THE LONG RUN? ANSWER IN TERMS OF THE CASH BUDGET AND THE
BALANCE SHEET. WHAT EFFECT SHOULD THIS HAVE ON EVA IN THE LONG RUN?
ANSWER: [SHOW S14-25 HERE.] IF CUSTOMERS PAY THEIR BILLS SOONER, THIS WILL
INCREASE THE COMPANY’S CASH POSITION IN THE SHORT RUN, WHICH WOULD
DECREASE THE AMOUNT OF FINANCING OR THE TARGET CASH BALANCE NEEDED.
OVER TIME, THE COMPANY WOULD HOPEFULLY INVEST THIS CASH IN MORE
PRODUCTIVE ASSETS, OR PAY IT OUT TO SHAREHOLDERS. BOTH OF THESE
ACTIONS WOULD INCREASE EVA.
IN ADDITION TO IMPROVING THE MANAGEMENT OF ITS CURRENT ASSETS, SKI IS
ALSO REVIEWING THE WAYS IN WHICH IT FINANCES ITS CURRENT ASSETS.
WITH THIS CONCERN IN MIND, DAN IS ALSO TRYING TO ANSWER THE FOLLOWING
QUESTIONS.
Q. IS IT LIKELY THAT SKI COULD MAKE SIGNIFICANTLY GREATER USE OF ACCRUED
LIABILITIES?
ANSWER: [SHOW S14-29 HERE.] NO, SKI COULD NOT MAKE GREATER USE OF ITS
ACCRUED LIABILITIES. ACCRUED LIABILITIES ARISE BECAUSE (1) WORKERS
ARE PAID AFTER THEY HAVE ACTUALLY PROVIDED THEIR SERVICES, AND (2)
28
TAXES ARE PAID AFTER THE PROFITS HAVE BEEN EARNED. THUS, ACCRUED
LIABILITIES REPRESENT CASH OWED EITHER TO WORKERS OR TO THE IRS. THE
COST OF ACCRUED LIABILITIES IS GENERALLY CONSIDERED TO BE ZERO, SINCE
NO EXPLICIT INTEREST MUST BE PAID ON THESE ITEMS.
THE AMOUNT OF ACCRUED LIABILITIES IS GENERALLY LIMITED BY THE
AMOUNT OF WAGES PAID AND THE FIRM’S PROFITABILITY, AS WELL AS BY
INDUSTRY CONVENTIONS REGARDING WHEN WAGE PAYMENTS ARE MADE AND IRS
REGULATIONS REGARDING TAX PAYMENTS. (INCREASINGLY, CONGRESS IS
PUTTING BUSINESSES ON A PAY-AS-YOU-GO, OR EVEN PAY-AHEAD-OF-TIME
BASIS THROUGH THE USE OF ESTIMATED TAXES.) A FIRM CANNOT ORDINARILY
CONTROL ITS ACCRUED LIABILITIES. FIRMS USE ALL THE ACCRUED
LIABILITIES THEY CAN, BUT THEY HAVE LITTLE CONTROL OVER THE LEVELS OF
THESE ACCOUNTS.
B. NOW ESTIMATE THE 2002 FINANCIAL REQUIREMENTS USING THE PERCENT OF SALES
APPROACH, MAKING AN INITIAL FORECAST PLUS ONE ADDITIONAL “PASS” TO
DETERMINE THE EFFECTS OF “FINANCING FEEDBACKS.” ASSUME (1) THAT EACH
TYPE OF ASSET, AS WELL AS PAYABLES, ACCRUALS, AND FIXED AND VARIABLE
COSTS, WILL BE THE SAME PERCENT OF SALES IN 2002 AS IN 2001; (2) THAT
THE PAYOUT RATIO IS HELD CONSTANT AT 30 PERCENT; (3) THAT EXTERNAL
FUNDS NEEDED ARE FINANCED 50 PERCENT BY NOTES PAYABLE AND 50 PERCENT
BY LONG-TERM DEBT (NO NEW COMMON STOCK WILL BE ISSUED); AND (4) THAT
ALL DEBT CARRIES AN INTEREST RATE OF 8 PERCENT.
ANSWER: SEE THE COMPLETED WORKSHEET. THE PROBLEM IS NOT DIFFICULT TO DO “BY
HAND,” BUT WE USED A SPREADSHEET MODEL FOR THE FLEXIBILITY SUCH A
MODEL PROVIDES, AND WE SHOW A THIRD PASS JUST TO SHOW THAT AFTER TWO
PASSES VERY LITTLE ADDITIONAL ACCURACY IS GAINED.
PREDICTED g: 25.00%
ACTUAL g: 25.00%
INCOME STATEMENT: 2001 2002 2002 ACTUAL PRO FORMA FEEDBACK 2ND PASS
SALES $2,000.00 $2,500.00 $2,500.00LESS: COGS(% SALES) 60.00% (1,200.00) (1,500.00) (1,500.00) SGA(% SALES) 35.00% (700.00) (875.00) ( 875.00)EBIT $ 100.00 $ 125.00 $ 125.00INTEREST (8%) (16.00) (16.00) +(14.34)* ( 30.34)EBT $ 84.00 $ 109.00 94.66
29
TAXES 40.0% (33.60) (43.60) ( 37.86)
NET INCOME $ 50.40 $ 65.40 $ 56.80
*FEEDBACK EQUALS NEW INTEREST ON NEW DEBT: $14.34 = 8%($179.22).
DIVIDENDS 30.0% $ 15.12 $ 19.62 $ 17.04ADD’N TO R.E. $ 35.28 $ 45.78 $ 39.76
BALANCE SHEET: 2001 2002 2002 ACTUAL PRO FORMA FEEDBACK 2ND PASS
CASH & SECURITIES $ 20.00 $ 25.00 $ 25.00ACCOUNTS RECEIVABLE 240.00 300.00 300.00INVENTORIES 240.00 300.00 300.00CURRENT ASSETS $ 500.00 $ 625.00 $ 625.00NET FA (% CAP) 100.0% 500.00 625.00 625.00TOTAL ASSETS $1,000.00 $1,250.00 $1,250.00
A/P AND ACCRUALS $ 100.00 $ 125.00 $ 125.00N/P (SHORT-TERM) 100.00 100.00 89.61 189.61L-T DEBT 100.00 100.00 89.61 189.61COMMON STOCK 500.00 500.00 500.00RETAINED EARNINGS 200.00 245.78 (6.02) 239.76TOTAL LIAB & EQUITY $1,000.00 $1,070.78 $1,243.98
AFN $ 179.22 $ 6.02CUM. AFN $ 179.22 $ 185.24
CAP. SALES = 2,000 = S1/% CAP. USED.
NEW FA = FA2 = 125: IF CAP. SALES > S1*(1 + g), FA2 = FA1.
OTHERWISE FA2 = (FA1/CAP S)*”EXCESS” SALES
AFN FINANCING: WEIGHTS DOLLARSN/P 0.50 $ 89.61L-T DEBT 0.50 89.61COMMON STOCK 0.00 0.00 1.00 $179.22
AFN EQUATION FORECAST:
AFN = (A*/S0) g S0 - (L*/S0) g S0 - M S1 (1 - PAYOUT)
= $250 - $25 - $44.1
= $180.9 VERSUS BALANCE SHEET FORECAST OF $185.24.
E. CALCULATE NWC’S FREE CASH FLOW FOR 2002.
ANSWER: = -
30
= NOPAT - NET INVESTMENT IN OPERATING CAPITAL
FCF = NOPAT - (OPERATING CAPITAL2002 - OPERATING CAPITAL2001)
= $125(1 - 0.4) + [($625 - $125 + $625) - ($500 - $100 +
$500)
= $75 - ($1,125 - $900) = $75 - $225 = -$150.
NOTE: OPERATING CAPITAL = NET OPERATING WORKING CAPITAL + NET FIXED
ASSETS.
H. BASED ON COMPARISONS BETWEEN NWC’S DAYS SALES OUTSTANDING (DSO) AND
INVENTORY TURNOVER RATIOS WITH THE INDUSTRY AVERAGE FIGURES, DOES IT
APPEAR THAT NWC IS OPERATING EFFICIENTLY WITH RESPECT TO ITS
INVENTORY AND ACCOUNTS RECEIVABLE? IF THE COMPANY WERE ABLE TO BRING
THESE RATIOS INTO LINE WITH THE INDUSTRY AVERAGES, WHAT EFFECT WOULD
THIS HAVE ON ITS AFN AND ITS FINANCIAL RATIOS? (NOTE: INVENTORIES
AND RECEIVABLES WILL BE DISCUSSED IN DETAIL IN CHAPTER 22.)
ANSWER: THE DSO AND INVENTORY TURNOVER RATIO INDICATE THAT NWC HAS EXCESSIVE
INVENTORIES AND RECEIVABLES. THE EFFECT OF IMPROVEMENTS HERE WOULD
BE SIMILAR TO THAT ASSOCIATED WITH EXCESS CAPACITY IN FIXED ASSETS.
SALES COULD BE EXPANDED WITHOUT PROPORTIONATE INCREASES IN CURRENT
ASSETS. (ACTUALLY, THESE ITEMS COULD PROBABLY BE REDUCED EVEN IF
SALES DID NOT INCREASE.) THUS, THE AFN WOULD BE LESS THAN PREVIOUSLY
DETERMINED, AND THIS WOULD REDUCE FINANCING AND POSSIBLY OTHER COSTS
(AS WE WILL SEE IN CHAPTER 22, THERE MAY BE OTHER COSTS ASSOCIATED
WITH REDUCING THE FIRM’S INVESTMENT IN ACCOUNTS RECEIVABLE AND
INVENTORY), WHICH WOULD LEAD TO IMPROVEMENTS IN MOST OF THE RATIOS.
(THE CURRENT RATIO WOULD DECLINE UNLESS THE FUNDS FREED UP WERE USED
TO REDUCE CURRENT LIABILITIES, WHICH WOULD PROBABLY BE DONE.)
AGAIN, TO GET A PRECISE FORECAST, WE WOULD NEED SOME ADDITIONAL
INFORMATION, AND WE WOULD NEED TO MODIFY THE FINANCIAL STATEMENTS.
K. HOW WOULD CHANGES IN THESE ITEMS AFFECT THE AFN? (1) THE DIVIDEND
PAYOUT RATIO, (2) THE PROFIT MARGIN, (3) THE CAPITAL INTENSITY RATIO,
AND (4) NWC BEGINS BUYING FROM ITS SUPPLIERS ON TERMS WHICH PERMIT IT
TO PAY AFTER 60 DAYS RATHER THAN AFTER 30 DAYS. (CONSIDER EACH ITEM
SEPARATELY AND HOLD ALL OTHER THINGS CONSTANT.)
ANSWER: 1. IF THE PAYOUT RATIO WERE REDUCED, THEN MORE EARNINGS WOULD BE
RETAINED, AND THIS WOULD REDUCE THE NEED FOR EXTERNAL FINANCING,
31
OR AFN. NOTE THAT IF THE FIRM IS PROFITABLE AND HAS ANY PAYOUT
RATIO LESS THAN 100 PERCENT, IT WILL HAVE SOME RETAINED EARNINGS,
SO IF THE GROWTH RATE WERE ZERO, AFN WOULD BE NEGATIVE, i.e., THE
FIRM WOULD HAVE SURPLUS FUNDS. AS THE GROWTH RATE ROSE ABOVE
ZERO, THESE SURPLUS FUNDS WOULD BE USED TO FINANCE GROWTH. AT
SOME POINT, i.e., AT SOME GROWTH RATE, THE SURPLUS AFN WOULD BE
EXACTLY USED UP. THIS GROWTH RATE WHERE AFN = $0 IS CALLED THE
“SUSTAINABLE GROWTH RATE,” AND IT IS THE MAXIMUM GROWTH RATE WHICH
CAN BE FINANCED WITHOUT OUTSIDE FUNDS, HOLDING THE DEBT RATIO AND
OTHER RATIOS CONSTANT.
2. IF THE PROFIT MARGIN GOES UP, THEN BOTH TOTAL AND RETAINED
EARNINGS WILL INCREASE, AND THIS WILL REDUCE THE AMOUNT OF AFN.
3. THE CAPITAL INTENSITY RATIO IS DEFINED AS THE RATIO OF REQUIRED
ASSETS TO TOTAL SALES, OR A*/S0. PUT ANOTHER WAY, IT REPRESENTS
THE DOLLARS OF ASSETS REQUIRED PER DOLLAR OF SALES. THE HIGHER
THE CAPITAL INTENSITY RATIO, THE MORE NEW MONEY WILL BE REQUIRED
TO SUPPORT AN ADDITIONAL DOLLAR OF SALES. THUS, THE HIGHER THE
CAPITAL INTENSITY RATIO, THE GREATER THE AFN, OTHER THINGS HELD
CONSTANT.
4. IF NWC’S PAYMENT TERMS WERE INCREASED FROM 30 TO 60 DAYS, ACCOUNTS
PAYABLE WOULD DOUBLE, IN TURN INCREASING CURRENT AND TOTAL
LIABILITIES. THIS WOULD REDUCE THE AMOUNT OF AFN DUE TO A
DECREASED NEED FOR WORKING CAPITAL ON HAND TO PAY SHORT-TERM
CREDITORS, SUCH AS SUPPLIERS.
32
