MICRO DRIVE INC.

BALANCE SHEETS ( mıl $)

ASSETS LIABILITIES AND EQUITY
YEAR 2 YEAR 1 YEAR 2 YEAR 1

Cash and Equivalents 10 15 Accounts Payable 60 30

Short Term Investments 0 65 Notes Payable 110 60
Accounts Receivable 375 315 Accruals 140 130
Inventories 615 415 Total Current Liabilities 310 220
Total Current Assets 1000 810 Long Term Bonds 754 580
Total Debt 1064 800
Preferred Stock
(400,000shares) 40 40
Common Stock
([Link]) 130 130
Retained Earnings 766 710

Net Plant and Equipment 1000 870 Total Equity 896 840
Total Assets 2000 1680 Total Liabilities and Equity 2000 1680

MICRO DRIVE INCOME STATEMENTS YEAR 2 YEAR 1

Net Sales 3000.0 2850.0
Costs Excluding Depreciation 2616.2 2497.0
Depreciation 100.0 90.0
Total Operating Costs (2716.2) (2587.0 )
Earnings Before Interest and Taxes 283.8 263.0
Interest (88.0 ) (60.0)
Earninge Before Taxes 195.8 203.0
Taxes (40%) (78.3) (81.0)
Net Income Before Preferred Dividends 117.5 122.0
Preferred Dividends (4.0) (4.0)
Earnings Available to Shareholders 113.5 118.0
Common Dividends (57.5) (53.0)
Addition to Retained Earnings 56.0 65.0
Per Share Data
Common Stock Price $ 23.00 $26.00
Earnings Per Share 2.27 2.36
Dividends per Share 1.15 1.06
Book Value Per Share 17.92 16.80
 MICRODRIVE COMPANY DATA
( in million)
YEAR 1 YEAR 2 CHANGE IND.
NOPAT $157.8 $ 170.3 8%
NOWC 585.0 800.0 37%
NFA 870.0 1000.0 15%
TOC 1455.0 1800.0 24%
FCF -- -174.7
NOPAT/ SALES 5.5% 5.7% 5.7%
TOC/ SALES 51.0% 60.0% 50.3%
ROIC 10.845 % 9.46%
WACC 10.8% 11.00%
EVA $ 0.66 $ - 27.7 -39%
MVA $ 460.0 $ 254.0
PRICE/ SHARE $ 26.0 $ 23.0
EPS $ 2.36 $ 2.27
BV/SHARE $ 16.80 $ 17.92
P/E 11.02x a
10.1x b 12.5x
M/B 1.55x c 1.28x d
N 50 50
a.26/ 2.36= 11.02x
b.23/2.27= 10.1x
c.26/ 16.80= 1.55x
d.23/ 17.92= 1.28x
NOTE:
Change in sales = 5%
Change in [Link]= 5%
Change in interest =46.7%
Change in net income= -3.6%
 FUNDAMENTALS OF FIRM VALUATION
You have been hired as a consultant to Kulpa Fishing Supplies(KFS), a
company that is seeking to increase its value. KFS has asked you to estimate
the value of two privately held companies that KFS is considering acquiring.
You are required to answer the following questions and estimate the value of
the two acquisition targets .

Questions:
[Link] the three types of assets that companies own.
[Link] are assets in place and how can their value be estimated.?
[Link] are growth options and how can their value be estimated?
[Link] are nonoperating assets and how can their value be estimated?
[Link] is the total value of a corporation ? Who has claims on this value?

The first acquisition candidate is a privately held company in a mature

[Link] company currently has free cash flow of $ 20 [Link] cost of
capital is 10% and it is expected to grow at a constant rate of 5%.The company
has marketable securities of $100 [Link] is financed with $ 200 million of
debt,$ 50 million of preferred stock and $ 210 million of book equity.

6. What is its value of operations?

[Link] is its total corporate value? What is value of equity?
[Link] is its MVA?
The second acquisition target is a privately held company in a growing industry. The
target has recently borrowed $ 40 million to finance its expansion; it has no other debt or
preferred [Link] pays no dividends and currently has no marketable securities. KFS
expects the company to produce free cash flows of -$ 5 million in one year, $ 10 million
in two years and $ 20 million in three years. After three years , FCF will grow at a rate of 6
%.Its cost of capital is 10% and it has 10 million shares of stock.

[Link] is its horizon value?

[Link] is its value of equity on per share basis?
[Link] are the four value drivers and how does each affect value?

KFS has two divisions .Both have current sales of $ 1000 current expected growth of 5 %
and a cost of capital of 10%.Division A has high profitability (OP=6%) but high capital
requirements ( CR=78%). Division B has low profitability (OP=4%) but low capital
requirements(CR=27%).

[Link] the following data., decide whether the growth policies of the divisions are
properly established.

Division A Division B

TOC $ 780 $ 780 $ 270 $ 270

GROWTH 5% 6% 5% 6%
SALES $ 1050 $ 1060 $ 1050 $ 1060
NOPAT $ 63 $ 63.6 $ 42 $ 42.4
ROIC 8.1% 8.2% 15.6% 15.7%
MVA $ (300.0) $ (360.0) $ 300.0 $ 385.0
WACC 10% 10% 10% 10%
 Data for valuation:

Projected free cash flows (FCF):

Year 1 FCF = -$5 million
Year 2 FCF = $10 million
Year 3 FCF = $20 million

FCF grows at constant rate of 6% after year 3.

The weighted average cost of capital, WACC, is 10%.

There are no marketable securities or other non-operating assets.

There is $40 million in debt.

The company has 10 million shares of stock.

 ∞
VOp= ∑ FCFt / (HWACC) t
t=1

0 1 2 3 4
kc=10% g=6%

-5 10 20

-4.55
8.26
15.03
398.20 530 = VOp= TV3 = 20(1+0.06) / (0.10-0.06)
$416.94

Value of Operations = PV of Cash Flows + PV of Terminal Cash Flow

= -4.55+8.26+15.03 +398.20
= 416.94 million.
Total Value of the Corporation = Value of Operations + Value of
nonoperating assets
= $416.94 + $0
= $416.94 million.

Value of Equity = Total Value – (Debt + Preferred Stock)

= $416.94 – ($40 +$0)
= $376.94 million.

Price per share = Value of Equity / Number of shares

= $376.94 / 10 = $37.69
Market Value Added (MVA) = Total value of the corporation – Book value of
debt and
equity

There are four drivers of value:

1. Growth in sales (g)

2. Operating Profitability (OP) = Net Operating Profit After Taxes / Sales
= NOPAT / Sales
3. Capital Requirements (CR) = Operating Capital / Sales
4. Weighted Average Cost of Capital (WACC)

Value always increases if:

5. OP increases
6. CR decreases
7. WACC decreases
 Growth can either increase or decrease value, depending on
the Expected Return on Invested Capital (EROIC), which is
defined as the expected NOPAT divided by the current Capital:

EROICt = NOPATt+1 / Capitalt

If EROICt > WACC then an increase in g increases value.

If EROICt < WACC, then an increase in g decreases value.
Week2a
• MICRO DRIVE [Link] SHEETS ( mıl $)
• ASSETS LIABILITIES AND EQUITY
• YEAR 2 YEAR 1 YEAR 2 YEAR 1
•
• Cash and Equivalents 10 15 Accounts Payable 60 30
• Short Term Investments 0 65 Notes Payable 110 60
• Accounts Receivable 375 315 Accruals 140 130
• Inventories 615 415 Total Current Liabilities 310 220
• Total Current Assets 1000 810 Long Term Bonds 754 580
• Total Debt 1064 800
• Preferred Stock
(400,000shares) 40 40
• Common Stock
([Link]) 130 130
• Retained Earnings 766 710
•
• Net Plant and Equipment 1000 870 Total Equity 896 840
• Total Assets 2000 1680 Total Liabilities and Equity 2000 1680

• MICRO DRIVE INCOME STATEMENTS YEAR 2 YEAR 1

• Net Sales 3000.0 2850.0

• Costs Excluding Depreciation 2616.2 2497.0
• Depreciation 100.0 90.0
• Total Operating Costs (2716.2) (2587.0 )
• Earnings Before Interest and Taxes 283.8 263.0
• Interest (88.0 ) (60.0)
• Earninge Before Taxes 195.8 203.0
• Taxes (40%) (78.3) (81.0)
• Net Income Before Preferred Dividends 117.5 122.0
• Preferred Dividends (4.0) (4.0)
• Earnings Available to Shareholders 113.5 118.0
• Common Dividends (57.5) (53.0)
• Addition to Retained Earnings 56.0 65.0
• Per Share Data
• Common Stock Price $ 23.00 $26.00
• Earnings Per Share 2.27 2.36
• Dividends per Share 1.15 1.06
• Book Value Per Share 17.92 16.80
MICRODRIVE
YEAR 2
MICRODRIVE CASH FLOW STATEMENT
 Source
Use
Decrease in cash 5
Decrease in short –term investments 65
Increase in receivables 60
Increase in inventories 200
Gross increase in fixed assets 230
Increase in accumulated depreciation 100
Increase in accounts payable 30
Increase in notes payable 50
Increase in accruals 10
Increase in long-term debt 174
Increase in retained earnings 56 _______
Total $ 490 $ 490
MICRODRIVE STATEMENT OF CASH FLOWS
YEAR 2

Cash Flow from Operating Activities:

Net Income $ 117.5

Additions to net income:
Depreciation 100.0
Changes in net working capital:
Increase in accounts payable 30.0
Increase in accruals 10.0
Increase in accounts receivable (60.0)
Increase in inventories (200.0)

Net cash provided by operations $ (2.5)

Long –Term Investments:

Fixed asset investments (230.0)

Financing Activities:
Sale of short-term investments 65.0
Increase in notes payable 50.0
Increase in bonds outstanding 174.0
Dividend payments (61.5)

Net cash provided by Financing Activities $ 227.5

Summary:
Net change in cash (5.0)
Cash at the beginning of the year 15.0
Cash at the end of the year 10.0
Week3a
CASH BUDGET : ENTRAC COMPANY
Entrac Company is preparing its cash budget for the first six months of Year [Link] sales
data for Year 1 and the sales forecasts for January through July of Year 2 are :

Actual Sales, Year 1 Sales forecast, Year 2

November $350
December 400 January $450
February 500
March 700
April 800
May 600
June 450
July 300

All sales are made on credit,with 70% collected in the first month following the sale and
30% collected in the second [Link] are 60% of the following month’s sales and
are paid in the following [Link] expenses equal to 30% of the current month’s
sales and are paid in the current [Link] cash is $ 100 and should not be
permitted to fall below this level in any of the following [Link] borrowing is used to
bring cash to this level when [Link] cash exceeds $100 level ,the excess
cash is used to pay off bank loans [Link] the cash budget for this company
for the first six months of Year 2 .
 SOLUTION
ENTRAC COMPANY
 Cash Budget
Entrac Company
January February March April May June July
Sales 450 500 700 800 600 450 300
Collections:
one month 280 315 350 490 560 420 315
two months 105 120 135 150 210 240 180
Total 385 435 485 640 770 660 495
Purchases 300 420 480 360 270 180
Cash Payments 270 300 420 480 360 270 180
for Purchases
Expenses 135 150 210 240 180 135 90
Total Payments 405 450 630 720 540 405 270
Net Gain (Loss) (20) (15) (145) (80) 230 255 225
Beginning Cash 100 80 65 -80 -160 70 325
Cumulative Cash 80 65 (80) (160) 70 325 550
Less:Desired Level -100 -100 -100 -100 -100 -100 -100
of Cash
Loans needed (20) (35) (180) (260) (30)
Surplus 225 450
 ALKA A.Ş.
NAKİT BÜTÇESİ
ALKA A.Ş. İşletmesinin nakit bütçesine temel teşkil eden bazı varsayımların
dökümü yapılmıştır. Üç değişik senaryo için geliştirilen varsayımlar
kullanılarak nakit bütçeleri hazırlanmaktadır. Öncelikle nakit akımları
hesaplanmış, bütçe hazırlanması sırasında gerekli yerlerde tahsilat, ödeme
planı gibi temel politikalarda bazı değişiklikler yapılmıştır. İşletme her ay
kasada 10,000 TL nakit bulundurmayı hedeflemektedir. Bu miktarı aşan
nakit menkul kıymetlere yatırılacak, bunun altında kalması halinde
bankadan kısa vadeli borçlanma yapılacaktır.

KOŞULLAR
VARSAYIMLAR En kötü Normal En iyi
Satış gelirleri %5 azalır Geçen yıl ile aynı %10 artar
Kredili Satışlar Satışların%95'i Satışların %90'ı Satışların %85'i
Tahsilatlar %80'i 30 günde %85'i 30 günde %100'ü 30 günde
%10'u 60 günde %10'u 60 günde
%10 tahsil edilemeyen %5'i tahsil edilemeyen
Harcamalar %5 artar Geçen yıl ile aynı %3 düşer
Yatırım Giderleri 0 100,000 150,000
(Şubat'ta) (Şubat'ta)
 ALKA A.Ş.
NAKİT BÜTÇESİ*
1.1.20X1 – 30.6.20X1
(Normal Koşullar Altında)
I. GELİRLER OCAK ŞUBAT MART NİSAN MAYIS HAZİRAN
Başlangıç nakit 20,000 16,000 (63,000) (3,000) (5,000) 25,000
Nakit Satışlar ve Tahsilatlar 50,000 65,000 75,000 65,000 75,000 65,000
Kira 25,000
Kar Payı ve Faiz 5,000 2,000 5,000 2,000
Toplam Nakit Girişi 55,000 67,000 100,000 70,000 75,000 67,000
Mevcut Toplam Nakit 75,000 83,000 37,000 67,000 70,000 92,000
II. NAKİT ÇIKIŞLARI
Ücretler 23,000 25,000 25,000 25,000 25,000 25,000
Maaşlar 5,000 5,000 5,000 5,000 5,000 5,000
Hammadde Ödemeleri 4,000 16,000 10,000 15,000 15,000 10,000
Kar Payı 2,000 2,000
Gelir Vergisi 25,000 25,000
Yeni Makina 100,000
Toplam Nakit Çıkışı 59,000 146,000 40,000 72,000 45,000 40,000
Nakit (Açığı) Fazlası 16,000 (63,000) (3,000) (5,000) 25,000 52,000

* Veriler ekonominin normal koşullar altında olduğu varsayımına dayalıdır.

 ALKA A.Ş.
DÜZELTİLMİŞ NAKİT BÜTÇESİ
1.1.20X1 – 30.6.20X1
I. NAKİT GİRİŞLERİ OCAK ŞUBAT MART NİSAN MAYIS HAZİRAN
Başlangıç Nakit 20,000 10,000 10,000 10,000 10,000 10,000
Tahsilat 50,000 65,000 75,000 65,000 75,000 65,000
Kar Payı 25,000
Kar Payı ve Faiz 5,000 2,000 5,000 2,000
Vadesi Gelen Menkul
Kıy.* 10,100* 43,531* 498 30,803
Toplam Nakit Girişi 55,000 77,100 143,531 70,000 75,498 97,803
Toplam Nakit Mevcudu 75,000 87,100 153,531 80,000 85,498 107,803
II. NAKİT ÇIKIŞLARI
Ücret 23,000 25,000 25,000 25,000 25,000 25,000
Maaş 5,000 5,000 5,000 5,000 5,000 5,000
Hammadde 4,000 16,000 10,000 15,000 15,000
Kar Payı 2,000 2,000
Vergi 25,000 25,000
Borç Faizi** 2,506**
Yeni Makina 100,000
Toplam Nakit Çıkışı 55,000 34,000 146,000 69,506 45,000 45,000
Nakit (Açığı) Fazlası 20,000 53,100 7,531 10,494 40,498 62,803
Minimum Nakit 10,000 10,000 10,000 10,000 10,000 10,000
Nakit (Açığı) Fazlası 10,000 43,100 (2,469) 494 30,498 52,803

*Nakit fazlasının aylık olarak %1 faizden yatırıldığı varsayılmıştır.

**Borçlanma bir ay için yapılmış ve faiz aylık %1.5 olarak hesaplanarak Nisan ayında geri ödenmiştir.

Bir önceki bütçedeki bazı varsayımlar değiştirilmiştir.

1-Yatırım Şubat ayından Mart ayına alınmıştır.
2-Hammadde ödemeleri 30 gün geciktirilmiştir.
3-İşletme her ay en az 10,000 TL kasa bulundurmayı hedeflemektedir.
Week3b
 CASES
• CASE I :FORETREND CORP.
• CASE II : WATSON LAB. AND SOLUTIONS
• CASE III:NWC [Link] & SOLUTIONS
 FORECASTING BALANCE SHEETS
THE FORETREND COMPANY BALANCE SHEET
YEAR 1 ( MİL $)
ASSETS LIABILITIES
Cash 10 Accounts Payable 50
Receivables 85 Accrued Taxes and Wages 25
Inventories 100 Mortgage Bonds 70
Net Fixed Assets 150 Common Stock 100
Retained Earnings 100
Total Assets 345 Total Liabilities and Equity 345

Balance Sheet as a Percentage of Sales

ASSETS LIABILITIES AND EQUITY
Cash 2.0% Accounts Payable 10.0%
Receivables 17.0% Accrued Wages and Taxes 5.0%
Inventories 20.0% Mortgage Bonds na
Total Current Assets 39.0% Common Stock na
Retained Earnings na
Net Fixed Assets 30.0%
Total Assets 69.0% Total Liabilities and Equity 15.0%

Sales for Year 1 is $ 500 million and the estimated sales for Year 2 is $ 750 million.

Estimated data:
Profit margin 4%
Dividend Payout ratio 40%
Earnings retention rate 60%

Required: Construct the forecasted balance sheet of the company using the percent of sales method.
WATSON LAB.

CASE
 A CASE ON FORECASTING
WATSON LABORATORIES
Dan Edwards,financial manager of Watson Laboratories, is currently working on his firm’s financial forecast for the coming year.
Watson’s balance sheet for the last year is given below:

BALANCE SHEET
( In thousands of dollars)
Cash $ 450 Accounts Payable $ 300
Receivables 750 Accruals 150
Inventory 1,500 Notes Payable 375
Total Current Assets 2,700 Total Current Liabilities 825
Net Fixed Assets 6,000 Long Term Debt 3,600
Total Debt 4,425
Common Stock 3,000

Retained Earnings 1,275

Total Assets 8,700 Total Claims 8,700

Watson was operating at full capacity last year and had sales of $ 15 [Link]’s marketing department is forecasting a 20 %
sales increase for the coming year. The firm has had a profit margin of 5 % and a 60 % payout ratio over the last several years, and
these values are expected to continue in the near term. In preparing the forecast, Edwards proceeds by answering the following
questions and completing the indicated tasks:
[Link] the percentage of sales method to prepare the coming year’s pro forma balance sheet.
[Link] is the external funds requirement?
[Link] assumptions are necessary to use this method?
Edwards assumes that AFN will be raised as 10 % short term debt, 40 % long term debt,
and 50 % common stock.
[Link] the pro forma balance sheet to reflect additional financing. Does additional debt and common stock have any impact on
the
income statement and the statement of retained earnings?
[Link] the forecasting formula to estimate Watson’s additional funds needed (AFN) at sales growth rates of 10 %,and 30%. Repeat
the analysis assuming zero sales growth. What effect does sales growth have on funds requirements?
[Link] is the maximum sales growth rate Watson can achieve without outside financing?
[Link] that Watson is operating at 80 % capacity with regard to fixed assets. What is AFN if sales are forecasted to increase to
$ 18 million?
8. What effects do a firm’s dividend policy,profitability, and capital intensity have on its external funds requirements?
SOLUTION TO
WATSON LAB
 Pro Forma Balance Sheet
(in thousands)
% of Sales Forecast Based on Sales=$18,000
Cash 3.0% $ 540
Receivables 5.0 900
Inventory 10.0 1,800
Current assets 18.0% $ 3,240
Net Fixed assets 40.0 7,200
Total assets 58.0% $ 10,440

Accounts Payable 2.0% $ 360

Accruals 1.0 180
Notes Payable n.a 375
Current liabilities n.a $ 915
Long-term debt n.a 3,600
Total debt n.a 4,515
Common Stock n.a 3,000
Retained earnings n.a 1,635
Total liabilities and equity n.a $ 9,150

AFN =Total assets-Total liabilities and equity

=$ 10,440,000 - $ 9,150,000
=$ 1,290,000

Notes:
1) Retained earnings =$ 1,275,000 + (0.05) ($18,000,000) (0.4)
=$ 1,635,000

2) n.a = not applicable = does not vary directly with sales.

Pro Forma Balance Sheets after Financing
AFN=$1,290. This shortfall will be raised, and the B.S. accounts will be as follows:

Increase + Old = New

Notes payable (10%) $ 129 $ 375 $ 504
Long-term debt (40%) 516 3,600 4,116
Common Stock (50%) 645 3,000 3,645
$1,290

Cash $ 540 Accounts payable $ 360

Receivables 900 Accruals 180
Inventory 1,800 Notes payable 504
Current assets 3,240 Current liabilities 1,044
Net fixed assets 7,200 Long-term debt 4,116
Total debt 5,160
Common Stock 3,645
Retained earnings 1,635
Total assets $10,440 Total liab. & equity $10,440
 AFN EQUATION
AFN= Increase in – Spontaneous increase – increase in
assets in liabilities retained earnings

= (A/S)∆S-(L/S)∆S-MS1(1-d)

Applying the formula to Watson gives the following (in thousands of dollars):

AFN= ($8,700/$15,000) ($3,000) – ($450/15,000)($3,000)

-0.05($18,000)(0.4)
= (0.58)($3,000)-(0.03)($3,000)-$900(0.4)
=$1,740-$90-$360
=$1,290
AFN at Various Sales Growth Rates
Sales Growth Rate Sales AFN
30% $19,500 $2,085
20 18,000 1,290
10 16,500 495
0 15,000 (300)

To find the sales growth rate at which AFN=0, solve this equation:

AFN=(0.58) )∆S-(0.03)∆S-0.05(S1)(0.4)=$0

But S1 = S0 + ∆S = $15,000+∆S, so
(0.58) ∆S - (0.03)∆S - 0.05($15,000+∆S)(0.4)=$0
(0.58) ∆S - (0.03)∆S - (0.02)∆S=$300
(0.53)∆S=$300
∆S≈$566.

Growth Rate= $566/$15,000=0.0377=3.77%

 AFN Calculation If Operating at 80% Capacity
Capacity Sales = Actual Sales
% of capacity

= $ 15,000,000
0.80

= $ 18,750,000

No addition to Fixed Assets required for sales of $18 million.

New AFN = Previously calculated AFN - ∆FA

= $1,290,000 – 0.4 ($3,000,000)
= $ 90,000
AFN Calculation If Operating at 90% Capacity
Capacity Sales = $ 15,000,000
0.90
= $16,666,667

“Proper” FA/S ratio = $6,000,000/$16,666,667 = 0.36.

New AFN to get to S=$16,666,667:

AFN1= (0.03 + 0.05 + 0.10) ∆S – 0.03 ∆S – 0.05 (S 1)(0.4)
= 0.18($ 1,666,667)–0.03($1,666,667)–0.05($16,666,667)(0.4)
= $300,000 - $50,000 - $333,333
=$-83,333.

New AFN to go from S=$16,666,667 to $18,000,000:

AFN2=(0.36 + 0.03 + 0.05 + 0.10) ∆S - 0.03 ∆S – 0.05 (S)(0.4)
=(0.54) ($1,333,333)-(0.03)($1,333,333)-(0.05)($1,333,333)(0.4)
=$720,000 - $40,000 - $26,667
=$653,333

Total AFN = AFN1 + AFN2

=$653,333 - $83,333
= $570,000.
NORTHWEST CHEMICALS I:

CASE
 NORTHWEST CHEMICALS
A CASE ON FORECASTING
Northwest Chemicals , an Oregon producer of specialized chemicals for use in fruit orchards , must prepare a financial forecast
forYear 1.. NWC’s sales were $ 2 billion and forecasts an increase of 25 % in sales. The company has the following assumptions:

[Link] 0 (Actual) profit margin ( 2.52 %) and dividend payout ( 30%) will be maintained
[Link] will increase by 25 % to $ 2,500
[Link] company borrows, the interest rate is forecasted to be 8 %.
[Link] funds needed will be financed 50% by notes payable and 50% by long term debt.
[Link] assets are at full capacity.

QUESTIONS:
[Link] the assumptions given above, what will the company’s financial requirements be for the coming year? Use the AFN formula
to answer this question.
[Link] the Year 1 requirements using the percent of sales method, making an initial forecast plus one additional “ pass” to
determine the effects of financing feedbacks.
[Link] do the two methods produce different AFN forecasts?
[Link] NWC’s forecasted ratios and compare them with the company’s Year 0 ratios and the industry averages.
5. Calculate the free cash flow for Year 1..
[Link] that the company operates at 75%of capacity how would the existence of excess capacity affect the AFN during Year1 ?
7. How would you expect the ratios to change in a situation where an excess capacity in fixed assets exists?
[Link] data is given for a typical firm in NWC’s industry. If regression analysis is used for forecasting, what would the forecast
for inventories be forYear 1 ?
Year Sales Inventories
-2 1280 118
-1 1600 138
0 2000 162
A regression is run using the data above and the resulting equation is as follows:
Y= 40+ 0.0611S

[Link] should the regression line justify the use of the percent of sales method?
III. Year 0 Key Ratios
Firm Industry

Basic earning power 10.00% 20.00%

Profit Margin 2.52% 4.00%
ROE 7.20% 15.60%
DSO 43.20 days 32.00 days
Inventory Turnover 8.33x 11.00x
Fixed assets turnover 4.00 5.00
Total assets turnover 2.00 2.50
Debt/assets 30.00% 36.00%
TIE 6.25x 9.40x
Current Ratio 2.50 3.00
Payout Ratio 30.00% 30.00%
NOPAT/Sales 3.00 5.00
Operating capital/Sales 45.00 35.00
NOPAT/Operating Capital 6.67 14.00

IV. Other Key Data

A. Fixed Assets were being operated at full capacity
B. Year 1 sales are forecasted to increase by 25%
I. Balance Sheet (Millions of Dollars):
Cash and securities $20 Accounts payable
Accounts receivable 240 and accruals $100
Inventories 240 Notes payable 100
Total current assets $500 Total current liabilities $200
Long-term debt 100
Common stock 500
Retained earnings
200
Net fixed assets 500 Total liabilities
Total assets $1,000 and equity $1,000

II. Income Statement (Millions of Dollars):

Sales $2,000.00
Less: Variable costs (60%) 1,200.00
Fixed costs (35%) 700.00
EBIT $ 100.00
Interest 16.00
EBT $ 84.00
Taxes (40%) 33.60
Net income $ 50.40
Dividends (30%) $15.12
Addition to retained earnings $35.28
 SOLUTION
NOTHWEST CHEMICALS I
I. Income Statement
Year 0 Forecast Year1
Actual Basis Pro
Forma
Sales $2,000.00 x1.25 $2,500.00
Less: Variable costs 1,200.00 60%xYear1 Sales 1,500.00
Fixed costs 700.00 35%xYear1 Sales 875.00
EBIT $ 100.00 $ 125.00
Interest 16.00 16.00
EBT $ 84.00 $ 109.00
Taxes (40%) 33.60
43.60
Net Income $ 50.40 $ 65.40
II. Balance Sheet
Year 1 Forecast
Year 0 Forecast Basis First Pass AFN Second
Actual
Pass___
Cash and
Securities $ 20 1% x Year 1 Sales $ 25.00 $ 25.00
Accounts
receivable 240 12%x Year 1 Sales 300 300
Inventories 240 12%x Year 1 Sales 300 300
Total current
assets $ 500 $ 625 $ 625
Net Fixed Assets 500 25%x Year 1Sales 625 625
Total assets $ 1000 $ 1250 1250
Accounts
payable/accruals $ 100 5% x Year 1 Sales $ 125 $ 125
Notes payable 100 100 +89.61 189.61
Total current
liabilities $ 200 $ 225.00 $ 314.61
Long-term debt 100 100 +89.61 189.61
Common stock 500 500 500.00
Retained earnings 200 +45.78 245.78 (6.02) 239.76
Total Liabilities and
equity $ 1000 $ 1070.78 $ 1243.98

AFN 179.22 $ 6.02

Cumulative AFN 179.22 $ 185.22

Notes:
1. AFN financed with 50% Notes Payable and 50% Long-term debt
2. Second Pass Balance Sheet doesn`t balance due to “Financing Feedbacks”
Additional funds= Increase in – Spontaneous increase – increase in
needed assets in liabilities retained earnings

AFN = (A*/S0)∆S - (L*/S0)∆S-MS1(1-d)

Assumptions:
1) All assets, accounts payable, and accruals will grow proportionally with
sales.
2) Year 0 profit margin and dividend payout will be maintained.

∆S=0.25 x $2,000 = $500

AFN= ($1,000/$2,000)($500) – ($100/$2,000)($500) – 0.0252($2,500)(1-0.30)

= $250 - $25 - $44.10

= $180.90
 Firm Industry
Year 1 (E) Year 0 Actual Year 0

Basic earning power 10.00% 10.00% 20.00%

Profit Margin 2.27 2.52 4.00
ROE 7.68 7.20 15.60
DSO 43.20 days 43.20 days 32.00 days
Inventory Turnover 8.33x 8.33X 11.00x
Fixed assets turnover 4.00 4.00 5.00
Total assets turnover 2.00 2.00 2.50
Debt/assets 40.34% 30.00% 36.00%
TIE 4.12% 6.25x 9.40x
Current Ratio 1.99 2.50 3.50
Payout Ratio 30% 30.00% 30.00%
NOPAT/Sales 3.00 3.00 5.00
Operating capital/Sales 45.00 45.00 35.00
NOPAT/Operating Capital 6.67 6.60 14.00
 % of Year 0 Capacity

Year 0 75% 100%

Basic earning power 10.00% 11.11% 10.00%

Profit Margin 2.52 2.51 2.27
ROE 7.20 8.44 7.68
Days Sales Outstanding 43.20 days 43.20 days 43.20 days
Inventory Turnover 8.33x 8.33X 8.33x
Fixed assets turnover 4.00 5.00 4.00
Total assets turnover 2.00 2.22 2.00
Debt/assets 30.00% 33.71% 40.34%
Times Interest Earned 6.25x 6.15 4.12
Current Ratio 2.50 2.48 1.99
Payout Ratio 30.00% 30.00% 30.00%
Regression equation forecasts inventories of
$192.7 at a projected sales level of $2,500:

Inventories = 40.0 + 0.0611($2,500) = $192.7

Balance sheet projection: $300

Cash Freed Up = $300 - $192.7 = $107.3

Week5
 EXAMPLE 1:
MPC Inc. has the following data. Calculate DOL for various sales levels.
P= $25 V= $ 12 FC= $ 135,000
Qb= 135,000
25-12
= 10,385 units

DOL for various sales levels above the breakeven:

DOL11,000= 17.9
DOL 12,000= 7.43
DOL 20,000=2.08

DOL for various sales levels below the breakeven:

DOL10,000= -26
DOL 7,000= -2.1
DOL 6,000= -1.37
DOL 5000= -0.93

[Link] is highest when it is nearest to the breakeven point.

[Link] decreases as move further above the breakeven.
[Link] decreases ( in absolute terms) as we move further below the breakeven
meaning that the decrease in loss is less as output decreases. As we get further
below the breakeven quantity, the same amount of change in demand has less
effect on losses.
 ILLUSTRATION:

A. 57% increase in demand (a rise to 11,000 units) when the

company is operating at 7,000 units:
DOL7,000 = EBIT 11,000-EBIT 7,000 / EBIT 7,000
11,000 - 7,000 / 7,000
= -1.18/ 0.57
= -2.1

B. 57% increase in demand ( a rise to 7850 units) when the firm is

operating at 5,000 units:
DOL5,000 = EBIT 7,850 - EBIT 5,000 / EBIT 5,000
7,850 - 5,000 / 5,000
DOL 5,000 = -0.53 / 0.57
= -0.93
When the firm operates at 7,000 units , a 57% increase in sales
decreases losses by 118% whereas the same increase in demand
decreases losses by only 53% when the firm operates at 5,000 units
which
is further below the breakeven point. So sensitivity of EBIT to changes in
demand decreases as we move further below the breakeven.

If breakeven changes, DOL will also change.

 Partial Income Statements for Firm U and Firm L

Firm U Firm L
Assets $20,000 $20,000
Equity $20,000 $10,000
EBIT $3,000 $3,000
INT (12%) $0 $1200
EBT $3,000 $1,800
Taxes(40%) $1,200 $720
NI $1,800 $1,080

BEP 15.0% 15.0%

ROI 9.0% 11.4%
ROE 9.0% 10.8%
TIE ∞ 2.5X
Note: ROI = Return to both stockholders and bondholders = INT  NI
Assets
E(BEPU ) = 0.25(10%) + 0.5(15%) + 0.25(20%) = 15.0%
E(BEPL ) = 0.25(10%) + 0.5(15%) + 0.25(20%) = 15.0%

E(ROIU ) = 0.25(6.0%) + 0.5(9.0%) + 0.25(12.0%) = 9.0%

E(ROIL ) = 0.25(8.4%) + 0.5(11.4%) + 0.25(14.4%) = 11.4%

E(ROEU ) = 0.25(6.0%) + 0.5(9.0%) + 0.25(12.0%) = 9.0%

E(ROEL ) = 0.25(4.8%) + 0.5(10.8%) + 0.25(16.8%) = 10.8%

σROE (Unleveraged) = 2.12%; CV = 0.24

σROE (Leveraged) = 4.24%; CV = 0.39

This example illustrates that financial leverage can increase

the expected return to stockholders, but at the same time it
increases their risk.
CASE STUDY

Northwest Chemicals
It is proposed that NWC should expand its operations and sell its chemicals in retail
establishments. To determine the feasibility of the idea, a breakeven analysis is
conducted. The fixed costs associated with producing and selling chemicals to retail
stores would be $ 60 million. The selling price per unit is expected to be $ 10 and the
variable cost ratio is 0.60 ( variable costs are 60 percent of sales) as given in the
income statement. The interest expense of the company at present is $16 million.

[Link] is the (operating) breakeven point in units and dollars?

[Link] the proposal be accepted if NWC can produce and sell 20 million units of the
chemical? What is the margin of safety at sales of 20 million units?

[Link] NWC can produce and sell 20 million units of its product, what would be its
degree of operating leverage? What would be NWC’s percent increase in operating
profits if sales actually were 10% higher than expected?

4. Assume NWC has excess capacity. So it does not need to raise any external funds to
implement the proposal( Its interest expenses remain the same).

[Link] should be its degree of financial leverage and degree of total leverage?
[Link] actual sales turn out to be 10% greater than expected, as a percent, how much
greater would the earnings per share be?
[Link] actual sales turn out to be 5% less than expected , how much would EPS be?

[Link] how the breakeven and leverage analyses can be used for planning the
implementation of this proposal. Does the proposal have high risk or low risk?
Week 5a- Breakeven Analysis
EXAMPLE 1:
I.H.A. INC: has the following income statement:
Net Sales $ 15,000
COGS 10,000
Gross profit 5,000
Selling, general&adm expenses 1,500
EBIT 3,500
Interest expense 2,000
EBT 1,500
Taxes 500
Net income 1,000

Expense Fixed portion Variable portion Total

COGS 2,500 7,500 10,000
Selling, Gen.&[Link]. 750 750 1,500
Interest 2,000 ------ 2,000
Total $ 5,250 8,250 13,500

A. Operating Breakeven :
TRb= 3,250* / 1- (8,250/ 15,000)
= 3,250/ (1-0.55)
= $ 7,222
* All expenses except financial expenses are included.

B .Financial Breakeven

EBT breakeven = 5,250 / 1-0.55

=$ 11,667

If sales are $ 11,667 pretax profits will be zero, indicating that this is also the breakeven point for net income.
This example illustrates that financial policies increase the breakeven point by $ 4,445,or by 62%.
E.2 Cash Breakeven

Cash breakeven analysis is useful in determining the risks of [Link] cash outlays are small even
during periods of losses, the firm may be operating above the cash breakeven [Link] this case ,the risk of
insolvency is small and the firm has more chance to reach for high profits through high operating leverage.

Cash Breakeven ( TRc)= Fixed Costs – Noncash fixed charges / ( 1-VC/TR)

The assumption is that all sales revenues are in cash ( No receivables) and all costs are paid in cash and
that there are no inventories.

II. MARGIN OF SAFETY

The margin of safety may be expressed as the ratio of actual volume to the breakeven point, or as the ratio
of the percent of the difference betwen sales and breakeven to sales

EXAMPLE II.
FIRM A FIRM B
SALES $ 100,000 100,000
BREAKEVEN $ 75,000 60,000

Margin of Safety A B
1. 133.3% * 166.7%
2. 25%** 40%
* 100,000/75,000
**100,000-75,000/100,000 =25%

Firm A is operating closer to the breakeven point than [Link] A will face losses if sales drop by more
than 25% while Company B will have profits until sales drop by more than 40%.Firm B has higher margin
of safety.
III. PRODUCT MIX

New product decisions and/ or decisions regarding elimination of some products in the product line or
decisions regarding how much to produce of each product in the product line are related to
determining the sales mix of the company. Sales mix refers to the relative proportions of the products
in the total sales of the company.

EXAMPLE III:

MAP INC. has the following sales mix:

SALES SALES MIX

Product 1 100 units x $10/unit= $ 1000 100/175= 57%

Product 2 75 units x $ 15/ unit = $ 1125 75/175 =43%
Total 175 units $ 2125

VARIABLE FIXED NET CONTR.

COSTS COSTS INCOME MARGIN
PRODUCT 1 $7.5 x100 units=750 100 150 $2.5/unit
PRODUCT 2 $10 x 75 units= 750 250 125 5.0/ unit

Average price= 2125/ 175= $ 12.14

Average VC / unit = 1500/ 175= $ 8.57

Breakeven point for the whole firm:

Qb= 350/ (12.14- 8.57)= 98 units

Breakeven for product 1 :

Qb= 100/ 10-7.5= 40 units

Breakeven for product 2:

Qb= 250/ 15-10= 50 units
[Link]= 60/ 10-6= 15 mil units Contribution Margin 88 000 000

Sales b= 60/ 10-6= 150 mil USD Fixed Costs 60 000 000
EBIT 28 000 000
2. [Link] since sales of 20 mil is above the breakeven.
EBIT is 28/20 =1.40 or 40 percent higher 4. At 20 mil units
[Link] of safety = 200 mil -150/ 200 =25%
a.
[Link] 20 mil units :
EBIT 20 000 000
Sales (20 mil x $10) 200 000 000
Interest 16 000 000
Variable Costs 120 000 000 EBT 4 000 000
Contribution Margin 80 000 000 Taxes (40%) 1 600 000
Fixed Costs 60 000 000 Net Income 2 400 000

Net Operating Income (EBIT) 20 000 000 DFL = 20 000 000/ 20 000 000- 16 000 000
= 5.0x [Link] actual sales are 10% greater than expected sales , EPS will be 200% greater than expected:
DOL = 80/20 = 4x
20 x 10%=200%
DTL = 4 x5
If sales increase by 10% = EBIT would be 40% higher.
[Link] sales drop by 5%,net income will drop by 20 x 5%= 100%
=20
Sales 220 000 000 Sales 190 000 000

VC 132 000 000 Variable costs 114 000 000

Contribution Margin 76 000 000

Fixed costs 60 000 000

EBIT 16 000 000

Interest 16 000 000

EBT 0

At this point the firm is at financial breakeven point.

[Link] shows that the proposal is fairly risky if the expected sales level is 20 million [Link] company is near the breakeven point.
WEEK 6 - WORKING
CAPITAL
[Link]
EXAMPLE 1: Suppose a firm expects sales of $ 2 million on 80,000 units of
output and expects a profit margin before interest and taxes(operating
profitability) of 10%. Fixed assets are $ 500,000 for the period and
management is considering asset positions of $ 400,000, $ 500,000, and $
600,000.
A B C
Sales $ 2,000,000 2,000,000 2,000,000
EBIT 200,000 200,000 200,000
Current Assets 600,000 500,000 400,000
Fixed Assets 500,000 500,000 500,000
Total Assets 1,100,000 1,000,000 900,000
Current Liabilities 500,000 500,000 500,000
Basic earning power
(EBIT / Total assets) 18.2% 20.0% 22.2%
Working Capital Turnover 3.3x 4.0x 5.0x
CA/Sales 0.30 0.25 0.20
Current Ratio 1.2x 1.0x 0.80x

Alternative A which provides the highest liquidity cushion against unexpected

demand for funds, gives the lowest rate of return as revealed by the basic earning
power ratio..
 CASH CONVERSION PERIOD
( Speedy Maintenance Inc.)
DATA:
[Link] ACCOUNTS RECEIVABLE = 65,000+85,000/ 2
= $ 75,000
[Link] RECEIVABLE TURNOVER = 430,500/ 75,000
= 5.74X
3.A/R CONVERSION PERIOD = 365/ 5.74
= 64 days
[Link] INVENTORY OF SUPPLIES = 18,000+ 21,000/ 2
= 19,500
[Link] TURNOVER = COGS*/ INVENTORY
= 70,000/ 19,500
= 3.59 X
[Link] PERIOD = 365/ 3.59
= 102 days
[Link] ACCOUNTS PAYABLE = 45,000+ 55,000/ 2
= $50,000
[Link] PAYABLE TURNOVER = COGS/ AV. A/P
= 360,000/ 50,000
= 7.2X
9.A/ P DEFERRAL PERIOD = 365 / 7.2
= 51 days
CASH CONVERSION PERIOD = 64+ 102 – 51

= 115 DAYS
This is COGS for supplies only.
 FINANCING CASH FLOW CYCLE

Asset Average Amount Average Investment Cost Of Financing

Invested Period
10% 15% 20%

Inventories $ 19,500 102 days $ 545 $817 $ 1090

Accounts
Receivable $ 75,000 64 days $1315 $1973 $ 2630

Accounts
Payable $ 50,000 ( 51 days) $(699) $(1048) $(1397)

Total Cost of Finance 115 days $ 1161 $1742 $ 2323

CASE I : BROWNING INC.
 A CASE ON WORKING CAPITAL MANAGEMENT

Timothy Wong is recently hired as the financial manager of Browning Office

Furnishings,Inc. , a small manufacturer of metal office furniture. His first duty is to
develop a working capital policy. Wong has identified three potential policies.

An aggressive policy
A conservative policy
A moderate policy

The balance sheet will look as follows under the three policies:

BALANCE SHEET

Aggressive Moderate Conservative

Current assets $300 $400 $500
Net fixed assets 400 400 400
Total assets 700 800 900
Short term debt (8%) 400 200 0
Long term debt(10%) 0 200 400
Common equity 300 400 500
Total claims 700 800 900
Variable costs are expected to be 60% of sales regardless of which
working capital policy is adopted, but fixed costs would increase when
more current assets are held because of increased storage and insurance
costs. Annual fixed costs would be $ 200,000 under an aggressive policy,
$ 210,000 with a moderate policy, and $ 220,000 under a conservative policy.

Because its working capital policy would influence the firm’s ability to
respond to customers’ needs , sales are expected to vary under different
economic scenarios are as follows ( in thousands of dollars) :

SALES

Economy Aggressive Moderate Conservative

Strong $ 1,000 $ 1,050 $ 1,100

Average 800 900 1,000
Weak 600 750 900
 QUESTIONS

[Link] are the two basic decisions in formulating a working capital

policy?

[Link] income statements for Browning for each working capital

policy
assuming an average economy, a strong economy and a weak economy.
Calculate ROE as well.

[Link] that there is a 50 % chance of an average economy and a

25 % probability for both a strong and a weak economy. What is the
expected ROE under each policy? Are the policies equally risky?

[Link] that the government adopts a tight monetary policy and

increases interest [Link] the firm adopts the conservative policy, it will
lock in its 10% long term cost. However, if it follows the aggressive
policy, the short term rates increase by 4 % and this will increase short
term debt cost to 12%. What impact would this have on the firm’s
profitability under each of the working capital policies,in an average
economy, as measured by ROE ?
ANSWERS TO SELECTED
QUESTIONS
BROWNING INC.