CASE STUDY CONTINUATION
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Assuming that all debt is constant, show that EFN can be written as:
EFN = −PM(S)b + [A − PM(S)b] × g
Hint: Asset needs will equal A × g. The addition to retained earnings will equal PM(S) b × (1 + g).
28. Sustainable Growth Rate Based on the results in Problem 27, show that the internal and sustainable growth rates can be calculated as shown in Equations 3.24 and 3.25. (Hint: For the internal growth rate, set EFN equal to zero and solve for g.)
29. Sustainable Growth Rate In the chapter, we discussed one calculation of the sustainable growth rate as:
In practice, probably the most commonly used calculation of the sustainable growth rate is ROE × b. This equation is identical to the sustainable growth rate equation presented in the chapter if the ROE is calculated using the beginning of period equity. Derive this equation from the equation presented in the chapter.
30. Sustainable Growth Rate Use the sustainable growth rate equations from the previous problem to answer the following questions. I Am Myself, Inc., had total assets of $410,000 and equity of $230,000 at the beginning of the year. At the end of the year, the company had total assets of $460,000. During the year the company sold no new equity. Net income for the year was $75,000 and dividends were $32,000. What is the sustainable growth rate for the company? What is the sustainable growth rate if you calculate ROE based on the beginning of period equity?
Excel Master It! Problem
Financial planning can be more complex than the percentage of sales approach indicates. Often, the assumptions behind the percentage of sales approach may be too simple. A more sophisticated model allows important items to vary without being a strict percentage of sales.
Consider a new model in which depreciation is calculated as a percentage of beginning fixed assets, and interest expense depends directly on the amount of debt. Debt is still the plug variable. Note that since depreciation and interest now do not necessarily vary directly with sales, the profit margin is no longer constant. Also, for the same reason, taxes and dividends will no longer be a fixed percentage of sales. The parameter estimates used in the new model are:
Cost percentage = Costs / Sales Depreciation rate = Depreciation / Beginning fixed assets Interest rate = Interest paid / Total debt Tax rate = Taxes / Net income Payout ratio = Dividends / Net income Capital intensity ratio = Fixed assets / Sales Fixed assets ratio = Fixed assets / Total assets Page 84
The model parameters can be determined by whatever methods the company deems appropriate. For example, they might be based on average values for the last several years, industry standards, subjective estimates, or even company targets. Alternatively, sophisticated statistical techniques can be used to estimate them.
The Loftis Company is preparing its pro forma financial statements for the next year using this model. The abbreviated financial statements are presented below.
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1. Calculate each of the parameters necessary to construct the pro forma balance sheet.
2. Construct the pro forma balance sheet. What is the total debt necessary to balance the pro forma balance sheet?
3. In this financial planning model, show that it is possible to solve algebraically for the amount of new borrowing.
Mini Case RATIOS AND FINANCIAL PLANNING AT EAST COAST YACHTS
Dan Ervin was recently hired by East Coast Yachts to assist the company with its short-term financial planning and also to evaluate the company’s financial performance. Dan graduated from college five years ago with a finance degree, and he has been employed in the treasury department of a Fortune 500 company since then.
East Coast Yachts was founded 10 years ago by Larissa Warren. The company’s operations are located near Hilton Head Island, South Carolina, and the company is structured as an LLC. The company has manufactured custom midsize, high-performance yachts for clients over this period, and its products have received high reviews for safety and reliability. The company’s yachts have also recently received the highest award for customer satisfaction. The yachts are primarily purchased by wealthy individuals for pleasure use. Occasionally, a yacht is manufactured for purchase by a company for business purposes.
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The custom yacht industry is fragmented, with a number of manufacturers. As with any industry, there are market leaders, but the diverse nature of the industry ensures that no manufacturer dominates the market. The competition in the market, as well as the product cost, ensures that attention to detail is a necessity. For instance, East Coast Yachts will spend 80 to 100 hours on hand-buffing the stainless steel stem-iron, which is the metal cap on the yacht’s bow that conceivably could collide with a dock or another boat.
To get Dan started with his analyses, Larissa has provided the following financial statements. Dan has gathered the industry ratios for the yacht manufacturing industry.
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1. Calculate all of the ratios listed in the industry table for East Coast Yachts.
2. Compare the performance of East Coast Yachts to the industry as a whole. For each ratio, comment on why it might be viewed as positive or negative relative to the industry. Suppose you create an inventory ratio calculated as inventory divided by current liabilities. How do you interpret this ratio? How does East Coast Yachts compare to the industry average?
3. Calculate the sustainable growth rate of East Coast Yachts. Calculate external funds needed (EFN) and prepare pro forma income statements and balance sheets assuming growth at precisely this rate. Recalculate the ratios in the previous question. What do you observe?
4. As a practical matter, East Coast Yachts is unlikely to be willing to raise external equity capital, in part because the owners don’t want to dilute their existing ownership and control positions. However, East
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Coast Yachts is planning for a growth rate of 20 percent next year. What are your conclusions and recommendations about the feasibility of East Coast’s expansion plans?
5. Most assets can be increased as a percentage of sales. For instance, cash can be increased by any amount. However, fixed assets often must be increased in specific amounts because it is impossible, as a practical matter, to buy part of a new plant or machine. In this case a company has a “staircase” or “lumpy” fixed cost structure. Assume that East Coast Yachts is currently producing at 100 percent of capacity. As a result, to expand production, the company must set up an entirely new line at a cost of $25 million. Calculate the new EFN with this assumption. What does this imply about capacity utilization for East Coast Yachts next year?