Financial Management

Integrated Case Chapter 16

New 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 2012. NWC’s 2011 sales were $2billion, and the marketing department is forecasting a 25% increase for 2012. Wilson thinks the company was operating at a full capacity in 2011, 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 2011 financial statements, the 2012 initial forecast, and a ratio analysis for 2011 and the 2012 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 2011 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 ill grow at the same rate as sales (4) that the 2011 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 forecast growth will require a new facility, which is expected to increase NWC’s next fixed assets to $700 million.

3. A relatively new inventory management system (installed last year) has taken some times 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 10X.

Incorporate that information into the 2012 initial forecast results, as these adjustments to the initial forecast represent the final forecast for 2012 (Hint: Total assets do not change from the initial forecast.)

c. Calculate NWC’s forecast ratios based on its final forecast and compare them with the

company’s 2011 historical ratios, the 2012 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 financial forecast, calculate NWC’s free cash flow for 2012. 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 since 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, 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 2011 2012E

Cash & 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 & 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 2011 2012E

Sales $2,000.00 $2,500.00

Variable costs 1,200.00 1,500.00

Fixed costs 700.00 875.00

Earnings before interest & taxes (EBIT) $100.00 $125.00

Interest 16.00 16.00

Earnings before taxes (EBIT) $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

C. Key Ratios NWC(2011) NWC(2012E) Industry Comment

Basic earning power 10.00% 10.00% 20.00%

Profit margin 2.52 2.62 4.00

Return on equity 7.20 8.77 15.60

Days sales outstanding 43.80 days 43.80 days 32.00 days

(365 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 30.00% 40.40% 36.00%

Times interest earned 6.25x 7.81x 9.40x

Current ratio 2.50 1.99 3.00

Payout ratio 30.00% 30.00% 30.00%