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. NWCS 2001 SALES WERE $2 BILLION, AND THE WILSON MARKETING DEPARTMENT IS FORECASTING A 25 PERCENT INCREASE FOR 2002.

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 WILSONS ASSISTANT, AND YOUR FIRST MAJOR TASK IS TO HELP HER DEVELOP THE FORECAST. BY ANSWERING THE FOLLOWING SET OF QUESTIONS. SHE ASKED YOU TO BEGIN

FINANCIAL STATEMENTS AND OTHER DATA ON NWC (MILLIONS OF DOLLARS)

A. 2001 BALANCE SHEET % OF % OF SALES SALES CASH & SECURITIES $ 20 1% ACCOUNTS PAYABLE AND ACCRUALS $ 100 5% ACCOUNTS RECEIVABLE 240 12 NOTES PAYABLE 100 INVENTORY 240 12 TOTAL CURRENT LIABILITIES $ 200 TOTAL CURRENT ASSETS $ 500 LONG-TERM DEBT 100 NET FIXED ASSETS 500 25 COMMON STOCK 500 RETAINED EARNINGS 200 TOTAL ASSETS $1,000 TOTAL LIABILITIES AND EQUITY $1,000 % OF SALES $2,000.00 1,200.00 700.00 $ 100.00 16.00 $ 84.00 33.60 $ 50.40 $ 15.12 $ 35.28 60% 35

B. 2001 INCOME STATEMENT

SALES COST OF GOODS SOLD (COGS) SALES, GENERAL, AND ADMINISTRATIVE COSTS EARNINGS BEFORE INTEREST AND TAXES INTEREST EARNINGS BEFORE TAXES TAXES (40%) NET INCOME DIVIDENDS (30%) ADDITION TO RETAINED EARNINGS

Integrated Case: 7 - 1

C. KEY RATIOS BASIC EARNINGS POWER PROFIT MARGIN RETURN ON EQUITY DAYS SALES OUTSTANDING (360 DAYS) INVENTORY TURNOVER FIXED ASSETS TURNOVER TOTAL ASSETS TURNOVER DEBT/ASSETS TIMES INTEREST EARNED CURRENT RATIO PAYOUT RATIO OPERATING PROFIT MARGIN AFTER TAXES (NOPAT/SALES) OPERATING CAPITAL REQUIREMENT (OPERATING CAPITAL/SALES) RETURN ON INVESTED CAPITAL

NWC 10.00% 2.52 7.20 43.20 DAYS 8.33 4.00 2.00 30.00% 6.25 2.50 30.00% 3.00% 45.00%

INDUSTRY 20.00% 4.00 15.60 32.00 DAYS 11.00 5.00 2.50 36.00% 9.40 3.00 30.00% 5.00% 35.00%

INTEGRATED CASE
(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 COMPANYS 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? THESE PROVISIONS MAKE BONDS MORE OR LESS RISKY?

DO

Integrated Case: 7 - 2

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 YEARS 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 BONDS 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 BONDS 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 BONDS VALUE AS TIME PASSES, AND AS THE MATURITY DATE APPROACHES. IF WE THEN PLOTTED
Bond Value ($)
1,400

$1,372 $1,211

k = 7%

1,200

k = 10%
1,000

$837
800

$775

k = 13%

30

25

20

15

10

Years Remaining to Maturity

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 BONDS 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 TODAYS 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 SHORTTERM 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 COMPANYS 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.

HOW MUCH SHOULD THE FIRM PLAN TO INVEST EACH YEAR?

ANSWER: START WITH A TIME LINE: 0 10% 20 | | 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. 1 | PMT 2 | PMT

18 | PMT

19 | PMT

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

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 1YEAR 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, LETS LOOK AT THIS TIME LINE: 0 20 | | 14,864.36 100,000 1-YEAR UNCERTAINTY 20-YEAR UNCERTAINTY 16,351 1,486 ? 1,486 ? ? GREATER LESS | |

18 |

19 |

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 COMPANYS PURPOSES?

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: 20 |
Value = 14,864.36 16,351 17,986 90,909 100,000 = FV

0 10% |

1 |

2 |

19 |

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

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 BONDS 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 | | 50 1 | 50 | 50 2 | 50 | 50 3 | 50 | 50 4 | 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 COMPANYS 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 DEBT B. SENIOR VS. SUBORDINATED DEBT C. GUARANTEE PROVISIONS D. SINKING FUND PROVISIONS E. DEBT MATURITY 3. OTHER FACTORS: A. EARNINGS STABILITY B. REGULATORY ENVIRONMENT C. POTENTIAL PRODUCT LIABILITY D. ACCOUNTING POLICY

INTEGRATED CASE

Allied Food Products Capital Budgeting and Cash Flow Estimation 11-18 AFTER SEEING SNAPPLES SUCCESS WITH NONCOLA SOFT DRINKS AND LEARNING OF COKES AND PEPSIS 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 ALLIEDS 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 PROJECTS 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. ALLIEDS 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 ALLIEDS 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. ALLIEDS LEMON JUICE PROJECT

(TOTAL COST IN THOUSANDS) END OF YEAR: 3 4
I. INVESTMENT OUTLAY

EQUIPMENT COST INSTALLATION INCREASE IN INVENTORY INCREASE IN ACCOUNTS PAYABLE 14

TOTAL NET INVESTMENT

II. OPERATING CASH FLOWS

UNIT SALES (THOUSANDS) PRICE/UNIT

$ 2.00 $200.0 $120.0 $199.2

100 $ 2.00

TOTAL REVENUES OPERATING COSTS, EXCLUDING DEPRECIATION DEPRECIATION 36.0 16.8 TOTAL COSTS OPERATING INCOME BEFORE TAXES 44.0 TAXES ON OPERATING INCOME 25.3 OPERATING INCOME AFTER TAXES 26.4 DEPRECIATION 36.0 OPERATING CASH FLOW $ 54.7
III. TERMINAL YEAR CASH FLOWS

$228.0 $

0.3 $ 79.2 $ 0.0 $ 79.7

RETURN OF NET OPERATING WORKING CAPITAL SALVAGE VALUE TAX ON SALVAGE VALUE TOTAL TERMINATION CASH FLOWS

NET CASH FLOW $ 89.7

V. RESULTS

IV. NET CASH FLOWS

($260.0)

NPV = 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 PROJECTS 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 YEAR YEAR YEAR 1 2 3 4 0.33 0.45 0.15 0.07 1.00 $240 $240 $240 $240 = $ 79.2 = 108.0 = 36.0 = 16.8 $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.

17

TABLE IC11-1. ALLIEDS LEMON JUICE PROJECT (TOTAL COST IN THOUSANDS) INPUTS: 0.0% PRICE: VC RATE: END OF YEAR: 4 I. INVESTMENT OUTLAY EQUIPMENT COST INSTALLATION INCREASE IN INVENTORY INCREASE IN ACCOUNTS PAYABLE TOTAL NET INVESTMENT ($200) (40) (25) 5 (260) 100 $ 2.00 $200.0 $120.0 79.2 $199.2 $ 0.8 0.3 $ 0.5 79.2 0.0 $ 79.7 100 $ 2.00 $200.0 $120.0 108.0 $228.0 ($ 28.0) (11.2) ($ 16.8) 108.0 $ 91.2 $ $ $ $ $2.00 60.0% 0 k: T-RATE: 1 10.0% 40% 2 3 INFL:

II. OPERATING CASH FLOWS UNIT SALES (THOUSANDS) 100 100 PRICE/UNIT 2.00 $ 2.00 TOTAL REVENUES $200.0 $200.0 OPERATING COSTS, EXCLUDING DEPRECIATION $120.0 $120.0 DEPRECIATION 36.0 16.8 TOTAL COSTS $156.0 $136.8 OPERATING INCOME BEFORE TAXES 44.0 $ 63.2 TAXES ON OPERATING INCOME 17.6 25.3 OPERATING INCOME AFTER TAXES 26.4 $ 37.9 DEPRECIATION 36.0 16.8 OPERATING CASH FLOW $ 62.4 $ 54.7
III.

RETURN OF NET OPERATING WORKING CAPITAL 20.0 SALVAGE VALUE 25.0 18

TERMINAL YEAR CASH FLOWS

TAX ON SALVAGE VALUE (10.0) TOTAL TERMINATION CASH FLOWS $ 35.0 IV. NET CASH FLOWS NET CASH FLOW 62.4 $ 89.7 ($260.0) $ 79.7 $ 91.2 $

CUMULATIVE CASH FLOW FOR PAYBACK: (260.0) (26.7) 63.0 COMPOUNDED INFLOWS FOR MIRR: 68.6 89.7 TERMINAL VALUE OF INFLOWS: 374.8 V. RESULTS NPV = -$4.0 IRR = 9.3% MIRR = 9.6% PAYBACK = 3.3 YEARS

(180.3) 106.1

(89.1) 110.4

19

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.

ANSWER: THE BASE CASE VALUE FOR UNIT SALES WAS 100; THEREFORE, IF 20

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 IS DOWNWARD SLOPING, BECAUSE A HIGHER COST OF 21

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

THE SENSITIVITY DATA ARE GIVEN HERE IN TABULAR FORM (IN THOUSANDS OF DOLLARS): CHANGE FROM CHANGE IN:
BASE LEVEL UNIT SALES

N (Thousand
k

RESULTING NPV AFTER THE INDICATED

SALVAGE VALUE

70 60 50

-30% $34.1 -20 27.5 -10 21.1 0 15.0 +10 9.0 +20 3.3 +30 (2.2)

($36.4) (19.3) (2.1) 15.0 32.1 49.2 66.3

$11.9 12.9 13.9 15.0 16.0 17.0 18.0

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

40 30

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.

INTEGRATED CASE

SKI Equipment Inc. 25

Working Capital Management

14-21 DAN BARNES, FINANCIAL MANAGER OF SKI EQUIPMENT INC. (SKI), IS

EXCITED, BUT APPREHENSIVE.

THE COMPANYS FOUNDER RECENTLY SOLD HIS EVA IS FOUND BY TAKING THE

51 PERCENT CONTROLLING BLOCK OF STOCK TO KENT KOREN, WHO IS A BIG FAN OF EVA (ECONOMIC VALUE ADDED). 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 SKIS 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 SKIS 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 SKIS MANAGERS TO CORRECT THE PROBLEM OR ELSE. BARNES HAS LONG FELT THAT SKIS 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. KORENS SPEECH MADE IT CLEAR THAT SUCH RESISTANCE WOULD NO LONGER BE TOLERATED.

AFTER-TAX OPERATING PROFIT AND THEN SUBTRACTING THE DOLLAR COST OF

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

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

SKIS

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 HOWEVER, IF SKI IS MAINTAIN GOOD RELATIONSHIPS WITH ITS CUSTOMERS.

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. STEPS TO REDUCE ITS WORKING CAPITAL. THIS SUGGESTS THAT IT SIMPLY HAS EXCESSIVE WORKING CAPITAL, AND THAT IT SHOULD TAKE

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, LIABILITY, PAYMENTS. A FIRMS AND DEPRECIATION DEPRECIATION EXPENSE AFFECTS DOES IMPACT ITS TAX TAX HENCE SKIS QUARTERLY

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 A COMPANY MAY UNFORTUNATELY,

EXPECTED, THE COMPANY COULD FACE A CASH SHORTFALL. IN ITS SALES FORECAST OR IF IT IS VERY CONSERVATIVE. HAVE THE LUXURY TO BE EXTREMELY CONSERVATIVE.

CHOOSE TO HOLD LARGE AMOUNTS OF CASH IF IT DOES NOT HAVE MUCH FAITH GIVEN ITS CURRENT PRESSURE TO PERFORM, SKIS MANAGEMENT DOES NOT

27

K.

IF THE COMPANY REDUCES ITS INVENTORY WITHOUT ADVERSELY AFFECTING SALES, WHAT EFFECT SHOULD THIS HAVE ON THE COMPANYS CASH POSITION (1) IN THE SHORT RUN AND (2) IN THE LONG RUN? THE CASH BUDGET AND THE BALANCE SHEET. EXPLAIN IN TERMS OF

ANSWER:

[SHOW S14-21 HERE.]

REDUCING INVENTORY PURCHASES WILL INCREASE THE

COMPANYS 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. HIGHER DIVIDENDS OR REPURCHASING ITS SHARES. ALTERNATIVELY, THE FIRM CAN DISTRIBUTE THE EXCESS CASH TO ITS SHAREHOLDERS THROUGH

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? THE BALANCE SHEET. RUN? ANSWER IN TERMS OF THE CASH BUDGET AND WHAT EFFECT SHOULD THIS HAVE ON EVA IN THE LONG

ANSWER:

[SHOW S14-25 HERE.]

IF CUSTOMERS PAY THEIR BILLS SOONER, THIS WILL

INCREASE THE COMPANYS 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?

28

ANSWER:

[SHOW S14-29 HERE.] ACCRUED LIABILITIES.

NO, SKI COULD NOT MAKE GREATER USE OF ITS ACCRUED LIABILITIES ARISE BECAUSE (1) WORKERS THUS, ACCRUED

ARE PAID AFTER THEY HAVE ACTUALLY PROVIDED THEIR SERVICES, AND (2) TAXES ARE PAID AFTER THE PROFITS HAVE BEEN EARNED. 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 FIRMS PROFITABILITY, AS WELL AS BY INDUSTRY CONVENTIONS REGARDING WHEN WAGE PAYMENTS ARE MADE AND IRS REGULATIONS PUTTING CONTROL REGARDING ON TAX A PAYMENTS. PAY-AS-YOU-GO, (INCREASINGLY, OR EVEN USE CONGRESS IS BUSINESSES ITS PAY-AHEAD-OF-TIME ALL THE ACCRUED

BASIS THROUGH THE USE OF ESTIMATED TAXES.) ACCRUED LIABILITIES. FIRMS

A FIRM CANNOT ORDINARILY

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: ACTUAL g: INCOME STATEMENT: 25.00% 25.00%
2001 ACTUAL $2,000.00 2002 PRO FORMA $2,500.00 2002 2ND PASS $2,500.00

FEEDBACK

SALES

29

LESS: COGS(% SALES) SGA(% SALES) EBIT INTEREST (8%) EBT TAXES NET INCOME

60.00% 35.00%

40.0%

(1,200.00) (700.00) $ 100.00 (16.00) $ 84.00 (33.60) $ 50.40

(1,500.00) (875.00) $ 125.00 (16.00) $ 109.00 (43.60) $ 65.40

(1,500.00) ( 875.00) $ 125.00 +(14.34)* ( 30.34) 94.66 ( 37.86) $ 56.80

*FEEDBACK EQUALS NEW INTEREST ON NEW DEBT: $14.34 = 8%($179.22). DIVIDENDS ADDN TO R.E. 30.0% $ $ 15.12 35.28 2001 ACTUAL $ 20.00 240.00 240.00 $ 500.00 500.00 $1,000.00 $ 100.00 100.00 100.00 500.00 200.00 $1,000.00 $ $ 19.62 45.78 $ $ 17.04 39.76 2002 2ND PASS $ 25.00 300.00 300.00 $ 625.00 625.00 $1,250.00 $ 89.61 89.61 (6.02) 125.00 189.61 189.61 500.00 239.76 $1,243.98 $ $ 6.02 185.24

BALANCE SHEET:

2002 PRO FORMA $ 25.00 300.00 300.00 $ 625.00 625.00 $1,250.00 $ 125.00 100.00 100.00 500.00 245.78 $1,070.78 $ $ 179.22 179.22

FEEDBACK

CASH & SECURITIES ACCOUNTS RECEIVABLE INVENTORIES CURRENT ASSETS NET FA (% CAP) TOTAL ASSETS A/P AND ACCRUALS N/P (SHORT-TERM) L-T DEBT COMMON STOCK RETAINED EARNINGS TOTAL LIAB & EQUITY AFN CUM. AFN

100.0%

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: N/P L-T DEBT COMMON STOCK WEIGHTS 0.50 0.50 0.00 1.00 DOLLARS $ 89.61 89.61 0.00 $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.

30

E. ANSWER:

CALCULATE NWCS FREE CASH FLOW FOR 2002.

FREE CASH FLOW

OPERATING CASH FLOW

GROSS INVESTMENT IN OPERATING CAPITAL

= 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: ASSETS. H. BASED ON COMPARISONS BETWEEN NWCS 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? WOULD 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 FIRMS INVESTMENT IN ACCOUNTS RECEIVABLE AND INVENTORY), WHICH WOULD LEAD TO IMPROVEMENTS IN MOST OF THE RATIOS. FREED UP WERE (THE CURRENT RATIO WOULD DECLINE UNLESS THE FUNDS USED TO REDUCE CURRENT LIABILITIES, WHICH WOULD THIS HAVE ON ITS AFN AND IF THE COMPANY WERE ABLE TO ITS FINANCIAL RATIOS? (NOTE: OPERATING CAPITAL = NET OPERATING WORKING CAPITAL + NET FIXED

BRING THESE RATIOS INTO LINE WITH THE INDUSTRY AVERAGES, WHAT EFFECT INVENTORIES AND RECEIVABLES WILL BE DISCUSSED IN DETAIL IN CHAPTER

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? PAYOUT RATIO, (2) THE PROFIT MARGIN, (3) THE (1) THE DIVIDEND CAPITAL INTENSITY

31

RATIO, AND (4) NWC BEGINS BUYING FROM ITS SUPPLIERS ON TERMS WHICH PERMIT IT TO PAY AFTER 60 DAYS RATHER THAN AFTER 30 DAYS. 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, 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 AT ZERO, THESE SURPLUS FUNDS WOULD BE USED TO FINANCE GROWTH. EXACTLY USED UP. SUSTAINABLE (CONSIDER

SOME POINT, i.e., AT SOME GROWTH RATE, THE SURPLUS AFN WOULD BE THIS GROWTH RATE WHERE AFN = $0 IS CALLED THE RATE, AND IT IS THE MAXIMUM GROWTH RATE GROWTH

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 HIGHER THE DOLLARS OF ASSETS REQUIRED PER DOLLAR OF SALES. TO SUPPORT AN ADDITIONAL DOLLAR OF SALES. CONSTANT. 4. IF NWCS PAYMENT TERMS WERE INCREASED FROM 30 TO 60 DAYS,

THE CAPITAL INTENSITY RATIO, THE MORE NEW MONEY WILL BE REQUIRED THUS, THE HIGHER THE CAPITAL INTENSITY RATIO, THE GREATER THE AFN, OTHER THINGS HELD

ACCOUNTS PAYABLE WOULD DOUBLE, IN TURN INCREASING CURRENT AND TOTAL LIABILITIES. DECREASED NEED FOR THIS WOULD REDUCE THE AMOUNT OF AFN DUE TO A WORKING CAPITAL ON HAND TO PAY SHORT-TERM

CREDITORS, SUCH AS SUPPLIERS.

32