978-1285190907 Chapter 10 Part 8

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Chapter 10

Forecasting Financial Statements

10-71

in whole or in part.

approach to assess how far net income and cash flows would need to decrease and how

much long-term debt and interest expense would need to increase before the minimum

liquidity and interest coverage ratios become binding.

Projected financial statements also enable students to test the potential impact of

strategic planning ideas. Suppose, at the beginning of Year +1, Starbucks is considering a

new contract with a distribution channel that should increase revenues by $1 billion by

Year +3 and that the firm should be able to sustain this new level of sales into the future.

Students can adapt the financial statement forecasts to incorporate the projected effects of

these potential sales (as well as related incremental expenses; receivables; inventory;

property, plant, and equipment; and capital) rather efficiently into expectations for

Starbucks’ future earnings, balance sheets, and cash flow.

Summary.

The preparation of financial statement forecasts for Starbucks requires numerous

assumptions about growth rates in revenues, cost behavior of various expenses, levels of

investment in working capital and fixed assets, mix of debt and equity financing, and

others. The case provides you and your students with an interesting setting in which to

discuss and develop realistic expectations for these activities and to capture those

expectations in financial statements that provide an objective and realistic portrait of the

firm in the future. After developing realistic expectations for future earnings, cash flows,

and dividends using financial statement projections, you and your students can begin to

make decisions with these data, including decisions about the firm as a potential equity

investment, or a potential credit risk, or a strategic plan. Chapters 11–14 will return to

this case to demonstrate and apply the valuation models and techniques.

Chapter 10

Forecasting Financial Statements

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in whole or in part.

Exhibit 10.M

Starbucks

Financial Ratios Analysis Based on Actual and Forecast Financial Statements

Actuals Forecasts

2010 2011 2012 Year +1 Year +2 Year +3 Year +4 Year +5 Year +6

FORECAST VALIDITY CHECK DATA:

GROWTH

Revenue Growth Rates: 9.5% 9.3% 13.7% 12.5% 12.0% 11.6% 10.9% 10.8% 3.0%

Net Income Growth Rates: 285.7% -14.8% -60.9% 13.6% 14.0% 13.7% 13.0% 24.7% 3.0%

Total Asset Growth Rates 14.5% 15.3% 11.7% 10.1% 12.4% 11.7% 10.8% 14.0% 3.0%

RETURN ON ASSETS (based on reported amounts):

Profit Margin for ROA 9.1% 10.9% 10.6% 10.7% 10.8% 11.0% 11.2% 12.5% 12.5%

× Asset Turnover 1.8 1.7 1.7 1.7 1.7 1.7 1.7 1.7 1.6

= Return on Assets 16.2% 18.5% 18.0% 18.5% 18.9% 19.1% 19.4% 21.4% 20.4%

RETURN ON ASSETS (excluding the effects of nonrecurring items):

Profit Margin for ROA 9.5% 10.6% 10.6% 10.7% 10.8% 11.0% 11.2% 12.5% 12.5%

× Asset Turnover 1.8 1.7 1.7 1.7 1.7 1.7 1.7 1.7 1.6

= Return on Assets 17.1% 18.0% 18.0% 18.5% 18.9% 19.1% 19.4% 21.4% 20.4%

RETURN ON COMMON EQUITY (based on reported amounts):

Profit Margin for ROCE 8.8% 10.6% 10.4% 10.5% 10.7% 10.9% 11.1% 12.5% 12.5%

× Asset Turnover 1.8 1.7 1.7 1.7 1.7 1.7 1.7 1.7 1.6

× Capital Structure Leverage 1.8 1.7 1.6 1.6 1.6 1.6 1.6 1.5 1.5

= Return on Common Equity 28.1% 30.9% 29.2% 29.7% 30.1% 30.1% 30.3% 32.0% 29.5%

RETURN ON COMMON EQUITY (excluding the effects of nonrecurring items):

Profit Margin for ROCE 9.3% 10.4% 10.4% 10.5% 10.7% 10.9% 11.1% 12.5% 12.5%

× Asset Turnover 1.8 1.7 1.7 1.7 1.7 1.7 1.7 1.7 1.6

× Capital Structure Leverage 1.8 1.7 1.6 1.6 1.6 1.6 1.6 1.5 1.5

= Return on Common Equity 29.7% 30.2% 29.2% 29.7% 30.1% 30.1% 30.3% 32.0% 29.5%

OPERATING PERFORMANCE:

Gross Profit / Revenues 58.4% 58.0% 56.3% 56.8% 57.1% 57.4% 57.7% 58.0% 58.0%

Operating Profit Before Taxes / Revenues 13.3% 14.8% 15.0% 15.3% 15.6% 15.9% 16.2% 18.2% 18.2%

ASSET TURNOVER:

Revenues / Avg. Accounts Receivable 37.3 34.0 30.5 27.7 25.9 24.9 24.6 24.6 23.7

COGS / Average Inventory 7.4 6.5 5.3 5.2 5.6 5.6 5.5 5.5 5.4

Revenues / Average Fixed Assets 4.3 4.9 5.3 5.2 4.9 4.8 4.7 4.4 4.1

LIQUIDITY:

Current Ratio 1.5 1.8 1.9 1.7 1.7 1.7 1.5 1.7 1.7

Quick Ratio 1.0 1.2 1.1 1.0 1.1 1.0 0.9 1.0 1.0

SOLVENCY:

Total Liabilities / Total Assets 42.3% 40.4% 37.8% 39.2% 37.0% 37.3% 35.8% 31.2% 31.2%

Total Liabilities / Total Equity 73.4% 67.8% 60.7% 64.6% 58.8% 59.5% 55.7% 45.4% 45.4%

Interest Coverage Ratio 44.9 55.4 64.0 69.4 78.9 89.6 101.1 250.5 250.5

Chapter 10

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in whole or in part.

Case 10.2: Massachusetts Stove Company: Analyzing Strategic Options

I. Case Objectives

1. Design a spreadsheet for the preparation of pro forma financial statements that

has the flexibility to analyze various strategic options.

2. Use tools of financial statement analysis to evaluate strategic options for a

business that is approaching maturity.

II. Teaching Strategy

We begin discussion of this case by asking students to identify clues from the

financial statements for Year 3 to Year 7 that Massachusetts Stove Company is in a

maturing business. We next discuss some of the difficulties students encountered in

designing their spreadsheets. We then ask three students to present their pro forma

financial statements, one each for the best-case scenario, the most likely case

scenario, and the worst-case scenarios. Also ask those students to comment on the

profitability and risk ratios for their scenarios. Finally, open the discussion to all

students to discuss their recommendation to Massachusetts Stove Company. Each

of these items is discussed more fully below.

III. Responses to Case Questions

a. Clues Indicating the Maturity of Massachusetts Stove Company’s Business

i. Decrease in profit margin and increase in asset turnover during the last three

years, which are indicative of increased margin pressure but cutbacks in

asset growth, particularly capital expenditures

ii. Buildup of cash on the balance sheet even after substantially reducing debt

iii. A counter clue is the substantial increase (15.1%) in sales between Year 6

and Year 7. Although sales growth has varied during the last five years, the

growth rate has always been positive. Thus, the financial statements do not

give convincing clues as to the maturity of the wood stove business. Perhaps

the direct marketing niche of Massachusetts Stove Company has permitted it

to remain profitable while the rest of the industry has experienced more

significant decline.

b. Design of Spreadsheet

The most difficult issue confronted in the design of the spreadsheet is the

projection of interest income on the income statement and cash on the balance

sheet. The approach was to project all amounts on the income statement except

interest income net of income taxes, all amounts on the balance sheet except

cash and retained earnings, and all amounts on the statement of cash flows

except the effects of interest income net of income taxes. When added to the

ending balance in cash from the previous period, the amounts of net cash flow

each period on the statement of cash flows gave a preliminary balance in cash at

the end of the period. This preliminary balance in cash was then used to

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in whole or in part.

compute the average balance in cash for the year on which interest income was

computed. Interest income net of income taxes was plugged back into the

income statement to compute final net income. Final net income was flowed

forward into retained earnings on the balance sheet. Finally, interest income net

of income taxes was added to the preliminary balance in cash at the end of the

period to obtain the final balance in cash for the balance sheet.

Use this case to emphasize that the design of spreadsheets should allow

flexibility in considering various alternatives. The different assumptions with

regard to sales growth, development costs, and selling expenses among the three

scenarios mean that students should be able to change assumptions without

having to change formulas in the spreadsheets. Students might design their

spreadsheets, as was done here, so that the assumptions appear at the bottom

and the formulas access these assumptions when students make computations.

c. Projected Financial Statements and Ratios

Exhibits 10.N–10.Q of this teaching note present the projected financial

statements and ratios for the best-case scenario. Exhibits 10.R–10.U present

them for the most likely scenario, and Exhibits 10.V–10.Y present them for the

worst-case scenario. We discuss below our observations about each scenario.

Best-Case Scenario—The best-case scenario results in financial ratios similar

to those of Massachusetts Stove Company in recent years. The profit margin

declines slightly between Year 7 and Year 9 as the firm incurs costs to gear up

its new product line but steadily increases in Year 10–Year 12 as a result of

economies of scale with respect to selling expenses. The asset turnover

increases, primarily as a result of an increasing fixed-asset turnover. Sales

increases are sufficient to provide economies of scale benefits for fixed capacity

costs. Massachusetts Stove Company decreases its financial leverage

continually as it repays its bank borrowing without adding additional borrowing

to finance capital expenditures or product development. The short-term liquidity

and long-term solvency ratios are strong throughout the five years.

Most Likely Scenario—The most likely scenario results in a declining profit

margin and asset turnover during the phase-in period as a result of incurring

development costs on the new stoves. Depreciation expense as a percentage of

sales increases while the fixed-asset turnover declines. The profit margin slowly

improves after the phase-in period as a result of reductions in the selling and

administrative expense percentage. The assets turnover slowly improves as well

as the fixed-asset turnover increases. By Year 12, the ROA and ROCE are

considerably less than their levels in Year 7. As with the best-case scenario, the

short-term liquidity and long-term solvency ratios appear strong.

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in whole or in part.

Worst-Case Scenario—The profit margin declines even further under the

worst-case scenario and turns negative in Year 10. The asset turnover again

increases beginning in Year 10 because of the increasing fixed-asset turnover.

The rate of return on assets and return on common shareholders’ equity decline

continually during the five years. The short-term liquidity risk ratios appear

satisfactory. The long-term solvency ratios, however, are at unsatisfactory

levels. The cash flow from operations to total liabilities ratio is below the 20%

considered desirable beginning in Year 9 and the interest coverage ratio is low

or negative in Year 9 to Year 12.

d. Assessment of Strategic Options

In evaluating the move into gas stoves, it is helpful to examine the financial

performance of Massachusetts Stove Company by assuming that it remains in

the wood-stove business and does not pursue the gas stove option. We prepared

pro forma financial statements assuming the business simply continues as it has

in the past. We assume capital expenditures of $20,000 each year and a six-year

depreciable life. We examine six different scenarios with respect to growth in

wood stove sales. The ROA and the ROCE under each scenario appear next.

Rate of Return on Assets

Sales Growth Year 7 Year 8 Year 9 Year 10 Year 11 Year 12

+0.04 13.14% 13.56% 13.23% 12.92% 12.60% 12.29%

+0.02 13.14% 13.19% 12.61% 12.11% 11.65% 11.23%

0.00 13.14% 12.83% 11.99% 11.29% 10.68% 10.16%

–0.02 13.14% 12.45% 11.37% 10.47% 9.71% 9.06%

–0.04 13.14% 12.08% 10.74% 9.65% 8.73% 7.95%

–0.10 13.14% 10.94% 8.85% 7.16% 5.74% 4.52%

Rate of Return on Common Shareholders’ Equity

+0.04 32.56% 27.84% 23.85% 21.09% 19.00% 17.40%

+0.02 32.56% 26.98% 22.60% 19.63% 17.47% 15.82%

0.00 32.56% 26.12% 21.34% 18.17% 15.90% 14.28%

–0.02 32.56% 25.24% 20.07% 16.69% 14.30% 12.53%

–0.04 32.56% 24.36% 18.79% 15.19% 12.66% 10.80%

–0.10 32.56% 21.65% 14.88% 10.56% 7.53% 5.25%

The most likely scenario from moving into the gas stove market provides rates

of return on assets in Year 12 similar to those above when sales of wood stoves

decrease approximately 1% each year and rates of return on common

shareholders’ equity when sales increase approximately 1% each year. The

worst-case scenario from moving into the gas stove market provides rates of

return worse than those above when sales of wood-stoves decrease by 10% each

year. On the other hand, the best-case scenario from moving into the gas stove

market provides rates of return on assets by Year 10 better than any of the

growth scenarios above for the wood stove market and better than those for

Year 7.

Chapter 10

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in whole or in part.

The most compelling arguments for adding gas stoves to the product line are

as follows:

• Growth opportunities in the wood stove market appear limited.

• Massachusetts Stove Company has garnered a position in retail direct

marketing that it might now leverage with a related product line.

• Massachusetts Stove Company has a reputation for high efficiency,

attractive stoves among a relatively affluent customer base. The gas stoves

are a natural extension of this product line as the company’s original

customers age.

• The expansion into gas stoves can be done incrementally, adding one stove

in Year 9 and delaying work on the second stove until the success of the first

stove becomes clear.

• The second product line is insurance against further erosion in wood stove

sales and may make the company more valuable if shareholders decide to

sell.

The most compelling arguments for not adding gas stoves to the product line

are as follows:

• The market appears saturated already, with some companies up for sale.

• The EPA might institute health or safety regulations in this new industry

that would increase costs unexpectedly.

• The profitability ratios from instituting the most likely scenario are no better

than those from remaining in the wood-stove business only and

experiencing sales declines of 1–3% annually.

• There is a risk that gas stove sales will cannibalize wood stove sales.

• There are uncertainties with respect to projected demand and projected costs

whenever a firm moves into a new product.

Chapter 10

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in whole or in part.

Exhibit 10.N

Massachusetts Stove Company

Projected Income Statements under Best-Case Scenario

(Case 10.2)

MASS. STOVE Year 7 Year 8 Year 9 Year 10 Year 11 Year 12

Income Statement Actual Projected Projected Projected Projected Projected

Sales:

Woodstoves 2,734,986 2,789,686 2,845,479 2,902,389 2,960,437 3,019,646

Gas Stoves — — 167,381 532,272 955,077 1,444,040

Total Sales 2,734,986 2,789,686 3,012,861 3,434,661 3,915,514 4,463,686

Cost of Good Sold (1,380,820) (1,394,843) (1,506,430) (1,717,331) (1,957,757) (2,231,843)

Depreciation (72,321) (75,654) (100,654) (125,654) (129,821) (133,988)

Facilities Income 41,004 41,004 20,502 20,502 20,502 20,502

Facilities Costs (45,309) (45,309) (75,309) (75,309) (75,309) (75,309)

Selling Expenses (926,175) (948,493) (994,244) (1,099,092) (1,213,809) (1,339,106)

Administrative Expenses (111,199) (141,199) (171,199) (191,199) (191,199) (191,199)

Operating Income 240,166 225,191 185,526 246,579 368,121 512,743

Interest Income 16,665

Interest Expense (42,108) (38,135) (36,223) (34,163) (31,943) (29,546)

Net Income before Tax 214,723 187,056 149,303 212,416 336,178 483,198

Income Tax Expense (60,122) (52,376) (41,805) (59,476) (94,130) (135,295)

Net Income (Prelim) 154,601 134,680 107,498 152,939 242,048 347,902

Interest Income (net) 13,741 15,728 20,397 29,677 42,737

Net Income (Final) 148,422 123,226 173,336 271,725 390,639

ASSUMPTIONS

Sales Growth:

Woodstoves 0.02 0.02 0.02 0.02 0.02

Gas Stoves 0 0.06 0.12 0.12 0.12

Total Sales 0.02 0.08 0.14 0.14 0.14

Cost of Goods Sold/Sales 0.5 0.5 0.5 0.5 0.5

Developmental Costs 100,000 100,000 — — —

Depre. of Devel. Costs — 20,000 40,000 40,000 40,000

Capital Expenditures 20,000 30,000 30,000 25,000 25,000

Additional Depreciation 3,333 8,333 13,333 17,500 21,667

Facilities Income Dec. 0 –0.5 –0.5 –0.5 –0.5

Facilities Costs Inc. 0 30,000 30,000 30,000 30,000

Selling Exp./Sales 0.34 0.33 0.32 0.31 0.30

Administrative Exp. Inc. 30,000 30,000 20,000 — —

Interest Income 0.05 0.05 0.05 0.05 0.05

Interest Rate on Debt 0.068 0.068 0.068 0.068 0.068

Income Tax Rate 0.28 0.28 0.28 0.28 0.28

Chapter 10

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in whole or in part.

Exhibit 10.O

Massachusetts Stove Company

Projected Balance Sheets under Best-Case Scenario

(Case 10.2)

MASS. STOVE Year 7 Year 8 Year 9 Year 10 Year 11 Year 12

Balance Sheet Actual Projected Projected Projected Projected Projected

Assets

Cash 351,588 425,555 477,698 691,593 1,007,226 1,439,458

Accounts Receivable 5,997 6,117 6,606 7,531 8,586 9,788

Inventories 452,709 461,763 498,704 568,523 648,116 738,852

Total Current Assets 810,294 893,435 983,008 1,267,647 1,663,928 2,188,098

Fixed Assets:

Cost 1,257,673 1,377,673 1,507,673 1,537,673 1,562,673 1,587,673

Accumulated Depre. (630,125) (705,779) (806,434) (932,088) (1,061,909) (1,195,897)

Net 627,548 671,894 701,239 605,585 500,764 391,776

Total Assets 1,437,842 1,565,329 1,684,248 1,873,232 2,164,692 2,579,874

Liabilities and Sh. Eq.

Accounts Payable 47,809 48,765 52,666 60,040 68,445 78,028

Cur. Portion—L.T. Debt 27,036 29,200 31,400 33,900 36,600 39,500

Other Current Liabilities 257,252 262,397 283,389 323,063 368,292 419,853

Total Current Liabilities 332,097 340,362 367,455 417,003 473,337 537,381

Long-Term Debt 547,296 518,096 486,696 452,796 416,196 376,696

Deferred Income Taxes 6,369 6,369 6,369 6,369 6,369 6,369

Total Liabilities 885,762 864,827 860,520 876,168 895,902 920,446

Common Stock 2,000 2,000 2,000 2,000 2,000 2,000

Additional Paid-In Cap. 435,630 435,630 435,630 435,630 435,630 435,630

Retained Earnings 189,450 337,872 461,098 634,434 906,159 1,296,799

Treasury Stock (75,000) (75,000) (75,000) (75,000) (75,000) (75,000)

Total Share. Equity 552,080 700,502 823,728 997,064 1,268,789 1,659,429

Total Liab. & Sh. Eq. 1,437,842 1,565,329 1,684,248 1,873,232 2,164,692 2,579,874

ASSUMPTIONS

Cash Statement of Cash Flows

Accounts Receivable Growth Rate of Sales

Inventories Growth Rate of Cost of Goods Sold

Fixed Assets at Cost Growth Equal to Devel. Cost Plus Cap. Expend.

Accumulated Depre. Amort. of Develop. Costs and Cap. Expend.

Accounts Payable Growth Rate of Inventories

Cur. Portion—L.T. Debt Given in Case

Other Current Liabilities Growth Rate of Sales

Long-Term Debt Reduced by Current Portion of Debt

Deferred Income Taxes No Change

Contributed Capital No Change

Chapter 10

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in whole or in part.

Exhibit 10.P

Massachusetts Stove Company

Projected Statements of Cash Flows under Best-Case Scenario

(Case 10.2)

MASS. STOVE Year 7 Year 8 Year 9 Year 10 Year 11 Year 12

State. of Cash Flows Actual Projected Projected Projected Projected Projected

Operations

Net Income (Prelim) 154,601 134,680 107,498 152,939 242,048 347,902

Depreciation 72,321 75,654 100,654 125,654 129,821 133,988

Deferred Taxes 909 0 0 0 0 0

Change in Acct. Rec. 24,992 (120) (489) (925) (1,054) (1,202)

Change in Inventories (43,036) (9,054) (36,941) (69,819) (79,593) (90,736)

Change in Acct. Pay. 8,639 956 3,901 7,373 8,406 9,582

Change in Ot.Cur.Liab. 13,011 5,145 20,992 39,674 45,229 51,561

Cash Flow from Oper. 231,437 207,262 195,615 254,898 344,856 451,095

Investing

Capital Expenditures (22,921) (120,000) (130,000) (30,000) (25,000) (25,000)

Cash Flow from Invest. (22,921) (120,000) (130,000) (30,000) (25,000) (25,000)

Financing

Repayment of L.T. Debt (115,076) (27,036) (29,200) (31,400) (33,900) (36,600)

Cash Flow from Fin. (115,076) (27,036) (29,200) (31,400) (33,900) (36,600)

Net Change in Cash 93,440 60,226 36,415 193,498 285,956 389,495

Cash—Beg. of Year 258,148 351,588 425,555 477,698 691,593 1,007,226

Cash—End of Yr (Prelim) 351,588 411,814 461,970 671,196 977,549 1,396,721

Interest Income 19,085 21,845 28,329 41,219 59,357

Inc. Taxes on Int. Inc. (5,344) (6,116) (7,932) (11,541) (16,620)

Cash Flow from Int. Inc. 13,741 15,728 20,397 29,677 42,737

Cash—End of Year (Final) 425,555 477,698 691,593 1,007,226 1,439,458