978-1305632295 Chapter 12 Solution Manual Part 2

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12-9 Garlington Technologies Inc.

Pro Forma Income Statement

December 31, 2017

Forecast Pro Forma

2016 Basis 2017

Sales $3,600,000 1.10  Sales16 $3,960,000

Operating costs 3,279,720 0.911  Sales17 3,607,692

EBIT $ 320,280 $ 352,308

Garlington Technologies Inc.

Pro Forma Balance Statement

December 31, 2017

Forecast

Basis % AFN With AFN

2016 2017 Sales Additions 2017 Effects 2017

Cash $ 180,000 0.05 $ 198,000 $ 198,000

Receivables 360,000 0.10 396,000 396,000

Inventories 720,000 0.20 792,000 792,000

Total curr. assets $1,260,000 $1,386,000 $1,386,000

Answers and Solutions: 12 – 1

website, in whole or in part.

*See income statement.

The additional investment in assets is equal to the change in total assets because there are

not short-term investments:

The additional financing from the increase in spontaneous liabilities and from the

reinvested earnings is:

Financing surplus (deficit) = Additional financing – Additional assets

Because this is negative, it is a financing deficit. This means the LOC should be

$128,783.

Answers and Solutions: 12 – 2

website, in whole or in part.

SOLUTION TO SPREADSHEET PROBLEMS

12-10 The detailed solution is available in the file Ch12 P10 Build a Model Solution.xlsx at the

textbook’s Web site.

12-11 The detailed solution for is available in the file Ch12 P11 Build a Model Solution.xlsx at

the textbook’s Web site.

Answers and Solutions: 12 – 3

website, in whole or in part.

MINI CASE

Hatfield Medical Supply’s stock price had been lagging its industry averages, so its

board of directors brought in a new CEO, Jaiden Lee. Lee had brought in Ashley Novak, a

finance MBA who had been working for a consulting company, to replace the old CFO, and

Lee asked Ashley to develop the financial planning section of the strategic plan. In her

previous job, Novak’s primary task had been to help clients develop financial forecasts, and

that was one reason Lee hired her.

Novak began as she always did, by comparing Hatfield’s financial ratios to the

industry averages. If any ratio was substandard, she discussed it with the responsible

manager to see what could be done to improve the situation. The following data shows

Hatfield’s latest financial statements plus some ratios and other data that Novak plans to

use in her analysis.

Hatfield Medical Supply (Millions of Dollars Except Per Share Data)

Balance Sheet, 12/31/2016 Income Statement, Year Ending 2016

Cash $ 20 Sales $2,000

Accts. rec. 280 Op. costs (excl. depr.) 1,800

Taxes (40%) 44

Accts. pay. & accruals $ 80 Net income $ 66

Line of credit $0

Total CL $ 80 Dividends $20.0

Answers and Solutions: 12 – 4

website, in whole or in part.

Selected Additional Data for 2016

Hatfield

Industr

y Hatfield Industry

(Op. costs)/Sales 90.0% 88.0% (Total liabilities)/(Total assets) 48.3% 36.7%

Depr./FA 10.0% 12.0% Times interest earned 3.8 8.9

Cash/Sales 1.0% 1.0% Return on assets (ROA) 5.5% 10.2%

Note: Hatfield was operating at full capacity in 2016. Also, you may observe small differences in items like the

ROE when calculated in different ways. Any such differences are due to rounding, and they can be ignored.

Answers and Solutions: 12 – 5

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a. Using Hatfield’s data and its industry averages, how well run would you say

Hatfield appears to be in comparison with other firms in its industry? What are

its primary strengths and weaknesses? Be specific in your answer, and point to

various ratios that support your position. Also, use the DuPont equation (see

Chapter 3) as one part of your analysis.

Answer: The DuPont equation shows the relationship among asset management, profitability

ratios, and leverage. By examining this equation we can determine where Hatfield

falls short of the industry.

ROEHatfield = Profit margin × Asset turnover ×(Equity multiplier)

ROEIndustry = Profit margin × Asset turnover ×(Equity multiplier)

From the DuPont equation, you can see that Hatfield’s profitability and asset

management ratios are lower than the industry average and its leverage is higher than

the industry average. The combined effect results in a much lower return on equity

Answers and Solutions: 12 – 6

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b. Use the AFN equation to estimate Hatfield’s required new external capital for

2017 if the sales growth rate is 10%. Assume that the firm’s 2016 ratios will

remain the same in 2017. (Hint: Hatfield was operating at full capacity in 2016.)

Answer:

Data for AFN Equation

Growth rate in sales (g) 10%

Sales (S0) $2,000

Here is the AFN equation:

AFN = (A0*/S0)∆S – (L0*/S0)∆S – M(S1)(1 – Payout)

c. Define the term capital intensity. Explain how a decline in capital intensity

would affect the AFN, other things held constant. Would economies of scale

combined with rapid growth affect capital intensity, other things held constant?

Also, explain how changes in each of the following would affect AFN, holding

other things constant: the growth rate, the amount of accounts payable, the

profit margin, and the payout ratio.

Answer: The capital intensity ratio is the amount of assets required per dollar of sales, A0*/S0,

and it has a major effect on capital requirements. A decline in the capital intensity

Answers and Solutions: 12 – 7

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Rapidly growing companies require large increases in assets and a corresponding

large amount of external financing, other things held constant. Accounts payable are

spontaneous liabilities that come about due to normal day-to-day business operations.

d. Define the term self-supporting growth rate. What is Hatfield’s self-supporting

growth rate? Would the self-supporting growth rate be affected by a change in

the capital intensity ratio or the other factors mentioned in the previous

question? Other things held constant, would the calculated capital intensity ratio

change over time if the company were growing and were also subject to

economies of scale and/or lumpy assets?

Answer: The self-supporting growth rate is the maximum growth rate the firm could achieve if

it had no access to external capital. From the data given, Hatfield’s self-supporting

growth rate is calculated as:

Self-supporting g = [M(1 – POR)(S0)]/[A0* – L0* – M(1 – POR)(S0)]

The higher the firm’s capital intensity ratio, the lower the firm’s self-supporting

Answers and Solutions: 12 – 8

website, in whole or in part.

The calculated capital intensity ratio will change over time if the firm company is

expanding and if economies of scale and lumpy assets exist. When economies occur,

the capital intensity ratio will change over time as the size of the firm increases. In

Answers and Solutions: 12 – 9

website, in whole or in part.