Problem_Set__2_Solutions

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Jan 9, 2024

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Fin 401 Problem Set #2 Financial Forecasting/Managing Growth Solutions 1. Do Higgins, Chapter 3, #5. Answer provided in the back of the book. 2. Income statements and balance sheets for Roxbury Corporation are below. Financial Statements for Roxbury Corporation 2019 and 2020, in $millions I N COME STATEME N T BALA N CE SHEET 2019 2020 2019 2020 Net sales $ 47,616 52,37 8 Cash & securities $ 951 1,046 Cost of goods sold 40,718 44,79 0 Accounts receivable 6,666 7,333 GS&A expense 6,171 6,788 Inventories 5,236 5,760 EBIT 727 800 Net fixed assets 2,048 2,253 Interest expense 215 255 Total assets $ 14,901 16,392 Earnings before tax 512 545 Tax 154 163 Short-term debt $ 392 547 Net income $ 359 382 Accounts payable 7,419 8,161 Long-term debt 2,148 2,551

a. What was Roxbury’s sustainable growth rate in 2020? What was their actual growth rate? SGR = retention ratio X ROE. retention ratio is 0.5 (equity increased by 191, divided by net income of 382) ROE is 382/4942=7.72% (remember for sustainable growth, use beginning-of-period equity) SGR = 0.5 * 7.72% = 3.86% Actual growth rate in sales was (52378 – 47616) / 47616 = 10.0% b. How much new external equity did Roxbury raise? New debt? Did its leverage (Assets/ Equity) increase or decrease? Retained earnings increased by 191 (3840 – 3649), as did total equity (5133 – 4942), so there was no additional external equity. Roxbury increased its short-term debt by 547 – 392 = 155 and its long-term debt by 2551 – 2148 = 403. Total new debt was then 558. Assets/Equity increased from 3.02 in 2019 (14901/4942) to 3.19 in 2020 (16392/5133). This is what we would expect since they grew more quickly than their sustainable growth rate and didn’t issue new equity. c. A firm’s cash conversion cycle is the amount of time that passes from when it pays for its inputs until it gets paid for its output. It is equal to the inventory period + the receivables period - the payables period. The longer the cash conversion cycle, the more external financing a firm will need. Calculate the length of Roxbury’s cash conversion cycle in 2020. Total liabilities 9,959 11,259 Common stock 1,293 1,293 Retained earnings 3,649 3,840 Total equity 4,942 5,133 Total liabilities & equity $ 14,901 16,392 2

CCC = inventory pd. + receivables pd. – payables pd. =Inventory/(COGS/365) + Receivables/(Sales/365) – Payables/(COGS/365) = 5760/(44790/365) + 7333/(52378/365) – 8161/(44790/365) = 46.9 + 51.1 – 66.5 = 31.5 days d. If we suppose that long-term debt is the marginal source of funds for Roxbury, how much new debt would they have needed if they reduced their payables period by 10 days? What if they reduced their receivables period by 10 days? Roxbury’s payables period was 66.5 days. To reduce it to 56.5 days would require: Payables/(COGS/365) = 56.5, so Payables = 56.5 * 44790/365 = 6933. Thus, payables would have to decrease by (8161-6933) = 1228. Roxbury would have required an additional 1228 of new debt, for a total of 1786, to pay its suppliers 10 days quicker. Roxbury’s receivables period was 51.1 days. To reduce it to 41.1 days would require: Receivables/(Sales/365) = 41.1, so Receivables = 41.1 * 52378/365 = 5898. Thus, receivables would have to decrease by (7333-5898) = 1435. Roxbury could have decreased debt by 1435 if it collected from its customers 10 days quicker. (Since debt actually increased by 558, the net decrease would have been 1435-558 = 877.) 3. For this problem download the financial statements for Ottawa Corporation from Learning Suite. First-stage pro forma financial statements for Ottawa (i.e., pro formas to identify any financing surplus or shortfall) have been completed. In addition to the assumptions listed on the spreadsheet, it has also been assumed that all asset accounts will grow at the same rate as sales, and that no new equity will be issued in 2020. a. Fill in the formula for the financing shortfall. How much extra financing does Ottawa need in 2020 to fund its projected asset needs? =G12-G16 $191 million is required b. Given your answer from (a), do you expect the sustainable growth rate to be greater than, less than, or equal to the sales growth rate for 2020? Fill in the formula for the sustainable growth rate. What is Ottawa’s sustainable growth rate? 3

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Since there is a financing shortfall, we’d expect the sustainable growth rate to be less than the actual sales growth rate. SGR = (1-C20)*(C14/F15) = 9.24% c. At what rate does the actual growth rate equal the sustainable growth rate? What is the financing shortfall or surplus at that growth rate? 8.65% The easiest way to find this is using goal seek. Set the financing shortfall to 0 by changing the sales growth rate. Given our assumptions, the financing shortfall will be 0 when sustainable growth=actual growth. d. Return the sales growth rate to 15%. Now determine how Ottawa can remedy the financing shortfall. Suppose Ottawa wants to solve the shortfall by increasing profit margin. How low would the ratio of COGS/Sales have to go in order to make up the shortfall? With COGS/Sales at this lower level, what is the sustainable growth rate? COGS/Sales would have to fall to 66.9%. You can find this using goal seek. Set the financing shortfall to 0 by changing COGS/Sales. 15% (sustainable growth = actual growth when the financing shortfall is 0) e. Return COGS/Sales to 75%. Now suppose Ottawa wants to solve the shortfall by increasing the retention ratio. How low would the dividend payout ratio have to be to eliminate the financing shortfall? The dividend payout ratio would have to fall to 2.6%. Again, goal seek is the best way to solve this. f. Return the dividend payout ratio to 40%. Now suppose Ottawa wants to make up any financing shortfall with increased debt. How high would the debt/equity ratio have to be to make up the difference? Debt/equity would have to rise to 57.9%. Again, goal seek is the best way to solve this. g. Given the above options, and any other options that you can find, make a recommendation for a reasonable and practical solution to Ottawa’s financing shortfall. Your solution can involve changing multiple variables. There are many options you could consider. Cutting COGS/Sales very far is difficult. Cutting dividends is easy to do, but is unpopular with shareholders. Reasonable options would include small improvements in COGS/Sales or operating expense/Sales, increasing debt, cutting back on capital expenditures (reduce PP&E), or using current assets more efficiently. Reducing sales growth is also an option, but it comes at the expense of profits. One possible solution (of many) would be the following: 4

Increase debt/equity to 53%. Reduce capital expenditures by 50. Reduce operating expense/sales to 9%. Cut COGS/sales to 74%. Keep accounts receivable at a maximum of 600. 5