Chapter 16, Problem 16IC

Integrated Case

NEW WORLD CHEMICALS INC.

16-16 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 2015. NWC’s 2014 sales were $2 billon, and the marketing department is forecasting a 25% increase for 2015. Wilson thinks the company was operating at full capacity in 2014, 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 2014 financial statements, the 2015 initial forecast, and a ratio analysis for 2014 and the 2015 initial forecast are given in Table 1C 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.

1. a. Assume (1) that NWC was operating at full capacity in 2014 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 will grow at the same rate as sales, and (4) that the 2014 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?
2. b. Consultations with several key managers within NWC, including production, inventory, and receivable managers, have yielded some very useful information.
   1. 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. 2. NWC was operating slightly below capacity; but its forecasted growth will require a new facility, which is expected to increase NWC's net fixed assets to $700 million.
   3. 3. A relatively new inventory management system (installed last year) has taken some time 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 10 ×.

Incorporate that information into the 2015 initial forecast results, as these adjustments to the initial forecast represent the final forecast for 2015. (Hint: Total assets do not change from the initial forecast.)

1. c. Calculate NWC’s forecasted ratios based on its final forecast and compare them with the company’s 2014 historical ratios, the 2015 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.
2. d. Based on the final forecast, calculate NWC’s free cash flow for 2015. How does this FCF differ from the POP forecasted by NWC's initial “business as usual” forecast?
3. e. Initially, some NWL managers questioned whether the new iacility expansion was necessary, especially as 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. Assuming that its fixed assets were operating 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?
4. 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)

Financial Statements and Other Data on NWC (Millions of Dollars) Table 1C 16.1

A. Balance Sheets	2014	2015E
Cash and equivalents	$ 20	$ 25
Accounts receivable	240	300
Inventories	240	300
Total current assets	S 500	$ 625
Net fixed assets	500	625
Total assets	$1,000	$1,250
Accounts payable and 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	2014	2015E
Sales	$2,000.00	$2,500.00
Variable costs	1,200.00	1,500.00
Fixed costs	700.00	875.00
Earnings before interest and taxes (EBIT)	$ 100.00	$ 125.00
Interest	16.00	16.00
Earnings before taxes (EBT)	$ 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 (2014)	NWC (2015E)	Industry	Comment
Basic earning power	10.00%	10.00%	20.00%
Profit margin	232	2.62	4.00
Return on equity	7.20	8.77	15.60
Days sales outstanding (365 days)	43.80 days	43.80 days	32.00 days
Inventory turnover	8.33×	8.33×	11.00×
Fixed assets turnover	4.00	4.00	5.00
Total assets turnover	2.00	2.00	2.50
Total 1iabi1ities/Assets	30.00%	40.40%	36.00%
Times interest earned	6.25 ×	7.81×	9.40×
Current ratio	2.50	1.99	3.00
Payout ratio	30.00%	30.00%	30.00%