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CFIN5 - CHAPTER 16

Integrative Problem

Sue Wilson is the new financial manager of Northwest Chemicals (NWC), an Oregon producer of specialized

chemicals sold to farmers for use in fruit orchards. She is responsible for constructing financial forecasts and

for evaluating the financial feasibility of new products.

Part I. Financial Forecasting

Sue must prepare a financial forecast for next year for Northwest. NWC’s sales this past year were $2 billion,

and the marketing department is forecasting a 25% increase next year. Sue thinks the company was

operating at full capacity last year, but she is not sure about this. Last year’s financial statements, plus some

other data, are given in the following table.

Last Year’s Financial Statements and Other Data on NWC ($ millions)

A. Balance Sheet
Cash & Securities $ 20 Accounts Payable and Accruals $ 100
Accounts Receivable 240 Notes Payable 100
Inventories 240 Total Current Liabilities $ 200
Total Current Assets $ 500 Long-Term Debt 100
Common Stock 500
Net Fixed Assets 500 Retained Earnings 200
Total Assets $1,000 Total Liabilities and Equity $1,000

B. Income Statement
Sales $2,000.00
Less: Variable Costs (1,200.00)
Fixed Costs (700.00)
Earnings Before Interest and Taxes $ 100.00
Interest (16.00)
Earnings Before Taxes $ 84.00
Taxes (40%) ( 33.60)
Net Income $ 50.40
Dividends (30%) $ 15.12
Addition to Retained Earnings $ 35.28

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in whole or in part.
C. Key Ratios
NWC Industry
Profit margin 2.52% 4.00%
Return on equity (ROE) 7.20% 15.60%
Days sales outstanding (360 days) 43.20 Days 32.00 Days
Inventory turnover 5.00x 8.00x
Fixed assets turnover 4.00x 5.00x
Total assets turnover 2.00x 2.50x
Total debt ratio 30.00% 36.00%
Times interest earned 6.25x 9.40x
Current ratio 2.50x 3.00x
Payout ratio 30.00% 30.00%

Assume that you were recently hired as Sue’s assistant, and your first major task is to help her develop

the forecast. She asked you to begin by answering the following set of questions:

a. Assume that last year NWC was operating at full capacity with respect to all assets. Estimate the next

year’s financing requirements using the projected financial statement approach, making an initial forecast

plus one additional “pass” to determine the effects of “financing feedbacks.” Assume that (1) each type of

asset, as well as payables, accruals, and fixed and variable costs, grow at the same rate as sales; (2)

the dividend payout ratio is held constant at 30%; (3) external funds needed are financed 50% by notes

payable and 50% by long-term debt (no new common stock will be issued); and (4) all debt carries an

interest rate of 8%.

b. Calculate NWC’s forecasted ratios and compare them with the company’s ratios from last year and with

the industry averages. How does NWC compare with the average firm in its industry, and is the company

expected to improve during the coming year?

c. Suppose you now learn that NWC’s receivables and inventories were in line with required levels last

year, given the firm’s credit and inventory policies, but that excess capacity existed with regard to fixed

assets. Specifically, fixed assets were operated at only 75% of capacity.

(1) What level of sales could have existed last year with the available fixed assets? What would the

fixed assets/sales ratio have been if NWC had been operating at full capacity?

(2) How would the existence of excess capacity in fixed assets affect the additional funds needed next

year?

© 2017 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website,
in whole or in part.
d. Without actually working out the numbers, how would you expect the ratios to change in the situation

where excess capacity in fixed assets exists? Explain your reasoning.

e. Based on comparisons between NWC’s 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

inventories and accounts receivable? If the company was able to bring these ratios into line with the

industry averages, what effect would this have on its AFN and its financial ratios?

f. How would changes in these items affect the AFN? (1) The dividend payout ratio, (2) the profit margin,

(3) the plant capacity, and (4) NWC begins buying 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.)

Part II. Breakeven Analysis and Leverage

One of NWC’s employees recently submitted a proposal that NWC should expand its operations and sell its

chemicals in retail establishments such as Home Depot and Lowe’s. To determine the feasibility of the idea,

Sue needs to perform a breakeven analysis. The fixed costs associated with producing and selling the

chemicals to retail stores would be $60 million, the selling price per unit is expected to be $10, and the

variable cost ratio would be the same as it is currently.

a. What is the operating breakeven point both in dollars and in number of units for the employee’s

proposal?

b. Draw the operating breakeven chart for the proposal. Should the employee’s proposal be adopted if

NWC can produce and sell 20 million units of the chemical?

c. If NWC can produce and sell 20 million units of its product to retail stores, what would be its degree of

operating leverage? What would be NWC’s percent increase in operating profits if sales actually were

10% higher than expected?

d. Assume NWC has excess capacity, so it does not need to raise any additional external funds to

implement the proposal—that is, its interest payments remain the same next year as they were last year.

What would be its degree of financial leverage and its degree of total leverage? If the actual sales turned

out to be 10% greater than expected, as a percent, how much greater would the earnings per share be?

e. Explain how breakeven analysis and leverage analysis can be used for planning the implementation of

this proposal.

© 2017 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website,
in whole or in part.