C A SE

TIPTON ICE CR EA M
FINANCIAL
FORECA STIN G

George Tipton began the Tipton Ice Cream Company nearly five decades ago.
He patented a soft ice cream and right from the outset paid special attention to
quality. "We only make one product, but we make it in many flavors and we
make it well," Tipton was fond of saying. The company was an immediate
success and sales quickly reached seven figures.

DEBT AVERSION

The firm expects strong growth in the coming year (2016) and Brenda Hood,
Tipton's chief financial officer, hopes she can make a strong case for borrowing
to finance the company's expansion. She realizes, however, that she is likely to
face stiff opposition from the Tipton family. George Tipton detested borrowing
money and his motto was "Never a lender nor borrower be." For nearly 25 years
all the company's stock was owned by the Tipton family, but due to expansion
new shares have been sold during the last 15 years to individuals outside the
family. By 2015 the Tipton family owns 60 percent of all shares, and although
the family has not been very active in running the firm, it does insist on one
family tradition: "Never a lender nor borrower be." To this day Tipton has never
owed anything beyond its accounts payable and accruals.

Hood knows this is an extreme case of debt aversion and the policy has hurt
the owners' profits. For example, historically Tipton has been slightly above the
industry average in return on total assets but consistently below in return on
owner 's equity. At each annual meeting she has tried unsuccessfully to
convince the Tipton clan to use more debt. And each year Hood heard a chorus
of "Never a lender. . . ." But perhaps this year would be different.
She recalls two sessions on financial management that she held for the
non­financial executives of Tipton. Same members of the Tipton family had
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attended these sessions. She explained that when sales increase, then inventory,
cash, and accounts receivable must also increase. Further, if the firm's existing
operating capacity was insufficient to support the increased sales, additional
fixed assets would be required. She had also stressed the need for pro forma
statements to determine the magnitude of the funds needed. It was the first
time members of the Tipton family had received any forma! financial exposure,
and she recalls they seemed interested and attentive.
At the previous annual meetings Hood had avoided using any technical
financial analysis to make her case for borrowing. But now she thinks, "Why
not?"

FORECASTING ASSUMPTIONS
She decides to estimate (1) the amount of funds Tipton will have to obtain in
2016; (2) the 2016 income statement assuming all of the financing is done
through borrowing; and (3) another income statement assuming all new stock
is issued. To help in the estimates Hood enlists Frank Davis, a recent MBA.
Davis reminds her that 2016 is expected to be a big year for the company; sales
are predicted to increase by 25 percent. Due to the strong demand, marketing
feels any cost increases can easily be passed on. Consequently, the gross
margin should exceed the current level of 21 percent. Hood notes that the sales-
to-inventory ratio will be lowered to 6.5, and that purchases should total
$101,481,000. This suggests cost of goods for 2016 would be $93,750,000.
"What about administrative and selling expenses?" Hood asks Davis. He
informs her that management salaries would have to rise sharply because these
salaries had increased very slightly over the past three years. Davis believes
a 20 percent increase in administrative and selling expenses is reasonable.
Fixed assets are likely to change sharply in the coming year. Currently,
Tipton is operating virtually near capacity, demand is expected to remain high,
and thus extra capacity will be needed. In addition, some major improvements
to existing equipment will have to be made in order for the company to remain
competitive. The planning for these changes has been anticipated for some
time, and though all of these changes do not have to be made in 2016, it is clear
that the company cannot grow beyond 2016 without them. In any event, it is
urgent that the financing question be resolved as soon as possible. A reasonable
estimate is that Tipton will purchase $5 million of new plant and equipment
in 2016.
"During the past year we've been a bit slow in paying our suppliers," Hood
remarks. "We definitely will have to pay more promptly or we're going to have
some annoyed creditors; plus we'll pick up cash discounts by paying earlier. See
if you can come up with an estimate of our payables using past information."
Hood and Davis also feel that over the last few years factors (other than
sales) affecting accruals and receivables have been relatively constant. For
example, the company has not altered its credit policy in the last three years.
Nor can they think of any reason why these items should change significantly
in the coming
 CASE 11 TIPTON ICE CREAM 3

year. "Of course, an exact relationship between each of these and sales is
unlikely to exist," Hood cautions. "We can expect some yearly random
fluctuation. And keep in mind the 'big/ little' mix will be changing since
we'll be selling to smaller food chains. This has implications for our
receivables since these firms are relatively slow to pay. This shouldn't be a
major factor, Frank, but it is something you should be aware of when you
make your estimate."
Hood and Davis think the cash management of the firm has been a "bit
sloppy" over the past few years, and both agree the company could make do
with lower level of liquidity. Davis suggests he assume a level of 2 percent of
sales, which is the approximate industry average, and Hood agrees. "What
about dividends?" Davis asks Hood. "Our payout ratio is usually around
50 percent. However, if we borrow all the extra money, let's work backwards on
the dividends; that is, out of net income subtract the amount of the retained
earnings we would obtain if we used all-equity financing."

FORECASTING RESTRICTIONS
There are two final problems. While Hood believes the company should use
more debt, she recognizes that the final decision rests with the Tipton family.
Given their debt aversion it is important that any projections not appear too
debt-heavy. She also wonders how much flexibility she would have to use
short-term debt, assuming the decision to borrow is made. Hood, therefore,
instructs Davis to work within the following constraints when doing the fore­
cast. As working hypotheses she wants Tipton's debt ratio to remain below 0.5,
and the current and quick ratios must not fall below 2 and 1, respectively. In
other words, the financial projection cannot violate any one of these restrictions.
"Given these limitations, see how much flexibility we have in raising any funds
needed," Hood tells Davis.

QUESTIONS
1. Project the 2016 income statement assuming no borrowing.
2. Project Tipton' s 2016 balance sheet assuming no borrowing.
3. Explain how the $93.75 million cost-of-goods estimate for 2016 was
obtained.
4. How much money will Tipton need to raise in 2016?
5. (a) How much of this money can Tipton borrow long term without
violating the constraints imposed by Hood?
(b) How much of this money can be raised using notes payable without
violating these constraints?
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6. Redo the 2016 income statement assuming all of the funds needed are
borrowed as long-term bonds at 8 percent. (Keep retained earnings at the
same level as in question 1.)
7. Will the Tipton family own less than 50 percent of the firm's stock if no
funds are borrowed? (Assume shares are sold to nonfamily members at
$11.50 per share, which nets $10.50 after brokerage fees.)
8. Calculate the dividend per share and earnings per share if the expansion is
(a) Financed by new equity.
(b) Financed by borrowing.
9. Use the percent of sales method to forecast the amount of financing. Why
does this estimate differ from your answer in question 4?
10. (a) When making a financial forecast, which one of the items that must be
estimated is the most important? Why?
(b) Which item do you think is typically the most difficult to forecast?
11. (a) What are same ratios you would calculate to help determine the risk
of using debt?
(b) Play the role of a consultant. Industry averages for all categories of
ratios are given in Exhibit 3. Based on your previous answers, the
ratios calculated in part (at and these industry averages, would you
endorse the debt financing if you were a member of the Tipton family?
Explain.

SOFTWARE QUESTION

12. Hood is generally quite comfortable with the assumptions of her forecast.
Still she recognizes that her estimates could be wrong and she decides to
analyze the following scenarios.

S-1 S-2 S-3 S-4

2016sales $115,000.00 $125,000.00 $125,000.00 $130,000.00

CGS/sales .76 .75 .75 .77
Cash/sales .023 .028 .025 .02
ACP 38.00 36.00 39.00 38.00
AP/sales .07 .06 .063 .063
Sales/inv. 6.30 6.50 6.30 6.10

Note: AP refers to accounts payable.

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The first two scenarios, S-1 and S-2, represent the estimates of the firm's
marketing director and sales manager, respectively, people whose judgment
Hood respects.
The third scenario considers the possibility that the firm's working capital
management won'! be as efficient as Hood expects. The final set of estimates
assumes that sales exceed Hood's original projection.
Analyze each scenario assuming first that all needed funds are raised by
equity, and then assume all needed funds are raised by selling bonds, that is,
"long-term debt." How, if at all, do the results affect your answer to question
11(b)? (Keep a ll other estimates a t their base-case values.)

EXHIBIT 1
Selected Financial Information for Previous Three Years. (OOOs)
2013 2014 2015

Sales $88,500 $96,000 $100,000

Receivables $7,432 $8,533 $8,000
Average collection period (days) 30.2 32 28.8
Accounts payable $5,700 $6,000 $9,500
Accruals $2,400 $1,800 $3,000

EXHIBIT 2
Balance Sheets (OOOs)
Equity Debt
2015 2016 2016

Assets
Cash & marketable securities $3,000
Accounts receivable 8,000
Inventory 11,500
Current assets 22,500
Gross fixed assets 24,000
Accumulated depreciation (4.000)
Net fixed assets 20,000
Total assets $42,500

Liabilities and Equity

Notes payable $0
Accounts payable 9,500
Accruals 3 000
Current liabilities 12,500
Bonds
Common stock 20,000
($10 par)
Retained earnings 10 000
Total liabilities and equity $42,500

(continued )
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EXHIBIT 2
(Continued)
Income Statement (000s)
Equity Debt
2015 2016 2017

Net sales $100 000

Cost of goods 79 000
Gross profit 21 000
Administrative & selling expenses 10 000
Depreciation 600 600 600
Miscellaneous 200 220 220
EBIT 10 200
Interest 0
Earnings before taxes 10 200
Taxes (50%) 5 100
Net income 5 100
Dividends 2 550
To retained earnings 2 550

EXHIBIT 3
Industry Averages

Current 1.8
Quick 0.8
Debt (%) 50.0
Times interest earned 6.0
Inventory turnover (sales) 6.0
Average collection period (days) 26.0
Total asset turnover 2.1
Gross profit margin (%) 18.0
Return on total assets ( %) 8.5
Net profit on sales (%) 3.9
Return on net worth (%) /,-, 17.0