8. The Whatleys have worked hard at firming up the estimates of the financial forecast. Shown below is the set of estimates that they feel most comfortable about, and they call it the Base-case Scenario. Karen has convinced Elizabeth that selling new equity is not a good idea, and both sisters would like to raise any needed funds by borrowing and/or using their own capital. They feel they could raise $200,000 of equity over the next three years (1996-98). Elizabeth is also concerned about the debt-equity constraint and would like it to be set at .75 instead of 1 . Neither sister has difficulty using the current ratio constraint of 2 . ART III FNANCIAL. PLANNING The other scenario shown below reflects a "pessimistic" set of estimates from a funds-needed standpoint. That is, if this scenario materializes, then the Whatleys will undoubtedly need more cash than if the Base-case Scenario occurs. Though they agree that the Pessimistic Scenario is unlikely, no one, of course, knows exactly what the future will bring. (a) Estimate funds needed for the next three years (1996-98) under the Basecase Scenario. If the debt-equity constraint is 1 , will the Whatleys' capital of $200,000 cover the firm's equity needs? What if the constraint is .75 ? (b) Estimate funds needed for the next three years under the Pessimistic Scenario. If the debt-equity constraint is 1 , will the Whatleys' capital of $200,000 cover the firm's equity needs? What if the constraint is 75 ? (c) Based on the results in (a) and (b), how reasonable is it to impose a debtequity constraint of .75 ? Defend your position. C A S E 13 TOPEKA ADHESIVES (II) F I N A N CIA L FRECASTING Karen and Elizabeth Whatley are twins and the owners of Topeka Adhesives, a company they started seven years ago. The technical expertise of the firm is unsurpassed, and Topeka has developed a number of adhesives like tapes and glues that are popular with industrial users as well as home supply and hardware stores. About twelve months ago the partners concluded that Topeka's products were "underappreciated" and that "sales could-and should-be substantially higher." They fired an unproductive salesperson and, more importantly, made a key marketing decision. They decided to reduce advertising in trade journals and increase the funds spent on attending trade shows. The marketing change worked. The firm's exhibits were impressive, and the Whatleys made important contacts with some major industrial users and even one large retailer, Spears. The sisters are in the process of negotiating a number of large contracts for the coming year (1996) and product inquiries are markedly higher. As a result of all this, Topeka's sales are expected to increase sharply in the next three years, more than doubling by the end of 1998 . The partners estimate sales of $1,933,100 in 1996,$2,609,700 in 1997 , and $3,131,600 in 1998 . On one hand the twins are extremely pleased with the forecast because it is evidence of what they have long believed: The company manufactures quality products at a reasonable price. The downside is that such large growth will undoubtedly require external financing and could cause managerial difficulties. FORECASTING CONSIDERATIONS The partners have met with Fred Lanzi, Topeka's accountant, and Karl Shatner, the firm's general manager, in order to compile a forecast for 1996-1998 and to discuss the financing options. The table below shows the 1996 pro forma balance sheet resulting from the meetings, and indicates that $226,100 needs to be raised. The partners need to develop forecasts for 1997 and 1998, though they are confident that 1996 will be the year of the "largest need" for extemal funds. The Whatleys do not intend to declare any dividends and expect the net profit margin (NI/sales) to equal 3.5 peroent. The net profit margin estimate is a bit conservative since it considers the possibility that new funds may be borrowed, which would increase interest expense. They also believe that there will be little if any economies of scale in working capital requirements, and consequently it is reasonable to assume that cument aseets will increase proportionately with sales in 1997 and 1998 , as will accruals and accounts payable, that is, "spontaneous liabilities." Net fixed assets are expected to increase by $140,000 in 1997 and $50,000 in 1998. Topeka has one loan outstanding and the amount due each year is $20,000. FINANCING DIFFERENCES It is no surprise, since the Whatleys are twins, that they are similar in many ways. For example, both ane gifted at math and science, they enjoy hiking and horseback riding in their spare time, and they rarely disigree about even the most important business decisions. Yet it is clear that they have very different views about how the expected growth should be financed. Karen Whatley wants to bomow all the necessary funds for a number of reasons. Finst, she angues that "we have very limited capital of our own." This implies that any equity beyond retained earnings will have to be raised from new investors. She is loathe to do this because she has been told that during the past twelve months privately held companies with sales under ten million have sold at four to six times EBDIT (eamings before depreciation, interest, and taves). During the five previous years the multiple was seven to ten. In short, Karen is convinced that any new shanes of stock would be sold at relatively low prices. In addition, she really believes that "profits are going to explocte" and she doesn't like the idea of "sharing them with outsiders." Further, Karen wants to borrow as much short-term debt as possible in part because of its relatively low interest rate. And she realizes that much of the external financing will be used to expand receivables and inventory. She considers these to be short-term assets and believes that it is appropriate to finance them using a short-term debt instrument. The possibility of borrowing makes Elizabeth a bit uneasy. Frankly, she doesn't believe that her sister thinks enough about the consequences of a "downside disaster." Elizabeth doesn't want to worry about "cash crunches," that is, the possibilty that in bad times the firm may have to scramble to raise the funds necessary to meet debt payments. Elizabeth agrees with Karen that this is not a good time to sell new equity. Still, she is not convinced that new equity could not be raised at an acceptable price. True, it appears that it is a buyer's market for small firms. Yet Topeka has an extremely strong customer and product base, and unusual growth prospects. Thus, Elizabeth reasons, an equity interest in Topeka might well be sold at a "very attractive price." She does admit, though, that borrowing at least some of the necessary funds is a good idea. Still, she is not willing to concede that she and her sister will be unable to supply additional capital. For example, the Whatleys own land that could be sold to raise needed funds. After further input from Lanzi and Shatner, the twins decide on two things. First, the forecast needs to be completed to see "what the numbers look like." Second, the forecast should consider "prudent liquidity and debt ratios." And the decision about what constitutes a "prudent" ratio was made for them. Topeka's bank, Kansas City Federal, said it would "strongly consider" a loan request but that any loan agreement would likely contain the following provisions: Topeka's current ratio must exceed 2 and its debt-to-equity ratio, that is, total debt divided by equity (at book values), can't fall below 1. These are numbers that Elizabeth is comfortable with, so the forecast will be made incorponting these constraints. MANAGERIAL CONTROL The partners are convinced that one reason Topeka has been and is successful is because they've been involved in all phases of the business: production, research, marketing, finance, and so on. The sisters believe they can "keep on top" of the business through 1998 . They are concemed, though, that "large growth" beyond that time may cause them to lose managerial effectiveness, and think it may be a grod idea tn limit sales growth beynnd 1998 . "I wonder," muses Karen, "whether we should cap our growth after 1998 at the amount we can internally finance?" QUESTION: 8. The Whatleys have worked hard at firming up the estimates of the financial forecast. Shown below is the set of estimates that they feel most comfortable about, and they call it the Base-case Scenario. Karen has convinced Elizabeth that selling new equity is not a good idea, and both sisters would like to raise any needed funds by borrowing and/or using their own capital. They feel they could raise $200,000 of equity over the next three years (199698). Elizabeth is also concerned about the debt-equity constraint and would like it to be set at .75 instead of 1 . Neither sister has difficulty using the current ratio constraint of 2 , The other scenario shown below reflects a "pessimistic" set of estimates from a funds-needed standpoint. That is, if this scenario materializes, then the Whatleys will undoubtedly need more cash than if the Base-case Scenario occurs. Though they agree that the Pessimistic Scenario is unlikely, no one, of course, knows exactly what the future will bring. Nab: SL. ndens to spontamous liabilitio. PGE nefers to plant and equipment (fixedasset purchrees). (a) Estimate funds needed for the next three years (1996-98) under the Basecase Scenario. If the debtequity constraint is 1, will the Whatleys' capital of $200,000 cover the firm's equity needs? What if the constraint is .75? (b) Estimate funds needed for the next three years under the Pessimistic Scenario. If the debteequity constraint is 1, will the Whatleys' capital of $200,000 cover the firm's equity needs? What if the constraint is 75 ? (c) Based on the results in (a) and (b), how reasonable is it to impose a debtequity constraint of .75 ? Defend your position. 8. The Whatleys have worked hard at firming up the estimates of the financial forecast. Shown below is the set of estimates that they feel most comfortable about, and they call it the Base-case Scenario. Karen has convinced Elizabeth that selling new equity is not a good idea, and both sisters would like to raise any needed funds by borrowing and/or using their own capital. They feel they could raise $200,000 of equity over the next three years (1996-98). Elizabeth is also concerned about the debt-equity constraint and would like it to be set at .75 instead of 1 . Neither sister has difficulty using the current ratio constraint of 2 . ART III FNANCIAL. PLANNING The other scenario shown below reflects a "pessimistic" set of estimates from a funds-needed standpoint. That is, if this scenario materializes, then the Whatleys will undoubtedly need more cash than if the Base-case Scenario occurs. Though they agree that the Pessimistic Scenario is unlikely, no one, of course, knows exactly what the future will bring. (a) Estimate funds needed for the next three years (1996-98) under the Basecase Scenario. If the debt-equity constraint is 1 , will the Whatleys' capital of $200,000 cover the firm's equity needs? What if the constraint is .75 ? (b) Estimate funds needed for the next three years under the Pessimistic Scenario. If the debt-equity constraint is 1 , will the Whatleys' capital of $200,000 cover the firm's equity needs? What if the constraint is 75 ? (c) Based on the results in (a) and (b), how reasonable is it to impose a debtequity constraint of .75 ? Defend your position. C A S E 13 TOPEKA ADHESIVES (II) F I N A N CIA L FRECASTING Karen and Elizabeth Whatley are twins and the owners of Topeka Adhesives, a company they started seven years ago. The technical expertise of the firm is unsurpassed, and Topeka has developed a number of adhesives like tapes and glues that are popular with industrial users as well as home supply and hardware stores. About twelve months ago the partners concluded that Topeka's products were "underappreciated" and that "sales could-and should-be substantially higher." They fired an unproductive salesperson and, more importantly, made a key marketing decision. They decided to reduce advertising in trade journals and increase the funds spent on attending trade shows. The marketing change worked. The firm's exhibits were impressive, and the Whatleys made important contacts with some major industrial users and even one large retailer, Spears. The sisters are in the process of negotiating a number of large contracts for the coming year (1996) and product inquiries are markedly higher. As a result of all this, Topeka's sales are expected to increase sharply in the next three years, more than doubling by the end of 1998 . The partners estimate sales of $1,933,100 in 1996,$2,609,700 in 1997 , and $3,131,600 in 1998 . On one hand the twins are extremely pleased with the forecast because it is evidence of what they have long believed: The company manufactures quality products at a reasonable price. The downside is that such large growth will undoubtedly require external financing and could cause managerial difficulties. FORECASTING CONSIDERATIONS The partners have met with Fred Lanzi, Topeka's accountant, and Karl Shatner, the firm's general manager, in order to compile a forecast for 1996-1998 and to discuss the financing options. The table below shows the 1996 pro forma balance sheet resulting from the meetings, and indicates that $226,100 needs to be raised. The partners need to develop forecasts for 1997 and 1998, though they are confident that 1996 will be the year of the "largest need" for extemal funds. The Whatleys do not intend to declare any dividends and expect the net profit margin (NI/sales) to equal 3.5 peroent. The net profit margin estimate is a bit conservative since it considers the possibility that new funds may be borrowed, which would increase interest expense. They also believe that there will be little if any economies of scale in working capital requirements, and consequently it is reasonable to assume that cument aseets will increase proportionately with sales in 1997 and 1998 , as will accruals and accounts payable, that is, "spontaneous liabilities." Net fixed assets are expected to increase by $140,000 in 1997 and $50,000 in 1998. Topeka has one loan outstanding and the amount due each year is $20,000. FINANCING DIFFERENCES It is no surprise, since the Whatleys are twins, that they are similar in many ways. For example, both ane gifted at math and science, they enjoy hiking and horseback riding in their spare time, and they rarely disigree about even the most important business decisions. Yet it is clear that they have very different views about how the expected growth should be financed. Karen Whatley wants to bomow all the necessary funds for a number of reasons. Finst, she angues that "we have very limited capital of our own." This implies that any equity beyond retained earnings will have to be raised from new investors. She is loathe to do this because she has been told that during the past twelve months privately held companies with sales under ten million have sold at four to six times EBDIT (eamings before depreciation, interest, and taves). During the five previous years the multiple was seven to ten. In short, Karen is convinced that any new shanes of stock would be sold at relatively low prices. In addition, she really believes that "profits are going to explocte" and she doesn't like the idea of "sharing them with outsiders." Further, Karen wants to borrow as much short-term debt as possible in part because of its relatively low interest rate. And she realizes that much of the external financing will be used to expand receivables and inventory. She considers these to be short-term assets and believes that it is appropriate to finance them using a short-term debt instrument. The possibility of borrowing makes Elizabeth a bit uneasy. Frankly, she doesn't believe that her sister thinks enough about the consequences of a "downside disaster." Elizabeth doesn't want to worry about "cash crunches," that is, the possibilty that in bad times the firm may have to scramble to raise the funds necessary to meet debt payments. Elizabeth agrees with Karen that this is not a good time to sell new equity. Still, she is not convinced that new equity could not be raised at an acceptable price. True, it appears that it is a buyer's market for small firms. Yet Topeka has an extremely strong customer and product base, and unusual growth prospects. Thus, Elizabeth reasons, an equity interest in Topeka might well be sold at a "very attractive price." She does admit, though, that borrowing at least some of the necessary funds is a good idea. Still, she is not willing to concede that she and her sister will be unable to supply additional capital. For example, the Whatleys own land that could be sold to raise needed funds. After further input from Lanzi and Shatner, the twins decide on two things. First, the forecast needs to be completed to see "what the numbers look like." Second, the forecast should consider "prudent liquidity and debt ratios." And the decision about what constitutes a "prudent" ratio was made for them. Topeka's bank, Kansas City Federal, said it would "strongly consider" a loan request but that any loan agreement would likely contain the following provisions: Topeka's current ratio must exceed 2 and its debt-to-equity ratio, that is, total debt divided by equity (at book values), can't fall below 1. These are numbers that Elizabeth is comfortable with, so the forecast will be made incorponting these constraints. MANAGERIAL CONTROL The partners are convinced that one reason Topeka has been and is successful is because they've been involved in all phases of the business: production, research, marketing, finance, and so on. The sisters believe they can "keep on top" of the business through 1998 . They are concemed, though, that "large growth" beyond that time may cause them to lose managerial effectiveness, and think it may be a grod idea tn limit sales growth beynnd 1998 . "I wonder," muses Karen, "whether we should cap our growth after 1998 at the amount we can internally finance?" QUESTION: 8. The Whatleys have worked hard at firming up the estimates of the financial forecast. Shown below is the set of estimates that they feel most comfortable about, and they call it the Base-case Scenario. Karen has convinced Elizabeth that selling new equity is not a good idea, and both sisters would like to raise any needed funds by borrowing and/or using their own capital. They feel they could raise $200,000 of equity over the next three years (199698). Elizabeth is also concerned about the debt-equity constraint and would like it to be set at .75 instead of 1 . Neither sister has difficulty using the current ratio constraint of 2 , The other scenario shown below reflects a "pessimistic" set of estimates from a funds-needed standpoint. That is, if this scenario materializes, then the Whatleys will undoubtedly need more cash than if the Base-case Scenario occurs. Though they agree that the Pessimistic Scenario is unlikely, no one, of course, knows exactly what the future will bring. Nab: SL. ndens to spontamous liabilitio. PGE nefers to plant and equipment (fixedasset purchrees). (a) Estimate funds needed for the next three years (1996-98) under the Basecase Scenario. If the debtequity constraint is 1, will the Whatleys' capital of $200,000 cover the firm's equity needs? What if the constraint is .75? (b) Estimate funds needed for the next three years under the Pessimistic Scenario. If the debteequity constraint is 1, will the Whatleys' capital of $200,000 cover the firm's equity needs? What if the constraint is 75 ? (c) Based on the results in (a) and (b), how reasonable is it to impose a debtequity constraint of .75 ? Defend your position