Hatfield Medical Supplies's stock price had been lagging its industry averages, so its board of directors brought in a new CEO, Adam Lee. Lee asked for the company's long-run strategic plan; when he learned that no formal plan existed, he decided to develop one himself. Lee had brought in Rick Novak, a finance MBA who had been working for a consulting company, to replace the old CFO, and he asked Rick to develop the financial planning section of the stra- tegic plan. In his previous job, Novak's primary task had been to help clients develop financial forecasts, and that was one reason Lee hired him. Novak began as he always did, by comparing Hatfield's financial ratios to the industry averages. If any ratio was substandard, he discussed it with the responsible manager to see what could be done to improve the situation. Figure MC-1 provides Hatfield's latest financial statements plus some ratios and other data that Novak plans to use in his analysis. Notice that the figure is extracted from an Excel spreadsheet. Novak learned back in his university days that, because of interactions among variables, any realistic financial forecast must be based on a computer model. (The model is available to your instructor on the textbooks Web site.) Of course, he is also aware of the well-known computer axiom-garbage in, garbage out (GIGO). Novak therefore plans to discuss the model's inputs carefully with Hatfield's operating man- agers, individually and also collectively in the company's financial planning conference. a. Do you think Adam Lee should develop a strategic plan for the company? Why? What are the central elements of such a plan? What is the role of finance in a strategic plan? b. Given the data in Figure MC-1, how well run would you say Hatfield appears to be in comparison with other firms in its industry? What are its primary strengths and weak- nesses? Be specific in your answer, and point to various ratios that support your posi- tion. Also, use the Du Pont equation (see Chapter 3) as one part of your analysis. c. Use the AFN equation to estimate Hatfield's required new external capital for 2011 if the 15% expected growth takes place. Assume that the firm's 2010 ratios will remain the same in 2011. d. Define the term capital intensity. Explain how a decline in capital intensity would affect the AFN, other things held constant Would economies of scale combined with rapid growth affect capital intensity, other things held constant? Also, explain how changes in each of the following would affect AFN, holding other things constant the growth rate, the amount of accounts payable, the profit margin, and the payout ratio. FIGURE MC-1 Financial Statements and Other Data (Millions, Except for Per Share Data) D E F 500 A B 4. 5 Balance Sheet, Hatfield, 12/31/10 6 Cash and securities $20 7 Accounts receivable 290 8 Inventories 390 9 Total current assets $700 10 Net fixed assests 11 Total assets $1.200 12 13 Accounts pay. + accruals $100 14 Notes payable 80 15 Total current liabilities 16 Long-term debt 520 17 Total liabilities $700 18 Common stock 300 19 Retained earnings 200 20 Total common equity $500 21 Total liab. & equity $1,200 Income Statement. Hatfield, 2010 Sales $2,000 Total operating costs 1,900 EBIT $100 Interest 60 EBT $40 Taxes (40%) 16 Net income $24 Dividends $9 Add'n to retain. earnings $15 Shares outstanding 10 $2.40 DPS $0.90 Year-end stock price $24.00 $180 EPS F D Hatfield $2.000 15.0% 1.2% 60.0% Sales set equal to Hatfield to make the data comparable. 67.5% B 23 Selected Ratios and Other Data, 2010 24 Sales, 2010 (5) 25 Expected growth in sales: 26 Profit margin (M): 27 Assests/Sales (A,"So): 28 Payout ratio (POR): 29 Equity multiplier (Assets/Equity): 30 Total liability/Total assests 31 Times interest earned (EBIT/Interest): 32 Increase in sales (AS =gSo): 33 (Payables + Accruals)/Sales (L.*S.) 34 Operating costs/Sales: 35 Cash/Sales: 36 Receivables/Sales: 37 Inventories/Sales: 38 Fixed assets/Sales: 39 Tax rate: 40 Interest rate on all debt: 41 Price/Earning (P/E): 42 ROE (Net income/Common equity): 2.40 58.3% 1.67 $300 5.0% 95.0% 1.0% 14.5% 19.5% 25.0% 40.0% 10.00% 10.0 4.80% E Industry $2.000 15.0% 2.74% 50.0% 35.0% 2.13 53.0% 5.20 $300 4.0% 93.0% 1.0% 11.0% 15.0% 23.0% 40.0% 9.5% 12.0 11.64% Note: Hatfield was operating at full capacity in 2010. e. Define the term self-supporting growth rate. Based on the Figure MC-1 data, what is Hatfield's self-supporting growth rate? Would the self-supporting growth rate be af- fected by a change in the capital intensity ratio or the other factors mentioned in ques- tion d? Other things held constant, would the calculated capital intensity ratio change over time if the company were growing and were also subject to economies of scale and/or lumpy assets? f. Forecast the financial statements for 2011 using the following assumptions. (1) Operat- ing ratios remain unchanged. (2) No additional notes payable, LT bonds, or common stock will be issued. (3) The interest rate on all debt is 10%. (4) If additional financing is needed, then it will be raised through a line of credit. The line of credit would be tapped on the last day of the year, so it would create no additional interest expenses for that year. (5) Interest expenses for notes payable and LT bonds are based on the av- erage balances during the year. (6) If surplus funds are available, the surplus will be paid out as a special dividend payment. (7) Regular dividends will grow by 15%. (8) Sales will grow by 15%. We call this the Steady scenario because operations remain unchanged. 1. How much new capital will the firm need (i.e., what is the forecasted AFN); how does it compare with the amount you calculated using the AFN equation; and why does any difference exist? 2. Calculate the firm's free cash flow, return on invested capital, EPS, DPS, ROE, and any other ratios you think would be useful in considering the situation. 3. Assuming all of the inputs turn out to be exactly correct, would these answers also be exactly correct? If not, why not? g. Repeat the analysis performed for Question f but now assume that Hatfield is able to achieve industry averages for the following input variables: operating costs/sales, receiv- ables/sales, inventories/sales, and fixed assets/sales. Answer parts (1) and (2) of funder the new assumptions. h. Could a strategic plan that included an incentive compensation program affect the firm's ability to move toward industry average operating performance? i. What is financing feedback? Hatfield Medical Supplies's stock price had been lagging its industry averages, so its board of directors brought in a new CEO, Adam Lee. Lee asked for the company's long-run strategic plan; when he learned that no formal plan existed, he decided to develop one himself. Lee had brought in Rick Novak, a finance MBA who had been working for a consulting company, to replace the old CFO, and he asked Rick to develop the financial planning section of the stra- tegic plan. In his previous job, Novak's primary task had been to help clients develop financial forecasts, and that was one reason Lee hired him. Novak began as he always did, by comparing Hatfield's financial ratios to the industry averages. If any ratio was substandard, he discussed it with the responsible manager to see what could be done to improve the situation. Figure MC-1 provides Hatfield's latest financial statements plus some ratios and other data that Novak plans to use in his analysis. Notice that the figure is extracted from an Excel spreadsheet. Novak learned back in his university days that, because of interactions among variables, any realistic financial forecast must be based on a computer model. (The model is available to your instructor on the textbooks Web site.) Of course, he is also aware of the well-known computer axiom-garbage in, garbage out (GIGO). Novak therefore plans to discuss the model's inputs carefully with Hatfield's operating man- agers, individually and also collectively in the company's financial planning conference. a. Do you think Adam Lee should develop a strategic plan for the company? Why? What are the central elements of such a plan? What is the role of finance in a strategic plan? b. Given the data in Figure MC-1, how well run would you say Hatfield appears to be in comparison with other firms in its industry? What are its primary strengths and weak- nesses? Be specific in your answer, and point to various ratios that support your posi- tion. Also, use the Du Pont equation (see Chapter 3) as one part of your analysis. c. Use the AFN equation to estimate Hatfield's required new external capital for 2011 if the 15% expected growth takes place. Assume that the firm's 2010 ratios will remain the same in 2011. d. Define the term capital intensity. Explain how a decline in capital intensity would affect the AFN, other things held constant Would economies of scale combined with rapid growth affect capital intensity, other things held constant? Also, explain how changes in each of the following would affect AFN, holding other things constant the growth rate, the amount of accounts payable, the profit margin, and the payout ratio. FIGURE MC-1 Financial Statements and Other Data (Millions, Except for Per Share Data) D E F 500 A B 4. 5 Balance Sheet, Hatfield, 12/31/10 6 Cash and securities $20 7 Accounts receivable 290 8 Inventories 390 9 Total current assets $700 10 Net fixed assests 11 Total assets $1.200 12 13 Accounts pay. + accruals $100 14 Notes payable 80 15 Total current liabilities 16 Long-term debt 520 17 Total liabilities $700 18 Common stock 300 19 Retained earnings 200 20 Total common equity $500 21 Total liab. & equity $1,200 Income Statement. Hatfield, 2010 Sales $2,000 Total operating costs 1,900 EBIT $100 Interest 60 EBT $40 Taxes (40%) 16 Net income $24 Dividends $9 Add'n to retain. earnings $15 Shares outstanding 10 $2.40 DPS $0.90 Year-end stock price $24.00 $180 EPS F D Hatfield $2.000 15.0% 1.2% 60.0% Sales set equal to Hatfield to make the data comparable. 67.5% B 23 Selected Ratios and Other Data, 2010 24 Sales, 2010 (5) 25 Expected growth in sales: 26 Profit margin (M): 27 Assests/Sales (A,"So): 28 Payout ratio (POR): 29 Equity multiplier (Assets/Equity): 30 Total liability/Total assests 31 Times interest earned (EBIT/Interest): 32 Increase in sales (AS =gSo): 33 (Payables + Accruals)/Sales (L.*S.) 34 Operating costs/Sales: 35 Cash/Sales: 36 Receivables/Sales: 37 Inventories/Sales: 38 Fixed assets/Sales: 39 Tax rate: 40 Interest rate on all debt: 41 Price/Earning (P/E): 42 ROE (Net income/Common equity): 2.40 58.3% 1.67 $300 5.0% 95.0% 1.0% 14.5% 19.5% 25.0% 40.0% 10.00% 10.0 4.80% E Industry $2.000 15.0% 2.74% 50.0% 35.0% 2.13 53.0% 5.20 $300 4.0% 93.0% 1.0% 11.0% 15.0% 23.0% 40.0% 9.5% 12.0 11.64% Note: Hatfield was operating at full capacity in 2010. e. Define the term self-supporting growth rate. Based on the Figure MC-1 data, what is Hatfield's self-supporting growth rate? Would the self-supporting growth rate be af- fected by a change in the capital intensity ratio or the other factors mentioned in ques- tion d? Other things held constant, would the calculated capital intensity ratio change over time if the company were growing and were also subject to economies of scale and/or lumpy assets? f. Forecast the financial statements for 2011 using the following assumptions. (1) Operat- ing ratios remain unchanged. (2) No additional notes payable, LT bonds, or common stock will be issued. (3) The interest rate on all debt is 10%. (4) If additional financing is needed, then it will be raised through a line of credit. The line of credit would be tapped on the last day of the year, so it would create no additional interest expenses for that year. (5) Interest expenses for notes payable and LT bonds are based on the av- erage balances during the year. (6) If surplus funds are available, the surplus will be paid out as a special dividend payment. (7) Regular dividends will grow by 15%. (8) Sales will grow by 15%. We call this the Steady scenario because operations remain unchanged. 1. How much new capital will the firm need (i.e., what is the forecasted AFN); how does it compare with the amount you calculated using the AFN equation; and why does any difference exist? 2. Calculate the firm's free cash flow, return on invested capital, EPS, DPS, ROE, and any other ratios you think would be useful in considering the situation. 3. Assuming all of the inputs turn out to be exactly correct, would these answers also be exactly correct? If not, why not? g. Repeat the analysis performed for Question f but now assume that Hatfield is able to achieve industry averages for the following input variables: operating costs/sales, receiv- ables/sales, inventories/sales, and fixed assets/sales. Answer parts (1) and (2) of funder the new assumptions. h. Could a strategic plan that included an incentive compensation program affect the firm's ability to move toward industry average operating performance? i. What is financing feedback