Most people think of pottery and figurines when they think of ceramics. However, ceramic material is particularly well suited for use under high temperatures and intense pressure, especially if light weight is desirable. Because of these properties, ceramics are ideal for use in high-performance engines used in turbocharged automobiles, jet aircraft, and heavy trucks. Unfortunately, though, ceramics are also very brittle, and this characteristic has long prevented their widespread use in such engines.

In 1986, however, Daniel Alexander, a materials engineer, and Roger Avalon, a chemical engineer, succeeded in combining silicon carbide fibers with ceramic materials in a manner that pre-served the desirable properties of ceramics but eliminated most of the brittleness. They then formed Space-Age Materials, Inc., and used their own limited capital to build 50 prototype turbine blades with the new ceramic material. On the basis of extensive testing by a number of large aerospace companies, the new firm began receiving production-quantity orders for the new blades. The new business was an immediate success. Production began in the summer of 1987. Operating losses were incurred during the first short year, but the company has earned a profit in each sub-sequent year. During 1991 and 1992 the number of new orders exceeded Alexander and Avalons projections. By the end of 1992, it was obvious to all-including Alexander and Avalonthat additional expansion would be required if the firm was to attain its full growth potential or even to keep competitors from eroding its position.

Ironically, Alexander and Avalons technological successes were making their financial fore-casts incorrect. Consequently, they hired Sue Li, an MBA, as the companys financial manager to develop a detailed financial plan. Li knew that the company had been lucky and that some large chemical companies, including Monsanto and DuPont, were thinking about entering the market. Space-Age, however, had not been sitting idle. In 1991, the companys research-and-development people produced some exciting breakthroughs, while at the same time there was an increasing trend toward using ceramics in jet engines. As a result, it became apparent that additional funds were probably needed if the company were to maintain, let alone increase, its market share. Therefore, a good financial plan accurately forecasting the future needs of the company is critical to the future success, and probably to the continued existence, of the company.

Space-Ages 1988 through 1992 historical financial statements, along with three key ratios and industry averages, are given in Tables 1 and 2. The company was operating its fixed assets at full capacity in 1992, so its $88.73 million of sales represented full-capacity sales. Since the firms marketing department is forecasting a 20 percent increase in sales for 1993, new assets will have to be added. For planning purposes, Li assumes (1) that accounts payable and accruals will sponta-neously increase in accordance with standard industry practices, (2) that new long-term capital will be raised in accordance with the firms target capitalization ratios, which call for 20 percent long-term debt and 80 percent common equity (measured at market value), and (3) that short-term bank loans, reported as notes payable, will be assumed to grow along with sales, since they are used to finance the firms working capital needs. (Note that new common equity includes both new retained earnings and new common stock sales.)

Space-Age currently has 4 million shares of common stock outstanding, and the market price is $9. The dividend in 1992 was $0.375 per share, and management does not intend to increase the dividend in 1993. New long-term debt would carry a 12.0 percent coupon, and it would be issued at par. New short-term debt will cost 10.0 percent. The combined federal and state tax rate is 40 percent.

Space-Ages senior managers go off on a one week retreat each November to work on the five-year plan and the budget for the coming year. Prior to the retreat, the various division managers must prepare reports which the top executives will review beforehand and then discuss at the retreat. As financial manager, Li normally prepares some first approximation financial forecasts which are then modified during the retreat as a result of strategic decisions made at that time. The modified statements are used to show the financial implications of different operating plans. However, Li recently underwent a difficult ulcer operation and, because of a slow recovery, she will neither be able to attend the retreat, nor to prepare the background report for it. Therefore, as her assistant, ready or not, you must assume her duties.

Even though she could not get out of bed, Li called you to the hospital to discuss what needed to be done. First, Li told you she had almost finished a computerized model that would aid in the process. Li also indicated that the model needed to be debugged, or at least checked out, by first making by-hand projections and then seeing if the model generated the same set of data. If a discrepancy is discovered, it will be necessary to find out where the error lies. Li also cautioned you that it will be necessary to explain to the executives how any changes in operating conditions would affect the funds requirements and also how any changes in the financing mix would affect other financial variables, including external funding requirements, earnings per share, and the stock price. In particular, Li warned you not to try to defend the inputs to the forecasting process; rather, the critical thing is to be able to make adjustments in the likely event the senior executives dont like all the assumptions used in the forecast. As Li pointed out, Its the top managers job to under-stand the business and to make the final assumptions used in the forecast and the budget. Its our job to tell them how those assumptions interact, and what the final outcome will be if their assumptions hold true. We ought to use reasonable inputs for our report and basic forecasts, but our real job in the planning process is to show top management what will happen under different operating conditions.

Question #9

What are some other methods that could be used to forecast the asset-and-liability balances and, thus, the forecasted financial requirements: If the senior executives asked you to incorporate these procedures into your analysis, how would you do it, how long would it take, and what additional data would you require?