Need help understanding how to do problem #1 please.
CASE 13 TOPE FINA FORE KA ADHESIVESUI) NCIAL CASTING Karen and Elizabeth Whatleyare marsand the owners ofTopekaAdl'esives, a cmrpmyeystartedsevenyearsagotetedvcalaperseofdemismeun passed, andTopekahasdeveloped anurnber ofadl'esivesljke tapes andglues that arepopularndrkreialmersasneaslenempplyarhardwaresbres. About twelve months ago ihe partners concluded that Topeka's products were "Imderapprecia " and that "sales couldand shouldbe substantially higher."r They red 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 impor- tant contacts with some major industrial users and even one large retailer, Spears. The sisters are in the process of regotiating a number of large contracts for the coming year (1996) and product inquiries are markedly higher. As a resultofallthis,Topeka'ssalesare expected toincrease sharplyinthe next three years, more than doubling by the end of 1998. The partners estimate sales of $1,933,1[I0 in 1996, $2,609,?[I] in 199?, and $3,131,600 in 1998. On one harrithetwinsareextremelypleased withtheforecastbecauseitisevidenceof 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, le 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 $26,101 needs to be Topeka's 1996 Pro Forma Balance Sheet (lls) A1585 Liabilities :3 Beauty (Sm-rent assets $4852 Payables r3: acquals $141.1 Net xed assets 2615 Debt due 20.0 Total assets $752.? Long-term debt (SUD Equity 3055 Funds needed 226.1 Total liabilities 3.: equity $32.? raised. The partners need to develop forecasts for 199? and 1998, though they areconfident that1996 will be theyearofthe"largest need" forextemal funds. TheWhatleysdomtintendtodeclare anydividendsandexpectthenet profit margin (NU sales) to equal 3.5 percent. 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 current assets will increase pmpm tionately with sales in 199?r and 1998, as will accruals and accounts payable, that is, "spontaneous liabilities."r Netfixed assetsareexpectedtoincreaseby $140,011 inl99?arr:l$50,lIDm 1998. Topeka has one loan outstanding and the amount due each year is $20,021]. FINANCING DIFFERENCES Itisnosurpse,sme&teMtaeysarenvts,iatteyaresirrularmmany ways. For example, both are gifted at math and science, they enjoy hiking and horseback riding in their spare time, and they rarely disagree 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. KarenWhatleywantstoborrowalltbenecessaryfundsforanumberofrea sons. First, she argues that "we have very limited capital of our own."r This implies that anyequitybeyond retainedearningswillhavetoberaisedfromnew investors. Sheis loathe todothisbecause shehasbeentold thatduringthepast twelve outts privately held companies with sales under ten million have sold at four to six times EBDlT (earning before depreciation, interest, and taxes). Dmingthevepmriousyearstherrmltiple wasseventotertlnshort,Karenis convinced that any new shares of stock would be sold at relatively low prices. In addition, she really believes that "prots are going to explode" 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 interestrate. And sherealizesthatmuch oftbeexternalfinancingwillbeused 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 does- n't believe that her sister thinks enough about the consequences of a "downside disaster." Elizabeth doesn't want to worry about "cash crunches,"r that is, the possibilty that in bad times the firm may have to scramble to raise the funds necessary to meet debt payments. ElizaberagreesndthKareniattlsisnotagoodmetosellreweqLty. 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 rms. 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 isagood idea. Sll,sheisnotwilljngtoconcede thatsheandhersisterwillbe unable to supply additional capital. For example, the Whatleys own land that could be sold to raise needed funds. AfterndeririputfromlanziandShamenttehtdnsdeddeonhvoiings. First, the forecast needs to be completed to see "what the numbers look like."r Second, the forecast should comider "pmdent liquidity and debt ratios." And the decision about what coretihrtes a "pmd " ratio was made for them. Topeka's bank, Kansas City Federal, said it would "strongly consider"r 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 incorporating these constraints. MANAGERIAL CONTROL TfeparnersareconrrzeddotonereasonTopekahasbeaiardissucoessis because they've been involved inall phases of the business: production, research, marketing,finance, andsoon.Thesistersbelievetheycan"keepontop"r ofthe businessthroughl998. Theyareooncemed, titouglythatqargegrowth" beyond thattirnemaycausethemtolosernanagerialeffectiveness,andthinkitmaybea goodideamlimitsalesgrowlhbeyorrl1998."1 worer,"nrusesl
