ness instruments, was preparing for the October meeting of the finance committee. He carmined various sources of funds available to finance the company's capital expansion and reviewed the company's financial statements (see Exhibit 1) with an eye toward Hawthome Business Instruments was founded in 1952 by Tessie Barnes to produce manual typewriters. Through the 1950s and 1960s, the company grew at a rapid pace, debt financing at the present time. Because the company's debt ratio is the same as the industry average, he felt that long-term lenders would demand a healthy risk premium Case Study 3 In late September 1990, Billy Edwards, vice president of finance for Hawthorne Busi- production capacity, but he indicated that it would be very difficult to obtain long-term PROFITABILITY ANALYSIS HAWTHORNE BUSINESS INSTRUMENTS stablishing a new working capital policy. expanding its product line to include manual calculators and other business instru- ments. But the company's growth then stagnated until the late 1970s, when electric bpewriters and calculators replaced their manual counterparts as the company's major was established in Raleigh, North Carolina, to produce a new generation of business Instruments. The company placed two other plants on line in 1988, one in Richmond, Virginia, and another in South Carolina. Hawthorne Business' major problem has been increasing production fast enough to meet the demand for its products. The company's capacity has been expanded steadily since 1988, but it has often lost sales because of insufficient production. Recognizing this problem, Jeanette Amoroso, president and chief executive officer, called a meeting of the finance committee to consider ways to increase production and to review financing alternatives proposed by Mr. Edwards. The meeting was attended by Jeanette Amoroso, president: Billy Edwards, vice president of finance, Courtney Cole, vice president of marketing and Evan Weinstein, director and banker. Courtney Cole reported that the company needs a new plant to produce enough typewriters and calculators to meet market demand. She also said that the company will have to diversify into the mini and desk computer field in the near future because 1986, Evan Weinstein agreed that it is important for Hawthorne Business to expand its Jeanette Amoroso interrupted at this point and stated that a common stock offering was perhaps out of the question for two reasons. First, the sale of new common stock is not desirable because it was currently selling in the over-the-counter market at $12 394 PART 2: CASE STUDIES per share, which is at least a three-year low. Second, most current stockholders are hitz in a position to purchase additional common stock, and the sale of new common stock to outsiders would produce a significant dilution of earnings and control Exhibit 1 Hawthorne Business Instruments Financial Data for Year-Ending August 30, 1990 Midwest Business Percent of Industry Total Averages A. Balance Sheet Current assets Net fixed assets Total assets $ 4,320,000 6.480.000 $ 10,800,000 40% 60% 100% 30% 20% 100% Current liabilities (8%) Long-term debt (10%) Common equity Total liabilities & common equity $ 1,404,000 4,320,000 5,076,000 $ 10,800,000 13% 40% 47% 100% 13% 40% 47% 100% B. Income Statement Sales Operating expenses Earnings before interest & taxes Interest Taxable income Taxes (50%) Earnings after taxes $ 14,400,000 12.240.000 $ 2,160,000 544.320 $1,615,680 807.840 $ 807,840 c. Key Ratios Current ratio Return on common equity Operating expenses to sales Debt to total assets 3.08x 15.92% 85.0% 53.0% 2.31% 13.85% 85.0% 53.0% liabilities might be increased and/or current assets might be decreased to produce the Billy Edwards, who has responsibility for accounting and finance, entered the discus- reduction of dividend payments were probably also out of the question. Restrictions in sion at this point and stated that other financing alternatives such as leasing and the the company's long-term debt agreements made lease financing practically impossible. The company cannot reduce its dividend payments drastically without risking further declines in its stock price. Thus, Mr. Edwards said that the best way to obtain funds for the company's capital expansion would be in the working capital area. Current 395 Case Study 3: Profitability Analysis necessary funds. Mr. Edwards proposed three working capital policies for consideration (1) a conservative policy that would maintain the current working capital structure; (2) an intermediate policy that calls for reducing current assets to the industry average percentage with no change in current liabilities; and (3) a liberal policy that calls for reducing current as- sets by 20 percent and increasing current liabilities by 20 percent. Long-term debt and common equity would be maintained at present levels under all of these policies. The intermediate policy is expected to increase sales by 5 percent, and the liberal policy is expected to increase sales by 10 percent. All finance committee members except Billy Edwards indicated apprehension about any change in working capital policy, but agreed to postpone the final decision on this matter until Mr. Edwards could prepare a more detailed analysis of the possibilities. QUESTIONS 1. Prepare an exhibit that will show (a) the balance sheet, (b) the income statement, and (c) the key ratios for each policy. 2. As current ratio is a measure of liquidity adequacy, does it mean the higher the current ratio, the better position the company is in? 3. Discuss the risk-return tradeoff among the alternative policies. 4. Which of the three alternatives should Mr. Edwards recommend at the next meeting? ness instruments, was preparing for the October meeting of the finance committee. He carmined various sources of funds available to finance the company's capital expansion and reviewed the company's financial statements (see Exhibit 1) with an eye toward Hawthome Business Instruments was founded in 1952 by Tessie Barnes to produce manual typewriters. Through the 1950s and 1960s, the company grew at a rapid pace, debt financing at the present time. Because the company's debt ratio is the same as the industry average, he felt that long-term lenders would demand a healthy risk premium Case Study 3 In late September 1990, Billy Edwards, vice president of finance for Hawthorne Busi- production capacity, but he indicated that it would be very difficult to obtain long-term PROFITABILITY ANALYSIS HAWTHORNE BUSINESS INSTRUMENTS stablishing a new working capital policy. expanding its product line to include manual calculators and other business instru- ments. But the company's growth then stagnated until the late 1970s, when electric bpewriters and calculators replaced their manual counterparts as the company's major was established in Raleigh, North Carolina, to produce a new generation of business Instruments. The company placed two other plants on line in 1988, one in Richmond, Virginia, and another in South Carolina. Hawthorne Business' major problem has been increasing production fast enough to meet the demand for its products. The company's capacity has been expanded steadily since 1988, but it has often lost sales because of insufficient production. Recognizing this problem, Jeanette Amoroso, president and chief executive officer, called a meeting of the finance committee to consider ways to increase production and to review financing alternatives proposed by Mr. Edwards. The meeting was attended by Jeanette Amoroso, president: Billy Edwards, vice president of finance, Courtney Cole, vice president of marketing and Evan Weinstein, director and banker. Courtney Cole reported that the company needs a new plant to produce enough typewriters and calculators to meet market demand. She also said that the company will have to diversify into the mini and desk computer field in the near future because 1986, Evan Weinstein agreed that it is important for Hawthorne Business to expand its Jeanette Amoroso interrupted at this point and stated that a common stock offering was perhaps out of the question for two reasons. First, the sale of new common stock is not desirable because it was currently selling in the over-the-counter market at $12 394 PART 2: CASE STUDIES per share, which is at least a three-year low. Second, most current stockholders are hitz in a position to purchase additional common stock, and the sale of new common stock to outsiders would produce a significant dilution of earnings and control Exhibit 1 Hawthorne Business Instruments Financial Data for Year-Ending August 30, 1990 Midwest Business Percent of Industry Total Averages A. Balance Sheet Current assets Net fixed assets Total assets $ 4,320,000 6.480.000 $ 10,800,000 40% 60% 100% 30% 20% 100% Current liabilities (8%) Long-term debt (10%) Common equity Total liabilities & common equity $ 1,404,000 4,320,000 5,076,000 $ 10,800,000 13% 40% 47% 100% 13% 40% 47% 100% B. Income Statement Sales Operating expenses Earnings before interest & taxes Interest Taxable income Taxes (50%) Earnings after taxes $ 14,400,000 12.240.000 $ 2,160,000 544.320 $1,615,680 807.840 $ 807,840 c. Key Ratios Current ratio Return on common equity Operating expenses to sales Debt to total assets 3.08x 15.92% 85.0% 53.0% 2.31% 13.85% 85.0% 53.0% liabilities might be increased and/or current assets might be decreased to produce the Billy Edwards, who has responsibility for accounting and finance, entered the discus- reduction of dividend payments were probably also out of the question. Restrictions in sion at this point and stated that other financing alternatives such as leasing and the the company's long-term debt agreements made lease financing practically impossible. The company cannot reduce its dividend payments drastically without risking further declines in its stock price. Thus, Mr. Edwards said that the best way to obtain funds for the company's capital expansion would be in the working capital area. Current 395 Case Study 3: Profitability Analysis necessary funds. Mr. Edwards proposed three working capital policies for consideration (1) a conservative policy that would maintain the current working capital structure; (2) an intermediate policy that calls for reducing current assets to the industry average percentage with no change in current liabilities; and (3) a liberal policy that calls for reducing current as- sets by 20 percent and increasing current liabilities by 20 percent. Long-term debt and common equity would be maintained at present levels under all of these policies. The intermediate policy is expected to increase sales by 5 percent, and the liberal policy is expected to increase sales by 10 percent. All finance committee members except Billy Edwards indicated apprehension about any change in working capital policy, but agreed to postpone the final decision on this matter until Mr. Edwards could prepare a more detailed analysis of the possibilities. QUESTIONS 1. Prepare an exhibit that will show (a) the balance sheet, (b) the income statement, and (c) the key ratios for each policy. 2. As current ratio is a measure of liquidity adequacy, does it mean the higher the current ratio, the better position the company is in? 3. Discuss the risk-return tradeoff among the alternative policies. 4. Which of the three alternatives should Mr. Edwards recommend at the next meeting