# Question

Sue Wilson is the new financial manager of Northwest Chemicals (NWC), an Oregon producer of specialized chemicals that are sold to farmers for use in fruit orchards. She is responsible for constructing financial forecasts and for evaluating the financial feasibility of new products.

Part I. Financial Forecasting Sue must prepare a financial forecast for 2016 for NWC. The firm’s 2015 sales amounted to $2 billion, and the marketing department is forecasting a 25 percent increase for 2016. Sue thinks the company was operating at full capacity in 2015, but she is not sure about her assumption. The 2015 financial statements, plus some other data, are given in Table IP8-1.

Assume that you were recently hired as Sue’s assistant, and your first major task is to help her develop the forecast. Sue has asked you to begin by answering the following questions:

a. Assume that NWC was operating at full capacity in 2015 with respect to all assets. Estimate the 2016 financial requirements using the projected financial statement approach, making an initial forecast plus one additional iteration to determine the effects of financing feedbacks. Make the following assumptions: (1) all assets, as well as payables, accruals, and fixed and variable costs, grow at the same rate as sales; (2) the dividend payout ratio is held constant at 30 percent; (3) external funds needed are financed 50 percent by notes payable and 50 percent by long-term debt (no new common stock will be issued); and (4) all debt carries an interest rate of 8 percent.

b. Calculate NWC’s forecasted ratios, and compare them with the company’s 2015 ratios and with the industry averages. How does NWC compare with the average firm in its industry? Is the company’s performance expected to improve during the coming year?

c. Suppose you now learn that NWC’s 2015 receivables and inventories were in line with required levels, given the firm’s credit and inventory policies, but that excess capacity existed with regard to fixed assets. Specifically, fixed assets were utilized at only 75 percent of the full capacity.

(1) What level of sales could have existed in 2015 with the available fixed assets? What would the fixed assets/turnover ratio have been if NWC had been operating at full capacity?

(2) How would the existence of excess capacity in fixed assets affect the additional funds needed during 2016?

d. Without actually working out the numbers, how would you expect the ratios to change in the situation where excess capacity in fixed assets exists? Explain your reasoning.

e. After comparing NWC’s days sales outstanding (DSO) and inventory turn- over ratios with the industry average figures, does it appear that NWC is operating efficiently with respect to its inventories and accounts receivable?

If the company could bring these ratios in line with the industry averages, what effect would this change have on its AFN and its financial ratios?

f. How would changes in the following items affect the AFN?

(1) The dividend payout ratio,

(2) The profit margin,

(3) The plant capacity,

(4) NWC beginning to buy from suppliers on terms that permit payments after 60 days rather than after 30 days? (Consider each item separately and hold all other things constant.)

Part II. Breakeven Analysis and Leverage One of NWC’s employees recently proposed that the company expand its operations and sell its chemicals in retail establishments such as Home Depot and Lowe’s Home Improvement Centers. To determine the feasibility of this idea, Sue needs to perform a breakeven analysis. The fixed costs associated with producing and selling the chemicals to retail stores would be $60 million, the selling price per unit is expected to be $10, and the variable cost ratio would be the same as it is now.

a. What is the breakeven point, in terms of both dollars and number of units, for the employee’s proposal?

b. Sketch a breakeven graph for the proposal. Should the employee’s proposal be adopted if NWC can produce and sell 20 million units of the chemical?

c. If NWC can produce and sell 20 million units of its product to retail stores, what would be its degree of operating leverage for the chemical? What would be NWC’s percentage increase in operating profits if sales actually were 10 percent higher than expected?

d. Assume that NWC has excess capacity, so it does not need to raise any additional external funds to implement the proposal—that is, its 2016 interest payments remain the same as the 2015 payments. What would be its degree of financial leverage and its degree of total leverage? If the actual sales turned out to be 10 percent greater than expected, how much greater (in percent) would the earnings per share be?

e. Explain how Sue can use breakeven analysis and leverage analysis in planning the implementation of thisproposal.

Part I. Financial Forecasting Sue must prepare a financial forecast for 2016 for NWC. The firm’s 2015 sales amounted to $2 billion, and the marketing department is forecasting a 25 percent increase for 2016. Sue thinks the company was operating at full capacity in 2015, but she is not sure about her assumption. The 2015 financial statements, plus some other data, are given in Table IP8-1.

Assume that you were recently hired as Sue’s assistant, and your first major task is to help her develop the forecast. Sue has asked you to begin by answering the following questions:

a. Assume that NWC was operating at full capacity in 2015 with respect to all assets. Estimate the 2016 financial requirements using the projected financial statement approach, making an initial forecast plus one additional iteration to determine the effects of financing feedbacks. Make the following assumptions: (1) all assets, as well as payables, accruals, and fixed and variable costs, grow at the same rate as sales; (2) the dividend payout ratio is held constant at 30 percent; (3) external funds needed are financed 50 percent by notes payable and 50 percent by long-term debt (no new common stock will be issued); and (4) all debt carries an interest rate of 8 percent.

b. Calculate NWC’s forecasted ratios, and compare them with the company’s 2015 ratios and with the industry averages. How does NWC compare with the average firm in its industry? Is the company’s performance expected to improve during the coming year?

c. Suppose you now learn that NWC’s 2015 receivables and inventories were in line with required levels, given the firm’s credit and inventory policies, but that excess capacity existed with regard to fixed assets. Specifically, fixed assets were utilized at only 75 percent of the full capacity.

(1) What level of sales could have existed in 2015 with the available fixed assets? What would the fixed assets/turnover ratio have been if NWC had been operating at full capacity?

(2) How would the existence of excess capacity in fixed assets affect the additional funds needed during 2016?

d. Without actually working out the numbers, how would you expect the ratios to change in the situation where excess capacity in fixed assets exists? Explain your reasoning.

e. After comparing NWC’s days sales outstanding (DSO) and inventory turn- over ratios with the industry average figures, does it appear that NWC is operating efficiently with respect to its inventories and accounts receivable?

If the company could bring these ratios in line with the industry averages, what effect would this change have on its AFN and its financial ratios?

f. How would changes in the following items affect the AFN?

(1) The dividend payout ratio,

(2) The profit margin,

(3) The plant capacity,

(4) NWC beginning to buy from suppliers on terms that permit payments after 60 days rather than after 30 days? (Consider each item separately and hold all other things constant.)

Part II. Breakeven Analysis and Leverage One of NWC’s employees recently proposed that the company expand its operations and sell its chemicals in retail establishments such as Home Depot and Lowe’s Home Improvement Centers. To determine the feasibility of this idea, Sue needs to perform a breakeven analysis. The fixed costs associated with producing and selling the chemicals to retail stores would be $60 million, the selling price per unit is expected to be $10, and the variable cost ratio would be the same as it is now.

a. What is the breakeven point, in terms of both dollars and number of units, for the employee’s proposal?

b. Sketch a breakeven graph for the proposal. Should the employee’s proposal be adopted if NWC can produce and sell 20 million units of the chemical?

c. If NWC can produce and sell 20 million units of its product to retail stores, what would be its degree of operating leverage for the chemical? What would be NWC’s percentage increase in operating profits if sales actually were 10 percent higher than expected?

d. Assume that NWC has excess capacity, so it does not need to raise any additional external funds to implement the proposal—that is, its 2016 interest payments remain the same as the 2015 payments. What would be its degree of financial leverage and its degree of total leverage? If the actual sales turned out to be 10 percent greater than expected, how much greater (in percent) would the earnings per share be?

e. Explain how Sue can use breakeven analysis and leverage analysis in planning the implementation of thisproposal.

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