Sue Wilson, the new financial manager of New World Chemicals (NWC), a California producer of specialized chemicals for use in fruit orchards, must prepare a formal financial forecast for 2006.
NWC’s 2005 sales were $2 billion, and the marketing department is forecasting a 25 percent increase for 2006. Wilson thinks the company was operating at full capacity in 2005, but she is not sure about this. The first step in her forecast was to assume that key ratios would remain unchanged and that it would be “business as usual” at NWC. The 2005 financial statements, the 2006 initial forecast, and a ratio analysis for 2005 and the 2006 initial forecast are given in Table IC17-1.

Assume that you were recently hired as Wilson’s assistant, and your first major task is to help her develop the formal financial forecast. She asked you to begin by answering the following set of questions. 

a. Assume (1) that NWC was operating at full capacity in 2005 with respect to all assets, (2) that all assets must grow at the same rate as sales, (3) that accounts payable and accrued liabilities will also grow at the same rate as sales, and (4) that the 2005 profit margin and dividend payout will be maintained. Under these conditions, what would the AFN equation predict the company’s financial requirements to be for the coming year?

b. Consultations with several key managers within NWC, including production, inventory, and receivable managers, have yielded some very useful information.

(1) NWC’s high DSO is largely due to one significant customer who battled through some hardships over the past 2 years but who appears to be financially healthy again and is generating strong cash flow. As a result, NWC’s accounts receivable manager expects the firm to lower receivables enough to make
the DSO equal to 34 days, without adversely affecting sales. 

(2) NWC was operating a little below capacity, but its forecasted growth will require a new facility, which is expected to increase NWC’s net fixed assets to $700 million.

(3) A relatively new inventory management system (installed last year) has taken some time to catch on and operate efficiently. NWC’s inventory turnover improved slightly last year, but this year NWC expects even more improvement as inventories decrease and inventory turnover is expected to rise to 10.

Incorporate this information into the 2006 initial forecast results, as these adjustments to the initial forecast represent the final forecast for 2006.

c. Calculate NWC’s forecasted ratios based on its final forecast, and compare them with the company’s 2005 historical ratios, the 2006 initial forecast ratios, and with the industry averages. How does NWC compare with the average firm in its industry, and is the company’s financial position expected to improve during the coming year?

d. Based on the final forecast, calculate NWC’s free cash flow for 2006. How does this FCF differ from the FCF forecasted by NWC’s initial, “business as usual” forecast?

e. Initially, some NWC managers questioned whether the new facility expansion was necessary, especially since it results in increasing net fixed assets from $500 million to $700 million (a 40 percent increase). However, after extensive discussions about NWC needing to position itself for future growth and being flexible and competitive in today’s marketplace, NWC’s top managers agreed the expansion was necessary. Among the issues raised by opponents was that NWC’s fixed assets were being operated at only 85 percent of capacity. Assuming that its fixed assets were operating at only 85 percent of capacity, by how much could sales have increased, both in dollar terms and in percentage terms, before NWC reached full capacity?

f. How would changes in these items affect the AFN? (1) The dividend payout ratio, (2) the profit margin, (3) the capital intensity ratio, and (4) if NWC begins buying from its suppliers on terms that permit it to pay after 60 days rather than after 30 days. (Consider each item separately and hold all other things constant.)

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Financial Statements and Other Data on NWC (Millions of Dollars) TABLE IC17-1 A. BALANCE SHEETS 2005 2006E Cash and equivalents 20 25 Accounts receivable 240 300 240 Inventories 300 $ 500 $ 625 Total current assets Net fixed assets 500 625 Total assets $1,000 $1,250 $ 100 $ 125 Accounts payable and accrued liabilities Notes payable 100 190 $ 200 $ 315 Total current liabilities Long-term debt 100 190 500 Common stock 500 Retained earnings 200 245 Total liabilities and equity $1,000 $1,250 B. INCOME STATEMENT 2005 2006E Sales $2,000.00 $2,500.00 Less: Variable costs 1,200.00 1,500.00 Fixed costs 700.00 875.00 Earnings before interest and taxes (EBIT) $ 100.00 $ 125.00 Interest 16.00 16.00 Earnings before taxes (EBT) 84.00 $ 109.00 Taxes (40%) 33.60 43.60 Net income 50.40 65.40 Dividends (30%) 15.12 19.62 Addition to retained earnings $ 35.28 $ 45.78 C. KEY RATIOS NWC(2005) NWC(2006E) Industry Comment Basic earning power Profit margin 10.00% 10.00% 20.00% 2.52 2.62 4.00 Return on equity 7.20 8.77 15.60 Days sales outstanding (365 days) 43.80 days 43.80 days 32.00 days Inventory turnover 8.33x 8.33x 11.00x Fixed assets turnover 4.00 4.00 5.00 Total assets turnover 2.00 2.00 2.50 Debt/assets 30.00% 40.34% 36.00% Times interest earned 6.25x 7.81x 9.40x Current ratio 2.50 1.99 3.00 Payout ratio 30.00% 30.00% 30.00%