New Worlds Chemical Inc.

Answer: a. 

NWC will need $180.9 million. 

Here is the AFN equation: 

AFN = (A 0 */S 0 )  S – (L 0 */S 0 )  S – M(S 1 )(RR) 

(A 0 */S 0 )(g)(S 0 ) – (L 0 */S 0 )(g)(S 0 ) – M(S 0 )(1 + g)(RR) 

($1,000/$2,000)(0.25)($2,000) – ($100/$2,000)(0.25)($2,000) 

– 0.0252($2,000)(1.25)(0.7) 

= $250 – $25 – $44.1 = $180.9 million. 

Answer: b.
Balance Sheets (In Millions of Dollars)						1 st Pass					Final Forecast
		2016					2017E					2017E
Cash and equivalents	$			20	$				25		$				67 e
Accounts receivable				240					300						233 a
Inventories				240					300						250 c
Total current assets	$			500	$				625		$				550 d
Net fixed assets				500					625						700 b
Total assets	$1,000				$1,250						$1,250
Accounts payable and accr. liab.	$			100	$				125		$				125
Notes payable				100					190						190
Total current liabilities	$			200	$				315		$				315
Long-term debt				100					190						190
Common stock				500					500						500
Retained earnings				200					245						245
Total liabilities and equity	$1,000				$1,250						$1,250

Notes: 

DSO will be reduced to 34 days, without adversely affecting sales. Sales = $2,500; DSO=34; AR=? 

DSO = AR/Sales/365 

= AR/$2,500/365 

= AR/$6.8493 

AR = $232.8767 ≈ $233. 

Given in problem that forecasted growth will require a new facility, which will increase the firm’s net fixed assets to $700 million. 

A new inventory management system will increase its inventory turnover to 10  . Sales = $2,500; Inv. TO = 10  ; Inv. =? 

Inv. TO = Sales/Inv. 

10 = $2,500/Inv. 

Inv. = $250. 

Total assets do not change; TA = $1,250. 

Total CA = Total assets – Net FA 

$1,250 – $700 

$550. 

Cash and equivalents = Total CA – AR – Inv. 

$550 – $233 – $250 

$67. 

The final forecasted Income Statement is the same as the initial forecast. 

Answer: c 

Key Ratios		1 st Pass	Final
	2016	2017E	2017E	Industry	Comment
Basic earning power
	10.00%	10.00%	10.00%	20.00%	Low
Profit margin	2.52	2.62	2.62	4.00	Low
Return on equity	7.20	8.77	8.77	15.60	Low
DSO (365 days)	43.80 days	43.80 days	34.00 days	32.00 days	OK
Inventory turnover	8.33 x	8.33 x	10.00 x	11.00 x	Slightly low
Fixed assets turnover	4.00	4.00	3.57	5.00	Low
Total assets turnover	2.00	2.00	2.00	2.50	Slightly low
Debt/assets	30.00%	40.40%	40.40%	36.00%	High
Times interest earned	6.2x	7.81 x	7.81 x	9.40 x	Low
Current ratio	2.50	1.98	1.98	3.00	Low
Payout ratio	30.00%	30.00%	30.00%	30.00%	OK

Compared with industry averages, the firm’s inventory turnover and total assets turnover are slightly low. Its payout ratio is identical to the industry average. The firm’s DSO is close to the industry average. All other ratios compare poorly to industry averages. 

For the trend analysis, the firm’s basic earning power, total assets turnover, and payout ratio are identical to 2016 ratios. The company’s profit margin, ROE, and TIE ratio have improved slightly from 2016, although they are still below the industry average. The company’s DSO and inventory turnover have improved somewhat from 2016. The firm’s DSO is close to the industry average, while its inventory turnover is still slightly below the industry average. The firm’s FA turnover and current ratio are below the 2016 ratios, and are lower than the industry average. The firm’s debt/assets ratio has increased from 2016 and is high for the industry; thus, it should try to reduce its use of debt. 

Answer: d. 

FCF = EBIT (1-T) + Depression -  Gross Capital -  NWC expenditures 

= EBIT (1-T) – Net investment in capital 

Net investment in capital = NWC + Net fixed assets. 

		2016		1 st Pass 2017		Final 2017
EBIT(1 – T)		$60		$75		$75
NWC = CA – Accruals	$400			$500		$425
Net FA	$500			$625		$700

FCF Initial 2017E = $75 – ($1,125 – $900) 

= $75 – $225 

= -$150. 

FCF Final 2017E = $75 – ($1,125 – $900) 

= $75 – $225 

= -$150. 

It is accurately the same, since only the composition of NWC and NFA are different. 

Answer: e. 

Full capacity sales =	Actual sales
	% of capacity at which
	FA were operated

$2,000 

0.85 

$2,352.94 million ≈ $2,353 million. 

$ Increase in sales = $2,353 – $2,000 = $353 million. 

Increase in sales = $2,353 - $2,000 = 17.65%. 

$2,000 

Answer: f. 

The dividend payout ratio. 

If the payout ratio were reduced, then more earnings would be retained, and this would reduce the need for external financing, or AFN. Note that if the firm is profitable and has any payout ratio less than 100%, it will have some retained earnings, so if the growth rate were zero, AFN would be negative, i.e., the firm would have surplus funds. As the growth rate rose above zero, these surplus funds would be used to finance growth. At some growth rate the surplus AFN would be exactly used up. This growth rate where AFN = $0 is called the “sustainable growth rate,” and it is the maximum growth rate that can be financed without outside funds, holding the debt ratio and other ratios constant. 

The profit margin. 

If the profit margin goes up, then both total and addition to retained earnings will increase, and this will reduce the amount of AFN. 

The capital intensity ratio. 

The capital intensity ratio is the ratio of required assets to total sales, or A0*/S0. In other words, it represents the dollars of assets required per dollar of sales. The higher the capital intensity ratio, the more new money will be required to support an additional dollar of sales. Therefore, the higher the capital intensity ratio, the greater the AFN, other factors held constant. 

If NWC begins buying from its suppliers on terms that permit it to pay after 60 days rather than after 30 days. 

If NWC’s payment terms were increased from 30 to 60 days, accounts payable would double, in turn increasing current and total liabilities. This would decrease the amount of AFN due to a decreased need for working capital on hand to pay short-term creditors, such as suppliers.