Managerial Finance Chapter 4—Financial Planning Illustration Updated by DBH, Jan. 2006

Wally’s Widget Works, Inc. Following are simplified financial statements for fiscal year ended in For the 2006 year, Wally and his marketing specialists are assuming 10% growth in sales. It is assumed that a 10% growth in sales would create a 10% increase in current assets and liabilities and a 10% increase in fixed asset capacity to accommodate this growth.

Wally’s Widget Works—2005 financial statements

Wally’s Widget Works—2005 Financial statements (continued)

Wally’s Widget Works—2005 Key Profitability Ratios

Problem-Part 1 Assuming costs remain constant as a percentage of sales, tax rate remains 40%, and equivalent % of dividend payout, calculate 2006 projected income statement & balance sheet for a 10% sales growth. Remember, Current Assets/Liabilities and Fixed assets will also increase by 10%

Wally’s Widget Works—2006 Estimated financials

Wally’s Widget Works—2006 estimated financials (continued)

Problem-Part 2 EFN needed to balance balance sheet is $25.2 (000): Calculate effect on profitability ratios if EFN were obtained through addition to LT debt or through new stock offering:

Wally’s Widget Works (2006 est.)—Impact of EFN acquired through debt:

Wally’s Widget Works (2006 est.)—Impact of EFN acquired through equity:

Calculate internal growth and sustainable growth rates: Part 3:

Internal & Sustainable Growth Rates (continued):

Wally’s Widget Works—Sustainable Growth Rate: Wally can accommodate a growth rate of 22.9% without new equity financing and while maintaining his debt to equity ratio of 2.11 (Total liabilities/Total equity). If his growth were limited to internal resources alone, his IGR could not exceed 6.38%

Calculate Wally’s Financials at the Sustainable Growth Rate:

Wally’s Financials at SGR (continued) Wally can issue up to $275,000 in new debt without altering his Debt to equity ratio, but no more than that.

Wally’s Widget Works—some conclusions Wally is poised for growth potential: Profit margin of 6% on sales isn’t spectacular, but Wally’s efficient use of assets (asset turnover) doubles that to an ROA of 12%, and Equity multiplier of 3.1 triples his return on equity to ROE=37.3%. Wally is using financial leverage effectively-- Wally’s willingness to absorb debt at 2.11 times equity and willingness to plow 50% of profits back into the business gives him a 22.9% SGR. Note: This is all assuming Wally’s borrowing cost (interest rate) is less than his ROA=12%. Otherwise this is unsustainable.

Wally’s Widget Works—conclusions (cont.) Also, the previous example assumed Wally was operating plant at full capacity—no excess capacity available If he were at <100% capacity, he could increase sales without increasing fixed assets. EFN would be less (thus less need for borrowing) But realistically, if Wally had idle capacity, asset turnover might be less than 2x, thus ROA, ROE, and growth rates would probably be lower. (marketguide.com—household prod. industry avg ROA=10.5%, AssetTurnover=1.26, ROE=34.72%)

End of Case Return to Chapter 4