Hatfield medical supplies mini case

1. Mini Case
11/21/18
Chapter 12 Mini Case
Hatfield Medical Supply’s stock price had been lagging its industry averages, so its board of directors brought in a new CEO, Jaiden Lee. Lee had brought in Ashley Novak, a finance MBA who had been working for a consulting company, to replace the old CFO, and Lee asked Ashley to develop the financial planning section of the strategic plan. In her previous job, Novak’s primary task had been to help clients develop financial forecasts, and that was one reason Lee hired her.
Novak began as she always did, by comparing Hatfield’s financial ratios to the industry averages. If any ratio was substandard, she discussed it with the responsible manager to see what could be done to improve the situation. The following data shows Hatfield’s latest financial statements plus some ratios and other data that Novak plans to use in her analysis.
Hatfield Medical Supply: Balance Sheet (Millions of Dollars), December 31 Hatfield Medical Supply: Income Statement (Millions of Dollars Except per Share)
2018 2018
Cash $90 Sales $9,000.9
Accts. rec. 1,260 Op. costs (excl. depr.) 8,100.9
Inventories 1,440 Depreciation 360.0
Total CA $2,790 EBIT $540.0
Net fixed assets 3,600 Interest 144.0
Total assets $6,390 Pretax earnings $396.0
Taxes (25%) 99.0
Accts. pay. & accruals $1,620 Net income $297.0
Line of credit 0
Total CL $1,620 Dividends $100
Long-term debt 1,800 Add. to RE $197
Total liabilities $3,420 Common shares 50
Common stock 2,100 EPS $5.94
Retained earnings 870 DPS $2.00
Total common equ. $2,970 Ending stock price $41.00
Total liab. & equity $6,390
Selected Ratios, Calculations, and Other Data, 2018
Operating Ratios and Data Hatfield Industry Other Ratios Hatfield Industry
(Op. costs)/Sales 90% 88% Profit margin (M) 3.30% 5.60%
Depr./FA 10% 12% Return on assets (ROA) 4.6% 9.5%
Cash/Sales 1% 1% Return on equity (ROE) 10.0% 15.1%
Receivables/Sales 14% 11% Sales/Assets 1.41 1.69
Inventories/Sales 16% 15% Asset/Equity 2.15 1.59
Fixed assets/Sales 40% 32% Debt/TA 28.2% 16.9%
(Acc. pay. & accr.)/Sales 18% 12% (Total liabilities)/(Total assets) 53.5% 37.3%
Tax rate 25% 25% Times interest earned 3.8 11.7
Target WACC 10% 11% P/E ratio 6.9 16.0
Interest rate on debt 8% 7% OP ratio: NOPAT/Sales 4.5% 6.1%
CR ratio: (Total op. capital)/Sales 53.0% 47.0%
ROIC 8.5% 13.0%
a. Using Hatfield’s data and its industry averages, how well run would you say Hatfield appears to be in comparison with other firms in its industry? What are its primary strengths and weaknesses? Be specific in your answer, and point to various ratios that support your position. Also, use the DuPont equation (see Chapter 3) as one part of your analysis.
Hatfield has lower operating profitability as shown by operating profitability (OP) ratio: 4.5% vs. 6.1%. Hatfield utilizes operating capital less efficiently, as shown by capital requirement (CR) ratio: 53% vs. 47%. As a consequence, Hatfield has a lower ROIC: 8.5% vs. 13%. In fact, Hatfield’s ROIC is less than its 10% WACC.
The debt/TA ratio and the TL/TA ratio indicate that Hatfield has more leverage than its industry competitors. The combination of higher interest payments and lower operating profitability cause Hatfield's times interest earned ratio to be much lower than the industry average.
Du Pont ROE M x Sales/Assets x Assets/Equity = ROE
Hatfield 3.30% 1.41 2.15 = 10.0%
Industry 5.60% 1.69 1.59 = 15.1%
The DuPont analysis confirms the conclusions.
b. Use the AFN equation to estimate Hatfield’s required new external capital for 2019 if the sale growth rate is 11.1%. Assume that the firm’s 2018 ratios will remain the same in 2019. (Hint: Hatfield was operating at full capacity in 2018.)
Data for AFN Method
Growth rate in sales (g) 11.1%
Sales (S0) $9,001
Required assets (A0*) $6,390
Spontaneous liabilities (L0*) $1,620
Forecasted sales (S1) $10,000
Increase in sales (ΔS = gS0) $999
Profit margin (M) 3.30%
Assets/Sales (A0*/S0) 71.0%
Payout ratio (POR) 33.7%
Spont. Liab./Sales (L0*/S0) 18.0%
AFNHatfield = Required increase in assets − Increase in spontaneous liabilities − Increase in retained earnings
= (A0*/S0)∆S − (L0*/S0)∆S − M ×S1 × (1–POR)
= (0.7099)(999.1) − (0.18)(999.1) − (0.033)(10000)(0.6633)
= $709.3 − $179.8 − $218.9
AFNHatfield = $310.60 million
c. Define the term capital intensity. Explain how a decline in capital intensity would affect the AFN, other things held constant. Would economies of scale combined with rapid growth affect capital intensity, other things held constant? Also, explain how changes in each of the following would affect AFN, holding other things constant: the growth rate, the amount of accounts payable, the profit margin, and the payout ratio. Answer: See PowerPoint Show
d. Define the term self-supporting growth rate. What is Hatfield’s self-supporting growth rate? Would the self-supporting growth rate be affected by a change in the capital intensity ratio or the other factors mentioned in the previous question? Other things held constant, would the calculated capital intensity ratio change over time if the company were growing and were also subject to economies of scale and/or lumpy assets? Answer: See PowerPoint Show
Self-Supporting Growth Rate. This is the maximum growth rate that can be attained without raising external funds, i.e., the value of g that forces AFN = 0, holding other things constant. We found this rate, ith Excel's Goal Seek function and also algebraically, as explained below.
1. Using algebra. The self-supporting growth rate can also be found by setting the AFN equation to zero and then solving for g.
M(1 – POR)(S0)
Self-Supporting g = = ───────────────────────
A0* – L0* – M(1 – POR)S0
M = 3.30% 3 3.300%
POR = 33.7% 3 33.700%
1-POR = 66.3% 66.300%
S0 = $9,000.9 0 $9,001.0
A* = $6,390 0 $6,390.0
L* = $1,620 0 $1,620.0
M(1 – POR)(S0) $197.00
Self-Supporting g = ─────────────────── = ──────── = 4.3%
A0* – L0* – M(1 – POR)S0 $4,573.00
2. Using Goal Seek. To find the self-supporting growth rate with Goal Seek, select Data, What-If Analysis, and Goal Seek; then choose cell with the AFN (B96) as the value for the "Set Cell" area of the Goal Seek dialog box, choose 0 as the value for the "To Value" area of the dialog box, and choose the cell with the growth rate (C54) as the value for the "By Changing Cell" area of the dialog box. Then hit OK.
e. Use the following assumptions to answer the questions below: (1) Operating ratios remain unchanged. (2) Sales will grow by 11.1%, 8%, 5%, and 5% for the next four years. (3) The target weighted average cost of capital (WACC) is 10%. This is the No Change scenario because operations remain unchanged.
Inputs for the forecast are shown below. You can change inputs in blue. You can show the original scenario by going to Data, What-If Analysis, Scenario Manager, and select the scenario named No Change.
Scenario:
No Change
Actual Forecast For inputs:
Mike Ehrhardt: The last 2 years of growth must have same value to get constant growth in FCF. The last 3 years of the operating ratios must have same value to get constant growth in FCF. An error message will appear if this condition is violated.
Inputs 2018 2019 2020 2021 2022 Error Check
Sales growth rate: 11.1% 8% 5% 5% Ok
(Op. costs)/Sales: 90.00% 90.0% 90% 90% 90% Ok
Depr./FA 10.00% 10% 10% 10% 10% Ok
Cash/Sales: 1.00% 1% 1% 1% 1% Ok
(Acct. rec.)/Sales 14.00% 14% 14% 14% 14% Ok
Inv./Sales: 16.00% 16% 16% 16% 16% Ok
FA/Sales: 40.00% 40% 40% 40% 40% Ok
(AP & accr.)/ Sales: 18.00% 18% 18% 18% 18% Ok
Tax rate: 25.00% 25% 25% 25% 25% Ok
Rate on all debt 8% 8% 8% 8%
Div. growth rate: 5.00% 10% 8% 5% 5%
Target WACC 10% 10% 10% 10%
e. (1) For each of the next four years, forecast the following items: sales, cash, accounts receivable, inventories, net fixed assets, accounts payable & accruals, operating costs (excluding depreciation), depreciation, and earnings before interest and taxes (EBIT).
Scenario:
No Change
Actual Forecast
2018 2019 2020 2021 2022
Net sales $9,000.9 $10,000 $10,800 $11,340 $11,907
Op. costs (excl. depr.) $8,100.9 $9,000 $9,720 $10,206 $10,716
Depreciation $360.0 $400 $432 $454 $476
EBIT $540.0 $600 $648 $680 $714
Cash $90.0 $100 $108 $113 $119
Accounts receivable $1,260.0 $1,400 $1,512 $1,588 $1,667
Inventories $1,440.0 $1,600 $1,728 $1,814 $1,905
Net fixed assets $3,600.0 $4,000 $4,320 $4,536 $4,763
Accts. pay. & accruals $1,620.0 $1,800 $1,944 $2,041 $2,143
e. (2) Using the previously forecasted items, calculate for each of the next four years the net operating profit after taxes (NOPAT), net operating working capital, total operating capital, free cash flow, (FCF), annual growth rate in FCF, and return on invested capital. What does the forecasted free cash flow in the first year imply about the need for external financing? Compare the forecasted ROIC compare with the WACC. What does this imply about how well the company is performing?
Scenario: Actual Forecast
No Change 2018 2019 2020 2021 2022 Definitions:
NOPAT $405 $450 $486 $510 $536 NOPAT = EBIT(1-T)
NOWC $1,170 $1,300 $1,404 $1,474 $1,548 NOWC = (Cash + accounts receivable + inventories) − (Accounts payable & accruals)
Total op. capital $4,770 $5,300 $5,724 $6,010 $6,311 Total operating capital = NOWC + Net fixed assets
FCF −$80 $62 $224 $235.30 FCF = NOPAT − Change in total operating capital
Growth in FCF -177.5% 261.5% 5.0%
ROIC 8.5% 8.5% 8.5% 8.5% 8.5% ROIC = NOPAT/Total operating capital
e. (3) Assume that FCF will continue to grow at the growth rate for the last year in the forecast horizon (Hint: 5%). What is the horizon value at 2022? What is the present value of the horizon value? What is the present value of the forecasted FCF? (Hint: use the free cash flows for 2019 through 2022). What is the current value of operations? Using information from the 2018 financial statements, what is the current estimated intrinsic stock price?
Scenario:
No Change
Horizon Value: Value of operations $3,683
+ ST investments $0
$4,941 Estimated total intrinsic value $3,683
− All debt $1,800
Value of Operations: − Preferred stock $0
Present value of HV $3,375 Estimated intrinsic value of equity $1,883
+ Present value of FCF $308 ÷ Number of shares $50
Value of operations = $3,683 Estimated intrinsic stock price = $37.65
f. Continue with the same assumptions for the No Change scenario from the previous question, but now forecast the balance sheet and income statements for 2019 (but not for the following three years) using the following preliminary financial policy. (1) Regular dividends will grow by 10%. (2) No additional long-term debt or common stock will be issued. (3) The interest rate on all debt is 8%. (4) Interest expense for long-term debt is based on the average balance during the year. (5) If the operating results and the preliminary financing plan cause a financing deficit, eliminate the deficit by drawing on a line of credit. The line of credit would be tapped on the last day of the year, so it would create no additional interest expenses for that year. (6) If there is a financing surplus, eliminate it by paying a special dividend. After forecasting the 2019 financial statements, answer the following questions.
Values, Not Live
No Change No Change
1. Balance Sheets Most Recent Forecast Note: see to right for the "No Change" financial statements with fixed values and not variables. 1. Balance Sheets Most Recent Forecast
2018 Input Basis for 2019 Forecast 2019 2019 Input Basis for 2020 Forecast 2020
Assets Assets
Cash $ 90 1.00% × 2019 Sales $ 100 Cash $90.0 1.00% × 2020 Sales $100.00
Accts. rec. 1,260 14.00% × 2019 Sales 1,400 Accts. rec. 1,260.0 14.00% × 2020 Sales $1,400.00
Inventories 1,440 16.00% × 2019 Sales 1,600 Inventories 1,440.0 16.00% × 2020 Sales $1,600.00
Total CA $ 2,790 $ 3,100 Total CA $2,790.0 $3,100.00
Net fixed assets 3,600 40.00% × 2019 Sales 4,000 Net fixed assets 3,600.0 40.00% × 2020 Sales $4,000.00
Total assets $ 6,390 $ 7,100 Total assets $6,390.0 $7,100.00
Liabilities and equity Liabilities and equity
Accts. pay. & accruals $ 1,620 18.00% × 2019 Sales $ 1,800 Accts. pay. & accruals $1,620.0 18.00% × 2020 Sales $1,800.00
Line of credit - Draw on LOC if financing deficit 298 Line of credit 0.0 Draw on LOC if financing deficit $298.00
Total CL $ 1,620 $ 2,098 Total CL $1,620.0 $2,098.00
Long-term debt 1,800 Carry over from previous year 1,800 Long-term debt 1,800.0 Carry over from previous year $1,800.00
Total liabilities $ 3,420 $ 3,898 Total liabilities $3,420.0 $3,898.00
Common stock $ 2,100 Carry over from previous year 2,100 Common stock 2,100.0 Carry over from previous year $2,100.00
Retained earnings 870 Old RE + Add. to RE 1,102 Retained earnings 870.0 Old RE + Add. to RE $1,102
Total common equity $ 2,970 $ 3,202 Total common equity $2,970.0 $3,202
Total liabs. & equity $ 6,390 $ 7,100 Total liabs. & equity $6,390.0 $7,100
Check: TA − Total Liab. & Eq. = $0 Check: TA − Total Liab. & Eq. = $0.00
2. Income Statement Most Recent Forecast 2. Income Statement Most Recent Forecast
2018 Input Basis for 2019 Forecast 2019 2019 Input Basis for 2020 Forecast 2020
Sales $ 9,000.9 1.111 × 2018 Sales $ 10,000 Sales $9,000.9 111.1% × 2019 Sales $10,000.00
Op. costs (excl. depr.) 8,101 90.00% × 2019 Sales 9,000 Op. costs (excl. depr.) 8,100.9 90.00% × 2020 Sales $9,000.00
Depreciation 360 10.00% × 2019 Net fixed assets 400 Depreciation 360.0 10.00% × 2020 Net fixed assets $400.00
EBIT $ 540.0 $ 600 EBIT $540.0 $600.00
Less: Interest on LTD 144 8.00% × Avg bonds 144 Less: Interest on LTD 144.0 8.00% × Avg bonds $144.00
Interest on LOC - 8.00% × Beginning LOC - Note: If there is an initial balance on the on the LOC, the assumption is that the balance will not change until the last day of the year. Therefore, the interest for the year is the based only on the beginning balance. Interest on LOC 0.0 8.00% × Beginning LOC $0.00
Pretax earnings $ 396.0 $ 456 Pretax earnings $396.0 $456.00
Taxes (25%) 99 25.00% × Pretax earnings 114 Taxes (25%) 99.0 25.00% × Pretax earnings $114.00
Net income $ 297.0 $ 342 Net income $297.0 $342.00
Regular common dividends $100 110% × 2018 Dividends $110 Regular common dividends $100.0 110% × 2019 Dividends $110.00
Special dividends $0 Pay if financing surplus $0 Special dividends $0.0 Pay if financing surplus $0.00
Addition to RE $197 Net income – Dividends $232 Addition to RE $197.0 Net income – Dividends $232.00
3. Elimination of the Financial Deficit or Surplus 3. Elimination of the Financial Deficit or Surplus
Increase in spontaneous liabilities (accounts payable and accruals) $180 Increase in spontaneous liabilities (accounts payable and accruals) $180.00
+ Increase in long-term debt and common stock $0 Note: If there is a LOC in the previous year, then it is necessary to subtract the previous year's line of credit. In other words, this is like paying off the old line of credit on the last day of the year and then drawing on a new line of credit. + Increase in long-term debt and common stock $0.00
− Previous line of credit $0 − Previous line of credit $0.00
+ Net income minus regular common dividends $232 + Net income minus regular common dividends $232.00
Increase in financing $412 Increase in financing $412.00
− Increase in total assets $710 − Increase in total assets $710.00
Amount of deficit or surplus financing: −$298 Amount of deficit or surplus financing: −$298.00
If deficit in financing (negative), draw on line of credit Line of credit $298 If deficit in financing (negative), draw on line of credit Line of credit $298.00
If surplus in financing (positive), pay special dividend Special dividend $0 If surplus in financing (positive), pay special dividend Special dividend $0.00
g. Repeat the analysis performed in the previous question, but now assume that Hatfield is able to improve the following inputs: (1) Reduce operating costs (excluding depreciation) to sales to 89.4% at a cost of $40 million. (2) Reduce inventories/sales to 14% at a cost of $10 million. (3) Reduce net fixed assets/sales to 38% at a cost of $20 million. This is the Improve scenario.
Go to Scenario Manager and choose the Improve Scenario. This will update the financial statements shown above. They are copied below as values.
Values, Not Live
Improvements
1. Balance Sheets Most Recent Forecast
2018 Input Basis for 2019 Forecast 2019
Assets
Cash $90 1.00% × 2019 Sales $100
Accts. rec. $1,260 14.00% × 2019 Sales $1,400
Inventories $1,440 14.00% × 2019 Sales $1,400
Total CA $2,790 $2,900
Net fixed assets $3,600 38.00% × 2019 Sales $3,800
Total assets $6,390 $6,700
Liabilities and equity
Accts. pay. & accruals $1,620 18.00% × 2019 Sales $1,800
Line of credit $0 Draw on LOC if financing deficit $0
Total CL $1,620 $1,800
Long-term debt $1,800 Carry over from previous year $1,800
Total liabilities $3,420 $3,600
Common stock $2,100 Carry over from previous year $2,100
Retained earnings $870 Old RE + Add. to RE $1,000
Total common equity $2,970 $3,100
Total liabs. & equity $6,390 $6,700
Check: TA − Total Liab. & Eq. = $0
2. Income Statement Most Recent Forecast
2018 Input Basis for 2019 Forecast 2019
Sales $9,000.9 111.1% × 2018 Sales $10,000
Op. costs (excl. depr.) 8,100.9 89.40% × 2019 Sales $8,940
Depreciation 360.0 10.00% × 20219Net fixed assets $380
EBIT $540.0 $680
Less: Interest on LTD 144.0 8.00% × Avg bonds $144
Interest on LOC 0.0 8.00% × Beginning LOC $0
Pretax earnings $396.0 $536
Taxes (25%) 99.0 25.00% × Pretax earnings $134
Net income $297.0 $402
Regular common dividends $100.0 110% × 2018 Dividends $110
Special dividends $0.0 Pay if financing surplus $162
Addition to RE $197.0 Net income – Dividends $130
3. Elimination of the Financial Deficit or Surplus
Increase in spontaneous liabilities (accounts payable and accruals) $180
+ Increase in long-term debt and common stock $0
− Previous line of credit $0
+ Net income minus regular common dividends $292
Increase in financing $472
− Increase in total assets $310
Amount of deficit or surplus financing: $162
If deficit in financing (negative), draw on line of credit Line of credit $0
If surplus in financing (positive), pay special dividend Special dividend $162
g. (1) Should Hatfield implement the plans? How much value would they add to the company?
Improve No Change Net Change in Value
Value of operations $5,662 $3,683 $1,980
Cost of Improvement -$70 -$70
Total value $5,592 $3,683 $1,910
g. (2) How much can Hatfield pay as a special dividend in the Improve Scenario? What else might Hatfield do with the financing surplus?