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Case 4 Growing pain 1. Since this is the first time Jim and Manson will be conducting a financial forecast for Oats ‘R’ Us, how do you think they should proceed? Which approaches or models can they use? What are the assumptions necessary for utilizing each model? As this is the first time Jim and Manson will be conducting a financial forecast for Oats ‘R’ Us, they should first do the sales forecasting planning. While preparing the sales forecasting report, Jim and Mason should takes note on the future economic conditions. Then, they should proceed to preparing the pro-forma financial statement. In the pro-forma financial statement, they can assume that the items in it vary proportionately with their sales or remain the same. Based on their utilization rate, they would be able to determine the asset requirements for growth. Fund needed in financing growth can be raised from accounts payables and accruals, future retained earnings, external sources (debt and stock offering). While for the approaches, Jim and Mason can consider of using one of the methods stated below: 1) Pro-forma approach – This approach is where most of the items in income statement and balance sheet are assumed to remained constant proportion to sales, but individual items can be forecasted using statistical techniques and feedback effects involving changes in interest costs can be added 2) External financing needed (EFN) – It is where they need to identify the funds needed to be raised in order to support their forecasted sales level. EFN is easy to use but it does not allow the inclusion of feedback effects

2. If Oats ‘R’ Us is operating its fixed assets at full capacity, what growth rate can it support without the need for any additional external financing? First, calculate % of sales for income statement. Table shown below:

Table 1 Table 1 refer to calculation where each items divided by sales times 100% Example: % of cost of goods sold in 2004 = (3877500 / 4700000) * 100% = 82.5% Then, calculate % of sales for balance sheet items as well with the same formula. Table 2 is shown on the next page.

Table 2 Net profit margin = net income / sales = 219900 / 4700000 = 4.678% Retention rate = 60% Current sales = $4700000 Asset to sales ratio (Ao/So) -used to compare how much in assets a company has relative to the amount of revenues that the company can generate using their assets = total asset / sales = 25.68% (refer table 2) Account payable to sales (Lo/So) = 2.87% (refer table 2)

Change in sales = calculated using EFN EFN = (Ao/So*changes in sales) – (Lo/So*changes in sales) – [net profit margin*retention ratio* (current sales + changes in sales)] = (25.68%*changes in sales) – (2.87%*changes in sales) – [4.678%*60 %*(4700000+changes in sales)] = changes in sales (25.68%-2.87%-2.807%) -131919.60 Changes in sales= 131919.60 / (25.68%-2.87%-2.807%) = 659499.08 Thus, growth rate that can be supported without external financing is: = 659499.08 / 4700000 = 14.03% 3. Oats ‘R’ Us has a flexible credit line with the Midway Bank. If Mason decides to keep the debt-equity ratio constant, up to what rate of growth in revenue can the firm support? What assumptions are necessary when calculating this rate of growth? Are these assumptions realistic in the case of Oats ‘R’ Us? Please explain. If Mason decides to keep the debt-equity ratio constant, which means that Oats ‘R’ Us is trying to achieve higher rate of growth called sustainable growth rate where it means that the maximum growth rate that a firm can sustain without having the increase in its financial leverage. Sustainable growth rate can be calculated as below: Sustainable growth rate = (ROE x Retention rate) / [1- (ROE x Retention rate)] = (0.46 x 0.6) / [1- (0.46 x 0.6)] = 38.1% *ROE = net income / shareholder equity = 219900 / 477964 = 0.46

*Retention rate = 100% - 40% = 60% There are few assumptions needed in calculating sustainable growth rate which includes: (i) Constant debt-equity ratio (ii) Constant net profit margin (iii) Constant total asset turnover (iv) Constant retention rate First assumption on maintaining a constant debt-equity ratio is realistic as it can be done easily as it’s depends on the firm management policy itself. While for the other three assumptions which are maintaining constant net profit margin, total asset turnover and retention rate are consider as unrealistic as these assumptions are dependable on the future performance of the firm such as firm sales. 4. Initially Jim assumes that the firm is operating at full capacity. How much additional financing will it need to support revenue growth rates ranging from 25% to 40% per year? So, in calculating the additional financing needed, we use EFN formula to calculate it. Formula as shown below: EFN = (Ao/So*changes in sales) – (Lo/So*changes in sales) – [net profit margin*retention ratio* (current sales + changes in sales)] Changes in sales, 4700000 x 25% = 1175000 , 4700000 x 30% =1410000 , 4700000 x 35% = 1645000 , 4700000 x 40% = 1880000 And where Ao/So=25.68%, Lo/So =2.87%, net profit margin =4.678%, retention rate =60%

For example we calculate the additional financing needed to support revenue growth rate of 25% and so, = (25.68%*1175000) – (2.87%*1175000) – [4.678%*60 %*(4700000+1175000)] = 103118

5. After conducting an interview with the production manager, Jim realizes that Oats ‘R’ Us is operating its plant at 90% capacity, how much additional financing will it need to support growth rates ranging from 25% to 40%? 6. What are some actions that Mason can take in order to alleviate some of the need for external financing? Analyze the feasibility and implications of each suggested action. Below are actions that Mason can take in order to alleviate some of the need for external financing: (i) Increase profit margin – it is achievable but difficult as there is competition (ii) Increase sales – can be achievable but need a strong marketing and promotional strategy (iii) Increase account payables by using more trade credit – this can be done but until certain point only as it can be very risky and expensive especially if the firm could avail itself of discounts for paying cash 7. How critical is the financial condition of Oats ‘R’ Us? Is Vicky justified in being concerned about the need for financial planning? Explain why. 8. Given that Mason prefers not to deviate from the firm’s 2004 debt-equity ratio, what will the firm’s pro-forma income statement and balance sheet look like under the scenario of 40% growth in revenue for 2005 (ignore feedback effects).