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CASE 22

HEMINGWAY FENCE INCORPORATION

Financial Forecasting

CASE 22 HEMINGWAY FENCE INCORPORATION

Case Summary
Hemingway Fence, Inc., is a hundred year old company specializing in the production of fencing materials. It started by producing fencing materials heavily demanded by the farms following the civil war. It has then expanded its line of products to residential-fencing equipment and decorative wood fences. Subsequently, it began to produce almost all types of home-fencing equipment by the 1980s. The growth in sales over the past years for Hemingway Fence, Inc. has brought about the need to assess their future financial position. In doing so, it was determined that in order to sustain its growth, external financing would be necessary. Because a

large part of the projected increase in assets can be attributed to an increase in fixed assets, a long-term loan was found to be the most practical solution. The Financial

Planning group (FPG) strongly believes that an equipment lease for the new equipment would best service this need because it would reduce the companys full amount of required external financing and provide tax incentives as well. Along with this source of external financing, new policies will also be implemented such as the modification of the pay as you go policy, as well as the declaration of dividends, policies for trade credit and the improvement for the collection of accounts receivable, which would give the company more working capital to supplement the growth in operations. The management of the company had always firmly upheld a conservative pay as you go policy that kept debt financing at a minimal, usually only to service temporary short-term needs. Unfortunately, the rapid growth in sales coupled with the necessity for modern automated equipment forced management to take on a term loan. The company started channeling debt financing in order to sustain its growth in sales and simultaneously be able to keep up with the rapid changes in its highly competitive market. Also, in 1979 the company had made a cash acquisition of a competitive firm resulted in liquidity problems for the company, leading to the addition of long-term debt.
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SUGGESTED ANSWERS TO QUESTIONS

Q.1. Based on the Information in the case, and assuming no dividends are declared, Construct a pro-forma Income statement for fiscal 1984 and a pro-forma balance sheet for June 30, 1984 for Hemingway Fence. Use additional funds required or excess cash to balance the entries on the liabilities side of the balance sheet.

Ans.

Hemingway Fence Incorporation Pro-forma Income Statement Fiscal Year 1984 In $000
Revenues Cost of Goods Sold Gross Profit Operating Expenses other Income/losses Operating Profit Interest Expenses Income Before Taxes Taxes Net Income 180,000 (106,200) 73,800 (41,543) 9,535 41,792 (5,500) 36,292 (16,331) 19,961

Hemingway Fence Incorporation Pro-forma Balance Sheet Fiscal Year 1984


ASSETS Cash Accounts Receivables, Net Inventory Prepaid Items Total Current Assets Land Plant & Equipment, Net Other Assets Goodwill Total Assets

In $000
8,000 35,716 46,884 1,710 92,310 2,176 55,000 1,691 6,000 157,177

LIABILITIES & CAPITAL Accounts payable other payables Short-term Debt Current Portion of Long Term Debt Additional funds needed Acquired Total current Liabilities Long-term Debt Total Liabilities Common stock Retained Earnings Total Equity Total Liabilities and Capital

29,994 10,937 8,609 3,000 13,245 65,785 24,300 90,085 14,327 52,765 67,092 157,177

Q.2. Based on the results of Question 1, how much additional funding, if any, is required? Ans. There is deficiency in the balance on the liabilities side of the balance sheet; so there is need of additional funds needed so as to balance the liabilities side of the balance sheet. Additional Funds Needed = Total Assets (Total Liability+ Equity) AFN = TA - (TL+E) Total Assets = 157,177 Total Liability = 76,840 Equity = 67,092 Additional Funds Needed = 157,177 (76,840 + 67092) AFN = 157177 - 143,932 AFN = $13245million Q.3. List all possible methods by which the additional funding can be obtained and indicate the advantages and disadvantages of each one. Do not be limited by the attitudes of managers and shareholders? Ans. External Source of Financing (Debt): Additional Funding can be obtained by: Additional funding can be obtained by taking long term loans or issuing long term debt instruments. Advantages of the Debt source of Financing: Debt Financing will give the corporation the benefit of Tax-Shield. The company EBT will decrease so the company will take benefit from it. Flexible source of Financing.
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Disadvantages of the Debt source of Financing: This source of Financing will take long time to obtain. This will increase the interest payments.

Internal Source of Financing (Common Stock): Additional Funding can be obtained internally by: Issuing Common stock will increase the equity of the business and will balance the Liability side of Balance sheet. Advantages of the Internal Source of Financing: Capital is immediately available. No interest payments. No control procedures regarding credit worthiness. Spares credit line No influence of third parties

Disadvantages of the Internal Source of Financing: Expensive because internal financing is not tax-deductible. No increase of capital. Not as flexible as external financing. Losses (shrinking of capital) are not tax-deductible. Limited in volume (volume of external financing as well is limited but there is more capital available outside - in the markets - than inside of a company). Hybrid Source of Financing (Preferred Stock): Hybrid Source of Financing is: Issuing Preferred Stock will finance the additional Funds Requirement of the business entity.

Advantages of the Hybrid Source of Financing: No Legal Obligation for Dividend Payment: There is no compulsion of payment of preference dividend because nonpayment of dividend does not amount to bankruptcy. This dividend is not a fixed liability like the interest on the debt which has to be paid in all circumstances. Improves Borrowing Capacity: Preference shares become a part of net worth and therefore reduces debt to equity ratio. This is how the overall borrowing capacity of the company increases. No dilution in control: Issue of preference share does not lead to dilution in control of existing equity shareholders because the voting rights are not attached to issue of preference share capital. The preference shareholders invest their capital with fixed dividend percentage but they do not get control rights with them. No Charge on Assets: While taking a term loan security needs to be given to the financial institution in the form of primary security and collateral security. There are no such requirements and therefore the company gets the required money and the assets also remain free of any kind of charge on them. Disadvantages of Hybrid Source of Financing: Costly Source of Finance: Preference shares are considered a very costly source of finance which is apparently seen when they are compared with debt as a source of finance. The interest on debt is a tax deductible expense whereas the dividend of preference shares is paid out of the divisible profits of the company i.e. profit after taxes and all other expenses. The tax shield is the main element which makes all the difference. In no tax regime, the preference share would be comparable to debt but such a scenario is just an imagination. Skipping Dividend Disregard Market Image: Skipping of dividend payment may not harm the company legally but it would always create a dent on the image of the company. While applying for some kind of debt or any other kind of finance, the lender would have this as a major concern. Under such a situation, counting skipping of dividend as an advantage is just a fancy. Practically, a company cannot afford to take such a risk.
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Preference in Claims: Preference shareholders enjoy similar situation like that of an equity shareholders but still gets a preference in both payment of their fixed dividend and claim on assets at the time of liquidation.

Q.4. How does your answer to Question. 2 change if the cash account is allowed to fall to 2 percent of sales. Does this eliminate the need for additional outside financing? Ans. When business requirements to cash account fall then ultimately company will

relax its credit term as result revenue proceed go and in return net profit will increase. Due to this the retained earning level will also increase, so it is possible that the additional funds requirement could be met by increased level of retained earnings, and the business will not go for debt to bridge the gap of additional funds required.

Q.5.How does your answer to Question. 2 change if dividends are paid in the amount of $2 million? Should the company pay dividends? Why and why not? Ans. If the company pays dividends in the amount of $2 million then the Additional

Fund needed requirement of the company will be $15245million. The company is already having a need of additional funds of $13245million. The company is not in the position to pay dividends because its having deficiency in the cash account need for additional funds to run the business smoothly. The company must make the ability to pay dividends to shareholders to increase the dignity of the company and by this more shareholders will take shares of company, so the additional funds needed gap will be filled. The company has second option if they try to convince their shareholders to hold their dividend in order to reinvest that dividend for future gain, and tell them they can get more return on that, as the company has the right too, to hold shareholders dividend when there is a need to reinvest to come up with better performance.

Q.6. What are the risks inherent in this method of forecasting, that is, where could errors be made? List each possible error and estimate the amount the forecast could be in error for each item. Ans. Forecasts are not perfect; actual results usually differ from predicted values; the presence of randomness precludes a perfect forecast. Allowances should be made for forecast errors. Forecast accuracy decreases as the time period covered by the forecast-the time horizon-increases. Generally speaking, short-range forecasts must contend with fewer uncertainties than longer-range forecasts, so they tend to be more accurate. There may possibility of error, forecasting of operating expenses etc may not be accurate, there are chances that last growth pattern may not continue, so estimation on past growth rate may be erroneous one.

Q.7. Based on all the information, recommend and support a financing plan for the company based on what you think is the best solution. Assume anyone of the above events could occur in making your recommendation. Ans. Recommendations for Financing Plan of the Company The Company should fulfill its financing needs from long-term debt resources to get the benefit in Tax shield. It may sale out its assets and gets the assets on lease, so the need for additional fund required will be recovered from that. The firm might not depend fully on the past data for forecasting, there may be some significant error exists. The Financial Planning Group might focus on the benefits of all stakeholders. The company might prepare itself for long-term strategy of issuing Long-term debt and public offering of stock; its expansion strategy might also be clear before forecasting for the future.

Appendix I

Hemingway Fence Inc Income Statement Fiscal Year 1981-1984 1,981 Revenues Cost of Goods Sold Gross Profit Operating Expenses other Income/losses Operating Profit Interest Expenses Income Before Taxes Taxes Net Income 1,982 In $"000" 1,983 1,984

122,987 138,987 161,939 180,000 (65,432) (73,454) (95,432) (106,200) 57,555 65,533 66,507 73,800 (23,876) (28,939) (34,673) (41,543) (9,803) (7,655) 2,839 9,535 23,876 28,939 34,673 41,792 (4,323) (4,675) (4,965) (5,500) 19,553 24,264 29,708 36,292 (8,799) (10,919) (13,369) (16,331) 10,754 13,345 16,339 19,961

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Appendix-II

Hemingway Fence Inc Balance Sheet Fiscal Year 1981-1984 1981 1982 ASSETS Cash Accounts Recievable, Net Irrecoverable Accountable Inventory Prepaid Items Total Current Assets Land Plant & Equipment, Net Other Assets Goodwill Total Assets 2,934 3,214 17,893 24,565 (2,000) 0 25,543 24,317 970 1,211 45,340 53,307

1983 8,000 32,132 0 33,765 1,439 75,336

1984 8,000 35,716 0 46,884 1,710 92,310

2,176 2,176 2,176 2,176 26,754 36,833 37,053 55,000 1,322 1,329 1,496 1,691 5,800 5,650 5,500 6,000 81,392 99,295 121,561 157,177

LIABILITIES & CAPITAL Accounts payable other payables Short-term Debt Current Portion of Long Term Debt Additional funds needed Acquired Total current Liabilities Long-term Debt Total Liabilities Common stock Retained Earnings Total Equity Total Liabilities and Capital

17,654 23,454 7,865 8,745 6,754 7,632 3,000 3,000 0 0 35,273 42,831 33,000 30,000 68,273 72,831 10,000 10,000 3,119 16,464 13,119 26,464

26,543 9,765 8,122 3,000 0 47,430 27,000 74,430 14,327 32,804 47,131

29,994 10,937 8,609 3,000 13,245 65,785 24,300 90,085 14,327 52,765 67,092

81,392 99,295 121,561 157,177

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CASE 6

AMERICAN DEPARTMENT STORES, INC

Financial Ratio Analysis

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CASE 6 AMERICAN DEPARTMENT STORES, INC

Case Summary
American Department Stores (ADS) is one of the largest retail chains in the United States. The company owns 2300 discount department stores in 48 states, Puerto Rico and Canada. In the past, the management of the corporation recommended implementing certain innovative plans to enhance the corporations rate of growth. The Board of Directors feels that the time has come to evaluate the success of those plans in maintain the companys industry leadership position. The Competition within the retail industry has been intensified. The inflation rate increased severely and the economy also had unusually high rates of unemployment and is displayed tendencies toward recession. With the relatively high rates of inflation, many consumers turned toward the discount stores. Factory Outlet mall, discount chain drugstores and discount retail department stores expanded dramatically. Price competition forced retailers to take lower markups on their products in order to attract customers by offering better prices. Due to this low price strategy the net income fell, so retailers had to turn to other strategies to maintain their return on equity. ADS have restructured its stores in order to improve sales, control costs and maintain return on equity. ADS have offered Cheap products with a low markup and the sales will be made on Cash only. It improved the merchandise mix by adding higher-quality/higher priced discount merchandise. New products were intended to attract the Upscale customer to the discount chain and maintain the image of its discount store image. Management sought to control the costs through several strategies. They installed a computerized inventory system to improve the inventory system. Acceptance of Third party Credit cards was also a way to increase the customers & Gross profit margin. Thus company faced retail competition from mall-based department stores as well as factory outlet malls, discount chain drugstores and other discount department stores.
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RECOMMENDED ANSWERS TO QUESTIONS


Q.1. Prepare a percentage Income Statement and percentage Balance Sheet for

ADS for each of the five years of financial statements? Ans.

%age Income Statement

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Interpretation of %age Income Statement with Industry Average: The Gross Profit of the firm is less as compared to industry average, it might be due to increase in Cost of goods sold. The Firms Operating expenses is low as compared to Industry average, it seems that the firm has control over the expenses. The firms operating profit is fluctuating and is higher as compared to industry average. There is also

fluctuation in industry which might be due to inflation, seasonality demand trend or other environmental factors involved.

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%age Balance Sheet

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Interpretation of %age Balance Sheet with Industry Average: There is instability in the company cash and less as compared to industry the industry average is also in instable trend. It is seemed instability also which might due high inflation rate. The Companys Account Receivables is in stable trend but lower than industry average. It seems that the firms credit sale is low or the credit policy is very tight to maintain its sale. The firms and industry inventory shows instable trend, and cover most of its asset side, which seems fluctuation in sales. The Firms & Industry Current asset is in decreasing trend, although the firms Current asset are less as compared to Industry which seems that it has less ability to pay short term liabilities from current assets. The Account Payables of the Firm is less as compared to Industry average, it seems that either the Credit Purchase is less or the firm is paying its payables timely. The Firm long-term debt is high as compared to industry average which seems that the firm has taken high loans which might be for expansion in the market or the firm. The Firms Net worth is low as compared to the Industry average; it seems that the Firm has financed its resources higher from Debt and the lesser from Equity. The firm will pay greater Interest as compared to Industry average. It might decrease its Debt and focus on Equity resources and look after from becoming liquidated.

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Q.2.

Calculate Five years of relevant financial ratios for ADS (including rates of

return, profitability ratios, efficiency ratios, leverage ratios, liquidity ratios, measures of valuation, and sustainable growth rates), as well as annual and compound rates of growth in sales and total assets? Ans.

Financial Ratios
current 4 Profitability ratios Gross profit margin Net profit margin Return on asset Return on equity Return on capital employed Efficiency ratios Inventory turn over rate Inventory retention period Receivable turnover rate Average collection period Operating cycle Fixed asset turnover rate Total asset turnover rate Liquidity ratios Current ratio Quick ratio Cash ratio Cash burn ratio/Defensive ratio Solvency ratio Debt to total asset ratio Debt to capital employed ratio Det to equity ratio Interest coverage ratio current 3 current- current 2 1 current

27.1 2.6 9.8 12.3 14.5

26.7 2.1 8.6 10.1 13.0

25.2 1.4 6.8 7.5 10.6

26.7 2.3 9.9 11.3 15.0

26.6 1.6 10.1 8.1 15.4

3.4 107.9 15.7 23.3 131.1 4.5 1.8

3.7 99.8 16.0 22.9 122.6 4.6 1.9

3.9 92.5 16.9 21.6 114.1 4.8 2.0

3.7 97.8 15.9 22.9 120.7 4.2 1.9

3.5 103.0 16.6 22.0 125.0 4.5 1.9

2.0 0.7 0.2 37.1

1.9 0.6 0.2 35.1

1.8 0.6 0.2 33.6

1.9 0.7 0.2 36.3

1.9 0.6 0.2 34.6

0.6 0.9 1.6 6.6

0.6 0.9 1.5 4.8

0.6 1.0 1.6 2.6

0.6 0.9 1.6 3.5

0.6 0.9 1.6 3.4

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Ans. Interpretation of Profitability: The G.P margin has got an instable trend; it seems to be of weaker control over cost of goods sold. However Operating Profit has decreasing trend because it might be due to instability of operating expenses It also has got a negative impact on the net profit of the business. The ROA is decreasing because Operating profit has got a decreasing trend. Interpretation of Efficiency:
Company sale has an increasing trend because of the improved selling techniques or improved inventory techniques. However the company is unable to control its receivable and collection is getting weaker year by year. Its seems to increase because of credit policy.

Interpretation of Liquidity ratios: The company seems to be stable however the company has invested in current assets. Interpretation of Solvency Ratios:
The company debts are increasing year by year however the EBIT has a decreasing trend which may affect the company solvency position in negative way. The company should tighten its credit policy and decrease its debts.

Q.4.

Analyze the book value return on equity relative to the companys risk.

Comment on the companys strengths and weaknesses uncovered by this analysis? Ans. ROE = Net Income/Sales * Sales/Total Assets * Total Assets/Shareholder Equity
Net Sales/Total Total asset /Average income/sales asset equity 0.03 1.83 0.02 1.91 0.01 2.01 0.02 1.85 0.02 1.93

Year current-4 current-3 current-2 current-1 current

2.59 2.51 2.62 2.60 2.57 19

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