Hatfield Medical Supply’s stock price had been lagging its industry averages, so

Question

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) 2016 2016 Cash $20 Sales $2,000.0 Accts. rec. $280 Op. costs (excl. depr.) $1,800.0 Inventories $400 Depreciation $50.0 Total CA $700 EBIT $150.0 Net fixed assets $500 Interest $40.0 Total assets $1,200 Pretax earnings $110.0 Taxes (40%) $44.0 Accts. pay. & accruals $80 Net income $66.0 Line of credit $0 Total CL $80 Dividends $20.0 Long-term debt $500 Add. to RE $46.0 Total liabilities $580 Common shares 10.0 Common stock $420 EPS $6.6 Retained earnings $200 DPS $2.0 Total common equ. $620 Ending stock price $52.80 Total liab. & equity $1,200 Selected Ratios and Other Data, 2016 Hatfield Industry Hatfield Industry (Op. costs)/Sales 90% 88% (Total liabilities)/(Total assets) 48.3% 36.7% Depr./FA 10% 12% Times interest earned 3.8 8.9 Cash/Sales 1% 1% Return on assets (ROA) 5.5% 10.2% Receivables/Sales 14% 11% Profit margin (M) 3.30% 4.99% Inventories/Sales 20% 15% Sales/Assets 1.67 2.04 Fixed assets/Sales 25% 22% Assets/Equity 1.94 1.58 (Acc. pay. & accr.)/Sales 4% 4% Return on equity (ROE) 10.6% 16.1% Tax rate 40% 40% P/E ratio 8.0 16.0 ROIC 8.0% 12.5% NOPAT/Sales 4.5% 5.6% (Total op. capital)/Sales 56.0% 45.0% 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 as one part of your analysis. b. Use the AFN equation to estimate Hatfield’s required new external capital for 2017 if the sale growth rate is 10%. Assume that the firm’s 2016 ratios will remain the same in 2017. (Hint: Hatfield was operating at full capacity in 2016.) 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. 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? e. Use the following assumptions to answer the questions below: (1) Operating ratios remain unchanged. (2) Sales will grow by 10%, 8%, 5%, and 5% for the next four years. (3) The target weighted average cost of capital (WACC) is 9%. This is the No Change scenario because operations remain unchanged. 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). 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? 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 2020? 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 2017 through 2020). What is the current value of operations? Using information from the 2016 financial statements, what is the current estimated intrinsic stock price? g. Repeat the analysis performed the previous question but now assume that Hatfield is able to improve the following inputs: operating costs (excluding depreciation)/sales = 89.5% and inventories/sales = 16%. This is the Improve scenario. g. (1) Should Hatfield implement the plans? How much value would they add to the company? g. (2) How much can Hatfiled pay as a a special dividend in the Improved scenario? What else might Hatfield do with the financing surplus? 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) 2016 2016 Cash $20 Sales $2,000.0 Accts. rec. $280 Op. costs (excl. depr.) $1,800.0 Inventories $400 Depreciation $50.0 Total CA $700 EBIT $150.0 Net fixed assets $500 Interest $40.0 Total assets $1,200 Pretax earnings $110.0 Taxes (40%) $44.0 Accts. pay. & accruals $80 Net income $66.0 Line of credit $0 Total CL $80 Dividends $20.0 Long-term debt $500 Add. to RE $46.0 Total liabilities $580 Common shares 10.0 Common stock $420 EPS $6.6 Retained earnings $200 DPS $2.0 Total common equ. $620 Ending stock price $52.80 Total liab. & equity $1,200 Selected Ratios and Other Data, 2016 Hatfield Industry Hatfield Industry (Op. costs)/Sales 90% 88% (Total liabilities)/(Total assets) 48.3% 36.7% Depr./FA 10% 12% Times interest earned 3.8 8.9 Cash/Sales 1% 1% Return on assets (ROA) 5.5% 10.2% Receivables/Sales 14% 11% Profit margin (M) 3.30% 4.99% Inventories/Sales 20% 15% Sales/Assets 1.67 2.04 Fixed assets/Sales 25% 22% Assets/Equity 1.94 1.58 (Acc. pay. & accr.)/Sales 4% 4% Return on equity (ROE) 10.6% 16.1% Tax rate 40% 40% P/E ratio 8.0 16.0 ROIC 8.0% 12.5% NOPAT/Sales 4.5% 5.6% (Total op. capital)/Sales 56.0% 45.0% 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 as one part of your analysis. b. Use the AFN equation to estimate Hatfield’s required new external capital for 2017 if the sale growth rate is 10%. Assume that the firm’s 2016 ratios will remain the same in 2017. (Hint: Hatfield was operating at full capacity in 2016.) 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. 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? e. Use the following assumptions to answer the questions below: (1) Operating ratios remain unchanged. (2) Sales will grow by 10%, 8%, 5%, and 5% for the next four years. (3) The target weighted average cost of capital (WACC) is 9%. This is the No Change scenario because operations remain unchanged. 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). 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? 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 2020? 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 2017 through 2020). What is the current value of operations? Using information from the 2016 financial statements, what is the current estimated intrinsic stock price? g. Repeat the analysis performed the previous question but now assume that Hatfield is able to improve the following inputs: operating costs (excluding depreciation)/sales = 89.5% and inventories/sales = 16%. This is the Improve scenario. g. (1) Should Hatfield implement the plans? How much value would they add to the company? g. (2) How much can Hatfiled pay as a a special dividend in the Improved scenario? What else might Hatfield do with the financing surplus?

Explanation / Answer

Auswer -A Hatfield Industry (Op. costs)/Sales 90% 88% op. cost of hatfield is more than as compare to industries 90%>88% Depr./FA 10% 12% hatfield charge lower deprecaiation as compare to industries these lead to show more profit as compare to industries Cash/Sales 1% 1% equal to industries Receivables/Sales 14% 11% this show that hatfield gives more credit period to customer/credit sale as compare to industries Inventories/Sales 20% 15% this show that hatfield store inventories or more investment in inventories as compare to industries Fixed assets/Sales 25% 22% this show that hatfield more investment in fixed assets as compare to industries as its also due to less depreciation charged (Acc. pay. & accr.)/Sales 4% 4% equal to industries Tax rate 40% 40% equal to industries ROIC 8.00% 12.50% this show that return on invest capital of hatfield is lower then industries this is weak point NOPAT/Sales 4.50% 5.60% Net operating profit after tax of hatfield is lower that industies this is weak point (Total op. capital)/Sales 56.00% 45.00% this show that hatfield invest more capital as compare to indsutries and its also show that this particular level sale is lower than industries this is weak point Hatfield Industry (Total liabilities)/(Total assets) 48.30% 36.70% this show that cirrent liabilies is more that as compare to industries this weak point Times interest earned 3.8 8.9 this show that profit is how much time cover interest exp. Hatfield is lower then industries Return on assets (ROA) 5.50% 10.20% lower then industries . Weak point Profit margin (M) 3.30% 4.99% lower then industries . Weak point Sales/Assets 1.67 2.04 lower then industries . Weak point Assets/Equity 1.94 1.58 more then industries . Weak point Return on equity (ROE) 10.60% 16.10% more then industries . Strengths P/E ratio 8 16 Auswer -b (Total op. capital)/Sales 56.00% Total op. capita =56% = 2000 Total op. capita 1120 Sales $2,000.00 growth 10% $2,200.00 required capital Total op. capita =56% 2200 Total op. capita 1232 new reuired capital= 1232-1120 new reuired capital= 112 Auswer -C The capital intensity ratio is defined as the ratio of required assets to total sales, or a*/s0. Put another way, 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. Thus, the higher the capital intensity ratio, the greater the AFN, other things held constant. If sales increase, more assets are required, which increases the AFN. If the profit margin goes up, then both total and retained earnings will increase, and this will reduce the amount of AFN. 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 percent, 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 point, i.e., 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 which can be financed without outside funds, holding the debt ratio and other ratios constant Auswer -d 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, g = 3.20986%, with Excel's Goal Seek function and also algebraically PM(1 – POR)(S0) Sustainable g    = = A0* – L0* – PM(1 – POR)S0 Auswer -e(1) growth 2000 sales 2017 10% 2200 2018 8% 2376 2019 5% 2494.8 2020 5% 2619.74

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