sure cut

Finance Theory II (15.402) Spring 2009 Carola Frydman

Sure Cut Shears


2

The Big Picture: Part I Financing

A. Identifying Funding Needs

Case: Wilson Lumber 1

Case: Wilson Lumber 2

Case: PlayTime Toys

Case: Surecut Shears

B. Optimal Capital Structure: The Basics

Lecture: Capital Structure 1

Case: Massey Ferguson

Lecture: Capital Structure 2

Case: Marriott

C. Optimal Capital Structure: Information and Agency

Lecture: Asymmetric Information and Agency Costs

Case: Intel

Case: MCI Communications


3

SureCut: Motivation

End of April, Mr. Stewart is going to Savannah. Why?

Whats problem here?

Whats purpose of trip?


4

SureCut: Setup

Complete line of scissors and shearsSevere competition, particularly from overseas

Sales/profits grown steadily, if not dramatically

Level production, seasonal sales patternShort term borrowings July DecBorrowing for working capital


5

History

6/95: 3.5M line of credit

Anticipated paid off by 12/95

9/95: Call

Need 500K more primarily plant modernization plan

1/96: Call

Havent paid because of sales decrease Unable to pay until 4/96

4/96: Call

Unable to pay before seasonal requirements startup


6

Why No Repayment?

Why cant they repay as forecast? Compare Exhibit 2 and 4:

Need 500 more in Sept. (3714 vs. 3270 forecast)Need 1256 more in March (1256 vs. 0 forecast)

In Sept. says that its the plant:

Potential Overruns Is it? Compare PPE:

So not really just plant

Forecast Actual Difference

Sept 27554 27848 294

March 27554 27812 258


7

Why No Repayment?

Compare differences between actual outcomes and forecasts

for:

Start with I/SThen do B/SFinally: Quasi Sources and Uses


8

Income Statement: Actual vs. Forecast (2)

Bottom Line:

Sales down by 11%Gross Profit down by 21%

Is this an indication of poor management?

Operating Leverage!Overhead constant and sales decreaseSimilar in spirit to effect of financial leverage which well

get to


9

Balance Sheet: Actual vs. Forecast

Should compare month by month.

Going to focus here on one point in time: 3/96

Other months calculated in similar manner


10

Balance Sheet: Actual vs. Forecast

Why is the difference column not a pure Sources/Uses

statement?

How should we interpret this table?

Forecast Actual Difference

Cash 2371 688 -1683

A/R 2850 2867 17

Inventory 6588 7374 786

NetPlant 27,554 27,812 258

Total Assets 39,393 38,741 -622

Bank Loan 0 1256 1256

A/P 777 514 -263

Taxes Payable 449 -127 -576

Misc 270 258 -12

Mortgage 11,661 11,661 0

CS 11,500 11,500 0

NW 14,706 13,679 -1027

Liab+NW 39,393 38,741 -622


11

Some analysis

Inventory (Asset)

In 6/95 Inventory is 8106Forecast for 3/96 is 6588Was supposed to be source of 1518

But in 3/96, Inventory was 7374.

So actual source of only 732

1518 732 = 786 less of a source than expected

Asset higher than expected; Didnt go down as much

MUST FUND THIS SHORTFALL!


12

Some analysis (2)

Net Plant (Asset)

In 6/95 Net Plant is 24,564Forecast for 3/96 is 27,554Was supposed to be use of 2990

But in 3/96, Net Asset was 27,812.

So actual use of 3248!

258 more of a use than expected

Asset higher than expected



13

Some analysis (3)

AP (Liability)

In 6/95 AP is 861Forecast for 3/96 is 777Was supposed to be use of 84

But in 3/96, AP was 514.

So actual use of 347!

263 more of a use than expected



14

Some analysis (4)

Cash (Asset)

In 6/95 Cash is 2121Forecast for 3/96 is 2371Was supposed to be use of 250

But in 3/96, Cash was 688.

So actual source of 1433!

Supposed to be use of 250 but was actually a source of 1433

ADDITIONAL SOURCE OF 1683!


15

Summary of Funding Shortfall

Source of Shortfall: Higher Assets and Lower Liabilities

Funding Shortfall: Lower Assets and Higher Liabilities

Cash 1683 AR 17

Bank 1256 Inv 786

Plant 258

AP 263

Taxes 576

Misc. 12

NW 1027

TOTAL 2939 2939

Funding of Shortfall Source of Shortfall


16

Is Management at Fault?

Sales decrease 11%, Profit decrease 21%

Recall operating leverage argument

How soon could they have forecasted decrease in sales?

In September sales down only by 7%By October down by 10%

How about purchases?

Purchases forecasted at 777 per monthActual purchase of raw material greater than forecast until

December!

By then sales off by 15%

Dont cut labor until February


17

Consequence

Whats the result of all this?

Lower sales, even labor, higher purchases

Inventory!

Total Inventory Forecast Actual Difference

Mar-96 6588 7374 786 more

Jan-96 5818 6925 1107 more

Finished Goods Forecast Actual Difference

Mar-96 2701 4171 1470 more


18

Did Fisher Know? Whats Going On?

9/95: Need 500K more primarily plant modernization plan

Plant 294 more (27,554 vs. 27,848)

1/96: Bank loan supposed to be 0

Actually 1376 (Pay you in April) (But loan down from 2279 in December)

4/96: Unable to pay before seasonal requirement startup

1256 loan at end of March

Whats going on?


19

Response Rate?

Were they slow to respond?

Fairly clear that sales decrease by October

But purchases more at first, and decreases purchases belowforecast only in Dec.

Maybe getting discounts due to recession deal?

Labor decreases in February

Slow?Layoffs in ChristmasLayoffs of skilled workers in face of temporary fluctuations in

demand may not be best idea


20

What do they do now?

Can they get back on track?

Currently, as of March:

Sales 83% of forecastLabor 83% of forecastPurchases 67% of forecast Inventory 112% of forecast

CAN THEY REPAY LOAN???


21

Loan Repayment

Going to do an 85% of Proforma analysis

Can they repay the loan if sales are set at 85% Proforma?Where did we get 85%?

Other Assumptions:

AR, AP, Inv at 85% of PFSGA unchangedTaxes 36%Dividend not cut


22

85% Pro Forma Income Statement

April May June July Aug Sept Oct Nov Dec TOTAL

Forecast 1500 1200 1500 2100 2700 3300 4500 3900 3300 24000

85% 1275 1020 1275 1785 2295 2805 3825 3315 2805 20400

CGS (60%) 765 612 765 1071 1377 1683 2295 1989 1683 12240

Overhead 300 300 300 300 300 300 300 300 300 2700

SGA 270 270 270 270 270 270 270 270 270 2430

PBT -60 -162 -60 144 348 552 960 756 552 3030

Taxes (36%) -22 -58 -22 52 125 199 346 272 199 1091

PAT -38 -104 -38 92 223 353 614 484 353 1939

Dividends 0 0 600 0 0 300 0 0 300 1200

Ret. Earnings -38 -104 -638 92 223 53 614 484 53 739

CumRetEarn -38 -142 -780 -688 -466 -412 202 686 739

Taxes Payable

3/96 (-127) -149 -207 -229 -177 -51 147 493 765 491


23

Balance Sheet 12/96

Cash Plug Bank Loan Plug

AR 4463 AP 660

Inv 4695 Taxes Payable 491

Plant 27812 Misc 270

Mortgage 11,063

C/S 11,500

Earned Surplus 14,418

Assets Liabilities+NW

36,970 + Cash 38,420 + Bank Loan

Note: Ignored Interest Payments


24

Balance Sheet 12/96

Cash 1432 Bank Loan 0

AR 4463 AP 660

Inv 4695 Taxes Payable 491

Plant 27812 Misc 270

Mortgage 11,063

C/S 11,500

Earned Surplus 14,418

Assets Liabilities+NW

36,970 + 1432 38,420 + 0

Can pay off loan at 85% easily.

What did we miss?


25

What did we miss?

Inventory

Assume inventory at 85% of PF, but have all this inventory we needto get rid of!

Actual inventory in 3/96 is 7374, while forecast was 6588 which at85% is 5600

Actual inventory is 1774 more than 85% forecast

How fast pull inventory down?

Inventory 12/96 @ 85% = 4695Work of excess by:Cutting purchases and labor


26

Inventory

End Inv = End Raw Materials + End Work in Process + End Finished Goods

End RM. = Beg RM + Purchases Trans. to Work in Process

End W in P = Beg W in P + Trans. to W in P + Labor Trans. to Finished Goods

End FG = Beg FG + Trans. to Finished Goods - CGS

End Inv = Beg RM + Purchases + Beg W in P + Labor + Beg FG -CGS

End Inv = Beg Inv. + [Monthly Purchases + Labor] - CGS


27

Pulling down Inventory

End Inv = Beg Inv. + [Monthly Purchases + Labor] - CGS

Beginning Inventory = 7374CGS @ 85% Pro Forma 3/96 - 12/96 = 12,240

So End Inv = 7374 + [Purchases + Labor] - 12,240


28

Pulling down Inventory (2)

Purchases and Labor at 100% forecast are 777 + 778 = 1555

At 85% thats 1322Production process is about half-half materials and labor

Say run production at 85% per month for 9 months

1322 x 9 = 11,898

Therefore

End Inv. at 12/96 = 7374 + 11,898 12,240 = 7032


29


At 3/96: Labor at 646 (83%) , Purchases at 518 (67%)

Together at 1164

If run production at current rates (1164) for 9 months

1164 x 9 = 10,476End Inv. = 7374 + 10,476 12,240 = 5610That goodbutBut production not balanced at 50-50 between labor and

purchases


30


Want to get to end inventory of 4695

End Inv = 7374 + [Purchases + Labor] - 12,240 4695 = 7374 + [Purchases + Labor] - 12,240

Purchases + Labor = 9561 over period of 9 months

Per month = 106750,50 production implies Purchases and Labor of 531

At 3/96 Purchases are in ballpark of what we need but Labor is at

646 instead of 531.

Lay off workers (skilled employees issue)


31

What about assuming 100% Pro Forma

Show that can still pay off loan!

Higher profits but higher AR and Inventory

Extra Inventory problem still exists but not as large


32

What Does Banker Do Upon Arrival?

Wants to make sure that they bring production in line with sales.

Afterwards, not much:

Especially when sees that theyve done all this analysis


33

Did Banker Make a Mistake?

Make loan in June 1995; Peak in Sept of 3270 (pro forma)

Only 28% of WC needs financed externally at peak Sept.

Sep-95 Forecast Actual

AR 4650 4395

Inv 7878 7963

AP 777 843

Tax Pay 78 (79)

Loan 3270 3714

Cash 736 702


34

Is Loan in Danger?

Not really!

Mar-96 Actual

AR 2867

Inv 4171 Finished

AP 514

Mortgage 11,661

Plant 27,812

Cash 688


65

Bottom Line

SureCut needs to weather downturn and undertake period of inventory

readjustment. Purchases and production will be at lower rate than sales

in order to bring finished good inventories in line.

After this readjustment, every reason to believe that Surecut will be able

to continue with policy of borrowing from bank only for seasonal needs


36

Comparisons

How would you compare Wilson, Playtime, and SureCut?

Some ratios:

This is the safest loan weve made!

Wilson Playtime SureCut

Current Ratio 1.6 3.12 5.7

NW/Assets 40%-45% 65% 65%

Nature of Loan long-term seasonal seasonal/cyclical

Risk of Loan moderate-low moderate low


37

Summary

Talked about impact of expected case not occurring

Mgt response to change in climate

Sources and Uses

Look at shortfall Both source of shortfall and funding of shortfall

Pro Forma as forecasting tool

For Firm For Bank

Pro Forma as diagnostic tool

Production calculations Ratio Analysis

sure cut

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