TOPEKA ADHESIVES(I)

This is a new case.

Case Abstract " .:/ /

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The owners of a relatlvely small buslness expect slgnlflcantsales growth and want to estimate how much of the needed funds mustbe externally financed. The case also raises issues about creditpolicy.

Level of Difficulty

Level "1" if question 10 is not assigned.

Numerical Uniformity

For questions 1-9, only accruals must be estimated. If ourestimate is given to the students, then all of these questions haveunique numerical answers. Q-10, the credit question, can generatedifferent answers depending on the assumptions used.

Suggestions for Reducing the Case's Difficulty

Q-10 should probably be omitted.have trouble with 3-a and 5-a.

Instructor's Note

In addition, students may

Topeka (II) can be used independently of this case. The caseis a composite of issues faced by two firms that we are familiarwith.

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ANSWERS

1. Davidson is confusing "retained earnings" with "cash on hand."Retained earnings on the balance sheet do not indicate theamount of cash' available to spend. It is best viewed as a"running total" of all profits which have been reinvested inthe firm.

2. 1996 Pro Forma IS ($000)

SalesCost of Goods SoldGross ProfitAdministrative CostsDepreciationEBITInterestEBTTaxes(40%)Net Income

Here's the rationale for each item.

$1,933.11,333.8

599.3441. 7

63.294.410.084.433.8

$50.6

3. a.

-The sales estimate is given.-Gross profit is predicted to be 31 percent of sales.

Note that Shatner's original 32 percent estimate wasreduced. ,

-CGS is sales less gross profit.-Administrative costs are estimated to increase by 20percent.-Depreciation is $34.0 , the 1995 amount, plus one­sixth of $175, the 1996 predicted spending on plant,land and equipment.

-Interest is assumed to remain constant (see case).

The overall ACP can be viewed as a weighted average ofthe average collection period, call it ACP30, of thosecustomers who receive terms of net 30, and the averagecollection period, ACP45, of those who receive terms ofnet 45.

ACP30 = .80(30) + .20(40) = 32 daysACP45 = .90(45) + .10(55) = 46 days

The "overall ACP" equals .40(32) + .60(46) = 40.4 days ....... l; -.

b. Receivables = ($1,933.1/360) * 40.4 = $216.9(000).I .;~': ~

4. 1996 inventory~ i.e., "ending inventory," is estimated to be$173.2 = $1333.8/7.7 since inventory turnover (CGS/INV) isestimated to be 7.7.

5.

0.-:1 f,,1 ltr~'?'

Purchases = CGS + Ending Inventory - Begi7ning(~ventoryPurchases = $1,333.8 + $173.2 - $149.5Purchases = $1,357.5(000)

a. APP = 1/3*10 + 2/3*30 = 23.33 days'~

b. Accounts Payable = 23.33*($1,357.5/360) = $87.9(000)

6. a. We will need an estimate of accruals. Using theinformation in Exhibit 1 and Exhibit 2, accruals haveaveraged 2.2% of sales during the 1993-95 period.

ASSETS LIABILITIES & NW

Cash $58.0 Accounts Payable $87.9Receivables 216.9 Accruals 42.5Inventory 173.2 Debt -Due 20.0Other Current 11. 6 Total Current $150.4Total Current $459.7Gross Fixed 441.1 Long-Term Debt 60.0(Accumulated Common stock 110.0depreciation) (188.7) Retained Earnings 215.5Net Fixed Assets 252.4 Funds Needed 176.2Total Assets $712.1 Total Lia. &NW $712 .. 1

= =

Here's the rationale for each item.-Cash is predicted to be 3 percent of sales.-Receivables were calculated in Q3-b.-Inventory turnover (CGS/inventory) is estimated to be7.7. Thus the inventory estimate is $1333.8/7.7 =$173.2.-Other current assets are predicted to be .6 percent ofsales.

-Gross fixed is $266.1 (1995 total) plus $175, thepredicted 1996 capital spending.

-Accumulated depreciation is $125.5 (1995 total) plUS$63.2, the 1996 amount.

-Debt due is given in the case.-Long-term debt is $80, the 1995 amount, less the debt

due of $20.-Retained earnings is $164.9 ,the 1995 BS total, plusthe estimated 1996 net income of $50.6 (no dividendswill be paid) .

-Funds needed is the "plug" or balancing item of theforecast.

b. The balance sheet indicates that the estimated sourcesof financing are $176.1(000) short of the projectedasset requirements.

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7.

8.

c. Inventory turnover (CGS/INV) was 7.1 in 1993, 7.3 in1994 and 7.2 in 1995. using this average of 7.2, 1996inventory is predicted to be $185.3 (=1333.8/7.2).This is $12.1(000) more than estimated above (see 6-a).Thus "funds needed" will be higher but, really, not bya large amount.

1995 assets are 29.6% of sales. Spontaneous liabilities,i.e. , accounts payable and accruals, are 5.3% of sales.The net profit margin is 2.3% and sales are predicted toincrease by $386.6(000) in 1996. Since no dividends willbe paid, the percent of e.ales method predicts that 1996funds needed will be $49 .. 4(000), as shown below.

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Funds Needed = (~296 - .053)*$386.6 -.0~3*$1933.1·

Funds Needed = 93.9 - 44.5 = $49.4(000)r ' i .' ,\. _\ L_ -),1_' .~ \l., ( •. :..'

The percent of sales method assumes that assets,spontaneous liabilities, and net income are constantpercentages of 'sales over the forecasting period. Theseconditions clearly do not hold here, as Topeka isexperiencing significant changes in its working capitaland fixed asset requirements. Note that 1996 assets areestimated to be 36.8% of sales and spontaneousliabilities are predicted to be 6.7% of sales.

In addition, the percent of sales method does not considerany debt due.

So, all things considered, there is no reason to supposethat the estimates in 6-a and 7 will be similar.

9. Let's calculate the retUJrn from taking the discount.

Percent return = discount %100-discount %

x _-:--_--=3::..;6:..0:..- _Final due date­discount period

Return % = 2/98 x 360/(30 - 10) = 36.7%

By taking the discount, a before-tax return of 36.7 percentis earned. While we don't know Topeka's cost of funds, thisstrikes us as a very hi9h return relative to current andhistorical US standards. Taking the discount, therefore,looks like a wise financial move.

10. Note that the relevant choice is between making this salewhile granting 45 days 1:0 pay, versus not making the saleand, thus, extending no credit.

Asset requirements, 'J J'i /'1 r',. ,. -. l ....I·./.

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p "'If"r; /.1-"The incremental asset requirements, assuming excesscapacity, will be the additional investment in receivable:;and, perhaps, inventory. ,/",,'1 ~'lf' ~.;' ~!I"

= AR*(1-.31) + INV/'", "I~

= $100,~00/360*.69*45 + $100,000*.69/7.7= 8,625 + 8,961 = $17,586

Let's first assume that CGS is the only variable cost andequals 69 percent' of -s~les.,-'-the 1996 estimate (see Q-2).so, the incremental after-tax profit to Topeka would be$100,000*.31*.6 = $31,000*.6 = $18,600.[

sideooint: Technical accuracy requires that we adjust thisfor any change in spontaneous liabilities.

Now we need to estimate the capital cost of the decision,which depends on the cost of capi.tal for funds tied up inreceivables and inventory. This isn't given, but using any"reasonable" figure these costs will be far less than theafter-tax profit. For instance, suppose the cost of fundsis 20 percent, a figure that is almost surely too high. Thecapital cost is $17,586*.20 = $3,517. The gain to Topekafrom this sale is as follows.

Gain = $18,600 - 3,517 = $15,083.

with these assumptions, we'd recommend that T~p~ka e'xtend4'5days of credit rather than lose the sale.

We have a "disclaimer," though. rfhe decision to grant thisfirm an extra 15 days could set a precedent that Topekawon't like. will "giving in" to this customer weakenTopeka'.s bargaining power with other clients? If so, thenthere are potential "spillover effects" that need to beconsidered.

Now let's assume that Topeka has no excess capacity whichimplies that the firm's "overhead" must rncrease if the 'salleis made. In Q-2, the 1996 IS indicates that administrativecosts are roughly 23 percent of sales. If these costs areproportional to sales, then the incremental after-tax profitis (100,000*.31 - 100,000*.23)*.6 = $4,800.

Asset requirements must now consider the increase in fixedassets. In Q-6, the 1996 BS shows that net fixed assets areabout 13 percent of sales. Assuming net fixed assets areproportional to sales,

Asset requirements = $17,586 + .13*100,000 = $30,586.

We previously assumed a 20 percent cost of capital for

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decisions of this sort. If so, then the capital cost is.20*30,586 = $6,117 and exceeds the expected after-taxprofit. Of course, this 20 percent figure is almost surelya "high guesstimate." However, if the cost of funds isabove 4,800/30,586 = .16 (which it may be), then grantingthis firm 45 days to pay is not a good deal even if thereare no potential spillover effects.

Sidepoint The analysis is relatively simple because we'veassumed that Topeka will not get the sale unless it offersterms of net 45. The issue becomes trickier if there issome chance of 'making the sale on terms of net 30. In thatcase, we must estimate the probability of making the sale onthese terms and incorporate this into the analysis.