Hatfield Medical Supplies'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 Supplies: Balance Sheet (Millions of Dollars), 12/31/2013 Hatfield Medical Supplies: Income Statement (Millions of Dollars Except per Share)
2013
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, 2013
Hatfield Industry Hatfield Industry
Op. costs/Sales 90% 88% Total liability/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%
Additional Data 2014
Exp. Saled growth rate 10%
Interest rate on LT debt 8%
Target WACC 9%
Question A: Using Hatfield's data and its industry averages, how well run would you say Hatfield appears to be compared to 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 Du Point equation.
Question B: Use the AFN equation to estimate Hatfield's required new external capital for 2014 if the sales growth rate is 10%. Assume that the firm's 2013 ratio will remain the same in 2014.
Question 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.
Question 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 help constant, would the calculated capital intensity ratio change over time if the company were growing and were also subject to economics of scale and/or lumpy assets?
Question E: Using 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.
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, depreciation, and earnings before interest and taxes.
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?
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 2017? 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 2014 through 2017). What is the current value of operations? Using information from the 2013 financial statements, what is the current estimated intrinsic stock price?