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Ceramic Structures Engineering, Inc. - Calculating AFN and Forecasting

Calculate the AFN for 2002 (see question #1) and the subsequent years 2003 and 2004. Need help getting started as far as forecasting goes as well.

See attached file for full problem description.

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Ceramic Structures Engineering, Inc.

Ceramics - to many people the word conjures up visions of dishes, flowerpots, and even art sculptures. But, this is not the vision of Darwin Townsend! When someone mentions ceramics, he immediately thinks of jet engines, turbocharged automobiles, and heavy trucks. Although unusual to many people, this vision is not the result of a bizarre sense of association. In fact, it makes a great deal of sense. Ceramics have been known for centuries to be able to function reliably for long periods under conditions of high temperature and pressure without failing. When combined with their lightweight, exceptional strength, and ability to dissipate heat evenly, ceramics have ideal properties for use in high-performance engines. Unfortunately, though, ceramics are also very brittle, a characteristic that has prevented their widespread use in many industrial applications. Townsend realized the natural match between ceramics and high-performance engines many years ago and started to develop ceramic materials that were strong without being brittle. Eventually he succeeded in combining silicon carbide fibers with ceramic materials in a manner that preserved the desirable properties of ceramics but eliminated most of the brittleness.

In 1989 Townsend and Elliott Walters, his co-researcher in developing the new process, formed Ceramic Structures Engineering, Inc (CSE). After receiving a patent on the process, they used their own limited capital to build numerous prototype turbine blades of the new ceramic material. On the basis of extensive testing by several large aerospace contractors and manufacturers of commercial diesel engines, firm orders were received for production-lot quantities. Townsend and Walters then wrote a business plan for the firm extending through 1995 and explored potential sources of seed money with which to commence production. They preferred to acquire capital from a single individual who would be content to serve as a "silent partner" in the firm rather than dealing with a large venture capital company. A wealthy Dallas oilman, Alston Granger, agreed to contribute the necessary startup capital for a 35 percent share of the equity. However, as part of the deal, Granger insisted that the company hire Rhoda Valentine, a graduate of the Fully-Employed MBA Program at Pepperdine University, as the chief financial officer and give her a 5 percent stake in the company. Valentine had worked with Granger on several other ventures and he considered her to be very knowledgeable and astute. With her as an insider, Granger would have an independent source of information about CSE and its operations. The resulting distribution of equity had Granger owning 437,500 shares (35 percent), Townsend and Walters each owning 375,000 shares (30 percent each), and Valentine owning 62,500 shares (5 percent).

The new business was an immediate success. Production began in the summer of 1990, and the first deliveries were made in August. An operating loss was realized for the five month operating period in 1990, but CSE has shown a profit every year since then. A long-term bank loan of $375,500 was negotiated with a Dallas bank in 1993 and was used to expand the firm's ability to make single-crystal threads of ultra-pure silicon carbide, the primary strengthening ingredient in the ceramic composition.

In 1996 CSE needed $4.25 million to upgrade their quality control and inventory handling systems. Townsend and Walters realized that at least part of this amount would have to be raised by issuing new equity, but they were adamant about retaining absolute control of the stock between them. Hence, $2.25 million was raised as equity and an additional long-term bank loan for $2 million was negotiated. At this point in time, Townsend and Walters together owned 2 shares over 50 percent, Granger held 29.2 percent, Valentine owned 4.1 percent, and the public owned 16.7 percent of CSE shares.

A short-term working capital loan for $1 million was obtained in 1997 to support an expanded product line. In 1998 it became apparent that an additional $5 million would be needed to expand the production line for high-speed turbine blades used in many racing turbochargers, and increase the working capital in support of this high-growth market segment. At the time financing alternatives were explored, CSE's stock was selling over-the-counter at below book value, interest rates were high, and credit was somewhat tight. Townsend and Walters strongly opposed another equity issue not only because of the depressed stock price, but also because it would cause them to lose their absolute majority ownership. Thus, they considered a debt issue to be the only viable alternative.

The bank from which CSE had obtained the previous $2.375 million of long-term capital was not willing to provide an additional $5 million, so the company turned to a major insurance company. A 15-year loan for $6 million ($5 million of new capital and $1 million to pay down the note payable) was negotiated with the insurance company at an interest rate of 15 percent. Although high, this rate was reasonable and in line with prevailing market rates for a firm with CSE's risk characteristics. However, particularly onerous indenture provisions were imposed on CSE because the insurance company had the stronger bargaining position. For example, the loan required the firm to maintain a current ratio of 3.5 to 1 and forbade any additional long-term financing without the consent of the insurance company. Moreover, the loan contract contained a provision that called for the payment of an extremely severe penalty in case of prepayment. Thus, if the company wanted to repay the loan before its due date (for example, the firm might want to refinance its debt at lower interest rates), it would have to pay an amount in addition to the principal. Although normal prepayment penalties usually amount to one year's interest, CSE was forced to agree to a provision calling for a sum equal to four year's interest.

Granger and Valentine strongly opposed the loan for two primary reasons. First, the prohibition on additional long-term financing, together with the extraordinarily high current ratio requirement, would hamstring the firm in its future expansion plans. They pointed to the need for additional capital in the past few years and the rapid growth rate of sales as evidence of increasing dependence on external financing. Second, the unprecedented severe prepayment penalty imposed such a high burden on the firm that it was unlikely that any future project requiring new external financing would be profitable, because it would be saddled with the prepayment penalty on the front end. Townsend and Walters rejected these criticisms, pointing out that CSE's current ratio had never been below 4 to 1 and had even increased to over 7 to 1 in the last year. Further, the rapidly expanding sales, whose growth rate exceeded 25 percent per year since 1991, would be generating substantial additions to retained earnings to finance future expansion. In the end, Townsend and Walters were able to commit the firm to the insurance company loan as they controlled a majority of the stock.

The business prospered, but certain frictions began to develop among the major stockholders. Townsend and Walters, the chairman of the board and president respectively, continued to dominate the affairs of the company. Granger and Valentine were cast in the role of dissenting minority shareholders. Specifically, Townsend and Walters were both perfectly content with receiving large salaries and perquisites from the firm and did not want to distribute any profits as cash dividends. This position was defended on the basis of needing all internally generated funds to support future growth. Granger and Valentine, on the other hand, preferred to distribute some of the profits as dividends, believing that this would enhance the value of the stock. It was their position that new stock would be required in the near future to support growth and that the stock price would increase if cash dividends were paid. Granger and Valentine also wanted wider public ownership that would lead to listing on one of the major stock exchanges and greater marketability of their shares. This, they argued, would also enhance the value of the stock and hence its market price. Townsend and Walters turned a deaf ear on these arguments since an additional stock offering would result in loss of their absolute control.

Events in 1999, 2000, and 2001 seemed to bear out Granger and Valentine's position. New orders exceeded projections and the newly upgraded plant facilities appeared to be inadequate. It was obvious to all that additional expansion would be required if the firm were to attain its full growth potential. The point of contention remained the same - how would the expansion be financed.

At the director's meeting in September 2002, Granger and Valentine made a joint presentation. They stated that from a production and marketing standpoint, the firm's policies had been excellent. But, from a financial standpoint, management had been much less satisfactory. They maintained that the major problem had been the failure to plan for growth and to arrange financing in the most advantageous manner. They felt the firm would need additional external capital and it was imperative plans be made to raise it by coordinated equity and debt offerings. They admitted that the provisions of the insurance loan would make additional long-term debt difficult, but stated that issuing additional equity could not be avoided. The firm could use short-term debt (notes payable) to support the expected growth, but this could cause problems in terms of the current ratio requirement. Past mistakes, they argued, made it even more important that a well-thought-out financial plan for the next few years be prepared.

For the purposes of such a plan, both Granger and Valentine believed that the 2002 sales projection should be adjusted in light of the first eight months sales. Assuming approximately as much business would be done the last four months as was done the last four months of 2000 and 2001 (in terms of percentage), total sales of CSE were projected at $84,293,470 with a 4.66 profit margin. Townsend and Walters agreed that this was a realistic estimate and all four agreed that sales of $96,937,490 were appropriate for 2003, and $116,324,990 was reasonable for 2004.

Townsend and Walters agreed that the introduction of formal financial planning would be beneficial, but were still not convinced that needed expansion could not be funded through additions to retained earnings and, perhaps, some short-term debt (notes payable). They pointed to the rapidly growing sales and their policy of not paying dividends as the source of their internal financing flexibility. Granger and Valentine argued that projected growth was in excess of the amount that could be supported internally and that current policies would limit the firm's potential. All four agreed that high sales and profit growth were their main objectives. Therefore, to settle the points of contention and get on with running the company, it is decided that CSE should: (1) make a projection of financing needs; and (2) make plans for obtaining outside funds if necessary.

As Valentine's assistant, you are asked to gather data for the report and make a recommendation. The following data should help in your assignment.

1. Using 2001 percentages, calculate additional funds needed, if any, from external sources for years 2002 - 2004. Assume no dividends are paid. In addition, to support sales in excess of $105 million, new equipment will have to be purchased and installed at a cost of $10 million. This will provide sufficient production capacity to support sales up to a level of $140 million.
2. Project the balance sheet for years 2002 - 2004 and check to see that the mandatory current ratio is not violated. Given this restriction, how much short-term financing, if any, could be used by CSE and maintain the required 3.50 - 1 current ratio. Assume current notes payable will be rolled-over.
3. Prior to the director's meeting, Granger and Valentine ran a simple linear regression in an attempt to predict with more accuracy the inventory levels necessary to support various levels of sales. Here is their resulting equation:

Inventories = $2,725,000 + 0.108426 (sales)

Construct a graph showing this method of inventory prediction with the percent-of-sales method. For the percent of sales, use the 2001 inventory/sales ratio. Explain which method seems more accurate and reliable upon which to base business decisions.
4. Are the assumptions involved in applying the AFN method of forecasting financial needs accurate for CSE? Explain.
5. Outline a three-year financial plan for the company showing which option is preferred - debt or equity financing - and why it is superior. Be sure to cover the following points: (a) the plan must not violate the existing loan agreement; and (b) sufficient funds must be on hand to support the target growth rates. Assume an industry average debt to total assets ratio of 40 percent and that the insurance company would be willing to renegotiate the loan agreement and provide more long-term debt if additional equity capital was raised. Note: if you suggest that the loan be renegotiated, explain "why" you believe the insurance company would be willing to do this. That is, how would it benefit them.

Table 1
Balance Sheet - in thousands

2000 2001
Assets
Cash $1,969.72 $2,250.17
Accts. receivables 10,146.44 11,707.43
Inventory 8,370.81 9,219,60
Current assets 20,486.97 23,177.20
Net fixed assets 9,324.85 10,354.12
Total assets 29,811.82 33,531.32

Liabilities & Equities
Accts. payable $3,504.31 $3,726.45
Notes payable 1,000.00 2,000.00
Accrual 566.09 717.95
Current liabilities 5,070.40 6,444.40
Long-term debt 8,357.50 8,357.50
Total liabilities 13,427.90 14,801.90
Common stock 3,500.00 3,500.00
Retained earnings 12,883.92 15,229.42
Equities 16,383.92 18,729.42
Total capital 29,811.82 33,531.32

Table 2
Income Statement

2000 2001

Sales $56,195.65 $70,244.56
COGS 45,124.95 55,559.90
Gross profits 11,070.70 14,684.66
G&A expenses 3,371.74 4,214.67
Fixed op. expenses 1,910.35 2,010.44
Depreciation 1,909.91 2,120.72
Miscellaneous 702.73 772.41
Total op. expenses 7,894.73 9,118.24
EBIT 3,175.97 5,566.42
Interest 1,122.90 1,222.90
EBT 2,053.07 4,343.52
Taxes 944.41 1,998.02
Net income 1,108.66 2,345.50

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