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FIN - CH 21 Mini Case _ Dan Barnes, financial manager of Ski Equipment Inc. (SKI)




Question;Dan Barnes, financial manager of Ski Equipment Inc. (SKI), is excited but apprehensive. The company?s founder recently sold his 51% controlling block of stock to Kent Koren, who is a big fan of EVA (Economic Value Added). EVA is found by taking the net operating profit after taxes (NOPAT) and then subtracting the dollar cost of all the capital the firm uses:EVA = NOPAT? Capital costs= EBIT (1 ? T) ? WACC (Total capital employed)If EVA is positive then the firm?s management is creating value. On the other hand, if EVA is negative, then the firm is not covering its cost of capital and stockholders? value is being eroded. Koren rewards managers handsomely if they create value, but those whose operations produce negative EVAs are soon looking for work. Koren frequently points out that if a company could generate its current level of sales with fewer assets, it would need less capital. This would, other things held constant, lower capital costs and increase its EVA.Shortly after taking control of SKI, Kent Koren met with SKI?s senior executives to tell them of his plans for the company. First, he presented some EVA data that convinced everyone that SKI had not been creating value in recent years. He then stated, in no uncertain terms, that this situation must change. He noted that SKI?s designs of skis, boots, and clothing are acclaimed throughout the industry but claimed that something was seriously amiss elsewhere in the company. Costs are too high, prices are too low, or the company employs too much capital, and Koren wants SKI?s managers to correct the problem?or else. Barnes has long felt that SKI?s working capital situation should be studied. The company may have the optimal amounts of cash, securities, receivables, and inventories, but it may also have too much or too little of these items. In the past, the production manager resisted Barnes?s efforts to question his holdings of raw materials, the marketing manager resisted questions about finished goods, the sales staff resisted questions about credit policy (which affects accounts receivable), and the treasurer did not want to talk about her cash and securities balances. Koren?s speech made it clear that such resistance would no longer be tolerated. Barnes also knows that decisions about working capital cannot be made in a vacuum. For example, if inventories could be lowered without adversely affecting operations, then less capital would be required, the dollar cost of capital would decline, and EVA would increase. However, lower raw materials inventories might lead to production slowdowns and higher costs, and lower finished goods inventories might lead to the loss of profitable sales. So, before inventories are changed, it will be necessary to study operating as well as financial effects. The situation is the same with regard to cash and receivables. Barnes begins by collecting the ratios shown below. (The partial cash budget shown after the ratios is used later in this mini case.)SKI IndustryCurrent 1.75 2.25Quick 0.92 1.16Total liabilities/assets 58.76% 50.00%Turnover of cash and securities 16.67 22.22Days sales outstanding (365-day basis) 45.63 32.00Inventory turnover 6.00 8.00Fixed assets turnover 7.75 13.220Total assets turnover 2.08 3.00Profit margin on sales 2.07% 3.50%Return on equity (ROE) 10.45% 21.00%Payables deferral period 30.00 33.00Cash Budget(Thousands of Dollars) Nov Dec Jan Feb Mar AprSales Forecast(1) Sales (gross) $71,218.00 $68,212.00 $65,213.00 $52,475.00 $42,909.00 $30,524.00Collections(2) During month of sale:(0.2)(0.98)(month?s sales) 12,781.75 10,285.10(3) During first month after sale:(0.7)(previous month?s sales) 47,748.40 45,649.10(4) During second month after sale:(0.1)(sales 2 months ago) 7,121.80 6,821.20(5) Total collections (Lines 2 + 3 + 4) $67,651.95 $62,755.40Purchases(6) (0.85)(forecasted sales 2 monthsfrom now) $44,603.75 $36,472.65 $25,945.40Payments(7) Payments (1-month lag) 44,603.75 36,472.65(8) Wages and salaries 6,690.56 5,470.90(9) Rent 2,500.00 2,500.00(10) Taxes(11) Total payments $53,794.31 $44,443.55NCFs(12) Cash on hand at start of forecast $ 3,000.00(13) NCF: Coll.? Pmts.= Line 5? Line 11 $13,857.64 $18,311.85(14) Cum NCF: Prior + this mos. NCF $16,857.64 $ 35169.49Cash Surplus (or LoanRequirement)(15) Target cash balance 1,500.00 1,500.00(16) Surplus cash or loan needed $15,357.64 $33,669.49a. Barnes plans to use the preceding ratios as the starting point for discussions with SKI?s operating executives. He wants everyone to think about the pros and cons of changing each type of current asset and how changes would interact to affect profits and EVA. Based on the data, does SKI seem to be following a relaxed, moderate, or restricted working capital policy?b. How can one distinguish between a relaxed but rational working capital policy and a situation in which a firm simply has excessive current assets because it is inefficient? Does SKI?s working capital policy seem appropriate?c. Calculate the firm?s cash conversion cycle given that annual sales are $660,000 and cost of goods sold represents 90% of sales. Assume a 365-day year.d. What might SKI do to reduce its cash without harming operations? In an attempt to better understand SKI?s cash position, Barnes developed a cash budget. Data for the first 2 months of the year are shown above. (Note that Barnes?s preliminary cash budget does not account for interest income or interest expense.) He has the figures for the other months, but they are not shown.e. Should depreciation expense be explicitly included in the cash budget? Why or why not?f. In his preliminary cash budget, Barnes has assumed that all sales are collected and thus that SKI has no bad debts. Is this realistic? If not, how would bad debts be dealt with in a cash budgeting sense? (Hint: Bad debts will affect collections but not purchases.)g. Barnes?s cash budget for the entire year, although not given here, is based heavily on his forecast for monthly sales. Sales are expected to be extremely low between May and September but then to increase dramatically in the fall and winter. November is typically the firm?s best month, when SKI ships equipment to retailers for the holiday season. Barnes?s forecasted cash budget indicates that the company?s cash holdings will exceed the targeted cash balance every month except for October and November, when shipments will be high but collections will not be coming in until later. Based on the ratios shown earlier, does it appear that SKI?s target cash balance is appropriate? In addition to possibly lowering the target cash balance, what actions might SKI take to better improve its cash management policies, and how might that affect its EVA?h. What reasons might SKI have for maintaining a relatively high amount of cash?i. Is there any reason to think that SKI may be holding too much inventory? If so, how would that affect EVA and ROE?j. If the company reduces its inventory without adversely affecting sales, what effect should this have on the company?s cash position (1) in the short run and (2) in the long run? Explain in terms of the cash budget and the balance sheet.k. Barnes knows that SKI sells on the same credit terms as other firms in its industry. Use the ratios presented earlier to explain whether SKI?s customers pay more or less promptly than those of its competitors. If there are differences, does that suggest SKI should tighten or loosen its credit policy? What four variables make up a firm?s credit policy, and in what direction should each be changed by SKI?l. Does SKI face any risks if it tightens its credit policy?m. If the company reduces its DSO without seriously affecting sales, what effect would this have on its cash position (1) in the short run and (2) in the long run? Answer in terms of the cash budget and the balance sheet. What effect should this have on EVA in the long run? In addition to improving the management of its current assets, SKI is also reviewing the ways in which it finances its current assets. With this concern in mind, Barnes is also trying to answer the following questions.n. Is it likely that SKI could make significantly greater use of accruals?o. Assume that SKI purchases $200,000 (net of discounts) of materials on terms of 1/10, net 30, but that it can get away with paying on the 40th day if it chooses not to take discounts. How much free trade credit can the company get from its equipment supplier, how much costly trade credit can it get, and what is the nominal annual interest rate of the costly credit? Should SKI take discounts?p. SKI tries to match the maturity of its assets and liabilities. Describe how SKI could adopt either a more aggressive or a more conservative financing policy.q. What are the advantages and disadvantages of using short-term debt as a source of financing?r. Would it be feasible for SKI to finance with commercial paper


Paper#49135 | Written in 18-Jul-2015

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