Financial Management, Spring 2000 Tire City Case Frequently Asked Questions

Note: What I'm trying to make you do is THINK! To read things carefully. To make judgements for yourself without your parents/teachers telling you what to do.  This is an INDIVIDUAL project and therefore, anyone who cheats will be given an F in the course.

Marine Corp. slogan: The weak quit when they experience pain, the strong quit only when the mission is accomplished.
Hawaiian: ho'oikaika

Collaborating with Others:

• I would like to know if we can work on the case with another student to make things a bit easier and more productive, but still hand in separate copies.

If you wish to discuss the case with another student that's fine. However, if you are "borrowing his spreadsheet" and modifying it slightly and/or "lifting his analysis" but putting it in your own words the answer is NO!!  It's always easier to work in a group but there is too much free ridership. I HATE remoras (a tiny fish that gets a free ride and free eats but sticking to the belly of a shark). Also, you already know the grade you'll be getting if your report and spreadsheet resemble another student's. I don't make idle threats.

• I was wondering whether you were going to post a completed version of the Financial Planning Spreadsheet on the net.

As far as posting a completed version of the Financial Planning Spreadsheet on the net, it is already in your Financial Modeling book written by yours truly on page 83.

• On page 1, towards the bottom of the page "At the end of 1995, the balance due on the loan..." is $875 for 1995 which consists of $750 in Long-term debt and $125 in short term debt (labeled Current maturities of long-term debt). This $875 for 1995 comes from the Long-term debt of $875 for 1994.

• One of the major rules of accounting is that assets = liabilities, I am rather certain that this is true in this case as well, but I am not 100% sure on that.  Would you please clarify that?

Did you look at your accounting text to see whether this is a true statement? You need to revisit your accounting principles. Finance doesn't exist in a vacuum. It builds on knowledge that you learn in accounting, marketing, management, etc. The term "balance" sheet means things must be in balance. Assets (your investments) must equal how you finance those investments (either through debt and/OR equity).  Debt is considered liabilities. What do you think the answer to your question should be??

• Do we use the assumption/income statement/balance sheet that you use in the sample sheet or do we use the set up in the Tire City case?

You can model it whichever way you want to. Hey, it's like eating an OREO cookie. Some people like to unscrew the cookie and eat the cream first, other people just put the whole cookie in their mouth.  I gave you an example where I like to put all of the assumptions on the top so that I can easily find where I made my mistake.

• How can we find the sales increase for year 1993 if we don't know the sales value for 1992?

Use sales for 1993 as the base year.
 
• Are we supposed to measure the annual increase in sales with 1993 for every year or are we supposed to compare it to the previous year?  The previous year seems more logical.  And I'm having trouble trying to figure out how I'm supposed to find the percentages for 1997 and the forecasting for 1998.

I think that you answered your own question. What does "annual increase" mean? Does it mean from one year to the next or from the base year to the year in question? The case suggests how you derive the percentages for 1997 (see the paragraph on page 2 entitled Mr. Martin's Task). Does the case ask you to forecast 1998???

• For the A/R in the Tire City Case, do we just take the percentage of sales from the actual income statement and balance sheets (years 1993 to 1995)? Or do we use the projected A/R given in the green textbook (Corporate Finance: A Valuation Approach), where Projected A/R = (projected average collection period)/365 x projected sales.

Do a straight forward A/R as a percentage of sales as stated in the case. The Benninga and Sarig (BS) give a variation of this simple ratio. This case also entails following instructions so the formulas may vary from what the BS book say
 
• When forecasting future A/R, A/P, and inventories, do we also use the percentage of sales technique?  In chapter 6 of BS, they project A/R, A/P, and inventories by calculating the average collection period, average payable period, and inventory days.  Which method do we use?

It's nice to know that students are reading the BS book prior to doing the assignment. Both methods are correct. We're doing a simple percentage as was demonstrated in class.  More specifically, calculate the relevant historical ratios such as accounts receivable/sales. Next, look at the trend in AR/Sales over time.  Apply the applicable AR/Sales ratio * Projected Sales to obtain the expected level of accounts receivable. Ditto for A/P and inventories.

Question: Why are both methods correct? Because we can use AR/Sales to obtain the average collection period. To prove this, take out a piece of paper and pencil and do the math. It will work out.
 

• I have a question about the percentage of sales technique we have to use for our pro forma income statement and balance sheet.  We use the historical percentages as references to forecast future financial statements.  The case mentions that current accounts and operations margins were expected to be consistent with past experience and maintain steady relationships with sales.  Although percentages of each account to sales were very similar throughout the past three years, they didn't have exact same number.  For example, the percentages of COGS to sales for 1993, 1994, and 1995 were 58.1%, 58.45%, and 57.91% respectively.  Are we suppose to take an average percentage or just take an educated guess?  How many decimal places in the percentage we need to take?  If we need to take an educated guess, everyone is going to have slightly different percentages.  For example, some may estimate the percentage of COGS to sales for the next two years to be 58% while some may say 58.2%.

Why would they have to be exactly the same number? Also, why calculate the historical percentage of sales ratios if you don't plan to use them in your decisionmaking process?  Look, forecasting is NOT a science although we have certain benchmarks to guide our predictions.  Given your example of 58% vs. 58.2%, suppose for illustrative purposes that sales are forecasted to be $25,000 (this is a made up number). Then if you use a COGS to Sales of 58% you would obtain $14,500 as the predicted COGs while if you use 58.2% the COGs is $14,550 for a difference of $50. Does it matter is you are off by .2%?  What if you did an IRR? (you don't need to do it in this case). Would the IRR really change?  When you covered statistics, you learned about the mean and standard deviation which are used in combination to obtain the confidence interval. What happens if an observation falls with the confidence interval? (Sorry but I can't give you the answer. Thinking is what I want you to do.)
 
• When forecasting items such as COGS, A/R, etc... on the 1996 &1997 financial statements, do we have to figure out the percentage of sales for these items for years 1993-1995? For example, I need to find the COGS for 1996.  Do I need to figure out COGS/Net Sales for years 1993-1995?  Or do I use the percentage calculated from 1995 to forecast COGS?

Please see the answer to the preceding question. Also, did you read your book and the financial modeling notes?
 
• I am also a little confused about the pro forma balance sheet.  In your financial modeling book pg 83, the pro forma balance does not either specify the components (cash, A/R, inventories) of current assets or the components of current liabilities.  Do we have to specify those components when we do a pro forma balance sheet for Tire City?  On page 131 of your financial modeling book, a more complicated pro forma balance sheet does list those components.

The reason for this is to give you a simplified example that we could get through in 1 hour and 15 minutes.  If I had given you an example  that looks exactly like the Tire City case, it would be very easy with little thinking involved.  Think of it this way. If cash to sales are relatively constant over time, A/R to sales are relatively constant over time, AND inventory to sales are relatively constant over time, doesn't this also mean that current assets to sales are relatively constant over time? Since current assets = cash & equivalents + A/R + inventory it follows that current assets as a percentage of sales = current assets/sales = (cash + A/R + inventory)/ sales = (cash/sales) + (AR/sales) + (inventory/sales) = cash as a percentage of sales + A/R as a percentage of sales + inventory as a percentage of sales. A similar logic process follows for current liabilities. And YES, you do have to specify each component.
 
• For Liabilties in the tire city case, there are current maturities of long-term debt, accounts payable, accrued expenses, which are not in your sample sheet, since you only ask for current liabilites. I can calculate the long term debt from the tire city case, but am I also suppose to calculate the accounts payable, etc. based on previous years?

Please read the answer to the preceding question.

• There's no dividends in the basic data balance sheets... and the numbers of all the data are different from the actual case itself...

You should ask for a refund from your accounting professor. Dividends aren't in the balance sheet. They're in the income statement. Whatever earnings is not paid as dividends is "plowed back" into the firm as retained earnings. Please read your accounting textbook regarding dividends and retained earnings.
 
• Should I take dividends as a function of net income or net sales?

Please re-read the case. Also, read the lecture notes and the book. What do we mean by the dividend payout ratio?

• The case mentions that TCI plans to invest $2.4 million in expansion of which $2 million will be incurred in 1996 and $0 in 1997. Do we just ignore the remaining $0.4 million of capital expenditure?

Please re-read the passage. If you don't get it, keep re-reading it until you do. The passage states "During the next 18 months TCI planned to invest $2,400,000 on its expansion, $2,000,000 of which would be spent during 1996 (no other capital expenditures were planned for 1996 and 1997)."

• Do we add the cost of the warehouse to the plant and equipment section of the balance sheet?

This case not only deals with finance but accounting as well.  What does your accounting textbook say about how the purchase/cost of the warehouse affects the Property, Plant, and Equipment (PPE) section of the balance sheet?  Think in terms of "T" accounts. Suppose you purchase a new pickup truck (a piece of equipment) for your business that costs $35,000. You wish to finance the purchase of this truck by putting down $2,000 in cash and taking out a loan from the auto dealer for the remainder of the purchase price ($33,000). How would this purchase affect your balance sheet? You would increase your Equipment by + $35,000 and decrease your Cash by - $2,000 in the Assets section of your balance sheet (the left hand side of your balance sheet). You would also increase your LT Debt by + $33,000 (the right hand side of your balance sheet). The effect of this transaction is that the left hand side has a net increase of + $33,000 and the right hand side has a net increase of + $33,000.  Thus, the balance sheet is in "balance" e.g. the left hand side = right hand side.  For all transactions, the left hand side and right hand side should be in balance.  What is left for you to also do is that this transaction will affect your income statement as well since you can take depreciation on this piece of equipment.

Depreciation:

• For recognizing the depreciation expense of the 'total' warehouse cost, is it referring to $2.4 million or just $2 million? For the depreciation expense of the other assets, they mentioned that it would be the same as the dollar value of 1995. Does this mean that it remains constant at $213 through the forward projections?

Once again re-read the passage and think about what you learned in your accounting class. Suppose you purchased a car for $35,000. You put down $2000 before walking out of the show room. For the next, 5 years, you pay $400 per month. What is the cost (purchase price) of the car?

If it says that it is the same dollar amount as in 1995, then it should be self evident what the depreciation expense of other assets will be in 1996 and in 1997.

• In the tire city case, there is deprection in the income statement, but not in your sample income statement. ARe we suppose to calculate that?

Of course you are suppose to put depreciation in your income statement. Gee whiz. I stated in the class that my example did not contain depreciation but that you need to consider depreciation in doing the Tire City case. So why didn't I use depreciation in my example? Because if my example was almost exactly like the Tire City case, people would simply copy my example and not THINK!  I want to have people think and also link what they've learned in accounting to what they are learning in finance.

• I'm not very clear about the financing of money from the bank. First of all, does the financing package or rate obtained from Midbank affect the pro-forma statement projections in any way or is the financing questions simply independent of the construction of the proforma statement?

IF Tire City can't finance their warehouse expansion using all internal financing (e.g. retained earnings and cash), then this means that the firm needs some source of external financing. Since the case suggests that the firm will use bank financing from MidBank in the event that external financing is required (this is the PLUG), does the financing rate affect the pro-forma projections?  Suppose you wish to start a dot.com company. You have $5,000 cash on hand and can raise an additional $5,000 from selling your stocks.  Depending on what you sell in your first year, you might have to borrow money from your local bank. If you do borrow the money, does the interest rate that they will charge you affect your pro-forma projections?
 
• When it comes to interest expense for the new loan, do we assume that the full 10% will be charged the year the loan is taken down?  I had a hard time following the in-class example.

The in-class example, like the Tire City case, involves first finding the amount of external financing that Tire City needs. The external financing (all of which is presumed to be NEW bank debt rather than a combination of new equity and new debt) represents "the plug". Interest expense is partly based on the new debt amount.  For additional insight, please read the preceding question and answer.
 
• For the pro forma financial statements, are we assuming that TCI will take out the loan?

What does it state in the case? Please refer to page 2, the paragraph above Mr. Martin's Task.
 
• I understand that there are two interest expense regarding the old and new loan.  And it also states explicitly that the interest rate is 10%.  But do I use the same int. rate (10%) for the new loan or I need to find out the interest rate charged to the old debt? In order words, besides having two interest expenses, so there will be two different interest rates also?

We just went over this in class today. Please read the lecture notes. The interest rate on the NEW loan is at 10%. Is the interest rate on the OLD loan also at the current interest rate or the existing interest rate? Hmm....
 
• When we use external financing as the "plug", do we take the external financing in one year and posted it as debt in the next year?

The way to think of external financing as the "plug" is to ask given that I plan to put new plant and equipment on my books e.g. increase my assets (the left hand side of the balance sheet), how am I going to finance these new assets? Am I going to increase my debt or increase my equity (the right hand side of the balance sheet)?  In the case, it suggests that the firm's owner wishes to fund new plant and equipment using debt financing e.g. issuing bonds or borrowing the money from the bank.  Thus, how much "new" debt is required in each period? "New" is defined as anything that is not existing debt as of the end of 1995 (the period prior to the forecast period).
 
• How do we calculate the net interest expense? Because I tried to divide it by the net sales from 93-95, but the percentages vary. They are more stable when I divide it by gross profit. Is that what I use to calculate it?

Interest does not vary with sales. Please read Chapters 3 and 4 of your textbook (RWJ) and also dust off your accounting textbook. Also, it is very clear that you did not go through the example on page 83 of my Financial Modeling book using an Excel spreadsheet. Why?

Staged-in Financing:

• Could you explain the meaning of taking down the loan into 2 separate parts. It is unclear in the case. Does this mean that each separate loan is to be repaid in 4 separate annual installments e.g. there is a first installment for the loan taken in 1996, and a separate first loan installment to be paid in 1997? As all installments paid in 1998, will they affect the pro-forma statement or are they just there so we can make the relevant calculations to see if the bank should extend the loan package to Tire City?

Taking down the loan in two separate parts on an as-needed basis means that suppose you have a line of credit with the bank for say $500,000 (that at any time, the bank will lend you at up to $500,000) and in 1996 you require $200,000 in external financing then you would borrow $200,000.  If you borrow $200,000 then you have a maximum left on your line of credit of $300,000 which you can use when you need additional financing.  "Taking down" the loan means that you set how much you borrow in each period. The maximum amount of all borrowings, using my contrived example, is $500,000. Thus, you can borrow $100,000 this year, $100,000 next year and $300,000 the subsequent year or you can borrow $400,000 this year and $100,000 next year. It's up to you. You decide when you need the money.

Taking down the loan has nothing to do with loan repayment. Taking down deals with borrowing the money. Repayment deals with how and when you pay the money back to the bank.  It says in the case that the loan is repaid in 4 equal installments. Thus, if you borrow $500,000 (suppose you don't do this all at once), the bank will require that $500,000/4 = $125,000 is paid each year.

The $125,000 paid each year assumes that BOTH principal and interest are paid per period. This is NOT what typically happens. Recall in class that a bond is debt. Suppose once again that you borrow $500,000 by issuing bonds. Assume that the contract rate of interest is 6%, interest is paid annually, and the bonds mature in 4 years. What is the equal annual payment each year? It will be
6%*$500,000 = $30,000 in interest. At the end of year 4, the principal amount of $500,000 is due.

Several of you have asked where does interest go on the balance sheet. It doesn't. If you go back and LOOK at your accounting text, interest is posted to your income statement.

• Do the analysis we need to write for the ratios be in MS Word format or can I write the analysis right there in Excel

under the actual figures?

If you were doing this presentation for your boss, would you put the analysis right there in Excel under the actual figures? Remember that you can use this case on job interviews.  How? Simply by waiting for the right "opening" e.g. in response to a question about which is your most challenging course or who was your toughest professor at Stern and why? This gives you the perfect opportunity to say this ##@@$%!! professor made the class to resemble a finance boot camp wherein we had to do pro-forma analysis and other financial modeling techniques. He also made sure that we could apply the corporate finance theories that we learned in his class.  Since you WILL be using for job interviews, do you want to signal what type of person you are by writing the analysis in the Excel spreadsheet?