Case: Hampton Machine Tool Company

Case: Hampton Machine Tool Company

Assignment Questions

Why can't a profitable firm like Hampton repay its loan on time and why does it need more bank financing? What major developments between November 1978 and August 1979 contributed to this situation?

The main reason why the company cannot repay its loan is because the company bought back 75,000 of shares at a cost of $3m. ($1m from the loan, $2m of cash)

The company have also poorly forecasted sales from January to August ($11.9) with actual sales amounting to $8.7m. The company wants to borrow more money because it wants to buy new machinery at a cost of $350k and this is due to no machinery being replaced because of the economic downturn.

The company purchased $420k worth of raw materials, which it will use by the end of the year.

There was a substantial backlog of orders amounting to $16.5m on 31st August.

There was a missing piece of electronic equipment to finish some machines valued at $1,320,000, which was due to arrive and then the orders can be finished.

The company needs to stay cash positive on a daily basis in order to finance its operations and business expansion.

Based on the information in the case, prepare a projected cash budget for the four months September through December 1979, a projected income statement for the same period, and a pro forma balance sheet as of December 31, 1979.

See attached excel spreadsheet below.

Review the results of your forecast. Do the cash budgets and pro forma financial statements yield the same results? Why?

Since we are using the indirect method to calculate the cash flow statement, we can only compare the operating cash flow on the cash flow statement to the net income on the P&L. The differences in the numbers are substantial due to the realisation of recognised revenue and expenses, which usually flow in the next month based on the given terms (30 days) in the case. Additionally, net income includes non-cash expenses such as depreciation, which also contribute to the difference in the figures.

Critically evaluate the assumptions on which your forecasts are based.

P&L

P&L as budgeted by the company -

Since the company is predicting a 23% EBT margin (we calculate the expected EBT based on the budgeted revenues) and we do know the financial costs associated with the existing debt plus the cost of the new debt, which will be assumed at the end of October 1979, we add that back to calculate the EBIT figure. The SG&A was calculated by looking at historical performance for the period Jan-Aug 1979 relative to the revenues and obtained an average SG&A to revenue ratio of about 11%. This is not the most ideal approach but because of the lack of information, we deemed this as the most appropriate approach even though SG&A expenses are not necessarily directly related to the volume of sales. Having said this, we applied the same ratio of 11% to calculate the SG&A monthly expenses for the remaining months of the year. Finally, for calculating the gross profit we simply added the SG&A expense to the EBIT figure. Based on the gross profit we calculate the COGS since we already know the projected revenues. Since depreciation is given as $10k on a monthly basis as a part of COGS the remaining we assume is the cost of raw materials directly related to sales.

P&L based on Bank's projections -

We predicted the revenue by using three revenue lines-- 1) Revenue of $1.32 million from the sale of machines in September. Since the machines have already been built, it would be fair to assume that the company would recognize the revenue in Sept. 2) The complex project to GA the company has worked on in the past three months, based on the size of unearned revenue dating back to June 1979, historical trends, and information given to us, the company has been able to finish all its complex orders and ship them within six months. Bearing this in mind it would be a fair estimate that the company would complete this particular order by the end of Dec 1979 as they have projected. Therefore, we expect the budgeted revenue figures to be recognised as noted by the company. 3) We have distinguished the third revenue line from normal business operations and the company has not specified the nature of the revenues and these make up the remainder of the budgeted revenues for the respected periods. Based on historical performance the company has, on average, reached 72.9% of their budgeted targets on a monthly basis and since we do not have any specific information about the aforementioned revenue line, it would be fair to assume that the budgeted figure would be realised at the same level of 72.9%. Based on this we expect the total forecasted revenue for the period Sept-Dec 1979 to amount to $6.4mill whereas the budgeted figure as presented by the company for the same period amounts to $7.5mill.

Based on the company budget and historical numbers, we calculated a sales margin of approximately 35%. Based on this information, we calculated the predicated COGS based on our revised revenue figures. We used the same approach when calculating the SG&A expense where we used the historical ratio of SG&A to sales, which amounts to approximately 11%. The interest expense was calculated as explained above and tax rate we used was the given tax rate of 48% to arrive at the Net Income figure.

Based on these calculations, we forecast a total income for the last 4 months of 1979 to amount to about $760,000, whereas based on the company's budget the figure is around 900,000

Working Capital

We calculated accounts receivable based on the ratio of accounts receivable to revenue for each historical month of 1979. Since the company is operating on 30-day terms in respect to their receivables, we should normally expect any revenue recognised in a particular month should not be less than the total amount of accounts receivable outstanding. Looking at the historical ratios, we see a relationship between accounts receivable to sales of above 100% meaning that the amount by which accounts receivable surpass the recognised monthly revenue has been outstanding for more than 30 days. Since this has been the case for all historical months given, it is fair to assume that the company would not be able to collect all of the receivables within a 30-day period. The historical