Case 11

Tipton Ice Cream

Financial

Forecasting

George Tipton began the Tipton Ice Cream Company nearly five decades ago. He
patented a soft ice cream and the right from the outset paid special attention to quality.
“We only make one product, but we make it in many flavors and we make it well,” Tipton
was fond of saying. The company was an immediate success and sales quickly reached
seven figures.

DEBT AVERSION

The firm expects strong growth in the coming year (1996) and Brenda Hood, Tipton‟s
chief financial officer, hopes she can make a strong case for borrowing to finance the
company‟s expansion. She realizes, however, that she is likely to face stiff opposition
from the Tipton family. George Tipton, perhaps unduly influenced by the Great
Depression of the 1930s, detested borrowing money and his motto was “Never a lender
nor borrower be.” For nearly 25 years all the company‟s stock was owned by the Tipton
family, but due to expansion new shares have been sold during the last 15 years to
individuals outside the family. By 1995 the Tipton family owns 60 percent of all shares,
and although the family has not been very active in running the firm, it does insist on
one family tradition: “Never a lender nor borrower be.” To this day Tipton has never
owed anything beyond its accounts payable and accruals.
Hood knows this is an extreme case of debt aversion and the policy has hurt the
owners‟ profits. For example, historically Tipton has been slightly above the industry
average in the return on total assets but consistently below in return on owner‟s equity.
At each annual meeting she has tried unsuccessfully to convince the Tipton clan to use
more debt. And each year Hood heard a chorus of “Never a lender…” But perhaps this
year would be different.
She recalls two sessions on financial management that she held for the non-financial
executives of Tipton. Some member of the Tipton family had attended these sessions.
She explained that when sales increase, then inventory, cash, and accounts receivables
must also increase. Further, if the firm‟s existing operation capacity was insufficient to
support the increase sales, additional fixed assets would be required. She had also
stressed the need for pro forma statements to determine the magnitude of the funds
needed. It was the first time members of the Tipton family had received any formal
financial exposure, and she recalls they seemed interested and attentive.
At the previous annual meetings Hood had avoided using any technical financial
analysis to make her case for borrowing. But now she thinks, “why not?”

FORECASTING ASSUMPTIONS

She decides to estimate (1) the amount of funds Tipton will have to obtain in 1996; (2)
the 1996 income statement assuming all of the financing is done through borrowing;
and (3) another income statement assuming all new stock is issued. To help in the
estimates Hood enlists Frank Davis, a recent MBA. Davis reminds her that 1996 is
expected to be a big year for the company; sales are predicted to increase by 25
percent. Due to the strong demand, marketing feels any cost increases can easily
passed on. Consequently, the gross margin should exceed the current level of 21
percent. Hood notes that the sales-to-inventory ratio will be lowered to 6.5, and that
purchases should total $101,481,000. This suggests cost of goods for 1996 would be
$93,750,000.
“What about administrative and selling expenses?” Hood asks Davis. He informs her
that management salaries would have to rise sharply because these salaries increased
very slightly over the past three years. Davis believes a 20 percent increase in
administrative and selling expenses is reasonable.
Fixed assets are likely to change sharply in the coming year. Currently, Tipton is
operating virtually near capacity, demand is expected to remain high, and thus extra
capacity will be needed. In addition, some major improvements to existing equipment
will have to be made in order for the company to remain competitive. The planning for
these changes has been anticipated for some time, and though all of these changes do
not have to be made in 1996, it is clear that the company cannot grow beyond 1996
without them. In any event, it is urgent that the financing question be resolved as soon
as possible. A reasonable estimate is that Tipton will purchase %5 million of new plant
and equipment in 1996.
“During the past year we‟ve been a bit slow in paying our suppliers,” Hood remarks.
“We definitely will have to pay more promptly or we‟re going to have some annoyed
creditors; plus we‟ll pick up cash discounts by paying earlier. See if you can come up
with an estimate of our payables using past information.”
Hood and Davis also feel that over the last few years factors (other than sales)
affecting accruals and receivables have been relatively constant. For example, the
company has not altered its credit policy in the last three years. Nor can they think of
any reason why these items should change significantly in the coming year. “Of course,
an exact relationship between each of these and sales is unlikely to exist,” Hood
cautions. “We can expect some yearly random fluctuation. And keep in mind the
„big/little‟ mix will be changing since we‟ll be selling to smaller food chains. This has
implications for our receivables since these firms are relatively slow to pay. This
shouldn‟t be a major factor, Frank, but it is something you should be aware of when you
make your estimate.”
Hood and Davis think the cash management of the firm has been a “bit sloppy” over
the past few years, and both agree the company could make do with a lower level of
liquidity. Davis suggests he assume a level of 2 percent of sales, which is the
approximate industry average, and Hood agrees. “What about dividends?” Davis asks
Hood. “Our payout ratio is usually around 50 percent. However, if we borrow all the
extra money, let‟s work backward on the dividends; that is, out of net income subtract
the amount of the retained earnings we would obtain if we used all-equity financing.”

FORECASTING RESTRICTIONS

There are two final problems. While Hood believes the company should use more debt,
she recognizes that the final decision rests with the Tipton family. Given their debt
aversion it is important that any projection not appear too debt-heavy. She also wonders
how much flexibility she would have to use short-term debt, assuming the decision to
borrow is made. Hood, therefore, instructs Davis to work within the following constraints
when doing the forecast. As working hypotheses she wants Tipton‟s debt ratio to remain
below 0.5, and the current and quick ratios must not fall below 2 and 1, respectively. In
other words, the financial projection cannot violate any one of these restrictions. “Given
these limitations, see how much flexibility we have in raising any funds needed,” Hood
tells Davis.
Questions

Q1.Project the 1996 income statement assuming no borrowing.

Answer:

Tipton Ice Cream

Income Statement

1995 1996

Net Sales 100 000 125 000

Cost of Goods 79 000 93 750
Gross Profit 21 000 31 250
Administrative and Selling Expenses 10 000 12 000
Depreciation 600 600
Miscellaneous 200 220
EBIT 10 200 18430
Interest 0 0
Earnings before Taxes 10 200 18 438
Taxes (50%) 5 100 9 215
Net Income 5 100 9 215
Dividends 2 550 4 607.5
To retained earnings 2 550 4 607.5

Q2.Project Tipton‟s 1996 balance sheet assuming no borrowing.

Answer:
Tipton Ice Cream
Balance Sheet

1995 1996
Assets
Cash and marketable Securities $3000 826.5
Accounts Receivable 8 000 10 000
Inventory 11500 19 231
Current Assets 22 500 30 057.5
Gross fixed Assets 24 000 29 000
Accumulated Depreciation (4 000) (4 600)
Net Fixed Asset 20 000 24 400
Total Asset 42 500 54 457.5
Liabilities and Equity
Notes Payable 0 0
Account Payable 9 500 11 250
Accruals 3 000 3600
Current liability 12 500 14 850
Bonds 0 0
Common Stock (RM/0) 20 000 25 000
Retained Earnings 10 000 14 607.5
Total Liabilities and Equity 42 500 54 557.5

Q3.Explain how the $93.75 million cost-of-goods estimate for 1996 was obtained.

Answer:

Beginning Inventory 11 500

Purchases 101 487
Goods available for sale 112 987
Ending inventory (19 231)
Cost of Goods Sold 93756

Q4.How much money will Tipton need to raise in 1996?

Answer:
Q5. (a) How much of this money can Tipton borrow long term without violating the
constraints imposed by Hood?
Answer:
(b) How much of this money can be raised using notes payable without violating
these constraints?
Answer:
Q6.Redo the 1996 income statement assuming all of the funds needed are borrowed as
long-term bonds at 8 percent. (keep retained earnings at the same level as in question 1.
Answer:
Q7.Will the Tipton family own less than 50 percent of the firm‟s stock if no funds arte
borrowed? (Assume shares are sold to nonfamily members at $11.50 per share, which
nets $10.50 after brokerage fees.)

Answer:
 Tipton Ice Cream will need to sell 1 089 714 shares at $11.50($10.50 after brokerage
fees) to obtain the needed funds (needed funds / $ 10.50). The Tipton family currently
owns 1 200 000 shares at par value of $10 per share and others own 800 000. This
means non-Tipton stockholders will possess 1 889 714 shares out of 3 089 714 total
shares, or 61.2% and the Tipton family owning only 38.8%.

Q8.Calculate the dividend per share and earnings per share if the expansion is
(a) Financed by new equity.
Answer:
(b) Financed by borrowing.
Answer:
Q9.Use the percent of sales method to forecast the amount of financing. Why does this
estimate differ from your answer in question 4?
Answer:
Q10.( a)When making a financial forecast, which one of the items that must be
estimated is the most important? Why?
Answer:
- When making a financial forecast, I think the item that must e estimated s the most
important is the sales forecast. How much sales revenue can i generate inside one year
for short term and five years for long term. I would work my way down to the cost the
cost of sales from which I can compute my gross margin. If the gross margin is
attractive ten I would start preparing my cash budget. It is important that I can estimate
as accurately as I can on the expected cash generated from the operation so that I can
make provision, if there‟s a short fall, for the cash needed to support the operation and
other investing and financing activities. In short, without sales there is no business.
Without business why bother with the other budgets? So sales forecast should be the
top of my priority.
(b)Which item do you think is typically the most difficult to forecast?
Answer:
-In forecasting we are dealing with the future. Unless we can travel through time
and back to see what is going on in the future, all things are difficult to forecast

Q11.(a) What are some ratios you would calculate to help determine the risk of using
debt?
Answer:
-The some ratios that I would calculate to help in determining the risk of using
debt is the Debt to Equity Ratio. Debt to Equity Ratio is a financial, liquidity ratio that
compares a company total debt to total equity. The debt to equity ratio shows the
percentage of company financing that comes from creditors and ad investors. A higher
debt to equity ratio indicates that more creditor financing (bank loans) is used than
investor financing (shareholders). A debt to equity ratio of one would mean that
investors and creditors have an equal stake in the business assets. A lower debt to
equity ratio usually implies a more financially stable business. Companies with a higher
to debt equity ratio are considered more risk to creditors and investors than companies
with a lower ratio.

(b)Play the role of a consultant. Industry averages for all categories of ratios are given in
Exhibit 3. Based on your previous answers, the ratios calculated in part (a), and these
industry averages, would you endorse the debt financing if you were a member of the
Tipton family? Explain.
Answer:

Software Question

12. Hood is generally quite comfortable with the assumptions of her forecast. Still,
she recognizes that her estimates could be wrong and she decides to analyze the
following scenarios.

S -1 S-2 S-3 S-4

1996 sales $115,000.00 $125,000.00 $125,000.00 $130,000.00

CGS/sales .76 .75 .75 .77
Cash/sales .023 .028 .025 .02
ACP 38.00 36.00 39.00 38.00
AP/sales .07 .06 .063 .063
Sales/inv. 6.30 6.50 6.30 6.10

Note: AP refers to accounts payable.

The first two scenarios, S-1 and S-2, represent the estimates of the firm‟s marketing
director and sales manager, respectively, people whose judgment Hood respects.
 The third scenario considers the possibility that the firm‟s working capital
management won‟t be efficient as Hood expects. The final set of estimates assumes
that sales exceed Hood‟s original projection.
Analyze each scenario assuming first that all needed funds are raised by equity, and
then assume all needed funds are raised by selling bonds, that is, “long-term debt.” How,
if at all, do the results affect your answer to question 11(b)? (keep all other estimates at
their base-case values.)

EXHIBIT 1
Selected Financial Information for Previous Three Years. (000s)

1993 1994 1995

Sales $88,500 $96,000 $100,000

Receivables $7,432 $8,533 $8,000
Average collection period (days) 30.2 32 28.8
Accounts payable $5,700 $6,000 $9,500
Accruals $2,400 $1,800 $3,000

EXHIBIT 2
Balance Sheets (000s)

Equity Debt
1995 1996 1996

Assets
Cash & marketable securities $3,000
Accounts receivable 8,000
Inventory 11,500 ______ ______
Current assets 22,500
Gross fixed assets 24,000
Accumulated depreciation (4,000 $(4,600) $(4,600)
 Net fixed assets 20,000 _______ _______
Total assets $42,500 ________ _______

Liabilities and Equity

Notes payable $0
Accounts payable 9,500
Accruals 3,000 ________ ________
Current liabilities 12,500
Bonds
Common stocks 20,000
($10 par)
Retained earnings 10,000 ________ _________
Total liabilities and equity $42,500 ________ _________

(Continued)
I. STATEMENT OF THE PROBLEM
What financial instrument would be most beneficial to the Tipton family in order to fund
the expansion of their company for the upcoming year (1996)?
Based on the financial instrument that the Tipton family decides to use, what is the
optimal amount needed to be procured without violating the constraints imposed by
Brenda Hood?