Champion Skates Inc.Page 1

Champion Skates Inc.Page 1

Champion Skates, Inc.
A Financial Forecasting and Capital Structure Decision /

"It’s time to decide, Ted. Although I feel pretty good about how we’re financing the company, we need to make sure that we’re doing it right." Cindy Cheng, co-founder of Champion Skates, Inc., is urging her business partner, Theodor (Ted) Schramm, to analyze the capital structure of their company.

With the financial backing of her brother, Cindy founded Champion Skates in 2000. Beginning with three employees and working out of a vacant warehouse in St. Paul, Minnesota, Cindy began the business with a single contract with a small chain of retail sporting goods stores. The company became profitable in its second year of operations and has established a reputation as a manufacturer of ice skates that emphasize comfort and top quality workmanship. The turning point for the company came in 2007 with the hiring of Schramm, a German engineer and former world-class skater. Schramm quickly expanded the product line, established a research program, and implemented a stringent quality control program. The company now has corporate customers in four countries. Its best selling line, the Jungfrau, focuses on young female skaters and has quickly become recognized by major participants.

The Production Facilities

Champion currently houses its production facilities in a rented metal building in Appleton, Wisconsin. The company purchases rectangular sheets of a metal alloy that are used to produce the blades. The company's workforce uses a special saw to cut the desired shapes. It then sharpens the blades, bathes the metal in several acid solutions to clean the metal and to remove small burrs and particles, ships the metal blades to a company that electronically bonds a layer of chrome to the surface, and (after receiving the chrome-laden blades) sharpens the blades again. The “boot” part of the skate is produced in the company’s sewing department (in another room of the building) and is attached to the blade in the assembly room. The completed skates are then boxed and shipped to customers (large chain stores and small sporting goods stores).

Schematic of Manufacturing Operations

The Financial Forecast

It’s early January, 2012, and both Cindy and Ted have come into the office to work on this assignment. Ted settles down in front of Cindy’s desk with a cup of coffee and places a sheet of paper in front of her. “Let’s review the recent financial results first, Cindy. Here’s some key data from the past four years’ performance.”

Champion’s Income Statements

2008 / 2009 / 2010 / 2011
Sales / $140,000 / 146,000 / 141,000 / 154,000
Net Income After Taxes / $ 5,600 / 4,380 / -4,230 / 6,160

Champion’s Balance Sheets (year-end)

2008 / 2009 / 2010 / 2011
Cash / $ 7,000 / 7,300 / 7,050 / 7,700
Accounts Receivable / 30,800 / 32,120 / 31,020 / 33,880
Inventory / 88,200 / 91,980 / 88,830 / 97,020
Current Assets / 126,000 / 131,400 / 126,900 / 138,600
Fixed Assets / 29,000 / 35,000 / 35,000 / 41,000
Total Assets / $155,000 / $166,400 / $161,900 / $179,600
Notes Payable / $ 32,670 / 39,390 / 39,370 / 50,260
Accounts Payable / 7,000 / 7,300 / 7,050 / 7,700
Long Term Debt / 10,000 / 10,000 / 10,000 / 10,000
Common Stock / 90,000 / 90,000 / 90,000 / 90,000
Retained Earnings / 15,330 / 19,710 / 15,480 / 21,640
Total Liabilities & Capital / $155,000 / $166,400 / $161,900 / $179,600

Ted continues, “Our aggressiveness is finally starting to pay off. Sales are expected to increase by $50,000 this year, over a 30% increase – that will be our best year yet. But, at the same time, it may place some financial pressure on the company. We also need to buy new equipment to meet the higher sales level. I estimate that we’ll need to buy $15,400 of fixed assets, to be delivered (and paid for) in April.”

Cindy says, “Thankfully, the additional profits will help to finance some of that expansion. I believe that we’ll be able to earn a 4% net profit margin[1] this year. As you know, we’ve agreed not to pay ourselves a dividend yet, so all of the profit can be used to reduce our outside financing.”

“Let’s begin with a quick estimate of how much money we’ll need to raise. We’ve used the Percent of Sales method in the past with some success. Let’s apply it again to see what it tells us.”

Task #1: At this point, use the Percent of Sales method to estimate the amount of cash that the company will need to raise outside the company. In particular, determine the amount of Notes Payable[2] for the end of 2012.

Cash Budget

Ted states, “Let’s compare the results of the percent of sales method to the results obtained from a cash budget. We know that our sales were $22,000 in November and $24,200 in December. Here’s a page that shows our sales budget (forecast) for each month of this year.”

Forecasted Sales for 2012

January16,000July23,000

February14,000August21,000

March12,000September18,000

April14,000October16,000

May14,000November17,000

June20,000December19,000

“In addition, sales in January and February usually drop off – most people have already bought their skates for that season. I believe that sales for January of 2013 will be $16,000 and for February will be $14,000. Thank goodness that the southern hemisphere’s sales will pick up in our summer months.[3] “

Champion sells all of its products on normal credit terms; there are no cash sales. Of total sales, 50.0% are collected in the month following the sale; the remaining 50.0% are collected in the second month following the sale. Due to a thorough credit investigation policy, no bad debts are expected.

Champion’s cost of materials are70% of sales. The company typically buys enough raw materials each month to produce enough products for the following month's expected sales. Of these purchases, 80% are paid for in cash and the remaining20% are paid one month after the purchase.

Cindy says, “I’ve put together a list of our key expenses. Fortunately, since we’re both personally financially well off, we don’t have to pay ourselves a salary right now and we can concentrate on growing the company. And our local government’s rent subsidy really helps too. In February, we’ll have to pay off that safety issue lawsuit that our former employee won. But other than that, our expenses are very manageable. Here’s the list of our expected expenses, including our monthly breakdown of wages.”

Fixed costs (per month):

Rent1,000

Salaries2,000

Lease Payments500

Variable costs:

Other Expenses (%)4% of sales

Irregular expenses:

Lawsuit payment21,000in February

Insurance payment$1,000in August

Wages:

January2,000July2,500

February2,000August2,500

March2,000September2,400

April2,000October2,200

May2,100November2,400

June2,300December2,600

Ted states, “We have a cash balance today of $7,700, which is slightly more than our minimum cash of $7,000 that we like to keep on hand.”

Cindy adds, “As you know, our bank loan has jumped quite a bit recently. We pay interest each month on the previous month’s loan balance. The interest rate has been constant for quite a while now at6.0% per year (i.e. 0.50% per month). Let’s plan on keeping our long-term debt and common stock outstanding constant for purposes of the cash budget. After the cash budget is constructed, we can decide where the best place to get the money will be – short-term or long-term financing.

Task #2: Use the 12-month cash budget spreadsheet (postedon Blackboard) to forecast the funds needed, in particular the amount of Notes Payable, both the maximum amount needed and the balance at the end of 2012.

Given the two forecasting methods (Percent of sales method and the Cash Budget), decide which you should use to make your estimate of the amount of money that will be needed. State the maximum amount of new money that will be needed during 2012 and justify your choice when selecting between the two methods.

Short-term vs. Long-term Financing

Staring at the completed cash budget, Ted states, “Well, that’s interesting. Now we know how much additional money we’ll need, we also have enough information to answer our next question, “How much of our financing should be short-term vs. long-term? Are we financing the company in the optimal manner to balance our twin goals of liquidity and profitability?”

Cindy adds, “Yes, we should be able to do that now. Applying the matching principle should help. Let’s see if we need to make any changes.”

Task #3: (For this task and from this point on, ignore the new financing needed for 2012 that was determined in tasks #1 and #2; we want to restructure the company’s financing in the most appropriate manner immediately – at the end of 2011.)

Given the total assets at the end of 2011, determine the amounts of short-term and long-term financing needed, e.g.:

Current Assets$______%

Fixed Assets$______%

Total Assets$179,600100%

Capital Structure

Ted says, “We’re making progress. Now we need to address the capital structure issue. We’ve determined how much of our financing should be long-term. Now we need to decide how much of this long-term financing should be debt and how much should be equity.”

Cindy pulls out a sheet of paper and says, “I have a good friend who is the CFO of a rapidly-growing company in Chicago. He is familiar with our company and he put together these estimates of interest rates and betas for me. I know that Champion is privately-owned and doesn’t have a beta, but he has compared us to some similar, publicly-owned companies and estimated what our beta would be at various debt levels. Here is his estimate of our after-tax cost of debt and our estimated beta, for different levels of debt.”

Ted is excited, “That’s great and it will save us a lot of work! We can use his estimates of beta to calculate our cost of equity, using the capital asset pricing model. I read that the current medium-term Treasury security rate is 3% and the estimated return for the S&P 500 Index is 12% for the next few years.”

Cindy pushes the paper across to Ted. “And we can calculate a weighted average of the cost of debt and the cost of equity to determine our marginal cost of capital for different levels of debt. Let’s get to work.”[4]

Debt proportion
(Debt/T.A.) / After-tax
Interest Rate / Equity proportion
(Equity/T.A.) / Beta
0.00 / 4.00% / 1.00 / 1.00
0.05 / 4.00% / 0.95 / 1.02
0.10 / 4.00% / 0.90 / 1.04
0.15 / 4.00% / 0.85 / 1.06
0.20 / 4.00% / 0.80 / 1.08
0.25 / 4.00% / 0.75 / 1.10
0.30 / 4.00% / 0.70 / 1.12
0.35 / 4.00% / 0.65 / 1.14
0.40 / 4.00% / 0.60 / 1.17
0.45 / 4.00% / 0.55 / 1.20
0.50 / 4.30% / 0.50 / 1.23
0.55 / 4.70% / 0.45 / 1.26
0.60 / 5.20% / 0.40 / 1.29
0.65 / 5.80% / 0.35 / 1.34
0.70 / 6.40% / 0.30 / 1.40
0.75 / 7.20% / 0.25 / 1.47
0.80 / 8.10% / 0.20 / 1.55
0.85 / 9.10% / 0.15 / 1.64
0.90 / 10.20% / 0.10 / 1.74

Task #4: Use a spreadsheet to calculate the cost of debt, cost of equity (using CAPM), and weighted marginal cost of capital for each level of debt shown above. Use Excel to construct a graph of these three lines, then copy and paste it into your written analysis.

Use the data and the graph to decide whether the company’s capital structure at the end of 2011 is appropriate (as recommended by the Trade-Off Theory). If not, what changes in debt and common equity would you recommend? In determining these amounts, use the total long-term financing that you calculated in task #3 for the total amount to be split between long-term debt and equity.

Once you have determined the total amounts for long-term debt and equity, break each down into its parts to show the final dollar total for each category and each’s percent of total liabilities and capital, as shown below:

Notes payable$______%

Accountspayable$ 7,700____%

Total Current Liabilities$______%

Long-term debt$______%

Common stock$______%

Retained earnings$ 21,640____%

Total equity$______%

Total Liabilities and Capital$ 179,600100 %

(Make sure that your final recommendations above are consistent with both the matching principle and the trade-off theory.)

Feasibility of Preferred Stock

Cindy says, “O.K., we’ve decided to make some changes to our ratio of long-term debt to common equity. But I’m wondering if we’re making a mistake by not considering the possible issuance of preferred stock.”

Ted replies, “I don’t think so. I don’t think that preferred stock will do anything for us that the debt cannot do. I’ve read that preferred stock is not a very good option for most companies.

Task #5: Explain why Ted is correct by explaining why debt is normally a superior financing method to preferred stock. Also explain under what conditions preferred stock may be a viable option for some firms.

Qualitative Factors

Cindy: “We’ve looked at the quantitative factors. Just as a possible tie-breaker, let’s apply a list of qualitative factors to Champion also. Maybe these will help us with our decision.”

Task #6: Review the list of qualitative factors on the schematic diagram[5] and recommend a financing alternative based upon a composite of these factors and how well they apply to Champion Skates. Explain your reasoning.

[1] Net profit margin = Net income after taxes / sales.

[2] Notes payable is just another name for total short-term bank loans.

[3] i.e., the winter months in the southern hemisphere.

[4] Marginal cost of capital = debt proportion * after-tax cost of debt + equity proportion * cost of equity

[5] In the lower right-hand quadrant, click on the small blue icon entitled “Click for details,” then (on the capital structure row) click on the icon for qualitative factors.