Most people think of pottery and figurines when they think of ceramics.

However, ceramic mate-

rial is particularly well suited for use under high temperatures and intense pressure, especially if light
weight is desirable. Because of these properties, ceramics are ideal for use in high-performance
engines used in turbocharged automobiles, jet aircraft, and heavy trucks. Unfortunately, though,
ceramics are also very brittle, and this characteristic has long prevented their widespread use in
such engines.
In 1986, however, Daniel Alexander, a materials engineer, and Roger Avalon, a chemical
engineer, succeeded in combining silicon carbide fibers with ceramic materials in a manner that pre-
served the desirable properties of ceramics but eliminated most of the brittleness. They then formed
Space-Age Materials, Inc., and used their own limited capital to build 50 prototype turbine blades
with the new ceramic material. On the basis of extensive testing by a number of large aerospace
companies, the new rm began receiving production-quantity orders for the new blades.
The new business was an immediate success. Production began in the summer of 1987. Oper-
ating losses were incurred during the rst short year, but the company has earned a prot in each sub-
sequent year. During 1991 and 1992 the number of new orders exceeded Alexander and Avalons
projections. By the end of 1992, it was obvious to all-including Alexander and Avalonthat addi-
tional expansion would be required if the rm was to attain its full growth potential or even to keep
competitors from eroding its position.
Ironically, Alexander and Avalons technological successes were making their nancial fore-
casts incorrect. Consequently, they hired Sue Li, an MBA, as the companys financial manager to
develop a detailed financial plan. Li knew that the company had been lucky and that some large
chemical companies, including Monsanto and DuPont, were thinking about entering the market.
Space-Age, however, had not been sitting idle. In 1991, the companys research-and-development
people produced some exciting breakthroughs, while at the same time there was an increasing
trend toward using ceramics in jet engines. As a result, it became apparent that additional funds were
probably needed if the company were to maintain, let alone increase, its market share. Therefore, a
good financial plan accurately forecasting the future needs of the company is critical to the future
success, and probably to the continued existence, of the company.
Li organized Space-Ages nancial planning process into ve steps:
(1) A study is made of basic trends in the materials industry and also in the aerospace and other
markets where Space-Age expects to operate. How will our customers needs change over
the next ve years, and what can we do to meet any existing or developing needs?
Copyright 1994. The Dryden Press. All rights reserved.
Case 37
Space-Age Materials, Inc.
Financial Analysis and Forecasting
Directed
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(2) A set of pro forma nancial statements is developed and used to analyze the effects of alter-
native operating plans on projected prots and nancial ratios. The plan encompasses ve
years, with the projections being relatively detailed for the coming year and much less
detailed for the following four years. The entire plan is updated every year in November.
(3) The specic nancial requirements needed to support the companys base-case operating
plan are determined. This information is obtained from the pro forma statements.
(4) The specic sources of capital that will be used to meet the nancial requirements are identied.
(5) The initially projected nancial statements are then modied to include the addition of the
capital needed to nance the projected assets. This involves adjusting the pro forma income
statement to include the interest charges associated with any additional debt and an adjust-
ment to dividends paid if new stock must be issued. These modications change the initially
projected retained earnings, and thus change the external funds needed to nance the
asset expansion. These feedback effects require the use of an iterative process to produce a
consistent nal set of nancial statements. In the past, all this has been done manually
which takes a good bit of timebut Li has been working to develop a computerized model
to speed up the process.
Space-Ages 1988 through 1992 historical nancial statements, along with three key ratios and
industry averages, are given in Tables 1 and 2. The company was operating its fixed assets at full
capacity in 1992, so its $88.73 million of sales represented full-capacity sales. Since the firms
marketing department is forecasting a 20 percent increase in sales for 1993, new assets will have to
be added. For planning purposes, Li assumes (1) that accounts payable and accruals will sponta-
neously increase in accordance with standard industry practices, (2) that new long-term capital will
be raised in accordance with the firms target capitalization ratios, which call for 20 percent long-
term debt and 80 percent common equity (measured at market value), and (3) that short-term bank
loans, reported as notes payable, will be assumed to grow along with sales, since they are used to
nance the rms working capital needs. (Note that new common equity includes both new retained
earnings and new common stock sales.)
Space-Age currently has 4 million shares of common stock outstanding, and the market price
is $9. The dividend in 1992 was $0.375 per share, and management does not intend to increase the
dividend in 1993. New long-term debt would carry a 12.0 percent coupon, and it would be issued at
par. New short-term debt will cost 10.0 percent. The combined federal and state tax rate is 40 percent.
Space-Ages senior managers go off on a one week retreat each November to work on the ve-
year plan and the budget for the coming year. Prior to the retreat, the various division managers must
prepare reports which the top executives will review beforehand and then discuss at the retreat. As
financial manager, Li normally prepares some first approximation financial forecasts which are then
modied during the retreat as a result of strategic decisions made at that time. The modied state-
ments are used to show the nancial implications of different operating plans. However, Li recently
underwent a difficult ulcer operation and, because of a slow recovery, she will neither be able to
attend the retreat, nor to prepare the background report for it. Therefore, as her assistant, ready or not,
you must assume her duties.
Even though she could not get out of bed, Li called you to the hospital to discuss what needed
to be done. First, Li told you she had almost nished a computerized model that would aid in the pro-
cess. Li also indicated that the model needed to be debugged, or at least checked out, by rst mak-
ing by-hand projections and then seeing if the model generated the same set of data. If a
discrepancy is discovered, it will be necessary to find out where the error lies. Li also cautioned
you that it will be necessary to explain to the executives how any changes in operating conditions
would affect the funds requirements and also how any changes in the financing mix would affect
other nancial variables, including external funding requirements, earnings per share, and the stock
price. In particular, Li warned you not to try to defend the inputs to the forecasting process; rather,
the critical thing is to be able to make adjustments in the likely event the senior executives dont
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like all the assumptions used in the forecast. As Li pointed out, Its the top managers job to under-
stand the business and to make the final assumptions used in the forecast and the budget. Its our
job to tell them how those assumptions interact, and what the nal outcome will be if their assump-
tions hold true. We ought to use reasonable inputs for our report and basic forecasts, but our real
job in the planning process is to show top management what will happen under different operating
conditions.
Finally, you will also have to make a presentation to the companys management. In prepara-
tion for the presentation, answer the following questions.
QUESTIONS
1. To begin, consider the percentage of sales formula used to determine external funds needed:
External Required Spontaneous Increase in
funds = increase in increase in retained
needed assets liabilities earnings
EFN = (A/S)DS (L/S)DS MS
1
(1 d).
Here,
A/S = Assets/Sales = required dollar increase in assets per $1 increase in sales
L/S = Spontaneous liabilities/Sales = spontaneously generated nancing per $1
increase in sales
S
1
= Total sales projected for next year (S
0
= last years sales)
DS = Change in sales = S
1
S
0
M = Prot margin
d = Dividend payout ratio
Use this equation to calculate Space-Ages EFN for 1993
2. Now, use the proportional growth (percentage of sales) method to forecast the rms nan-
cial statements and EFN for 1993. (Hint: Table 3 has been provided to speed up your work.)
Compare the EFN obtained here with that obtained from the percentage of sales formula
given in Question 1. Why are the results different?
3. The major assumption inherent in the proportional growth (percentage of sales) method is
that all assets increase proportionally with sales. In effect, this means that the regression of
each asset account against sales would result in a straight line that passes through the origin.
To check on this assumption, used both in the formula and in Table 3, you could run a
regression of each asset against sales, using data from Table 1. As a quick check, run a
regression of total assets on sales to test the assumption. (Hint: You can use a nancial cal-
culator or the Lotus 1-2-3 model, or you can get an approximation from a graph.)
a. Does it appear that the proportionality assumption holds true? Explain.
b. Repeat the Part a. regression analyses assuming the following data:
Year Sales Total Assets
1988 $30.00 $29.40
1989 42.00 31.88
1990 54.59 37.73
1991 68.25 43.08
1992 88.73 44.34
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Under these conditions, does it appear that the proportionality assumption holds true?
Explain.
c. Which of the situations above is likely to hold for most rms? What implications does
your answer here have for the percentage of sales method?
4. Assume that you are now at the retreat, discussing the forecast with Space-Ages senior
executives. The vice president for manufacturing informs you that xed assets were actually
being operated at only 80 percent of capacity in 1992. What effect would this have on your
projected external capital requirement for 1993? In answering this question, disregard any
nancing feedback effects and answer the question by modifying the 1st pass columns of
Table 3, but explain how you could go on to reach a balanced solution. Also, in answering
this and the next question, assume that depreciation expenses remain constant as a percent-
age of sales.
5. In the 80 percent of capacity utilization scenario, excess funds will be generated. Suppose
one of the senior executives asked you, as the nance representative, what you would rec-
ommend doing with the money. How would you answer? If you are using the Lotus model,
how could it be modied to handle EFN surpluses?
6. a. Re-do Question 4 under the assumption that Space-Age was operating at 90 percent of
capacity in 1992.
b. Discuss the general relationship between capacity utilization and projected capital
requirements in situations (a) where assets are lumpy and (b) where they are not lumpy.
c. If you are using the Lotus model, set up a data table and then graph the relationship
between EFN and 1992 capacity utilization.
7. In general, what impacts do a rms dividend policy, protability, and capital intensity have
on its nancing requirements? (Again, if you are using the Lotus model, you could do a sen-
sitivity analysis wherein you change certain input data and then observe the effect on EFN.
It would be relatively easy to change the input data section to use a payout ratio rather than
dividends per share in the event that management wanted to see the relationship between the
payout and EFN. To change the prot margin, it would be necessary to change some of the
income statement data. This would, of course, depart from the assumption that the 1993
ratios will be the same as 1992 ratios.)
8. The percentage of sales method has been used to forecast the rms nancial statements. Sup-
pose one of the senior executives asked you what assumptions are implied when one uses the
percentage of sales method. That is, under what circumstances would the percentage of sales
method produce a valid, as opposed to an incorrect, forecast? How would you answer?
9. What are some other methods that could be used to forecast the asset-and-liability balances
and, thus, the forecasted nancial requirements? If the senior executives asked you to incor-
porate these procedures into your analysis, how would you do it, how long would it take,
and what additional data would you require?
10. The case states that Space-Ages optimal capital structure calls for 20 percent long-term debt
and 80 percent common equity. However, according to the 1992 balance sheet, the rms
capitalization ratio is Long-term debt/Total permanent capital = $12,570,000/($12,570,000 +
$17,490,000 + 11,310,000) = 0.304 = 30.4 percent, and its total-debt-to-total-assets ratio is
$15,540,000/$44,340,000 = 35.1 percent. Do these gures indicate that the capital structure
is seriously out of balance, that the company is using far too much debt, and that you should
modify the mix of debt and equity used in the forecasts? (Hint: Think about whether the
optimal capital structure should be stated in book value or market value terms.)
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11. Regardless of whether or not you think the capital structure should be changed, if it were
changed, how would a change affect the other elements in the forecast, including the interest
rate, the stock price, and the projected earnings per share? If you are using the Lotus model,
conduct a sensitivity analysis.
12. Calculate the following values based on the 1992 nancial statements: (a) current ratio, (b)
prot margin, (c) ROE, and (d) EPS. Then calculate those projected values for 1993 and dis-
cuss how the projected ratios would change as such things as the sales growth rate, the pay-
out ratio, the capital structure, and the prot margin change. Do you think the senior
executives at the retreat would be interested in this type of data? If so, could you provide
them with it on a real time basis? Explain.
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TABLE 1
Historical Financial Statements
(in Millions of Dollars)
1988 1989 1990 1991 1992
Balance Sheets:
Cash and securities $ 0.75 $ 1.05 $ 1.36 $ 1.71 $ 2.18
Accounts receivable 2.40 3.36 4.37 5.46 7.10
Inventories 2.85 3.99 5.19 6.48 8.43
Current assets $ 6.00 $ 8.40 $10.92 $13.65 $17.71
Net xed assets 9.00 12.60 16.38 20.48 26.63
Total assets $15.00 $21.00 $27.30 $34.13 $44.34
Accounts payable $ 0.29 $ 0.40 $ 0.53 $ 0.65 $ 0.84
Notes payable 1.81 2.18 0.75 0.94 1.23
Accrued wages & taxes 0.30 0.42 0.54 0.69 0.90
Current liabilities $ 2.40 $ 3.00 $ 1.82 $ 2.27 $ 2.97
Long-term debt 2.11 3.91 7.74 9.67 12.57
Total liabilities $ 4.51 $ 6.91 $ 9.56 $11.94 $15.54
Common stock $10.55 $11.93 $12.86 $13.89 $17.49
Retained earnings (0.06) 2.16 4.88 8.30 11.31
Total common equity $10.49 $14.09 $17.74 $22.19 $28.80
Total liabilities & equity $15.00 $21.00 $27.30 $34.13 $44.34
1988 1989 1990 1991 1992
Income Statements:
Sales $30.00 $42.00 $54.59 $68.25 $88.73
Cost of goods sold 25.37 35.08 45.76 57.21 74.25
Depreciation 1.80 2.52 3.28 4.10 5.33
Gross prot $ 2.83 $ 4.40 $ 5.55 $ 6.94 $ 9.15
Interest expense 0.44 0.69 1.01 1.26 1.64
Taxable income $ 2.40 $ 3.71 $ 4.54 $ 5.68 $ 7.51
Taxes 0.96 1.49 1.82 2.28 3.00
Net income $ 1.44 $ 2.22 $ 2.72 $ 3.42 $ 4.51
Dividends 0.00 0.00 0.00 0.00 1.50
Additions to R.E. $ 1.44 $ 2.22 $ 2.72 $ 3.42 $ 3.01
Note: The gures in the tables were generated using a Lotus model; therefore some numbers may not add up properly
because of rounding differences.
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TABLE 2
Historical and Industry-Average Ratios
Industry
1988 1989 1990 1991 1992 Average
Current 2.5 2.8 6.0 6.0 6.0 3.3
Debt/assets 30.1% 32.9% 35.0% 35.0% 35.1% 40.0%
ROE 13.7% 15.8% 15.3% 15.4% 15.7% 16.4%
TABLE 3
Historical 1992 and Projected Financial Statements
(in Millions of Dollars)
Percentage Projected
1992 of sales 1993 2nd Pass 3rd Pass 4th Pass
Balance Sheet:
Cash and securities $ 2.18 2.46% $ 2.62 $ 2.62 $ 2.62 X
Accounts receivable 7.10 8.00 X X X X
Inventories 8.43 9.50 10.12 10.12 10.12 X
Current assets $17.71 N.A. X X X X
Net xed assets 26.63 30.01 31.96 31.96 31.96 X
Total assets $44.34 N.A. $53.21 $53.21 $53.21 X
Accounts payable $ 0.84 0.95% X X $1.01 X
Notes payable 1.23 1.39 X X 1.48 X
Accrued wages & taxes 0.90 1.01 1.08 1.08 1.08 X
Current liabilities $ 2.97 N.A. X X $ 3.56 X
Long-term debt 12.57 N.A. 12.57 13.40 13.45 X
Total liabilities $15.54 N.A. $16.13 $16.97 $17.01 X
Common stock $17.49 N.A. $17.49 $20.83 $21.00 X
Retained earnings 11.31 N.A. 15.41 15.20 15.19 X
Total common equity $28.80 N.A. $32.90 $36.03 $36.19 X
Total liabs. & equity $44.34 N.A. $49.04 $52.99 $53.20 X
External funds needed (EFN) $ 4.17 $ 0.21 $ 0.01 X
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TABLE 3
Continued
Percentage Projected
1992 of sales 1993 2nd Pass 3rd Pass 4th Pass
Income Statement:
Sales $88.73 100.00% $106.48 $106.48 $106.48 X
Cost of goods sold 79.58 89.69 95.50 95.50 95.50 X
EBIT $ 9.15 10.31% $ 10.98 $ 10.98 $ 10.98 X
Interest expense 1.64 N.A. X X X X
Taxable income $ 7.51 N.A. $ 9.34 $ 9.22 $ 9.21 X
Taxes 3.00 N.A. 3.74 3.69 3.68 X
Net income $ 4.51 N.A. $ 5.60 $ 5.53 $ 5.53 X
Dividends 1.50 N.A. 1.50 1.64 1.65 X
Additions to R.E. $ 3.01 N.A. $ 4.10 $ 3.89 $ 3.88 X
Projected
1992 1993 2nd Pass 3rd Pass 4th Pass
External funds needed (EFN) $ 4.17 $ 0.21 $ 0.01 X
Assumed additional long-term debt $ 0.83 $ 0.04 $ 0.00 X
Assumed additional stock $ 3.34 $ 0.17 $ 0.01 X
Additional interest (ST and LT) $ 0.12 $ 0.01 $ 0.00 X
Additional dividends $ 0.14 $ 0.01 $ 0.00 X
Selected Ratios (Adjusted for Assumed Financing)
Current 5.96 5.96 5.96 5.96 X
Prot margin 5.1% 5.3% 5.2% 5.2% X
ROE 15.7% 15.3% 15.3% 15.3% X
EPS $ 1.13 $ 1.28 $ 1.26 $ 1.26 X
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