An Alternative Scenario

The assumption that assets are a fixed percentage of sales is convenient, but it may not be suitable in many cases. In particular, note that we effectively assumed that Rosen-

garten was using its fixed assets at 100 percent of capacity, because any increase in sales led to an increase in fixed assets. For most businesses, there would be some slack or excess capacity, and production could be increased by, perhaps, running an extra shift.

For example, in early 1999, Ford and GM both announced plans to boost truck production in response to strong sales without increasing production facilities. GM increased its 1999 production schedule by 250,000 vehicles to 975,000, a 35 percent increase over 1998. Similarly, Honda Motor Co. announced plans to boost its North American production capacity by about 100,000 vehicles over the next three years. Honda planned to achieve its expansion by making production improvements, not by building new plants. Thus, in all three cases, the auto manufacturers apparently had the capacity to expand output without adding significantly to fixed assets.

If we assume that Rosengarten is only operating at 70 percent of capacity, then the need for external funds will be quite different. When we say "70 percent of capacity," we mean that the current sales level is 70 percent of the full-capacity sales level:

Current sales = $1,000 = .70 X Full-capacity sales

This tells us that sales could increase by almost 43 percent—from $1,000 to $1,429— before any new fixed assets would be needed.

In our previous scenario, we assumed it would be necessary to add $450 in net fixed assets. In the current scenario, no spending on net fixed assets is needed, because sales are projected to rise only to $1,250, which is substantially less than the $1,429 full-capacity level.

As a result, our original estimate of $565 in external funds needed is too high. We estimated that $450 in net new fixed assets would be needed. Instead, no spending on new net fixed assets is necessary. Thus, if we are currently operating at 70 percent capacity, then we need only $565 - 450 = $115 in external funds. The excess capacity thus makes a considerable difference in our projections.

EFN and Capacity Usage

Suppose Rosengarten were operating at 90 percent capacity. What would sales be at full capacity? What is the capital intensity ratio at full capacity? What is EFN in this case?

Full-capacity sales would be $1,000/.90 = $1,111. From Table 4.3, we know that fixed assets are $1,800. At full capacity, the ratio of fixed assets to sales is thus:

Fixed assets/Full-capacity sales = $1,800/1,111 = 1.62

This tells us that Rosengarten needs $1.62 in fixed assets for every $1 in sales once it reaches full capacity. At the projected sales level of $1,250, then, it needs $1,250 x 1.62 = $2,025 in fixed assets. Compared to the $2,250 we originally projected, this is $225 less, so EFN is $565 - 225 = $340.

Current assets would still be $1,500, so total assets would be $1,500 + 2,025 = $3,525. The capital intensity ratio would thus be $3,525/1,250 = 2.82, less than our original value of 3 because of the excess capacity.

These alternative scenarios illustrate that it is inappropriate to blindly manipulate financial statement information in the planning process. The results depend critically on the assumptions made about the relationships between sales and asset needs. We return to this point a little later.

Ross et al.: Fundamentals of Corporate Finance, Sixth Edition, Alternate Edition

II. Financial Statements and Long-Term Financial Planning

4. Long-Term Financial Planning and Growth

© The McGraw-Hill Companies, 2002

PART TWO Financial Statements and Long-Term Financial Planning

Work the Web

Calculating company growth rates can involve detailed research, and a major part of a stock analyst's job is to provide estimates of them. One place to find earnings and sales growth rates on the Web is Yahoo! Finance at finance.yahoo.com. Here, we pulled up a quote for Minnesota Mining & Manufacturing (MMM, or 3M as it is known) and followed the "Research" link. Below you will see an abbreviated look at the results.

Consensus Estimates
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