THE ATTITUDE TOWARD DEBT - Quacker Cracker

Play the role of a financial analyst and explain your recommended course of action. (read the case study, answer 3 to 5 sentences).

THE ATTITUDE TOWARD DEBT
QC expects strong growth this year (assume that it is now January 2012) and
Dianne McCabe, the chief fi nancial offi cer (CFO), hopes she can make a case for
borrowing to fi nance the company’s expansion. She realizes, however, that she
is likely to face stiff opposition from Quincy’s family.
Quincy detested borrowing money, and his motto was, “Never go into debt
and hang onto cash as long as possible—because you never know . . .” In fact,
his family and employees called him chintzy Quincy.
For the fi rst half of the company’s existence, the Cynsky family owned all
the company’s stock. Due to the need to fi nance expansion, shares have been
sold during the last 30 years to individuals outside the family. By 2007, the
Cynsky family’s ownership share had declined to half of all shares, and although
the family has not been active in running the fi rm in recent years, it does insist
on keeping the family traditions: avoiding debt and keeping high cash balances.
To this day, QC has never owed anything beyond its accounts payable and
accruals. (Accrued expenses are liabilities that have been incurred but not yet
invoiced.) CFO McCabe believes that the “no debt” and “high cash” policies
have hurt the owners’ profi ts. At each annual meeting, she has tried unsuccessfully
to convince the Cynsky family to consider more aggressive fi nancial
management. She is becoming concerned that her objective fi nancial advice
is irritating the family.
FINANCIAL PLANNING
McCabe decides to estimate the amount of funds QC will have to obtain in 2012.
She knows that 2012 is expected to be a big year for the company, particularly as
the weak economy increases the sales of fancy foods for entertaining at home. As
a result, sales are predicted to increase by 25 percent, to $230 million.
Due to the strong demand, the marketing vice president feels any cost
increases can easily be passed on, and McCabe estimates that the cost of goods
sold (mostly food ingredients) will be $180 million. Cost of goods sold does not
include depreciation (estimated at $5 million), and administrative and selling
expenses ($15 million). The corporate tax rate is 35 percent.
Financial Planning ? 243
Fixed assets are likely to increase sharply in the coming year. Currently,
QC is operating near capacity, demand is expected to remain high, and new
plant and equipment will be needed. In addition, some major improvements
to existing facilities will have to be made in order for the company to remain
competitive. The planning for these changes has been occurring for some time,
and though all of these changes do not have to be made in 2012, it is clear that
the company cannot continue to grow without them. The total cost of these
capital improvements is $30 million. See Exhibits C5.1 and C5.2.
EXHIBIT C5.1 Ratios for the Fancy Foods Industry
Price–earnings ratio (times) 16.0
Current ratio (times) 1.8
Quick ratio (times) 0.6
Total debt ratio (%) 53.0
Total asset turnover ratio (times) 1.5
Return on equity (%) 8.0
Return on sales (%) 2.5
Average collection period
(days)
27.0
EXHIBIT C5.2 Quacker Cracker Balance Sheet for 2012 ($000s) (prepared
before any fi nancing decisions have been made)
Assets Liabilities and Equity
Cash and
marketable
securities
$ 16,000 Notes payable $ 0
Accounts
receivable
16,000 Accounts payable 19,500
Inventory 23,000 Accrued expenses 6,000
Current assets 55,000 Current liabilities 25,500
Gross fi xed assets 52,000 Long?term debt 0
Accumulated
depreciation
–12,000 Common stock ($10 par)* 40,000
Net fi xed assets 40,000 Retained earnings 29,500
Total assets $ 95,000 Total liabilities and equity $ 95,000
* Not publicly traded; the last private sale was at $50 a share.
244 ? Quacker Cracker
QUESTIONS
1. Show changes to the 2012 pro forma balance sheet assuming the company
borrows the necessary funds for the capital improvements at an interest
rate of 7 percent. Ignore depreciation on the new equipment. Does this
cause any significant change in the fi nancials?
2. Play the role of a fi nancial analyst and explain your recommended course
of action.
3. The Cynsky family controls the company through its ownership of one?
half of the outstanding stock, with outsiders owning the balance. Should
this infl uence McCabe’s presentation of her recommendations? What arguments
can you make in support of and against McCabe’s position?
4. Why was information provided in the second paragraph about
competitive companies in the fancy food industry?