CASE 9 Palmetto Soups is a household name in much of the Southeast and Southwest. It wasn’t always so. Thirty years ago Robert Rivera founded Palmetto Soups when numerous “informaland unscientific” taste tests convinced him that his recipes generated soups that were different and flavorful. Only six years out of college, Rivera lit- erally bad to pester grocery stores to sell his soups. The first three years were difficult as few stores were willing to give shelf space to the products of a firm owned by someone not quite thirty years of age. Yet the soups were good and grocers who did carry Palmetto products quickly noticed that customers began asking for Palmetto by name. Sales and profits grew rapiclly and, in fact, in the last few years eamings per share have increased at a rate well above companies of similar size, And the future looks bright also, The company’s market area is experiencing an economic boom, and sales are projected to increase in real terms (ie,, adjusted for inflation) for at least the next three years. COST REDUCTION Earlier this year (1995), Palmetto’s board of directors approved a switch to a highly capital-intersive method of production. This change will be made in part to accommodate the anticipated sales growth but mainly to lower unit costs. At ppresent raw materials and direct labor are 77 percent of sales, which is the indus- tay average. By 1997, these inputs are expected to be roughly 45 percent of sales—primarily due to substantial labor savings—and the gross margin should ‘be 52 percent, which would be the highest in the industry, The year 1996, how- ever, will bea transition year. Thatis, it will take time to fully implement the new production techniques.” Management believes that raw materials and direct labor will be 60 percent of sales. Since variable selling expense is predicted to be 3 percent of sales, the 1996 gross margin is estimated to be 37 percent, Of course,oo PART Il FINANCIAL ANALYSIS the change will increase the firm's overhead costs. Administrative and other fixed expenses are predicted to reach $3 million and $1 million, respectively, in 1996 due in part to the necessity of hiring a number of experienced technicians. Depreciation in 1996 will be $3.75 million. Production is confident that these cost estimates are quite reasonable and also believes that the projected future level of sales will not strain the firm’s capacity, For example, in 19% the company will operate at roughly 57 percent of its production capability, Everyone in the company believes the change will be very profitable in the long run, but there is a heated debate over the financing of the project. The company’s investment banking firm, Smith, Peabody and Associates, believes that all money could easily be borrowed considering Palmetto’s “extremely strong net working capital position, very competitive debt ratio, and low busi- ness risk.” FINANCING CONTROVERSY Rivera, the company president, wants to use this debt alternative. First, he feels the risk is minimal since the demand for the company’s product is quite stable. “After all” he argues, “we've never been more than 10 percent off in any of our sales forecasts.” Second, sales and profits are both expected to increase for at least thenext three years, Next year’s (1996) sales, for example, are predicted to increase 10 percent, though half of this is pure inflation. Rivera simply finds it hard to believe that the money to pay the debt won't be there. Third, equity will bring in outsiders to the business, and he is very proud of the fact thatall the firm’s stock is owned by the Rivera family. Finally, since he strongly believes that the company’s profits will “take off,” Rivera is loathe to “divide up the pie into more slices,’ which could be the result if additional stock were issued, As he puts it, “The possibility of sharing what I've worked so hard to develop bothers me a great deal.” ‘Theodore Tipps, a financial officer, has a very different view. He worries that the hhuge interest expense associated with the debt may embarrass the company. ‘Specifically, his concem is that net operating income in 196, the transition year, will bbe insufficient to pay the firnYs interest, which he estimates would increase by $14 million if debt is used. Tipps agrees with Rivera about Palmetto’s future prospects but cautiously points out that “too much debt could mean we won't be around to enjoy the fruits of our investments, And there is another problem: the ‘Hireat of bankruptcy needs to be considered. Adverse rumors could cause key employeesto leave, make it difficult to deal with oursuppliers, and might even cost us sales It is, therefore, not just a question of whether we can pay the debt, but whether wecan do so without disrupting the operation ofthe firm.” Tipps also sug- gests lengthening the term of the loan in order to lower the yearly payment, assum- ing the firm decides to borrow, Rivera is reluctant to do this because (1) it would raise the interest rate; and (2) he wants to repay any debt as soon as possible, Though Tipps feels strongly that the firm’s borrowing should be completely from Palmetto's yearly operations, he admits that in a pinch assetsCASE9 PALMETTOSOUPS 61 could be liquidated. But he initially told Rivera that he would be reluctant to do this because “we need all our assets to adequately support our future sales pitjections.” When pressed by Rivera, though, Tipps conceded that Palmetto’s working capital position is too conservative; also, if sales were below projec- tion, less working capital would be needed, As they part, Rivera feels that Tipps has made a number of good points but wonders if he isn’t overreacting and thinking too conservatively, However, Rivera has a great deal of respect for Tipps’s financial savvy and is taking the objections very seriously. QUESTIONS 1. Project the 1996 income statement assuming the firm uses debt. (Assume sales will increase by 10 percent.) 2. Compute the company’s EBT break-even sales volume and DOL for 1996. Express the break-even sales volume as a percent of sales. (In 1995, this breakeven sales volume was $14,750,000, and 578 percent of sales. The firm’s DOL was 2.) 3. Ifsalesare 10 percent below the 1996 estimate, predict the firms net operat- ing income (EBIT). Would it be sufficient to cover the interest due? 4. After reviewing the answers to 1 to 3, Rivera says, “What we're really after is the level of sales that generates sufficient cash flow to pay the principal and interest due on our debt. What is that sales amount?” (Principal due will ‘be $1,900,000 in 1996 if the company borrows.) Use (FC = Dep) + Prin 1-Vis 5. The correct use of the break-even formulas in questions 2 and 4 rests on certain assumptions. What are they? Do these assumptions appear to hold for Palmetto? Explain. 6. Based on your answers to 1 to Sand information provided in the case, would you recommend the use of debt to finance the new production methods? Explain. 7. What additional information would you like to have to make a more informed decision? 8. One of Rivera's arguments for using debt is that Palmetto expects increases in bothsales and profits in the coming years. Apparently, he believes that the larger expected profits will generate Sufficient cash to pay any debt due. Is there a fallacy in this reasoning? That is, is it possible that larger profits resulting from higher sales could actually be associated with less casi avail- able for debt service? Explain.a SOFTWARE QUESTION 9, Robert Rivera, the company president and major stockholder, feels pretty good at this point about the decision to borrow all the funds needed to finance the new production techniques. Still, he is taking very seriously the objections of Theodore Tipps, a financial officer, Rivera doesn’t want to be bothered with any cash flow problems, especially over the next few years during the production changes. He decides to “think pessimistically” regarding, the future, and analyze the firn’s ability to meet the debt due under adverse circumstances, ‘The scenarios Rivera will investigate are shown below, and the debt due is $1,900(000) in both 1996 and 1997. Interest expense will be $1,400(000) in 11996 and $1,210(000) in 1997. ‘Scenatio vey Buveae Conenative Pessimistic Pessinisic 1996/1997 19961197 1995/1957 19961197 Sales growth 10/05 05/05 05/02 2/00 (Gross margin 37/2 36/49 35/47 34/ad Overhead 3000/3200 4200/4400 4400/4800 4600/5000 “Overhead represents fbed cash operating sts and sexpresed in thousanc of dollars NOTE: The large increase in the gross margin from 1996 to 1997 in all scenarios isa result of the implementation of the new production techniques, Perform the appropriate analysis. How do the results affect your answer to question 6? EXHIBIT 1 Income Statement (000s) 1995 (Preset) 1936 Sales 925500 Cost of goods sold 2080 Grss profit 510) ‘Administrative 125 Depreciation ‘$50 Other fixed 05 EBIT 250 Interest ‘400 Eamings before taxes 21) Taxes 0%) ‘840 Net inaome S120