Advanced Topics

 

Determining Capital Needs and Financial Structure

Estimating Total Capital Requirement:
The starting point is the cost of building your plant. For example:

Total plant construction cost $1.531.250
Site fee            80.000
  $1.611.250

A rule of thumb can be applied to estimate working capital needs: assume working capital is equal to the amount invested in plant and equipment. Total capital need is then:

Fixed investment:                    $1.611.250
Working capital:                      $1.611.250
Total capital needs:                 $3.222.500

A more reliable estimate of total assets required can be made by estimating your expected assets at the end of the first year (cash + marketable securities + accounts receivable + finished goods + raw materials + plant and equipment). If production and sales are not stable but growing, you will need to increase working capital by the percentage of growth in sales each quarter (accounts receivable and inventories increase when sales increase).

The relationship between fixed assets and working capital is also influenced by your strategy. Following is an example of how firms in a previous simulation designed their asset structure.

Firm N°  % of assets in plant          % in working capital         
12  39     61  
11   46     54    
14   60    40
16   74     26

Both firms 12 and 16 had outstanding performance in spite of radically different structures. Firm 16 had a preponderance of fixed assets (a high degree of operating leverage). It kept its plant working at maximum production (two shifts and a good deal of overtime). It used just-in-time production that is no finished goods and just enough raw materials to meet two weeks of manufacturing. Cash was always at the minimum with extra cash paid out in dividends. If cash was short, accounts receivables were factored. This was a risky strategy, but it worked because they had perfect forecasting and never had to face a major cash crisis. However, the workload and tension on team members were considerable. Firm 12 had a more conservative asset structure. It put the customer first in quality and delivery. They always wanted to end the quarter with finished goods rather than run the risk of disappointing customers. Raw materials were always available in advance.

Long-term Financial Structure: The next question is how to finance your capital needs. A general rule is to use long-term financing (equity capital, term loan, and bonds) to finance fixed assets and short-term borrowing to finance working capital. (Equity capital refers to capital raised from the sale of shares.) What rules guide the choice of the type of long-term financing? In general, creditors are reluctant to lend more to a firm than the amount of stockholders’ equity. Financial risk is measured by the debt-to-equity ratio: zero means no debt (100% equity financing); a 1/1 ratio means half debt and half equity. If debt financing represents more than half of long-term financing, the bond market might not respond to requests for further funding. Firms can be audited during the simulation. If your firm is audited and your debt-to-equity ratio is over 1.5, you may be forced to convert borrowed funds above $1.000.000 into a special loan at a rate of 36% annually.

Financing Working Capital: Part of working capital can be financed partly with long-term financing, but short-term loans should cover the major part. The short term loan is paid off each quarter with interest, but can be renewed each quarter. If you are building up inventory for Q4, you may want to increase the short-term loan. When you calculate the debt-equity ratio, the short-term loan (and accounts payable) should be included in the numerator. 

We have said that stockholders expect a 20% return per year on their investment, while banks and bondholders are satisfied with 10 to 12%. Before opting for borrowing from the bank or bondholders, you should understand that if your firm’s performance does not satisfy your stockholders, all you get are complaints and mediocre stock performance. If you do not reimburse the bank or pay the bondholders, you will be forced into bankruptcy. On the other hand, if you can increase earnings per share by more than 20% per year, then it is interesting to borrow money at 10 to 12 % (called ‘leveraging’ or ‘gearing’). So debt financing is useful when you have good growth opportunities.

In the example above, firm 12 was conservatively financed, having issued 1 million shares of stock. It could withstand extreme market or financial shocks. As profits came in, they repurchased shares down to the minimum of 300.000 shares. Firm 16 issued only 350.000 shares and secured borrowed funds from all available sources. It had extreme risk—a high risk asset structure financed by a high risk capital structure. In the same simulation, two other firms tried firm 16’s strategy and went bankrupt. Concluding that it is best to start out with the minimum number of shares is risky since it could constrain growth opportunities (unless your strategy is ‘to niche’ the market). If you do start out with the minimum of 300.000 shares, you can try to overcome the problem by heavy borrowing. If you survive, retained earnings will increase and the firm’s debt-to-equity ratio will decline over time. You will end up with a very large company with very few shares and a very high stock price. On the other hand, assume you start out with a large number of shares. You are conservative with respect to financial risk and have a maximum potential for growth. Then, as profits increase, you can repurchase shares. At the end of the game, you will have a very large company with very few shares and a very high stock price. The choice will depend upon your strategy and attitude toward risk. 

 

Manufacturing Plant - challenging concepts

Overtime and Subcontracting
Overtime may be defined as the hours which you schedule above and beyond your current capacity. If you have a plant which is 5,000 hours large in Stage 1 and 7,500 hours large in Stage 2, and you use up all of these hours in the given 13 week period yet your scheduled production is not yet met, then production will slip into overtime.

Labor hours required to produce one case of aftershave or perfume in each production stage:

  Stage 1 Stage 2
Aftershave (P1): 1.7 hours 2 hours
Perfume (P2): 3 hours   2.5 hours

Labor Costs:
Stage 1 workers receive $12.00 per hour including benefits.
Stage 2 workers receive $5.50 per hour, including benefits.
Overtime = another 25% of your shift hours at a rate of 1.5 times the regular labor cost
Subcontracting = anything beyond overtime (moves incrementally from 2.2 times the cost to 4.4 times to 6.6 times)

Workers are paid based on production scheduled, not the size of the plant.

For example, let's assume that you schedule 5,000 units of Product 1 to be produced, and it takes 1.0 hour to process one unit of Product 1. In this case, everyone in Stage 1 will be working full time for the 13 week quarter. Now assume it takes 1.5 hours to process one unit of Product 1 in Stage 1, and you schedule production of 5,000 units. This means your workers will need to work 7,500 hours to meet your scheduled production.

They will use up 5,000 regular hours and then go to overtime up to 25% of normal or 1,250 hours. That still leaves 1,250 hours short. The union will not let them put in more hours. Therefore, the remaining 1,250 hours will be subcontracted out at a labor cost of 2.2 times the normal rate!

If production is scheduled such that subcontracting reaches beyond 100% of regular hours + overtime hours, the labor rate goes up again to 4.4 times the normal rate. If production is scheduled such that subcontracting reaches beyond 200% percent of regular hours + overtime hours, the labor rate rises further to 6.6 times the normal rate. If no hours exist and subcontracting is used for production, the program assumes 5,000 hours (in each stage) at 2.2 times the normal labor cost prior to moving into the 4.4 times labor cost.


Locating a Plant in Mexico and/or The Czech Republic

Mexico

The labor rate in Mexico is 60% of the labor rate in Area 1. All transactions in Mexico are in U.S. dollars, including wages. Studies have shown that production is more variable than other area 1 locations.

The Czech Republic
The labor rate in The Czech Republic is 70% of the labor rate in Area 2. Czech Republic wages are paid in euros. Studies have shown that production is more variable than other area 2 locations.

Special Entries Required to Locate in Mexico/Czech Republic: To construct a plant in Mexico or the Czech Republic you will have to make a contract decision entry, along with the normal "add capacity" decision in the main decision set. Contracts will specify the Mexico or Czech Republic choice and make necessary changes to labor rates and production, while the Student Decision Program will specify the number of hours to be constructed and the corresponding costs.

Calculating Production Costs: Production costs consist of two components - labor and raw materials. Other variable and semi-variable expenses, such as sales commission, are not included in the simulation's calculation of unit manufacturing cost. To determine unit manufacturing cost use the following procedure.

(Number of Type 1 raw material units needed) x (cost of a R.M. unit) +
(Number of Type 2 raw material units needed) x (cost of a R.M. unit) +
(Hours of Stage 1 labor needed) x (cost of one hour of labor) +
(Hours of Stage 2 labor needed) x (cost of one hour of labor)
= cost of producing one unit.

To determine the cost of manufacturing a unit in overtime, multiply the cost of one hour of labor in Stage 1 and Stage 2 by 1.5. Then, recalculate to determine overtime unit manufacturing cost. To determine subcontracting unit cost, do the same thing as for overtime, but use 2.2 (4.4 or 6.6) times one hour of labor instead of 1.5.


NPV

A winning strategy is one that permits the firm to earn positive net income after taxes and to increase its earnings over the duration of the game. Shareholders are counting on a 20% return per year. This means that dividend payments and increases in share price must yield at least this rate of return. The measure of performance is net present value (NPV). It is used to rank firms each week (see the Dollars and Scents Quarterly). Increases in stock price and dividends paid to shareholders are the drivers of NPV. Profit per share and the debt-equity ratio are the two principal determinants of stock price.

Net present value = present value (including stock and dividend value) less stockholder investment in period zero.

The average price of the stock in the last four quarters of the simulation is seen as the stock value created that can be accessed by the stockholder.

Any dividend paid by the firm is valued in the period received.

Stockholder's original investment on the day the corporation is formed equals stockholder investment at period zero. For example, let's say the stock is issued on day one of the first quarter played at $4.25

The stockholder expects that if dividends are not paid, that the stock price will increase over time at a minimum rate of 5% per quarter.

The following example shows dividends paid over 14 quarters of the simulation (second column) and share price in each of the last four quarters (third column). The last four quarters are used for share price instead of just the last quarter.
 

Period Dividend Share Price Present Value Factors
0 $.0 $4.25 1
1 $.0 x .952
2 $.0 x .907
3 $.0 x .864
4 $.0 x .823
5 $.5 x .784
6 $1 x .746
7 $0 x .711
8 $0 x .677
9 $0 x .645
10 $0 x .614
11 $0 $20 .585
12 $0 $18 .557
13 $0 $25 .53
14 $0 $26 .5

 

The last column of numbers were taken from a present value discount table and relate to the period beside which they are listed. The NPV calculations are normally done on a calculator or computer. But, it is important in setting dividend policy, to visualize how time destroys the value of receiving funds. A $1 dividend received in Q1 is worth $.952 to the stockholder. If a stockholder must wait until quarter 14 to receive a $1 dividend, it is only valued at $.50.

Let's calculate ending NPV, given the information in the preceding table.

First determine the present value of the firm's stock (using the average of the last four stock prices).

(.25)($20)(.585) +

(.25)($18)(.557) +

(.25)($25)(.530) +

(.25)($26)(.500) = $11.99

Next, determine present value of all dividends paid. To do this, you must discount each quarter's dividend back to period zero.
($.5)(.784) +

($1 )(.746) = $1.138

Now, total the two present value numbers. This gives you a total value of $13.128. Subtract the original investment in period zero ($4.25) and you arrive at the ending NPV = $8.88.

It is important that the team understand how NPV is determined. Take the above example and do not pay dividends. Assume stock price the last four quarters are $28, $30, $30 and $36. Is NPV higher? Would it have been better to retain dividends to promote growth and thus a higher stock price?

Try the original NPV calculation but this time add dividends in period 10 of $1, along with $1 in period 11 and $1 in period 12. What is your NPV? How much was it worth to the stockholder to receive the dividends early.

Dividends are valued for themselves, but they also can influence stock price in a positive direction if declared in a financially prudent manner. Thus, dividend policy for a mature firm with limited growth opportunities needs to be addressed.

Remember that your firm is restricted to a $.50 dividend increase per quarter.



Bankruptcy

Bankruptcy is something which all firms hope to avoid. Unfortunately this is not always possible. This chapter will help you to figure out whether you are in danger of bankruptcy and what actions you can take to salvage your firm. Sometimes it is best to abandon a sinking firm and start fresh with your hard earned knowledge.

When you have lost 100% of the stockholder's value, your firm is considered bankrupt. More precisely, when your negative retained earnings account plus your bond discount account equals the sum of the common stock account plus the Paid in Capital account, your team has lost 100% of the stockholder's investment (in other words, when equity equals zero).

When this occurs, your firm is owned wholly by creditors.

If large losses continually erode your stockholder's investment, consult with your instructor. Many options exist. Some of those follow:

1. Issue more stock.

2. Search the balance sheet for assets that can be liquidated. Take the resulting cash and pay off the most expensive debt. Liquidate accounts receivable by factoring. Do not order raw material futures (except for a two week supply). Make an effort to sell out finished goods. Perhaps liquidate some plant hours. These actions trim the assets and create a leaner corporation.

3. Seek a consulting partnership with a successful firm. Perhaps they will agree to payment only if and when profits reach a predetermined level.
 

4. Enlist the aid of Venture Capitalists. Venture Capitalists Inc. can be reached through your simulation consultant. These investors will exchange shares of stock for debt in a private off-line deal. They will NOT consider requests for other arrangements. Consider this your last line of defense.

To close an existing firm and start another, your firm must have permission from your instructor. Once permission is secured, a new firm and password will be issued. Securing permission from your instructor for a firm closing and the opening of a new firm usually requires a grade concession or extra work agreements.


Subsidiaries

A subsidiary occurs when a firm creates a new firm in another market group. Your firm, called the parent, owns 51% of the stock of the new firm. The other 49% of the stock must be made available to the public. A parent firm is not allowed to open a subsidiary in its own market group. A parent firm may only open one subsidiary during the course of the simulation.

The parent must make payment for 51% of the subsidiaries' stock issued in the quarter first subsidiary decisions are made (payment = shares issued X sale price per share X 51%). This amount is taken out of cash, AR or creates a special loan after the quarterly run. A confirmation of this transaction should be sent to your firm by your administrator, as there will be no record on the quarterly report.

The parent firm has the right to 51% of any dividends. Note that cash from dividends issued does not come into the parent firm until the following quarter. A parent firm may sell product to the subsidiary or buy product from the subsidiary through the contracts program.

When the subsidiary closes, or when the simulation comes to an end, it is necessary to merge the value of the subsidiary with the value of the parent firm. This ensures that proper effects of the subsidiary are applied to the parent firm. It also ensures that teams do not simply open a subsidiary in order to bleed it do death.

Ending NPV calculation:

Subsidiary NPV x 51% = Y

Subsidiaries Number Shares / Parents Number of Shares = Z

Y x Z = Change to Parent's NPV

Strategy

The first step is to decide what your product and market strategy will be. Do you want to be a low-cost producer of aftershave selling large quantities on the low-price segment in both retail market areas? Or, do you want to specialize in luxury perfume on the European market, selling at a high price with lots of spending on advertising and quality? Once this decision is made, you can make a preliminary calculation of the number of units you think you can sell each year. If, for example, the demand for perfume in Europe is expected to be around 200.000 units per year, and there are seven firms in your market group, an average market share would be 14%. However, if you are in the high-price end, your market share might be only 5% or 7%. With a 5% share, you would sell 10.000 units per year, or an average of 2500 units per quarter. With a 7% share, you could sell 14.000 units per year or 3500 units per quarter. This estimation permits you to calculate the plant size that will be necessary to produce these quantities. Knowing the plant size, you can calculate construction cost and estimate working capital requirements (50% to 100% of the value of the fixed asset) to get the total amount of financing required. The next step is to decide the best way to finance this sum. 

If your goal is to be in the top 10 in the NPV standings, you will need a good strategy and the ability to implement it effectively. You will also probably take more risks than if your goal is simply to be in the top 30. Managers must make difficult decisions under conditions of uncertainty and time constraints. It will help to define the company’s mission and vision. Some firms want to be niche players with assured product delivery. Others want to manage a large international firm, maybe with a subsidiary.

Competitive conditions can pose problems. In a recent simulation one market group had all firms attempting to niche the upper market segment. The average market group price was high, the firms were small with few sales reps, little advertising, but high average quality. In year three, they raised prices for P2 so high (each trying to be the price leader) sales fell to zero. All firms suffered. In another market group, which started out under the same conditions, business was booming. This group had large firms with high volume in the middle price range and a couple of market nichers. Given the large number of sales reps, large advertising budgets, and lower average market group price, everyone was profitable.

In each simulation, different scenarios can develop. Two years ago, firms had an unexpected opportunity to invest in plants in Indonesia, which offered low-cost production advantages and special privileges for exporting to Europe. Firms which seized the opportunity were heavily represented in the top 10 in NPV. Firms operating plants in the EU failed in their attempt to organize a political campaign to gain tariffs protection and had poor performance. Strikes with labor negotiations and electrical blackouts have been other scenarios.

Successful performance also depends on strategy implementation. A chain is as strong as its weakest link. A firm may have the lowest production costs; but if its sales forecasts are poor, it will be unable to exploit its advantage. Different strategies require different capabilities. Traders will want to develop close relations with suppliers and will focus on communication tools and negotiating skills. Low cost producers will develop spread sheets for estimating costs and managing inventories. Risk takers will sharpen their marketing and financial skills.  Some teams have found that they were able to make better decisions and make them faster by using a team approach to analysis and decision making, rather than assigning these to separate individuals. Good implementation depends on the cooperation of all team members. Do not forget that everyone is involved in human resource management.

When starting out, there are some guiding principles that might help. From a management point of view, what are the personal ambitions, strengths and weaknesses, risk preferences of each team member? Can these be channelled into goals, a corporate mission statement, a strategy, and an organizational structure which all members can agree upon? What is already known about the positions and strategies of competitors and how the industry is evolving? Preliminary consideration of these questions can help in thinking about possible strategic options. In the first two quarters, gather as much market research information as possible on competitors and products in different market groups. Always monitor the competitors in your market group and be aware that existing firms or new firms may enter your market group later in the simulation.

Losses early in the game are usually unavoidable. Keep an eye on your long run objectives. Some short term losses can be tolerated to gain long run market position. Finally, don’t forget that long run strategies take time to play out. Do not get caught in a short term NPV contest. It is the last four quarters that count. However, if your long run strategy is unattainable, or turns out to be unrealistic, you will be forced to make modifications to your initial strategy. Strategy is also about action and realism, and this requires adapting to changes in the environment and/or to the development of new capabilities within your firm.

 

Forecasting Demand

The following model can be used to forecast unit demand for your firm. Be aware, however, as you work with the model that it is just that, a model. No one can provide an exact calculation for predicting the future. Learn your environment, the markets, the competition, your own team's capabilities; and your forecasting will grow more precise.

To show you the possible range in forecasting, the formula is applied to a conservative and an aggressive estimate (actual would probably fall in the middle of these two extremes).

Forecasting Model:

1. Determine overall market demand.
2. Determine your real market share
3. Multiply real market share times forecasted market demand

In order to begin, you must calculate from your own firm's numbers and those given on the Industry Report, demand for the entire market group. Once you have an accurate picture of overall demand, you can then work backwards to determine what share of that potential market you actually captured.

Step 1: Determine overall market demand.
Following are the variables which you must use to calculate overall demand within your market group.
 

Market Group Demand Variables
Conservative Aggressive
Unit Sales Add (+) Add (+)
BO this Q Do not use Add (+)
BO last Q Subtract (-) Do not use
Mkt Share Use Use
Mkt Group Ending Sales Lost Add (+) Add (+)
Mkt Group Contract Sales Subtract (-) Subtract (-)
Seasonal
Ratio
Use Use

 

Note that the only difference between the conservative forecast and the aggressive forecast is the treatment of backorders. The aggressive forecaster assumes that all firms had similar backorders this quarter, and that no competing firms had backorders in the previous quarter.  The conservative forecaster seeks to make sure that demand in the coming quarter is fully met. The aggressive forecaster tries to hone the number more precisely.

Also note that the Ending Sales Lost figure and the Contract Sales figure are for the entire market group, not just for your individual firm.

Now, assume the firm in question had 5000 unit sales of Product 1 in Area 1 and 1000 backorders of Product 1 in Area 1 for Quarter 1. In Quarter 4 of the previous year they had 2000 backorders. Their market share for Product 1 in Area 1 was 10%. Ending Sales Lost for the market group was 500 P1A1. Contract sales within the market group for Product 1 in Area 1 was 4000 units. The seasonal ratio for Quarter 2 forecasting is 1.2/.8.

The firm must apply the variables as indicated in the table in order to determine total market group demand.

 

Conservative Calculation

Step1
5000 sales - 2000 B.O. last qtr/ .10 = 30000 units

Step 2
30000 units + 500 Ending Sales Lost  - 4000 market group contract sales = 26500

Step 3
26500 units x (1.2 /.8 seasonal ratio) = 39750

Total  = 39750 forecasted market group demand Q2


Aggressive Calculation

Step1
5000 units + 1000 B.O. this qtr / .10 = 60000

Step 2
60000 units + 500 Ending Sales Lost  -4000 market group contract sales = 56500

Step 3
56500 units x (1.2/.8 seasonal ratio) = 84750

Total  = 84750 forecasted market group demand Q2

Step 2: Determine Your Real Market Share

Now that you know what the potential market was for Quarter 1, you need to find your adjusted market share. Continue with the previous example.

First calculate the firm's adjusted units sold. To do this subtract contract sales for the firm and last quarter's backorders for the firm from the unit sales figure.

Next, divide the adjusted units sold by the market group demand figure calculated previously. Note: do not use the forecasted number, but the demand figure for the current quarter (before the seasonal ratio was applied).

Assume the firm in our example sold 1200 units of P1A1 through contracts.
 
 

Conservative Calculation

Step 1.
5000 units - 1200 contract sales - 2000 B.O. last qtr = 1800 adjusted unit sales

Step 2.
1800/26500 = 6.79% adjusted mkt shr


Aggressive Calculation

Step 1.
Same as above = 1800 adjusted unit sales

Step 2.
1800/56500 = 3.18% adjusted mkt shr


Step 3 Multiply real market share times forecasted market demand:

Now you have an accurate figure for market group demand and an accurate number for market share. The last calculation is very simple. Multiply the forecasted market demand figure by the adjusted mkt share figure

 

Conservative Calculation

39750 units x 6.79% =  2699  forecasted unit demand for Q2


Aggressive Calculation

84750 units x 3.18% = 2695 forecasted unit demand for Q2