Question

Garnett Jackson, the founder, and CEO of Tech Tune-Ups, stared out the window as he finished his customary peanut butter and jelly sandwich, contemplating the dilemma currently facing his firm. Tech Tune-Ups is a start-up firm, offering a wide range of computer services to its clients, including online technical assistance, remote maintenance, and backup of client computers through the Internet, and virus prevention and recovery. The firm has been successful in the 2 years since it was founded; its reputation for fair pricing and good service is spreading, and Mr. Jackson believes the firm is in a good position to expand its customer base rapidly. But he is not sure that the firm has the financing in place to support that rapid growth. Tech Tune-Ups’ main capital investments are its own powerful computers, and its major operating expense is salary for its consultants. To a reasonably good approximation, both of these factors grow in proportion to the number of clients the firm serves. Currently, the firm is a privately held corporation. Mr. Jackson and his partners, two classmates from his undergraduate days, have contributed $250,000 in equity capital, largely raised from their parents and other family members. The firm has a line of credit with a bank that allows it to borrow up to $400,000 at an interest rate of 8%. So far, the firm has used $200,000 of its credit line. If and when the firm reaches its borrowing limit, it will need to raise equity capital and will probably seek funding from a venture capital firm. The firm is growing rapidly, requiring continual investment in additional computers, and Mr. Jackson is concerned that it is approaching its borrowing limit faster than anticipated. Mr. Jackson thumbs through past financial statements and estimates that each of the firm’s computers, costing $10,000, can support revenues of $80,000 per year but that the salary and benefits paid to each consultant using one of the computers is $70,000. Sales revenue in 2014 was $1.2 million, and sales are expected to grow at a 20% annual rate in the next few years. The firm pays taxes at a rate of 35%. Its customers pay their bills with an average delay of 3 months, so accounts receivable at any time are usually around 25% of that year’s sales. Mr. Jackson and his co-owners receive minimal formal salary from the firm, instead taking 70% of profits as a “dividend,” which accounts for a substantial portion of their personal incomes. The remainder of the profits are reinvested in the firm. If reinvested profits are not sufficient to support new purchases of computers, the firm borrows the required additional funds using its line of credit with the bank. Mr. Jackson doesn’t think Tech Tune-Ups can raise venture funding until after 2016. He decides to develop a financial plan to determine whether the firm can sustain its growth plans using its line of credit and reinvested earnings until then. If not, he and his partners will have to consider scaling back their hoped-for rate of growth, negotiate with their bankers to increase the line of credit, or consider taking a smaller share of profits out of the firm until further financing can be arranged. Mr. Jackson wiped the last piece of jelly from the keyboard and settled down to work. Can you help Mr. Jackson develop a financial plan and Do you think his growth plan is feasible? financial statement (income statement & balance sheet)

Answer 1

Based on the information provided the case in 2015 the firm was operating 15 computers. Since each computer could support $80,000 revenues, it is consistent with the 2015 revenues:

15 x $80,000 = $1,200,000. Each computer needed one consultant and the salary and benefits are $70,000 so the cost of goods sold in 2011 was 15 x $70,000 = $1,050,000. The 2015 interest expense, based on the initial line of credit of $125,000 was .08 x 125,000 = 10,000. So income statement and balance sheet (statement of financial position) for 2015 are:

Income Statement	Details of Calculations	2015
Revenue		1,200,000
Cost of goods sold	15 x 70,000=	1,050,000
EBIT		150,000
Interest expense	.08 x 12,500=	10,000
Earnings before taxes		140,000
Taxes	.35 x Earnings before taxes=	49,000
Net income		91,000
Dividends	.7 x Net income =	63,700
Addition to Retained earnings		27,300
Balance Sheet (year end) Assets Net operating working capital	.25 x 2011 sales = .25 x 1,200,00	2015 300,000
Long-term assets		150,000
Total assets		450,000
Liabilities and equity	Initial line of credit + required external
Line of credit	financing = 125,000 + 47,700	172,700
Shareholders' equity	initial equity + addition to retained earnings = 250,000 + 27,300=	277,300
Total liab. & share. equity		450,000
Required external financing	Total assets – initial line of credit – shareholders’ equity =450,000 – 125,000 – 277,300 =	47,700

To forecast 2016-2020 use the provided info. & calculate ratios using 2015 financial statements:

A. Model inputs

Sales growth rate	0.200
Tax rate	0.350
Interest rate	0.080
NWC/Sales ratio	0.250
Long-term assets/sales	0.125
COGS/sales	0.875
Payout ratio	0.700

Income Statement	2016	2017	2018	2019	2020
Revenue	1,200,000	1,440,000	1,728,000	2,073,600	2,488,320
Cost of goods sold	1,050,000	1,260,000	1,512,000	1,814,400	2,177,280
EBIT	150,000	180,000	216,000	259,200	311,040
Interest expense	10,000	13,816	18,424	23,981	30,680
Earnings before taxes	140,000	166,184	197,576	235,219	280,360
Taxes	49,000	58,164	69,152	82,327	98,126
Net income	91,000	108,020	128,425	152,892	182,234
Dividends	63,700	75,614	89,897	107,024	127,564
Retained earnings	27,300	32,406	38,527	45,868	54,670
Balance Sheet (year end)
Assets
Net operating working
capital	300,000	360,000	432,000	518,400	622,080
Fixed assets	150,000	180,000	216,000	259,200	311,040
Total assets	450,000	540,000	648,000	777,600	933,120
Liabilities and equity
Line of credit	172,700	230,294	299,767	383,499	484,349
Shareholders' equity	277,300	309,706	348,233	394,101	448,771
Total liab. & share. equity	450,000	540,000	648,000	777,600	933,120
Required external financing	47,700	57,594	69,473	83,732	100,850

But given the dividends paid in 2020 were $127,564 another option could be to plan to cut dividend in 2020. There is no right answer, you just need to make an argument about what you think they should plan to do in 2020.