The purpose of this assignment is to apply principles and skills associated with financial forecasting. Using what you have learned from the topic resources, complete Case 10.2 in the textbook. Prepar

CASE 10.2 Massachusetts Stove Company:

Analyzing StrategicOptions22The Woodstove Market Since the early 1990s, woodstove sales have declined from 1,200,00 0 units per year to approximately 100,000 units per year. The d decline has occurred because of (1) stringent new federal PA regulations, which set maximum limits on stove emissions beginning in 1992; (2) stable energy prices, which reduced the incentive to switch to woodstoves to save on heating costs; and (3) changes in consumers’ lifestyles, particularly the growth of two-income families. During this period of decline in industry sales, the market was ﬂooded with woodstoves at distressed prices as companies closed their doors or liquidated invent ores made obsolete by the new EPA regulations. Downward pricing pressure forced surviving companies to cut prices, output, or both. Years of contraction and pricing pressure left many of the surviving manufacturers in a precarious position ﬁnancially, with excessive inventory, high debt, little cash, uncollectible receivables, and low margins. The shakeout and consolidation among woodstove manufacturers and, to a lesser extend not, woodstove specialty retailers have been dramatic. The number of manufacturers selling more than 2,000 units a year (characterized in the industry as ‘‘large manufacturers’’) has declined from 90 to 35 in the prior 10 years. The number of manuka curers selling less than 2,000 units per year (characterized as ‘‘small manufacture rest’’) has declined from 130 to 6. Because the current wood stove market is not large enough to sup-port all the surviving producers, manufacturers have attempted to diversify to staying business. Seeking relief, near y all the survivors have turned to the manufacture of ga appliances’ Gas Appliance Market The gas appliance market includes three segments: (1) gas log sets, (2) gas ﬁreplaces, and (3) gas stoves. Gas log sets are ‘‘faux ﬁres’’ that can be installed in an existing ﬁreplace. They are primarily decorative and have little heating value. Gas ﬁreplaces are fully assembled ﬁreboxes that a builder or contractor can install in new construction or in renovated buildings and houses. They are decorative and are less expensive and easier to maintain than a masonry/brick ﬁreplace. Gas stoves are freestanding appliances with a decorative appearance and efﬁcient heating characteristics. The ﬁrst two segments of the gas appliance market (log sets and ﬁreplaces) are large, established, stable markets. Established manufacturers control these markets, and distribution is primarily through mass merchandisers. The third segment (gas stoves) is less than ﬁve years old. Although it is growing steadily, it has an annual volume of only about 100,000 units (almost identical to the annual volume of the woodstove market). This is the market to which wood-stove manufacturers have turned for relief. The gas stove market is not as heavily regulated as the woodstove market, and there are currently no EPA regulations governing the emissions of gas heating appliances. Gas stoves are perceived as being more ap propriate for an aging population because they provide heat and ambiance but require no effort. They can be operated with a wall switch or thermostat or by remote control. Because actual fuel l cost (or cost savings) is not an issue for many buyers, a big advantage of heating with wood is no longer a consideration for many consumers. Gas stoves are sold and distributed through mass merchandisers and through natural gas or propane dealers. The gas industry has the ﬁnancial, prom optional, organizational, and lobbying influence to support the development of the gas stove market, attributes that the tiny woodstove industry lacks. Unfortunately, life has not been rosy for all the woodstove companies entering this Newmarket. Development costs and selling costs for new products using a different t fuel and differ-Ent distribution system have been substantial. Improvements in gas logs and gas burners have required rapid changes in product design. In contrast, woodstove designs are stable and slow to change. Competition for market share has renewed pricing pressure on gas stove pro-dicers. Companies trying to maintain their woodstove sales while introducing gas products must carry large inventories to service both product lines. Failure to forecast demand accurately has left many companies with inventory shortages during the selling season or with large inventories of unsold product at the end of the season. Many surviving manufacturers who looked to gas stoves for salvation are now quietly looking for suitors to acquire them. A combination of excessive debt and inventory levels, to-gather with high devil open a Nd dist. rebutton costs, has made ﬁnancial success highly uncertain. Continued consolidation will take place in this d if cult market during the next ﬁve years. Massachusetts Stove Company Massachusetts Stove Company (MSC) is one of the six ‘‘small manufacturers’’ to survive the Epiregulations and industry meltdown. The company has just completed its sixth consecutive year of slow but steady growth in revenue and proﬁt since complying with the EPA regulations. Exhibits 10.13–10.15 present the ﬁnancial statements of MSC for Year 3–Year 7. Exhibit 10.16(see page 719) presents selected ﬁnancial statement ratios. The success of MSC in recent years is a classic case of a company staying small, marketing in a speciﬁc niche, and vigorously applying a ‘‘stick-to-your-knitting’’ policy. MSC is the onlywoodstove producer that has not developed gas products; 100% of its sales currently come from woodstove sales. MSC is the only woodstove producer that sells by mail order directly to consumers. The mail-order market has sheltered MSC from some of the pricing pressure that other manufacturers have had to bear. The combination of high entry costs and high risks make it unlikely that another competitor will enter the mail-order niche.

MSC’s other competitive advantages are the high efﬁciency and unique features of its wood stoves. MSC equips its woodstoves with a catalytic combustor, which reburns gases emit-ted from burning wood. This reburning not only increases the heat generated by the stoves, but also reduces poll mutants in the air. MSC offers a woodstove with inlaid soapstone. This soapstone heats up and provides warmth even after the ﬁre in the stove has dwindled. The soapstone also adds to the attractiveness of the stove as a piece of furniture. MSC’s customer base includes many middle- and upper-income individuals. MSC believes that proﬁtable growth of woodstove sales beyond gross revenues of $3 million a year in the mail-o red niche is unlikely. However, no one is selling gas appliances by mail-order. Many of MSC’s customers and prospects have asked whether MSC plans to produce agas stove. Management of MSC is contemplating the development of several gas appliances to sell by mail order. There are compelling reasons for MSC to do this, as well as some good reasons to be cautious. Availability of Space MSC owns a 25,000-square-foot building but occupies only 15,000square feet. MSC leases the remaining 10,000 square feet to two tenants. The tenants pay rent plus their share of insurance, property taxes, and maintenance costs. The addition of gas appliances to its product line would require MSC to use 5,000 square feet t of the space currently rented to one of its tenants. MSC would have to give the tenant six months’ notice to cancel its lease. Availability of Capital MSC has its own internal funds for product development and invent-tory, as well as an unused line of credit. But it will lose interest income (or incur interest expense) if it invests these funds in development and increased inventory. Existing Demand MSC receives approximately 50,000 requests for catalogs each year and has a mailing list of approximately 220,000 active prospects and 15,000 recent owners of woodstoves. There is anecdotal evidence of sufﬁcient demand so that MSC could introduce its gas stoves with little or no additional marketing expense, other than the cost of printing some additional catalog pages each year. MSC’s management worries about the risk of the gas stove sales cannibalizing its existing woodstove sales. Also, if the current base of woodstove sales is eroded through mismanagement, inattention, or cannibalization, attempts to grow the business through expansion into gas appliances will be self-defeating.

Vacant Market Niche No other manufacturer is selling gas stoves by mail order. Because the entry costs are high and the unit volume is small, it is unlikely that another producer will enter the niche. MSC has had the mail-order market for woodstoves to itself for approximately seven years. MSC believes that this lack of existing competition will give it additional time to develop new products. However, management also believes that a timely entry will help solidify its position in this niche. Suppliers MS C has existing relationships with many of the suppliers necessary to manufacture new gas products. The foundry that produces MSC’s woodstove castings is one of the largest suppliers of gas heating appliances in central Europe. On the other hand, MSC would be a small, new customer for the vendors that provide e the ceramic logs and gas burners. This could lead to problems with price, delivery, or service for these parts. Synergies in Marketing and Manu factoring MSC would sell gas appliances through its existing direct-mail marketing efforts. It would incur additional marketing expenses for photog-raphe, printing, and customer service. MSC’s existing plant can manufacture the shell of the gas units. It would require additional expertise to assemble ﬁreboxes for the gas units (valves, burners, and log sets). MSC would have to increase its space and the number of employees to process and paint the metal parts of the new gas stoves. The gross margin for the gas products should be like that of the woodstoves. Lack of Manage Ent Experience E Managing new product development, larger production levels and inventories, and a more complex business would require MSC to hire more manage-mint expertise. MSC also would have to institute a new organizational structure for its more complex business and deﬁne responsibilities and accountability y more carefully. Up to now, MS Chas operated with a loose organizational philosophy.

REQUIRED (additional requirements follow on page 723) REQUIRED (additional requirements follow on page 723

) a. Identify clues from the ﬁnancial statements and ﬁnancial statement ratios for Year 3–Year7 that might suggest that Massachusetts Stove Company is a mature business.

b. Design a spreadsheet for the preparation of projected income statements, balance sheets, and statements of cash ﬂows for MSC for Year 8–Year 12. Also forecast the ﬁnancial state-mints for each of these years under three scenarios: (1) best case, (2) and (3) worst case. The following sections describe the assumptions you can make.

Development Costs MSC plans to develop two gas stove models, but not concurrently. It will develop the ﬁrst gas model during Year 8 and begin selling it during Year 9. It will develop the second gas model during Year 9 and begin selling it during Year 10. MSC will capitalize the de-elopement costs in the year incurred (Year 8 and Year 9) and amortize them straight-line verve years, beginning with the year the stove is initially sold (Year 9 and Year 10). Esty-mated development cost for each stove are as follows: Best Case: $100,000Most Likely Case: $120,000Worst Case: $160,000Capital Expenditures Capital expenditures, other than development costs, will be as follows: Year 8, $20,000; Year 9, $30,000; Year 10, $30,000; Year 11, $25,000; Year 12, $25,000. Assume six-year depreciable life, straight-line depreciation on, and a full year of depreciation in the year of acquisition.

Sales Growth Changes in wood and gas stove sales relative to total sales of the preceding year are as follows: Best Case Most Likely Case Worst Case Year Wood Gas Total Wood Gas Total Wood Gas Total8 þ2% — þ2% –2% — –2% –4% — –4%9 þ2% þ6% þ8% –2% þ4% þ2% –4% þ2% –2%10 þ2% þ12% þ14% –2% þ8% þ6% –4% þ4% þ0%11 þ2% þ12% þ14% –2% þ8% þ6% –4% þ4% þ0%12 þ2% þ12% þ14% –2% þ8% þ6% –4% þ4% þ0%Because sales of gas stoves will start at zero, the projections of sales should use the preceding growth rates in total sales. The growth rates shown for woodstove sales and gas stove sales simply indicate the components of the total sales increase. Cost of Goods Sold Manufacturing costs of the gas stoves will equal 50% of sales, the same as for woodstoves. Depreciation will increase for the amortization of the product development costs on the gas stoves and depreciation of additional capital expenditures. Facilities Rental Income and Facilities Costs Facilities rental income will decrease by fifty% beginning in Year 9 when MSC takes over 5,000 square feet of its building now rented to another company and will remain at that reduced level for Year 10–Year 12. Facilities costs will increase by $30,000 beginning in Year 9 for facilities costs now paid by a tenant and for additional facilities costs required by gas stove manufacturing. These costs will remain at that increased level for Year 10–Year 12.Selling Expenses Selling expenses as a percentage of sales are as follows: Year Best Case Most Likely Case Worst Case8 34% 34.0% 34%9 33% 33.5% 35%10 32% 33.0% 36%11 31% 32.5% 37%12 30% 32.0% 38%Administrative Expenses Administrative expenses will increase by $30,000 in Year 8, $30,000in Year 9, and $20,000 in Year 10, and then will remain at the Year 10 level in Years 11 and 12.Interest Income MSC will earn 5% interest on the average balance in cash each year. Interest Expense The interest rate on interest-bearing debt will be 6.8% on the average amount of debt outstanding each year. Income Tax Expense MSC is subject to an income tax rate of 28%. Accounts Receivable and Inventories Accounts receivable and inventories will increase at the growth rate in sales.

Property, Plant, and Equipment Property, plant, and equipment at cost will increase each year by the amounts of capital expenditures and expenditures on development costs. Accumulated depreciation will increase each year by the amount of depreciation and amortization expense. Accounts Payable and Other Current Liabilities Accounts payable will increase with the growth rate in inventories. Other current liabilities include primarily advances by customers for stoves manufactured soon after the year-end. Other current liabilities will increase with the growth rate in sales. Current Portion of Long-Term Debt Scheduled repayments of long-term debt are as follows: Year 8, $27,036; Year 9, $29,200; Year 10, $31,400; Year 11, $33,900; Year 12, $36,600; Year 13, $39,500. Deferred Income Taxes Deferred income taxes relate to the use of accelerated depreciation for tax purposes and the straight-line method for ﬁnancial reporting. Assume that deferred income taxes will not change. Shareholders’ Equity Assume that there will be no changes in the contribute ed capital of MSC. Retained earnings will change each year in the amount of net income. REQUIRED (continued from page 721)

REQUIRED (continued from page 721)

c. Calculate the ﬁnancial statement ratios listed in Exhibit 10.16 for MSC under each of the three scenarios for Year 8–Year 12. Note: You should create a fourth spreadsheet as part of your pre parathion of the pro-jested ﬁnancial statements that will compute the ﬁnancial ratios.

d. What advice would you give the management of MSC regarding its decision to enter the gas stove market? Your recommendation should consider the proﬁtability and risks of this action as well as other factors you deem relevant.

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