CHAPTER 9 Financial Planning and Forecasting Financial Statements

CHAPTER 9 Financial Planning and Forecasting Financial Statements 1

Topics in Chapter n n n Financial planning Additional Funds Needed (AFN) formula Forecasted financial statements n n Sales forecasts Percent of sales method 2

Financial Planning and Pro Forma Statements n Three important uses: n n n Forecast the amount of external financing that will be required Evaluate the impact that changes in the operating plan have on the value of the firm Set appropriate targets for compensation plans 3

Steps in Financial Forecasting n n n Forecast sales Project the assets needed to support sales Project internally generated funds Project outside funds needed Decide how to raise funds See effects of plan on ratios and stock price 4

2009 Balance Sheet (Millions of $) Cash & sec. $ 20 Accounts rec. Inventories Total CA 240 $ 500 Net fixed assets Total assets 500 $1, 000 Accts. pay. & accruals Notes payable Total CL L-T debt Common stk Retained earnings Total claims $ 100 $ 200 100 500 200 $1, 000 5

2009 Income Statement (Millions of $) Sales Less: COGS (60%) SGA costs EBIT Interest EBT Taxes (40%) Net income Dividends (40%) Add’n to RE $2, 000. 00 1, 200. 00 700. 00 $ 100. 00 10. 00 $ 90. 00 36. 00 $ 54. 00 $21. 60 $32. 40 6

AFN (Additional Funds Needed) Formula: Key Assumptions n n n Operating at full capacity in 2009. Each type of asset grows proportionally with sales. Payables and accruals grow proportionally with sales. 2009 profit margin ($54/$2, 000 = 2. 70%) and payout (40%) will be maintained. Sales are expected to increase by $500 million. 7

Definitions of Variables in AFN n n n A*/S 0: assets required to support sales; called capital intensity ratio. ∆S: increase in sales. L*/S 0: spontaneous liabilities ratio M: profit margin (Net income/sales) RR: retention ratio; percent of net income not paid as dividend. 8

Assets vs. Sales Assets 1, 250 1, 000 Assets = 0. 5 sales Assets = (A*/S 0) Sales = 0. 5($500) = $250. 0 2, 000 2, 500 A*/S 0 = $1, 000/$2, 000 = 0. 5 = $1, 250/$2, 500. Sales 9

If assets increase by $250 million, what is the AFN? AFN = (A*/S 0)∆S - (L*/S 0)∆S - M(S 1)(RR) AFN = ($1, 000/$2, 000)($500) - ($100/$2, 000)($500) - 0. 0270($2, 500)(1 - 0. 4) AFN = $184. 5 million. 10

How would increases in these items affect the AFN? n Higher sales: n n Increases asset requirements, increases AFN. Higher dividend payout ratio: n Reduces funds available internally, increases AFN. (More…) 11

n Higher profit margin: n n Higher capital intensity ratio, A*/S 0: n n Increases funds available internally, decreases AFN. Increases asset requirements, increases AFN. Pay suppliers sooner: n Decreases spontaneous liabilities, increases AFN. 12

Forecasted Financial Statements Method n n Project sales based on forecasted growth rate in sales Forecast some items as a percent of the forecasted sales n n n Costs Cash Accounts receivable (More. . . ) 13

n Items as percent of sales (Continued. . . ) n n Inventories Net fixed assets Accounts payable and accruals Choose other items n n n Debt Dividend policy (which determines retained earnings) Common stock 14

Sources of Financing Needed to Support Asset Requirements n Given the previous assumptions and choices, we can estimate: n n n Required assets to support sales Specified sources of financing Additional funds needed (AFN) is: n Required assets minus specified sources of financing 15

Implications of AFN n n If AFN is positive, then you must secure additional financing. If AFN is negative, then you have more financing than is needed. n n n Pay off debt. Buy back stock. Buy short-term investments. 16

How to Forecast Interest Expense n n Interest expense is actually based on the daily balance of debt during the year. There are three ways to approximate interest expense. Base it on: n n n Debt at end of year Debt at beginning of year Average of beginning and ending debt More… 17

Basing Interest Expense on Debt at End of Year n n Will over-estimate interest expense if debt is added throughout the year instead of all on January 1. Causes circularity called financial feedback: more debt causes more interest, which reduces net income, which reduces retained earnings, which causes more debt, etc. More… 18

Basing Interest Expense on Debt at Beginning of Year n n Will under-estimate interest expense if debt is added throughout the year instead of all on December 31. But doesn’t cause problem of circularity. More… 19

Basing Interest Expense on Average of Beginning and Ending Debt n n Will accurately estimate the interest payments if debt is added smoothly throughout the year. But has problem of circularity. More… 20

A Solution that Balances Accuracy and Complexity n Base interest expense on beginning debt, but use a slightly higher interest rate. n n n Easy to implement Reasonably accurate For examples that bases interest expense on average debt, see: n n Web Extension 9 A. doc and IFM 10 Ch 09 Web. A Tool Kit. xls IFM 10 Ch 09 Mini Case Feedback. xls 21

Percent of Sales: Inputs COGS/Sales SGA/Sales Cash/Sales Acct. rec. /Sales Inv. /Sales Net FA/Sales AP & accr. /Sales 2009 Actual 60% 35% 1% 12% 25% 5% 2010 Proj. 60% 35% 1% 12% 25% 5% 22

Other Inputs Percent growth in sales 25% Growth factor in sales (g) 1. 25 Interest rate on debt 10% Tax rate 40% Dividend payout rate 40% 23

2010 First-Pass Forecasted Income Statement Calculations 2010 1 st Pass Sales 1. 25 Sales 09 = $2, 500. 0 Less: COGS 60% Sales 10 = 1, 500. 0 35% Sales 10 = 875. 0 SGA EBIT Interest EBT $125. 0 0. 1(Debt 09) = 20. 0 $105. 0 Taxes (40%) 42. 0 Net Income $63. 0 Div. (40%) $25. 2 Add to RE $37. 8 24

2010 Balance Sheet (Assets) Cash Accts Rec. Inventories Total CA Net FA Total Assets Calcuations 1% Sales 10 = 12%Sales 10 = 2010 $25. 0 300. 0 12%Sales 10 = 300. 0 $625. 0 $1, 250. 0 25% Sales 10 = 25

2010 Preliminary Balance Sheet (Claims) Calculations AP/accruals Notes payable Total CL 2010 Without AFN 100 5% Sales 10 = Carried over $125. 0 100. 0 $225. 0 L-T debt 100 Carried over 100. 0 Common stk 500 Carried over 500. 0 Ret earnings 200 +37. 8* 237. 8 Total claims $1, 062. 8 26

What are the additional funds needed (AFN)? n n Required assets = $1, 250. 0 Specified sources of fin. = $1, 062. 8 Forecast AFN: $1, 250 - $1, 062. 8 = $187. 2 NWC must have the assets to make forecasted sales, and so it needs an equal amount of financing. So, we must secure another $187. 2 of financing. 27

Assumptions about how AFN will be raised n n No new common stock will be issued. Any external funds needed will be raised as debt, 50% notes payable, and 50% L -T debt. 28

How will the AFN be financed? n n Additional notes payable =0. 5 ($187. 2) = $93. 6. Additional L-T debt = 0. 5 ($187. 2) = $93. 6. 29

2010 Balance Sheet (Claims) AP accruals Notes payable Total CL L-T Debt Common stk Ret earnings Total claims w/o AFN $125. 0 100. 0 $225. 0 100. 0 500. 0 237. 8 $1, 071. 0 AFN +93. 6 With AFN $125. 0 193. 6 $318. 6 193. 6 500. 0 237. 8 $1250. 0 30

Equation AFN = $184. 5 vs. Pro Forma AFN = $187. 2. n n Equation method assumes a constant profit margin. Pro forma method is more flexible. More important, it allows different items to grow at different rates. 31

Forecasted Ratios Profit Margin ROE DSO (days) Inv turnover FA turnover Debt ratio TIE Current ratio 2009 2. 70% 7. 71% 43. 80 8. 33 4. 00 30. 00% 10. 00 2. 50 2010(E) Industry 2. 52% 4. 00% 8. 54% 15. 60% 43. 80 32. 00 8. 33 11. 00 4. 00 5. 00 40. 98% 36. 00% 6. 25 9. 40 1. 96 3. 00 32

What are the forecasted free cash flow and ROIC? Net operating WC (CA - AP & accruals) 2009 2010(E) $400 $500 Total operating capital (Net op. WC + net FA) $900 $1, 125 NOPAT (EBITx(1 -T)) Less Inv. in op. capital $60 $75 $225 -$150 6. 7% Free cash flow ROIC (NOPAT/Capital) 33

Proposed Improvements Before After 43. 80 32. 00 12. 00% 8. 77% 8. 33 11. 00 Inventory/Sales 12. 00% 9. 09% SGA/Sales 35. 00% 33. 00% DSO (days) Accts. rec. /Sales Inventory turnover 34

Impact of Improvements (see IFM 10 Ch 09 Mini Case. xls for details) Before After $187. 2 $15. 7 -$150. 0 $33. 5 ROIC (NOPAT/Capital) 6. 7% 10. 8% ROE 7. 7% 12. 3% AF Free cash flow 35

If 2009 fixed assets had been operated at 75% of capacity: Capacity sales = Actual sales % of capacity $2, 000 = 0. 75 = $2, 667. With the existing fixed assets, sales could be $2, 667. Since sales are forecasted at only $2, 500, no new fixed assets are needed. 36

How would the excess capacity situation affect the 2010 AFN? n n The previously projected increase in fixed assets was $125. Since no new fixed assets will be needed, AFN will fall by $125, to: $187. 2 - $125 = $62. 2. 37

Economies of Scale Assets 1, 100 1, 000 Declining A/S Ratio Base Stock 0 2, 000 2, 500 Sales $1, 000/$2, 000 = 0. 5; $1, 100/$2, 500 = 0. 44. Declining ratio shows economies of scale. Going from S = $0 to S = $2, 000 requires $1, 000 of assets. Next $500 of sales requires only $100 of assets. 38

Lumpy Assets 1, 500 1, 000 500 Sales 500 1, 000 2, 000 A/S changes if assets are lumpy. Generally will have excess capacity, but eventually a small S leads to a large A. 39

Summary: How different factors affect the AFN forecast. n n n Excess capacity: lowers AFN. Economies of scale: leads to less-thanproportional asset increases. Lumpy assets: leads to large periodic AFN requirements, recurring excess capacity. 40