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CHAPTER 14

Financial Planning and Forecasting Financial Statements

Topics in Chapter

Financial planning Additional Funds Needed (AFN) formula Pro forma financial statements

Sales forecasts Percent of sales method

Financial Planning and Pro Forma Statements

Three important uses:

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
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Steps in Financial Forecasting


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

2007 Balance Sheet (Millions of $)


Cash & sec. Accounts rec. Inventories Total CA $ 20 Accts. pay. & accruals Notes payable Total CL L-T debt Common stk Retained earnings Total claims

240 240 $ 500

$ 100 100 $ 200 100 500


200 $1,000
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Net fixed assets Total assets

500 $1,000

2007 Income Statement (Millions of $)


Sales Less: COGS (60%) SGA costs EBIT Interest EBT Taxes (40%) Net income Dividends (40%) Addn to RE $2,000.00 1,200.00 700.00 $ 100.00 10.00 $ 90.00 36.00 $ 54.00 $21.60 $32.40

AFN (Additional Funds Needed): Key Assumptions


Operating at full capacity in 2007. Each type of asset grows proportionally with sales. Payables and accruals grow proportionally with sales. 2007 profit margin ($54/$2,000 = 2.70%) and payout (40%) will be maintained. Sales are expected to increase by $500 million.
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Definitions of Variables in AFN

A*/S0: assets required to support sales; called capital intensity ratio. S: increase in sales. L*/S0: spontaneous liabilities ratio M: profit margin (Net income/sales) RR: retention ratio; percent of net income not paid as dividend.
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Assets vs. Sales


Assets

1,250 1,000

Assets = 0.5 sales


Assets = (A*/S0)Sales = 0.5($500) = $250.

0 2,000 2,500 A*/S0 = $1,000/$2,000 = 0.5 = $1,250/$2,500.

Sales
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If assets increase by $250 million, what is the AFN?


AFN = (A*/S0)S - (L*/S0)S - M(S1)(RR) AFN = ($1,000/$2,000)($500) - ($100/$2,000)($500) - 0.0270($2,500)(1 - 0.4) AFN = $184.5 million.
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How would increases in these items affect the AFN?

Higher sales:

Increases asset requirements, increases AFN. Reduces funds available internally, increases AFN.

Higher dividend payout ratio:

(More)
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Higher profit margin:

Increases funds available internally, decreases AFN.

Higher capital intensity ratio, A*/S0:

Increases asset requirements, increases AFN.


Decreases spontaneous liabilities, increases AFN.

Pay suppliers sooner:

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Projecting Pro Forma Statements with the Percent of Sales Method

Project sales based on forecasted growth rate in sales Forecast some items as a percent of the forecasted sales

Costs Cash Accounts receivable


(More...)
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Items as percent of sales (Continued...)


Inventories Net fixed assets Accounts payable and accruals Debt Dividend policy (which determines retained earnings) Common stock 14

Choose other items

Sources of Financing Needed to Support Asset Requirements

Given the previous assumptions and choices, we can estimate:


Required assets to support sales Specified sources of financing Required assets minus specified sources of financing
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Additional funds needed (AFN) is:

Implications of AFN

If AFN is positive, then you must secure additional financing. If AFN is negative, then you have more financing than is needed.

Pay off debt. Buy back stock. Buy short-term investments.


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How to Forecast Interest Expense

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:

Debt at end of year Debt at beginning of year Average of beginning and ending debt
More
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Basing Interest Expense on Debt at End of Year

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
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Basing Interest Expense on Debt at Beginning of Year

Will under-estimate interest expense if debt is added throughout the year instead of all on December 31. But doesnt cause problem of circularity.

More

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Basing Interest Expense on Average of Beginning and Ending Debt

Will accurately estimate the interest payments if debt is added smoothly throughout the year. But has problem of circularity.

More

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A Solution that Balances Accuracy and Complexity

Base interest expense on beginning debt, but use a slightly higher interest rate.

Easy to implement Reasonably accurate

See Ch 14E Toolkit.xls for an example basing interest expense on average debt.
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Percent of Sales: Inputs


COGS/Sales SGA/Sales Cash/Sales Acct. rec./Sales Inv./Sales Net FA/Sales AP & accr./Sales 2007 Actual 60% 35% 1% 12% 12% 25% 5% 2008 Proj. 60% 35% 1% 12% 12% 25% 5% 22

Other Inputs
Percent growth in sales Growth factor in sales (g) Interest rate on debt Tax rate Dividend payout rate 25% 1.25 10% 40% 40%
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2008 First-Pass Forecasted Income Statement


Calculations 2008 1st Pass

Sales
Less: COGS SGA EBIT Interest EBT Taxes (40%)

1.25 Sales07 =
60% Sales08 = 35% Sales08 = 0.1(Debt07) =

$2,500.0
1,500.0 875.0 $125.0 20.0 $105.0 42.0

Net Income
Div. (40%) Add to RE

$63.0
$25.2 $37.8
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2008 Balance Sheet (Assets)


Cash Accts Rec. Inventories Total CA Net FA Total Assets Calcuations 1% Sales08 = 12%Sales08 = 12%Sales08 = 25% Sales08 = 2008 $25.0 300.0 300.0 $625.0 625.0 $1,250.0
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2008 Preliminary Balance Sheet (Claims)


5 AP/accruals Notes payable Total CL L-T debt Common stk Ret earnings Total claims 100 100 500 200 Calculations 5% Sales08 = Carried over Carried over Carried over +37.8* 2008 Without AFN $125.0 100.0 $225.0 100.0 500.0 237.8
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What are the additional funds needed (AFN)?


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.
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Assumptions about how AFN will be raised


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

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How will the AFN be financed?

Additional notes payable =0.5 ($187.2) = $93.6.

Additional L-T debt = 0.5 ($187.2) = $93.6.

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2008 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 +93.6 With AFN $125.0 193.6 $318.6 193.6 500.0 237.8 $1250.0
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Equation AFN = $184.5 vs. Pro Forma AFN = $187.2.

Equation method assumes a constant profit margin. Pro forma method is more flexible. More important, it allows different items to grow at different rates.

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Forecasted Ratios
Profit Margin ROE DSO (days) Inv turnover FA turnover Debt ratio TIE Current ratio

2007 2.70% 7.71% 43.80 8.33x 4.00x 30.00% 10.00x 2.50x

2008(E) Industry 2.52% 4.00% 8.54% 15.60% 43.80 32.00 8.33x 11.00x 4.00x 5.00x 40.98% 36.00% 6.25x 9.40x 1.96x 3.00x 32

What are the forecasted free cash flow and ROIC?


Net operating WC (CA - AP & accruals)

2007 $400 $900


$60

2008(E) $500 $1,125


$75 $225 -$150 6.7%

Total operating capital (Net op. WC + net FA)


NOPAT (EBITx(1-T)) Less Inv. in op. capital Free cash flow ROIC (NOPAT/Capital)

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Proposed Improvements
Before DSO (days) Accts. rec./Sales Inventory turnover Inventory/Sales 43.80 12.00% 8.33x 12.00% After 32.00 8.77% 11.00x 9.09%

SGA/Sales

35.00%

33.00%
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Impact of Improvements (see Ch 14 Mini Case.xls for details)


Before After $15.7 $33.5 10.8% 12.3%
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AF
Free cash flow

$187.2 -$150.0 6.7% 7.7%

ROIC (NOPAT/Capital) ROE

If 2007 fixed assets had been operated at 75% of capacity:


Actual sales Capacity sales = % of capacity $2,000 = = $2,667. 0.75
With the existing fixed assets, sales could be $2,667. Since sales are forecasted at only $2,500, no new fixed assets are needed.
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How would the excess capacity situation affect the 2008 AFN?

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.

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Economies of Scale
1,100 1,000 Assets

Declining A/S Ratio

Base Stock

Sales
2,000 2,500
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$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.

Lumpy Assets

1,500

Assets

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

Summary: How different factors affect the AFN forecast.


Excess capacity: lowers AFN. Economies of scale: leads to less-thanproportional asset increases. Lumpy assets: leads to large periodic AFN requirements, recurring excess capacity.

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