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Topics in Chapter
Financial planning Additional Funds Needed (AFN) formula Forecasted financial statements
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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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
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.
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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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1,250 1,000
Sales
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Higher sales:
Increases asset requirements, increases AFN. Reduces funds available internally, increases AFN.
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Project sales based on forecasted growth rate in sales Forecast some items as a percent of the forecasted sales
Inventories Net fixed assets Accounts payable and accruals Debt Dividend policy (which determines retained earnings) Common stock 14
Required assets to support sales Specified sources of financing Required assets minus specified sources of financing
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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.
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
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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.
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Will under-estimate interest expense if debt is added throughout the year instead of all on December 31. But doesnt cause problem of circularity.
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Will accurately estimate the interest payments if debt is added smoothly throughout the year. But has problem of circularity.
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Base interest expense on beginning debt, but use a slightly higher interest rate.
Web Extension 9A.doc and IFM10 Ch09 WebA Tool Kit.xls IFM10 Ch09 Mini Case Feedback.xls
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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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Sales
Less: COGS SGA EBIT Interest EBT Taxes (40%) Net Income
1.25 Sales09 =
60% Sales10 = 35% Sales10 = 0.1(Debt09) =
$2,500.0
1,500.0 875.0 $125.0 20.0 $105.0 42.0 $63.0
Div. (40%)
Add to RE
$25.2
$37.8
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100
100 500 200
Carried over
Carried over Carried over +37.8*
100.0 $225.0
100.0 500.0 237.8
Total claims
$1,062.8
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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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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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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
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
$1,125
$75 $225 -$150 6.7%
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Proposed Improvements
Before DSO (days) Accts. rec./Sales Inventory turnover Inventory/Sales 43.80 12.00% 8.33 12.00% After 32.00 8.77% 11.00 9.09%
SGA/Sales
35.00%
33.00%
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AF
Free cash flow
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$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.
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How would the excess capacity situation affect the 2010 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
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.
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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